What is accounting cycle?
The accounting cycle is the steps in preparing financial statements. It is called a cycle because the steps are repeated each reporting period. The accounting cycle incorporates all the accounts, journal entries, T accounts, debits and credits, adjusting entries over a full cycle.
The accounting cycle is used comprehensively through one full reporting period. Thus, staying organized throughout the process’s time frame can be a key element that helps to maintain overall efficiency. Accounting cycle periods will vary by reporting needs. Most companies seek to analyze their performance on a monthly basis, though some may focus more heavily on quarterly or annual results.
The accounting cycle involves:
An optional step at the beginning of the next accounting period is reverse and post entries.
The first step in the accounting cycle is identifying transactions. Companies will have many transactions throughout the accounting cycle. Each one needs to be properly recorded on the company’s books. Recordkeeping is essential for recording all types of transactions. Many companies will use point of sale technology linked with their books to record sales transactions. Beyond sales, there are also expenses that can come in many varieties.
The second step in the cycle is the creation of journal entries for each transaction. Point of sale technology can help to combine steps one and two, but companies must also track their expenses. The choice between accrual and cash accounting will dictate when transactions are officially recorded. Keep in mind, accrual accounting requires the matching of revenues with expenses so both must be booked at the time of sale.
Cash accounting requires transactions to be recorded when cash is either received or paid. Double-entry bookkeeping calls for recording two entries with each transaction in order to manage a thoroughly developed balance sheet along with an income statement and cash flow statement.
With double-entry accounting, each transaction has a debit and a credit equal to each other. Single-entry accounting is comparable to managing a checkbook. It gives a report of balances but does not require multiple entries.
Once a transaction is recorded as a journal entry, it should post to an account in the general ledger. The general ledger provides a breakdown of all accounting activities by account. This allows a bookkeeper to monitor financial positions and statuses by account. One of the most commonly referenced accounts in the general ledger is the cash account that details how much cash is available.
At the end of the accounting period, a trial balance is calculated as the fourth step in the accounting cycle. A trial balance tells the company its unadjusted balances in each account. The unadjusted trial balance is then carried forward to the fifth step for testing and analysis.
Adjusting entries make up the fifth step in the cycle. A worksheet is created and used to ensure that debits and credits are equal. If there are discrepancies then adjustments will need to be made. In addition to identifying any errors, adjusting entries may be needed for revenue and expense matching when using accrual accounting.
An adjusted trial balance may be prepared after adjusting entries are made and before the financial statements are prepared. This is to test if the debits are equal to credits after adjusting entries are made.
When the accounts are already up-to-date and equality between the debits and credits have been tested, the financial statements can now be prepared. The financial statements are the end-products of an accounting system.
A complete set of financial statements is made up of: (1) Statement of Comprehensive Income (Income Statement and Other Comprehensive Income), (2) Statement of Changes in Equity, (3) Statement of Financial Position or Balance Sheet, (4) Statement of Cash Flows, and (5) Notes to Financial Statements.
Temporary or nominal accounts, i.e., income statement accounts, are closed to prepare the system for the next accounting period. Temporary accounts include income, expense, and withdrawal accounts. The accounts are closed to a summary account (usually, Income Summary) and then closed further to the capital account. Again, take note that closing entries are made only for temporary accounts. Real or permanent accounts, i.e. balance sheet accounts, are not closed.
In the accounting cycle, the last step is to prepare a post-closing trial balance. It is prepared to test the equality of debits and credits after closing entries are made. Since temporary accounts are already closed at this point, the post-closing trial balance contains real accounts only.
Reversing entries are optional. They are prepared at the beginning of the new accounting period to facilitate a smoother and more consistent recording process, especially if the company uses a cash-basis accounting system.
In this step, the adjusting entries made for accrual of income, accrual of expenses, deferrals under the income method, and prepayments under the expense method are reversed.
Accounting Cycle Fundamentals
To fully understand the accounting cycle, it’s important to have a solid understanding of the basic accounting principles. You need to know about revenue recognition, the matching principle and the accrual principle.
These fundamental concepts are important to construct an income statement, balance sheet, and cash flow statement, which are the most important steps in the accounting cycle.
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The writer, Sapna Agnihotri, is an Accounting and Human Resources Intern at Thaddeus Resource Center. Prior to Joining Thaddeus Resource Center, she worked as a teacher. A graduate in Family Finance and Consumer Science, she studied Accounting from Waukesha Technical College, and lives in Wisconsin.