What is Accounting Cycle?
Accounting cycle is a traditional concept. But if you understand the accounting cycle completely, you will be able to make prudent decisions. But what is the accounting cycle?
Accounting cycle is a combination of collecting data for creating post-closing trial balance. An accounting cycle starts with a transaction and ends when the books of accounts get closed.
Here are the 9 steps of the accounting cycle –
- Collection of data and analysis of transactions
- Recording the journals into the ledger accounts
- Creating unadjusted trial balance
- Performing adjusting entries
- Creating adjusted trial balance
- Creating financial statements from the trial balance
- Closing the books
- Creating the post-closing trial balance
Diagram of Accounting Cycle
So above we saw the 9 steps of the accounting cycle, Below is the Diagram of Accounting cycle with an explanation –
9 Steps of the Accounting Cycle
Now let’s explain the 9 steps of the accounting cycle briefly.
Step: 1 – Collection of data and analysis of transactions
- At this juncture, the accounting cycle begins. In this first step of accounting cycle, the accountant of the company collects the data and analyze the transactions.
- For a smoothly running business, there would be many, many transactions. The accountant needs to look at each transaction, find out why it occurred, put it under the right accounts, and then analyze it.
- This step is the most critical of all because this kick-starts the process of accounting.
Step: 2 – Journalizing
- After collecting and analyzing the transactions, it’s time to record the entries into the first books of accounts.
- In this step of the accounting cycle, each transaction is transferred to the general journal and under each entry, a narration is written to mention the reason behind debiting or crediting one account.
- Recording the entries in the journal is important since if there is any error at this stage of recording, it will linger on in the next books of accounts as well.
Step: 3 – Recording the journals into the ledger accounts
- Accounting is a series of steps taken one by one.
- After journalizing all the transactions, it’s time for the accountant to record the entries into the secondary books of accounts.
- That means if there are cash and capital, there will be two ‘t-tables’ in the general ledger and then the balances of respective accounts will be transferred.
- General ledgers allow the accountant to get the closing balance for preparing the trial balance in the next step of the accounting cycle.
Step: 4 – Creating an unadjusted trial balance
- As you know that trial balance is the source of all the financial statements. That’s why special attention should be given to the trial balance.
- From the closing balances of the general ledger accounts, an unadjusted trial balance is prepared.
- In this trial balance, the debit balances will be recorded on the debit side and the credit balances will be recorded on the credit side.
- Then the debit side is totaled and the credit side is also totaled.
- And then the accountant will see whether both the side have similar balances or not.
Step: 5 – Performing adjusting entries
- At this juncture, the unadjusted trial balance is already prepared.
- In this step of the accounting cycle, the adjusting entries are prepared.
- The adjusting entries are typically related to accrual adjustments, periodical depreciation adjustments or amortization adjustments.
- Without performing these adjusting entries, no adjusted trial balance would be prepared.
Step: 6 – Creating adjusted trial balance
- After passing the adjusting entries, it’s time to create a fresh trial balance.
- This trial balance is called adjusted trial balance since it is prepared after the adjustment entries are passed and as a result, this trial balance can be used to prepare the most important financial statements.
Step: 7 – Creating financial statements from the trial balance
This step of accounting cycle is the most critical part of the accounting cycle. As an investor, you must know how all the financial statements are coming from. From the adjusted trial balance, all the financial statements are born. There are four most important financial statements that are prepared using the adjusted trial balance.
- Income statement: The first financial statement that every investor should look at is the income statement. In the income statement, the first item is sales and the cost of sales and other operating expenses are deducted from the sales to ascertain the operating profit. From the operating profit, other expenses are deducted to compute the net profit of the year.
- Balance Sheet: The next financial statement on the list is the balance sheet. In the balance sheet, we record the assets and the liabilities. And we see whether the balance of assets is in harmony with the balance of liabilities.
- Shareholders’ Equity Statement: This is the next financial statement that would be prepared. Here along with share capital, the retained earnings would be taken into account. Retained earnings are the percentage of profit that has been reinvested into the company.
- Cash flow Statement: Finally, the cash flow statement would be prepared. In cash flow statement, the accountant needs to find out cash flow from three kinds of activities – operating activities, financial activities, and investing activities. The cash flow operating activities can be prepared in two ways – the direct and indirect cash flow from operations.
Step: 8 – Closing the books
- This step is the penultimate step in the accounting cycle.
- Closing the books means that all financial statements are prepared and all transactions have been recorded, analyzed, summarised, and recorded.
- After closing the books, a new accounting period would start and the accountant would need to start repeating the above steps of the accounting cycle once again.
- However, before that, there are other steps of the accounting cycle.
Step: 9 – Creating a post-closing trial balance
- To ensure that the accounting transactions are properly recorded, analyzed, and summarized, a post-closing trial balance is prepared.
- Here all the accounts are taken into account and then the closing balances are recorded as per their respective position.
- Then the credit side and the debit side are being matched to see whether everything is in the right order or not.
If an investor can understand these 9 steps of the accounting cycle, it would be clear to her how she should approach the company and its progress or decline. The knowledge of the accounting cycle will help her decide whether she should invest in the company or not. And at the same time, she would get a concrete idea about the financial accounting of the company.
Accounting Cycle Video
This has been a guide to Accounting cycles. Here we discuss steps in accounting cycle with diagram – Collection of Data, Journalizing, Ledger, Accounts, Unadjusted Trial Balance, Performing Adjusting Entries, Adjusted Trial Balance, Creating Financial Statements, Closing the Books and Post-closing Trial Balance. You may learn more about basic accounting here –
- 5 Examples of Accounting Transactions
- Examples of SG&A Expenses
- What is the Accounting Equation Formula?
- Operating Expenses under SG&A | Top 13 List
- Examples of T Accounts
- General Journal and General Ledger
- Definition of Financial Accounting
- What is Share Capital?
- Key Differences Bookkeeper vs Accountant
- Accounting Equation Formula
- Journal vs Ledger
- Double Entry Accounting System