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What’s it: Accounting cycle refers to the set of processes for identifying, analyzing, and recording accounting events. The cycle starts with identifying transactions and ends with entering these transactions in the financial statements. During the cycle, the accountant will use some additional accounting records such as ledgers and trial balances.
Why is the accounting cycle important
The accounting cycle matters to ensure that the procedures in financial reporting are running correctly. It is important to produce accurate financial reports and following applicable accounting standards.
Nowadays, computers speed up the cycle. Most software enables the complete automation of the accounting cycle. They require less human effort. Also, the use of software reduces errors associated with manual processing.
The complete accounting cycle begins and ends during the accounting period in which financial statements are prepared. Generally, the accounting period is either annually or quarterly, although this can vary between companies and countries.
At the end of the year, companies prepare financial reports. For public companies, they have to submit financial statements by a specific date. Thus, one cycle begins and ends between the reporting dates.
Differences in the accounting cycle and budget cycle
We should differentiate the accounting cycle from the budget cycle. The accounting cycle focuses on historical events. It ensures that previous financial transactions are appropriately reported. The main output is financial reports.
Meanwhile, the budget cycle relates to future plans related to performance targets and planning transactions in the future. The accounting cycle is a summary of the company’s financial evaluation. But, the budget cycle is for planning what the company would do in the future.
Furthermore, the accounting cycle produces information in the form of financial statements for external users. Meanwhile, the budget cycle produces an annual budget and is primarily for internal management purposes.
Stages in the accounting cycle
An accounting cycle begins with recording each transaction and ends with a comprehensive report on the business’s financial activities. In general, the accounting cycle is divided into the following stages:
- Identify transactions
- Analyze transactions
- Record transactions in a journal
- Post to the ledger
- Prepare a trial balance
- Prepare an adjusting entry
- Prepare an adjusted trial balance
- Preparing financial statements
- Prepare a closing journal
Identify transactions
The cycle begins by recording transactions using journal entries. Accountants have to sort out various financial transactions in business. Not all transactions must be recorded. So they have to sort out what should be entered and what is not.
They will only record transactions that result in a change in financial position. Another critical point is that these transactions can be valued in monetary units objectively and are evidence.
Proof of transactions is related to changes in the company’s financial condition. It can be in the form of receipt of invoices, cash-out receipts, receivables write-off memo, sales acknowledgment, and so on. The evidence must be valid and verifiable.
Analyze transactions
This stage requires the accountant to determine the effect of the transaction on financial position. Due to the double-entry system, each transaction affects at least two accounts.
Each transaction has a debit and credit and is at an equal amount. Thus, the financial position will always be balanced and following the accounting equation.
Assets = Liabilities + Equity
For example, suppose a company gets an injection of funds from shareholders of $200. From this transaction, the accountant will record cash amounting to $200. At the same time, he will record equity at the same amount.
One more example. A company received an order for $500 and has shipped it all to the customer. Of the total value, the customer pays $400 and will pay the rest next year.
The accountant will record $500 as revenue (the equity component through retained earnings). Then, in the assets section, he records trade receivables of $100 and cash of $400.
Record transactions in a journal
From the results of the analysis, the accountant then records all transactions in a journal coherently. In the journal, we can find various transactions that occurred during an accounting period. Accountants keep these records chronologically.
When entering a journal, the accountant will divide each transaction into two parts, debit and credit. They must ensure that all previously identified transactions are entered into the journal.
Post to the ledger
After recording transactions in the journal, the accountant then carries all transactions to the ledger, consisting of a collection of accounting accounts.
The ledger contains details of all transactions according to the accounts in the report. That way, the accountant or general ledger can track every transaction for each account.
Prepare a trial balance
In this step, the accountant moves the ledger’s balances into a trial balance to be put together. The trial balance ensures that total debits are equal to total credits in the financial records. When total debits and total credits are unequal, the accountant should look for the problem before compiling the report.
Prepare an adjusting entry
In this journal, accountants note several things. For example, when they find that some transactions have not been entered, they will record them in an adjusting entry. When they find wrong transactions and need adjustments, they also record it in this journal.
Accountants do it periodically, and the process is the same as the previous process. After that, the accountant then books it into a ledger.
Prepare an adjusted trial balance
After adjusting the ledger with the entries in the adjusting journal, the accountant then moves the accounts into the new trial balance. They then group the accounts according to their category in the financial statement component.
Preparing financial statements
The accountant then compiles the financial report’s main parts from the adjusted trial balance information, starting from the income statement, retained income statement, balance sheet, and cash flow statement.
Accountants will include income and expense accounts in the income statement. Meanwhile, they enter the accounts into the sub-categories of assets, liabilities, and shareholder equity for the balance sheet.
Compile a closing journal
The cycle ends by compiling a closing journal. Its purpose is to delete all temporary accounts and transfer the balance to the permanent account. Thus, when starting the next accounting cycle, it starts with zero balances for all temporary accounts.
Closing entries are only for income, expense, and dividend accounts, not assets and liabilities.
