The accounting cycle includes the recording and summarizing of a transaction for a business. The transaction is analyzed, journalized, and recorded to the accounts and then summarized, reported, and used for evaluation purposes.
- Suppose you were asked how much to the nearest dollar you spent on food last year. To answer this question would require that you gather information like receipts, credit card statements and canceled checks for all your expenditures. Analyze that information to determine which outflows related to food and summarize those outflows into one number, the cost of your food expenditures for the year. Now, once you've answered that question, answer this one. How much did you spend on clothes last year? Again, you would have to go through the same process of collecting data, analyzing the information to identify those expenditures related to clothing and then summarizing those expenditures into one number.
Without a method for gathering and organizing day-to-day financial data, answers to seemingly routine questions like these can get quite complex. Now you may be thinking, doesn't my detailed electronic bank statement allow me to easily answer these questions? Well your bank statement would certainly help but it's limited in that it only tracks the transactions that go through you bank account, like checks you write or debit card payments. It does not track the cash in your pocket, savings account or other investment accounts.
These payments are also not categorized by purpose and the totals are not summarized. Now, consider the dilemma for businesses. They typically have far more transactions than you and the kinds of transactions are much more varied. Businesses buy and sell goods or services, borrow and invest money, pay wages to employees, purchase land, buildings and equipment, distribute earnings to owners and pay taxes to the government. These activities are referred to as exchange transactions because the entity is actually trading or exchanging one thing for another.
A bookstore for example, exchanges books for cash. Business documents such as a sales invoice, a purchase order or a check stub are often used to confirm that a transaction has occurred to establish the amounts to be recorded and to facilitate the analysis of the business event. To determine how well an entity is managing its resources, the results of transactions must be analyzed. The accounting cycle makes the analysis possible by recording and summarizing an entities transactions and preparing reports that present the summary results.
A transaction kicks off the accounting cycle. A transaction is when a business exchanges something and gets something in return. The value exchange needs to be quantified and recorded. Once all the transactions for a period have been recorded, those transactions must then be summarized. Once the day-to-day transactions are summarized, then financial reports can be created. Does this sound complicated? Well it would be without a system to capture that information.
But there's no need for us to invent the accounting wheel. That wheel was cotified over 500 years ago and is still used by virtually all businesses around the world to capture and compile financial information. Large multi-national corporations have millions of business transactions each day. And the more detailed and complex the accounting system, the more likely it is to be automated. Even small businesses generally use some type of inexpensive accounting software to reduce the number of routine clerical functions and to improve the accuracy and timeliness of their accounting records.
Now regardless of whether an automated or manual system is used, the steps and the process are basically the same. A transaction occurs. The transaction is then analyzed, journalized and recorded to the accounts and then summarized and reported and used for evaluation purposes. The difference lies in who or what does the work. With a computer based system, the software transform the recorded data, summarizes the data into categories and prepares the financial statements and other reports.
Nevertheless, human judgment is still essential in analyzing and recording transactions. Especially those of a non-routine nature.
- Reviewing financial statements
- Analyzing transactions
- Categorizing transactions
- Obtaining financing and buying equipment
- How revenue and expenses fit in the accounting equation
- Recording the sale of goods or services
- Posting journal entries to accounts
- The accounting cycle: step by step