Farwah Jafri | June 7 2023
The accounting cycle is a systematic process businesses follow in recording, analyzing, and reporting their financial transactions. It encompasses a series of steps that enable accurate and reliable financial reporting. By understanding and implementing the accounting cycle, organizations can maintain proper financial records, evaluate their financial performance, and make informed decisions. This article will explore the eight important steps in the accounting cycle.
The accounting cycle begins with identifying and analyzing business transactions. These transactions can include sales, purchases, payments, receipts, and other financial activities impacting the company’s financial position. Ensuring that all transactions are properly documented and supported by relevant source documents is crucial.
Once the transactions are identified, the next step is to prepare journal entries. Journal entries are a chronological record of each transaction and its corresponding impact on the accounts. They follow the double-entry bookkeeping principle, meaning every transaction affects at least two accounts with equal debits and credits.
After the journal entries are prepared, they are posted to the general ledger. The general ledger contains individual accounts for assets, liabilities, equity, revenues, and expenses. Posting the journal entries to the general ledger involves transferring the debits and credits from the journal entries to the respective accounts in the ledger.
At the end of the accounting period, an unadjusted trial balance is prepared. The unadjusted trial balance lists all the accounts and their balances before making any adjustments. The purpose of the trial balance is to ensure that the total debits equal the total credits, which indicates that the books are in balance.
After the unadjusted trial balance is prepared, adjustments are made to certain accounts to account for accrued expenses, prepaid expenses, unearned revenues, and other adjusting entries. Adjusting entries is necessary to recognize revenues and expenses in the appropriate accounting period. These adjusted entries are then posted to the general ledger.
Once the adjusting entries are posted, an adjusted trial balance is prepared. The adjusted trial balance includes the updated account balances after the adjustments. Like the unadjusted trial balance, the adjusted trial balance ensures that the debits still equal the credits, verifying the accuracy of the adjustments.
With the adjusted trial balance as a foundation, the next step is to prepare the financial statements. The three primary financial statements are the income statement, the balance sheet, and the statement of cash flows. The income statement shows the company’s revenues, expenses, and net income or loss for a specific period. The balance sheet presents the company’s assets, liabilities, and equity at a specific point in time. The statement of cash flows provides information on the cash inflows and outflows during the accounting period.
The final step in the accounting cycle is to close the books for the current accounting period. Closing entries are made to transfer the balances of temporary accounts (revenue, expense, and dividend accounts) to the retained earnings account. By doing so, the temporary accounts are zeroed out, and the company’s financial records are ready for the next accounting period.
The accounting cycle is a systematic process that encompasses the steps involved in recording, classifying, summarizing, and reporting the financial transactions of a business. It is crucial to provide accurate and reliable financial information for decision-making purposes.
Here are the key reasons why the accounting cycle is important:
The accounting cycle ensures that financial transactions are properly recorded and summarized, leading to accurate financial statements. These statements, including the balance sheet, income statement, and cash flow statement, provide valuable insights into a company’s financial health and performance.
Following the accounting cycle, businesses adhere to financial regulations and standards such as the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Compliance with these standards ensures transparency and enhances the credibility of financial information.
Accurate and timely financial information obtained through the accounting cycle enables informed decision-making. Managers can analyze financial statements to assess profitability, liquidity, solvency, and overall business performance. This information aids in determining pricing strategies, investment decisions, expansion plans, and cost control measures.
The accounting cycle allows for the monitoring and controlling of a company’s financial activities. Regularly reviewing financial statements, such as comparing budgeted versus actual figures, helps identify discrepancies, inefficiencies, and areas for improvement. It facilitates effective financial management and fosters the achievement of organizational goals.
The accounting cycle provides a mechanism to evaluate business performance over a specific period. Comparative financial statements, generated through the cycle, enable the assessment of financial trends, growth patterns, and profitability ratios. This evaluation assists in benchmarking against industry standards and identifying opportunities for enhancing performance.
The accounting cycle establishes a well-documented and organized financial record system. This documentation is a basis for internal and external audits, ensuring accuracy, transparency, and accountability. Additionally, it aids in complying with tax laws and facilitates the preparation of tax returns.
Many legal and regulatory requirements necessitate the completion of the accounting cycle. For instance, public companies are required to publish audited financial statements for their shareholders and regulatory bodies. Similarly, creditors, investors, and other stakeholders rely on financial statements generated through the accounting cycle to make informed decisions.
Properly executing the accounting cycle helps businesses track their financial resources, liabilities, and obligations. This knowledge allows for effective cash flow management, budgeting, and forecasting. With accurate financial information, organizations can plan for future investments, manage risks, and ensure long-term sustainability.
The accounting cycle is a crucial process that ensures accurate and reliable financial reporting. Following the eight steps outlined in this article, businesses can maintain proper financial records, analyze their financial performance, and comply with accounting standards. Understanding the accounting cycle is essential for individuals pursuing a career in accounting or for entrepreneurs looking to manage their company’s finances effectively.
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.