|Accounting cycle with diagram
The accounting process is a continuous and systematic working process that begins with the analysis of business transactions and ends with preparing the post-closing trial balance. According to the going concern concept, it is presumed that a business organization will run for an indefinite period. But, this indefinite period is divided into mini periods to know the operating result and financial position of a business organization.
The accounting process is a constitutional working process in determining these financial results. These constitutional rules of the accounting process require systematic and successive recording of business transactions.
What Is Accounting Cycle?
The accounting cycle is the successive working process of the accounting method. This cycle begins with the analysis of business transactions and ends with preparing a post-closing trial balance. The accounting working process starts with the identification of transactions and their journalisation. After recording the transactions in a journal, these are to be classified and posted to ledger accounts.
The trial balance is prepared with balances of ledger accounts to prove the arithmetical accuracy of accounts. After preparation of the trial balance adjusting, you will use the entries for preparing the adjusted trial balance. Furthermore, you will prepare a worksheet from the adjusted trial balance for easy and fair financial statements preparation.
The statements of accounts are interpreted and analyzed and provide necessary information for making decisions. After preparing financial statements, closing entries are passed for closing periodic expenses and income to close these. Afterwards, you will prepare a post-closing trial balance, with which the next year's activities start.
What are steps of accounting cycle?
The steps in the cycle are performed in sequence and repeated in each accounting period. Therefore, the accounting cycle is a complete accounting process, which starts with the identification of the transaction and its journalization and reaching the final stage of accounting activities step-by-step, and starts the next year's activities with opening journal entries and again reaching the final stage of accounting activities in the same process. This accounting process repeats so long as a business exists.
What Are The 11 Steps In The Accounting Cycle?
The various steps or phases of the accounting cycle are explained in the following flowchart, along with an explanation:
|Accounting cycle with diagram
The steps of accounting cycle are explained below:
1. Identification of Transaction and Other Events
The first step of the accounting cycle is the identification of transaction and other events. In an organization, many events occur every day. But all of them are not transactions because every transaction will involve cash. Only the events measurable in terms of money and cause changes in financial position/accounting equation are transactions. They should be recorded, and in the next stage, keep accounts for these.
In the second stage of the accounting cycle, transactions are recorded initially in chronological order of dates, debiting one account and crediting the other with a brief explanation before transferring to the accounts. Thus, the journal is the ‘book of original entries.’ If transactions are not recorded earlier in the journal, in a later stage, ledger accounts become almost complex.
3. Posting to ledger accounts
Step three of the accounting cycle is to classify business transactions. A ledger is a statement prepared to classify and summarize the transactions in groups like income expense, assets, and liabilities. The systematic process of transferring journal entries to the ledger accounts is known as posting. As all transactions are finally recorded in this book permanently, it is called a ‘permanent book of account.’
4. Preparation of Trial Balance
In forth step of accounting cycle a trial balance is prepared with the help of ledger accounts list and their balances at a given time. As a matter of course, at a particular date of period end the accounts are listed in the order in which they appear in the ledger, with debit balances listed in the left column and credit balances in the right column.
Primarily a trial balance is prepared to prove the arithmetical accuracy of debits and credits after posting and facilitate preparing financial statements. A trial balance also uncovers errors in journalizing and posting.
Adjustments are needed to ensure that you follow the revenue recognition and matching principles. To determine the operating result and the exact financial position at a particular date of a business concern, you must account for various information regarding accruals and advances.
Adjustments are done in the following ways:
- According to accrual concept, payable expense lime payable salary, rent and accrued income like accrued interest on investment etc. are to be adjusted in the books of accounts for determining actual income or loss of a particular period.
- According to income-expense matching concept for determining actual profit expense incurred for earning income like advance, expense, depreciation expense, uncollectible allowance etc. are to be adjusted in the book of account.
6. Adjusted Trial Balance
In this step of the accounting cycle, adjusting entries have been journalized and posted in the ledger accounts again to ascertain relevant ledger balances at the end of the period. The trial balance prepared again with these ledger balances is called an adjusted trial balance. The purpose of an adjusted trial balance is to show the effects of all financial events during the accounting period.
7. Financial Statement Preparation
Financial statements are prepared from the adjusted trial balance directly. First, you will prepare the income statement from the revenue and expense accounts to determine the net income or loss. After that, you will derive the owner’s equity statement from the owner’s capital and drawing account and the net income or net loss from the income statement.
Finally, you will complete the balance sheet by listing all the assets, liabilities, and owner’s equity. The assets will always equal the liabilities and equity. It is the reason why this statement is called a balance sheet, and it shows the financial condition of the enterprise at a period.
8. Closing Entries
Journalizing and posting closing entries is a required step in the accounting cycle. Generally, after preparing the financial statements, the temporary accounts, such as revenue or expense and gain or loss, including balance of income statement, are closed by passing closing journal entries. These accounts are closed to a temporary income summary account, then the balance is transferred to the retained earnings account (capital).
Any dividend or withdrawal accounts also are closed to capital. The necessity of closing expenses and incomes arises as their utilities ended during the particular accounting period and are not carried forward to the next year, like assets, liability, and owner’s equity.
9. Post Closing Trial Balance (optional)
A third trial balance may be taken after journalizing and posting the closing entries, called the post-closing trial balance, which shows that equal debits and credits have been posted to the income summary accounts. The goal of post-closing trial balance is to prove the equality of the permanent account balances carried forward into the next accounting period as opening balances. Therefore, only the permanent accounts (total assets, liabilities, and owner’s equity) appear since the temporary accounts have been closed.
10. Reversing Entries (optional)
The preparation of reversing entries is the last step of the accounting cycle. It is an optional bookkeeping procedure and not a required step in the accounting cycle. A reversing journal entry is recorded on the first day of the new period. Reversing entries are adverse to adjustment entries forwarded to the beginning of the next financial year.
Reversing entries are passed for outstanding and advances of the previous year at the beginning of an accounting year which are opposite of adjusting entries. By reversing the adjusting entry, one avoids double counting the transaction that occurs in the next period. Reversing entries are made only for adjusting entries of outstanding and advances. And for the other adjusting entries, no reversing entries are required.
11. Work Sheet (optional)
The accounting process is complete when all accounts are closed and "reset" for the new financial cycle. It involves working with a worksheet that condenses all the financial statements onto one table. Using worksheet helps the accountant prepare the financial statements on a timelier basis.
A worksheet is crucial to facilitate the end-of-period (monthly, quarterly, or annually) accounting and reporting process. In big business organizations where the number of accounts and adjustments is comparatively large, a worksheet is prepared to help prepare financial statements conveniently and accurately.
The 10-column worksheet provides columns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. Completing the worksheet assures that all of the details related to the end-of-period accounting and statement preparation are correct.