What Is the Accounting Cycle? A Step-by-Step Explanation

The accounting cycle is a structured series of steps businesses follow to record, process, and report financial transactions over a specific accounting period. This systematic approach ensures financial records are accurate, consistent, and reliable. It manages a company’s financial information, from initial transaction to financial statement creation, offering insights into performance and financial position.

Recording Business Transactions

The initial phase of the accounting cycle involves capturing business activity data. Every financial event, such as a sale, purchase, or payment, must be identified as a transaction. This identification relies on source documents, like sales invoices, purchase receipts, or bank statements, which provide evidence of a transaction. These documents detail the date, amount, and parties involved for recording.

Once a transaction is identified, it is journalized, meaning chronologically recorded in the general journal. This step applies the principles of double-entry accounting, where every transaction affects at least two accounts, using debits and credits. Debits increase asset and expense accounts, while decreasing liability, equity, and revenue accounts. Conversely, credits increase liability, equity, and revenue accounts, and decrease asset and expense accounts. For example, a cash sale debits the Cash account (an asset) and credits the Sales Revenue account, ensuring total debits equal total credits.

After transactions are recorded in the journal, they are posted to the general ledger. The general ledger is a collection of accounts, detailing financial transactions by type, such as cash, accounts receivable, or sales revenue. Posting involves transferring debit and credit amounts from journal entries to their respective accounts in the ledger. This process allows for a running balance for each account, offering a summarized view of transactions affecting that account.

Preparing and Adjusting Trial Balances

Next, account balances are summarized and adjusted. An unadjusted trial balance is prepared, a list of all general ledger accounts and their balances at the end of an accounting period. Its primary purpose is to verify that total debit balances equal total credit balances. While this confirms mathematical accuracy, it doesn’t guarantee correct recording or absence of errors.

Adjusting entries are then prepared and posted to the general ledger. These entries ensure financial statements accurately reflect a business’s financial position and performance according to the accrual basis of accounting. Accrual accounting recognizes revenues when earned and expenses when incurred, regardless of cash flow. Common adjusting entries include depreciation, accrued salaries, unearned revenue adjustments, and prepaid expense accounting. These adjustments match revenues and expenses to the period in which they occurred.

After all adjusting entries are posted, an adjusted trial balance is prepared. This updated trial balance includes the effects of all adjustments, providing account balances ready for financial statement preparation. It serves as the direct source for creating accurate financial reports, ensuring revenues, expenses, assets, liabilities, and equity balances are properly stated.

Generating Financial Reports and Closing Accounts

The accounting cycle culminates in transforming refined financial data into meaningful reports and preparing accounts for the next period. The adjusted trial balance directly prepares the primary financial statements. The income statement reports a company’s revenues and expenses over a period, revealing profitability (net income or loss). The statement of owner’s equity or retained earnings details changes in owner’s investment over that period, incorporating net income or loss. Finally, the balance sheet presents a snapshot of the company’s financial position, listing assets, liabilities, and equity.

After financial statements are prepared, closing entries are made. These entries reset temporary accounts (revenue, expense, and owner’s drawing/dividend accounts) to zero at period end. This ensures accounts start fresh for the next period, allowing accurate performance measurement. Balances from these temporary accounts transfer to a permanent equity account, such as Retained Earnings or Owner’s Capital.

The final step is preparing a post-closing trial balance. This is created after all closing entries are posted to the general ledger. Its purpose is to verify that only permanent accounts (assets, liabilities, and equity) have remaining balances, and total debits equal total credits. This final check confirms the ledger is balanced and ready for the new accounting period, completing one cycle.