What Are the 8 Steps in the Accounting Cycle?

The accounting cycle is a systematic process businesses follow to record and process financial transactions. This structured approach ensures accurate financial records and reliable financial statements. It tracks a company’s financial activities over a specific period, typically a month, quarter, or year, providing a clear picture of its financial health.

Recording and Initial Summarization

The accounting cycle begins with identifying and analyzing financial transactions. A financial transaction involves an exchange of economic value, such as sales, purchases, or payments. Each transaction generates source documents, like invoices, receipts, or bank statements, which serve as evidence of the event. Analyzing these documents helps determine how the transaction impacts the fundamental accounting equation: Assets = Liabilities + Equity.

Once identified, transactions are chronologically recorded in a journal. This process, known as journalizing, involves noting the date, the accounts affected, and the debit and credit amounts for each transaction. Debits and credits are the fundamental mechanics of double-entry accounting, ensuring every transaction impacts at least two accounts and maintains the accounting equation’s balance.

After journalizing, the information is transferred to the ledger. The ledger is a collection of all accounts, organized by type, providing a consolidated view of each account’s activity. Posting systematically moves debit and credit amounts from the journal to their respective individual ledger accounts, allowing businesses to track the balance of each account.

At the end of an accounting period, an unadjusted trial balance is prepared. This document lists all general ledger accounts and their balances. Its primary purpose is to verify that total debit balances equal total credit balances. While it helps identify certain errors, an unadjusted trial balance does not guarantee that all transactions have been recorded or that individual transactions are accurate.

Adjusting and Final Summarization

After preparing the unadjusted trial balance, adjustments are necessary to adhere to the accrual basis of accounting. This method recognizes revenues when earned and expenses when incurred, regardless of when cash is exchanged. Adjusting entries ensure financial statements accurately reflect a period’s financial performance and position.

Accrued revenues represent income earned but not yet received in cash, such as services completed for a client who has not yet paid. Accrued expenses are costs incurred but not yet paid, like utility services used but not yet billed.

Deferred revenues occur when cash is received for services or goods not yet delivered. Conversely, deferred expenses are payments made for future benefits, such as rent paid in advance or supplies purchased but not yet used.

Depreciation is an adjusting entry, allocating the cost of long-lived assets, like equipment or buildings, over their useful lives. These adjustments ensure that revenues and expenses are matched to the period in which they relate, providing an accurate portrayal of a company’s financial results.

Following the preparation and posting of all adjusting entries, an adjusted trial balance is created. This updated trial balance ensures that total debits equal total credits. It serves as the definitive source for preparing financial statements, providing the finalized account balances.

Reporting and Closing

The adjusted trial balance provides the data to prepare the financial statements, which communicate a company’s financial performance and position to stakeholders. The income statement summarizes revenues and expenses to report a company’s net income or loss over a specific period.

The statement of owner’s equity or retained earnings details changes in the owner’s investment or retained earnings over a period. The balance sheet provides a snapshot of a company’s assets, liabilities, and equity at a specific point in time, illustrating what the company owns and owes.

The final step in the accounting cycle involves closing temporary accounts. Temporary accounts, such as revenues, expenses, and dividends or owner’s drawings, reflect activities for a single accounting period. They are contrasted with permanent accounts, like assets, liabilities, and equity, which carry their balances forward from one period to the next.

Closing entries transfer the balances of these temporary accounts to a permanent equity account. This process resets the temporary account balances to zero, preparing them for the next accounting period. It summarizes the period’s net income or loss and transfers it to the company’s long-term equity.