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Basic Principles of Accounting
Before delving deep into the Accounting Cycle, we must first grasp basic accounting principles. These principles ensure consistency, accuracy, and reliability in the world of finance.
Double-Entry Accounting System
Every financial transaction has two sides - a debit and a credit. The Double-Entry Accounting System, first codified by Luca Pacioli in the 15th century, ensures that every debit has an equivalent and opposite credit.
For example, if a company purchases equipment for $10,000, it might debit (increase) the "Equipment" account and credit (decrease) its "Cash" account by the same amount.
Accrual Accounting vs. Cash Accounting
The difference between Accrual and Cash Accounting lies in timing. Accrual Accounting recognizes revenue when it's earned and expenses when incurred, while Cash Accounting records transactions only when cash changes hands.
For example, a law firm using accrual accounting would recognize revenue as soon as it provides legal services, not when it receives payment.
Generally Accepted Accounting Principles (GAAP)
To ensure consistency and transparency in financial reporting, companies in the U.S. adhere to Generally Accepted Accounting Principles (GAAP). GAAP, enforced by the Financial Accounting Standards Board (FASB), governs many aspects of accounting, from revenue recognition to the classification of balance sheet items.
These principles play a pivotal role in the Accounting Cycle, setting the rules for how transactions are recorded and reported. But why does this matter to an investment banking professional?
Detailed Breakdown of the Accounting Cycle
The Accounting Cycle is a nine-step process that records, summarizes, and reports a company's financial transactions. Here's the breakdown:
Identifying and Analyzing Financial Transactions. This is the starting point, where a transaction such as a sale or a purchase is identified and analyzed for its financial impact.
Journalizing the Transaction. The transaction is recorded in the company's general journal chronologically.
Posting to the Ledger. The transaction is then transferred from the journal to the relevant ledger accounts.
Preparing a Trial Balance. This involves summing up all debits and credits in each account to verify that the company's books are balanced.
Adjusting Entries. These correct any discrepancies before final financial statements are prepared. For instance, accrued expenses that haven't been invoiced yet.
Adjusted Trial Balance. After adjusting entries, a new trial balance is prepared to ensure the accounts are balanced.
Preparing Financial Statements. The company generates its income statement, balance sheet, statement of cash flows, and statement of changes in equity.
Closing the Books. All temporary accounts like revenue and expenses are closed, and the net income (or loss) is transferred to a permanent equity account.
Post-Closing Trial Balance. Finally, another trial balance is prepared to ensure the accounts are balanced after closing.
Let's illustrate this with a real-world example. In 2017, Microsoft purchased LinkedIn for $26.2 billion. This transaction was identified, analyzed, journalized, and then posted to the ledger. It influenced the preparation of Microsoft's trial balance, the adjustment entries, and the financial statements. After the financial year, the books were closed, and a post-closing trial balance was prepared.
Interconnections between the Accounting Cycle and Financial Reporting
The Accounting Cycle directly impacts a company's financial reports.
Balance Sheet
The Accounting Cycle determines the assets, liabilities, and shareholders' equity figures appearing on the balance sheet.
Income Statement
It affects the revenue, expenses, and ultimately the net income or loss reported.
Statement of Cash Flows
The cash inflows and outflows from operating, investing, and financing activities are derived from the transactions recorded during the Accounting Cycle.
Statement of Changes in Equity
This is impacted by the net income (or loss) and dividends, both of which are determined during the Accounting Cycle.
The Accounting Cycle and Auditing
A robust Accounting Cycle is a company's first defense during audits. It provides a systematic and transparent record, vital for internal auditors and external bodies like Ernst & Young. Moreover, compliance with the Sarbanes-Oxley Act (SOX) requires companies to have an effective control environment, in which the Accounting Cycle plays a crucial role.
Technological Advances and the Accounting Cycle
With modern software like QuickBooks, Sage, or Zoho Books, businesses can automate and streamline the Accounting Cycle. Moreover, evolving technologies like AI and Blockchain hold the potential to further revolutionize the accounting landscape.
Practical Application of the Accounting Cycle in Finance
A thorough understanding of the Accounting Cycle can enhance financial decisions in several ways:
Investment Analysis: Enables finance professionals to evaluate a company's financial health.
Private Equity Due Diligence: Helps identify accounting red flags during due diligence.
Corporate Finance Decisions: Supports effective decision-making in regard to investments, funding, and cash management.
Conclusion
Mastering the Accounting Cycle is vital for finance professionals. By understanding how transactions are recorded, summarized, and reported, we can make more informed financial decisions and contribute to the success of businesses.