The accounting cycle is a process that bookkeepers, accountants and businesses use to prepare financial statements. It’s a systematic and disciplined approach that ensures the consistency and accuracy of financial reporting. Below are components of the accounting cycle and the relevance to business stakeholders.
Accounting Cycle Defined
The process of identifying relevant transactions and economic events, and transforming that information into reliable financial statements, is called the accounting cycle. There are many steps including journalizing transactions, posting journals to the general ledger, preparing an unadjusted trial balance and posting adjusting entries. The net result of the cycle are financial statements that show assets, liabilities, cash flow and the relevant accounting period under review, among many other important data points.
Transaction analysis is one of the most critical elements of the accounting cycle, because it impacts all the other process steps in the cycle. During this stage, bookkeepers, accountants and business owners analyze source documents and determine the business purpose of transactions. Revenues, expenses, assets, liabilities and other transactions are reviewed for recordation. Clerks typically work in tandem with supervisors and technical experts, to determine how to treat transactions correctly. The complexity of the transaction dictates the level of review needed.
Once the business purpose and nature of transactions are identified, then journal entries can be prepared. Debits and credits are entered into the journal based on U.S. Generally Accepted Accounting Principles, or another set of comprehensive accounting principles such as International Financial Reporting Standards. The debits and credits need to equal on the journal entry. Otherwise, the general ledger system will likely reject the entry from being posted. Journal entries typically go through a series of reviews before being posted.
Recording Journals to the Ledger
When a journal entry is prepared, approved and balanced, it can be posted to the general ledger. In an electronic ledger system, this process is seamless once the journal entry is posted. With a manual ledger, the process of recording a journal to the ledger is more involved. The journal entry must be transferred from a specific journal to a specific ledger. All subsidiary ledgers must in turn be closed to the general ledger, before a trial balance and financial statements can be created.
Creating an Unadjusted Trial Balance
An unadjusted trial balance is created after I post journal entries to the general ledger. The trial balance contains all the permanent accounts and temporary accounts listed in the chart of accounts. The trial balance is unadjusted, because the temporary accounts have not been closed out to the income summary and retained earnings accounts. Also, correcting or adjusting entries may not yet be posted to the ledger. The unadjusted trial balance is an excellent tool for gauging the accuracy of financial statements, before they’re published.
Recording Adjusting Entries
Adjusting journal entries to the trial balance can take many forms. Before the temporary accounts are closed to the permanent accounts, journals adjusting revenue, prepaid expenses and the allowance for bad debt, among many other accounts, can be posted to the ledger. These adjustments are typically done during a month-end-close process by accounting teams. These entries are often standardized and repeated systematically to reduce the potential for errors. Once all corrections are made, the closing entries can be made to the trial balance.
Adjusted Trial Balance
Before publishing financial statements, it’s important to generate an adjusted trial balance and perform a thorough review. This trial balance should reflect all closing entries. If there are any business transactions missing from the trial balance and accounting software, this is the stage to identify the need and record transactions. Supervisors often use an adjusted trial balance to perform a final review, before publishing financials and conducting a horizontal or vertical analysis.
Creating Financial Statements
Financial statements are derived from the general ledger and the adjusted trial balance. The balance sheet is generated from the permanent accounts, and the income statement is created using the activity from the temp accounts. The balance sheet represents a moment in time, and the income statement illustrates transaction activity for a period. The statement of cash flows and stockholder’s equity are also created using the adjusted trial balance.
While the presentation of each of the financial statements may differ, depending on the size of the company and industry the organization exists in, the process for financial reporting is similar. Accountants, senior leaders, department heads and other important stakeholders review the financials looking for trends and variances. These reviews are documented and kept on file, if there is an audit of internal control over financial reporting.
Post Closing Trial Balance
To verify the closing process was completed accurately, a post closing trial balance is created. This trial balance should reflect the closing entries made earlier in the accounting cycle. If there are any temp accounts with remaining balances, then the closing process and financial statements require additional review. Any errors during the closing process should be identified at this time. This final check adds to the credibility of the financial statements and the professionals preparing them.
The accounting cycle is an important element of preparing financial statements, because it gives accounting professionals a methodology for recording transactions. This process helps take complex data and transform it into usable information that business owners can make decisions with. Without this process, financial information would be less timely, complete and relevant.