Accounting Cycle

The accounting is a systematic process that starts with identifying & measuring transactions and ends with summarizing and reporting. As all the steps maintain a chain relationship with each other, the process  is called the accounting cycle. The basic steps of the accounting cycle can easily be understandable through this diagram:

  • 1. Identifying and Recording Transactions and Other Events
  • 2. Journalizing
  • 3. Posting
  • 4. Trial Balance
  • 5. Adjustments
  • 6. Worksheet
  • 7. Adjusted Trial Balance
  • 8. Preparing Financial Statements
  • 9. Closing Entries
  • 10. Post Closing Trial Balance
  • 11. Reversing Entries

1. Identifying and Recording Transactions and Other Events:

Identifying and recording transactions and other economic events is the first step in the accounting cycle. Identifying the transaction to be recorded is most important step in accounting cycle. Those transactions should be recorded in the accounting which are measurable, economic events and they can be expressed in their monetary value. The other events of any company are also significant like the employees the skills, the knowledge of employees, the policies of company. But these transactions are not recorded in the accounting system. All cash sales or purchases transactions of entity also should identified and recorded in the accounting. Accounting procedures are of two types:

  • External events which connect between an entity and its environment of business transitions or operational activities, such as a transaction with another entity for earning revenue, a change in the price of a good or service that an entity buys or sells.
  • Internal events means those events which are occur within an entity, such as using buildings and machinery in business operations, or consuming raw materials in production processes. The events also could be both external and internal events. Moreover there also could some unusual events like an interest rate change, theft.

2. Journalizing:

The transactions and events are recorded by any entity which that affect its assets, liabilities, and owner’s equity. The general ledger includes all the asset, liability, and stockholders’ equity accounts of any company. An account shows the effect of transactions which are generated from asset, liability, equity, revenue, and expense accounts.

Companies do not record transactions and other economic events originally in the ledger. The journal contains the record of each transaction in one place. Basically a general journal chronologically enlists the transactions and other events by expressing them in terms of debits and credits to accounts.

Journal entry consists of four parts:

  • (1) The accounts and amounts to be debited (Dr.),
  • (2) the accounts and amounts to be credited (Cr.),
  • (3) a date, and
  • (4) an explanation.

Journal consists of four recording activity:

  • The source of transactions is specified from respective documents such as check, stubs, sales invoice or bank deposit slips etc.
  • Classify the transactions and specify accounts according to debit and credit effect.
  • Based on debit and credit rules increase or decrease in the accounts is recorded in debit and credit side.
  • Entering the data in the journal with explanation in its respective place.

A company enters debits first, followed by the credits. Then comes the explanation that begins below the name of the last account which needs to be credited. Explanation should be brief but well explained and may take one or more lines. Also there is a “Ref” column which should be filled with proper reference number like invoice number etc. Some larger companies’ uses special journals in addition to the general journal which summarize transactions by recording common characteristic accounts (e.g., cash receipts, sales, purchases, cash payments) which reduce the time of recording data or accounting events.

3. Posting:

Posting refers the process of transferring journal entries from journal book to the ledger accounts. Posting include the following steps.

  • Enter in the appropriate columns of the debited account(s) the date, journal page, and debit amount from the journal.
  • In the reference column of the journal, write the account number to which the debit amount was posted.
  • Enter in the appropriate columns of the credited account(s) the date, journal page, and credit amount from the journal.
  • In the reference column of the journal, write the account number to which the credit amount was posted.

Some companies call this form the three-column form of account because it has three money columns—debit, credit, and balance. The balance in the account is measured after each transaction. The explanation space and reference columns of ledger present detailed information about the transaction. The numbers in the “Ref.” column of the general journal refer to the ledger accounts to which a company posts the items.

The posting of the general journal is completed when a company records all of the posting reference numbers opposite the account titles in the journal. The reference column of ledger account refers the journal page from where it was transferred.

4. Trial Balance:

A trial balance lists accounts and their balances within particular time of accounting period. At the end of an accounting period a company usually prepares a trial balance. The company record transaction or lists the accounts in the trial balance in the same order in which manner they recorded in the ledger, with debit balances and credit balances. The total summation of two columns should be equal. After posting the trial balance proves the mathematical equality of debits and credits.

This equality occurs when the sum of the debit account balances equals the sum of the credit account balances following the concept of double entry system. There are several benefit of preparing trail balance such as a trial balance finds out the errors in journalizing and posting, helpful in the preparation of financial statements of any entity.

But equality of trial balance does not prove that a company recorded all transactions or that the ledger is correct. There could be numerous errors exist even though the trial balance columns agree. And these are the limitation of trial balance. Such as:

  • Trial balance may balance when there a is omission of any journal entry,
  • Error of posting a correct journal entry,
  • A journal entry is posted twice,
  • Uses incorrect accounts in errors in recording the amount of a transaction.

When any company record equal amount of debits and credits in the recording process, whether it is in the wrong account or recorded with incorrect amount the total debits column will equal the total credits column.

5. Adjusting Entries:

Adjusting entries means to record revenues in the period in which it is earned, and to recognize expenses in the period in which it is incurred companies makes adjusting entries at the end of the accounting period, which ensures that company follows revenue recognition and matching principles.

The appropriate assets, liabilities, and owners’ equity of any company are reported in the balance sheet within proper accounting period for making the adjusting entries. Adjusting entries also make it possible to record the proper revenues and expenses for the accounting period on the income statement. Basically Companies make adjustment entries after the balance sheet; they also date the entries as of the balance sheet date.

Adjusting Entries are mainly categorized into 2 distinct groups:

1. Deferrals:

  • Prepaid Expenses: Prepaid expenses are those expenses which are paid in cash and recorded as asset before those are used or consumed.
  • Unearned Revenues: Unearned expenses are those expenses which are earned in cash and recorded as liabilities before revenue is earned.

2. Accruals:

  • Accrued Revenues: Accrued Revenues are those revenues which are earned but not yet received in cash or recorded in accounting books.
  • Accrued Expenses: Accrued expenses are those expenses which incurred or consumed but not yet paid in cash and recorded.

6. Worksheet:

Accountants from all round the world trend to use some working papers for some analysis or exercising before preparing final statements. Such working papers are very helpful but those are not regarded as Formal Accounting Record. Worksheet, a multiple column working tool but not a permanent accounting record is used by accountants to summarize accounting entries and account balances in the adjustment process and in the time of preparing financial statements. For more detail tutorial on accounting worksheet please follow this tutorial: How to Prepare an Accounting Worksheet

7. Adjusted Trial Balance:

An economic entity again prepares a trial balance from ledger after journalizing and posting all adjusting entries, which is called adjusted trial balance as it is prepared from the adjusting entries. At the end of the accounting period the adjusted trial balance presents the balance of all accounts, including those adjusted. Therefore the adjusted trial balance shows the effects of all financial events that happened during the accounting period.

8. Preparing Financial Statements:

The next step is to prepare financial statement. From the adjusted trial balance an economic entity prepares financial statement. The company usually prepares three financial statements the income statement, the retained earnings statement and the balance sheet. First the income statement is prepared from the revenue and expense accounts. And then the company prepared the retained earnings statement from the retained earnings and dividends accounts and the net income or net loss is appeared in the income statement. And finally the balance sheet is prepared from the asset and liability accounts, the common stock account, and the ending retained earnings balance which is reported in the retained earnings statement.

9. Closing entries:

Closing entries means at end of particular accounting period close the temporary accounts, by journalizing and posting for the future transaction of next accounting period. The closing entries lead the temporary accounts to zero balance preparing the accounts for the next accounting. In the closing process at the end of accounting period a company transfers all of the revenue and expense account balances to Income Summary for computing net income or net loss. The determined net income or net loss is then transferred to the retained earnings statement or owner’s equity statement. Then the entity posts all closing entries to the appropriate general ledger accounts. Company reports the amount in the balance sheet as the ending amount which is reported on the retained earnings statement. The Income Summary account is used only in closing process. For measuring net income or net loss the balances of the temporary account should be zero balance. So at the end of accounting period the temporary accounts which can determined net income or net loss are closed as fixed account do not represent net income.

10. Post-Closing Trial Balance:

After posting the closing entries the company makes another trial balance called the post-closing trial balance, which include only asset, liability, and owners’ equity accounts. A post-closing trial balance is the evidence which proves that the company has accurately journalized and posted the closing entries. It also shows that the accounting equation is in balance at the end of the accounting period.

11. Reversing Entries:

Reversing entries is an optional step of accounting system. Sometimes a company reverses some the adjusting entries after preparing the financial statements and closing the accounts which are called reversing entries. At the beginning of the next accounting period a company makes a reversing entry which is the opposite of the related adjusting entry that made in the previous period.