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Understanding the accounting cycle and importance of accounting

  • For example, a personal loan made by the owner that does not have anything to do with the business entity is not accounted for;
  • For this, it is important to get back to basics of accounting and understand what goes on in the entire accounting cycle;
  • Financial statements such as income statement, statement of cash, equity and debentures are prepared on a monthly, quarterly or yearly basis, depending upon the need of the business;
  • Preparation of Trial Balance;
  • Financial information is presented in reports called financial statements.

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.

  1. Transactions are recorded in chronological order and as they occur.
  2. 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.
  3. The journal entries are referred to create individual ledger accounts that are prepared as per the rules of accounting to interpret effects on individual transactions. All account balances are extracted from the ledger and arranged in one report.
  4. To simplify the recording process, special journals are often used for transactions that recur frequently such as sales, purchases, cash receipts, and cash disbursements.
  5. The transactions identified are then analyzed to determine the accounts affected and the amounts to be recorded.

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. 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. Transactions are recorded in chronological order and as they occur. Journals are also known as Books of Original Entry.

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.

Accounting Cycle Steps

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. 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.

Accounting cycle

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.

Accounting Cycle

Some errors could exist even if debits are equal to credits, such as double posting or failure to record a transaction. Adjusting Entries Adjusting entries are prepared as an application of the accrual basis of accounting.

  1. Afterwards, all debit balances are added. Real or permanent accounts, i.
  2. Only those that pertain to the business entity are included in the process.
  3. The journal entries are referred to create individual ledger accounts that are prepared as per the rules of accounting to interpret effects on individual transactions. All asset balances such as cash flows, bank balance, prepaid expenses, inventory, goodwill and fixed assets like land, property and machinery appear on the right side of the balance sheet.
  4. The accounts are closed to a summary account usually, Income Summary and then closed further to the appropriate capital account. The accounting cycle begins with simple, manual recording of every transaction such as purchases, sales, payments, incomes and expenses where there is a debit and credit of cash and finances.

At the end of the accounting period, some expenses may have been incurred but not yet recorded in the journals. Adjusting entries are prepared to update the accounts before they are summarized in the financial statements.

Major Steps in Accounting Cycle

Adjusting entries are made for accrual of income, accrual of expenses, deferrals income method or liability methodprepayments asset method or expense methoddepreciation, and allowances. 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.

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: Closing Entries Temporary or nominal accounts, i.

  • Optional step at the beginning of the new accounting period Reversing entries are optional;
  • Each step will be illustrated one by one in later chapters;
  • 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 transactions identified are then analyzed to determine the accounts affected and the amounts to be recorded;
  • Journals are also known as Books of Original Entry.

Temporary accounts include income, expense, and withdrawal accounts. These items are measured periodically.

  • So there you have the nine steps in the accounting cycle;
  • The transactions identified are then analyzed to determine the accounts affected and the amounts to be recorded;
  • Adjusted Trial Balance An adjusted trial balance may be prepared after adjusting entries are made and before the financial statements are prepared.

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. 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. 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.

So there you have the nine steps in the accounting cycle. This is just an overview of the accounting process. Each step will be illustrated one by one in later chapters. Online resource for all things accounting.