4. The Accounting Cycle: An Overview
The accounting cycle is a series of steps that companies follow to record, process, and report financial transactions over a specific period. This process ensures that a company’s financial statements are accurate, complete, and in compliance with accounting standards. The cycle repeats regularly, often monthly or quarterly, as companies continue to carry out their business activities.
The primary goal of the accounting cycle is to ensure that all financial information is captured, classified, and reported correctly. While this process may vary slightly based on the company or industry, it generally follows the same basic steps. Let's break it down to understand each stage of the cycle in detail.
The first step in the accounting cycle is to identify all financial transactions that occur during the period. This includes any event or activity that affects the company’s financial position. A transaction might involve the exchange of goods, services, or money, such as a sale, purchase, or loan.
For example, if a company sells a product for $1,000, this is a financial transaction that will be recorded in the accounting system. Transactions may also include payroll expenses, inventory purchases, or even the depreciation of an asset.
Once the transactions are identified, they need to be recorded in the company's accounting system. This is done through journal entries, which are the written records of each financial transaction.
Each transaction must be recorded in a manner that reflects the dual-entry system of accounting. In this system, every transaction has two parts: a debit and a credit. For example, when a company sells goods for cash, it records the sale by debiting the Cash account and crediting the Sales Revenue account.
After recording the journal entries, the next step is to post them to the general ledger. The general ledger is a complete record of all the company’s accounts, which are organized by account type (such as assets, liabilities, revenues, and expenses).
Each account in the general ledger reflects the transactions that have affected that specific category. For example, the sale of goods would be posted to the Sales Revenue account and the Cash account in the ledger.
Posting journal entries to the general ledger ensures that the company has an up-to-date and accurate record of all its financial activity.
After posting all transactions to the general ledger, the next step is to create an unadjusted trial balance. This is a report that lists all the accounts and their balances from the general ledger. The purpose of the trial balance is to ensure that the total debits equal the total credits, indicating that the accounting records are balanced.
If the debits do not equal the credits, it means there has been an error in the recording or posting of transactions. This could be due to a mistake in the journal entry, posting, or calculation. Identifying and correcting these errors is essential to the integrity of the financial statements.
At the end of the accounting period, companies need to make adjustments to their financial records to ensure that the revenues and expenses are recorded in the correct period. This process is known as adjusting entries.
Adjusting entries are necessary for transactions that have not been recorded or have been recorded incorrectly. For example, a company may need to adjust for accrued expenses, prepaid expenses, or depreciation of assets. These adjustments are made before preparing the adjusted trial balance and the financial statements.
Once all the necessary adjusting entries have been made, an adjusted trial balance is prepared. This trial balance includes the updated balances from the adjusted journal entries. The adjusted trial balance is important because it provides the final balances that will be used to create the company’s financial statements.
After completing the adjusted trial balance, the next step is to prepare the company’s financial statements. The three main financial statements are:
Income Statement – Shows the company’s revenues and expenses over a specific period, and calculates the net income or loss.
Balance Sheet – Displays the company’s assets, liabilities, and equity at a given point in time.
Cash Flow Statement – Reports the inflow and outflow of cash, showing how cash is being used in the business.
These statements provide a summary of the company’s financial performance and position, which is used by investors, creditors, and management to make informed decisions.
After preparing the financial statements, the next step is to close the accounts. Closing involves transferring the balances from temporary accounts (such as revenues and expenses) to permanent accounts (such as retained earnings or owner’s equity).
This process resets the temporary accounts to zero for the next accounting period. For example, the balances from the revenue and expense accounts are transferred to the Retained Earnings account, which reflects the company's accumulated profits.
Once the accounts are closed, a post-closing trial balance is prepared to ensure that the books are balanced after the closing entries. This trial balance only includes permanent accounts, as the temporary accounts have been closed. The purpose of this step is to verify that the financial records are ready for the next accounting period.
In some cases, companies choose to make reversing entries at the beginning of the next accounting period. These entries reverse certain adjusting entries made in the previous period. Reversing entries are optional, but they can help streamline the accounting process by eliminating the need for duplicate adjustments in the new period.
The accounting cycle is a crucial process for ensuring that a company’s financial records are accurate, complete, and in compliance with accounting standards. By following these steps — from identifying transactions to preparing financial statements and closing the accounts — businesses can maintain accurate financial reporting, which is essential for making sound business decisions, attracting investors, and ensuring compliance with regulatory requirements. The accounting cycle helps ensure that all financial information is properly documented and presented in a way that provides stakeholders with a clear understanding of the company’s financial health.