Our topic of the Life Cycle of the Accounting Process continues. This time I add more details about the 10 steps of the entire accounting life cycle process.
The detailed description of each of the accounting process cycle follows here below:
1. Gathering of information About External Transactions from Source Documents
This information relates to the external transactions that involve an exchange transaction with an outside entity. They include: Sales invoices, bills from suppliers, cash register tapes etc.
2. Analysis of the Transactions
This involves reviewing source documents to determine the dual effect on the accounting equation, that is, determine which accounts to debit and credit.
3. Recording of the Transactions in the Journal
This involves recording the details of the transaction in a journal in order to post the item in the General Ledger. Journals provide a chronological record of all economic events affecting an organization.
4. Posting of the Journals to the General Ledger Accounts
Once the journals are recorded the next step is to record the journal into the general ledger. A general ledger is simply a collection of all the entity’s various accounts. Most accounting systems today are computerized. For these systems, the journal input information is automatically and instantaneously posted to the general ledger accounts.
5. Preparation of an Unadjusted Trial Balance
Before financial statements are prepared and before adjusting journal entries are recorded at the end of an accounting period an adjusted trial balance is usually prepared. A Trial balance is simply a list of the general ledger accounts and their balances at a particular date. This step is necessary to ensure that the debits and credits are in balance. This does not mean there are no errors. Compensating errors can still make this ledger balanced.
6. Recording of Adjusting Journal Entries and the Posting to the General Ledger
This is the time to record the internal transactions. These transactions do not involve an exchange transaction with another external entity and therefore are not initiated by a source document. They are recorded at the end of any period when financial statements are prepared. These transactions are commonly known as adjusting journal entries. Adjusting journal entries are required to satisfy the accrual basis of accounting. Specifically, these entries are required to satisfy the realization and matching principle. Further, the recording of adjusting journal entries ensures that all revenues and expenses are recognized appropriately in the accounting period. Adjusting journal entries include:
- Prepayments (deferrals) -When cash flow precedes either expense or revenue e.g. supplies, deferred revenue, depreciation, rent insurance etc
- Accruals- When the cash flow comes after either the expense or revenue recognition e.g. salary expense, interest expense etc
- Estimates- e.g. depreciation, bad debt expense, etc
7. Preparation of the Adjusted Trial Balance
After the adjusting journal entries are posted to the general ledger accounts, the next step is to prepare an adjusted trial balance. The term adjusted refers to the fact that adjusting entries have now been posted to the accounts.
8. Preparation of Financial Statements
The purpose of each of the previous processing cycles to this point is to provide information for the preparation of the financial statements. The financial statements are the primary means of communicating financial information to the external parties. The four basic financial statements are:
- The Balance Sheet
- The Income Statement
- The Statement of Cash Flows
- The Statement of Shareholders Equity
9. Closing of the Income Statement Accounts to Retained Earnings
An interim reporting period is any period when the financial statements are produced other than at the end of the fiscal year. However, at the end of the fiscal year, two final steps are necessary; closing the Income Statement accounts and preparing the post closing trial balance. The closing process serves a dual purpose as follows:
- The Income Statement accounts, revenues and expenses are reduced to zero balances making them ready to measure activity in the upcoming accounting period.
- These Income Statement account balances are closed and transferred to retained earnings to reflect the changes that have occurred in the account during the period.
10. Preparation of Post Closing Trial Balance (at year-end only)
After the closing entries are posted to the ledger accounts, a post closing trial balance is prepared. The purpose of this trial balance is to verify that the closing entries were prepared and posted correctly and that the accounts are now ready for next year’s transactions.
To make the Accounting Process Flow more fun and even more easier to understand, in my next blog post I will summarize the Life Cycle of the Accounting Process in a single process follow diagram.
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