The Accounting Cycle Laid Out: Eight-Step Method

The Accounting Cycle: A Step-by-Step Guide

The 8-step accounting cycle is a fundamental process for all bookkeepers. It breaks down the entire process of a bookkeeper's responsibilities into eight essential steps. While some of these steps may be automated by accounting software and technology platforms, understanding and using the steps manually can be important for small business accountants who work with minimal technical support. Regardless, most bookkeepers will have an awareness of the company's financial position on a daily basis.

What Is the Accounting Cycle?

The accounting cycle is a process that businesses use to record, analyze, and report their financial transactions. It is a standard eight-step process that begins when a transaction occurs and ends with the preparation of financial statements and the closing of the books.

Here is an example of the accounting cycle:

• Step 1: Identifying transactions

A business identifies all of the transactions that have occurred during the accounting period. This includes both financial transactions, such as sales and purchases, and non-financial transactions, such as depreciation and accruals.

Example: A business sells goods to a customer for $100. This is a financial transaction that needs to be recorded in the accounting cycle.

• Step 2: Recording transactions in a journal

Once the transactions have been identified, they need to be recorded in a journal. A journal is a chronological record of all of the transactions that have occurred during the accounting period.

Example: The business records the sale of goods to the customer in the journal. The journal entry would debit the accounts receivable account and credit the sales account.

• Step 3: Posting to the general ledger

After the transactions have been recorded in the journal, they need to be posted to the general ledger. The general ledger is a collection of accounts that summarizes all of the financial activity of the business.

Example: The business posts the journal entry for the sale of goods to the accounts receivable and sales accounts in the general ledger.

• Step 4: Preparing an unadjusted trial balance

Once the transactions have been posted to the general ledger, an unadjusted trial balance can be prepared. The unadjusted trial balance is a list of all of the accounts in the general ledger and their respective balances.

Example: The business prepares an unadjusted trial balance for the month of January. The unadjusted trial balance shows that the accounts receivable account has a balance of $100 and the sales account has a balance of $100.

• Step 5: Preparing to adjust entries

The unadjusted trial balance may not be accurate because it does not take into account all of the financial activity of the business. For example, the unadjusted trial balance may not include accrued expenses or depreciation. Adjusting entries are made to correct the unadjusted trial balance and ensure that it is accurate.

Example: The business has accrued $50 of salaries expense that has not yet been paid. The business makes an adjusting entry to debit the salaries expense account and credit the accrued salaries payable account.

• Step 6: Preparing an adjusted trial balance

Once the adjusting entries have been made, an adjusted trial balance can be prepared. The adjusted trial balance is a more accurate representation of the financial position of the business than the unadjusted trial balance.

Example: The business prepares an adjusted trial balance for the month of January. The adjusted trial balance shows that the accounts receivable account has a balance of $100, the sales account has a balance of $100, and the salaries expense account has a balance of $50.

• Step 7: Preparing financial statements

The adjusted trial balance is used to prepare the financial statements of the business. The financial statements include the balance sheet, income statement, statement of cash flows, and statement of retained earnings.

Example: The business prepares the financial statements for the month of January. The financial statements show that the business has a profit of $50 for the month.

• Step 8: Closing the books

The final step in the accounting cycle is to close the books. This involves transferring the balances of the temporary accounts to the permanent accounts. The temporary accounts are the accounts that are used to record the day-to-day financial activity of the business. The permanent accounts are the accounts that are used to track the accumulated financial activity of the business over time.

Example: The business closes the accounts receivable and sales accounts at the end of the month. The balances of these accounts are transferred to the retained earnings account.

How does the accounting cycle work?

An accounting cycle is a set of rules that ensure the accuracy and relevance of financial statements. Computerized accounting systems and streamlined accounting cycles have reduced mathematical errors. Today, most software completely automates the accounting cycle, which results in fewer human measures and errors associated with manual processing.

Here is an example of how computerized accounting systems and streamlined accounting cycles can reduce mathematical errors:

Traditional Accounting

In a traditional accounting system, transactions are recorded manually in a journal. The journal is a chronological record of all financial transactions that have occurred during a period. After the transactions are recorded in the journal, they are posted to the general ledger. The general ledger is a collection of accounts that summarizes all of the financial activity of a business.

The process of recording and posting transactions manually can be prone to errors. For example, if a number is entered incorrectly in the journal, it will be incorrect in the general ledger as well. This can lead to inaccurate financial statements.

Computerized Accounting

Computerized accounting systems automate the process of recording and posting transactions. This reduces the risk of mathematical errors. For example, if a number is entered incorrectly in the journal, the computerized accounting system will not post it to the general ledger. This helps to ensure that the financial statements are accurate.

Streamlined Accounting Cycles

In addition to using computerized accounting systems, businesses can also streamline their accounting cycles to reduce mathematical errors. This can be done by:

• Standardizing the accounting procedures used by the business.
• Training employees on accounting procedures.
• Using automated tools to help with the accounting process.

By following these steps, businesses can reduce the risk of mathematical errors in their financial statements.

Table:- Here is a table that summarizes the benefits of computerized accounting systems and streamlined accounting cycles:

Why is the Accounting Cycle Important?

Accounting cycles are used by businesses and associations to register transactions and formulate financial statements. The standardized accounting cycle approach (supported by accounting systems) is essential because it enables business owners, small businesses, and designated enterprises to close their books for the accounting period. It also permits the development of financial information to perform financial statement analysis and control the business. 

Accounting departments use detailed, customized accounting completion checklists that reflect the items to be completed during each accounting cycle. Document assigned responsibilities and deadlines also completion times and approvals for each task. A checklist with deadlines in the accounting cycle enhances responsibility and operation management. Stakeholders, including administration, the Board of Directors, lenders, shareholders, and creditors, can examine the financial statement outcomes for the accounting cycle period.

Here is a table that summarizes the benefits of the accounting cycle:

The Importance of Accuracy and Relevance in the Accounting Cycle

The accounting cycle is a process that businesses use to record, analyze, and report their in financial transactions. It is a standard process that begins when a transaction occurs and ends with the preparation of financial statements and the closing of the books.

The main purpose of the accounting cycle is to provide accurate and relevant financial information to stakeholders, such as investors, creditors, and management. The accounting cycle ensures that all financial transactions are recorded accurately and that the financial statements are prepared in accordance with generally accepted accounting principles (GAAP).

The accounting cycle is an essential process for businesses of all sizes. By following the accounting cycle, businesses can ensure that their financial records are accurate and reliable and that they are meeting their financial reporting obligations.

Here are some additional benefits of the accounting cycle:

• Improved decision-making: Accurate financial information can help businesses to make better decisions about their finances.
• Increased efficiency: The accounting cycle can help businesses to operate more efficiently by providing a systematic way to record and report financial information.
• Reduced risk: The accounting cycle can help businesses to reduce their risk of financial problems by identifying and correcting errors in their financial records.

Understanding the Accounting Cycle

The 8-step accounting cycle is a process that businesses use to record, analyze, and report their financial transactions. It is a standard process that begins when a transaction occurs and ends with the preparation of financial statements and the closing of the books.

The 8 steps of the accounting cycle are:

1. Identifying transactions. The first step is to identify all of the transactions that have occurred during the accounting period. This includes both financial transactions, such as sales and purchases, and non-financial transactions, such as depreciation and accruals.
2. Recording transactions in a journal. Once the transactions have been identified, they need to be recorded in a journal. A journal is a chronological record of all of the transactions that have occurred during the accounting period.
3. Posting to the general ledger. After the transactions have been recorded in the journal, they need to be posted to the general ledger. The general ledger is a collection of accounts that summarizes all of the financial activity of the business.
4. Preparing an unadjusted trial balance. Once the transactions have been posted to the general ledger, an unadjusted trial balance can be prepared. The unadjusted trial balance is a list of all of the accounts in the general ledger and their respective balances.
5. Preparing to adjust entries. The unadjusted trial balance may not be accurate because it does not take into account all of the financial activity of the business. For example, the unadjusted trial balance may not include accrued expenses or depreciation. Adjusting entries are made to correct the unadjusted trial balance and ensure that it is accurate.
6. Preparing an adjusted trial balance. Once the adjusting entries have been made, an adjusted trial balance can be prepared. The adjusted trial balance is a more accurate representation of the financial position of the business than the unadjusted trial balance.
7. Preparing financial statements. The adjusted trial balance is used to prepare the financial statements of the business. The financial statements include the balance sheet, income statement, statement of cash flows, and statement of retained earnings.
8. Closing the books. The final step in the accounting cycle is to close the books. This involves transferring the balances of the temporary accounts to the permanent accounts. Temporary accounts are accounts that are used to record the day-to-day financial activity of the business. The permanent accounts are the accounts that are used to track the accumulated financial activity of the business over time.

Accrual accounting vs. cash accounting

There are two main types of accounting: accrual accounting and cash accounting. Accrual accounting is the most common type of accounting and it records transactions when they occur, regardless of when the cash is received or paid. Cash accounting records transactions only when the cash is received or paid.

Single-entry accounting vs. double-entry accounting

There are also two main types of accounting systems: single-entry accounting and double-entry accounting. Single-entry accounting is a simpler system that only records the debits and credits for each transaction. Double-entry accounting is a more complex system that records the debits and credits for each transaction, as well as the resulting balance in each account.

The accounting cycle can be modified to fit the needs of each business.

The accounting cycle can be modified to fit the needs of each business. For example, businesses that use accrual accounting may need to make adjustments for accrued expenses and depreciation. Businesses that use cash accounting may not need to make these adjustments.

The accounting cycle is an important process that businesses use to record, analyze, and report their financial transactions. By following the accounting cycle, businesses can ensure that their financial records are accurate and reliable.

Timing of the Accounting Cycle

The accounting cycle begins and ends within the accounting period in which financial statements are prepared. Billing periods vary and depend on many factors. However, the most common type of accounting period is the annual accounting period. Many transactions occur and are recorded during the accounting cycle.

Annual financial statements are usually prepared at the end of the year. This is often required by law. Public institutions have deadlines for submitting annual accounts. All publicly traded companies doing business in the United States are required to file registration statements, periodic reports, and other forms with the United States Securities and Exchange Commission.

The Accounting Cycle Vs. Budget Cycle

The accounting cycle is dissimilar to the budget cycle. The accounting cycle concentrates on historical circumstances and confirms that incurred financial transactions are reported correctly. Alternatively, the budget cycle links to future operating performance and planning for coming transactions. The accounting cycle helps to produce data for external users, while the budget cycle is used for internal management objectives.

Accounting Cycle versus Operating Cycle

The accounting cycle and operating cycle are very different financially. The accounting cycle consists of the steps from entering business transactions to producing the annual financial statements for the accounting period. The operating cycle measures the time it takes to buy inventory, sell it as a product, and collect cash from the sale transaction.

The operating cycle can be expressed mathematically as the sum of the financial calculation ratios for days’ sales outstanding and the average collection duration. Comprehending the operating cycle of your business is critical to cash flow management.

The Bottom Line

The eight-step accounting cycle procedure constructs accounting easier for bookkeepers and dynamic entrepreneurs. It assists the guesswork of how to manage accounting activities. It also helps to provide consistency, accuracy, and efficient financial performance research.