Steps in Accounting cycle.

Definition and explanation:

Accounting Cycle, also known as “accounting process” or “Book-keeping Process” is the
start-to-end process to be followed sequentially, or at times, simultaneously for recording
the financial and accounting events occurring in any organization.

In earlier times, these steps were followed manually and sequentially by an accountant. But
these days, many softwares, like Tally, SAP, ERP, etc complete all the steps involved in
accounting process simultaneously, and the user is just required to initiate the process by
providing the relevant financial data.

Steps in accounting cycle:

A typical accounting cycle is a 9-step procedure:
1. Analyzing:

The first step of the accounting cycle is to analyze the accounting transaction and determine
the nature of the accounts involved so that proper recording can be done.

2. Journalize:

After determining the accounts involved, the next step is to journalize the transaction in a
Journal Book, which is also called the Book of Original Entry because this is the first record
where transactions are entered. Transactions in a Journal are entered as and when they
occur in a chronological order. A Journal is prepared on the concept of Double Entry, where
every transaction affects at least two accounts, i.e. debit to one account and credit to
another.

3. Posting:

After Journalizing, the accounting transactions are posted to Ledger accounts in order to
classify and group transactions relating to a single account at one place. Read more about
posting from journal to ledger accounts.

4. Summarizing:

The accounting cycle requires summarizing of the entries pertaining to a particular period in
a trial balance. A trial balance is essentially a list of all accounts (debit as well as credit) and
provides an overview of the various types of financial transactions entered into by any
organization during a period.

5. Adjusting:

After preparation of trial balance, the next step is to pass journal entries pertaining to certain
adjustments, like, recording of closing stock, adjusting prepaid/outstanding expenses,
recording advance/accrued income, etc. These journal entries are known as adjusting
entries.

6. Correcting:

After the adjusting entries are passed and posted to respective ledger accounts, the trial
balance has to be corrected and adjusted to show the impact of the adjusting entries. For
this purpose an amended trial balance is prepared. This amended trial balance is known
as adjusted trial balance.

7. Organizing:

The next step in the accounting cycle is to organize the various accounts by preparing the financial
statements, namely, income statement and balance sheet. The income statement shows all the
expenses incurred and incomes earned by the organization during a financial period. The balance
sheet is a depiction of the financial position of the business and displays the various assets owned and
liabilities owed (to owners and outsiders) by and organization.

8. Closing:

After preparation of the profit and loss account/income statement and balance sheet, the
accounts have to be closed to prepare for the next accounting period. The temporary
accounts, i.e. nominal accounts (income and expenses accounts) are closed by transferring
their balances to the profit & loss account by means of a single consolidated journal entry
and then the profit & loss account is closed by transferring the profit or loss to the capital
account.

9. Finalizing:

The last step is to prepare the final trial balance showing the effect of all the transactions of
the year and having closing balances of the accounts for the year. This closing trial
balance serves as the base/opening trial balance for the next year’s accounting cycle.

A Journal entry is the first step of the accounting or book-keeping process. In this step, all
the accounting transactions are recorded in general journal in a chronological order. The
general journal is maintained essentially on the concept of double entry system of
accounting, where each transaction affects at least two accounts.

Other names used for general journal are “journal book” and “book of original entry”.

General journal:
A Journal entry is the first step of the accounting or book-keeping process. In this step, all
the accounting transactions are recorded in general journal in a chronological order. The
general journal is maintained essentially on the concept of double entry system of
accounting, where each transaction affects at least two accounts.

Other names used for general journal are “journal book” and “book of original entry”

The process of making a journal entry

The first step in the process of preparing a journal entry is to analyze the accounts involved
in a business transaction and then apply the rules of debit and credit based on the type of
each account. After identifying the accounts involved in the transaction and deciding upon
the applicable rules, the journal entry is recorded in the general journal in a specified format
which includes the following details:

1. Date of transaction
2. Ledger accounts involved
3. Amount of transaction
4. A brief narration to describe the transaction

Format of general journal

Let’s understand the format of general journal and the process of making a journal entry
through an illustration.

Transaction:

January 05: Purchase of machinery by making cash payment of $15,000.

Analysis of transaction:

Recording journal entry:

According to rules of debit and credit, when an asset increases, its account is debited and
when an asset decreases, its account is credited. In this transaction, machinery (an asset)
is increasing, and cash (an asset) is decreasing.  So the journal entry would be made as
follows:
All business transactions are recorded in the general journal in a manner illustrated
above. After making journal entries in the journal, they are periodically posted to the ledger
accounts.

Example:
The Moon Service Inc. engaged in the following transactions during the month of November
2015:

 Nov. 01: Issued 20,000 shares of common stock at $20 per share
 Nov. 03: Paid office rent for the moth of November $500.
 Nov. 06: Purchased office supplies $250.
 Nov. 12: Purchased office equipment on account $4,500
 Nov. 16: Purchased business car for $25,000. Paid $10,000 cash and issued a note
for the balance.
 Nov. 21: Billed clients $24,000 on account.
 Nov. 25: Declared dividends $3,000. The amount of dividends will be distributed in
December.
 Nov. 28: Paid utility bills for the month of November $180.
 Nov. 29: Received $20,000 cash from clients billed on November 21.
 Nov. 30: Paid salary for the month of November $7,500

Required: Record the above transactions in a general journal.

Solution:
The use of software packages for journalizing:
These days most of the companies use some form of software package that automates
many tasks involved in journalizing their business transactions. A basic understanding of
manual procedure to record transactions in a general journal is, however, necessary to
know how software packages perform their function.

General Ledger:
Posting from general journal to general ledger (or simply posting) is a process in which
entries from general journal are periodically transferred to ledger accounts (also known as
T-accounts). It is the second step of accounting cycle because business transactions are
first recorded in the journal and then they are posted to respective ledger accounts in the
general ledger.

Ledger accounts are a way of presenting and grouping transactions relating to a particular
account at one place. The book in which ledger accounts are maintained is known by
various names such as ledger, ledger book or general ledger.

The format of ledger account and posting process

The process of posting journal entries to ledger accounts is very simple. No new information
is needed to prepare ledger accounts. The information that has already been recorded in
the journal is just transferred to the relevant ledger accounts in the general ledger.

For the purpose of posting to general ledger, we can divide a journal entry into two parts – a
debit part and a credit part. Both the parts essentially contain one or more accounts. The
amount of the account (or accounts) in the debit part of the entry is written on the debit side
of the respective account and the amount of the account (or accounts) in the credit part of
the entry is written on the credit side of the respective account in the general ledger.

To have a better understanding of the posting process and to illustrate the format of ledger
accounts, we need to take a transaction, prepare a journal entry and then transfer it to the
relevant ledger accounts.

Transaction: On January 1, 2015, US company sold goods to customers for cash $25,000.

The journal entry of the above transaction and its posting to ledger accounts is illustrated
below:
The debit part of the above journal entry is “cash account” and the credit part is “sales
account”. So the amount of the journal entry ($25,000) is written on the debit side of the
cash account and credit side of the sales account. All journal entries are similarly posted to
accounts in general ledger.

General ledger and the use of computer software

In a manual accounting system, the journal entries are prepared first and then transferred to
general ledger at some later period. It may be a tedious and time consuming process for
companies with numerous business transactions. A computerized accounting system, on
the other hand, is more fast and more accurate. Once enough information is provided and
the journal entry is correctly recorded, computer software automatically posts it to the
relevant accounts in the general ledger and thus increases the efficiency in terms of speed
and accuracy.

Unadjusted trial balance:

The unadjusted trial balance is a list of ledger accounts and their balances that is
prepared after the preparation of general ledger but before the preparation of adjusting
entries. It is the third step of accounting cycle and is usually prepared at the end of
accounting period.
After preparing adjusting entries, an adjusted trial balance is prepared that can be directly
used for the preparation of financial statements.

Format of unadjusted trial balance

The unadjusted trial balance consists of three columns. All account names are written in the
first column, the debit balances are written in the second column and the credit balances
are written in the third column. The accounts are listed in the order in which they appear in
the general ledger. A simple format of unadjusted trial balance is given below:

The total of the debit column of the unadjusted trial balance must be equal to the total of the
credit column. If they aren’t in agreement, it means that the trial balance has been prepared
incorrectly or the journal entries have not been transferred to the ledger accounts
accurately.

Example
We can prepare unadjusted trial balance from the ledger accounts of the Moon Service
Inc. prepared on the general ledger page.
The purpose of unadjusted trial balance:
The main purposes of preparing an unadjusted trial balance is to check the mathematical
equality of debits and credits.

If all the transactions have been correctly recorded in the general journal according to

double entry principle of bookkeeping and have been correctly transferred to the ledger
accounts, the total of the debit balances should be equal to the total of the credit
balances of ledger accounts. An unbalanced trial balance, on the other hand, indicates one
or more of the following typical errors:

1. A debit amount has been incorrectly posted as credit or a credit amount has been
incorrectly posted as debit.
2. The balances of the ledger accounts have been incorrectly determined.
3. The balances of ledger accounts have been incorrectly copied to the trial balance.
4. A debit balance has been incorrectly listed in the credit column or a credit balance
has been incorrectly listed in the debit column of the trial balance.
5. The debit or credit columns of the trial balance has been incorrectly totaled.
The above errors are typical errors that an unbalanced trial balance indicates. One should
keep in mind that the errors may still exist even if the totals of debit and credit columns of
the trial balance are equal. A few examples of such errors are given below:

Examples of errors that will not be detected by trial balance:

1. The transaction is not correctly analyzed and recorded. For example, the receipt of
cash is erroneously debited to another account instead of cash.
2. A transaction is completely omitted from the journal or ledger.
3. The debit and credit amounts of a journal entry are equally overstated.
4. The debit and credit amounts of a journal entry are equally understated.

We may conclude that if the trial balance is balanced, the errors may or may not exist; and if
the trial balance is not balanced, the errors certainly exist.

 Adjusted trial balance

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Adjusted trial balance is the fifth step of accounting cycle that is prepared after the
preparation and posting of adjusting entries to the relevant ledger accounts. Adjusted trial
balance provides enough information for the preparation of a number of financial statements
such as income statement, balance sheet and statement of changes in equity.

Format and methods of preparing adjusted trial

balance
The format of adjusted trial balance is similar to that of unadjusted trial balance. It has three
columns. The first column is used to write account names or titles, the second column is
used to write debit amounts and the third column is used to write credit amounts. Adjusted
trial balance is prepared using one of the two methods explained below:

First method:

The first method is similar to the preparation of an unadjusted trial balance. The ledger
accounts are adjusted for the end of period adjusting entries and the account balances are
listed to prepare adjusted trial balance. This method is time consuming but is considered
more systematic and is usually used by large companies where a lot of adjusting entries are
prepared at the end of each accounting period.

Second method:

The second method is simple and fast but less systematic and is usually used by small
companies where only a few adjusting entries are found at the end of accounting period. In
this method, the adjusting entries are directly added to the unadjusted trial balance to
convert it to adjusted trial balance.
Both the methods are in practice and produce the same result. To simplify the procedure,
we shall use the second method in our example.

Example:
Marketing Consulting Service Inc. adjusts its accounts at the end of each month. The
unadjusted trial balance on December 31, 2015 and adjusting entries for the month of
December are given below. The adjusting entries for the first 11 months of the year 2015
have already been made.

Solution are given to next page.

Required: Prepare an adjusted trial balance of Marketing Consulting Service Inc. on
December 31, 2015.

Solution
The accounts that have been affected as a result of making adjusting entries for the month
of December are shown in red color in the adjusted trial balance. It is just for the purpose of
explanation and you don’t need to change the color in your home work assignments or
examination questions.

Preparation of financial statements

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Preparation of financial statements is the sixth step of accounting cycle that comes after
the preparation of adjusted trial balance. Once the adjusted trial balance has been correctly
prepared, its amounts can be directly used to prepare income statement, statement of
retained earnings and balance sheet