The accounting cycle, a basic concept in management accounting, essentially consists of five steps:
1. An economic event, or business transaction, occurs
For example, your company might rent laboratory space, take a loan from the bank or sell inventory. The key is that in these transactions something is gained and something is given up.
2. Accountants interpret the event and translate it into the language of accounting
The event is then recorded in the company’s books as a journal entry. Journal entries form the basic units of the accounting system. They record the date of the transaction as well as the accounts and money involved, together with a brief explanation of what occurred and a reference number to track it in the ledger. (See “Interpreting Economic Events” [below] for further information.)
3. Accountants post the journal entries to the ledger
A running tally shows the current balance for company accounts such as assets, liabilities, revenue, expenses and stockholders’ equity.
4. Accountants add up the ledger accounts
At the end of the fiscal period, accountants add up the ledger accounts.
5. Accountants prepare the financial statements
Using the figures attained in step 4, accountants prepare the financial statements.
Most of the steps described above are mechanical exercises. Step 2, however, involves decision-making.
These judgments about how to translate economic events into the accounting process that influence what appears on the financial statements—and therefore bear economic consequences.
Many principles exist to guide accountants with their decision making. In theory, all business transactions are objectively measurable. In reality, many circumstances are subjective and do not fall under an established methodology.
Faced with these ambiguous real-life situations, accountants must use their own ethical and experienced judgment about how to record an event.
Markle, K. (2004, August). Introduction to Accounting. Presentation delivered at Schulich School of Business, York University, Toronto, Canada.
Pratt, Jamie. (2003). Financial Accounting in an Economic Context.New York: John Wiley & Sons.