The various steps or phases of accounting cycle are shown in the following flowchart along with explanation:
The steps of accounting cycle are shortly described below:
Identification of Transaction and Other Events
The first step of the accounting cycle is identification of transaction and selected other events. In an organization, many events occur every day. But all of them are not transactions, because every transaction will not involve cash. Only the events measurable in terms of money and make change in financial position/accounting equation are identified as transaction- it should be recorded and in the next stage accounts are maintained for these.
Journalizing
In the second stage of accounting cycle transactions are recorded initially in chronological order of dates debiting one account and crediting the other with brief explanation before transferred to the accounts. Thus, the journal is referred to as the ‘book of original entry.’ If transactions are not recorded earlier in journal, in later stage ledger accounts becomes almost complex.
Posting to ledger accounts
Step three of accounting cycle is to classify business transaction. The statement that is prepared classifying and summarizing the transactions in groups like income expense, assets and liabilities is called ledger. The procedure of transferring journal entries to the ledger accounts is called posting. As all transactions are finally recorded in this book permanently, it is called ‘permanent book of account.’
Preparation of Trial Balance
In forth step of accounting cycle a trial balance is prepared with the help of ledger accounts list and their balances at a given time. As a matter of course, at a particular date of period end the accounts are listed in the order in which they appear in the ledger, with debit balances listed in the left column and credit balances in the right column. Primarily a trial balance is prepared to prove the arithmetical accuracy of debits and credits after posting and facilitate preparing financial statement. A trial balance also uncovers errors in journalizing and posting.
Adjustment
Adjustments are needed to ensure that the revenue recognition and matching principles are followed. To determine operating result of a particular period and exact financial position at a particular date of a business concern various information regarding accruals and advances is essential to be accounted. Adjustments are done in the following ways:
a) According to accrual concept, payable expense lime payable salary, rent and accrued income like accrued interest on investment etc. are to be adjusted in the books of accounts for determining actual income or loss of a particular period.
b) According to income-expense matching concept for determining actual profit expense incurred for earning income like advance, expense, depreciation expense, uncollectible allowance etc. are to be adjusted in the book of account.
Adjusted Trial Balance
In this step of accounting cycle adjusting entries have been journalized and posted in the ledger accounts again for finding out relevant ledger balances at the end of the period. The trial balance that is prepared again with these ledger balances is called adjusted trial balance. The purpose of an adjusted trial balance is to show the effects of all financial events that have occurred during the accounting period.
Financial Statement Preparation
Financial statements are prepared from adjusted trial balance directly. At first to determine net income or net loss, the income statement is prepared from the revenue and expense accounts. After that, the owner’s equity statement is derived from the owner’s capital and drawing account and the net income or net loss from the income statement. Finally, the balance sheet is completed by listing all the assets, liabilities and owner’s equity. Assets will always equal the liabilities and equity that is why this statement is called balance sheet and it shows the financial condition of the enterprise at a given time.
Closing Entries
Journalizing and posting closing entries is a required step in the accounting cycle. Generally, after preparation of financial statements the temporary accounts such as revenue or expense and gain or loss including balance of income statement are closed by passing closing journal entries These accounts are closed to a temporary income summary account, from which the balance is transferred to the retained earnings account (capital). Any dividend or withdrawal accounts also are closed to capital. The necessity of closing expenses and incomes arises as their utilities ended during the particular accounting period and these are not carried forward to the nest year like assets, liability and owner’s equity.
Post Closing Trial Balance (optional)
A third trial balance may be taken after journalizing and posting the closing entries, called the post closing trial balance, shows that equal debits and credits have been posted to the income summary accounts. The purpose of this trial balance is to prove the equality of the permanent account balances that carried forward into the nest accounting period as opening balances. At this point, only the permanent accounts (total assets, liabilities and owner’s equity) appear since the temporary accounts have been closed.
Reversing Entries (optional)
The preparation of reversing entries is the last step of accounting cycle and it is an optional bookkeeping procedure that is not a required step in the accounting cycle. A reversing journal entry is recorded on the first day of the new period. Reversing entries are adverse to adjustment entries which are passed at the beginning of next financial year. In fact, reversing entries are passed for outstanding and advances of previous year in the beginning of an accounting year which are opposite to adjusting entries. By reversing the adjusting entry, one avoids double counting the transaction occurs in the next period. Reversing entries are made only for adjusting entries of outstanding and advances. And for the other adjusting entries no reversing entries are required.
Work Sheet (optional)
The accounting process is completed when all accounts are closed and "reset" for the new financial cycle. This involves working with a work sheet that condenses all the financial statements onto one table. Use of work sheet helps the accountant prepare the financial statements on a timelier basis. To facilitate the end of period (monthly quarterly or annually) accounting and reporting process, a work sheet is often used. Big business organizations where number of accounts and adjustments are comparatively huge, work sheet is prepared to facilitate preparation of financial statements conveniently and accurately. The 10-column work sheet provides columns for the first trial balance, adjustments, adjusted trial balance, income statement and balance sheet. Completing the work sheet provides considerable assurance that all of the details related to the end of period accounting and statement preparation have been properly brought together.
