Accounting Cycle Steps Explained: 8 Steps to Know

What did come to your mind when you heard the word Accounting?
Someone not familiar with the accounting profession may think that accounting is something related to a boring job where people deal with a bunch of data, or profit-loss, money.
Their guesses are not entirely wrong. Accounting is indeed a boring subject that deals with providing financial feedback to users by identifying, analyzing, recording, and incorporating economic events.

Accounting is also considered a social science since it is a disciplined process that works inside society to maintain the harmony of social structure. Accounting is also an art as information has been classified, organized, and processed articulately.
A question may come to your mind about how this process is cycled. If we want to know, we have to go through the Accounting Cycle.

Accounting Cycle

To understand how accounting works, the accounting cycle would be a good idea to start with since it talks about the process of how information is prepared to make it more meaningful in a complex world. An accounting cycle is started by identifying transactions and ends with reversing entries.

Identifying transaction

Many events have been happening since you start a business. Accounting is all about storing and processing events in an understandable manner. Okay, let me be more clearer that not every event goes to the process of accounting. So identifying events is an essential step to differentiate which events can start their journey to be processed. This is the first step. There is a checklist to identify whether an event is qualified as a transaction of business that is required to be recorded, corporated.

• Events must have the capacity to be evaluated in terms of money
• Events must have financial effects on the organization

Let’s get to the examples. Here is a list of events that happened in January 2021: 

1. Mr. Issac started his business with CU10,000 on January 1, 2021
2. Mr. Issac appointed two employees to his business on January 1
3. Purchased a machine CU 2,000 on January 15
4. Paid the salary to his employee CU 1500 on January 28
5. Sold goods on account CU 200 on January 29
6. Purchased goods on account CU 350 on January 29
7. Paid the utility bill CU 200 January 30

All these transactions except no. 2 can be evaluated in terms of monetary value, has financial effects on his business. On number second event, it lacks those features.

Journalizing

The second job is to prepare a detailed account of all the events that you previously identified as financial transactions. The process is called journalizing. This is the part of the accounting cycle where you actually record your transactions initially.

When the financial transaction occurs, you will receive the source document where information related to the particular transaction is kept. These source documents could be invoices, credit notes, debit notes, vouchers. But the thing is you have to summarize these documents in order to prepare understandable disciplined financial feedbacks. The place where you record these transactions at first is called the Book of Original Entry.
As an accountant, we have already identified these transactions which will be required to be initially recorded in the book of original entry. So we have to make a journal book as the business is pretty small in size. But we can journalize these transactions through the application of the double-entry system.

Posting to Ledger

In this stage, a transaction has to be transferred to a ledger, a book also known as a collection of accounts. Ledger decorates more cleanly as all transactions are summarized into individual accounts. It would be convenient for accountants to prepare financial feedbacks in a more meaningful way. Let’s prepare a ledger account by using the previous example mentioned in Journalizing section.

Preparation of Trial Balance

To check whether the ledger accounts have the mathematical correction, the trial balance is prepared. It has been prepared on a date, not for the period. The debit and the credit balance must be equal. Let’s prepare the trial balance from the ledger accounts.

Adjusting Entries

Sometimes an entry may be unrecognized in accordance with the accrual basis. An error can happen. You may post the capital expenditure as the revenue expenditures by mistake. But what can you do afterward?
Adjusting Entry is there to help you as it is prepared to rectify the entries that are erroneously recorded, to recognize the entries that have not yet been posted. So a journal entry can be made to record the proper situation of a financial situation.

Let’s say Mr. Issac has not paid the electricity bill yet though the expense was incurred. So he needs to make an adjusting entry.

Adjusted Trial Balance

An adjusted trial balance is basically a trial balance that is adjusted with adjusting entries that were made to recognize or rectify transactions in accordance with the accrual basis or any other corrective reasons. So let’s use the previous example we made in the Adjusting Entry section.

Preparation of Financial Statements

There are many aspects of how significant financial statements are for accounting users. For instance, according to Company Act 1994 (Bangladesh), preparation of financial statements is mandatory for a public limited company.
Sometimes bank loans are granted on the basis of financial statements as these statements describe the financial situation, earning capacity, the liquidity position of a business organization. It is important for internal analysis as a manager can compare the business outcome with projections he made before.
The financial statements are pivotal from the shareholder’s point of view as these statements are more meaningful and understandable than other documents.

There are basically five financial statements according to IFRS.

• Statement of Financial Position
• Statement of Comprehensive Income
• Statement of Changes in Equity
• Statement of Cash Flows
• Notes

Let’s prepare these financial statements using previous examples.

Preparation of Closing Entry

Closing entries are prepared at the end of the period so that temporary accounts of the current period will be closed and transferred to permanent accounts.  As these temporary accounts’ effects are limited to that period, they cannot move forward after the period.

This is how an accounting cycle moves from period to period. We have discussed the cycle using the same set of examples so that the process could be understood more easily.