What is Accounting Cycle? Steps, Example

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What is Accounting Cycle?

The entire process starting from the point when a business transaction occurs till it gets included in the financial statements is called the accounting cycle. The accounting cycle of every business starts with the beginning of the accounting period and ends with an end of the accounting period, as the books of accounts can be closed only after the accounting period is over.

For every business, the accounting period could be different depending on various factors. But, mostly the Calendar Year (January to December) or Financial Year (April to March) is taken. During the accounting period, many transactions occur and all are recorded.

Many transactions undergo changes during the year, so adjustments are made and at the end of the year the accounts are finalised and frozen. Every business is required to finalise its accounts and pay taxes within the stipulated time given by taxation authorities.

Steps in Accounting Cycle

Generally, there are eight steps in the accounting cycle as mentioned below:

Identifying a business transaction

Not every transaction could be recorded. For example, a quotation is issued to just let the prospective buyer know the prices of a product or service. There is no business transaction involved in this case that can be recorded. Thus, only those transactions that have a financial impact should be identified and recorded.

Recording the business transaction by making a journal entry

For example, when cash is paid for the purchase of stationary, an entry will be made in the journal which affects two accounts. The office stationery account will be debited and the cash account will be credited.

Posting the journal entry in the respective ledgers

As in the above example, office expenses ledger and cash book will be affected.

Creating unadjusted trail balance

When the balances of these ledger accounts change, a trial balance is calculated. A trial balance reveals the unadjusted balances in each account. Such unadjusted balances are carried forward to the next step for testing and analysis.

Preparing worksheets

The trial balance debit always has to be equal to the credit and if it is not so then the accountant has to prepare worksheets to see where there is a difference and where is the error.

Adjusting journal entries

At the end of the financial period, adjusting entries are made. For example, if there are corrections in orders or payments like more discounts are given, then all this need to be recorded.

Preparing financial statements

After these adjusting entries, the adjusted trial balance is finalised and financial statements are ready.

Closing books

Once all transactions are recorded and the profit is declared and the taxes are paid accordingly, the books of accounts are closed. Thereafter, no entry is made in that financial year.

Accounting Cycle Example

Let us understand the concept of the accounting cycle with the help of an example.

If Ben purchases a laptop from Dell Electronics at ₹ 40,000. For this Ben receives a receipt of ₹ 40,000 from Dell Electronics and an invoice for ₹ 40,000 is raised by Dell Electronics for Ben. The accounts are settled as Ben has paid in full.

There will be the following steps for this transaction

  1. Source Document One (Quotation): This document represents information on the laptop issued to Ben by Dell Electronics including specifications and price of the laptop. The quotation has a serial number and date. No accounting entry is made for this source document.

  2. Source Document Two (Purchase Order): Purchase order given by Ben to Dell Electronics which shows the authentication of the order received for that particular laptop with specifications and price. One copy is to be handed over to Dell and another is to be retained by Ben. Transaction will be recorded in the Purchase/Asset register of Ben and the Sales Register of Dell.

  3. Source Document Three (Invoice): Invoice will be raised by Dell Electronics for the purchase order given by Ben with the same specifications and price including taxes and other charges acceptable to Ben. This invoice is made in two copies, original is issued to Ben and other is retained by Dell. This transaction is recorded in the sales register of Dell and the purchase/asset register of Ben

  4. Source Document Four (Receipt): A receipt is issued to Ben on making a payment of ` 40,000 by debit card to Dell Electronics. Transaction is recorded in the Bank Book after verifying the bank statement for the receipt of payment

  5. Source Document Five (Delivery Challan): Delivery challan is issued by Dell on the delivery of the laptop. Two copies are generated. One is acknowledgment of Ben and is retained by Dell. The other copy given to Ben along with the laptop. This transaction is recorded in the inventory register of one laptop sold by Dell Electronics. In Ben’s books, assets are increased.

Now, the transaction is complete, where the sales of ₹ 40,000 is included in the sales figure in the financial statement, inventory is reduced by one laptop and value of inventory is reduced by ₹ 40,000. Revenue increases and the accounting equation balances with the balance sheet.

From the above example, you can see that the accounting cycle is a methodical set of rules you need to abide to ensure accuracy in financial statements. In the above example, we see that for Dell Electronics, the sales, inventory and revenue figures changed in the financial statement with this transaction.

Hence, the process from where the transaction is initiated to finally getting recognised in the financial statement is the accounting cycle. With computerised accounting, a uniform process for each transaction is set and thus there is little chance of human intervention and error. Fully automated software eliminates errors and helps to complete the accounting cycle successfully.

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