Every business involves accounting procedures like recording, classifying as well as summarizing all the transactions. Accounting is required if you want to be able to track and predict how your company will grow. If you have a system for tracking your assets, liabilities, and revenue, you can make sound, educated business decisions based on your company’s past success and present financial health. If you have a clear, structured accounting system, you can not only review your company’s financial data but also help it to grow and profit. It is essential in operating a business since it lets you track income and spending, maintain statutory compliance, and provide measurable financial data to investors, management, and the government to help them make business decisions.
Did you know?
The word “accounting” comes from the French “compter” meaning to count or score.
What is accounting cycle?
The accounting cycle refers to the specific operations necessary to complete the accounting process. The cycle is structured like a circle. It begins at one position and rotates through specified steps before returning to the same place and repeating the procedure. The accounting cycle is a procedure that results in the preparation of financial statements that summarise these events.
Accounting cycle fundamentals
To fully understand the accounting cycle, you must first understand basic accounting principles. You must be familiar with revenue recognition (the process through which a company records sales revenue), the matching principle (the matching of expenses to revenues), and the accrual concept. The key concepts mentioned above will enable you to prepare an income statement, balance sheet, and cash flow statement, which are the three most important parts of the accounting cycle.
What is accounting cycle?
The accounting cycle refers to the specific operations necessary to complete the accounting process. The cycle is structured like a circle. It begins at one position and rotates through specified steps before returning to the same place and repeating the procedure. The accounting cycle is a procedure that results in the preparation of financial statements that summarise these events.
Accounting cycle fundamentals
To fully understand the accounting cycle, you must first understand basic accounting principles. You must be familiar with revenue recognition (the process through which a company records sales revenue), the matching principle (the matching of expenses to revenues), and the accrual concept. The key concepts mentioned above will enable you to prepare an income statement, balance sheet, and cash flow statement, which are the three most important parts of the accounting cycle.
Various steps of accounting cycle
There are differences in the accounting cycle, most noticeably between cash and accrual accounting. The accounting cycle may have seven to ten phases, depending on how comprehensive each phase is.
Also read: Know the Basics of Managerial Accounting
The eight steps of the accounting cycle include the following:
- Step 1: Identify Transactions
- Step 2: Record Transactions in a Journal
- Step 3: Posting
- Step 4: Unadjusted Trial Balance
- Step 5: Worksheet
- Step 6: Adjusting Journal Entries
- Step 7: Financial Statements
- Step 8: Closing the Books
Steps of accounting cycle in detail
Step 1:Identify transactions
In the first step of the accounting cycle, you are able to identify all the financial transactions that have occurred in the business. The accountant aggregates all data of various transactions like purchases, payments, sales, and receipts. The accountant organises this data in order to complete the next stage of the accounting cycle.
Step 2: Record transactions in a Journal
The second step is to enter transactions into a journal. A journal is a detailed account that records a company’s financial transactions. It is used for future account reconciliations. This stage is also known as a ‘Journal entry’. All the transactions are recorded in a chronological manner alongside the ledger accounts. A transaction is often recorded in a company’s journal using a double-entry rule, although it can alternatively be recorded using a single-entry rule of bookkeeping. This indicates that each transaction affects at least two accounts. Each transaction must have a debit and a credit, with the sum of the debits and credits equalling the transaction’s value. In the journal, debits are recorded before credits, and entries are written in chronological order.
Also read: What is the List of Accounting Standard
Step 3: Ledger Posting
Every transaction that has been recorded in journal books is posted to individual ledger statements. In the case of a cash ledger account, you post all Debits like receipts and Credits like payments into a statement. The difference between these two (including the opening cash balance) is considered as the closing balance.
The general ledger is a record of all accounting transactions split down by account. This allows a bookkeeper to keep track of account financial problems. A separate ledger is generated for each account head, such as Purchase A/c, Sales A/c, Wage A/c, Rent A/c, Capital A/c, Machinery A/c, and so on.
Step 4: Unadjusted Trial Balance
At the end of the accounting period, you have to create an unadjusted trial balance. The unadjusted trial balance is a list of general ledger account balances at the end of a reporting period before making any adjusting entries to prepare financial statements. The unadjusted trial balance is used as the starting point for analysing account balances and making adjusting entries. An unadjusted trial balance is used only in double-entry accounting where all account entries must balance. When employing a single-entry system, it is not possible to create a trial balance in which the total of all transactions is equal to zero.
Step 5: Worksheet
The next stage is to examine a worksheet and look for adjustment entries. Accounting worksheets are documents used by accountants to analyse the entries to the minutest detail. A worksheet can assist in ensuring that accounting entries are computed correctly. It may also be used to keep track of account changes that could vary across each month.
Step 6: Adjusting Journal Entries
An adjusting journal entry is a journal entry made in a company’s general ledger at the end of an accounting period to record any unrealized revenue or expenditures. To properly account for a transaction that begins in one accounting period and ends in another, an adjusting journal entry is required.
Adjusting journal entries are financial transactions that remedy a mistake made earlier, in the accounting period. If corrected entries were not made, there would be unresolved transactions in the journal. The most typical sorts of modifying journal entries are accruals, deferrals, and estimates.
Accrual
Accrual adjustment entries are used to include transactions that happened during the current fiscal period but have not yet been recorded in a company’s general ledger accounts. Those transactions will most likely be recorded in a subsequent accounting period if accrual adjustment entries are not made. As a result, the financial statements for two accounting periods will include inaccurate numbers.
Utility bills, wages, and taxes are examples of items that are often charged after they have been incurred.
Also read: Learn About Accounting Principles and Concepts
Deferral
A deferred adjusting entry refers to a transaction that has already been recorded in the general ledger accounts. The deferred adjusting entry ensures that the right amounts are recorded on the balance sheets and income statements of a corporation.
Deferred expenses include items like insurance fees and rent. If rent is paid in advance for the entire year but recognized monthly, adjustment entries will be made each month to recognize the percentage of prepayment assets spent in that month.
Estimates
When an item’s precise value cannot be determined, accountants must make estimates, which are also recorded as modifying journal entries. Taking estimates for non-cash things into account, a firm can better manage its revenues and costs, and the financial statements can more correctly portray the company’s financial picture. For example, depreciation expenses for Property, Plant & Equipment (PP&E) are estimated based on depreciation schedules with assumptions on useful life and residual value.
Step 7: Financial Statements
A company prepares its financial statements after making all adjusting entries. All businesses have to maintain a Profit and loss statement, a balance sheet, and a cash flow statement.
Profit and Loss Statement
The income statement is also referred to as the statement of operations, profit and loss statement, and profits statement. It is one of the most important financial statements for a business. The income statement’s goal is to present a summary of a company’s sales, costs, profits, losses, and consequent net income for a certain year, quarter, or another time period.
Balance Sheet
The balance sheet of a company shows:
1. Assets (resources that were acquired in past transactions)
2. Liability (obligations and customer deposits)
3. The equity of shareholders (the difference between the amount of assets and liabilities)
The balance sheet may be thought of as a summary of assets and claims against those assets (liabilities and shareholders’ equity). The balance sheet may also be viewed as showing a corporation’s assets as well as the amounts given by creditors (the liabilities) and the amounts provided by the owners (the stockholders’ equity).
Cash Flow Statement
The cash flow statement summarises a company’s key cash inflows and outflows over the same time period as the income statement. Because the income statement uses the accrual method of accounting, the cash flow statement is essential. This means that the income statement reflects revenues as they are earned (rather than when money is received) and costs and losses as they occur (not when money is paid out).
The cash flow statement closes by demonstrating that the amounts correspond to the change in the company’s cash and cash equivalents from the start to the conclusion of the accounting period.
Step 8: Closing the Accounting Books
There is one more step to take. It is referred to as the closure procedure. The closure procedure serves two purposes:
- Closing is a procedure for updating the ledger’s retained profits account to equal the end-of-period balance. Keep in mind that recording each item of income, cost, or dividend does not result in an automatic deduction or credit to retained earnings. As a result, the retained profits amount at the start of the period remains in the ledger until the closing procedure “updates” the retained earnings account to reflect the impact of the period’s operations.
- Revenue, cost, and dividend accounts represent quantities over time; at the conclusion of each period, these accounts must be “zeroed out” (as a result, revenue, expense, and dividend accounts are called nominal accounts). In essence, zeroing out these accounts resets them to the start of the following accounting period. Asset, liability, and equity accounts, on the other hand, are referred to as real accounts since their balances are carried forward from period to period.
Also read: 3 Golden Rules of Accounting, Explained with Best Examples
What is the importance of an accounting cycle?
Financial statements give you a complete perspective of your business. An accounting cycle assists you to analyse key data points which aid the said authorities to better decision-making choices. Business owners have to maintain accurate and updated records of all financial transactions. Such accurate details help to raise more funds in the future and also makes the business more attractive to new investors. When you follow the accounting cycle, it indicates that you are consistently compliant with all the regulations and accounting standards.
Conclusion
The key purpose of the accounting cycle is to observe and abide by all the statutory changes as well as accounting standards for the business to function in an efficient manner and yield more positive results. Follow Legal Tree for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.