What is Accounting Cycle?
The accounting cycle is collective a process of accounting. It ensures the step-by-step flow of information. It starts with the occurrence of a financial transaction and ending with the accurate and efficient inclusion of such transactions in the financial statements. Every financial transaction meets the destiny of true and fair financial statements. The completeness of the accounting cycle is achieved when the adjustment entries are passed in the system. The effectiveness of the accounting cycle is achieved when the financial statements are able to give a true and fair view and comparability with previous performance. However, substantial parts of the accounting cycle are now automated by computers.
8 Steps of Accounting Cycle
Accounting cycle is simply a process of accounting wherein the accountant ensures the step-by-step flow of information for achieving the true and fairness of the financial statements and it starts from the occurrence of a financial transaction and ending with the accurate and efficient inclusion of such transactions in the financial statements.
- Accounting cycle is nothing but a cycle through which a financial transaction is recorded. The entire cycle is divided into detailed 8 parts for easier and quick processing of the data.
- Let’s think from the base. Investors invest their money into company stocks and become shareholders. As a shareholder, they do not have access to the books of account and thus, require the management to present the financial statements on a periodic basis.
- Say the company has sold 8 units at the rate of $ 600 each. This is a financial transaction. The accounting cycle starts when the company sells the product and ends when this transaction is reflected in the total revenue of the Company. The preparation of the financial statements is the last step of the accounting cycle and the occurrence of sale events is the first step of the accounting cycle.
- Before going into the detailed explanation of each step, let’s have a broad naming of the 8 steps of the accounting cycle:
- Occurrence of financial transactions
- Recording of the transactions in a Journal
- Posting of the transaction in the general ledger
- Preparing the unadjusted Trial Balance
- Adjusting the Journal Entries
- Preparation of the Financial Statements
- Closing the Books of accounts
- Occurrence of the financial transaction:
An entity enters into various events such as dealing with the customer, taking quotations from various suppliers, interviewing the employees, sale of the product, purchase of raw material, payment of salary, etc. But does the event need to record? Not necessarily. Only the financial transactions are to be recorded. Every transaction is an event but every event is not necessarily a transaction. Thus, the first step of the accounting cycle starts with the identification of the financial transaction.
Example: An entity received a sales order of say $ 350,000. Mere receipt of a sales order is not a financial transaction. Later, the company produces are sales the goods to the customer. Here, the financial transaction has occurred when the Company has sold the goods.
- Recording the entries in Journal:
Once the transaction has been identified, the next step is to record the transaction in a “journal”. Journal is a chronological record of the transactions. The accountant here ensures the debit and credit matches at the entry-level. Recording of the transaction is supported by some evidence such as the invoice or mail communication.
Example: The accountant records the transaction of sale of goods worth $ 350,000 by debiting the customer account and crediting the sales account.
- Post entries to a general ledger
The general ledger includes all transactions entered into by the entity. Whether the transaction relates to the sale of goods, or sale of assets, purchase of goods or acquiring a loan, etc. everything is included in the list of transactions in a general ledger. However, a general ledger is prepared for each nature of the transaction. When goods are sold, the accounting will flow to a GL of sales after recording in the journal. This posting is done automatically after recording the transaction in the journal.
Example: The sale transaction of $ 350,000 needs to be recorded in the sales GL prepared by the accountant. Similarly, the receivable amount of $ 350,000 from a customer is posted in the said Customer GL Account.
- Unadjusted trial balance:
The summarised details of each GL have either a debit balance or a credit balance. A list of all such GLs is nothing but a trial balance. The total of debits will equate with the total of credits. Now, why do we call it unadjusted? A mere listing of balances does not mean that the job is done. Remember the quality of the financial statements – True and fair! The unadjusted trial balances give an overall picture of the financial transactions during the entire accounting period. Additional entries may be required to ensure the completeness of the accounting.
- Check accuracy of worksheets
In a double-entry bookkeeping system, it is not possible to have an unbalanced trail balance. Still, if accounting has been maintained in a manual worksheet, there are chances of clerical errors leading to a difference in the trial balance. In such a case, the accountants need to brainstorm to detect the cause of the difference.
Please note that this step will not be required in case accounting software is used. Software do not allow maintain a difference in the trial balance.
- Pass adjustment entries:
Adjustment entries are required to ensure that accrual of expenses, the estimation of doubtful debts, provision for the obsolesces of inventory, deferral of any revenue, knocking off of prepaid expenses, provision for bonus payable, recording of depreciation expense, etc. and there is no limit on the adjustment entries. This step ensures the principles of matching, consistency, accrual, accounting period, etc.
- Organize or prepare the financial statements:
The adjustment entries are given effect into the unadjusted trial balance. This ensures the completeness of the trial balance. Once the trial balance is frizzed, the management can go ahead with preparing the financial statements i.e., Statement profit or loss, statement of cash flows, balance sheet, and notes accompanying the financial statements.
- Closure of Books of Accounts:
After the financial statements have been prepared, the last step in the accounting cycle is to close the books of accounts. The closure of books ensures transferring of the net income amount (from the statement of profit and loss) to the retained earnings figures (in the balance sheet). The balances in the GL accounts of balance sheet items become the opening balance of the next period. The closed books of account are kept as records of the Company transactions. One accounting cycle is closed for a new cycle to start again.
The accounting world has evolved a lot in the last 2 decades. Today, even the events (like receipt of sales order, sending POs to suppliers, etc.) are also recognized in the accounting software.
- The majority of parts of the accounting cycle can be automated to an extent that the mechanical & calculative type of work is done by the technology and not by humans. Let the human brain be involved in the creative and decision-making roles. Today the automation has increased to such an extent that many of the steps can be skipped.
- For example, entries for the sale of goods do get the record when the logistics department dispatches the goods from the factory gate. Today posting the transactions in GL happens automatically without any hint from the human brain. Further, some accounting software are so advanced that the draft financials are always ready as soon as any accounting entry is passed. Also, the adjustment entries passed in the system automatically updates the trial balance and financial statements.
- Today the knowledge of the above steps is necessary for us to understand the actual flow of accounting before the computer regime of accounting.
The actual accounting cycle is divided into eight steps that ensure the accuracy, consistency, and efficiency of the financial activities of an entity. The entire cycle ends when the accounting period has ended. Today the computerized accounting and uniform type of work have eaten away the jobs of accountants. However, computers can only present the data in an easy and structured manner. The decision-making is still in the hands of the management and cannot be automated.