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What is Accounting Cycle

accounting cycle

What is Accounting Cycle

Financial statements have to be produced accurately at the end of the accounting period for tax purposes. An accounting period may be a month, a quarter of a year, or a whole year.

The accounting cycle is the series of steps that take place in order to produce  financial statements.

A term that describes the steps when processing transactions (analyzing, journalizing, posting, preparing trial balances, adjusting, preparing financial statements) in a manual accounting system. Today many of the steps occur simultaneously when using accounting software.

Following are the steps that complete an accounting cycle:

  1. Identify the transaction. This transaction could be the revenue from the sale of a product or a payment to another business for services.
  2. Analyze the transaction and how it is related to the accounting balance sheet. For example, determine which accounts are affected by the transaction and how they are affected.
  3. Record the transaction to a journal such as a sales journal.  Journals are kept in chronological order and may be updated continuously, daily, or however often it is necessary.
  4. Record the transaction to the general ledger. Take all of your entries and categorize them by the account.
  5. Perform a trial balance. Debits and credits need to be equal at the end of an accounting cycle, so calculate the entries to ensure they match.
  6. Prepare adjustments. Just because entries are recognized, does not mean the work has been performed. Revenue can only be recognized when the work has been completed, so adjust the entries accordingly.
  7. Perform trial balance with adjustments. Take the adjustments from Step 6 and prepare a trial balance. If the debits and credits do not match, then you need to adjust them to make sure they do match.
  8. Prepare financial statements. From the adjusted trial balance, these corrected balances are used to prepare the financial statements.
  9. Close the accounts in preparation of the next accounting cycle. Revenues and expenses need to be closed out, which means they need to have zero balances. Balances are moved to the next cycle.

Watch This Video for a Clear Understanding of Accounting Cycle: Use CC (closed captions) Button for Subtitles.

Some Important Accounting Terms:

Account

A record in the general ledger that is used to collect and store similar information. For example, a company will have a Cash account in which every transaction involving cash is recorded. A company selling merchandise on credit will record these sales in a Sales account and in an Accounts Receivable account.

 

Accounting Department

Part of a company’s administration that is responsible for preparing the financial statements, maintaining the general ledger, paying bills, billing customers, payroll, cost accounting, financial analysis, and more. The head of the accounting department often has the title of controller.

 

Accounting Equation

Assets = Liabilities + Owner’s Equity. For a corporation the equation is Assets = Liabilities + Stockholders’ Equity. For a nonprofit organization the accounting equation is Assets = Liabilities + Net Assets. Because of double-entry accounting this equation should be in balance at all times. The accounting equation is expressed in the financial statement known as the balance sheet.

Accounts Payable

This current liability account will show the amount a company owes for items or services purchased on credit and for which there was not a promissory note. This account is often referred to as trade payables (as opposed to notes payable, interest payable, etc.)

 

Accounts Receivable

A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a) net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale.

 

Adjusting Entries

Journal entries usually dated the last day of the accounting period to bring the balance sheet and income statement up to date on an accrual basis (as required by the matching principle and the revenue recognition principle).

Adjusting entries are made to report (1) revenues that have been earned but not yet entered into the accounting records, (2) expenses that have been incurred but have not yet been entered into the accounting records, (3) revenues already recorded that involve more than the current accounting period, or (4) expenses already recorded that involve more than the current accounting period.

Activity-Based Costing 

A technique for allocating costs to a product, service, customer, etc. The premise is that activities cause an organization to incur costs. Once the costs of the activities have been identified and each activity’s cost has been determined, the cost of the activities is then allocated to the product, service, customer, etc. that required the activity. This technique is more logical for allocating overhead than simply allocating costs based on machine hours or direct labor hours.

Quick Ratio

Also known as the acid test ratio. This ratio compares the amount of cash + marketable securities + accounts receivable to the amount of current liabilities.

 

Adjusted Trial Balance

A listing of the general ledger accounts and their account balances at a point in time after the adjusting entries have been posted. The grand total of the accounts with debit balances should equal the grand total of the accounts with credit balances.

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