Question

With the aid of relevant examples, explain the steps of the accounting cycle

Answer 1

The six steps involved in an accounting cycle are as follows :

1. Analyze and record transactions : This is a very crucial step which forms the basis for all the next steps. If this step is wrong then the whole accounting cycle gets impacted. This involves performing an analysis of the transaction, determine which accounts and of what nature are being impacted, whether it is assets, liabilities, expenses, income etc. and then recording such transaction in the respective accounts.

Example :

Transaction : Rent paid $1,000 for period 1st July, 2019 to 30th June, 2020.

i) Analyzing transaction : Here the accounts being impacted are Cash a/c (Outflow of cash) and Rent expense a/c.

ii) Recording transaction : Cash a/c will be credited and rent expense a/c will be debited.

2. Post transactions to the ledger : Next step is to post the transactions recorded in the General Journal to the respective ledger accounts. Ledger accounts are very important as they form the basis for preparing a trial balance. First the opening balance is recorded, then transactions during the year and accordingly the closing balance is arrived at as the balancing figure.

Continuing example in Step 1 : Now, we will post the transaction of step 1 in the respective ledgers :

Cash a/c
Debit			Credit
Date	Particulars	Amount ($)	Date	Particulars	Amount ($)
XX	To Opening Balance	2,000	1st July, 2019	By Rent a/c	1,000
			31st December, 2019	Closing Balance	1,000
Rent Expense a/c
Debit			Credit
Date	Particulars	Amount ($)	Date	Particulars	Amount ($)
1st July, 2019	To Cash a/c	1,000	31st December, 2019	Closing Balance	1,000

Note : Assumed opening balance in cash a/c was $2,000.

3. Prepare an unadjusted trial balance : The next step is to prepare an unadjusted trial balance using the closing balances of the ledger accounts. This step is easily explained by continuing the example taken in above steps :

Trial Balance
Particulars	Debit	Credit
Cash a/c	1,000
Rent Expense a/c	1,000

4. Prepare adjusting entries at the end of the period : This is necessary for various accrual entries and for ensuring the matching concept which means that the expenses belonging to the period shall be recorded in the period in which respective revenue is recognized.

Hence in the above example where rent has been paid for the period 1st July, 2019 to 30th June, 2020 and the financial statements are being prepared on 31st December, 2019, it means that 6 months rent has been paid in advance which is an asset and hence following adjusting entry needs to be passed on 31st December, 2019 :

Date	General Journal	Debit	Credit
31-Dec-19	Prepaid Rent a/c ..Dr	500
	To Rent expense a/c		500

5. Prepare an adjusted trial balance : This step involves taking the impact of adjusting entries passed at year end and incorporating the impact in the unadjusted trial balance.

Taking impact of adjusting entry passed in step 4, adjusted trial balance will appear as follows :

Adjusted Trial Balance
Particulars	Debit	Credit
Cash a/c	1,000
Prepaid Rent a/c	500
Rent Expense a/c	500

6. Prepare financial statements : The final step is preparing the financial statements. Financial statements consists of 3 main components :

1. Balance sheet : This is a statement of financial positing of the company, i.e., the position of its assets and liablities as on a given date.

2. Income Statement : This statement contains the details regarding the financial performance of the company involving the sales, expense etc. It shows the profit earned or loss incurred by the company for a given period.

3. Cash Flow Statement : This usually shows the movement of cash balance from beginning till end and classified the various activities during the year into operating, investing and financing activities.