What Is the Accounting Cycle?
The accounting cycle is a collective process of identifying, analyzing, and recording the accounting events of a company. It is a standard 8-step process that begins when a transaction occurs and ends with its inclusion in the financial statements and the closing of the books.
The key steps in the eight-step accounting cycle include recording journal entries, posting to the general ledger, calculating trial balances, making adjusting entries, and creating financial statements.
- The accounting cycle is a process designed to make the financial accounting of business activities easier for business owners.
- The first step in the eight-step accounting cycle is to record transactions using journal entries.
- The eighth and final step is the closing of the books after preparing financial statements.
- The accounting cycle generally comprises a year or other accounting period.
- Accounting software today mostly automates the accounting cycle.
How the Accounting Cycle Works
The accounting cycle is a methodical set of rules that can help 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.
Steps of the Accounting Cycle
There are eight steps to the accounting cycle.
- Identify Transactions: An organization begins its accounting cycle with the identification of those transactions that comprise a bookkeeping event. This could be a sale, refund, payment to a vendor, and so on.
- Record Transactions in a Journal: Next comes the recording of transactions using journal entries. The entries are based on the receipt of an invoice, recognition of a sale, or completion of other economic events.
- Posting: Once a transaction is recorded as a journal entry, it should post to an account in the general ledger. The general ledger provides a breakdown of all accounting activities by account.
- Unadjusted Trial Balance: After the company posts journal entries to individual general ledger accounts, an unadjusted trial balance is prepared. The trial balance ensures that total debits equal total credits in the financial records.
- Worksheet: The fifth step is to create and analyze a worksheet of debits and credits to identify necessary adjusting entries, if there are discrepancies.
- Adjusting Journal Entries: At the end of the period, adjusting entries are made. These result from corrections made on the worksheet and the passage of time. For example, an adjusting entry may involve interest revenue that has been earned over time.
- Financial Statements: Upon the posting of adjusting entries, a company prepares an adjusted trial balance followed by the actual, formal financial statements.
- Closing the Books: An entity finalizes temporary accounts, revenues, and expenses, at the end of the period using closing entries. These closing entries include transferring net income to retained earnings. Finally, a company prepares the post-closing trial balance to ensure debits and credits match and the cycle can begin anew.
An accounting cycle is used by most but not all businesses. Sole proprietorships, other small businesses, and entrepreneurs may not follow it.
Timing of the Accounting Cycle
The accounting cycle is started and completed within an accounting period, the time in which financial statements are prepared. Accounting periods vary and depend on different factors. However, the most common type of accounting period is the annual period.
During the accounting cycle, many transactions occur and are recorded. At the end of the fiscal year, financial statements are prepared (and are often required by government regulation).
For example, public entities are required to submit financial statements by certain dates. All public companies that do business in the U.S. are required to file registration statements, periodic reports, and other forms to the U.S. Securities and Exchange Commission. Therefore, their accounting cycles are tied to reporting requirement dates.
Accounting Cycle vs. Budget Cycle
The accounting cycle is different from the budget cycle. The accounting cycle focuses on historical events and ensures that incurred financial transactions are reported correctly.
Alternatively, the budget cycle relates to future operating performance and planning for future transactions. The accounting cycle assists in producing information for external users, while the budget cycle is mainly used for internal management purposes.
Why Is the Accounting Cycle Important?
It’s important because it can help ensure that the financial transactions that occur throughout an accounting period are accurately and properly recorded and reported. This can provide businesses with a clear understanding of their financial health and ensure compliance with federal regulations.
What Are Benefits of the Accounting Cycle?
The accounting cycle can aid a company in keeping accurate books (and not losing important financial information), analyzing financial events, preparing required financial statements, and, overall, managing a business successfully.
Who Is Responsible for Performing the Accounting Cycle?
Usually, accountants are employed to manage and conduct the accounting tasks required by the accounting cycle. If a small business or one-person shop is involved, the owner may handle the tasks, or outsource the work to an accounting firm.
The Bottom Line
The accounting cycle is a comprehensive accounting process that begins and ends in an accounting period. It involves eight steps that ensure the proper recording and reporting of financial transactions. Once a company’s books are closed and the accounting cycle for a period ends, it begins anew with the next accounting period and financial transactions.