ACCOUNTING CYCLE
The accounting cycle, also commonly referred to as accounting process, is
a series of procedures in the collection, processing, and communication of
financial information.
As defined in earlier lessons, accounting involves recording,
classifying, summarizing, and interpreting financial information.
Financial information is presented in reports called financial
statements. But before they can be prepared, accountants need to gather
information about business transactions, record and collate them to come up
with the values to be presented in the reports.
The cycle does not end with the presentation of financial statements.
Several steps are needed to be done to prepare the accounting system for the
next cycle.
Accounting Cycle Steps
1. Identifying and
Analyzing Business Transactions
The accounting process starts with identifying and analyzing business
transactions and events. Not all transactions and events are entered into the
accounting system. Only those that pertain to the business entity are included
in the process.
For example, a personal loan made by the owner that does not have
anything to do with the business entity is not accounted for.
The transactions identified are then analyzed to determine the accounts
affected and the amounts to be recorded.
The first step includes the preparation of business documents, or source
documents. A business document serves as basis for recording a transaction.
2. Recording in the
Journals
A journal is a book – paper or electronic – in which transactions are
recorded. Business transactions are recorded using the double-entry bookkeeping
system. They are recorded in journal entries containing at least two
accounts (one debited and one credited).
To simplify the recording process, special journals are often used for
transactions that recur frequently such as sales, purchases, cash receipts, and
cash disbursements. A general journal is used to record those that cannot be
entered in the special books.
Transactions are recorded in chronological order and as they occur.
Journals are also known as Books of Original Entry.
3. Posting to the
Ledger
Also known as Books of Final Entry, the ledger is a collection of
accounts that shows the changes made to each account as a result of past
transactions, and their current balances.
After the posting all transactions to the ledger, the balances of each
account can now be determined.
For example, all journal entry debits and credits made to Cash would be
transferred into the Cash account in the ledger. We will be able to calculate
the increases and decreases in cash; thus, the ending balance of Cash can be
determined.
4. Unadjusted Trial
Balance
A trial balance is prepared to test the equality of the debits and
credits. All account balances are extracted from the ledger and arranged in one
report. Afterwards, all debit balances are added. All credit balances are also
added. Total debits should be equal to total credits.
When errors are discovered, correcting entries are made to
rectify them or reverse their effect. Take note however that the purpose of a
trial balance is only test the equality of total debits and total credits and
not to determine the correctness of accounting records.
Some errors could exist even if debits are equal to credits, such as
double posting or failure to record a transaction.
5. Adjusting Entries
Adjusting entries are prepared as an application of the accrual
basis of accounting. At the end of the accounting period, some expenses may
have been incurred but not yet recorded in the journals. Some income may have been
earned but not entered in the books.
Adjusting entries are prepared to update the accounts before they are
summarized in the financial statements.
Adjusting entries are made for accrual of income, accrual of expenses,
deferrals (income method or liability method), prepayments (asset
method or expense method), depreciation, and allowances.
6. Adjusted Trial
Balance
An adjusted trial balance may be prepared after adjusting
entries are made and before the financial statements are prepared. This is to
test if the debits are equal to credits after adjusting entries are made.
7. Financial
Statements
When the accounts are already up-to-date and equality between the debits
and credits have been tested, the financial statements can now be prepared. The
financial statements are the end-products of an accounting system.
A complete set of financial statements is made up of: (1) Statement of
Comprehensive Income (Income Statement and Other Comprehensive Income),
(2) Statement of Changes in Equity, (3) Statement of Financial Position or Balance
Sheet, (4) Statement of Cash Flows, and (5) Notes to Financial Statements.
8. Closing Entries
Temporary or nominal accounts, i.e. income statement accounts, are closed
to prepare the system for the next accounting period. Temporary accounts
include income, expense, and withdrawal accounts. These items are
measured periodically.
The accounts are closed to a summary account (usually, Income Summary)
and then closed further to the appropriate capital account. Take note that
closing entries are made only for temporary accounts. Real or permanent
accounts, i.e. balance sheet accounts, are not closed.
9. Post-Closing
Trial Balance
In the accounting cycle, the last step is to prepare a post-closing trial
balance. It is prepared to test the equality of debits and credits after
closing entries are made. Since temporary accounts are already closed at this
point, the post-closing trial balance contains real accounts only.
10. Reversing
Entries: Optional step at the beginning of the new accounting period
Reversing entries are optional. They are prepared at the beginning of the
new accounting period to facilitate a smoother and more consistent recording
process.
In this step, the adjusting entries made for accrual of income,
accrual of expenses, deferrals under the income method, and prepayments under
the expense method are simply reversed.
