Definition of Accounting
Though there have been many definitions of the word ‘Accounting’, the most appropriate and explicit is “the entire procedure of recording, summarizing and classifying of transactions of any business is known as Accounting.” This is important in explaining accountign cycle.
It is a sequential course of events which begins with the recording or documentation of any transaction of a business dealing which ultimately results into the development and compilation of the financial statements of the defined period which is in consideration.
The main objective of this methodical procedure is to extract useful financial information or financial statements that can be transformed into useful documents to provide a detailed analysis of owner’s equity and cash flow statement, balance sheets and income statements etc.
The primary objective of documenting the transactions in an accounting cycle is to keep a track of all the dealings as and when they take place and result into creation of detailed financial statements on a regular basis.
This procedure is replicated for each accounting cycle/period taken into consideration.
The Procedure of Documenting the Transactions in an Accounting Cycle
This is a 10-step methodical procedure as outlined below
• Identifying and carefully examining the various transactions in the business
• Stepwise documentation of the various business transactions
• Updating the dealings/ transaction into the Ledger Accounts
• Carefully planning and entering of unadjusted trial balance
• Updating the adjustments in entries
• Preparing the trial balance according to the adjusted entries
• Making the Financial Statements
• Updating the closing entries
• Updating and documenting the Post-Closing Trial balance
• Finally recording the Reverse Entries
STEP 1: Identifying and Carefully Examining the Various Transactions in the Business
The initial step is to identify and analyze all the sources of documents, events and dealings/ transactions of the business, which include the receipts, voucher, invoices etc.
STEP 2: Stepwise documentation of the various business transactions
After careful analysis of all the sources of documents, events and dealings/ transactions of the business, these are documented in the journal, which refers to the entire record or documentation of each and every dealing/ transaction. This will mean that for every debit entry there will be a corresponding credit entry and vice versa. All of these dealings are then documented in the journal which is followed by a double-entry bookkeeping system.
STEP 3: Updating the dealings/ transaction into the Ledger Accounts
A Ledger is the main referring book/ document where the amounts from the journal are posted corresponding to different headers or accounts. It is a mandatory rule that for every debit entry under any header/account, there should be an equivalent credit. This is done to ensure that the sum total on both the sides is equal and figures match at the end of the procedure.
STEP 4: Carefully planning and entering of unadjusted trial balance
The carefully documented entry of all ledger accounts and their corresponding balances before documenting the adjusted entries is known and the unadjusted trail balance. An unadjusted trial balance is created to make sure that the total of all debit entries is equivalent to the sum or total of all credit entries. This is a testimony that all the transaction entries have been documented correctly and there is no error in recording of transactions.
STEP 5: Updating the adjustments in entries
Those entries that are documented to rectify the mistakes in amount entries and are those of the current period into consideration are referred to as Adjusting Entries. These entries are made with respect to the corresponding principle or sum amount that is accounted at the end of the period into consideration.
STEP 6: Preparing the trial balance according to the adjusted entries
The trial balance which is unadjusted where the adjusted entries are recorded is popularly known as the adjusted trial balance in accounting language. An adjusted trial balance must also make sure that the sum total of all credit entries is equal to the sum total of all debit entries, which in later referred in the careful preparation of the financial statements.
STEP 7: Making the Financial Statements
The most important document of any business is its financial statement. It holds so much importance due to the fact that it has all the relevant details of complete summary of the business dealings and transactions. Another reason for its importance if due to the fact that it is primary document that is used to calculate the profits of any business. Financial Statements are recorded in a pre-defined format which follows a sequence of documentation of:
• Income statement,
• Statement of retained earnings,
• Balance sheet, and
• The statement of cash flows.
It is a mandate to follow this particular format of documentation and recording of the above mentioned statements, as the preparation of one helps in the subsequent preparation of the next statement in the order.
STEP 8: Updating the closing entries
After the recording of all the financial statements is done, the person doing the accounting also referred to as the accountant starts working on the accounts of the next subsequent period into consideration. In the context of the same, Closing Entries are those entries which are documented or recorded, to mark the business transaction of the next subsequent period into consideration.
STEP 9: Updating and documenting the Post-Closing Trial balance
By carefully deriving out the balances from the balance sheet, an accountant is able to prepare the post closing trial balance. It is the documentation of all the accounts both permanent and temporary which will be used or referred to in the next accounting period. It is usually prepared after careful documentation of financial accounts.
STEP 10: Finally recording the Reverse Entries
This step is not mandatory and one can also opt out to perform it. Those entries which are documented at the beginning of the accounting period to cancel out an adjusting entry made in the previous period are referred to as Reverse Entries.
Some companies perform to do this step while others do not.
Example of an Accounting Cycle
Following is an Example of a Dummy Accounting Cycle:
Cost of buying/procuring raw materials in cash for $10,000.
STEP 1: The bill/charge for the procurement will be recorded and carefully analyzed.
STEP 2: A journal entry will be done, debiting the procurement A/C and crediting the Cash A/C with $10,000.
STEP 3: The journal entry will be done/recorded in the ledger accounts.
STEP 4: The balance of the accounts will be taken out and used to document the unadjusted trial balance.
STEP 5: Adjusting Entry: Moreover, Procurement of $5,000 in cash was not documented.
An adjusting entry will be passed and then recorded in the ledger.
STEP 6: The adjusting entry will be documented in the unadjusted trial balance by making adjustments in the Purchase A/C and the Cash A/C to prepare the adjusted trial balance.
STEP 7: Financial statements are prepared by extracting balances from the adjusted trial balance. Financial statements are made in a specific sequence.
STEP 8: Closing entries concerning revenues, expenditure etc are documented for the next year.
STEP 9: A post-closing trial balance is drafted by extracting the balances from the balance sheet.
STEP 10: Reverse entries are documented to cancel the previous years’ adjusting entries.