What Are the Six Steps in the Accounting Cycle?

The accounting cycle provides a structured approach for businesses to record and process all financial transactions within a specific accounting period. This systematic process ensures financial activities are accurately captured and represented in financial statements. Following the accounting cycle is important for generating reliable financial reports, which supports informed business decision-making. The cycle culminates in preparing financial statements that reflect a company’s performance and financial position.

Analyzing and Recording Transactions

The accounting cycle begins with analyzing and recording transactions. A financial transaction is an economic event that affects a company’s financial position and can be reliably measured and recorded. Businesses rely on source documents, such as invoices, receipts, and bank statements, to provide objective evidence of these transactions. Each transaction is then analyzed to determine its impact on the fundamental accounting equation: Assets = Liabilities + Equity. This analysis helps identify which specific accounts are affected by the transaction.

Once analyzed, transactions are chronologically recorded in a journal, often referred to as the “book of original entry.” This process, known as journalizing, uses a system of debits and credits to ensure the accounting equation remains balanced after each entry. For instance, a cash sale would involve debiting the Cash account (an asset) and crediting the Sales Revenue account (which increases equity), maintaining the equality. This initial step ensures all financial activities are captured precisely.

Posting to the Ledger

After transactions are recorded in the journal, the next step involves posting this information to the ledger. A ledger is a collection of all individual asset, liability, equity, revenue, and expense accounts used by a business. Its purpose is to organize and summarize financial data, providing a detailed record for each specific account.

Individual debit and credit amounts from the journal entries are transferred, or posted, to their corresponding accounts within the ledger. For example, a debit to the Cash account in the journal would be posted as a debit to the Cash account in the ledger. This accumulation of all transactions for each specific account allows for a running balance to be maintained. T-accounts are often used to illustrate how debits and credits affect individual ledger accounts.

Preparing an Unadjusted Trial Balance

Following the posting of all journal entries to the ledger, an unadjusted trial balance is prepared. This document is a list of all ledger accounts and their respective debit or credit balances at a specific point in time. Its primary purpose is to verify that the total of all debit balances equals the total of all credit balances. This equality confirms that the accounting equation remains in balance after the journalizing and posting steps.

The term “unadjusted” signifies that this trial balance reflects account balances before any end-of-period adjustments have been made. These adjustments are necessary for accruals and deferrals, which align financial reporting with accounting principles. While the unadjusted trial balance confirms mathematical equality, it does not guarantee that all transactions were recorded correctly or that no errors of omission occurred. This step serves as an internal control, helping to identify basic mathematical errors before proceeding to subsequent stages of the accounting cycle.

Making Adjusting Entries

Adjusting entries are a necessary part of the accounting cycle, made at the end of an accounting period to ensure accurate financial reporting. These entries adhere to the revenue recognition and expense matching principles. The revenue recognition principle dictates that revenues are recorded when earned, regardless of when cash is received. Similarly, the expense matching principle requires expenses to be recognized in the same period as the revenues they helped generate, irrespective of cash payment.

Common types of adjusting entries address accruals and deferrals. Accruals include expenses incurred but not yet paid, such as accrued salaries, and revenues earned but not yet received, like accrued interest revenue. Deferrals involve prepaid expenses, such as insurance paid in advance but not yet expired, and unearned revenues, which represent cash received for services not yet rendered.

Depreciation, the systematic allocation of the cost of long-term assets over their useful life, is another common adjusting entry. These entries are typically made at the close of an accounting period, such as monthly, quarterly, or annually, before the preparation of financial statements.

Preparing Financial Statements and Closing the Books

After adjusting entries are made, the information is used to prepare the primary financial statements. The Income Statement reports a company’s revenues and expenses over a period, ultimately showing its net income or loss. The Statement of Owner’s Equity (or Retained Earnings for corporations) details the changes in owner’s equity over the accounting period. The Balance Sheet presents a snapshot of a company’s assets, liabilities, and equity at a specific point in time. These statements summarize the financial activities of the period.

The final step in the accounting cycle is closing the books. This process involves preparing closing entries to reset temporary accounts, such as revenues, expenses, and dividends or owner’s drawings, to zero at the end of the accounting period. Their balances are then transferred to a permanent equity account, typically Retained Earnings or Owner’s Capital. Permanent accounts, including assets, liabilities, and equity (excluding drawings/dividends), are not closed and carry their balances forward to the next accounting period. A post-closing trial balance may then be prepared as a final verification, ensuring the system is ready for a new accounting period.