Accounting is a system meant for measuring business activities, processing of information into reports and making the findings available to decision-makers. The documents, which communicate these findings about the performance of an organisation in monetary terms, are called financial statements.
Accounting information serves many purposes. Not only does it reveal the financial performance of a company; it also highlights the causes of weakness and deviation from plans. Accounting provides information that helps people in business increase their chances of making benefitting decisions. It is said that accounting is the language of business. This is because accounting is the means by which business information is communicated to the stake-holders. Like all other languages, it has its own terms and rules. For the success of a business, it is important to learn and understand this language.
Accounting information is in all aspects of our lives. When we earn money, pay taxes, invest savings, budget earnings, and plan for the future, we use accounting. Accounting has four broad areas of opportunities: financial, managerial, taxation, and accounting-related.
A major role of accounting is to provide stakeholders with information on the financing, investing, and operating activities of businesses. Financial statements are one source of such information. Another goal of accounting is to summarize the financial performance of the firm for external users, such as banks and governmental agencies.
Broadly speaking, there are two users for an accounting system – internal and external. Internal users of accounting information are managers who plan, organize, and run the business. External users are individuals and organizations outside a company who want financial information about the company. The two most common types of external users are investors and creditors.
Accounting consists of three basic activities — it identifies, records, and communicates the economic events of an organization to interested users. Likewise, an accounting cycle is an ongoing process of identifying, analyzing, and recording the accounting events of an organization. In simple words, the accounting cycle traces the path of each and every transaction your business makes, and ensures that all of the money is correctly “accounted” for. It is a process that begins when a transaction occurs and ends with its inclusion in the financial statements. It is pertinent to note that an accounting cycle is also called as ‘bookkeeping cycle’, but for this article, we will stick with the term ‘accounting cycle’. The whole purpose of the accounting is to convert the raw financial data a company or an organization generates into financial statements. A well maintained accounting cycle ensures that the financial statements of the organisation or company are correct, consistent, and adhere to existing accounting norms as prescribed by the law of your country.
Steps for Accounting Cycle
Now that you have understood what an accounting cycle is, let us see what it actually entails. To reiterate, an accounting cycles traces all the transactions from the moment money enters a business till the time it exits it and accounts for it. There are various steps involved in maintaining this cycle. Some people believe that an accounting cycle can be described in six steps, some believe it can be defined in 8 step, and yet others believe it can be properly defined in 10 steps. However, as long as you have understood the goals and most importantly the flow of accounting cycle, the actual number steps do not really matter. Here is a gist of the modalities involved in capturing an accounting cycle: Identifying and recording, Journal entries, trial balance, adjusting entries, adjusted trial balance, preparing financial statements based on trial balance, closing of books, post-closing trial balance and reversing entries.
We will now define the information flow in an accounting cycle.
This is where the accounting cycle begins. Transactions may include a debt payoff, any purchases or acquisition of assets, sales revenue, or any expenses incurred.
After taking cognizance of transactions, it is necessary to record this data. The first book of accounts is usually the general ledger, and each transaction is transferred here. It is preferable to record the transactions using the double-entry bookkeeping system, whereby at least one account is debited, and one account is credited.
The general ledger is a group of accounts that sort, store and summarize a company's transactions. Once all transactions are posted to the ledger, the balances of each account can be determined.
Unadjusted Trial Balance
The next step in the accounting cycle is to prepare the trial balance, which is nothing but a list and total of all the debit and credit accounts for an entity for a given period. All account balances from the ledger are arranged in a report; all the debit balances are added and compared to the total of all the credit balances. The trial balance checks only whether the total debits match total credits; it does not authenticate the data entered.
Adjusting Journal Entries
The adjusting of journal entries is done so that all revenues, expenses, gains, and losses (and related assets and liabilities) are properly stated and allocated to the proper period or periods. Adjusting journal entries are prepared for revenue accrual or deferral, expense accrual, expense prepayments, depreciation and allowances.
A worksheet is a multiple-column form used in the adjustment process and in preparing financial statements. As its name suggests, the worksheet is a working tool. It is not a permanent accounting record; it is neither a journal nor a part of the general ledger. The worksheet is merely a device used in preparing adjusting entries and the financial statements. Companies generally computerize worksheets using an electronic spreadsheet program.
Adjusted Trial Balance
The Adjusted Trial balance is nothing but a list of all the General ledger accounts (both revenue and capital) contained in the ledger of a business after adjusting entries are made. While a trial balance verifies your accounting books are accurate, and an adjusted trial balance corrects errors in your books. It is used to generate financial statements.
A financial statement is a report that shows the financial information of a business. It contains the following information about the business in report format: income statement: balance sheet; cash flow statement; statement of changes in equity; and notes to the financial statements. It is like the report card of a company, as it shows its financial health at a glance.
A closing entry is a journal entry that is made at the end of an accounting period to transfer balances from a temporary account to a permanent account. Temporary include all income, expense and withdrawal accounts. However, balance sheet accounts are not closed.
Post-Closing Trial Balance
The post-closing trial balance or the after-closing trial balance is the last step of accounting cycle. It is prepared after making and posting all necessary closing entries to relevant ledger accounts.
Timing of the Accounting Cycle
By its very definition, an accounting cycle needs to be carried out for a stipulated period. It is prepared at the time financial statements are prepared. Typically, an accounting cycle lasts for one financial year.