What is accounting cycle?

An accounting cycle is a multiple-step process that analyzes, verify, record and summarize the entities financial data. The accounting cycle starts when the transaction occurs between two parties and ends when the transaction is completed. The accounting cycle changes the entity's financial position as it involves identifying, verifying, and recording the financial transaction in chronological order. Financial position is the summary of business transactions that occurred throughout the particular accounting period. The accounting cycle recurs at the beginning of each financial year.

What are the steps in accounting cycle?

There are eight steps in the accounting cycle.

Step:1 Financial transaction occurs

As we learned above accounting cycle occurs when financial activity happens. When the financial transaction occurs, it will influence the entity's financial position; other transactions will not be recognized as financial transactions. Documents for financial transactions act as source documents for the entire accounting cycle.

Example for the financial transaction: A company purchased machinery for $250,000.

Examples for the non-financial transaction: A company recruits three new employees in the sales department, dividend declaration-in this case, dividend not paid at the time of declaration.

Step:2 Journal entry for the transaction

After the transaction occurs, the immediate process in the accounting cycle is to record general journal entries for business transactions. Journal entries are recorded by following the single entry system and double-entry system.

Cashbook is prepared using a single entry system, where the cash account is debited for cash inflow, and a cash account is credited for cash outflow. In a single entry system, transactions are recorded one-sided. Only one account gets debits or credits. A single entry system is used where entities manually record transactions.

General journal entries influence two general ledger accounts where one account is debited, and the other is credited. This process is called double-entry bookkeeping. Under the double-entry system, all assets& expenses are debited, and all liabilities& incomes are credited. Journalizing the transaction requires analyzes of data, that what should be debited, and what needs to be credited.

Example: $3,000 received from customers for their services. Here, cash is an asset to be debited, and service revenue is income; it will be credited.

Step:3 Post the entries to the Ledger

After journalizing entry, the accounting items are posted to the respective general ledgers based on their dates. These steps allow the entity to monitor the entire financial activity. Also, entities can trace the transactions that happened in a specific account with the help of ledger accounts. The chart of accounts may differ from business transactions to business transactions. Usual general ledgers include cash, purchase, equipment, service revenue, rent, salaries, and wages.

Step:4 Unadjusted trial balance

This is the record of all the general ledger heads, along with their closing balances. Normally unadjusted trial balance is developed at the end of the reporting period. The purpose of an unadjusted Trial balance is to check the possible errors and to double-check whether debit and credit columns are tally. After summarizing all the ledgers and their balances, an entity should not assume that the trial balance is error-free. Even if debit and credit columns are equal, there could still be a possible inaccuracy. For example, if the transaction is entirely omitted from the books of accounts or transactions posted in the general ledger twice. Simple steps to prepare unadjusted trial balance: summarize the accounts heads and their closing balances, find the total balances of all debit and credit ledgers, and check whether debit and credit columns match.

Step:5 Adjusting entries

After finishing the unadjusted trial balance and corrections, further action is to prepare to adjust journal entries. Adjusting journal entries is used to record unrecognized income or loss. These entries will be made at the end of the accounting period. The reason for adjusting entries is to make financial statements up to date and ensure that financial statements contain relevant information. An entity can prepare a worksheet regarding these adjusting entries. Adjusting journal entries includes provisions, accruals, and deferrals.

Provisions in accounting mean an amount set aside to cover probable future expenses. For example, income tax provision should be created in accounts to cover income tax expenses due after the end of the reporting period.

Accruals in accounting terms are income and expenditures which do not require instant cash flow. An example of accrued expense is a salary expense which is accrued at the end of every month, but the real payment may be made after the accruing date.

Deferrals are cash received or spent before getting into any service or sales. They include prepaid expenses and unearned revenue. Examples are prepaid insurance and newspaper membership.

Step:6 Prepare an adjusted trial balance

An adjusted trial balance is a record that catalogs all the ledger balances obtainable after passing adjusting journal entries. Once the unadjusted trial balance is adjusted, adjusted closing entries need to add up in the trial balance. Then it will become a fully adjusted trial balance.

Step:7 Creation of financial Statements

Financial statements represent the financial condition of the company. The adjusted trial balance entity can be straightly entered into financial statements. There are four main financial statements that the entity must prepare.

Income statements: It includes all revenue and expenses that occurred during the financial year. The purpose is to identify the net profit/(loss) of the entity during the particular accounting period.

Owner’s equity statements: It comprises owner’s equity accounts, investments, drawings, and net income/ (Loss) of the business/profession. The goal is to show how the owners have made much financial contribution to the entity and changes in the owner’s capital investment.

Balance sheet: It displays all assets and liabilities of the entity at the end of the reporting period. It will show whether the entity has liquidity and financial ability to meet the financial requirements of the entity. In the balance sheet, assets are grouped into fixed assets, long-term loans & advances, and current assets. Liabilities are grouped into owner’s equity capital, reserves & surplus, long-term liabilities, and current liabilities.

Statement of cash flow: It presents the entity’s cash inflows and cash outflows under three heads. These are operating activities, investing activities, and financial activities. The cash flow statement reflects actual cash inflows and cash outflows. Expenses which does not have real cash flows are added back to the net profit of the entity. An example of such expense is depreciation.

Step:8 Closing the books

This is the final step of the accounting cycle. It is an accounting approach that takes place at the end of the reporting period. The purpose of closing the books at the end of the reporting period is to enable the entities to prepare final accounts that convey the entity's prosperity. This process should be done by passing appropriate closing entries. Closing the books must have been finished by the entity for the new accounting period. All the T-accounts need to be closed and the balances transferred to appropriate balance sheet items through closing entries. While closing the books, the entity shall divide the accounts into two- temporary accounts and permanent accounts

Balance in income statement transferred to retained earnings account. Temporary accounts include all revenue and expense accounts. Balances in temporary accounts need to transfer to permanent accounts at the end-of-period. These accounts must have zero balance when the new accounting period begins.

Permanent accounts include all assets, liabilities, and owner’s equity accounts. The owner’s equity account should have the balance of revenue and expenses. Balances in these accounts should be carried to the next financial year as an opening balance. Balance sheet items are considered permanent accounts.

Significance of accounting cycle

• The accounting cycle helps the entity to maintain and record-keeping the books of accounts neat and in order.
• Help to analyze and evaluate the performance and financial condition of the entity.
• The accounting cycle allows the entity to comply with statutory obligations like income tax, GST, PF, ESI TDS, etc.
• It helps the stakeholders, investors, creditors, and customers to realize the entities' ability to repay their debts and investments.
• The accounting cycle helps the management in the decision-making process. Financial statements reflect an entity’s wealth and growth; based on that, management makes decisions for the future growth of the entity.

Context and Applications

This topic is significant in the professional exams for graduate courses and competitive exams, especially for bachelors in commerce, bachelors in business administration, and CA-entrance level.

Practice Problems

Question 1: Which one is not a financial statement?

a) Balance sheet

b) Income statement

c) Cash flow statement

d) Disclosures

Answer: Option d is correct.

Explanation: Disclosures are not financial statements. The four main financial statements are the balance sheet, cash flow statement, income statement, and owner’s equity statement.

Question 2: Which ledger account needs to be credited when cash sales happen?

a) Cash

b) Sales

c) Customer

d) None of the above

Answer: Option b is correct.

Explanation: When a sales transaction happens cash account gets debited and the sales account gets credited.

Question 3: The balance sheet contains the balances of which accounts?

a) Income

b) Expense

c) Assets and liabilities

d) All of the above

Answer: Option c is correct.

Explanation: The balance sheet shows all assets and liabilities balance.

Question 4: Which transaction is a non-financial transaction?

a) Sales occurred on 31 December

b) Salaries paid to employees

c) Dividend declared

d) An equipment purchased

Answer: Option c is correct.

Explanation: The dividend declaration does not involve any cash transaction. So it is a non-financial transaction as a dividend announced by the company at General Meeting.

Question 5: Trial balance is ______.

a) List of liabilities

b) List of assets

c) List of expenses

d) List of all ledger accounts

Answer: Option d is correct.

Explanation: Trial balance is the summary of all ledger accounts.