What Are the Four Steps in the Accounting Cycle?

The accounting cycle is a systematic process that businesses follow to record, classify, and summarize financial transactions over a specific accounting period. This structured framework ensures the accuracy and completeness of financial information, which is then used to produce reliable financial statements. By consistently applying this cycle, businesses maintain organized records and generate statements that reflect their economic performance.

Recording Financial Transactions

The accounting cycle begins with identifying financial transactions, such as sales, purchases, payments, or receipts. These are captured through source documents like invoices or receipts. Each transaction is then chronologically recorded in a general journal through “journalizing.”

Journalizing uses the double-entry bookkeeping method, where every transaction affects at least two accounts with equal debits and credits. For instance, paying cash for rent decreases cash (credited) and increases rent expense (debited), ensuring the accounting equation (Assets = Liabilities + Equity) remains balanced. Once journalized, entries are “posted” to individual general ledger accounts. The general ledger organizes all financial data by account, providing a summary of transactions for each, such as Cash, Accounts Receivable, or Sales Revenue.

Adjusting and Summarizing Accounts

Following initial recording, the second stage involves adjusting and summarizing accounts, particularly for businesses using the accrual basis of accounting. This method recognizes revenues when earned and expenses when incurred, regardless of when cash changes hands. Adjusting entries are made at the end of an accounting period to update account balances and ensure they reflect the correct amounts. Common adjusting entries address situations like depreciation, accrued expenses (such as utilities used but not yet billed), accrued revenues (like services performed but not yet invoiced), unearned revenues (cash received for future services), and prepaid expenses. After these adjustments, an “adjusted trial balance” is prepared, listing all general ledger accounts and their balances, providing the accurate data needed for financial statement preparation.

Preparing Financial Statements

Once the adjusted trial balance is finalized, financial statements are prepared. These statements provide a comprehensive overview of a company’s financial performance and position, serving stakeholders like investors, creditors, and management. There are three primary financial statements: the Income Statement, the Balance Sheet, and the Statement of Cash Flows.

The Income Statement reports a company’s financial performance over a specific period, detailing revenues, expenses, and the resulting net income or loss. The Balance Sheet offers a snapshot of a company’s financial position at a specific point in time, outlining its assets, liabilities, and equity. The Statement of Cash Flows tracks cash movement into and out of the business, categorizing it into operating, investing, and financing activities.

Closing the Books

The final step is closing the books, which prepares accounts for the next accounting period. This involves distinguishing between “temporary accounts” and “permanent accounts.” Temporary accounts, such as revenues, expenses, and dividends, measure activities over a specific period and are reset to zero. Permanent accounts, including assets, liabilities, and equity, carry their balances forward.

The closing process transfers temporary account balances to a permanent equity account. This zeroing out allows for accurate performance measurement in the subsequent period. A “post-closing trial balance” is then prepared as a final verification, ensuring only permanent accounts have balances and debits continue to equal credits.