Every business’ management has to undertake various economic decisions on a day-to-day basis using the accounting information recorded in financial statements. Thus, accounting plays a critical role not only in operating a business but also in meeting statutory compliance and developing future financial projections.
The American Institute of Certified Public Accountants (AICPA) defines the term accounting as the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of such information.
Therefore, we can say that accounting not only quantifies and measures transactions in monetary terms. But it also communicates accounting information both to internal and external users for them to make important decisions.
Now, for such decision making to be effective, the accounting information must be collected, analyzed, summarized and interpreted in a systematized manner. Therefore, the accounting records need to be processed through a series of steps in order to ensure that effective decisions are undertaken by financial information users.
So, these series of steps or stages are what constitute Accounting Cycle.
Accounting Cycle Definition
The collective process of recording, processing, classifying and summarizing the business transactions in financial statements is known as accounting cycle.
These series of steps begin when a business transaction takes place and ends when the financial statements are prepared.
This process is also called as the bookkeeping cycle. Thus, the main task of a bookkeeper is to complete each of the steps in the accounting cycle. It is referred to as a cycle because the accounting workflow is circular. Thus, Accounting Cycle includes:
- entering transaction
- processing, classifying and adjusting the business transactions through the accounting cycle
- closing books of accounts at the end of an accounting period and
- starting the cycle again for the next accounting period
Accordingly, an accounting cycle has the following nine basic steps.
Accounting Cycle Steps
1. Identify Transactions
The accounting process begins with identifying economic events that impact the financial position of the business. The economic events are the ones that can be measured in monetary terms and relate with the business organization.
This is the most important stage as all the following stages depend upon the accuracy with which the business transactions are identified and recorded.
Now, the proof of occurrence of such business transactions include documents like sales invoices, receipts, cheques etc. So, while recording details from the source document, errors of omission or commission may arise.
Such errors may result in incorrect information being recorded in the original books of entry, thus impacting financial position of the business. Therefore, bookkeeper needs to be careful while recording information from the source documents.
2. Record Transactions in Journal
Once the authenticity of the source document is ascertained, the next step is to record the accounting information in the book of original entry called the ‘Journal’.
Journal is the book in which business transactions are recorded for the first time. This is the reason why Journal is also known as the Book of Original Entry.
Now, transactions in journal are recorded in the order in which they occur. The whole exercise of recording transactions in journal is referred to as journalising.
Journalising results in documenting all transactions at one place. Furthermore, they are recorded based on the principle of duality which is the foundation of double entry system of accounting. As per this system, every transaction has a minimum of two accounts i.e. a debit and credit.
Thus, all the debits must be equal to the credits done in an accounting period.
3. Post Journal to Ledger
The second stage in the accounting cycle is posting entries from journal to the ledger account.
Ledger is the principal book of accounting system. Whereas, journal is the original book of entry. General Ledger consists of numerous accounts in which transactions pertaining to these accounts are recorded.
Basically, all the accounts involved in the journal entries form part of ledger. It is one of the most important books of accounting for a business. This is because the aggregate result of all transactions pertaining to a particular account can only be known through ledger.
Each account is opened separately in a ledger. Furthermore, all the transactions pertaining to the account are recorded collectively in the account itself.
Additionally, the accounts in ledger are opened in specific order to make posting and locating the transactions easily. Usually, accounts are opened in the order in which they appear in the profit and loss account and balance sheet.
All accounts are divided into five categories in order to record business transactions. These include assets, liabilities, capital, expenses/losses and income/gains.
Posting involves the practice of transferring journal entries from the journal to the ledger.
Further, this includes recording all the transactions related to a specific account at one place. This is done to make locating and posting transactions easy and drawing the overall inference of the account in question.
4. Prepare Trial Balance
The closing debit or credit balances in various ledger accounts then go into the Trial Balance of the business for a particular year.
Trial Balance is prepared basically to check if debit or credit amounts recorded in the ledger accounts are accurate. Therefore, Trial Balance is a technique for checking the accuracy of the debit and credit amounts recorded in the various ledger accounts.
It is basically a statement that exhibits the total of the debit and credit balances recorded in various accounts of ledger.
Accordingly, Trial Balance is prepared to check the accuracy of the various transactions that are posted into the ledger accounts. It is certainly one of the important accounting tools as it reveals the final position of all accounts.
Further, it is used in preparing the final accounting statements of the business.
Now, the whole idea of preparing Trial Balance is to simplify the task of preparing the basic financial statements.
Thus, a business owner or the accountant can simply draw balances of all accounts from Trial Balance rather than looking for such balances in each ledger account.
After all the balances are brought down in Trial Balance, each side of the trial balance is added. If both the sides tally, it means that the accounts were prepared with accuracy.
However, where both sides do not tally with each other, it means that the error is committed. Thus, in such a situation one needs to make adjustments to the trial balance to correct such errors.
5. Record Adjusting Entries
The next step in the accounting cycle is to record adjusting entries. Adjusting entries are the journal entries that are made at the end of the accounting period. This is done in order to correct the errors committed in preparing accounts before preparing the financial statements.
These entries are recorded according to the matching principle of accounting in order to match revenue and expenses in the accounting period in which they occur. Thus, the adjusting journal entries include prepayments, accruals and non – cash expenses.
So, each of these entries adjust incomes or expenses in order to match them with the revenues and expenses of the current period.
6. Prepare Adjusted Trial Balance
Adjusted Trial Balance is the one that records all the company accounts after the adjusting journal entries have been made at the end of the accounting period.
This is the last step before preparing financial statements of the company. Therefore, all the accounts appearing in the adjusted trial balance will appear on the financial statements.
There are two ways to prepare the adjusted trial balance. Either you can pick up adjusted account balances from the ledger accounts and list these on the trial balance.
Or, you can simply add the adjustments made to the accounts directly in the unadjusted trial balance. Once, all the accounts are listed, you need to check whether debit and credit side match.
7. Prepare Financial Statements
Financial statements are the basic and formal annual reports. Through these fundamental accounting statements, the corporate management communicates financial information to all of its stakeholders.
These stakeholders include owners, management and employees and other external parties such as investors, creditors, tax authorities, government, etc.
Such users of principal accounting statements take financial decisions based on the entity’s 1) financial position, 2) operating performance and 3) financial health.
Furthermore, the financial statements reflect a combination of recorded facts, accounting principles, basic accounting assumptions and personal judgments.
Thus, financial statements include:
- Income Statement
- Balance Sheet
- Statement of Cash Flows
8. Post Closing Entries
Closing entries are the journal entries that are made at the end of the accounting period to close temporary accounts and then transfer their balances to permanent accounts.
Temporary accounts include income and expense accounts. Whereas, permanent accounts include all assets, liabilities and capital accounts.
Thus, temporary accounts are closed at the end of every accounting period so that the beginning of the next accounting period have zero balance to start with. This concept is in accordance with the matching principle of accounting.