Accounting Cycle: Complete basic accounting in 8 steps

The Accounting Cycle is a topic that varies according to the level of accounting that you are studying or doing for a business. If you research Accounting Cycle, you would be bombarded with versions that might make your head spin. This article focusses on basic accounting for small business owners and students to understand the steps involved when recording the financial performance of a business.

In the Accounting Cycle, some of the steps are the responsibilities of a bookkeeper and the others are done by the accountant. When an entrepreneur starts a business, it is necessary to keep a record of every single transaction that was made in order for you the bookkeeper or the accountant to include in the Accounting Cycle.

It is possible to use only 6 steps to complete the books for one business and up to 8 steps for another. The less steps you use may mean that you hardly made mistakes, you made none at all, or you are only required to prepare the books up to a certain point. Here are 8 steps that are involved in the Accounting Cycle at the basic level of accounting.

8 Steps in the Accounting Cycle

1. Source documents

Business transactions accumulate source documents. These are receipts, invoices, bills, credit notes, emails, text messages and bank statements. They are required to prove that transactions have taken place. If there is no written evidence of a transaction, then it cannot be recorded in the books.

The bookkeeper is responsible for sorting through source documents. First, they must be separated into cash and credit transactions. Then, the credit transactions must be separated into goods for resale, fixed assets and other items not for resale, documents to open books, errors to be corrected, bad debts, provision for doubtful debts, depreciation, and provision for depreciation.

2. Journals

The bookkeeper then takes the source documents and allocates them to the appropriate Journals or Day Books. The 7 Journals are Cash Book, Petty Cash Book, Sales Journal, Purchases Journal, Returns Inwards Journal, Returns Outwards Journal and General Journal.

Cash transactions are recorded in the Cash Book. Small cash transactions are recorded in the Petty Cash Book. All transactions that involve goods for resale on credit are recorded in the Sales, Purchases, Returns Inwards and Returns Outwards Journals. All other transactions go to the General Journal.

3. Ledgers

The bookkeeper takes the totals of the Journals and records them into 3 Ledgers called General Ledger, Sales Ledger and Purchases Ledger. These are also called T accounts because they are shaped like a capital T. The left side is called debit and the right side is called credit.

When assets and expenses increase, they are debited and when they decrease, they are credited. When liabilities, income and capital increase, they are credited and when they decrease, they are debited.

The purpose of the Ledgers is to total the left side and right side of the accounts, and then subtract the lesser side from the greater side to see if there is a balance on the account. If there is a balance, then the account goes on to the next step of the Accounting Cycle. If there is no balance, the account is closed off.

4. Trial Balance

The bookkeeper then transfers the balances from the Ledger accounts to the Trial Balance. Drawing up a Trial Balance is usually a nail-biting experience for students and bookkeepers. It is the fourth step in the Accounting Cycle that can be the end of the tasks for the bookkeeper or not, based on accuracy.

The names of the accounts with balances are recorded on the left side of the page. On the right side of the page, there are the headings Dr and Cr next to each other which means debit and credit. Dollar signs are written under these headings. Accounts with debit balances go under Dr and accounts with credit balances go under Cr. The Dr and Cr amounts are then totalled and it may or may not balance.

5. Making Adjustments

Whether a Trial Balance has totals that are the same or not, it is a bookkeeper’s responsibility to check for accuracy. This is because there are errors that do not affect the Trial Balance as well as there are errors that affect the Trial Balance.

Students of basic accounting are usually given the errors that were found and are asked to fix them using control systems. When you are doing the books for a business, however, you have to go back to the beginning of the Accounting Cycle and double check your handling of the source documents, Journals, Ledgers and calculations.

Here is a video showing step by step instructions on how to correct errors that do not affect the Trial Balance. Other control systems for correcting errors are as follows:

• Suspense account
• Debtors and Creditors Control accounts
• Bank Reconciliation Statement
• Draft Net Profit

When errors are corrected, an adjusted Trial Balance is created. This is the end of the bookkeeper’s duties in the Accounting Cycle.

6. Income Statement

The accountant uses the income and expenses in the Trial Balance to draw up an Income Statement. This shows the profitability of the business. It starts with revenue earned and subtracts the returns of goods to the business to show a realistic figure of sales made.

Then, cost of sales is totalled to show exactly what it costs the business to create a product to sell. This is the opening stock add purchases of goods, add carriage inwards because you have to include the transport of goods, subtract closing stock. Subtract the cost of sales from net sales and that is your gross profit.

If goods were returned to suppliers, you have to subtract it. If the business received a discount, you have to add it because it is cash still in hand. This figure subtracts all the expenses in the business that allows it to function. These expenses are carriage outwards, discount allowed, rent, insurance, utilities, advertising, repairs, depreciation and bad debts.

7. Balance Sheet

Then, the accountant uses the assets, liabilities and capital from the Trial Balance to draw up a Balance Sheet or Statement of Financial Position. This shows the worth or equity of the business.

It starts with the non-current assets which are goodwill, land, building, vehicle, machinery, equipment, and fixtures and fittings. These are added to the current assets which are inventory, prepaid expenses, accounts receivable, bank and cash.

The short-term liabilities are loans under a year and accounts payable. These are subtracted from the total assets to show the capital employed for the financial period. This figure must balance with the total non-current liabilities, opening capital and net profit. If the owner withdrew money from the business, you have to subtract it to find the owner’s equity.

8. Cash Flow

The accountant then uses the cash and cash equivalent information in the balance sheet to show the liquidity of the business. Even though a business’ assets may look impressive, the fixed assets and debtors may be much higher than the amount of money in the bank and in hand. Drawing up a Cash Flow Statement shows the immediate capability of the business to pay off debts in a short space of time. The Cash Flow Statement shows:

1. Cash flow from operating activities
2. Cash flow from investing activities
3. Cash flow from financing activities
4. Disclosure of non-cash activities

Conclusion

The Accounting Cycle covers the handling of a business’ financial information from start to end. It is different for many businesses as some people may want to see their business’ profitability and worth while others may want to present an investor with comprehensive information about the business’ performance.

Many students are introduced to the Accounting Cycle as 6 types which are Source Documents, Journals, Ledgers, Trial Balance, Income Statement and Balance Sheet. However, the steps called Making Adjustments and Cash Flow are crucial in basic accountant and was therefore included in this article.

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See also:

ALICE: Assets, Liabilities, Income, Capital, Expenses

Assets: Owned fixed and liquid items with a debit balance

Liabilities: Owed long and short term items with a credit balance

Income: Earned, unearned and contributed money

Expenses: Spending that’s direct, indirect, operating and non-operating

Capital: Invested assets and the liquidity of a business