Accounting cycle is a series of steps performed to generate financial statement for the business. Any error or omission in any of the stages has a significant impact on the accuracy and completeness of financial statement.
Accounting cycle steps
Generally, six steps are followed to generate financial statement via an accounting cycle.
1-Identification of financial transactions
The accountant is responsible for identifying all business transactions. Bank statement, cash receipts, sales invoices, purchase invoices, contracts, and all other business documents can help to identify these transactions.
It’s important to note that a bank statement is an extremely important document to ensure all transactions have been posted in the accounting system. It’s based on the concept of the bank reconciliation process.
2-Recording financial transactions in an accounting system
Once financial transaction is identified, the next step is to post transaction in the appropriate chart of account. For instance, the credit purchase of a machine should be posted as an increase in assets and an increase in liability. If an appropriate chart of accounts is not selected while posting transactions, it might result in impaired financial statement.
3-Preparation of unadjusted trial balance
Once all operational transactions are posted in the accounting system, these transactions are combined, grouped, and presented in a summarized layout that is called trial balance. For instance, all asset codes are combined to calculate the total asset balance, all equity codes, all liability codes, all revenue codes, and all expense codes are combined and shown as a summarized balance.
However, the trial balance generated is unadjusted and needs to be adjusted for periodic entries.
4-Posting adjusting entries
Adjusting entries are periodic entries that need to be posted in the accounting system. For instance, if the business has paid prepaid premium, prepaid rent, or prepaid salaries, these need to be adjusted in the accounting system. Similarly, depreciation for the PPE, impairment, accrued expense, deferred expenses, accrued revenue etc.
Once all adjusting entries are posted in the accounting system, the trial balance is called adjusted trial balance, which is ready to prepare financial statement.
5-Preparing financial statement
A financial statement is prepared using an adjusted trial balance. All respective codes for the asset, liability, and equity are classified in certain sequences and fashion that are easy to understand for the user. It’s important to note that all five components of a financial statement are prepared using an adjusted trial balance.
6-Closing books of accounts
Once financial statement has been finalized/audited, it’s time to close ledgers. All revenue and expense codes are closed in profit and loss, and the final profit is then transferred to retained earnings/equity in the balance sheet. Similarly, all the codes for assets, liabilities, and equity are closed, and balances are carried forward.
The accounting cycle is a series of steps used in the preparation of a financial statement of the business. Generally, there are six steps in accounting cycle. These steps include identification of financial transactions, recording financial transactions, preparation of unadjusted trial balance, posting adjusting entries, adjusted trial balance, preparation of financial statement, and closing books.
Closing books refer to closing revenue, expenses in the profit and loss statement, and carrying forward balance sheet items in the next accounting period.