The entity’s financial statements are produced through analyzing and recordings the business transactions in many difference steps of accounting cycle.
Those including analyzing sales, purchases and others business transactions and then recording those transactions in monetary term into the key importance areas like journal entries, ledger accounts, trial balance and then draft the financial statements.
In the traditional accounting records, each areas like journal entries, ledgers, and trial balance are not integrate to each other and the recording and movement of accounting transactions from one book to others 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, accountant or bookkeeper analyze and records the sales transaction into the journal entries and then this sales transactions will run automatically into ledger, trial balance, and then directly affect the financial statements.
Even though the accounting system make us ease to use and records the financial transaction, it is importance to have a good understanding about the accounting cycles that we can have the better understanding of how 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:
First step in accounting cycle is analyzing the business transactions and then records those transaction into journal entries. There are many business transactions occur in 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 discount during the next holiday is not the accounting transactions. And this should not records in the accounting system.
However, sales transactions that entity made every day are the financial transactions and need to records in the monetary term in the accounting system. The journal entries for these sales transaction should records 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 sales ledger and account receivable will need to transfer into account receivable ledger.
2) Transfer the journal transactions into ledger accounts
The second step of accounting cycle is transferring the journal transactions from general journal into the ledger accounts or general ledger.
The transfer will help accountant or bookkeeper to get the total balance of each types of account. For example, all the sales journal that records in the general journal are transfer into sales ledgers.
These sales transactions will records in the credit side of the sales ledgers and when accountant balancing this ledger, he will get the total amount of sales during the period.
Sales as sales journal, others 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 ledgers accounts, debit and credit role will have to be follow. For example, assets are increasing in the debit side while liabilities and equities are increase in the credit side. The decrease of these accounts are moved in difference direction.
Revenues and expenses accounts are increase and decrease in the difference direction. Revenues increase in the credit side while expenses are increase in debit side like assets.
All of the sub-accounts of these financial statements element are increase or decrease in respect to the main element. For example, non-current assets and current assets are increase in the debit side and decrease in the credit side.
3) Preparing unadjusted trial balance:
Unadjusted trial balance are preparing after accountant close all the ledgers accounts at the end of the financial period. For example, the entity financial period end at 31 December. Accountant will closed the account ledger by 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 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 statements and the reason that we prepare this statement is because we want to check whether the debit and credit role are properly apply during journal and ledger accounts.
This statement also help to assess the mathematical correctness of financial statements. If Trial balance is not reconciled or the debit side and credit is not equal, the financial statements especially balance sheet is not equal.
When moving the ledger account into trial balance, assets account need to punt in the top of trial balance follow by liabilities and equity. Revenues and expenses are records all the way down by follow 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 are come from many reasons some of those are because of under or over recognition, wrong classification, or sometime because of audit adjustments.
Once the list of adjusting transactions are approve by the authorized person, then all of those adjustment need to process in the account ledgers and reflect to trial balance.
Sometime adjustments are book directly into account ledgers and then update into trial balance. And sometime, the adjustments book both in account ledgers and then also book in trial balance.
5) Preparing adjusted trial balance:
Once all the adjusting entries are made to trial balance and account ledgers, the fifth step of accounting cycle is preparing the adjusted trial balance. This statements should be done before drafting the financial statements.
Most of the cases, accountant or auditors use the trial balance to draft financial statements. This is because the process of drafting the financial statements take after accountant confirm trial balance is reconcile.
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 the importance step of 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, accountant need to prepare the financial statements.
The four main types of financial statements along with the noted to the statements are prepared using the information from 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 the temporary account at the end of accounting period, accountant need to close that account so that accountant can open the account for the next period.
The temporary accounts need to close and transfer to its permanence account. This is normally done for the manual accounting records.
8) Preparing post-closing trial balance:
In the last step of accounting cycle, accountant require to perform the post-closing trial balance. This statement is prepared after accountant make all necessary adjustment to general ledger and the adjusted trial balance, and all the suspend accounts are close.
The main purpose of preparing this post-closing trial balance is to ensure that all accounts are balance and ready for recording next period financial transactions.