When a transaction takes place its recording passes through a series of steps to post it in various books and statements. A simple definition of the accounting cycle is the process of recording and processing a transaction through various accounting books, journals or ledgers.
There are nine (9) basics steps in the cycle and we shall briefly describe each step here.
1. Preparing the source documents.
These are the documents which record the transaction as evidence as soon as it takes place. They are called the source documents because they are the first or original documents recording the transactions. They are also referred to as vouchers, slips or receipts. Examples of source documents are invoices; cash deposit slips, cash receipts, check payments etc. Suppose Scot paid James $400 by bank check. The first source document for the bank is Scot’s check. To credit James account with the same amount, the bank will record it on another slip called credit slip or credit voucher. So the check and credit slip are the source documents for this transaction.
2. Journal Entries
These are called journal entries because these are in chronological order. Beginning with the first date of the month till the end, and the the next month and so on. The journal entries are entries of debit and credit because when one account is debited, another is credited. For instance, a business buys a computer for $700 and pays by check. The journal entries for this transaction would be:
Dr (Debit) Computing equipment A/C $700
Cr (Credit) Bank Account $700
3. Posting to Ledger
The third step in the accounting cycle is posting to ledger. This ledger is normally called a general ledger. In the general ledger all accounts runs under one single head for each category. For example, all purchases are recorded under the purchase account. Similarly, all sales, expenses etc are recorded under their respective heads. The general ledger records only the total amount to be debited or credited under a specific account. The debit or the credit balance under each account shows the total amount owed or outstanding in that account.
4. Preparing Trial Balance
The fourth step in the accounting cycle is preparing the trial balance. The purpose of the trial balance is to make sure that all the credit and debits amount are accurately posted and all entries in the respective books have been correctly entered. All the entries from the general ledger are jotted down to the trial balance. The debit balances are written on the left side while the credit balances are written on the right side. Each side is totalled and if they are equal, the entries made in the books are balanced. Although, the trial balance shows that the accuracy of the entries in the books, it does not ensure that all entries were made error free as there could be postings under wrong accounts.
5. Correction in the Trial Balance
If the trial balance is not balanced, there could be posting errors. There are many reasons for such errors. Following are some of the most common posting errors.
- To post an incorrect amount
- To omit a posting
- To post in the wrong columns
- To double post
6. Adjusting Entries
These are made at the end of accounting period to make provision for those revenues and expenses which are actually applicable to the period but may not yet have accrued. For example, an electric bill for the month may be received on a date after the accounting period. It is important to make an entry for this as it is an expense of the current accounting period.
7. Posting Adjusting Entries
All adjusting entries are then posted to their respective ledgers accounts.
8. Adjusted Trial Balance
After the adjusted entries and corrections have been made, the next step is to prepare adjusted trial balance. This ensures that all entries have correctly been posted and there are no balancing errors.
9. Preparing Financial Statement
Financial statements are reports showing the financial position, performance and cash flow of a company. These statements are prepared once a year at the end of the accounting period. Here are some of the financial statements prepared at the end of the accounting period.
- Income statement
- Balance sheet
- Cash flow statement
- Retained Earnings
The following simple diagram shows important steps in the accounting cycle.