Accounting Cycle for Service Companies: A Comprehensive Guide
The accounting cycle is a sequence of steps that companies follow to track and manage their financial transactions throughout an accounting period. For service companies, which provide intangible products rather than tangible goods, the accounting cycle largely mirrors that of companies in other industries, but with a few specific considerations. This article provides a detailed look at the accounting cycle for service companies, explaining each step involved from the initial transaction to the preparation of financial statements.
1. Identifying and Analyzing Transactions
The accounting cycle begins with the identification and analysis of business transactions. For service companies, transactions typically include client service agreements, expense receipts (such as office supplies and utilities), payroll transactions, and service revenue entries. The primary objective in this phase is to accurately capture all economic events that affect the company’s financial position.
Steps:
1. Collect Source Documents : Gather invoices, receipts, bank statements, and contracts.
2. Analyze Transactions : Assess each transaction to determine its impact on the financial statements. For instance, recognizing service revenue when a service is rendered.
2. Journalizing Transactions
Once transactions are identified and analyzed, the next step is to record them in the general journal. This involves making journal entries that document each transaction’s debit and credit components.
Steps:
1. Determine Accounts Impacted : Identify which accounts are affected (e.g., Cash, Service Revenue, Accounts Receivable).
2. Record Journal Entries : Document the transactions in the general journal using double-entry accounting. Each entry should explain the transaction, the accounts affected, and the amounts debited and credited.
3. Posting to the General Ledger
The journal entries are then posted to the general ledger, which is a comprehensive record of all accounts used by the company. Each journal entry is transferred to the appropriate individual account in the ledger.
Steps:
1. Transfer Entries : Post each journal entry from the general journal to the corresponding ledger accounts.
2. Update Balances : Ensure the ledger accounts reflect the correct balances after each posting.
4. Preparing an Unadjusted Trial Balance
The next step involves preparing an unadjusted trial balance to ensure that all debits and credits recorded in the ledger are in balance. This helps identify any discrepancies or errors that may have occurred during the journalizing or posting processes.
Steps:
1. List All Accounts and Balances : Compile a list of all ledger accounts and their ending balances.
2. Total Debits and Credits : Summarize the total debits and credits to check for equality.
5. Making Adjusting Entries
Adjusting entries are necessary to account for revenues and expenses that have occurred but have not yet been recorded. For service companies, common adjusting entries might include accrued revenue, prepaid expenses, depreciation, and accrued expenses.
Examples and Steps:
1. Accrued Revenue : Recognize revenue earned but not yet billed. Debit Accounts Receivable and credit Service Revenue.
2. Prepaid Expenses : Allocate prepaid expenses to the relevant period. Debit the expense account and credit Prepaid Expenses.
3. Depreciation : Allocate the cost of long-term assets over their useful lives. Debit Depreciation Expense and credit Accumulated Depreciation.
4. Accrued Expenses : Recognize expenses incurred but not yet paid. Debit the appropriate expense account and credit Accounts Payable.
6. Preparing an Adjusted Trial Balance
After making all the necessary adjusting entries, prepare an adjusted trial balance. This ensures that the ledger accounts are correctly updated and balanced.
Steps:
1. List Adjusted Accounts and Balances : Update the ledger accounts with the adjusting entries and compile a list of these adjusted balances.
2. Total Adjusted Debits and Credits : Ensure that the adjusted trial balance debits and credits are still equal.
7. Preparing Financial Statements
With the adjusted trial balance in place, the next step is to prepare the financial statements. These include the income statement, statement of retained earnings, balance sheet, and cash flow statement.
Financial Statements Overview:
1. Income Statement : Summarizes revenues and expenses to show net income or loss for the period.
2. Statement of Retained Earnings : Shows changes in retained earnings, including net income and dividends.
3. Balance Sheet : Provides a snapshot of the company’s financial position at the end of the period, showing assets, liabilities, and equity.
4. Cash Flow Statement : Details cash inflows and outflows from operating, investing, and financing activities.
8. Making Closing Entries
Closing entries are made to transfer balances from temporary accounts (revenues, expenses, dividends) to permanent accounts (retained earnings) and to reset the temporary accounts for the next period.
Steps:
1. Close Revenue Accounts : Debit revenue accounts and credit Income Summary.
2. Close Expense Accounts : Debit Income Summary and credit expense accounts.
3. Close Income Summary : Transfer the net income or loss to Retained Earnings.
4. Close Dividends : Debit Retained Earnings and credit Dividends.
9. Preparing a Post-Closing Trial Balance
After closing entries, prepare a post-closing trial balance to ensure that all temporary accounts have been properly closed and that the ledger is balanced.
Steps:
1. List Permanent Accounts and Balances : Compile a list of all ledger accounts that remain after closing and their balances.
2. Total Debits and Credits : Confirm that total debits equal total credits.
10. Reversing Entries (Optional)
Some companies use reversing entries to simplify the recording of regular transactions in the new accounting period. These entries reverse certain adjusting entries made in the previous period.
Steps:
1. Identify Reversible Adjustments : Common reversals include accrued revenues and expenses.
2. Record Reversing Entries : Make entries that reverse the initial adjusting entries at the beginning of the new period.
Conclusion
The accounting cycle for service companies provides a comprehensive framework for accurately tracking financial transactions and preparing reliable financial statements. While each company may have unique transactions and specific needs, following the outlined steps ensures consistency, accuracy, and regulatory compliance. By meticulously adhering to the accounting cycle, service companies can maintain a clear and accurate picture of their financial health, supporting informed decision-making and strategic planning.
