Definition and explanation:
Accounting Cycle, also known as “accounting process” or “Book-keeping Process” is the start-to-end process to be followed sequentially, or at times, simultaneously for recording the financial and accounting events occurring in any organization.
In earlier times, these steps were followed manually and sequentially by an accountant. But these days, many softwares, like Tally, SAP, ERP, etc complete all the steps involved in accounting process simultaneously, and the user is just required to initiate the process by providing the relevant financial data.
Steps in accounting cycle:
A typical accounting cycle is a 9-step procedure:
The first step of the accounting cycle is to analyze the accounting transaction and determine the nature of the accounts involved so that proper recording can be done.
After determining the accounts involved, the next step is to journalize the transaction in a Journal Book, which is also called the Book of Original Entry because this is the first record where transactions are entered. Transactions in a Journal are entered as and when they occur in a chronological order. A Journal is prepared on the concept of Double Entry, where every transaction affects at least two accounts, i.e. debit to one account and credit to another. read more about journal entries.
After Journalizing, the accounting transactions are posted to Ledger accounts in order to classify and group transactions relating to a single account at one place. Read more about posting from journal to ledger accounts.
The accounting cycle requires summarizing of the entries pertaining to a particular period in a trial balance. A trial balance is essentially a list of all accounts (debit as well as credit) and provides an overview of the various types of financial transactions entered into by any organization during a period.
After preparation of trial balance, the next step is to pass journal entries pertaining to certain adjustments, like, recording of closing stock, adjusting prepaid/outstanding expenses, recording advance/accrued income, etc. These journal entries are known as adjusting entries.
After the adjusting entries are passed and posted to respective ledger accounts, the trial balance has to be corrected and adjusted to show the impact of the adjusting entries. For this purpose an amended trial balance is prepared. This amended trial balance is known as adjusted trial balance.
The next step in the accounting cycle is to organize the various accounts by preparing the financial statements, namely, income statement and balance sheet. The income statement shows all the expenses incurred and incomes earned by the organization during a financial period. The balance sheet is a depiction of the financial position of the business and displays the various assets owned and liabilities owed (to owners and outsiders) by and organization.
After preparation of the profit and loss account/income statement and balance sheet, the accounts have to be closed to prepare for the next accounting period. The temporary accounts, i.e. nominal accounts (income and expenses accounts) are closed by transferring their balances to the profit & loss account by means of a single consolidated journal entry and then the profit & loss account is closed by transferring the profit or loss to the capital account.
The last step is to prepare the final trial balance showing the effect of all the transactions of the year and having closing balances of the accounts for the year. This closing trial balance serves as the base/opening trial balance for the next year’s accounting cycle.