What is the Accounting Cycle?
Definition: The accounting cycle is a series of steps taken each accounting period culminating with the preparation of financial statements. In other words, the cycle is a set of reoccurring bookkeeping procedures designed to record accounting information and create financial statements for end users.
The accounting cycle is a collective process of identifying, analyzing, and recording the accounting events of a company. The series of steps begin when a transaction occurs and end with its inclusion in the financial statements. Additional accounting records used during the accounting cycle include the general ledger and trial balance.
What Does Accounting Cycle Mean?
The accounting cycle is the process of accepting, recording, sorting, and crediting payments made and received within a business during a particular accounting period. Companies generally balance their books each quarter and then again at year-end, though others may prefer to settle the books every day or every week – that’s a lot of work, but it can be done if you choose to.
Based on the transactions recorded as part of the accounting cycle, financial statements such as cash flow reports, profit and loss statements, and balance sheets can be prepared. Once all the business accounts have been balanced, they are closed out for that period and new ones created for the next accounting period.
Once the accounts have been closed, the general purpose financial statements can be prepared. A standard set of financial statements includes a balance sheet, income statement, cash flow statement, and statements of changes in equity. This completes the accounting cycle for the period.
After the financials are prepared, the next period opens and the cycle starts over again.
How the Accounting Cycle Works
The accounting cycle is a methodical set of rules to ensure the accuracy and conformity of financial statements. Computerized accounting systems and the uniform process of the accounting cycle have helped to reduce mathematical errors. Today, most software fully automates the accounting cycle, which results in less human effort and errors associated with manual processing.
There are nine main steps in the accounting cycle starting with identifying business events that need to be recorded. Before anything can be recorded in an accounting system, specific events must be identified.
Next, journal entries are made to record the transactions in the accounting system and the various T-accounts. These T-accounts are then used to prepare an unadjusted trial balance. This trial balance represents the actual account balances in the ledger. It does not however reflect the balances that should be in the accounts. Some period-end adjustments typically need to be made before the books can be closed.
The unadjusted trial balance is modified with adjusting journal entries to correct account balances for errors and record expenses like depreciation that are usually booked at the end of a period.
Once the T-accounts have been adjusted, a new trial balance called the adjusted trial balance can be created to reflect the new changes. This trial balance represents the accounts with their corrected balances at the end of the accounting period.
After the adjusted trial balance is created, the temporary accounts are closed to the permanent accounts with a series of closing journal entries. All of the income and expense accounts are typically closed to a general income summary account, which is later closed to the retained earnings or capital account.
Steps in the Accounting Cycle
Here are the 9 steps of the accounting cycle –
- Collection of data and analysis of transactions
- Recording the journals into the ledger accounts
- Creating unadjusted trial balance
- Performing adjusting entries
- Creating adjusted trial balance
- Creating financial statements from the trial balance
- Closing the books
- Creating the post-closing trial balance
Step: 1 – Collection of data and analysis of transactions
- At this juncture, the accounting cycle begins. In this first step of accounting cycle, the accountant of the company collects the data and analyze the transactions.
- For a smoothly running business, there would be many, many transactions. The accountant needs to look at each transaction, find out why it occurred, put it under the right accounts, and then analyze it.
- This step is the most critical of all because this kick-starts the process of accounting.
Step: 2 – Journalizing
- After collecting and analyzing the transactions, it’s time to record the entries into the first books of accounts.
- In this step of the accounting cycle, each transaction is transferred to the general journal and under each entry, a narration is written to mention the reason behind debiting or crediting one account.
- Recording the entries in the journal is important since if there is any error at this stage of recording, it will linger on in the next books of accounts as well.
Step: 3 – Recording the journals into the ledger accounts
- Accounting is a series of steps taken one by one.
- After journalizing all the transactions, it’s time for the accountant to record the entries into the secondary books of accounts.
- That means if there are cash and capital, there will be two ‘t-tables’ in the general ledger and then the balances of respective accounts will be transferred.
- General ledgers allow the accountant to get the closing balance for preparing the trial balance in the next step of the accounting cycle.
Step: 4 – Creating an unadjusted trial balance
- As you know that trial balance is the source of all the financial statements. That’s why special attention should be given to the trial balance.
- From the closing balances of the general ledger accounts, an unadjusted trial balance is prepared.
- In this trial balance, the debit balances will be recorded on the debit side and the credit balances will be recorded on the credit side.
- Then the debit side is totaled and the credit side is also totaled.
- And then the accountant will see whether both the side have similar balances or not.
Step: 5 – Performing adjusting entries
- At this juncture, the unadjusted trial balance is already prepared.
- In this step of the accounting cycle, the adjusting entries are prepared.
- The adjusting entries are typically related to accrual adjustments, periodical depreciation adjustments or amortization adjustments.
- Without performing these adjusting entries, no adjusted trial balance would be prepared.
Step: 6 – Creating adjusted trial balance
- After passing the adjusting entries, it’s time to create a fresh trial balance.
- This trial balance is called adjusted trial balance since it is prepared after the adjustment entries are passed and as a result, this trial balance can be used to prepare the most important financial statements.
Step: 7 – Creating financial statements from the trial balance
This step of accounting cycle is the most critical part of the accounting cycle. As an investor, you must know how all the financial statements are coming from. From the adjusted trial balance, all the financial statements are born. There are four most important financial statements that are prepared using the adjusted trial balance.
- Income statement: The first financial statement that every investor should look at is the income statement. In the income statement, the first item is sales and the cost of sales and other operating expenses are deducted from the sales to ascertain the operating profit. From the operating profit, other expenses are deducted to compute the net profit of the year.
- Balance Sheet: The next financial statement on the list is the balance sheet. In the balance sheet, we record the assets and the liabilities. And we see whether the balance of assets is in harmony with the balance of liabilities.
- Shareholders’ Equity Statement: This is the next financial statement that would be prepared. Here along with share capital, the retained earnings would be taken into account. Retained earnings are the percentage of profit that has been reinvested into the company.
- Cash flow Statement: Finally, the cash flow statement would be prepared. In cash flow statement, the accountant needs to find out cash flow from three kinds of activities – operating activities, financial activities, and investing activities. The cash flow operating activities can be prepared in two ways – the direct and indirect cash flow from operations.
Step: 8 – Closing the books
- This step is the penultimate step in the accounting cycle.
- Closing the books means that all financial statements are prepared and all transactions have been recorded, analyzed, summarised, and recorded.
- After closing the books, a new accounting period would start and the accountant would need to start repeating the above steps of the accounting cycle once again.
- However, before that, there are other steps of the accounting cycle.
Step: 9 – Creating a post-closing trial balance
- To ensure that the accounting transactions are properly recorded, analyzed, and summarized, a post-closing trial balance is prepared.
- Here all the accounts are taken into account and then the closing balances are recorded as per their respective position.
- Then the credit side and the debit side are being matched to see whether everything is in the right order or not.
Accounting Cycle Today
The above steps were clear in a manual accounting system. However, today these steps are occurring with electronic speed and accuracy within sophisticated yet inexpensive accounting software. The accountant can enter adjusting entries into the software and can instantaneously obtain a complete set of financial statements by simply selecting them from a menu. After reviewing the financial statements, the accountant is able to make additional adjustments and almost immediately obtain the revised reports. The software will also prepare, record, and post the closing entries. It will also reverse adjusting entries that have been designated to be reversed.
The Trouble with Balancing
The accounting cycle’s purpose is to ensure that all the money coming into or going out of a business is accounted for. That’s why balancing is so critical.
However, errors are frequently made when recording entries, leading to an incorrect trial balance that needs to be adjusted so that debits and credits match. The most common reasons for an account imbalance include:
- Forgetting a transaction
- Posting a transaction to the wrong account
- Posting a transaction as a debit instead of a credit, or vice versa
- Duplicate postings
- Posting the wrong amount
Once discovered, the error is easily corrected.