What Are the Accounting Cycle Steps?

The accounting cycle represents a structured series of steps that businesses follow to systematically record, process, and report their financial transactions over a specific period. This process ensures financial activities are accurately captured, providing a reliable overview of a company’s financial health. By consistently applying these steps, organizations maintain precise records, generate financial statements, and gain insights for informed decision-making.

Transaction Identification

The accounting cycle begins with the identification of financial transactions, which are economic events that affect a company’s financial position and can be reliably measured in monetary terms. Common examples include sales of goods or services, purchases of inventory or supplies, payment of expenses like rent or salaries, and receipt of cash from customers. Each transaction must be supported by a source document, which serves as objective evidence of the event.

Source documents provide initial data for the accounting system, ensuring accuracy and auditability. These documents can include sales invoices, purchase orders, cash register receipts, bank statements, payroll records, and signed contracts. For instance, a sales invoice confirms the details of a revenue transaction, while a vendor invoice substantiates an expense or asset acquisition.

Before any recording takes place, each identified transaction is analyzed to determine its impact on the fundamental accounting equation: Assets = Liabilities + Equity. This analysis involves identifying the specific accounts affected and determining whether those accounts increase or decrease. For example, purchasing inventory on credit affects both the inventory asset account and the accounts payable liability account.

Recording in Ledgers

Following the identification and analysis of financial transactions, the next step involves formally recording them in a systematic manner. This process typically begins with journalizing, where transactions are entered chronologically into a general journal. The general journal serves as a day-by-day record of all financial events, detailing the date, accounts involved, and the monetary amounts.

Journal entries utilize the double-entry accounting system, which dictates that every transaction affects at least two accounts, with total debits always equaling total credits. Debits and credits represent increases or decreases in specific account types. For instance, an increase in an asset account is recorded as a debit, while an increase in a liability or equity account is recorded as a credit. Conversely, a decrease in an asset is a credit, and a decrease in a liability or equity is a debit.

After transactions are recorded in the general journal, the information is then transferred, or “posted,” to the general ledger. The general ledger organizes financial data by individual account, such as Cash, Accounts Receivable, Accounts Payable, Sales Revenue, and Rent Expense. Each account provides a summary of all transactions affecting it, allowing a detailed view of its balance. For example, all cash inflows and outflows are consolidated in the Cash account, enabling a quick determination of the current cash balance.

Adjustments and Balances

Upon the completion of posting all journal entries to the general ledger, an unadjusted trial balance is prepared. This internal document lists all general ledger accounts and their respective debit or credit balances, serving as an initial check to confirm that the total debits equal the total credits. While the unadjusted trial balance confirms mathematical equality, it does not guarantee the accuracy or completeness of the financial records.

Adjusting entries are then prepared at the end of an accounting period to ensure that revenues and expenses are recognized in the period they are earned or incurred, regardless of when cash is exchanged. This adherence to the accrual basis of accounting, which aligns with generally accepted accounting principles (GAAP), ensures accurate presentation of a company’s financial performance and position. Common types of adjusting entries include recording accrued expenses like unpaid salaries, accrued revenues for services performed but not yet billed, and deferred revenues for payments received for services not yet delivered.

Depreciation is another common adjustment, systematically allocating the cost of a long-lived asset over its useful life. For instance, the cost of equipment is spread out as an expense over several years rather than expensed entirely in the year of purchase. These adjustments match expenses with the revenues they help generate, providing a more accurate picture of profitability for the period.

After all adjusting entries have been journalized and posted to the general ledger, an adjusted trial balance is prepared. This revised trial balance reflects the impact of the adjustments, ensuring that all revenue and expense accounts are up-to-date and that asset and liability accounts show their correct balances at the end of the period.

Financial Reporting

The adjusted trial balance serves as the foundational document from which a company’s primary financial statements are prepared. These statements provide an overview of a business’s financial position and performance to both internal and external stakeholders, conveying financial information in a standardized format.

The income statement, also known as the profit and loss statement, reports a company’s financial performance over a specific accounting period, typically a quarter or a year. It presents revenues earned and expenses incurred during that period, ultimately calculating the net income or net loss. This statement helps understand a company’s profitability and operational efficiency.

The balance sheet offers a snapshot of a company’s financial condition at a specific point in time, such as the end of a fiscal quarter or year. It details the company’s assets (what it owns), liabilities (what it owes), and equity (the owners’ residual claim on assets). The balance sheet adheres to the accounting equation, ensuring that assets always equal the sum of liabilities and equity.

The statement of cash flows summarizes the cash inflows and outflows over a specific period, categorized into operating, investing, and financing activities. Operating activities relate to the primary revenue-generating operations, investing activities involve the purchase or sale of long-term assets, and financing activities concern debt and equity transactions. This statement provides insights into how a company generates and uses cash, which is distinct from its profitability.

Periodic Closure

The final step in the accounting cycle is the periodic closure process, which typically occurs at the end of each accounting period, such as a fiscal quarter or year. This step involves preparing closing entries to zero out the balances of temporary accounts, making them ready for the next accounting period. Temporary accounts include all revenue, expense, and dividend accounts, which accumulate balances for a single period.

In contrast to temporary accounts, permanent accounts—such as asset, liability, and equity accounts—are not closed at the end of the period. Their balances carry forward from one accounting period to the next, reflecting the cumulative financial position of the business. For example, the Cash account balance at the end of one year becomes the starting balance for the next year.

Closing entries involve transferring the balances from all temporary accounts to a permanent equity account, typically Retained Earnings. For instance, revenue accounts are closed with a debit, and expense accounts are closed with a credit, with the net effect flowing into Retained Earnings. This process ensures that the income or loss for the period is ultimately reflected in the owner’s equity. After closing entries are posted, a post-closing trial balance is prepared, containing only permanent accounts, confirming that the ledger is balanced and ready for the next cycle.