What Are the Six Steps in the Accounting Cycle?

The accounting cycle is a structured series of steps businesses follow to record and process financial transactions over a specific period. This systematic approach ensures financial data is accurately captured, laying the groundwork for reliable financial reporting. It transforms raw financial activities into organized information that reflects a company’s financial health and performance.

Recognizing and Recording Transactions

The accounting cycle begins with identifying financial events that impact a business’s financial position. These events, such as sales, purchases, or payments, are considered transactions and must be supported by source documents like invoices, receipts, or bank statements. These documents provide the objective evidence needed to record each event accurately.

Once identified, transactions are analyzed to determine their effect on the accounting equation: Assets = Liabilities + Equity. This analysis ensures that the fundamental balance of a company’s financial structure is maintained with every entry. Each transaction is then chronologically recorded in a general journal, which serves as the initial book of entry.

This recording process involves using debits and credits, the fundamental mechanism of double-entry accounting. For every transaction, at least two accounts are affected, with one receiving a debit and another a credit, ensuring total debits always equal total credits. For instance, a cash sale debits the Cash account (an asset) and credits the Sales Revenue account (an equity component). This dual-entry system keeps the accounting equation in balance.

Categorizing Account Information

After transactions are initially recorded in the general journal, the next step involves transferring this information to the general ledger. This process, known as posting, moves the debit and credit amounts from the journal entries to their respective individual accounts within the ledger. The general ledger acts as a comprehensive collection of all the company’s financial accounts, such as Cash, Accounts Receivable, Sales Revenue, and Rent Expense.

Each account in the general ledger provides a running balance of its activity, consolidating all related transactions. For example, the Cash account shows all cash inflows and outflows, providing its current balance. This categorization summarizes and organizes all transactions by account type.

This systematic organization allows accountants to determine the total balance for each asset, liability, equity, revenue, and expense account. Grouping similar transactions, the general ledger provides a clear overview of how each financial element is performing. This step provides the summarized data needed for preparing subsequent financial reports.

Adjusting and Verifying Balances

At the end of an accounting period, an unadjusted trial balance is prepared, listing all general ledger accounts and their current balances. This list’s primary purpose is to verify that total debit balances equal total credit balances before final adjustments. This step serves as an initial check for mathematical accuracy within the ledger.

Adjusting entries are necessary to apply the accrual basis of accounting, which ensures that revenues are recognized when earned and expenses are recognized when incurred, regardless of when cash changes hands. These entries are important for accurately reflecting a company’s financial performance and position at the end of the period. Common examples include recording depreciation on assets, recognizing accrued expenses like salaries earned but not yet paid, accounting for deferred revenues where cash was received but services have not yet been rendered, and adjusting for prepaid expenses that have been consumed.

Adjusting entries are journalized and then posted to the general ledger accounts. After these adjustments are completed, an adjusted trial balance is prepared. This updated trial balance ensures account balances are current and accurately reflect the business’s financial status, serving as the direct source for preparing primary financial statements.

Producing Financial Statements

The adjusted trial balance serves as the direct source for generating the primary financial statements, the end product of the accounting cycle. These statements provide a summarized view of a company’s financial performance and position. They are prepared after all adjustments have been made.

The income statement, also known as the profit and loss statement, is prepared first, utilizing revenue and expense accounts from the adjusted trial balance. This statement reports a company’s profitability over a specific period by matching revenues earned with expenses incurred to generate them. Its result, net income or net loss, indicates financial performance for the period.

Following the income statement, the balance sheet is prepared using asset, liability, and equity accounts from the adjusted trial balance. The balance sheet presents a company’s financial position at a specific point in time, showing what the company owns (assets), what it owes (liabilities), and the owners’ stake (equity). The income statement and balance sheet are primarily derived from the adjusted trial balance within this cycle.

Finalizing the Period’s Records

The final steps in the accounting cycle prepare the company’s records for the next accounting period. This process begins with closing entries, journal entries made at the end of the accounting period. These entries reset the balances of temporary accounts—revenues, expenses, and dividends or owner’s withdrawals—to zero.

By zeroing out these temporary accounts, their balances are transferred to a permanent equity account. This action ensures the next accounting period starts with a clean slate for measuring revenues and expenses, allowing for accurate period-to-period comparisons. The income summary account is used as an intermediate step during this closing process.

After closing entries are journalized and posted, a post-closing trial balance is prepared. This final trial balance contains only permanent accounts—assets, liabilities, and equity—as all temporary accounts now have zero balances. It confirms the ledger remains in balance after closing, ensuring financial records are ready for a new accounting cycle.