Accounting Cycle
Accounting Cycle is another name for accounting process which initiates with the occurrence of an event and ends with the preparation of the financial results of a company. Since this process takes place every year, it is also known as “accounting cycle.” It consists of the following methods:
- Analyzing business events and identifying transactions which need to be recorded in the books of accounts. Only business related sales are registered, and personal affairs are left out (like buying a car for personal use).
- Passing Journal entries to record these transactions.
- The journal entries are then registered to the relevant ledger accounts.
- Now, an unadjusted trial balance is prepared to know the arithmetical accuracy of the books of accounts. It may be noted that even if the trial balance balances here, it does not necessarily signify the absolute correctness of the accounting process. Some errors may still be present, like transactions which have not been recorded at all or journal entries which have been posted twice in the ledger.
- Post-trial balance, all the adjusting entries which are in the form of accrued income or expenses, deferred expenses, and pre-payments are passed in the books of accounts.
- An adjusted trial balance is prepared (including the adjusting entries) to verify the arithmetical accuracy.
- Based on the trial balance, financial statements of the company are ready, including the income statement, balance sheet, and a cash flow statement.
- The books of accounts are finally closed for a given accounting year, and for this appropriate closing, entries are passed. Closing entries are required to be passed to close the temporary accounts like income and expenses (transferred to income summary) and drawings (transferred to capital).
- Post-closing, again a trial balance is prepared to check whether the debit entries made are equal to the credit entries.
Accrual and Cash Basis
Accrual and Cash basis are two principal accounting methods, and one has to opt between the two before business transactions are recorded. The primary difference between the two approaches lies in the timing of filing the events.
In Cash basis of accounting, transactions are recorded as and when cash is received or paid; say, for example, when goods are sold on credit, no operation is recorded. The accounting entry is made in the books of accounts only when the revenue is received, which may be in the form of cash, cheque, credit card, or electronic transfer of payment. Likewise, the expenses are also recorded in the books of accounts only when the actual amount is made and not when the cost is incurred. It is a simple method of accounting and is generally employed by smaller concerns, say coaching centers. This method fails to record significant expenses like depreciation and amortization.
In comparison, in Accrual basis of accounting, expenses and revenues are recorded as when the same are incurred. Thus credit sales are recorded as when the purchases are made and not when the actual cash is received, and expenses are recorded as when the same is activated and not at the time of actual payment. This method of accounting is more useful as compared to a cash basis by matching the correct expenses against the actual revenues of a given period. The former thus provides a fair view of the financial position of the business concern at any time. However, this method also has its drawback. One may not be able to know the actual cash balance of a business at a given time. Thus many companies using accrual basis also keep track of cash flow alongside to avoid any operational hassles due to cash deficiency.
Trial Balance
Preparation of Trial Balance marks the beginning of the development of the financial statements of a company, i.e., usually at the end of an accounting year. After all journal entries have been passed, and all the ledger accounts have been balanced. A statement in the form of the trial balance is prepared where all the debit ledger balances are written on the left-hand side, and all the credit balances are written on the right-hand side. If the total of the left-hand side equals the right-hand side, it can be assumed that all the journal entries and ledger accounts have been prepared accurately. Trial Balance is based on the fundamental accounting assumption that for every debit entry made, there is a corresponding credit entry.
Format of a Trial Balance
Sunshine Ltd.
Trial Balance as of December 31, 2019
| Account heads | Debit
($) |
Credit
($) |
| Capital Account | 15,000 | |
| Plant and Machinery | 7,000 | |
| Vehicles | 2,500 | |
| Creditors | 1,000 | |
| Debtors | 2,500 | |
| Cash | 4,000 | |
| Total | 16,000 | 16,000 |
As can be seen from the above, all the credit balances such as share capital and creditors are written on the right-hand side while the debit ones, say, plant and machinery and debtors are written on the left-hand side.
Here, it may be noted that tallying of the trial balance is not full-proof evidence of error-free accounting. There are specific errors that may be present even if the trial balance has counted. For example, if an entry has not been recorded at all in books of account or if a wrong amount is entered at the time of passing a journal entry, the trial balance will still agree. Again, if an incorrect debit entry has been made for which there is a corresponding incorrect credit entry, such error shall not be pointed out through trial balance.