What is the accounting cycle?
The accounting cycle is the name given to the overall process of recording a series of transaction in the financial records of a business. This process ommences at the inception of the transaction and finishes once the transaction enters the financial statements and the financial statements have been finalised and the period end ledgers closed down.
The first stage of the accounting cycle is to identify the transaction or recognise the event. There are many different things that gives rise to a transaction or a recognisable event and such things may include a verbal order, a memo or an email to name but a few.
Once the transaction is recognised the next step in the accounting cycle is to prepare the source documentation. For example, let’s assume the transaction is a verbal request for some office stationery. The source documentation for this request is a purchase order, therefore we would need to draft an appropriate purchase order at this stage in the accounting cycle.
The next stage in the process is analysing and classifying the transaction. In this stage we need to identify the monetary amounts and identify which accounts in the general ledger are going to be affected. Using the example of the requested stationery, we will need to quantify the cost of stationery, identify the best supplier from which to purchase the stationery and identify which accounts we will use in the purchase.
The next stage is to take all the information gathered in the previous stages and record the transaction in the business accounts. You post the transaction to the financial records by way of a journal and you post the relevant amounts to the appropriate accounts in the general ledger.
During the accounting period a business will undertake several hundred, if not thousand, transactions and each one is dealt with in line with the above. All of the above stages are ongoing throughout the accounting period and never cease.
At the end of the accounting period the accounting cycle will change and there are a range of new stages to complete.
The first stage after the period end is to prepare a trial balance and ensure the total of the debit entries equals the total of the credit entries. If the trial balance does not balance you have made an error somewhere and you have to go and not only find it but also correct it. You cannot move on to the next stage of the accounting cycle until the trial balance is prepared and you cannot prepare the trial balance until the debits equal the credits.
Once the initial trial balance is prepared, the next stage of the accounting cycle is to identify any necessary adjustments. The adjustments at this stage of the accounting cycle will include accruals and prepayments adjustments, bad debt write off and bad debt provision adjustments, depreciation adjustments, stock provision adjustments, sales credit adjustments, purchase credit adjustments and any other estimates.
The next stage of the accounting cycle involves posting the adjustments above to the accounting records via a journal. The adjustment stage of the accounting cycle is very important and you need to ensure that you complete this stage of the accounting cycle with thought, care, attention to detail and accuracy.
With all the adjustments posted the next stage of the accounting cycle is to prepare the adjusted trial balance and use this to prepare the financial statements, which consist of an income statement, a profit and loss statement, a balance sheet and a cash flow statement. A set of financial statements will also include some notes to the primary statements, which is another task you have to complete at this stage of the accounting cycle.
The next stage of the accounting cycle is to prepare the closing journals closing the profit and loss accounts and adjust the balance sheet accounts as required.
The final stage of the accounting cycle is to prepare a schedule of reversing journal entries, i.e. the opening balances journal. This journal is important to ensure the period end balances transfer to the new accounting period correctly.
The accounting cycle is simply the name given to the process of identifying and recording a transaction. The accounting cycle consists of specific stages as pre period end stages that occur throughout the accounting period, as follows;
- Identifying the transaction or event
- Preparing the source documentation for the transaction or event
- Analysing and classifying the transaction or event
- Recording the transaction or event in the financial records
At the end of the accounting period the accounting cycle changes and there are additional steps to complete as follows;
- Prepare the trial balance
- Prepare a list of accounting adjustments
- Post the accounting adjustments to the trial balance
- Prepare the financial statements and accompanying notes
- Prepare the closing journals