Introduction to Accounting Cycle

What is Accounting Cycle?

Accounting is the process of recording the transaction to make the financial information consolidated to give a clear picture and understanding about the financial health. Accounting can be broadly classified into two broad categories include Financial Accounting and Managerial Accounting based on users of accounting. Basically there are two types of users of accounting as internal users (includes management, managers, owners, BOD, employees, etc.) and as external users (includes suppliers, customers, governments, etc.)

Financial Accounting is basically prepared for external users that provides the clear and understandable information of the company. While Managerial Accounting is basically prepared for internal users that helps to make proper decision in the organization for stability, growth and opportunity.

An accounting cycle is the process of preparing the financial statements (include Income Statement, Balance Sheet and Cash Flow Statement) to ascertain the financial position of the company. An accounting cycle consists nine steps which starts with positing journal entries and ends with posting the closing entries. 

The main purpose of accounting cycle is to records all the transactions properly without missing any entry. An accounting cycle starts when any transactions takes place. Without have any transactions an accounting cycle will not start.

Process of Accounting Cycle

In the process of an accounting cycle, there are nine steps to complete one cycle of accounting that is used to prepare the financial statements (include Income statement, Balance Sheet and Cash Flow Statement). The following are the steps explained as bellows.

Fig: Accounting Cycle

1. Journal Entries: All the transactions of a business are recorded first, in a book of original entry as and when they take place. Such book of original entry is popularly known as 'Journal'.

2. Ledger Accounts: When all transactions of a particular account are collected at one place, then it is called 'ledger'. In other words, a ledger is a book in which all the accounts of a business relating to persons, assets, expenses, incomes etc. are maintained.

3. Trial Balance: It is a statement of debit and credit totals or balances of the ledger account, which is prepared to check the arithmetical accuracy of the recorded transactions.

4. Adjustments: The transactions that do not appear in a ledger account are to be noted as adjustments. Those financial transactions not included in the concerned ledger account are mentioned separately as adjustments after the preparation of trial balance.

5. Adjusted Trial Balance: It is a statement of debit and credit totals or balances of the ledger account including adjusted ledger account, which is prepared to check the arithmetical accuracy of the recorded transactions. 

6. Income Statement: The Income Statement summarizes the results of operations of an entity for a period of time. At a minimum, all companies prepare income statements at least once a year.

7. Balance Sheet: A balance sheet is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific period of time. It is one of the three fundamental financial statements (Income Statement, Balance Sheet, and Cash Flow Statement).

8. Cash Flow Statement: The statement of cash flows summarizes a company's operating, investing, and financing activities for the period. Each of these categories can result in a net inflow or a net outflow of cash. 

9. Closing Entries: Closing entries is prepared to make the balances of temporary accounts zero and transferring all temporary accounts into permanent accounts.

Mistakes in Accounting Cycle

There are basically four types of accounting error or mistakes that can be occurred while following an accounting cycle described as bellows:

1. Error of Principle: It refers to recording the transactions against the principle of accounting (GAAP). Example: some furniture was bought on credit for Rs50000/- for office use.
   

   • Wrong Entry
   •  Furniture A/c........................Dr  Rs.50000
     
   • To Purchase A/c                                    Rs50000
     
   • Right Entry
   • Furniture A/c.........................Dr   Rs50000
   • To Sundry Creditor A/c                         Rs50000
     

2. Error of Omission: It refers to avoiding the transactions and not recorded in the books of account. Example: Check received of Rs10000 from debtors but not sent to bank for collection

   • Wrong Entry
   • Bank A/c.................................Dr Rs10000
     • To Sundry Debtors A/c                        Rs10000
   • Right Entry
   • Bank A/c.................................Dr N/A
     
   • To Sundry Debtors A/c                       N/A

3. Error of Commission: It refers to recording the transaction incorrectly in the books of account. Example: Goods sold to Mr. X on credit for Rs5000

   • Wrong Entry
   •  Mr. X A/c...............................Dr Rs10000
   • To Mr. Y A/c                                        Rs10000
     
   • Right Entry
   • Mr. X A/c................................Dr Rs10000
   • To Sales A/c                                         Rs10000
     

4. Compensating Error: It refers to recording the transaction with wrong amount. Example: Purchase goods for Rs5000 on cash

   • Wrong Entry
   • Purchase A/c...........................Dr Rs50000
   • To Cash A/c                                              Rs50000
     
   • Right Entry
   • Purchase A/c...........................Dr Rs5000
   • To Cash A/c                                              Rs5000
     

An accounting errors are unintentional error and sometime easy to identify and fix it. These errors can be rectified by identifying and recording correct entry. Rectification of errors are the procedure of revising mistakes in recording the transactions. 

Note: Suspense account is a temporary account in the ledger book that is used for doubtful entries when the right transaction are not identified at the time. But after identifying the right transaction or account balances will be removed from suspense account. It is done before publishing the financial statements.

Conclusion

An accounting cycle is the process of preparing the financial statements (include Income Statement, Balance Sheet and Cash Flow Statement) to ascertain the financial position of the company. An accounting cycle consist nine steps which starts with positing journal entries and ends with posting the closing entries. An accounting cycle is used to prepare the financial statements (include Income statement, Balance Sheet and Cash Flow Statement). There are basically four types of accounting error or mistakes that can be occurred while following an accounting cycle includes error of principle, error of omission, error of commission and compensating error. These error can be avoided by doing rectification entries. Rectification entries are procedure of revising mistakes in recording the transactions.

Come On, Tell Me What You Think!

Did I miss something?  Come on! Tell me what you think about this post on Introduction to Accounting Cycle in the comments section.