The accounting cycleis a standard practice in financial accounting that allows anorganization to record and calculate its financial activities. Theaccounting cycle is a series of activities accountants use to recordtransactions, post to the general ledger, make adjustments, close thebooks and prepare financial documents.
The accounting cycleis a process by which a company identifies, analyzes and records itsfinancial and accounting details.
For the purposes of acompany’s financial records, all transactions are recorded, andthose transactions are documented from the moment the transactionbegins to the moment it’s finalized on the company’s financialstatements.
The cycle consists ofa number of steps, each of which relies on earlier steps to collectdata and organize it in a meaningful way.
Small businesses,which lack full-time accounting departments, rely on the accountingcycle to establish methods for financial accounting that fit withintheir budgets and give owners clear views of their changing positionsin competitive markets.
Organizations useaccounting methods to track and analyze financial transactions andmonitor the company’s money.
Managers use thefinancial information accounting provides to make decisions for thecompany.
Thepurpose of the accounting cycle is to generate reports known asfinancial statements. A business uses financial statements to analyzeits performance over a fiscal period.
The accounting cycleworks by a series of rules meant to ensure a uniform production offinancial statements that are accurate and conform to industrystandards.
In earlier periods,mathematical errors were common, but the introduction of computersthroughout organizations reduced the likelihood of such errors.
In many cases,software automates the accounting cycle, creating even less error inthe calculation of various accounting numbers.
The accounting cycleensures that all accounts that have been debited and credited aredocumented and that the money going into accounts and the moneyleaving accounts is equal. It also makes it possible for businessesto compare their results with other businesses in their industrybecause there are accepted time frames for accounting purposes.
The quarter and yearare two such accepted time frames.
Importance of theAccounting Cycle to a Business
Below are the four (4)basic importance of accounting cycle to a business as well as thefour (4) reasons why accounting cycle is necessary to a business:
An accounting cycleenables the financial accounting that businesses need to perform tobe in compliance with federal regulations and tax codes. Thegovernment requires companies of all sizes to disclose theirfinancial results and pay taxes on their profits, which they mustcalculate on their own. The accounting cycle ensures accuracy anduniformity among companies, making the market fairer for competitionand making information available to interested parties.
For any business with accounting needs, the accounting cycle provides a model for efficient accounting procedures and ongoing processes. The cycle consists of steps, meaning that it functions as a checklist. As one step is completed, accountants use the cycle to determine which actions to perform next. This is of particular benefit to a small business, which may rely on its owner to handle much of the day-to-day accounting in addition to other duties.
3. Internal Analysis
Within a business, the need for an accounting cycle extends to the necessity of analyzing internal financial performance. Some steps of the accounting cycle, such as analyzing, journalizing and posting transactions, occur on an ongoing basis. Others, such as preparing and adjusting trial balances, occur only at the end of the cycle and provide the financial statement data that a company’s leaders use to make decisions about future spending and financial strategies going forward.
Accounting cyclesallow accountants to manage their time based on fiscal periods, suchas years and quarters. By comparing the cycle to a calendar, anaccounting team can set realistic goals for completing each step inthe process in order to have financial statements ready on time. Theaccounting cycle also perpetuates itself, ending with steps thatprepare an accounting team to perform the same process again for thenext fiscal period.
Like earliermentioned, a common accounting cycle in any given business often hasnine (9) or Ten (10) steps, depending on the procedures outlined bythe given accounting department.
Each step in theaccounting cycle plays an important role in creating accurate entriesand managing the company’s finances each time a purchase is made orrevenue is earned.
If a company decidesto implement an accounting cycle, it is important that each step isfollowed in the right order.
Now let us discussabout the 9 or 10 steps of a common accounting cycle in any givenbusiness below:
The nine-stepaccounting cycle has the same steps as the 10-step accounting cycle,except for the last step; whereas the nine-step cycle ends at closingthe trial balance, the 10-step cycle includes a reversing step, ifrequired. Since this last step is not a required step in each cycle,it is often left out of the cycle.
Common steps includeanalyzing transactions, journalizing the information, posting thetransactions to the ledger, preparing an un-adjustable trial balance,adjusting any necessary trial balance data, preparing the finaladjusted trial balance, preparing a list of financial statements,closing the accounts and preparing a post-closing trial balance.
The Accounting Process and Steps
In the accountingprocess, daily transactions are posted in separate journals, such asa cash-receipt journal or a sales journal. Accountants transfer theinformation from daily journals into a general ledger for theorganization in a series of debits and credits. The general ledgercontains information such as accounts payable and accounts receivableas well as other accounts the organization uses to track and analyzefinancial data.
The process alsoincludes adjustments to the general ledger that are not recorded injournals, such as taxes. The final stage in the accounting cycle, orprocess, is closing the books. The revenue and expenses for theorganization are accounted for, and the profit is transferred to theowner’s equity account.
At the end of theaccounting cycle, the accounts are brought to zero before beginningthe next cycle. From this information, the organization can preparefinancial statements. Financial statements provide a summary of alltransactions and accounting activity during the accounting cycle.
The accounting cycle10 steps include the following:
- Identify and analyze transactions.
- Record data in journals.
- Post data to the ledger.
- Unadjust trial balance.
- Adjust the accounting entries.
- Adjust the trial balance.
- Prepare financial statements.
- Close the entries.
- Enter post-closing trial balance.
- Reverse the entries.
Although theaccounting cycle is typically broken up into these 10 steps, somemodels of the accounting cycle collapse this list into fewer steps tosimplify the list or ease communication about how the cycle works.
IdentifyTransactions and Record Them
Any accounting cyclebegins with identifying business transactions and analyzing whichaccounts are affected by the transactions. The process starts withthe source documents where the company initially recorded thetransactions. These transactions are recorded in a business journal.These journals contain, at minimum, debited and credited accounts.
Debited accounts are the accounts that increase with an influx of money, and credited accounts are the accounts that reduce due to the outflow of money. This is why at least two accounts are necessary for the journal because it must reflect the account the money is taken from and the account the money is deposited to.
Postingto Ledgers and Adjusting Trial Balances
A business ledger isalso known as a book of final entry. This ledger is important becauseit shows the company’s accounts and the changes that happened tothose accounts because of various transactions, along with thecurrent balance on the account. With the balances of each accountdetermined, it is time to unadjust the trial balance.
To unadjust thebalance, all account balances are taken from the ledger and placedinto a single report that contains all debit and credit balances. Ifthe record-keeping is accurate, then the total debits and credits areequal. If not, then a company performs entry corrections to resolvewhere a debit or credit was not recorded.
AdjustingEntries and Trial Balances
After any errors arecorrected, further adjustments may be necessary. These include casesin which income has been earned but not yet recorded or expensesaccrued that have not been documented in the business journal.
The company makesentry adjustments before preparing the final financial statement, andthese adjustments reflect any financial transactions that wentunrecorded, including income, expenses, deferrals, prepayments,depreciation’s and allowances.
A second form ofadjustment that takes place is an adjustment to the trial balance.After the entries are adjusted, a review of the report is made priorto finalization. This review is meant to verify that after alladjustments are accounted for, the debits and credits are equal toone another on the completed financial statement.
FinancialStatements and Closing Entries
After updating theaccounts, adjusting entries, and verifying that the debits andcredits are equal, the company can issue its financial statement.This statement describes the company’s income, equity, financialposition and cash flow, and includes notes that provide any finaldetails about the company’s operations.
After the financial statement is finalized, preparations for the next accounting period begins. Temporary accounts, which are characterized by accounts including income, expenses and withdrawals, need to be closed and posted to an income summary.
Only temporary accounts, not permanent accounts, are closed after the financial statement is finalized.
Post-Closingand Reversing Entries
The final step of the accounting cycle is the preparation of a post-closing trial balance. This is yet another review to see if the debits and credits are equal after the closing entries of temporary accounts has been made.
With temporary accounts closed, only permanent accounts, including their debits and credits, are reflected in the post-closing trial balance.
An optional 10th step,the reversal of entries, does not start during the accounting period.Instead, it begins during the new accounting period. When the newaccounting period begins, adjusted entries of expenses, deferrals,income, and prepayments are reversed.
Entries are reversedbecause these accruals and prepayments are paid off during the newaccounting period and are no longer recorded in accounts as eitherliabilities or assets.
AccountingCycle Timing and Periods
An accounting cyclecoincides to an accounting period. An accounting period is the rangeof time in which various accounting functions are completed. Thisperiod occurs within either a calendar or fiscal year. Accountingperiods are necessary because they provide a set period within whichstakeholders in the company can determine whether the company metexpectations.
The accounting periodmost typically happens during an annual period. Regardless of whetherthe accounting cycle corresponds perfectly with the year or not, atthe end of the cycle, all the company’s transactions must beaccounted for. The final financial statement that the companyproduces at the end of the accounting cycle demonstrates whether thecompany was successful during the accounting cycle.
For public companies,financial statements are not optional at the end of the year. Thesestatements, most often produced in the form of an annual report, notonly demonstrate that company’s success over the previous fiscalyear but also provide a picture into how the company is likely toperform the following fiscal year.
These statements are critical for investors, who use them to guide their decisions and investments in the following year. At the conclusion of the accounting cycle and the end of the fiscal year, these reports are available in the investor relations sections of a company’s website.
Am certain by now that you can confidently Defend the Importance of the Accounting Cycle to a Business when asked to do so after going through this article.