Therefore, an annual accounting period could involve multiple operating cycles as shown in Figure 3.2. It is used to calculate accounts receivable turnover, inventory turnover, average collection period (accounts receivable days), and average payment period (inventory days). CPA firms can review or audit the financial statements and drill down to the underlying financial transactions and accounting records to test account balances. As can be seen the longer the inventory period and the accounts receivable collection period the longer the operating cycle of the business. To fully understand the accounting cycle, it’s important to have a solid understanding of the basic accounting principles.

Identifying and recording transactions.

At the end of a fiscal year, after financial statements have been prepared, the revenue, expense, and dividend account balances must be zeroed so that they can begin to accumulate amounts belonging to the new fiscal year. Closing entries transfer each revenue and expense account balance, as well as any balance in the Dividend account, into retained earnings. Revenues, expenses, and dividends are therefore referred to as temporary accounts because their balances are zeroed at the end of each accounting period. Balance sheet accounts, such as retained earnings, are permanent accounts because they have a continuing balance from one fiscal year to the next. The closing process transfers temporary account balances into a permanent account, namely retained earnings.

Cash Flow Statement

• As a result of this entry, salaries expense is reported on the January income statement when cash is paid.
• The entry creates a payable that will be reported as a liability on the balance sheet at January 31.
• As can be seen the longer the inventory period and the accounts receivable collection period the longer the operating cycle of the business.
• At the end of a fiscal year, after financial statements have been prepared, the revenue, expense, and dividend account balances must be zeroed so that they can begin to accumulate amounts belonging to the new fiscal year.

After 4 years, the asset will likely be sold (journal entries related to the sale of plant and equipment assets are discussed in Chapter 8). The accounting cycle is the accounting process used to record business transactions in accounting books and supply the end-of-accounting-period financial statements. The operating cycle is the business transaction process in which business inventories are purchased, processed and eventually sold to customers.

Steps in the Accounting Cycle

If a company is a reseller, then the operating cycle does not include any time for production – it is simply the date from the initial cash outlay to the date of cash receipt from the customer. The general ledger serves as the eyes and ears of bookkeepers and accountants and shows all financial transactions within a business. Essentially, it is a huge compilation of all transactions recorded on a specific document or in accounting software.

Accruing Income Tax Expense

The balance sheet can be prepared once the statement of changes in equity is complete. The income statement is prepared first, followed by the statement of changes in equity as shown below. On January 15, Big Dog received a $400 cash payment in advance of services being performed.

The Differences in Dates Between a Balance Sheet and an Income Sheet

You need to know about revenue recognition (when a company can record sales revenue), the matching principle (matching expenses to revenues), and the accrual principle. GAAP requires that assets and liabilities must be broken out into current and non-current categories on a balance sheet. This allows the financial statement user to see what assets will be used and what liabilities will come due in the current year or current operating cycle. Operating cycle refers to number of days a company takes in converting its inventories to cash.

The operating cycle (OC) differs from the cash conversion cycle (CCC) in that the OC does not allow for the accounts payable payment period. The OC measures the time difference between the purchase of inventory and the collection of operating cycle cash unlike the CCC which measures the time difference between the payment for inventory and the collection of cash. The accounts receivable collection period is the average number of days it takes to collect accounts receivable.

• Revenues, expenses, and dividends are therefore referred to as temporary accounts because their balances are zeroed at the end of each accounting period.
• Since there are no credit sales, time taken in recovering cash from accounts receivable is zero.
• This means that it would take a retailer an entire year to sell its inventory.
• If a company is able to keep a short operating cycle, its cash flow will consistent and the company won’t have problems paying current liabilities.
• The income summary balance agrees to the net income reported on the income statement.
• For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.

Do you own a business?

Two GAAP requirements — recognition and matching — provide guidance in this area, and are the topic of the next sections. Financial statements must be prepared in a timely manner, at minimum, once per fiscal year. For statements to reflect activities accurately, revenues and expenses must be recognized and reported in the appropriate accounting period. In order to achieve this type of matching, adjusting entries need to be prepared. As a result, some account balances reported on the January 31, 2023 unadjusted trial balance in Figure 2 have changed.

• Operational efficiency also affects finance because it affects things like cash flow and inventory levels.
• Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping.
• All of our content is based on objective analysis, and the opinions are our own.
• If the adjustment was not recorded, assets on the balance sheet would be understated by $400 and revenues would be understated by the same amount on the income statement.
• For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
• The above adjusting entry enables the company to match the income tax expense accrued in January to the income earned during the same month.

How does operating cycle relate to a company’s financial health?

The $36 debit to interest payable will cause the Interest Payable account to go to zero since the liability no longer exists once the cash is paid. Notice that the total interest expense recorded on the bank loan was $39 – $18 expensed in January, $18 expensed in February, and $3 expensed in March. The net book value of the truck on the balance sheet is shown as $7,900 ($8,000 – $100). On average, it takes the company 97 days to purchase raw material, turn the inventory into marketable products, and sell it to customers.

One example would be to decrease the amount of inventory your company holds. This means that companies can reduce or eliminate slow-moving or obsolete inventory, which in turn reduces the cost and time needed to dispose of these items. The higher the operating cycle, the lower the liquidity will be because more time elapses before cash is obtained. Also, high inventory turnover can reflect a company’s efficient operations, which in turn lead to increased shareholder value. By optimizing the operation cycle, a company can greatly improve its cash management and decrease costs.