What is the accounting cycle?
The accounting cycle is a collective process of identifying, analyzing and recording the accounting events of a company. This is a standard 8-step process that begins when a transaction occurs and ends with its inclusion in the financial statements.
The key steps in the eight-step accounting cycle include posting journal entries, posting to the general ledger, calculating trial balances, entering adjusting postings, and creating financial statements.
Key points to remember
- The accounting cycle is a process designed to facilitate financial accounting of business activities for business owners.
- The first step in the eight-step accounting cycle is to record transactions using journal entries, ending with the eighth step of closing the books after preparing the financial statements.
- The accounting cycle typically consists of one year or other accounting period.
- Today, accounting software primarily automates the accounting cycle.
How the accounting cycle works
The accounting cycle is a systematic set of rules designed to ensure the accuracy and compliance of financial statements. Computerized accounting systems and a uniform accounting cycle process have helped reduce mathematical errors. Most software today fully automates the accounting cycle, resulting in less human effort and errors associated with manual processing.
Stages of the accounting cycle
The accounting cycle has eight stages.
- Identify transactions: An organization begins its accounting cycle by identifying the transactions that constitute an accounting event. This could be a sale, refund, payment to a seller, etc.
- Rrecord transactions in a journal: Comes next recording transactions using journal entries. Entries are based on receipt of an invoice, recognition of a sale, or the occurrence of other economic events.
- Assignment: Once a transaction is posted as a journal entry, it should be posted to a general ledger account. The general ledger provides a breakdown of all accounting activities by account.
- Unadjusted trial balance: After the business posts the journal entries to the individual general ledger accounts, an unadjusted trial balance is prepared. The trial balance ensures that the total debits equal the total credits in the financial records.
- Worksheet: The analysis of a spreadsheet and the identification of the adjustment entries is the fifth step of the cycle. A spreadsheet is created and used to ensure debits and credits are equal. If there are any discrepancies, adjustments will need to be made.
- Adjustment of journal entries: At the end of the period, adjustment postings are made. These are the result of the corrections made on the spreadsheet and the results of the passage of time. For example, an adjusting entry can generate interest income that has been earned over the passage of time.
- financial state: When posting adjustment entries, a company establishes a regularized trial balance followed by actual formalized financial statements.
- Close books: An entity provisionally finalizes accounts, income and expenses, at the end of the period using closing entries. These closing entries include the transfer of net income to retained earnings. Finally, a company prepares the post-close trial balance to ensure debits and credits match and the cycle can start again.
Accounting cycle calendar
The accounting cycle begins and ends during an accounting period, when financial statements are prepared. Accounting periods vary and depend on different factors; however, the most common type of posting period is the annual period. During the accounting cycle, many transactions occur and are recorded.
At the end of the year, financial statements are usually prepared, which is often required by regulation. Public entities are required to submit financial statements by certain dates. Therefore, their accounting cycle revolves around the reporting requirement dates.
The accounting cycle vs. Budget cycle
The accounting cycle is different from the budget cycle. The accounting cycle focuses on historical events and ensures that financial transactions incurred are correctly reported. Alternatively, the budget cycle relates to future operational performance and the planning of future transactions. The accounting cycle helps produce information for external users, while the budget cycle is mainly used for internal management purposes.