What is the Accounting Cycle?
Accounting Cycle is a process of identifying, collecting and summarizing financial transactions of the business with the objective of generating useful information in the form of three financial statements namely Income Statement, Balance Sheet and Cash Flows. It starts with an accounting transaction and ends when the books of accounts get closed.
Here are the nine 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
Below is the Diagram of Accounting cycle with an explanation –
9 Steps of the Accounting Cycle
Step 1 – Collection of data and analysis of transactions:
- In this first step of the accounting cycle, the accountant of the company collects the data and analyzes 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, each transaction transfers to the general journal. Under each entry, a narration written mentions the reason behind debiting or crediting one account.
- Recording the entries in the journal is essential 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 trial balance gets special attention.
- Closing balances of the general ledger accounts prepare an unadjusted trial balance.
- In this trial balance the debit side records the debit balances, and the credit side records the credit balances.
- 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 ready.
- In this step, the adjusting entries are prepared.
- The adjusting entries are typically related to accrual adjustments, periodical depreciation adjustments, or amortization adjustments.
- These adjusting entries are required to prepare an adjusted trial balance.
Step 6 – Creating adjusted trial balance:
- After passing the adjusting entries, it’s time to create a new trial balance.
- This trial balance is called adjusted trial balance since it is prepared after passing the adjustment entries. This trial balance prepares many critical financial statements.
Step 7 – Creating financial statements from the trial balance:
This step of the accounting cycle is the most critical part. As an investor, you must know how and from where all the financial statements are coming. From the adjusted trial balance, all the financial statements are born. Adjusted trial balance prepares four important financial statements:
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- 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. Other expenses when deducted from the operating profit, it computes 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 liabilities. And we see whether the balance of assets is in harmony with the balance of liabilities.
- Shareholder’s Equity Statement: This is the next financial statement that is prepared. In this share capital and the retained earnings are taken into account. Retained Earnings are percentage of profit reinvested into the company .
- Cash flow Statement: Finally, the cash flow statement is prepared. In the cash flow statement, the accountant needs to find out cash flow from three kinds of activities – operating activities, financial activities, and investing activities. Two ways of preparing cash flow operating activities are – 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 once again.
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 nine 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 this 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 article has been a guide to Accounting cycles and its definition. Here we discuss the top 9 steps in the 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 –