Accounting Cycle Explained

Accounting Cycle

The Accounting Cycle reflects the sequential transformation of data into financial statements. It is a simplistic view of how the accounting data from source documents finds its way from recording into books of original entry to converging into profit & loss accounts and balance sheets of business concerns. 

Here you can find about what is accounting cycle & how many steps are involved in an accounting cycle with detailed explanation.

This is how Accounting Cycle works:

1 .) Transaction Identification, Analysis & collection of source documents

2 .) Recording in Books of Original Entries

3 .) Recording in Ledgers

4 .) Preparing a Trial Balance from Ledger Balances (Unadjusted Trial Balance)

5 .) Making Adjusting entries

6 .) Preparing an Adjusted Trial Balance

7 .) Preparing Financial Statements from Adjusted Trial Balance

8 .) Closing Entries

9 .) Preparing Post Closing Trial Balance

Steps involved in Accounting Cycle - AccountingSir.com

Steps involved in Accounting Cycle – AccountingSir.com

1 .) Transaction: Identification, Analysis & Collection of Source Documents

First of all the event is identified whether it is relevant to the business or not. For instance if the owner of a firm buys a car for his personal use and does not use any money from the business accounts, then we cannot consider it as a business transaction, since it is the firm’s owner personal expense that is not connected with the business in anyway. Now, if the owner of a firm buys a car by withdrawing money from business accounts, then definitely it is a transaction that is identified with the business & should be recorded in the relevant books of accounts.

For any transaction there always exists some sort of source documents that verifies that the event actually happened and was properly authorised and well documented as well. These documents could be purchase requisitions, contracts, invoices, goods received notes, dispatch / delivery notes, gate passes, cash receipts, bank statements, debit notes, credit notes, acknowledgements etc.

2 .) Recording in the Books of Original Entries

The second part of the accounting cycle is to record the identified transaction in the books of original entries.

Briefly speaking there are six books of original entries where transaction is recorded before posting to the ledger accounts.

1 ) Sales Day Book

2 ) Purchase Day Book

3 ) Return Inwards Book

4 ) Return Outwards Day Book

5 ) Cash Book

6 ) General Journal

After the transaction is identified as a business transaction with supporting evidence, it is then recorded in the books of Original entries. This step is also known as Journalizing the transaction. A Firm records all necessary details regarding the transaction in the Journals. No matter how complex is the transaction, there always exist a double entry aspect of it, that means an event has to be recorded as debit in one account & credit in another. A detailed discussion on books of original entries is available at this site as a general purpose accounting read.

 

3 .) Posting to Ledgers

Posting to Ledger accounts is the third step in a Firm’s Accounting Cycle. In this part, the transactions are posted to the ledger accounts. A detailed discussion on Types of Ledgers is available to read at this site.

 

4 .) Unadjusted Trial Balance

Preparing an unadjusted trial balance is the fourth step in Accounting Cycle. This helps in considering the accuracy of transactions posted in the ledger accounts. Why we call it an unadjusted trial balance? Simply, because we are preparing this trial balance before passing the adjusting entries. At this stage we can check that both debit & credit balances totals should come equal, if the ledgers are made correct. It is very important to note that there may exist chances of errors in the ledger accounts, even if the unadjusted trial balance shows debits total equal to the credits total. However, unadjusted trial balance still helps in verifying the ledgers substantially, without guaranteeing hundred percent accuracy in the ledgers.

 

5 .) Making Adjusting entries

After the unadjusted trial balance is made, there comes the fifth step in accounting cycle, that is to pass adjusting entries in the general journal, which can then be transferred to the ledger accounts. These entries are related to Accruals, deferrals or estimates. Adjusting entries are made at the end of accounting period. This helps in aligning accounting records and reporting statements with due consideration to the reporting standards such as IFRS (International Financial Reporting Standards). Making adjusting entries in the Journal is a very significant part of an accounting cycle that helps in complying the financial statements with international accounting standards & principles. By making adjusting entries in its accounting books, a firm ensures that the revenues and expenses are related to the appropriate period to which they pertains. Some of the examples of adjusting entries are, making adjustments for accrued incomes and expenses, depreciation & bad debts.

 

6 .) Adjusted Trial Balance

This step in Accounting Cycle incorporates all adjusting entries (made in the fifth step) in the Unadjusted trial balance to finally view a trial balance that has all the ledger account balances. All the debits total must be equal to the credit side total in this adjusted trial balance ( a trial balance always has debits & credits side total equal, both in adjusted trial balance as well as unadjusted trial balance).

7 .) Preparing Financial Statements from Adjusted Trial Balance

The next step after preparing adjusted trial balance is to prepare Financial Statements while considering relevant International Financial Reporting Standards (IFRS), and existing IAS (International Accounting standards) where applicable. These are the major financial reports & statements that a business prepares,

a ) Balance Sheet or Statement of Financial Position

b ) Income Statement or Profit & Loss Account (In certain cases a business is also required to prepare Statement of Comprehensive Income)

c ) Cash Flow statement

d ) Statement of Changes in Equity

Financial Statements may consist of various other items & notes, however the above stated statements form a major part financial statements.

8 .) Closing Entries

Closing entries are journal entries made at the end of the accounting period to close all temporary accounts. These temporary accounts balances are transferred to the permanent accounts. Revenue & expense accounts & dividend accounts are temporary accounts that are closed with the permanent accounts. The stages involved in their balance transfer include,

a ) Close all revenue & expense accounts by transferring their balance to INCOME SUMMARY

b ) Close Income Summary by transferring it to the Retained Earnings Account

c ) Similarly, close Dividends Account by transferring its balance to the Retained Earnings.

The main purpose of passing closing entries is to close all the temporary accounts specially the Income & Expenses account, so that all the remaining accounts with balances can be reflected in the Balance Sheet or the Statement of Financial position. There should remain no balance in any revenue and expense accounts, and first we transfer all these balances to Income Summary & then close this Income Summary Account with Retained Earnings Account.

 

9 .) Preparing Post Closing Trial Balance

After closing entries are made, a business prepares a post closing trial balance that reflects the balances from all the accounts that appear in Balance Sheet. Since the temporary accounts have already been closed, there is no income & expense,  dividends & withdrawals account’s balances shown in the post closing trial balance. Preparing a post closing trial balance is the last stage in an Accounting Cycle. At the beginning of next accounting period, as an optional step & on the very first day adjusting entries are reversed, in order to avoid any doubling of expense & revenue items that have already been taken in the previous period.

 

Important to Consider – The Era of Accounting Softwares & Applications

These accounting cycle steps had long been used since the days of manual accounting system. Now most businesses make use of accounting softwares that completes various steps in this accounting cycle almost instantly & simultaneously. You don’t need to record an accounting entry again & again in different books & ledgers. The computerised accounting softwares also prepares trial balances & financial statements & after analysing different reports the accountants can make adjusting entries which can then be processed by the accounting softwares to finalise financial reports & posting the closing entries & preparing the post closing trial balance.

Here it is quite important to note that substantial evidences & supporting documents for every transaction holds key importance whether they are digital or have physical existence. Accountants have to manage these verifiable records separately for audit purposes & complying with accounting standards and regulations.

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