The accounting cycle, also commonly referred to as accounting process, is a series of procedures in the collection, processing, and communication of financial information. It involves specific steps in recording, classifying, summarizing, and interpreting transactions and events for a business entity.
The accounting cycle involves:
An optional step at the beginning of the next accounting period is to record and post reversing entries.
Financial information is ultimately presented in reports called financial statements (step 7). But before financial statements can be prepared, accountants need to gather information about business transactions, then record and collate them to come up with values to be reported (steps 1-6).
The process does not end with the presentation of financial statements though. Subsequent steps are necessary to prepare the accounting system for the next period (steps 8-9).
Let's briefly go over each step.
The accounting process starts with identifying and analyzing business transactions and events. Not all transactions and events are entered into the accounting system. Only those that pertain to the business entity are included in the process.
For example, a personal loan made by the owner that does not have anything to do with the business entity is not to be recorded by the business.
The identified business transactions are then analyzed to determine the accounts affected and the amounts to be recorded.
This step also involves the preparation or collection of business documents, or as auditors would call them – source documents. A business document serves as basis for recording a transaction.
A journal is a book – paper or electronic – in which transactions are recorded. Journals are also known as Books of Original Entry.
Business transactions are usually recorded using the double-entry bookkeeping system. They are recorded in journal entries under at least two accounts (at least one debited and at least one credited). Transactions are recorded in chronological order and as they occur.
To simplify the recording process, special journals are often used for transactions that recur frequently such as sales, purchases, cash receipts, and cash disbursements. And a general journal is used to record those that cannot be entered in the special books.
Also known as Books of Final Entry, the ledger is a collection of accounts that shows the changes made to each account as a result of past transactions recorded. It also shows their current balances.
For example, all journal entry records under the "Cash" are posted into the Cash account in the ledger. We will be able to calculate the increases and decreases in cash; and from that, we can determine the ending balance of the Cash account.
A trial balance is prepared to test the equality of the debits and credits. All account balances are extracted from the ledger and arranged in one report. Afterwards, all debit balances are added. All credit balances are also added. Total debits should be equal to total credits.
When errors are discovered, correcting entries are made to rectify them or reverse their effect. Take note however that the purpose of a trial balance is only test the equality of total debits and total credits and not to determine the correctness of accounting records.
Some errors could exist even if debits are equal to credits, such as double posting or failure to record a transaction.
Adjusting entries are prepared as an application of the accrual basis of accounting. At the end of the accounting period, some expenses may have been incurred but not yet recorded in the journals. Some income may have been earned but not entered in the books.
Adjusting entries are prepared to update the accounts before they are summarized in the financial statements.
Adjusting entries are made for accrual of income, accrual of expenses, deferrals (income method or liability method), prepayments (asset method or expense method), depreciation, and allowances.
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. These items are measured periodically, hence need to be closed to have a "fresh slate" for the next accounting period.
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.
Author's Notes: So there you have the nine steps in the accounting cycle. This is just an overview of the accounting process. Each step will be illustrated one by one in later chapters.