What Is the Accounting Process? A Step-by-Step Breakdown

The accounting process is a structured approach businesses use to track, organize, and summarize their financial activities. It helps in identifying, recording, summarizing, and reporting financial transactions. This provides a clear picture of how money moves within a business, which is fundamental for making informed decisions, ensuring regulatory compliance, and understanding overall financial health.

Understanding Financial Transactions

A financial transaction is any economic event affecting a business’s financial position that can be measured in monetary terms. Common examples include sales, purchases, employee payments, and customer receipts. Every transaction must be supported by a source document as evidence.

Source documents are initial records generated when a financial event occurs. These include invoices, cash receipts, bank statements, checks, and payroll records. For instance, a purchase invoice becomes the source document when a business buys inventory. The details on these documents, like the date, amount, and description, are crucial for accurate record-keeping.

Each financial transaction impacts at least two accounts within a business, maintaining the accounting equation: Assets = Liabilities + Equity. Assets represent what the business owns, such as cash, accounts receivable, and equipment. Liabilities are what the business owes, including accounts payable and loans.

Equity represents the owners’ stake, including initial investments and retained earnings. When a transaction occurs, the initial analysis determines which accounts are affected and whether their balances increase or decrease. For example, if a business purchases equipment with cash, the “Equipment” asset account increases, and the “Cash” asset account decreases, keeping the equation balanced.

Recording Financial Data

After identifying and analyzing financial transactions, the next step is formally recording them. The general journal serves as the “book of original entry,” where transactions are recorded chronologically. Each entry details the accounts affected, whether debited or credited, and the monetary amount.

Debits are entries on the left side of an account, and credits are entries on the right. For asset and expense accounts, a debit increases the balance, while a credit decreases it. Conversely, for liability, equity, and revenue accounts, a credit increases the balance, and a debit decreases it. Every journal entry must have equal total debits and credits.

Once transactions are recorded in the general journal, they are “posted” to the general ledger. The general ledger is a collection of all individual accounts, such as Cash, Accounts Payable, and Sales Revenue. Posting involves taking the debit and credit amounts from the journal and entering them into their respective accounts.

This posting process organizes and summarizes all transactions for each account, providing a running balance for every asset, liability, equity, revenue, and expense item. For example, all cash inflows and outflows from various journal entries are consolidated into the single Cash account.

Preparing Financial Statements

After all transactions are recorded and posted, a trial balance is prepared. This internal report lists the ending balance of every general ledger account. Its primary purpose is to verify that total debits equal total credits, confirming the mathematical accuracy of recorded transactions before financial statements are created.

Even if the trial balance shows equality, certain adjustments are necessary to ensure financial statements accurately reflect the period’s activities. These are known as adjusting entries. Adjusting entries are made at the end of an accounting period and do not involve cash. They recognize revenues when earned and expenses when incurred, regardless of when cash is exchanged.

Common adjusting entries include accrued expenses (incurred but not yet paid), accrued revenues (earned but not yet received), deferred revenues (cash received for services not yet performed), and prepaid expenses (paid in advance but not yet consumed). Depreciation, which allocates the cost of a long-term asset over its useful life, is also a common adjusting entry. These adjustments ensure financial statements adhere to the accrual basis of accounting.

Once adjustments are made, the data is used to prepare the three primary financial statements. The Income Statement, also known as the Profit and Loss (P&L) statement, summarizes a business’s revenues and expenses over a specific period to show its net profit or loss. The Balance Sheet provides a snapshot of a company’s financial position at a specific moment, detailing its assets, liabilities, and equity.

The Cash Flow Statement details cash inflows and outflows over a period, categorized into operating, investing, and financing activities. It provides insights into a company’s liquidity and solvency, showing how cash is generated and used.

Finalizing the Accounting Period

The final step involves “closing the books,” which prepares the accounting system for the next reporting period. This is accomplished through closing entries. Closing entries transfer the balances of temporary accounts to permanent accounts, resetting them to zero for the new period.

Temporary accounts include revenues, expenses, and dividends. These accounts track financial activity for a specific accounting period and are closed at its end. For example, a revenue account’s balance from one year is zeroed out for the next.

Permanent accounts, conversely, carry balances forward from one accounting period to the next. These include asset accounts (like Cash and Accounts Receivable), liability accounts (like Accounts Payable and Loans Payable), and equity accounts (like Owner’s Capital and Retained Earnings).

The closing process involves four main closing entries: closing revenue accounts to an Income Summary account, closing expense accounts to the Income Summary account, closing the Income Summary account to Retained Earnings, and closing the Dividends account to Retained Earnings. After these entries are posted, a post-closing trial balance is prepared. This final trial balance contains only permanent accounts and ensures total debits still equal total credits, verifying accuracy for the new accounting period.