A beginner’s guide to the accounting cycle
- 27 Dec 2021
- 3 minutes read
The accounting cycle is the process of identifying, analysing and recording financial transactions. Robust processes and controls surrounding the accounting process are responsible for effective financial operation management.
Why is the accounting cycle important?
An accounting cycle is essential for a business because it provides the following benefits:
- Accuracy of financial records
Under the accounting cycle, all the business's financial transactions are recorded in the books of accounts. It ensures the accuracy of the financial records.
- Provide financial information to users
The accounting cycle provides financial information to both internal users (like the employees and the management) and the business's external users (like the government, investors, creditors).
- Better decision-making
The accounting cycle helps generate the business's financial statements, which indicates its financial health. The management can analyse this information to make better decisions in the future.
The accounting cycle allows the business to verify whether its records are compliant with the relevant government laws and regulations or not.
- Analysis of a business's performance
Analysing the financial reports of a business allows the management to formulate strategies for the better working of the business.
- Improve efficiency
The record of the business financial activities helps the management determine the business's profitability and improve its efficiency.
What are the steps involved in the accounting cycle?
The entire process of the accounting cycle involves the following 7 steps:
1. Identifying the transactions
An accounting transaction is a business activity with a monetary impact. It is essential to identify the business transactions to record in the business books.
A few examples of financial transactions in a business are:-
The cost incurred on new equipment
- Payment made to suppliers
- Income received from a client
- Returns from customers
- Purchase of fixed assets
- Payment of wages to employees
- Funds borrowed from a lender
- Investment in business
2. Recording transactions in a journal
After identifying the financial transactions, the next step is to record those transactions chronologically. The business maintains a detailed record of the transactions (including the amount, date and description) in the journal.
This helps to organise and classify the transactions into different accounts in the general ledger.
3. Recording in the general ledger
The general ledger lists all the accounting transactions broken down by account. A general ledger consolidates all the journal entries of a similar account in one place. For example, salaries to all employees are recorded as Salaries.
Under the double-entry bookkeeping system, mistakes are minimal since all the journal entries are recorded into two concerned accounts in the ledger.
4. Preparing an unadjusted trial balance
The balances of all the accounts in the general ledger are transferred to a trial balance.
- It is essential to prepare a trial balance because:
- It helps to verify whether the amount on the debit and credit sides are the same.
- It helps to spot errors in journalising and posting.
- It enables the management by listing all the accounts at a single spot.
- It helps to prepare the financial statements of the business.
If the debits and credits are not equal, there is some error, and the trial balance is unadjusted. Before proceeding, fix such errors.
5. Preparing an adjusted trial balance
To prepare an adjusted trial balance, the bookkeeper needs to find the error in the business's subsidiary ledgers. If there are any discrepancies, it is vital to make a few adjusting entries to cover them.
Some non-cash items require adjustments, like depreciation and amortisation of assets.
6. Preparing financial statements
With the help of the adjusted trial balance, the accountant can prepare the financial statements for the business.
Most businesses prepare three financial statements:
- Profit and loss statement
A profit and loss statement or an income statement helps determine the profit or loss in a given period.
- Balance sheet
A balance sheet represents all the assets and liabilities that a business has.
- Cash flow statement
The cash flow statement provides an overview of the business's cash inflows and cash outflows.
The companies prepare financial statements because:
- The financial statements act as a decision-making tool for the management.
- Investors tend to look at a business's financial information before investing.
- Financial statements help to check the compliance of the business records and calculate the tax that the business has to pay.
- Financial statements help determine the business's financial position and allow the management to improve it.
- Laws and local government bodies require these.
7. Closing of accounts
On specific closing date, a business closes its books and ends the accounting period—the closing statements help analyse its performance.
After closing, the business can start the new accounting cycle again.
While there are seven basic steps in the accounting cycle, each business can modify these steps as per their own needs and requirements.
Many businesses prefer to use accounting software to automate the accounting cycle. While accounting software can work efficiently and accurately, it is still essential to get the right expertise.