Also called bookkeeping cycle, accounting cycle refers to all the steps made on a transaction from recording in the journal until the preparation of financial statement. Preparation of financial statements occurs at the end of the financial period. It is a cycle since the process is repetitive in every financial period following a systematic order. The order of accounting cycle in most organizations starts with recording a journal entry, then posting to the ledger then preparation of a trial balance and finally preparation of financial statements. Let us discuss in detail different steps in accounting cycle below.
Steps followed in accounting cycle
Analyze a transaction
This is the first stage in the accounting cycle and involves analyzing of source documents or any other document that indicates that the transaction under analysis actually took place. At this stage, we analyse all the accounts that will have an effect as a result of double entry rule and the effect on the account balance. An example of source document is a bank statement, invoice, receipt or a bill.
Recording a transaction in the journal (journal entry)
After receipt of the source document, the recording of the transaction will take place in the general journal. The general journal, also known as the book of original entry since it reflects on all transactions made and the ledger accounts reflecting the same transaction. The purpose of journal entry is to avoid confusion through keeping a chronological order in which transactions took place.
Posting a transaction
This is the third stage in accounting cycle and it entails posting a transaction in the correct ledger account. Ledger posting involves either debiting or crediting a specific ledger account depending on the nature of transaction and it effect on the ledger account as per the double entry rule. We add all transactions affecting a single account.
Preparation of a trial balance
We will prepare a trial balance to test if the debits and credits balance posted in the ledger accounts and the general ledger balance off. It checks for accuracy in the posting made in the ledger accounts. It is not a legal requirement for businesses to prepare a trial balance, however it serves an important purpose of testing accuracy of ledger entries made and double entry rule.
After preparation of trial balance, the accountant proceeds to adjust prepaid expenses and accrued income entries. This is important in order to provide an accurate preparation of accounting statements. Adjusting of entries serves two main purposes. First is to match revenue earned or expenses incurred in the appropriate period and secondly is to provide an accurate measure for assets and liabilities in a specific period.
Adjusting the trial balance
The trial balance undergoes adjusted in order to come up with a list of company accounts that will appear in the final financial statements. It indicates both internal and external entries for a trading period identified. The format of adjusted trial balance is similar to that of unadjusted trial balance.
Preparation of financial statements
Preparation of financial statements is done to determine the performance of the business in an identified period. Financial statements acts as an output of a financial accounting system. They are meant for shareholders, creditors, government and potential investors to gauge their interests in a firm.
Closing of temporary and nominal accounts is the final step of the accounting cycle. This happens as we prepare for the next trading period. Real and permanent accounts are kept and carry their balances to the next period. Opening of new revenue and expenses accounts with zero balance is done.