The Accounting Cycle
The Accounting Cycle
The ‘accounting cycle’ refers to the process in which data is recorded and processed until it becomes part of the financial statements at the end of the period. Understanding the accounting cycle helps to visualize and contextualize the whole accounting process which eventually helps to understand each piece of the accounting process.
Now that we’ve covered all aspects of bookkeeping entries, we can show the full accounting cycle in the form of the diagram below.
Stages in Accounting Cycle
1. Identifying transactions
The first step in the accounting cycle is to identify transactions from an event. For example, if a customer enters into a shop and asks for prices, this is an event and need not be recorded in accounting until he buys something.
2. Vouching
The first document in the accounting cycle is a voucher that serves as proof of transaction. Vouchers are prepared at the time when actual transactions occur. These documents have a special legal value and are usually hand/ digitally signed by the person who is preparing these.
Vouchers are carefully saved, even after the transactions have been recorded into the book of accounts so these can later be reproduced if required during verification (at the time of dispute or audit) of the transaction. In some jurisdictions, it is mandatory for the business to save vouchers for a particular number of years. Particularly taxation authorities may ask to reproduce vouchers in later years while auditing the financial reports/ tax filing of the company.
Examples are Sales Invoices/ Bill, Goods Receipt notes, etc. We will discuss vouchers in more detail in the coming chapters.
3. Journalizing/ Entry in Daybooks
Each transaction is then briefly entered into a relevant Day Book OR Journal. The record entered into the daybooks is a brief summary of the content written on vouchers issued at the time of the transaction. At the end of each day, the persons responsible for making the transaction i.e. cashier, salesman, storekeeper, etc. are usually responsible to fill the records into the daybooks/ journals/ registers before closing the day/ shift.
Following are examples of journals are the Purchase day book and Sales daybook.
Purchase return daybook/journal
Later in the coming chapters, we will study each of the above daybooks/journals/registers in detail.
4. Posting into Ledgers
After a specific interval, and review by a senior staff member/ supervisor (depending on organizational hierarchy) all transactions from daybooks are summarized by posting them into ledgers.
When a business is small, all double-entry accounts can be kept in one book, called the ‘ledger‘. However, as the business grows, it will be impossible to keep all records in just one Ledger. Further, a high volume of transactions for almost every aspect of the business means the various types of Ledgers needed to be classified separately for better financial and performance management.
The answer to this problem is to keep as many ledger books as required. When we do this, we put together similar transactions and have a separate book to record transactions for each category.
5. Closing of Accounts
At the end of each period, all ledgers are reviewed and to balance them various entries are posted into Ledgers. These balancing entries result in the closing of various period-specific ledgers, therefore this process at each period end is called “Closing Process” or simply closing. Examples of closing entries include posting revenues and expenses into profit and loss accounts, temporarily closing/ balancing Assets, liability, and capital accounts, and posting entries like depreciation, accruals, and prepayments. The Detailed closing process will be deliberated in upcoming sections.
6. Preparation of Trial Balance
Trial Balance in a simple list of accounts with the amounts of closing balances at each period end.
After the closing process n most companies, an initial trial balance statement is prepared. Any errors identified during the closing and audit process are rectified through the creation of the suspense account, and then after complete rectification of errors suspense account is closed and a final error-free trial balance, also called adjusted trial balance is prepared.
At the end of this chapter, the purpose and preparation of the trial balance have been discussed in detail.
7. Financial Statements
After the finalization of the trial balance report, Financial Statements are prepared and presented to senior management for approval and further reporting to owners. Financial statements include Profit and Loss Statement, Balance Sheet, cash-flow statements, statement of changes in equity, and notes to these financial statements.
8. Reversing Entries/ Opening Balances
At the beginning of the new financial year, all temporarily closed ledgers (Assets, Liabilities, and capital) and entries posted for accrual during the closing process (stated at the 5th Stage of the accounting cycle) are reversed.
Note: Each stage of the accounting cycle will be discussed in a relevant chapter. Further, depending on the systems and control mechanism of each company, the stage of the accounting cycle provided here may vary. However, the details of the accounting cycle given here will help you to understand the accounting process being followed in real life.
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