What Are the Steps of the Accounting Cycle?

The accounting cycle is a systematic process businesses follow to record and process financial transactions, leading to the creation of financial statements. This structured approach ensures financial information is consistently captured and reported, providing a reliable basis for internal decision-making and external reporting. Maintaining accurate and consistent financial records through this cycle helps businesses understand their performance and financial position over time.

Recording Transactions

The initial phase of the accounting cycle involves recognizing and documenting financial activities as they occur. Every financial event, such as sales, purchases, payments, or receipts, constitutes a transaction. These transactions are supported by source documents like invoices, receipts, and bank statements, which serve as objective evidence for the financial event.

Transactions are recorded chronologically in a journal, often called the “book of original entry.” This process, known as journalizing, uses the double-entry accounting system, where every transaction affects at least two accounts. Each entry must have equal debits and credits to maintain the fundamental accounting equation: Assets = Liabilities + Equity. For example, when a company purchases supplies on credit, “Supplies” is debited and “Accounts Payable” is credited, keeping the equation balanced. The journal provides a sequential record of all financial events, detailing the date, accounts affected, and amounts.

Summarizing and Balancing Accounts

After transactions are recorded, the next step involves organizing and summarizing this information. This process is called posting to the general ledger, where entries from the journal are transferred to their respective accounts. The general ledger is a comprehensive collection of all accounts, providing a running balance for each asset, liability, equity, revenue, and expense account. This step aggregates similar transactions, allowing for a clear overview of activity within each account.

Following posting, an unadjusted trial balance is prepared. This is a list of all general ledger accounts and their balances at the end of an accounting period, before any adjustments. Its purpose is to verify that total debit balances equal total credit balances, a fundamental check in the double-entry system. While it confirms mathematical equality, it does not guarantee that all transactions have been recorded accurately or that the accounts reflect their true economic value. This report serves as a starting point for further analysis.

Adjusting Accounts and Preparing Financial Statements

At the close of an accounting period, adjusting entries ensure financial statements accurately reflect a company’s financial position and performance. These entries adhere to the accrual basis of accounting, which mandates that revenues are recognized when earned and expenses when incurred, regardless of when cash is exchanged. Common adjusting entries include depreciation, accrued expenses (expenses incurred but not yet paid), unearned revenue (cash received for services not yet performed), and prepaid expenses (expenses paid in advance that have been partially used). For instance, a portion of prepaid rent would be recognized as an expense for the current period through an adjusting entry.

After all adjusting entries are journalized and posted, an adjusted trial balance is prepared. This revised trial balance contains updated balances for all accounts, ensuring total debits equal total credits after adjustments. The adjusted trial balance forms the direct basis for preparing the main financial statements.

The primary financial statements include the income statement, which summarizes revenues and expenses to show net income or loss. The statement of owner’s equity or retained earnings details changes in the equity section. The balance sheet presents a snapshot of the company’s assets, liabilities, and equity at a specific point in time. These statements provide insights for stakeholders to assess business performance and stability.

Closing the Books for a New Period

The final steps involve preparing accounts for the upcoming accounting period. This begins with closing entries, which transfer temporary account balances to a permanent equity account. Temporary accounts, such as revenues, expenses, and dividends or owner’s drawings, accumulate balances for a single period and are reset to zero for the next. This ensures each period’s financial performance can be tracked independently.

The closing process involves four steps: closing revenue accounts to an Income Summary account, closing expense accounts to the Income Summary account, closing the Income Summary account (which holds net income or loss) to a permanent equity account like Retained Earnings or Capital, and closing any dividend or drawing accounts to the same permanent equity account. The net effect of the period’s operations is reflected in the permanent equity account, and temporary accounts are prepared for new data.

Following the posting of closing entries, a post-closing trial balance is prepared. This final trial balance includes only permanent accounts (assets, liabilities, and equity), as temporary accounts have been zeroed out. Its purpose is to verify that total debits equal total credits after the closing process, confirming the books are balanced and ready for the next period. This ensures a smooth transition, allowing the accounting cycle to repeat.