What is Accounting Cycle and Accounting Equation?

People who are doing online accounts course often get confused between similar sounding terms. Today we are going to cover similar sounding but two very different terms Accounting Equation and Accounting Cycle. With this article we hope to clear some basic accounting homework help terms.

So let us first understand, What is accounting equation?

In case of any business firm, the accounting equation forms the basis of its balance sheet.  The equation states that:

Assets = Liabilities + Equity

If we consider a horizontal balance sheet, all assets will be recorded on the right hand side while all the liabilities along with the equity amount shall be recorded on the left hand side.  Following the aforesaid accounting equation, all the assets (written on the right hand side) shall be equal to the sum of the liabilities and equity (written on the left hand side). 

Now, we shall first discuss the terms - “assets”, “liabilities” and “equity”.  Assets are resources owned by a business from which benefit is expected to be received over a period of time, long or short.  “Liabilities” are the obligations of a business and these have to be paid back by the firm over a given period of time. “Equity” refers to the funds brought in by the owners of a business in order to finance the same. 

The accounting equation is not only valid in case of balance sheet but is also valid in any business transaction. Say, for example, when a firm raises funds from the markets in the form of debentures, there is an increase in assets in the form of bank/cash. Also, the liabilities of firm also increase to the extent of the amount of debentures.  It can be shown as follows:

 Assets (increase) = Liabilities (increase) + Equity (constant)

This is an example where both assets and liabilities increase by an equal amount while the equity remains constant. There may also be similar cases where change may take place only on one side of the equation, i.e. individual amounts of liabilities and equity may change such that the total assets amount remains constant.

Now that we have covered the topic of Accounting equation let us understand, What is 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 basically consists of the following processes:

-Analyzing business events and identifying transactions which need to be recorded in the books of accounts. Only business related transactions are recorded and personal events are left out (like buying a car for personal use).

-Passing Journal entries to record these transactions.

-The journal entries are then posted to the appropriate ledger accounts.

-Now, an unadjusted trial balance is prepared in order to know the arithmetical accuracy of the books of accounts. It may be noted that even if the trial balance agrees here, it does not necessarily signify the absolute correctness of 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 prepared 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 in order 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 in order to check whether the debit entries made are equal to the credit entries. 

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