What Are The Steps of Accounting Cycle? (Accounting Process)

The accounting cycle is a series of steps beginning with recording business transactions and ending with closing. The purpose of recording business transactions as a part of accounting is to prepare balance sheet, income statement and cash flow statement. The accounting cycle repeats every financial period as long as an entity remains in business. Through accounting cycle, profitability can be compared from one accounting period to another because income and expense accounts are closed at the end of the financial period. Below are the steps of the accounting cycle with explanations.

1. Identify Business Transactions

2. Record Transactions in General Journal

3. Post Transactions to General Leger (T-Accounts)

4. Prepare Un-Adjusted Trial Balance

5. Make Adjusting Entries

6. Prepare Adjusted Trial Balance

7. Prepare Financial Statements

8. Make Closing Entries

9. Prepare Post-Closing Trial Balance

10. Make Reversing Entries (Optional)

1. Identify Business Transactions

The accounting cycle starts with identification of business transactions. Not all transactions are entered into the accounting system, only those that are related to the business. For example, an accountant don’t need to record personal loan made by the business owner. The business transactions may be purchase of goods, acquisition of assets, sales revenue, payment for business debt or expense. Use source documents to record business transactions. The source documents are evidence that transactions were taken place. This record is raw material for preparing financial statements. There may be many transactions, the accountant needs to identify each transaction and put it into the right head of account.

2. Record Transactions in General Journal

Once the transactions have been identified, the next step is to record the transactions in a General Journal which is also known as The Book of Original Entry. The transactions are recorded in the General Journal using the Double Entry system where at least one account is debited and one account is credit. For example, the sale for cash is made for Rs. 40000, this transaction would be recorded as cash debit Rs. 40000 and sales credit Rs. 40000. Each transaction is recorded with date and narration. When recording the transaction, both the debit and credit amount must be equal.

3. Post Transactions to General Leger (T-Accounts)

After recording transactions in a General Journal, the next step is to post the transactions in a General Ledger which is also called The Book of Final Entry. The General Ledger classifies transactions by posting the transactions to the relevant head of accounts (Asset, Expense, Income, Liability and Capital). The General Ledger gives the closing balance of each account in order to prepare trial balance which is the next step. In simple words, the General Ledger shows the group of accounts. If the organization uses an accounting software, posting to the ledger is generally done by the software.

4. Prepare Un-Adjusted Trial Balance

The un-adjusted trial balance is prepared from the closing balance of the general ledger accounts. While preparing un-adjusted trial balance, the debit balances are taken in left column and the credit balances are taken in right column.  According to Double Entry Accounting System the debit and credit balances must be equal. The un-adjusted trial balance is prepared to check the equality of debit and credit balances. If they are not equal, there may be some errors in your records that need to be corrected. However, the equality of the balance columns do not guarantee that there is no error. For example, if a transaction is omitted or recorded into the wrong account would not cause an imbalance.  At this stage, no adjustments are made, which is the next step.

5. Make Adjusting Entries

At the end of the financial period, there might have some expense which have been occurred but not yet paid or there might have some incomes which have been earned but not yet received. These types of transactions are recognized in order to make adjusting entries.   Adjusting entries are made to update the head of accounts (Asset, Expense, Income, Liability and Capital). The adjusting entries are made for accrued income, accrued expenses, deferrals and for depreciation.

·         Accrued income: It is the income which has been earned but not yet received. (Asset)

·         Accrued expense: It is the expense which has been occurred but not yet paid. (Liability)

·         Deferral: It is the advance payment received from customer. It may also be prepaid expense.

·         Depreciation: It is the reduction in the value of a fixed asset over its useful life. (Expense)

6. Prepare Adjusted Trial Balance

An adjusted trial balance is prepared after adjusting entries are made. It is prepared in order to check the equality of debit and credit columns.  The adjusted trial balance is similar to un-adjusted trial balance.  But only one thing is different, the adjusted trial balance contains adjustments.

7. Prepare Financial Statements

Once the adjusted trial balance is prepared, the next step is to prepare financial statements (Income Statement, Balance Sheet and Cash Flow Statement).

·       Income Statement: This statement shows profit or loss for a financial period. The profit or      loss is determined by subtracting all expenses from revenues.

·      Balance Sheet: The balance represents the financial position of a business. It contains assets,  liabilities and owner’s equity.

·      Cash Flow Statement:  This statement shows inflow and outflow of cash for a certain period. The inflow and outflow of cash is determined by operating, investing and financing activities. 

8. Make Closing Entries

At this stage, the nominal or temporary accounts are closed for preparing of the next accounting period. The temporary or nominal accounts are income, expense and withdrawal accounts. The income and expense accounts are closed to Income Summary Account. The difference of income and expense (income summary) is closed to capital account.  Then withdrawal account is closed to capital account. It should be considered that closing entries are only made for nominal accounts. The real or permanent accounts are transferred to the balance sheet while preparing financial statements. The real accounts  are asset, liability and capital.

9. Prepare Post-Closing Trial Balance

At this stage, the post-closing trial balance is prepared to make sure the equality of debit and credit columns after closing entries are made. In this trial balance, only real accounts are appeared because the nominal accounts are already closed. This closing trial balance is the base for the next financial period.

10. Make Reversing Entries (Optional)

Making reversing entries are optional. These entries are made on the first day of the new accounting period. These entries are made for accruals (accrued income and accrued expense) and for deferrals (prepaid expense and advance from customer) that were adjusted in the last accounting period.

In earlier days, the above steps were followed manually by an accountant. However, in these days, many accounting softwares complete all the steps with speed and accuracy and yet inexpensive. The user is just need to initiate the process by providing the relevant financial data. After analyzing the financial statements, the accountant can make adjustments and can obtain the revised reports immediately. The software can also reverse the entries for accrual and deferral payments.