What is the Accounting Cycle?
Accounting follows a process called The Accounting Cycle.
The process involves a series of steps which begins when a transaction happens in a Business and ends with reports called Financial Statements.
The purpose of the Accounting Cycle is to convert ALL the transactions that have happened in the business into meaningful financial information for the reader through Financial Statements.
Regardless of the number of transactions or the size of the organization, the steps involved are similar.
Some companies prepare financial statements on a quarterly basis whereas other companies prepare them annually.
This means that quarterly companies complete one entire accounting cycle every three months while annual companies only complete one accounting cycle per year.
Each step in the accounting cycle is designed to act as a check and balance along the way to prevent errors and mistakes that could have been made in a previous step.
The advent of modern day accounting software has eliminated some of the steps but it is essential for a person wishing to master the language of accounts to understand how the Accounting Cycle works.
Let's take a look at how these steps in a bit more detail .
The 8 Steps in the Accounting Cycle
The Accounting Cycle has 8 Basic Steps.
STEP 1 - A Transaction takes place in the company
When a Financial transaction takes place in the company, it starts the Accounting Cycle.
Monitoring and proper record keeping of these transactions is essential at this step.
Companies have systems in place to retain what are called 'Source Documents' here.
Examples for Source Documents are Receipts, Invoices, Purchase orders etc.
The first step involves Bookkeepers who document ALL daily transactions.
STEP 2. Listing the transaction in Journals
Sound knowledge of Journal Entries is essential and plays a big role at this stage.
The Debits and Credits pertaining to each account effected are recorded in Journals.
Journals are also called Books in many parts of the world and therefore the place where the term "bookkeeping" comes from.
A Business can have many Journals but the main ones are -
1. The Cash Receipts Journal
2. The Cash Disbursements Journal
3. The Sales Journal
4. The Purchase Journal
5. The General Journal
Accountant(s) decide which and how many accounts they want to keep journals for based on the business operation about financial transactions.
Each transaction goes in the appropriate Journal in chronological order.
The Journals show both the Debit Side and the Credit Side involved in a transaction.
Other columns include the date of the transaction, the accounts effected as well as the source material used for developing the transaction.
STEP 3. Posting the Journal Entries to the General and Subsidiary Ledger(s).
At the end of each period, companies summarize the Journals by totaling up the Debits and Credit columns from each Journal and transferring these to the General Ledger.
This process is called POSTING to the Ledgers.
STEP 4. Preparing an Unadjusted Trial Balance
The General Ledger Balances are then taken and transferred to an Unadjusted Trial balance.
The goal of preparing an unadjusted trial balance is simply to ensure that all debits and credit balances are equal.
Any difference in the debits and credits would indicate an error made in one of the previous steps.
STEP 5. Adjusting Entries are made.
Adjusting Entries are made to adjust income and expense accounts so that they comply with the accrual concept of accounting.
Their main purpose is to match incomes and expenses to appropriate accounting periods.
Examples of Adjusting Entries are entries related to depreciation, amortization and prepayments such as rent and insurance.
STEP 6. An Adjusted Trial Balance is prepared
An Adjusted Trial Balance is a list of the balances of ledger accounts which is created after the preparation of adjusting entries.
STEP 7. Preparing of Financial Statements
The adjusted trial balance is used to create financial statements such as The Income statement, The Balance sheet and the Statement of Cash Flows.
STEP 8. Closing the books
Business Owners and Management need to able to gauge profit and resources from period to period.
This enables them to compare two periods and see if a company has improved or declined in it's financial health.
To get these insights, Revenue and Expense accounts must start with a zero balance at the end of every accounting period.
Any net income is transferred to Retained Earnings.
The Balance Sheet accounts such as Assets, Liabilities and Equity need to be carried forward to the next period since they are ongoing parts of the business.
It is at this stage that the Accounting Cycle begins all over again.
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