In Basha film, Superstar Rajini Kanth defined the life cycle in eight stages, here in the Accounting cycle also we have eight stages. It is the Book Keepers’ responsibility to know all the eight stages to complete the accounting cycle. Here comes a Start up’s Guide about Accounting Cycle.
The accounting cycle is the complete process of recording and processing all financial transactions of a company. The Process starts from the recording of individual transactions and ends on the preparation of financial statements and closing entries. Every Business should prepare its financial statements on a periodic basis, therefore this process is followed during each accounting period as long as the company remains in business.
There are eight important Stages to be tracked by the bookkeeper to get a full accounting cycle from start to finish. The process gets complete when it generates useful financial information in the form of financial statements including income statement, balance sheet, cash flow statement, and Profit & Loss Account. Many of these stages have been automated through accounting software and advanced automated technical coding. Even then knowing these stages manually becomes essential for small business accountants.
Whether the Accounting Cycle is needed?
Yes, Of Course.
- The accounting cycle is a process designed to make an accounting of business activities easier for business owners and accountants.
- This Accounting cycle concept makes sure that all the money entered into your business is accounted for properly or not.
- The Correct order of following the accounting cycle guarantees that the financial statements your company provides are consistent, accurate, and conform to official accounting standards.
- The closing of the accounting cycle keeps business owners with full financial performance reporting that helps to analyze the business.
Let’s have an overview of those eight Stages of the accounting cycle.
Being an owner or an accountant, it is very important to know and understand the concept & the process involved in the accounting cycle clearly before starting a finalization work.
The Sequence of Accounting cycle is as follows
1. Identifying Business transactions.
The Accounting process starts with identifying and analyzing the business transactions and events whether to be accounted for or not. Only those transactions which are pertaining to business need to be accounted for. The owner’s personal transaction does not have anything to do with the business entity to account for it.
The first stage includes the preparation of business documents, or sources documents. A business document serves as a basis for recording a transaction.
Here comes a question of what are the sources documents that can be considered for accounting?
A document which provides an evidence/proof of a transaction is called the source document
- Cash Memo
- Pay-in Slip & so on.
Companies will have many transactions during the accounting cycle. Each one needs to be properly identified which takes to the Next Stage of recording in the books of the accounts.
2. Recording of Business Transactions:
With the documents & transactions set in the process, the next essential and vital Stage of the accounting cycle is recording the business transaction. The Accountant has to record the business transactions in the books of accounts. This Stage of recording is done through Journal entries and it is also known as Journal Books
Journal can be recorded in paper or through electronic device usually through a double-entry bookkeeping system that contains at least two accounts (One account is debit & another account is credit) along with a brief message of the transaction called narration.
Debits denote the money spent and credits denote the money that is received. Finally, the debits and credits of the transaction must have a matching balance.
All the transactions are recorded in chronological order in a journal.
3. Ledger Posting
This Stage involves posting the recorded business transactions in journal books to individual ledger accounts. The ledger account provides a breakup of all the business activities by account. This helps the accountant to monitor the financial positions and status of that particular account / Ledger.
For Example, in preparing any ledger account, it contains the summary of opening balances; all debit transactions, credit transactions, and finally the closing balance. This is known as the General ledger Statement. This is the Master document of bookkeeping setup which depicts the fastest way of checking the ledger balance.
Posting of the ledger is done on a continuous basis whenever the business transactions occur; this makes the books of accounts up to date.
4. To prepare an unadjusted trial balance
Next comes the preparation of Trial Balance, this is the primary source for preparing the final accounts and all other financial statements. In this Stage, the accountant must list all ledger accounts with closing balances posted from individual ledger accounts statements.
The format of the trial balance contains the Debit column and Credit column in which the closing balance of each ledger accounts will be posted. After posting the closing balance of all the ledger accounts, the debit balance should match with the credit balance.
This report is prepared to check the debits and credits of the ledger account and not to determine the correctness of accounting records. Normally, this report won’t match; errors will be discovered, rectify those errors correction entries to be posted to reverse their effect. This will be discussed in our next Stage.
5. Adjusting Entries
The Next Stage in the accounting cycle is to record adjusting entries. Adjusting entries are the journal entries that are made at the end of the accounting period. This is done in order to correct the errors found in trial balance before preparing the financial statements which result in updated accounts.
These adjustment entries are prepared on applying the accrual basis of accounting, which means the recording only the entries which are occurred for that financial year alone.
There are 4 types of making adjusting entries
- Deferral entries – Money which is received in advance from a client for which sales/service is not done so far. Money spent on some expenses resulting in future revenue
- Accrual entries – Salary needs to be paid for employees, the rent which we owe to landlord & haven’t paid still now. Service already provided but not billed so far.
- Tax Adjustment entries – Entries like depreciation, Tax deductions entries to be accounted
- Missing transaction entries – helps to accounts for the business transactions which might have been done through personal accounts or other accounts where we might have forgotten to account it at the time of bookkeeping.
6. To prepare the adjusted trial balance
This is the last Stage before preparing the financial statements of the company. After passing all adjusting entries, it’s time to create another trial balance; this new statement is called as Adjusted Trial Balance.
Adjusted Trial Balance is a statement listing all the closing balances of all ledger accounts with necessary adjustment entries incurred only for that particular period of books of accounts.
The purpose of creating this adjusted trial balance confirms the matching of debit and credit balance of all ledger accounts after adjustments.
There are 2 ways to prepare the adjusted trial balance.
1. Simply add the adjustment entries alone to the unadjusted trial balance prepared already
2. To prepare a new trial balance with all ledger accounts along with adjusting entries to form a new adjusted trial balance.
Once the adjusted trial balance is prepared, it’s time to start preparing the company’s financial statement which can be discussed in our next Stage
7. Prepare Financial Statements
This is the most important & most critical Stage of the accounting cycle. From an adjusted trial balance all the financial statements are prepared. This financial statement will be the end process of this accounting system. This statement acts as a basic and formal annual report which can be submitted to the investors and stakeholders. This includes owners, management members, employees, investors, creditors, tax authorities, etc
This financial statement helps to take financial decision based on the organizations
- Financial position
- Operating Performance
- Financial Status
Preparation financial statements include:
Income Statement – The first & very important statement that every investor will see. Sales & Cost of sales is depicted in this statement to know the turnover of the business. To ascertain the gross profit the operating expenses are deducted from the sales & from that to arrive at the Net profit of the year other expenses are deducted.
Balance Sheet – we record the assets and liabilities. And we see whether the balance of assets is in harmony with the balance of liabilities. It helps the external stakeholders to evaluate the financial performance of the business on a given date.
Cash flow Statement– This financial statement provides aggregate data regarding all cash inflows receiving from its ongoing operations and external investment sources. It also includes all cash outflows that pay for business activities and investments during a given period. This statement helps the accountant to find out cash flow from three kinds of activities –
o Operating activities,
o Financial activities, and
o Investing activities.
Shareholders’ Equity Statement: This statement reveals the share capital, the retained earnings would be taken into account. Retained earnings are the percentage of profit that re-invested back into the company for growth purposes.
8. Closing the books of accounts
As a final point, a company ends the accounting cycle in the eighth Stage by closing its books at the end of the day on the specified closing date. This provides a report for analysis of performance over the period.
- This Stage is the penultimate Stage in the accounting cycle.
- Closing the books means freezing books of accounts mentioning that all financial statements are prepared and all transactions have been recorded, analyzed, summarized, and reported.
- After closing the books, a new accounting period would start and the accountant would need to start repeating the above Stages once again for subsequent years.
Closing entries means closing the temporary accounts (Income & Expenses Accounts) and then transfer their balances to permanent accounts (Assets, liabilities, and capital accounts). This is done to begin the next financial year with zero balances to start with because temporary accounts are a nominal account that shows the performance of income & expenses account of a specific period, so it is closed & begins a fresh start for next year.
Note that closing entries are not done for Permanent accounts (Personal & Real Accounts) because they show the financial position of an entity at a certain point in time. i.e balance sheet
This process helps the accountant & owner how to handle the accounting activities and makes accounting easier. It also helps to ensure consistency, accuracy, and efficient financial performance analysis. At closing, it is a good time to file paperwork, plan for the next reporting period, and evaluate a chart of upcoming events and tasks.
Modern Day Accounting Cycle
Using accounting software gets rid of all the above complex procedures involved in the accounting cycle. The software automates the entire accounting cycle by just recording the business transactions, the trial balance, and other various financial statements that are auto-generated. For a Business maintaining software or an ERP, the version is not possible, so it is better to outsource the accounting activities to an expert & hence reduce the overhead cost.