The term, accounting cycle, is commonly referred to as accounting process or the steps involved for all the business activities during an accounting period. It’s a standard practice in financial accounting that allows an organization to record and calculate its financial activities appropriately. Each step in the accounting cycle plays an important role in making accurate entries and managing the company’s finances in an efficient manner. The series of activities begin with a transaction and ends with its inclusion in the financial statements.
Accounting entails recording, classifying and summarizing of business transactions. It is a process of identification, measurement and communication of economic information. The accounting cycle is like a circle which begins at one point and revolves through specific steps around recognizing financial transactions and reporting the results. The accounting cycle includes the following 8 steps.
1-Identifying and analyzing business transactions
The accounting process starts with financial transactions. This step involves identifying and analyzing business transactions. The transactions are first identified and are then analyzed in order to determine what accounts are affected as well as the amount to be recorded.
It should be noted that not all transactions and events are entered in the accounting system. Only those events that involve money or payments, such as, borrowing money, depositing money into a bank etc. are to be entered in the accounting system. Thus, in order to measure as a business transaction, an activity or an event must be of financial character (in a certain amount of money).
2-Recording transactions as journal entries
Every transaction is listed in the appropriate journal which is maintained in chronological order. All the transactions are recorded through journal entries that show the recording date of transactions, account names, Ledger Folio or Reference, brief narration amounts, and whether those accounts are to be recorded in debit or credit side of the accounts. The journals are known as the books of original entry. Journals are used to systematically record all accounting transactions before they are entered into the general ledger. Thus, the general journal is a place to first record an entry before it gets posted to the appropriate accounts.
3-Posting to the appropriate ledger accounts
The third step in the accounting cycle is to post each journal entry to the appropriate ledger accounts. Every transaction is posted to the account that it impacts. These accounts are part of the General Ledger, where you can find a summary of all the business’s accounts. Ledger posting is the process by which all the transactions are synthesized account-wise, so that the accumulated balance of each of those accounts can be determined. The process of ledger posting is vitally important as it helps in ascertaining the net effect of various transactions during a given period.
Preparing a trial balance is a key step in the accounting cycle. Depending on the business practices or when it publishes its financial statements, the trial balance is prepared at the end of the accounting period. It could be monthly, quarterly or yearly. The information used in a trial balance comes from the ledgers. Thus, a trial balance is a list of all accounts and their balances at a point in time. Preparing the trial balance involves the arrangement of all ledger accounts having been aggregated into debit and credit balances. This activity enables to check and confirm whether the total of debits is equal to that of credits.
Whether or not it’s tallied trial balance, it does not ensure that all transactions are free from errors or have been recorded appropriately. There is possibility of errors in the accounts which cannot be deducted thoroughly or even meticulously sometimes. If that’s the case, you look for errors and make corrections called adjustments, which are tracked on a worksheet. This requires making adjustment entries employing worksheet.
6- Adjusting Journal Entries
It is through this step you need to make any corrections needed to the affected accounts. It involves making adjustment entries. Adjusting entries are journal entries that are recorded at the end of the accounting period to adjust income and expense accounts, so that they can conform to the accrual concept of accounting. The purpose of adjusting entries is to match incomes with expense during the accounting period. It must be noted that the transactions that are recorded through adjusting entries do not arise without any cause, but they are relevant and spread over a period of time. Adjusting entry involves either income or expense accounts. The adjusting entries are related to Accruals, prepayments and non-cash items, such as, depreciation expense, allowance for doubtful debts etc. They are sometimes called Balance Day adjustments, because they are made on balance day. After you make and record adjustments, you take another trial balance to be sure the accounts are in balance. Now that the trial balance is made, it can be used to prepare the financial statements.
7-Preparing Financial statements
An adjusted trial balance is a listing of all company accounts that will appear on the financial statements after year-end adjusting journal entries have been made. In this way, after having made all the adjustment entries and prepared the final trial balance, you prepare the balance sheet and income statement using the corrected account balances. Preparing general purpose financial statements includes the balance sheet, income statement, statement of retained earnings.
8-Closing the books
It’s through this step that the books for the revenue and expense accounts are closed which leads to begin the entire cycle again with zero balances in the said accounts. At this stage, it is important to mention that closing all temporary accounts to the retained earnings account is faster than using the income summary account method because it saves a step as well as efforts.
Since there is a need for determining the profit and loss on month by month, quarter by quarter and year by year bases, Revenue and expense accounts must be started with a Zero Balance at the beginning of each accounting period, whereas, the asset, liability and Equity accounts are carried over from cycle to cycle. A complete accounting cycle is vital to producing accurate financial statements. On the one hand it helps in verifying the source documents of transactions, on the other hand, it aids greatly in tracking and analyzing financial transactions and monitoring the company’s money. It’s not just about working with numbers, but it’s about following guidelines to get the jobs done in an effective and efficient manner and providing relevant, timely and accurate financial information.
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