The primary objectives of the accounting function in an organization are to process financial information and to prepare financial statements at the end of the accounting period. Companies must systematically process financial information and must have staff who prepare financial statements on a monthly, quarterly, and/or annual basis. To meet these primary objectives, a series of steps is required. Collectively these steps are known as the accounting cycle.
THE STEPS OF THE CYCLE
- Collect and analyze data from transactions and events: As transactions and events related to financial resources occur, they are analyzed with respect to their effect on the financial position of the company. As an example, the sales for a day in a retail establishment are collected on a cash register tape. These sales become inputs into the accounting system. Every organization establishes a chart of accounts that identifies the categories for recording transactions and events. The chart of accounts for the retail establishment includes Cash and Sales.
- Journalize transactions: After collecting and analyzing the information obtained in the first step, the information is entered in the general journal, which is called the book of original entry. Journalizing transactions may be done continually, but this step can be done in a batch at the end of the day if data from similar transactions are being sorted and collected, on a cash register tape, for example. At the end of the day, the sales of $4,000 for cash would be recorded in the general journal in this form:
- Post to general ledger: The general journal entries are posted to the general ledger, which is organized by account. All transactions for the same account are collected and summarized; for example, the account titled Sales will accumulate the total value of the sales for the period. If posting were done daily, the Sales account in the ledger would show the total sales for each day as well as the cumulative sales for the period to date. Posting to ledger accounts may be less frequent, perhaps at the end of each day, at the end of the week, or possibly even at the end of the month.
- Prepare an unadjusted trial balance: At the end of the period, double-entry accounting requires that debits and credits recorded in the general ledger be equal. Debit and credit merely signify position—left and right, respectively. Some accounts normally have debit balances (e.g., assets and expenses) and other accounts have credit balances (e.g., liabilities, owners' equity, and revenues). As transactions are recorded in the general journal and subsequently posted to the ledger, all amounts recorded on the debit side of accounts (i.e., recorded on the left side) must equal all amounts recorded on the credit side of accounts (i.e., recorded on the right side). Preparing an unadjusted trial balance tests the equality of debits and credits as recorded in the general ledger. If unequal amounts of debits and credits are found in this step, the reason for the inequality is investigated and corrected before proceeding to the next step. Additionally, this unadjusted trial balance provides the balances of all the accounts that may require adjustment in the next step.
- Prepare adjustments: Period-end adjustments are required to bring accounts to their proper balances after considering transactions and/or events not yet recorded. Under accrual accounting, revenue is recorded when earned and expenses when incurred. Thus, an entry may be required at the end of the period to record revenue that has been earned but not yet recorded on the books. Similarly, an adjustment may be required to record an expense that may have been incurred but not yet recorded.
- Prepare an adjusted trial balance: As with an unadjusted trial balance, this step tests the equality of debits and credits. However, assets, liabilities, owners' equity, revenues, and expenses will reflect the adjustments that have been made in the previous step. If there should be unequal amounts of debits and credits or if an account appears to be incorrect, the discrepancy or error is investigated and corrected.
- Prepare financial statements: Financial statements are prepared using the corrected balances from the adjusted trial balance. These are one of the primary outputs of the financial accounting system.
- Close the accounts: Revenues and expenses are accumulated and reported by period, either a monthly, quarterly, or yearly. To prevent their not being added to or commingled with revenues and expenses of another period, they need to be closed out—that is, given zero balances—at the end of each period. Their net balances, which represent the income or loss for the period, are transferred into owners' equity. Once revenue and expense accounts are closed, the only accounts that have balances are the asset, liability, and owners' equity accounts. Their balances are carried forward to the next period.
- Prepare a post-closing trial balance: The purpose of this final step is two-fold: to determine that all revenue and expense accounts have been closed properly and to test the equality of debit and credit balances of all the balance sheet accounts, that is, assets, liabilities and owners' equity.
COMPUTERIZED ACCOUNTING SYSTEM
A computerized accounting system saves a great deal of time and effort, considerably reduces (if not eliminates) mathematical errors, and allows for much more timely information than does a manual system. In a real-time environment, accounts are accessed and updated immediately to reflect activity, thus combining steps 2 and 3. The need to test for equality of debits and credits through trial balances is usually not required in a computerized system accounting since most systems test for equality of debit and credit amounts as they are entered. If someone were to attempt to input data containing an inequality, the system would not accept the input. Since the computer is programmed to post amounts to the various accounts and calculate the new balances as new entries are made, the possibility of mathematical error is markedly reduced.
Computers may also be programmed to record some adjustments automatically at the end of the period. Most software programs are also able to prepare the financial statement once it has been determined the account balances are correct. The closing process at the end of the period can also be done automatically by the computer.
Human judgment is still required to analyze the data for entry into the computer system correctly. Additionally, the accountant's knowledge and judgment are frequently required to determine the adjustments that are needed at the end of the reporting period. The mechanics of the system, however, can easily be handled by the computer.
see also Accounting
Dansby, Robert, Kaliski, Burton, and Lawrence, Michael (2004). Paradigm College Accounting (5th ed.). St. Paul, MN: EMC-Paradigm.
Ingram, Robert W., Baldwin, Bruce A., and Albright, Thomas L. (2004). Financial Accounting: A Bridge to Decision Making (5th ed.). Cincinnati, OH: South-Western College Publishing.
Larson, Kermit D. (1997). Essentials of Financial Accounting: Information for Business Decisions. Chicago: Irwin/McGraw-Hill.
Meigs, Robert F., Meigs, Mary A., Bettner, Mark, and Whittington, Ray (1998). Financial Accounting. Boston: Irwin.
Needles, Belverd E., Jr., and Powers, Marian (2005). Financial Accounting (8th ed.). Boston: Houghton Mifflin.
Porter, Gary A., and Norton, Curtis L. (2004). Financial Accounting: The Impact on Decision Makers (4th ed.). Mason, OH: Thomson/South-Western.
Allie F. Miller