Accounting cycle explained

Accounting cycle is a comprehensive process of accounting starting from identifying and recording the financial transactions and ending at preparation of financial statements and closure of books of account of an entity for an accounting period. Accounting cycle generally includes the following steps:

  1. Recording financial transactions through journal entries
  2. Posting journal entries to relevant ledger accounts
  3. Preparing an unadjusted trial balance
  4. Determining and recording adjusting entries
  5. Preparing adjusted trial balance
  6. Preparing financial statements
  7. Closing books of account for an accounting period

Let’s briefly go through each step of accounting cycle.

Recording financial transactions through journal entries

This is the first step of accounting cycle which involves identification, understanding, evaluation and recording of financial transactions through journal entries. Some business transactions are simple, but some are complex and require greater attention to understand them. This is particularly important as only after completely understanding the  business transactions, relevant ledger accounts are identified, and journal entries are recorded. Usually at the time of recording the journal entries, accountants also get some supporting documents such as invoices, agreements and other source documents and maintain this record for transparency and internal control purposes.

Posting journal entries to relevant ledger accounts

After recording journal entries in the general ledger, these entries are posted into relevant ledger accounts or T-accounts. Rules of debits and credits are followed while recording journal entries and posting them into relevant ledger accounts.

Preparing an unadjusted trial balance

The first two steps of accounting cycle are done on daily basis as and when financial transactions occur. However, the next steps of accounting cycle are related to preparation of financial statements. According to relevant needs and requirements of each entity, periodical reporting is done such as monthly reporting, quarterly reporting, semi-annual reporting and annual reporting. Unadjusted trial balance is a summary report of all the accounts in which journal entries are posted and contains the balances of these accounts.

Determining and recording adjusting entries

After preparing the unadjusted trial balance, it is evaluated and adjusting entries are identified which are usually required at the end of each accounting period as per accrual method of accounting. These adjusting entries are recorded through journal entries and posted in relevant ledger accounts.

Preparing adjusted trial balance

After posting adjusting entries, trial balance is prepared again which is called adjusted trial balance. This adjusted trial balance forms the basis of financial statements.

Preparing financial statements

Accounts of adjusted trial balance are sorted out and linked (grouped) to each financial statement line item. After grouping of accounts, financial statements are prepared which include balance sheet, income statement, statement of cash flows, statement of changes in equity and notes to the financial statements.

Closing books of account

Last step of accounting cycle is the closure of books of account for an accounting period. By posting closing entries, all temporary accounts (mainly income statement accounts) are closed and the net balance is transferred to an equity account known as retained earnings or accumulated loss account. Purpose of this exercise of closing the books of account is to prepare for the next accounting period. A post-closing trial balance is prepared in which all the income statement accounts have zero balances whereas the balances of balance sheet accounts are deemed as opening balances of next accounting period.

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Accounting cycle and modern-day accounting

As the information technology has evolved over the years, it has left its footprints in the field of accounting as well. Previously when all the accounting was done manually, all the steps of the accounting cycle were required to be done by accountants. However, businesses all around the world have started using various accounting software programs, which has contributed a lot in terms of reducing the human effort and increasing the accuracy and efficiency of financial reporting. Now a days, accountants record journal entries in accounting system mentioning relevant accounts that need to be debited or credited. The accounting software does the rest. Journal entries are posted in relevant accounts and system generated trial balance and financial statements can be extracted by just one click. Most of the systems post the closing entries as well and post-closing trial balance can be extracted by just one click. Isn’t it great! 😊