What is an Accounting Cycle?

Financial Accounting is the process of identifying, recording, summarizing, and analyzing an entity’s financial transactions and reporting them in financial statements to its existing and potential investors, lenders, and creditors.

An accounting cycle is a systematic approach to recording all the financial transactions during an accounting period.

Step 1. Identifying transactions 

A regular task of identifying and analysing all transactions made, including expenses, debt payments, sales revenue, and cash received, throughout the accounting period. (I.e., creating invoices, collecting cash for the sales, paying bills, buying inventory, preparing payroll, etc.)

Step 2. Preparing journal entries (recording)

All financial transactions are double-sided in nature—debit and credit. 

In accounting, it is important to know the difference between a debit and a credit, as they have different meanings compared to debit and credit cards issued by a bank. 

A debit entry in accounting either increases the asset or expense accounts while decreasing the liability accounts. 

Examples of debit transactions are cash deposits into the bank account or the payment of rent due. 

A Credit entry increases the revenue and liabilities while decreasing the assets. 

Example credit transactions are earning sales income or recognising rent payable due for next month. 

Every accounting entry has at least one oppositely corresponding entry in a different account. 

Knowing the debits and credits can help you understand the assets, liabilities, and owner’s equity on the balance sheet. 

In the formula “ASSET = LIABILITIES + EQUITY“: 

Assets are basically anything and everything that your business owns (i.e., cash, property, office furniture, equipment, etc.) that is either tangible or intangible. 

Liabilities are records of your unpaid payables and/or loans (i.e., payroll payable, tax payable, current loan, noncurrent loan, etc.). 

Lastly, equity shows the total investments of the owners in the business and the retained earnings to date.

Step 3. Posting to the general ledger

General Ledger is a database that stores a complete record of all accounts and journal entries.

An account is a place where we record, sort, and store all financial transactions that affect a related group of items.

We use the T-account to visualise how we sort the debits (left side) and credits (right side) of an account.

There are three (3) more types of accounts besides assets, liabilities, and equities, namely: dividends, expenses, and revenue.

Dividends refer to the amount to be distributed to the owners or shareholders. This is determined after calculating net income. Any excess after deducting the dividends is recorded in the retained earnings to be used as capital or reserved cash for the business.

Expenses are financial transactions incurred to ensure the operations of the business. This is categorised into the cost of sales, operating expenses, and other expenses (interest expense and taxes).

Step 4. Post adjusting entries to have an adjusted trial balance

The closing balances from all the general ledger accounts are extracted and presented as an unadjusted trial balance.

The adjusting entries will then make this unadjusted trial balance into an adjusted trial balance, which is used as a reference for the preparation of the financial statements.

The adjusting entries include:

Step 5. Create financial statements

After posting the adjusting entries to the unadjusted trial balance, your accountant will start preparing the financial statements. Financial Statements are accounting reports that summarises business transactions over a certain period. These reports consist of a balance sheet, an income statement, and a cash flow statement. Click here to learn more about these reports.

Step 6. Post closing entries

Posting closing entries refers to transferring the balances from temporary accounts—like revenue, expenses, and dividends—into the permanent accounts in the balance sheet—like retained earnings, assets, and accounts payables.

These are the steps to prepare the financial reports given to you. We hope that this article gives you a better understanding of how your financial reports came to be!