Accounting Cycle
The Accounting Cycle is a systematic process of recording, analyzing, and reporting financial transactions of a business. It ensures accurate and consistent financial records, helping businesses make informed decisions. The cycle consists of eight steps, starting from identifying transactions to preparing financial statements and closing accounts.
1. Identifying Transactions
Every business transaction must be identified and analyzed to determine its impact on financial statements. Transactions include sales, purchases, expenses, payments, and receipts.
2. Recording in the Journal (Journalizing)
Once transactions are identified, they are recorded in the journal using the double-entry system, where each transaction affects at least two accounts. The format follows debit and credit rules based on the nature of the account (assets, liabilities, equity, revenue, and expenses).
3. Posting to the Ledger
After journalizing, transactions are posted to the ledger accounts, where similar transactions are grouped under respective account headings. This helps in tracking balances of different accounts over a period.
4. Preparing an Unadjusted Trial Balance
A trial balance is prepared by listing all ledger balances at the end of an accounting period. The total debits should equal total credits. If they do not match, there may be errors that need to be corrected.
5. Making Adjusting Entries
At the end of the period, adjustments are made for transactions that were not recorded during regular journal entries. These adjustments include:
Accrued revenues & expenses (earned/incurred but not yet recorded)
Prepaid expenses (expenses paid in advance)
Depreciation (allocating cost of assets over their useful life)
6. Preparing an Adjusted Trial Balance
After adjustments, an adjusted trial balance is prepared to ensure the accuracy of financial records before creating financial statements.
7. Preparing Financial Statements
The financial statements provide a summary of the business’s financial performance and position:
Income Statement – Shows revenue and expenses, determining net profit or loss.
Balance Sheet – Displays assets, liabilities, and owner’s equity.
Cash Flow Statement – Reports cash inflows and outflows from operations, investing, and financing activities.
8. Closing Entries & Post-Closing Trial Balance
At the end of the accounting period, temporary accounts (revenues, expenses, and drawings) are closed to the capital account to reset balances for the next period. A final post-closing trial balance is prepared to ensure accounts are balanced before starting a new cycle.
Importance of the Accounting Cycle
Ensures accuracy and completeness of financial records.
Helps in fraud prevention by maintaining systematic records.
Provides useful financial insights for decision-making.
Ensures compliance with accounting standards and regulations.
The Accounting Cycle repeats every accounting period (monthly, quarterly, or annually) and is crucial for maintaining reliable financial records.