Accounting is the process of keeping financial accounts and records. There are several ways to look at the process of accounting, but the easiest way is through the accounting cycle. The accounting cycle is a simple term that describes the steps and processes involved in recording all the transactions of a company. It is called a cycle because the process is continuous, and the end often leads back to the beginning. The process extends from when the transactions occur to when you close the accounts.
The five steps to accounting (‘The Accounting Cycle’)
Depending on who you ask, there are several steps involved in the accounting cycle. However, they are all aimed at the same goal, which is to keep records of the flow of cash in the business. With these goals in mind, we can divide accounting into five simple steps:
- Entries into the ledgers and journals
- Trial balance
- Adjusting entries
- Financial Statement
Each of these steps fills a different role when it comes to keeping records. When you’re involved with simple transactions, you can go through these steps with paper journals and ledgers. However, if you’re dealing with several transactions spread out over long periods, you may need to use accounting software. This will simplify the whole accounting cycle into simple tasks that can be completed with even minimal knowledge of accounting. Additionally, they can compute the figures in much less time and with no errors.
But for now, let’s take a closer look at each of the activities involved with each of these steps, as well as the roles they play in the accounting cycle.
Transactions simply means all the cash and asset-related activities that are worth documenting. Generally, everything financial about a business is included in this category, ranging from net income to expenses. It even includes gifts and goodwill assets. However, since the records are being kept strictly for the business, then you normally exclude certain transactions from the books.
For example, if the owner of the business takes a personal loan, this does not reflect in the business’ records. The salary the owners pay themselves, on the other hand, will.
You will often see this step divided into two: ‘journal entry’ and ‘ledger entry’. Although these two involve different activities, they can be considered to be a single step because they are the first entries in the business’ books. The journal entry is the next step following the completion of the transaction.
The journal can be either paper-based or electronic, and it’s where you record the credit and debit transactions of the business. While recording, it often helps to have separate journals for different kinds of transactions––one for transactions that happen frequently (daily and weekly) and another for transactions that happen seldomly.
Next, the journal entries are posted into the ledger. Ledgers are also called books of final entry, and they record the changes made to each account and the current balances of the accounts. For example, assume a business has separate accounts for cash-based and cheque-based transactions. Journal entries on cash-based transactions (like debits and credits) would be transferred into the cash ledger, while the cheque ledger would have no entry. So while the ledger would reflect an increase or decrease in cash, the cheque ledger would remain unchanged.
A trial balance is a statement of all the debits and credits in your journal. Accountants and bookkeepers prepare trial balances at the end of the accounting period (it may be three months, six months, or even a year) to see test the equality of the debits and credits, and spot any errors. To prepare a trial balance, you add all the debits in the journal and add all the credits. Ideally, they should be equal to each other. If they are not, it often indicates errors in entries.
To correct these errors, correcting entries are made. They are exactly as their name implies, and their purpose is to correct the entries in the journal, ensuring that the final debit and credit score are equal to each other. Some of the errors that can cause unevenness in the trial balance include double posting errors (entering the same figure twice) and failure to record transactions.
Adjusting entries can also be made in addition to correcting entries. But unlike correcting entries, these are made because of transactions that have been completed but not yet recorded, as opposed to errors. Adjusting entries are usually made for things like accrual of income, accrual of expenses, deferrals, depreciation, and even allowances.
Adjusting entries are made at the end of the accounting period and are usually done before preparing the business’ financial statement. Sometimes, trial balances can be prepared after adjusting entries to make sure that the books are balanced (to make sure that the debits equal the credits). A trial balance prepared after the adjusting entries have been prepared is known as the adjusted trial balance.
The Financial Statement
A business’ financial statement is prepared when all the entries have been made, and trial balances have been prepared to confirm the equality between the debits and the credits. You can think of the financial statement as a quick look at the overall financial position of the business at the end of that accounting period. The financial statement often contains the following information:
- A statement of the business’ comprehensive income
- A statement of changes in equity (where concerned)
- A statement of the business’ financial position (or at least a balance sheet)
- A statement of the business’ cash flows
- Notes and additional relevant information
After the financial statement has been prepared, temporary accounts like the income and expense accounts are closed, and the next system for the next accounting period is prepared. Permanent accounts like balance sheet accounts, on the other hand, are not closed.
These five steps represent the basics of accounting, and as mentioned earlier, they are present in every accounting cycle. Even though businesses grow and have more credit and debit entries in their accounting journals, these five steps still guide the whole bookkeeping process.