Definition:
The entity’s financial statements are produced through analyzing and recordings the business transactions in many different steps of the accounting cycle.
These include analyzing sales, purchases, and other business transactions and then recording those transactions in the monetary term into the key important areas like journal entries, ledger accounts, trial balance, and then draft the financial statements.
In the traditional accounting records, each area like journal entries, ledgers, and trial balance are not integrated into each other and the recording and movement of accounting transactions from one book to another book must be done manually.
However, accounting records currently are performed by using accounting system where all of the books are integrated to each other.
For example, an accountant or bookkeeper analyzes and records the sales transaction into the journal entries, and then these sales transactions will run automatically into the ledger, trial balance, and then directly affect the financial statements.
Even though the accounting system makes us easy to use and records the financial transaction, it is important to have a good understanding of the accounting cycles that we can have a better understanding of how the accounting system works and especially process the accounting information.
The following are the list of 8 steps accounting cycles that accountant or bookkeeper use to recording and preparing the entity’s financial statements:
8 Steps of Accounting Cycles:
1) Records the transaction in journal entries:
The first step in the accounting cycle is analyzing the business transactions and then records that transaction into journal entries. There are many business transactions that occur in an entity every day.
Some of those might need to records as financial information and some of those might be not. For example, the company memo issue for sales discounts during the next holiday is not the accounting transactions. And this should not record in the accounting system.
However, sales transactions that an entity made every day are financial transactions and need to records in the monetary term in the accounting system. The journal entries for these sales transactions should record in the general journal.
For example, in the general journal, the entry should be credit sales and debit account receivable or cash depending on the nature of sales transactions.
All of the business transactions are analyzed and make the journal entries in the general journal. The journal entries will then need to transfer into the specific ledger accounts based on the nature of transactions.
For example, sales will need to transfer into the sales ledger, and account receivable will need to transfer into the account receivable ledger.
2) Transfer the journal transactions into ledger accounts
The second step of the accounting cycle is transferring the journal transactions from the general journal into the ledger accounts or general ledger.
The transfer will help the accountant or bookkeeper to get the total balance of each type of account. For example, all the sales journal that records in the general journal are transferred into sales ledgers.
These sales transactions will record in the credit side of the sales ledgers and when the accountant balances this ledger, he will get the total amount of sales during the period.
Sales as a sales journal, other financial transaction that records in the general journal will transfer to the ledgers account and then closing those ledgers. The ledgers are closed, the total balance of each ledger will transfer into trial balance.
When transferring the journal entries into the ledger accounts, the debit and credit role will have to be followed. For example, assets are increasing on the debit side while liabilities and equities are increasing on the credit side. The decrease in these accounts is moved in a different direction.
Revenues and expenses accounts are increase and decrease in a different direction. Revenues increase on the credit side while expenses are increasing on the debit side like assets.
All of the sub-accounts of these financial statements element are increase or decrease with respect to the main element. For example, non-current assets and current assets are an increase on the debit side and decrease on the credit side.
3) Preparing the unadjusted trial balance:
Unadjusted trial balance is preparing after the accountant close all the ledgers accounts at the end of the financial period. For example, the entity financial period ended on 31 December. An accountant will close the account ledger by the cut off the transactions at the end of 31 December.
Once all of the account ledgers are closed, account the total amount of those ledgers account will need to move to trial balance. This trial balance is called an unadjusted trial balance. This is because there is no adjustment is processed to the trial balance or ledger yet.
Trial balance is not the financial statement and the reason that we prepare this statement is that we want to check whether the debit and credit roles are properly applied during journal and ledger accounts.
This statement also helps to assess the mathematical correctness of financial statements. If the trial balance is not reconciled or the debit side and credit are not equal, the financial statements especially the balance sheet is not equal.
When moving the ledger account into trial balance, the assets account needs to punt in the top of trial balance follow by liabilities and equity. Revenues and expenses are records all the way down by following equities accounts.
4) Make the adjusting entries:
Once the unadjusted trial balance is prepared, the next step of accounting cycle is making the necessary adjustments.
The adjustments come from many reasons some of those are because of under or over recognition, wrong classification, or sometimes because of audit adjustments.
Once the list of adjusting transactions is approved by the authorized person, then all of that adjustment need to process in the account ledgers and reflect in the trial balance.
Sometimes adjustments are book directly into account ledgers and then update into trial balance. And sometimes, the adjustments book both in account ledgers and then also book in the trial balance.
5) Preparing the adjusted trial balance:
Once all the adjusting entries are made to trial balance and account ledgers, the fifth step of the accounting cycle is preparing the adjusted trial balance. These statements should be done before drafting the financial statements.
In most cases, the accountant or auditors use the trial balance to draft financial statements. This is because the process of drafting the financial statements takes after the accountant confirms the trial balance is reconciled.
The adjusted trial balance is quite similar to the unadjusted trial balance. The key information that included in this statement is entity name, the accounting period, name of the statements, list of account along with the debit or credit balance.
6) Draft the financial statements:
This is an important step of the accounting cycle. Once all of the accounts ledgers are closed and transfer into the trial balance and all the necessary adjustments are made into those ledgers and trial balance, the accountant needs to prepare the financial statements.
The four main types of financial statements along with the notes to the statements are prepared using the information from the adjusted trial balance.
Those financial statements including balance sheet, income statement, statement of change in equity, statements of cash flow, and noted to financial statements.
7) Journalize and post the closing entries:
If there is a temporary account at the end of the accounting period, an accountant needs to close that account so that the accountant can open the account for the next period.
The temporary accounts need to close and transfer to their permanence account. This is normally done for the manual accounting records.
8) Preparing post-closing trial balance:
In the last step of the accounting cycle, the accountant requires to perform the post-closing trial balance. This statement is prepared after an accountant makes all necessary adjustments to the general ledger and the adjusted trial balance, and all the suspended accounts are closed.
The main purpose of preparing this post-closing trial balance is to ensure that all accounts are balanced and ready for recording the next period’s financial transactions.
