What would happen to businesses if there was no accounting system? Does the question seem unthinkable? Let us ask you another one. What would happen to businesses if accounting was not streamlined?
The term ‘accounting’ is the backbone of every business, without which businesses will fail to survive. While this is true, an inefficient accounting system is equal to having no accounting system. For every company to succeed, it requires efficient financial management and proper documentation. Every company has full services accounting team or a finance department, where transactions are analyzed, books of accounts are maintained, and financial statements are prepared. Full services accounting helps you keep a track of your income and expenses, and also lets you evaluate your financial standing. The knowledge of the state of your finances is vital for you to provide direction to your business. But, if the process is not streamlined, then the actual function of accounting remains unfulfilled. Hence, a systematic accounting process is vital for achieving accurate results and to set the right path ahead.
Understanding this, every business follows a standard procedure also known as the accounting cycle or process. But, it is not restricted to recording transactions in the right place. There’s more to it. Let’s look at what an accounting cycle is, its importance, and the steps involved:
The accounting cycle is nothing but a cumulative process of recording and managing the accounts of a company. It includes a series of steps involved in the collection, processing, and communication of the financial information. It begins with transactions taking place and ends when the transactions are recorded in the books of accounts and the results of the financial analysis are generated.
The purpose of accounting is to ensure that your business money is managed well. Its function is to let you know where your money is going, how much is coming in, and how much is left with you. Money is important to run a business. And, when you know the state of your finances, it is easier to make future decisions for your business.
The accounting process follows a series of steps to let you know where your business stands. Such a structured accounting process helps you with accurate results and boosts your chance of success. The number of steps may vary from company to company as some firms may combine certain steps. Nonetheless, the accounting cycle is a process, where steps will follow naturally.
Transactions are imperative to the accounting cycle. If there is no transaction, there is no accounting cycle. Identifying a transaction is the starting point of the accounting cycle. Whether there is a sale, payment of salaries, or buying of raw materials from suppliers, you need to identify the transaction and find or prepare the source documents for it. Once you know there is a transaction and also have the proof of it, then you need to analyze the deal. This is to ascertain which accounts of the business will be affected and what amount has to be recorded.
The next step in the process is the recording of the transactions identified in the journal. A journal is a book – paper or electronic – where the transactions are recorded as they occur. The journal is also called the ‘book of original entries’ as the transactions get recorded there first. Journal entries are recorded using a double entry system, where the entry is made in at least two accounts. One account is credited and the other is debited. For frequently occurring transactions like sales, purchases, cash reimbursements, there is a special journal. The ones that cannot be recorded in the special journal, they go into the general journal.
Also known as the book of final entry, the ledger can be simply described as the collection of accounts. It contains various accounts, like cash, goods, and bank, which are marked in a T-account format. Every account has a debit column on the left and credit on the right. Once you are done making the journal entries, you have to transfer the entries to the ledger in their specific accounts. The ledger shows you the financial status of each account by taking into consideration all the past transactions. For instance, every cash transaction is recorded in the cash account. The debits and credits are weighed against each other to estimate the closing balance of the cash account. Ledgers give you an estimate of the status of each aspect of your business.
The next thing you got to do is to prepare a trial balance. This is done by summarizing the ledger account balances in the debits and credit columns of the trial balance. The trial balance is created to ensure that the debit amount equals credit amount and that there is no error in the records and no transaction is missed. If there is any discrepancy found, then it means that you have made an error while posting the original transactions. You will need to go back to the original record and re-evaluate the transactions. It may be that you have made a calculation mistake or posted an entry wrongly. You may even have missed out on posting a transaction. Identify the problem and rectify it. Make a note that some errors may occur even if the debits and credits match.
Adjusting entries are a part of the accrual basis of accounting. In the accrual basis of accounting, the expenses are recorded as they occur and not when the cash is paid. At the end of your accounting period, you may find some expenses that may have occurred, but not recorded. For instance, depreciation expenses like the depreciation of equipment. Such entries, if not recorded, can give you an unclear picture of your profitability. Hence, these adjusting entries need to be made to decipher a better idea of the company’s profitability. These entries should also be posted in the journal and ledger.
Now, that you have rectified errors found in the initial trial balance and also included the adjusting entries, it is time for you to prepare the adjusted trial balance. Total and subtract the debits and credits of all the accounts and prepare a trial balance again. See to it that the debit and credit in the trial balance are equal. If not, then go back to finding errors and rectifying them. Making this trial balance is important as it will become the basis for preparing financial statements.
Once all your accounts are updated, the trial balance is prepared, and the debit and credit tally, you need to start preparing the financial statements. Financial statements include the Income Statement, Balance Sheet, Cash Flow Statement, Statement of Retained Earnings, and Notes to the Financial Statement. The Income Statement reflects the picture of your company’s financial performance and the Balance Sheet states the financial position of your company. These statements show your company’s financial status and help you decide the future course of action.
Certain items are measured periodically and need to be closed to prepare for the next accounting period. Temporary or nominal accounts like expenses, income, and withdrawals need to be closed for the period. To close them, you need to close the journal entries. The remaining amount gets transferred to the retained earnings account or the income statement summary. It is then transferred to the appropriate capital account on the balance sheet. But, remember that closing entries are only made to the temporary accounts. Permanent accounts or balance sheet accounts are not closed.
The last step in the accounting cycle involves the preparation of the post-closing trial balance or the final trial balance. This is undertaken to ensure that the debits and credits remain equal after the closing of the nominal accounts. Since the temporary accounts are closed now, this trial balance only contains real or permanent accounts.
So, here were all the steps involved in an accounting cycle. Even though you use accounting software, knowing the basics is vital to ensure reliable results. If you want to know more or need help with financial management of your company, avail of our full services accounting at Altitude Accounting.
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