Why Is an Accounting Cycle Necessary?
The accounting cycle is a process by which a company identifies, analyzes and records its financial and accounting details. For the purposes of a company’s financial records, all transactions are recorded, and those transactions are documented from the moment the transaction begins to the moment it’s finalized on the company’s financial statements.
The purpose of the accounting cycle is to generate reports known as financial statements. A business uses financial statements to analyze its performance over a fiscal period.
The accounting cycle works by a series of rules meant to ensure a uniform production of financial statements that are accurate and conform to industry standards. In earlier periods, mathematical errors were common, but the introduction of computers throughout organizations reduced the likelihood of such errors.
In many cases, software automates the accounting cycle, creating even less error in the calculation of various accounting numbers.
The accounting cycle 10 steps include the following:
- Identify and analyze transactions.
- Record data in journals.
- Post data to the ledger.
- Unadjust trial balance.
- Adjust the accounting entries.
- Adjust the trial balance.
- Prepare financial statements.
- Close the entries.
- Enter post-closing trial balance.
- Reverse the entries.
Although the accounting cycle is typically broken up into these 10 steps, some models of the accounting cycle collapse this list into fewer steps to simplify the list or ease communication about how the cycle works.
Any accounting cycle begins with identifying business transactions and analyzing which accounts are affected by the transactions. The process starts with the source documents where the company initially recorded the transactions. These transactions are recorded in a business journal. These journals contain, at minimum, debited and credited accounts.
Debited accounts are the accounts that increase with an influx of money, and credited accounts are the accounts that reduce due to the outflow of money. This is why at least two accounts are necessary for the journal because it must reflect the account the money is taken from and the account the money is deposited to.
A business ledger is also known as a book of final entry. This ledger is important because it shows the company’s accounts and the changes that happened to those accounts because of various transactions, along with the current balance on the account. With the balances of each account determined, it is time to unadjust the trial balance.
To unadjust the balance, all account balances are taken from the ledger and placed into a single report that contains all debit and credit balances. If the record-keeping is accurate, then the total debits and credits are equal. If not, then a company performs entry corrections to resolve where a debit or credit was not recorded.
After any errors are corrected, further adjustments may be necessary. These include cases in which income has been earned but not yet recorded or expenses accrued that have not been documented in the business journal.
The company makes entry adjustments before preparing the final financial statement, and these adjustments reflect any financial transactions that went unrecorded, including income, expenses, deferrals, prepayments, depreciations and allowances.
A second form of adjustment that takes place is an adjustment to the trial balance. After the entries are adjusted, a review of the report is made prior to finalization. This review is meant to verify that after all adjustments are accounted for, the debits and credits are equal to one another on the completed financial statement.
After updating the accounts, adjusting entries, and verifying that the debits and credits are equal, the company can issue its financial statement. This statement describes the company’s income, equity, financial position and cash flow, and includes notes that provide any final details about the company’s operations.
After the financial statement is finalized, preparations for the next accounting period begins. Temporary accounts, which are characterized by accounts including income, expenses and withdrawals, need to be closed and posted to an income summary. Only temporary accounts, not permanent accounts, are closed after the financial statement is finalized.
The final step of the accounting cycle is the preparation of a post-closing trial balance. This is yet another review to see if the debits and credits are equal after the closing entries of temporary accounts has been made. With temporary accounts closed, only permanent accounts, including their debits and credits, are reflected in the post-closing trial balance.
An optional 10th step, the reversal of entries, does not start during the accounting period. Instead, it begins during the new accounting period. When the new accounting period begins, adjusted entries of expenses, deferrals, income, and prepayments are reversed.
Entries are reversed because these accruals and prepayments are paid off during the new accounting period and are no longer recorded in accounts as either liabilities or assets.
An accounting cycle coincides to an accounting period. An accounting period is the range of time in which various accounting functions are completed. This period occurs within either a calendar or fiscal year. Accounting periods are necessary because they provide a set period within which stakeholders in the company can determine whether the company met expectations.
The accounting period most typically happens during an annual period. Regardless of whether the accounting cycle corresponds perfectly with the year or not, at the end of the cycle, all the company’s transactions must be accounted for. The final financial statement that the company produces at the end of the accounting cycle demonstrates whether the company was successful during the accounting cycle.
For public companies, financial statements are not optional at the end of the year. These statements, most often produced in the form of an annual report, not only demonstrate that company’s success over the previous fiscal year but also provide a picture into how the company is likely to perform the following fiscal year.
These statements are critical for investors, who use them to guide their decisions and investments in the following year. At the conclusion of the accounting cycle and the end of the fiscal year, these reports are available in the investor relations sections of a company’s website.
The accounting cycle ensures that all accounts that have been debited and credited are documented and that the money going into accounts and the money leaving accounts is equal. It also makes it possible for businesses to comapre their results with other businesses in their industry because there are accepted timeframes for accounting purposes.
The quarter and year are two such accepted timeframes.