Accounting Cycle

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 –

  1. Collection of data and analysis of transactions
  2. Journalizing
  3. Recording the journals into the ledger accountsLedger AccountsLedger in Accounting, also called the Second Book of Entry, is a book that summarizes all the journal entries in the form of debits & credits to use for future reference & create financial statements. read more
  4. Creating unadjusted trial balance
  5. Performing adjusting entries
  6. Creating adjusted trial balanceCreating Adjusted Trial BalanceAdjusted Trial Balance is a statement which incorporates all the relevant adjustments. Although it is not a part of financial statements, the adjusted balances are carried forward in the different reports that form part of financial statements. read more
  7. Creating financial statements from the trial balance
  8. Closing the books
  9. Creating the post-closing trial balance

Diagram of Accounting Cycle

Below is the Diagram of Accounting cycle with an explanation –

Diagram of Accounting Cycle

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Source: Accounting Cycle (wallstreetmojo.com)

9 Steps of the Accounting Cycle

Below given are the steps for accounting cycle.

  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.

  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 journalGeneral JournalThe General Journal is a book of entry that holds the initial record of every transaction before being posted to the concerned accounts like Sales Journal, Purchase Journal, & Cash Journal etc. read more. 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.

  3. Recording the journals into the ledger accountsLedger AccountsLedger in Accounting, also called the Second Book of Entry, is a book that summarizes all the journal entries in the form of debits & credits to use for future reference & create financial statements. read more

    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.

  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.

  5. Performing adjusting entries

    At this juncture, the unadjusted trial balanceThe Unadjusted Trial BalanceAn unadjusted trial balance is the account balances reported directly from the general ledger without adjusting for the year-end journal entries. It acts as a starting point for analyzing account balances and adjusting entries.read more 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.

  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.

  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:
    Income statement: The first financial statement that every investor should look at is the income statementThe Income StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. 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 expensesOther ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more 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 sheetIn The Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, 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 capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side.read more and the retained earnings are taken into account. Retained EarningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more are percentage of profit reinvested into the company.
    Cash flow StatementFinally, 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 activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more are – the direct and indirect cash flow from operations.

  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 periodNew Accounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more would start, and the accountant would need to start repeating the above steps once again.

  9. Creating a post-closing trial balance

    To ensure that the accounting transactionsAccounting TransactionsAccounting Transactions are business activities which have a direct monetary effect on the finances of a Company. For example, Apple representing nearly $200 billion in cash & cash equivalents in its balance sheet is an accounting transaction. read more 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.

Conclusion

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 accountingFinancial AccountingFinancial accounting refers to bookkeeping, i.e., identifying, classifying, summarizing and recording all the financial transactions in the Income Statement, Balance Sheet and Cash Flow Statement. It even includes the analysis of these financial statements.read more 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 –

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  1. lonyia emmy says

    nice work