Whether your company is big or small, accounting is important to monitor and control your company’s finances. The accounting cycle is a group of steps that companies undertake to ensure their financial records are accurate and up to date. These steps assists in documenting, evaluating, and compiling all financial transactions that take place over a specific period of time.
In this blog, we will learn about the accounting cycle, its steps and the importance of maintaining an accounting cycle in your business.
What is the Accounting Cycle?
The process by which companies record, organize, and report their financial transactions is known as the Accounting Cycle. It starts when a company makes its first transaction of a certain period and ends when it releases its financial reports at the end of the period. This procedure helps companies stay organized and adhere to accounting standards.
How does the Accounting Cycle Work?
The accounting cycle is a process of following a set of steps in sequence, from the identification of financial transactions to generating accurate financial statements. Every step builds on what has been done earlier and helps companies in maintaining their accounts in order. The cycle begins whenever there is a financial transaction and ends when the financial statements are made and the books are closed for the accounting period.
Accounting Cycle Steps
Step 1: Identify Transactions
The first step is identifying and gathering all financial transactions. It includes sales, purchases, or payments made by the business.
Step 2: Recording Journal Entries
After identifying the transactions, they are recorded in a journal. Each transaction is entered as a journal entry, which includes the date, amounts, and accounts affected.
Step 3: Posting to the General Ledger
The next step is posting the journal entries to the general ledger, which is a record of all accounts used by the business. This step helps organize the data in a way that makes it easier to prepare financial reports.
Step 4: Preparing a Trial Balance
After posting the journal entries, a trial balance is prepared to ensure that total debits equal total credits. If the trial balance doesn’t match, it indicates that an error was made in recording or posting transactions.
Step 5: Analyzing the Worksheet
The worksheet is an internal document used to help analyze and prepare financial statements. It includes the trial balance and other necessary information for making adjustments.
Step 6: Making Adjustments
Adjustments are made to ensure that revenues and expenses are recorded in the correct period. This includes things like depreciation, accruals, or prepaid expenses.
Step 7: Generating Financial Statements
Once the adjustments are made, the financial statements (Income Statement, Balance Sheet, and Cash Flow Statement) are prepared. These statements summarize the company’s financial position and performance.
Step 8: Closing the Books
The final step is closing the books. This involves transferring the temporary account balances (like revenue and expenses) to permanent accounts (like retained earnings). After this, the books are closed, and the cycle starts over for the next period.
What is the Importance of Accounting Cycle?
The accounting cycle is important for various reasons:
- Accuracy: It makes the books of accounts error-free and places all the data in proper order.
- Consistency: The Accounting cycle enables businesses to keep consistent records progressively.
- Compliance: The cycle ensures businesses meet legal regulations that makes their financial statements compliant with accounting regulations.
- Decision-Making: Proper financial statements assist business owners, managers, and investors in making informed decisions regarding the future of the company.
Accounting Cycle vs Operating Cycle
Here is a quick difference between Accounting and Operating Cycle:
| Accounting Cycle | Operating Cycle |
| Focuses on financial transactions and reporting. | Focuses on the time taken from receiving inventory to selling goods and receiving cash. |
| Involves steps like recording transactions, making adjustments, and preparing financial statements. | Involves activities such as purchasing raw materials, manufacturing, selling products, and collecting payments. |
| Aims at ensuring financial records are accurate and up-to-date. | Aims at evaluating the efficiency of a company’s operations and cash flow. |
Accounting Cycle vs Budget Cycle
Here is a quick difference between Accounting and Budget Cycle:
| Accounting Cycle | Budget Cycle |
| A series of steps to record and report financial transactions. | The process of planning and controlling income and expenses for a specific period. |
| Helps in preparing financial statements and reports. | Helps in allocating resources, controlling spending, and setting financial goals. |
| Includes identifying transactions, posting to the general ledger, and closing the books. | Involves creating, approving, and monitoring budgets throughout the year. |
Conclusion
The accounting cycle is a necessary and important process for any business, ensuring the accurate recording and reporting of all the financial activities.
By following each and every step, companies can keep financial records in order, avoid regulatory issues, and make best decisions. Whether it’s a small business or multinational corporation, knowing and using the accounting cycle keeps your financial statements transparent and trustworthy.
FAQs
1. What is the accounting cycle in simple terms?
The accounting cycle is a process of recording, adjusting, and summarizing financial transactions to prepare financial statements.
2. How long does the accounting cycle take?
The accounting cycle typically takes one year, aligning with the company’s fiscal year. However, businesses may also perform the cycle quarterly.
3. What happens if the accounting cycle is not followed?
If the accounting cycle is not followed, businesses may face inaccurate financial records, compliance issues, and difficulty making informed decisions.
4. Is the accounting cycle the same for every business?
Yes, the steps of the accounting cycle are the same, but the complexity may vary depending on the size and type of the business.
5. Can the accounting cycle be done manually?
Yes, businesses can complete the accounting cycle manually using paper records, but most companies use accounting software for efficiency and accuracy.
6. What is the purpose of adjusting entries in the accounting cycle?
Adjusting entries ensure that revenues and expenses are recorded in the correct period, providing accurate financial reports.
Reference Links:
