What is the Accounting Cycle and What are Accounting Cycle Steps?
The Accounting Cycle is a complete and steps by step process of analyzing, recording, accepting and summarization the business transactions. Basically, the accounting cycle is the flow of developing financial statements. So that we can make a decision about our business. What are we getting from our financial activities and what we are losing?
Steps of Accounting Cycle
If we talk about the steps of the accounting cycle. Few experts consider 8 steps and few consider 9 steps. Few consider the Closing and Adjusting entries the part of Accounting cycle. Now we are going to discuss all steps one by one so that we will have a clear understanding of the Accounting Cycle process.
- Identification of business transaction
- Recording business transaction in General Journal
- Posting entries to General ledger
- Preparation of Unadjusted trial balance.
- Making adjustments and recording Adjusting entries
- Preparation of Adjusted Trial Balance
- Preparation of financial statements (P/L, B/S, SOCE etc.)
- Closing the entries
- Extracting post closing trial balance (Remember this trial balance is adjusted)
Now, we will be discussing each of these steps in some detail:
1. Identification of Business Transaction
A business transaction is an interaction between a supplier and a customer. You need to identify business transaction that relate to the entity. the next step is to analyze all these business transactions. This is where the accounting cycle or accounting process starts. After identifying and analyzing these transactions, a document called Source Document is prepared.
Quick Tip: You need to record only those transactions that relate to your business. Do not include unnecessary transaction in the source document.
2. Recording business transaction in General Journal
The next step in accounting cycle is to record business transaction in general journal. Now, you might be wandering what is General Journal? well, General Journal is nothing but just a register or book in which transactions are recorded. This book may be in physical form or in electronic form. General Journals are also called Books of Original entry. For each transaction, two effects one debit and one credit is recorded.
Quick Tip: Books of original entry or General Journal is prepared in chronological order i.e. transactions are recorded date wise.
3. Posting entries to General Ledgers
The third step in accounting cycle or accounting process is to record these entries in General Ledgers. Now you might be asking what is General Ledgers? Let me answer you in the simplest way- General Ledger is nothing but a book or register showing the current balance of each account. You just need to record all the debits and credits in the General ledger for a particular account. It will give you the final balance at the given time. Therefore, General ledger is also called books of final entry.
4. Preparation of Unadjusted Trial Balance
So far, you have recorded two effects for each business transaction that is a debit effect and a credit. But how do you know that you have recorded every transaction with correct debit and credit amount. This is verified by preparing a trial balance. As you are preparing this trial balance before the closure of the books, therefore it is commonly called pre-closing or unadjusted trial balance. A trial balance contains a list of all the debits and credits. After extracting the list, you have to calculate the totals for both the debits and credits. These totals should match. If total of the debit amount is not equal to the total of credit amount, it means you have done something wrong.
Quick Tip: Trial balance is just used to test the mathematical accuracy of the debits and credits (in total). It might not exactly be used to detect any incorrect double entry.
5. Recording Adjusting Entries
The fifth step in accounting cycle or accounting process is to record adjusting entries. This step is included in the cycle due to the accrual basis of accounting. Now, you might be asking what is accrual basis of accounting? Accrual basis of accounting is an accounting method under which incomes are recorded when they are earned and expenses are recorded when they are incurred rather than when the cash is received or paid. So, your business might have some expenses for which you haven’t paid yet, but you need to record them in your books. similarly, you might have some incomes for which you haven’t received any cash. Therefore, you need to record adjusting entries for such transactions.
6. Preparation of Adjusted Trial Balance
The next big step after you have recorded the adjusting entries is to prepare the adjusted trial balance. This trial balance is called adjusted because all the adjustments are made in the unadjusted trial balance and an adjusted version of trial balance is prepared. This adjusted trial balance is prepared just to make sure that all the debits and credits are equal after all the adjustments have been made.
7. Preparation of Financial Statements
As for now, you have:
Recorded all the business transactions,
Posted these transactions to general journal and general ledger, and
tested the total of all the debits and credits (by preparing adjusting trial balance).
Now, you are ready to prepare financial statements for your business. A complete set of financial statements has the followings:
- Statement of comprehensive incomes (SOCI) or Profit and loss statement,
- Statement of financial position or Balance sheet,
- Statement of Changes in Equity (SOCE),
- Statement of Cash Flows (SOCF), and
- Notes to the Financial Statements.
8. Closing Entries
Now, it’s time to prepare for the next accounting period or cycle. All the nominal accounts also called as temporary accounts are closed. While, Real or Permanent accounts are not closed, these are carried forward to the next accounting period or cycle.
9. Post Closing Trial Balance
The last step in accounting cycle is to prepare the final post closing trial balance for your business. So far we have prepared three different trial balance:
- Unadjusted Trial Balance to test the mathematical accuracy of recorded transaction
- Adjusted Trial Balance to test the mathematical accuracy after making adjusting entries
- Closing Trial Balance to test the mathematical accuracy after making closing entries.
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