Understanding the Accounting Cycle
If we discuss anything related to business, we could never omit or altogether overlook the inclusion of accounting. Accounting, after all, is said to be the “language of business”.
How could that be the case, you ask?
Well, that is because accounting aids members of the organization (internal) and even the external parties, understand what exactly is going on with the business. In short, it is a means of communicating information about the business.
In this guide, we explore 1) what is accounting, 2) what is the accounting cycle, and 3) the major steps of the accounting cycle.
WHAT IS ACCOUNTING?
Let us kick things off by talking about what accounting is. Accounting is the systematic process of identifying, measuring, recording, classifying, summarizing, and interpreting financial information, and communicating the results thereof by way of the preparation of financial statements.
True to its other identity as the language of business, it provides relevant information on the resources available to a business, how these resources are being used in business operations, and the results of these operations.
You may have already heard of several business functions, not realizing that they are actually part of the bigger picture that is accounting. You see, accounting is not just limited to the recording of transactions preparation of financial records, and maintaining or keeping these records. Performing internal audits is also an accounting function. Providing advise on taxation matters is also another. Evaluating the feasibility of potential projects or business ventures also falls under accounting.
Beyond the simple acceptance of the statement that accounting is the language of business, what is the importance of accounting?
Accounting aids in the decision-making processes of management.
It can be said that this is the ultimate reason why accounting is in place. The information measured, recorded, maintained and communicated through accounting are used by the owners or management team of a business in making business decisions.
Analysis of the financial reports and records generated through the accounting process will allow management to make important decisions on matters such as operations, investments, marketing, and the like.
Budgeting is one area that greatly benefits from accounting, particularly from its recording function. The records and reports generated through accounting will be used as basis or benchmarks for budgeting and forecasting purposes.
Accounting is useful in tracking the performance and growth of a business.
Through accounting, a company is able to generate its income statement, also known as the Statement of Financial Performance, which shows if the company is earning money or losing it. Just by looking at the figures and conducting subsequent financial analyses, management and other stakeholders will have an idea if the business is profitable or not.
Likewise, the Balance Sheet, or the Statement of Financial Position, will also indicate the status of the business for growth and continuous operations. Without accounting, there would be no way for the business to have quantified and objective information on the true state that the business is currently in.
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Accounting communicates to management whether the company is using its resources efficiently or not.
Imagine a company that does not record its transactions, or keep records and reports of how the business is performing. There is a great chance that the business may be spending more than it should, increasing business inefficiencies.
Prevention of fraud is also made possible by the implementation of the accounting process. Accounting entails having an effective and strong internal control in place within the company, which means that it facilitates the early detection and discovery of fraud, and prevent the occurrence of potential fraud.
Accounting improves a company’s reputation and credit.
If a company has a sound accounting system in place, and its accounting records are well kept and updated, it will make it look more appealing to others. This is already an indication of management’s effectiveness and efficiency, and it will also build trust among external parties, such as creditors, banks, financial institutions and regulatory agencies.
Do not forget that businesses that seek financing through loans or outside investments are going to be asked to present their financial reports. If accounting is implemented well, these financial reports will be readily available, and help the company acquire the funding it needs.
No one is exempt from implementing the accounting process or using the accounting cycle in business. Large multinational companies also employ accountants to do their accounting work for them, which is the same in small businesses.
THE ACCOUNTING CYCLE
Defining the “accounting cycle” is easy enough, because it is basically described by the definition of accounting. This cycle makes up the whole process, from identification and measurement of accounting events and recording them until the completion of the accounting process. Most of this is recorded in accounting software systems.
The cycle begins when an accounting event, or a transaction, takes place. It will end when the event has been included in the financial statements or reports of the company, and the cycle begins anew when other accounting events take place.
The accounting cycle is not to be confused with the Budget Cycle. There are two major differences between the two.
- Accounting cycle pertains to historical transactions, or transactions that have already taken place. Budget cycle is more concerned with forecasting or predicting the future operations and performance of the business, meaning the transactions have not yet been incurred.
- Accounting cycle is concerned with information that will be used by both internal and external users. This means that management and members of the organization, as well as stakeholders and third parties outside the organization (including the general public) and will find the information relevant. The budget cycle is more focused on information that will be used primarily internally, or by management.
Timing of the Accounting Cycle
Businesses have their predetermined accounting periods, which could be monthly, quarterly, biannually, or annually, depending on several factors. The most common accounting period, however, is annual, since most regulatory agencies require the submission of financial statements on an annual basis, usually at the end of a fiscal year or a calendar year.
The reporting dates usually mark the end of the accounting cycle for most businesses. The transactions take place throughout the year, but the end of the cycle, which is the preparation of the financial reports, takes place at the end of the year.
Watch a full lecture on the accounting cycle.
Importance of the Accounting Cycle
Why is there a lot of emphasis put into the accounting cycle? We have already discussed why accounting, in general, is vital to the operations of a business, but what of the accounting cycle?
For uniformity and consistency
Without the accounting cycle serving as a guide in the accounting process, businesses may have chaos in its hands when it comes to recording its financial transactions. The accounting cycle provides order to the process, ensuring uniformity and consistency all throughout.
The business will then follow the same recording and record-keeping guidelines and standards, allowing for comparability when it is time to perform analysis on the operations of the business. This uniformity will also give a sense of commonality, since it basically means that the business is speaking the same “language” as everyone else.
Keep in mind that businesses’ financial statements are viewed and referred to by various parties and entities, aside from management and employees. Other possible parties are investors, banks, financing institutions, competitors, customers, regulatory and other government agencies.
Following the accounting cycle will ensure that these parties will also understand what they are seeing once they take a look at your financial statements or financial reports.
For check and balance
Through the accounting cycle, the company will be better able to catch any transaction errors. A very effective tool to catch these errors is the trial balance prepared at the end of the accounting period. And the trial balance is generated using the accounting cycle.
For evaluation of company performance
Profitability is a primary concern for management and other stakeholders of the company. By following the accounting cycle, assessing the performance or results of operations of a business from one accounting period to the next is easier.
Comparative assessments of performance from period to period is facilitated by the accounting cycle, since the expense and income accounts are closed at the end of each accounting or reporting period, instead of the amounts being carried over to accumulate in succeeding periods.
International and local accounting standards require compliance with the steps involved in the accounting cycle. There are also tax laws and federal regulations that have the same requirement.
Government agencies often require public companies to periodically submit their financial reports, duly prepared by following the accounting cycle.
For efficiency of business processes
Notice how many processes tend to be cumbersome and inefficient when there is no order involved. The steps in the accounting cycle ensure efficiency in carrying out the accounting process.
This will prevent accountants and bookkeepers from repeating steps or being redundant in carrying out their tasks, because they are following a sequence. Thus, time management is another advantage to be obtained from implementing the accounting cycle.
THE STEPS IN THE ACCOUNTING CYCLE
Depending on the nature of the business and the operations and transactions involved, there may be several steps that will be followed by a company in its accounting cycle.
However, we will take a general approach and discuss the ten steps involved in this methodical process.
Step #1 Identification and analysis of business transactions and events
The beginning of the accounting cycle (and the accounting process as a whole) is the identification and analysis of business transactions and economic events. Take note that businesses deal with numerous transactions and events, but not all of them will be included in the accounting cycle.
The quantifiable transactions must be distinctly identified from the non-quantifiable transactions. Quantifiable transactions are those that can be expressed in monetary terms, using the currencies used by the business.
Between the sale of products and services and the signing of an agreement with a distributor company, the former is clearly the quantifiable transaction, since it involves the exchange of goods and services for cash or other forms of payment. The mere signing of the agreement is not quantifiable and will therefore be excluded from the accounting cycle.
If, however, the signing involved the company spending a specific amount of money on incidental expenses such as meals and transportation in the conduct of the event, then it will be included in quantifiable transactions.
Identification and analysis of these transactions begin from source documents, such as invoices, official receipts and other financial documents. These source documents will serve as the basis for the next step, which is recording in journals.
Analysis of the identified transactions involves:
- Determination of the accounts affected; and
- Determination of the amounts to be recorded;
Step #2 Recording of transactions and events in the Accounting Journals
The transactions or events that have been identified will now be recorded in the accounting journals.
The Journal, or the “General Journal”, is also referred to as the “book of original entry”, since this is where the transaction will first be recorded.
- Transactions are recorded in the journal, or journalized, in chronological order, as they happen.
- Transactions are recorded using the “double-entry bookkeeping system”, where two accounts are recorded: one account is debited while the other is credited.
Businesses with frequently occurring similar transactions also make use of special journals to simplify the recording process. Examples of these special journals are Sales Journal, Purchase Journal, Cash Receipts Journal and Cash Disbursements Journal. Transactions that do not fall under these special journals are recorded in the General Journal.
Step #3 Posting of the transactions and events to the Ledger
The transactions that have been journalized are then posted to the General Ledger, or the “book of final entry”. The ledger is where all accounts are shown, including the movements in the account or the changes that occurred because of past transactions. It also shows the current balances of the accounts.
Journalized transactions are posted in their respective account ledgers, showing increases, decreases, and the current ending balances. Businesses with many transactions may also make use of Subsidiary Ledgers, which are basically breakdowns of the General Ledger.
Step #4 Preparation of the Unadjusted Trial Balance
The ending balances of the accounts in the ledger are extracted and placed in one financial report, which is the unadjusted trials balance.
- The unadjusted trial balance has two columns – Debit and Credit – that reflect the ending balances of the accounts in the ledger.
- The unadjusted trial balance is an excellent tool to test the accuracy of the recording and posting process, since the Debit and Credit sides must be equal or balanced. The total Debit should be equal to the total Credit amount.
- Errors must be corrected through the appropriate correcting entries to make the Debit and Credit balanced.
Step #5 Preparation of Adjusting Entries
Businesses make use of the accrual method of accounting, which upholds the matching principle, where the expenses are matched with the corresponding or related revenue or receipts.
The accrual method also maintains that expenses must be recorded when they are incurred rather than when they are paid, and revenue must be recognized when they are earned, regardless of when they are received in cash.
To adhere to the accrual basis of accounting, adjusting entries must be prepared.
Step #6 Preparation of the Adjusted Trial Balance
Effecting the correcting and adjusting entries, you will now be able to prepare the Adjusted Trial Balance.
This will further allow the evaluation of accuracy, to see whether the debits will still equal the credits after the adjustments have been incorporated.
Step #7 Preparation of the Financial Statements
We now come to the end-products or final outputs of the accounting process and the accounting cycle: the financial statements. There are five financial statements that are prepared, and will make up the financial reports of the company.
- Statement of Financial Position (Balance Sheet). There are three main components: Assets, Liabilities and Equity. The accounting equation must be adhered to in this statement, where the Assets will be equal to the combined Liabilities and Equity of the company.
- Statement of Performance (Income Statement). In other cases, they prepare the Statement of Comprehensive Income, which also includes income earned by the business from sources other than its main operations.
- Statement of Changes in Equity. This will include details of the Equity section in the Balance Sheet.
- Statement of Cash Flows. This will show the movement or flow of cash into and out of the company. Cash receipts and disbursements will be presented and classified appropriately, depending on whether they are for Operating activities, Investing activities, or Financing activities. The ending Cash balance must be equal to the Cash balance presented in the Asset section of the Balance Sheet.
- Notes to Financial Statements. This will contain notes and important disclosures regarding the items presented in the other four financial statements.
The figures that will be presented in these financial statements will be lifted or extracted from the Adjusted Trial Balance.
Step #8 Preparation of Closing Entries
There is a need to “close” the nominal or temporary accounts to the appropriate capital accounts, in preparation for the next accounting period or cycle. Closing entries are required because the business will once again start on a clean slate.
Nominal or temporary accounts are the accounts normally seen in the income statement, such as the income and expense accounts. Real accounts or permanent accounts – those that appear on the balance sheet – are not subject to closing entries.
Step #9 Preparation of the Post-Closing Trial Balance
After effecting the closing entries, the Post-Closing Trial Balance will then be prepared. The purpose of this is to once again test accuracy and ensure that the debits and credits are still equal.
Since all the nominal or temporary accounts have already been closed, this trial balance will contain only the real or permanent accounts. It basically resembles the Balance Sheet, although it is presented in two columns, Debit and Credit.
Step #10 Preparation of Reversing Entries
To maintain consistency of the accounting process and ensure a smooth transition into the next accounting cycle, there is a need to reverse the adjusting entries that were previously prepared to comply with the accrual method of accounting. These entries are called the reversing entries.
This is actually an optional step, since the business may opt to prepare reversing entries at the beginning of the next accounting period, making it the first step in the succeeding accounting cycle.
One of the first considerations when setting up a new business, creating a new product, or …