The Accounting Cycle

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December 3, 2008 The Accounting Cycle

This training handout is designed for non-finance department directors so that they may better understand the accounting cycle. This is the cycle that we use at regular intervals to record transactions, classify them, and then summarize in financial reports. The process starts with the initial record of the transaction and ends with the formal financial report. As this is a ‘cycle’, the steps are repeated on a regular interval and new financial reports are produced each time.

These financial reports are used by department directors in many areas, so the accuracy of the accounting cycle and the reconciliation of the entries is important for many reasons. These reports are used to establish accountability for this company’s assets under a director’s control.

It allows us to keep track of our routine expenses and can provide detailed information on partic- ular transactions. With this information, we can establish and evaluate efficiency goals for each department. In addition, the law requires that we keep accurate accounting records of our transactions for tax purposes (Dansby, et al, 1999).

There are generally eight steps or procedures to completing the accounting cycle. These are: (1), recording the transactions; (2) post each entry to the proper ledger account; (3) prepare a trial balance; (4) make end-of-the-period adjustments; (5) prepare an adjusted trial balance; (6) prepare financial reports; (7) journalize and post closing entries; and, (8) prepare an after-closing trial balance (Meigs, et al, 1998).

In the accounting cycle, each transaction is required to have a separate and unique record.

This could be cash coming in from sales, cash going out from paying invoices, or gaining/losing assets. These records are also referred to as accounts and the total of the accounts is called the ledger. The most important step of the accounting cycle is the first step of recording the transaction. If a mistake is made in this step, it can affect the final financial report for the reporting period. These transactions can be as detailed as the department directors need them to be. The transaction records could be invoices being paid by our company, payment the company receives for invoices we have sent out, and purchases made by employees and staff. Records of the transactions need to be made as soon as they occur. This eliminates some sources of error (Meigs, et al, 1998).

The next step is to apply the transaction to the proper ledger account. Each department has its own account and there are also accounts for overhead and general expenditures. While the individual transactions are recorded as they occur, the application of the records to the ledger can be done less frequently. Some accounts may require that the ledger be updated daily, while others may require the postings at the end of the week or even at the end of the month (Larson,

1997).

The third step in the accounting cycle is the preparation of a trial balance. This tests whether the debits and credits or assets and liabilities are equal in the as they are recorded in the ledger. If an inequality is found, it can be adjusted in the next step.

Adjustments are sometimes needed at the end of the reporting period. This may be due to an invoice that we have sent out and not yet received payment for or a payment that we have not made though we have been billed. These adjustments consider transactions that have not yet occurred in the reporting period.

After adjustments have been made to the ledger, an adjusted trial balance can be pre- pared. This is essentially the same test as the unadjusted trial balance but takes into considera- tions the adjustments made in the previous step of the accounting cycle. If there are still discrep- ancies between the debits and credits or if the trial balance seems to be inaccurate, the records should be reviewed to determine where the error occurred.

The preparation of the financial reports follows the adjusted trial balance preparation.

These are the primary outputs that the directors use to assess the company in each reporting period. What the reports show is a culmination of the work that was done in the previous steps of the accounting cycle.

To prevent errors in following reporting periods, accounts such as debits and credits are closed out at the end of each reporting cycle. This gives the ledger a zero balance for the start of the next cycle and prevents either an over-reporting or an under-reporting of cash and expenditures. The only accounts that will have a balance that carries over to the next reporting cycle are assets, liabilities, and equity accounts.

The final step in the accounting cycle is the preparation of an after-closing trial balance.

There are two purposes for this step. The first is to make sure that the revenue and expense

(credit and debit) accounts have been closed and zeroed out as required. The second reason is to provide one final test of the equality of the balances (Meigs, et al, 1998).

This accounting cycle is important to the operations of our company and its various de- partments, though most non-financial directors are only familiar with the product of the cycle: the financial report. With this training, it is the intention that the directors will possess a greater understanding of the accounting cycle and the steps of the process. The integrity of the process is dependent upon those who initiate the transactions that are recorded and subsequently incorpo- rated into the final reports. The checks and balances within the cycle are designed to ensure the accuracy of the reports and computer systems have made this once tedious task much easier. However, the human element of understanding how the cycle works and starting the process cor- rectly cannot be substituted by any computer program (Larson, 1997).

References

Dansby, Robert, Kaliski, Burton, and Lawrence, Michael (1999). College Accounting. St. Paul,

MN: EMC Paradigm.

Larson, Kermit D. (1997). Essentials of Financial Accounting. Boston: Irwin/McGraw-Hill.

Meigs, Robert F., Meigs, Mary A., Bettner, Mark, and Whittington, Ray. (1998). Financial

Accounting. Boston: Irwin/McGraw Hill.