If you’re new to accounting, understanding the accounting cycle is essential. This process involves recording, analyzing, and reporting the financial transactions of a business, ensuring accuracy and compliance with standards. The cycle consists of eight steps, repeated in each accounting period. In this blog post, we’ll delve into each step, providing examples for better comprehension.
What Is the Accounting Cycle?
The Accounting Cycle is a systematic series of steps that companies use to record their financial transactions and prepare their financial statements. This cycle plays a crucial role in providing accurate and timely financial information, which is essential for management decisions, investor relations, and legal compliance.
The cycle begins with the occurrence of a financial transaction and ends with its representation on the financial statements. It includes nine key steps: identifying the transaction, recording it in the journal, posting it to the ledger, preparing an unadjusted trial balance, adjusting entries, preparing an adjusted trial balance, preparing financial statements, closing the books, and preparing a post-closing trial balance.
Each step in the Accounting Cycle ensures that the company’s financial information is accurate and up-to-date. Understanding this cycle is fundamental to comprehending the financial processes within a company, making it a vital topic for anyone interested in accounting.
In the following sections, we will delve deeper into each step of the Accounting Cycle, providing examples and insights to help you grasp this essential accounting concept.
The Accounting Cycle Steps:
The Accounting Cycle is a comprehensive process that allows businesses to record and organize their financial transactions systematically. This cycle is crucial for maintaining accurate financial records and making informed business decisions. Here, we will break down the nine key steps involved in the Accounting Cycle:
Step 1: Identify and Analyze Transactions
Every journey starts with a single step, and in the accounting cycle, that step is identifying and analyzing transactions. But what does this mean? Let’s break it down.
Imagine you’re a detective, and each transaction is a clue. These clues can come in many forms – a sale, a purchase, a payment, or a receipt. Each one tells a story about the financial health of your business.
Your job is to gather these clues and make sense of them. You’ll need to use source documents, like invoices and receipts, to identify which accounts are involved in each transaction. These documents are like your detective’s notebook, providing vital information about each case.
Once you’ve gathered your clues, it’s time to analyze them. This involves determining whether each transaction increases or decreases the accounts involved.
Let’s look at an example:
Imagine your business makes a sale. This is great news for your business, as it means your sales revenue increases. But that’s not the only account affected. Because the sale was made on credit, your accounts receivable also increases. This represents the money owed to your business by the customer.
By identifying and analyzing each transaction in this way, you can ensure your business’s financial records are accurate and up-to-date. It’s a crucial first step in the accounting cycle, setting the stage for everything that follows.
- Sales revenue (increases)
- Accounts receivable (increases)
Step 2: Record Transactions in a Journal
The second step in the accounting cycle is like writing a diary, but instead of recording your thoughts and feelings, you’re recording your business’s financial transactions. This diary is known as a journal, and it’s where you’ll keep a chronological record of your business’s economic activities.
Each journal entry tells a story about a financial transaction. It includes the date of the transaction, the accounts involved, the amounts debited or credited, and a brief description of the transaction. This way, you can look back at your journal and see a clear history of your business’s financial past.
But there’s a catch. In accounting, we use a system called double-entry accounting. This means that for every transaction, the total amount debited must equal the total amount credited. It’s like a financial seesaw – both sides must always be balanced.
Let’s look at an example:
On January 1, your business makes a sale on credit. This transaction affects two accounts: sales revenue and accounts receivable. The sale increases your sales revenue by $1,000, so you credit your sales revenue account. At the same time, your accounts receivable also increase by $1,000, so you debit your accounts receivable account.
| Date | Account | Debit | Credit | Description |
| Jan 1 | Sales revenue | $1,000 | Sold goods on credit | |
| Jan 1 | Accounts receivable | $1,000 | To record receivable |
By recording transactions in a journal, you’re creating a detailed financial narrative of your business. It’s a crucial step in the accounting cycle that helps ensure your financial records are accurate and complete.
Step 3: Post Transactions to a General Ledger
Think of the general ledger as the grand library of your business’s financial story. It’s where all the individual tales of your transactions come together to form a cohesive narrative. Posting transactions to the general ledger is like adding new chapters to this story.
Here’s a more detailed breakdown:
- Organizing Accounts: The general ledger organizes accounts into five categories: assets, liabilities, equity, revenues, and expenses. This organization is crucial as it provides the structure for the financial statements.
- Transferring Journal Information: Each transaction recorded in the journal is transferred to the corresponding ledger accounts. This process is known as posting. During posting, the date, details, and amount of each transaction are added to the appropriate ledger accounts.
- Maintaining the Double-Entry System: The double-entry system is a fundamental concept in accounting where every debit has a corresponding credit. This system keeps the accounting equation (Assets = Liabilities + Equity) in balance.
Let’s consider an example to understand this better:
Suppose your company made a sale of $1,000 on account. Here’s how you would post this transaction to the general ledger:
| Account | Debit | Credit | Balance |
| Sales revenue | $1,000 | $1,000 | |
| Accounts receivable | $1,000 | $1,000 |
In this transaction, the Accounts Receivable account is debited to increase the amount of money owed to the business by customers. Simultaneously, the Sales Revenue account is credited to reflect the revenue earned. This transaction shows the double-entry system in action, as the debit entry in one account corresponds to the credit entry in another.
Remember, the general ledger holds the key to understanding the financial health of an organization. It’s where all financial transactions come together and begin to form the big picture. So, mastering this step is crucial for effective financial management.
Step 4: Prepare an Unadjusted Trial Balance
Imagine you’re a chef who’s just finished a busy day in the kitchen. You’ve used a variety of ingredients, each in different quantities. Now, it’s time to take stock of what’s left. This is similar to preparing an unadjusted trial balance in the accounting cycle.
Here’s a more detailed explanation:
- Listing All Accounts and Balances: The unadjusted trial balance is like a snapshot of all your accounts before any adjustments are made. It includes every account that has had activity during the period, along with their balances. This list provides a comprehensive view of the financial transactions that have occurred.
- Ensuring Total Debits Equal Total Credits: In the world of accounting, balance is key. The total of debit balances should equal the total of credit balances. This principle, rooted in the double-entry system, ensures that your books are balanced. It’s like making sure both sides of the scale are equal.
- Verifying Journal Entry and Ledger Accuracy: The unadjusted trial balance serves as a tool for checking the accuracy of the journal entries and ledgers. If the total debits don’t equal total credits, it’s a signal that there may be an error that needs to be investigated.
Let’s continue with our example:
| Account | Debit | Credit |
| Sales revenue | $1,000 | |
| Accounts receivable | $1,000 | |
| Total | $1,000 | $1,000 |
Step 5: Make Adjusting Entries
Imagine you’re a gardener, and your financial records are a garden. Just as a garden needs regular pruning and adjusting to ensure it grows properly, your financial records need regular adjusting entries to ensure they accurately reflect your business’s financial health.
- Adjusting Entries at Period-End: As the sun sets on your accounting period, whether it’s a month, a quarter, or a year, it’s time to make adjusting entries. These are like the final touches you add to your garden before you step back and admire your work.
- Updating Accounts Based on Accrual Accounting: Accrual accounting is like the seasons of your garden. It recognizes that some things, like revenue and expenses, occur over time and not necessarily when cash changes hands. Adjusting entries ensure that your accounts reflect these ongoing processes.
- Types of Adjusting Entries: There are several types of adjustments you might need to make, much like the different types of care your garden might need. These include accruals, deferrals, depreciation, and inventory adjustments.
Let’s consider an example to understand this better:
On January 31, you receive your utility bill for the month but haven’t paid it yet. This transaction affects two accounts: utility expense and accounts payable. The utility expense for January is $500, so you debit your utility expense account. At the same time, your accounts payable increase by $500, so you credit your accounts payable account.
| Date | Account | Debit | Credit | Description |
| Jan 31 | Utility expense | $500 | To record utility expense for January | |
| Jan 31 | Accounts payable | $500 | To record payable to utility company |
By making adjusting entries, you’re ensuring that your financial records accurately reflect your business’s activities. It’s like giving your garden the care it needs to truly flourish. So, grab your gardening gloves, and let’s dive into the next step of the accounting cycle!
Step 6: Prepare an Adjusted Trial Balance
Imagine you’re a chef, and your financial records are a recipe. Just as a chef checks their recipe to ensure they’ve included all the ingredients in the right amounts before they start cooking, you need to prepare an adjusted trial balance to ensure all your accounts and balances are correct before you prepare your financial statements.
- Listing All Accounts and Adjusted Balances: This is like listing all your ingredients and their quantities. You need to list all your accounts and their adjusted balances after making adjustments. This ensures that you’ve accounted for everything and nothing has been left out.
- Ensuring Total Debits Equal Total Credits: Just as a chef ensures the ingredients are balanced to create a delicious dish, you need to ensure that your total debits equal your total credits. This is the fundamental principle of double-entry accounting, ensuring that your books are always balanced.
- Using the Trial Balance for Financial Statement Preparation: Once you’ve prepared your adjusted trial balance, you can use it to prepare your financial statements, much like a chef uses their recipe to prepare a meal. This gives you a clear picture of your business’s financial health.
Let’s continue with our example:
After making adjustments, you prepare an adjusted trial balance. This includes your sales revenue, accounts receivable, utility expense, and accounts payable. The total of your debits and credits is $1,500, ensuring your books are balanced.
| Account | Debit | Credit |
| Sales revenue | $1,000 | |
| Accounts receivable | $1,000 | |
| Utility expense | $500 | |
| Accounts payable | $500 | |
| Total | $1,500 | $1,500 |
By preparing an adjusted trial balance, you’re ensuring that your financial records are accurate and complete. It’s a crucial step in the accounting cycle that sets the stage for the preparation of your financial statements. So, put on your chef’s hat, and let’s get cooking with the next step of the accounting cycle!
Step 7: Prepare Financial Statements
Imagine you’re an artist, and your adjusted trial balance is your palette of colors. Each color represents a different account, and your canvas is the financial statements. Your task is to use these colors to paint a picture that accurately represents the financial health of your business.
- Income Statement: This is like the base layer of your painting. It shows your revenues and expenses, resulting in net income or loss. It tells the story of your business’s profitability during a specific period.
- Statement of Retained Earnings: This layer adds depth to your painting. It shows how much of your net income was retained in the business versus distributed to owners. It’s a bridge between your income statement and balance sheet.
- Balance Sheet: This is the main body of your painting. It shows your business’s assets, liabilities, and equity at a specific point in time. It gives viewers a snapshot of your business’s financial position.
- Statement of Cash Flows: This is like the finishing touches on your painting. It shows where your business’s cash came from and where it went during a specific period. It provides a detailed view of your business’s cash activities.
Let’s continue with our example:
After preparing your adjusted trial balance, you use this information to prepare your financial statements. Your income statement shows sales revenue of $1,000 and utility expense of $500, resulting in net income of $500.
Example (Income Statement):
| Account | Amount |
| Sales revenue | $1,000 |
| Less: Utility expense | ($500) |
| Net income | $500 |
By preparing financial statements, you’re creating a comprehensive picture of your business’s financial health. It’s a crucial step in the accounting cycle that helps you understand your business’s performance and make informed decisions. So, grab your palette and let’s start painting the next step of the accounting cycle!
Step 8: Close the Accounts
Think of this step as the grand finale of a spectacular fireworks show. It’s the moment when the sky lights up with a dazzling display, marking the end of an eventful night. In the accounting cycle, closing the accounts is that grand finale.
Closing the accounts means resetting the temporary accounts (revenues, expenses, dividends) to zero, ready for the next accounting period. It’s like cleaning up the stage after a performance, ensuring everything is in order for the next show.
But it’s not just about resetting these accounts. It’s also about transferring the net income or loss and dividends to the retained earnings account. This is like the final bow, where the results of the performance are acknowledged and appreciated.
Let’s look at an example:
At the end of January, you close your accounts. You debit your sales revenue account by $1,000 to close it, and credit the same amount to your income summary account. You do the same for your utility expense account. Finally, you close your income summary account, transferring the net income of $500 to your retained earnings account.
| Date | Account | Debit | Credit | Description |
| Jan 31 | Sales revenue | $1,000 | To close revenue account | |
| Jan 31 | Income summary | $1,000 | To transfer revenue to income summary | |
| Jan 31 | Utility expense | $500 | To close expense account | |
| Jan 31 | Income summary | $500 | To transfer expense to income summary | |
| Jan 31 | Income summary | $500 | To close income summary | |
| Jan 31 | Retained earnings | $500 | To transfer net income to retained earnings |
Closing the accounts is a crucial step in the accounting cycle. It’s the moment when you can look back at the financial story you’ve told, appreciate the journey, and prepare for the next chapter. So, let’s take a bow and get ready for the next performance!
Conclusion to Steps in the Accounting Cycle
The accounting cycle is like a symphony, with each step playing a crucial part in creating a beautiful piece of financial music. It’s a process that involves recording, analyzing, and reporting the financial transactions of a business.
This symphony consists of eight movements, each one building on the last:
- Identify and Analyze Transactions: This is the overture, setting the tone for the rest of the symphony. It involves identifying and analyzing transactions, like a detective gathering clues and making sense of them.
- Record Transactions in a Journal: This is the first movement, where the melody begins to take shape. Transactions are recorded in a journal, creating a chronological record of the business’s economic activities.
- Post Transactions to a General Ledger: The second movement, where the melody is developed and expanded upon. Transactions are posted to a general ledger, providing a complete record of all financial transactions.
- Prepare an Unadjusted Trial Balance: The third movement, a slower section that provides a moment of reflection. An unadjusted trial balance is prepared, providing a snapshot of the business’s financial position before adjustments.
- Make Adjusting Entries: The fourth movement, where the tempo picks up again. Adjusting entries are made to ensure that the financial statements reflect the accrual basis of accounting.
- Prepare an Adjusted Trial Balance: The fifth movement, a repeat of the third, but with a sense of progression. An adjusted trial balance is prepared, reflecting the changes made in the adjusting entries.
- Prepare Financial Statements: The sixth movement, the climax of the symphony. Financial statements are prepared, providing a comprehensive overview of the business’s financial performance and position.
- Close the Accounts: The final movement, a triumphant finale. Temporary accounts are closed, ready for the next accounting period, and the net income or loss and dividends are transferred to the retained earnings account.
By following the accounting cycle, you’re not just ensuring the accuracy and reliability of your financial statements. You’re also conducting a symphony of financial information, helping you to monitor the performance and position of your business, and to make informed decisions based on the financial data. So, let the music play, and let your business thrive in the harmony of sound financial management.
Related External Resources:
Accounting Cycle Explained : 8-Step Process – Tipalti
Accounting Cycle Definition: Timing and How It Works
8 Steps in the Accounting Cycle, Diagram, Guide
