What is the Accounting Cycle?
The accounting cycle is a series of activities used to identify and record an entity's individual transactions. These transactions are then aggregated at the end of each reporting period into financial statements. The accounting cycle is essentially the core recordation activity that an accounting department engages in on an ongoing basis, and is the basis upon which the financial statements are constructed. Most accounting controls and procedures relate to the accounting cycle.
The following discussion breaks the accounting cycle into the treatment of individual transactions, and then closing the books at the end of the accounting period.
The accounting cycle for individual transactions is:
- Identify the event that is causing an accounting transaction. Examples of such events are:
- Buy materials
- Pay wages to employees
- Apply overhead to inventory and the cost of goods sold
- Sell goods to customers
- Provide services to customers
- Receive payment from customers
- Recognize an expense
- Prepare the business document associated with the accounting transaction, such as a supplier invoice, customer invoice, petty cash voucher, or cash receipt.
- Identify which accounts are affected by the business document. With a computerized accounting system, there is usually a default account associated with each supplier, so that the system assigns the amount listed on a supplier invoice to the default account (unless you override it). Similarly, there is usually a default account associated with each customer, so that the system assigns billed amounts to a specific revenue account whenever an invoice is created for a customer. There may also be standardized template journal entries in the accounting software for various standard transactions, such as for recording monthly depreciation or accrued wages.
- Record in the appropriate accounts in the accounting database the amounts noted on the business document. This may involve recording transactions in a specific journal, such as the cash receipts journal, cash disbursements journal, or sales journal, which are later posted to the general ledger. Such transactions may also be posted directly to the general ledger.
The preceding accounting cycle steps were associated with individual transactions. The following accounting cycle steps are only used at the end of the reporting period, and are associated with the aggregate amounts of the preceding transactions:
- Prepare a preliminary trial balance, which itemizes the debit and credit totals for each account. All debits are listed in the left column, and all credits in the right column. The totals of the two columns should be identical. If not, then there is an error somewhere in the underlying transactions (a one-sided entry) that should be corrected before proceeding. In most accounting software systems, it is impossible to have transactions that do not result in matching debit and credit totals. If the trial balance is being prepared manually, then likely reasons for unbalanced debit and credit totals are:
- Only entering a portion of a transaction
- Entering part of a transaction more than once
- Entering an incorrect amount
- Entering an amount as a debit instead of a credit (or vice versa)
- Add accrued items, record estimates, and correct errors in the preliminary trial balance with adjusting entries. Examples of such items are:
- Record expenses for supplier invoices that have not yet arrived
- Record revenue for customer invoices that have not yet been billed
- Record errors spotted in the month-end bank reconciliation
- Adjust for transactions that were initially recorded in the wrong account
- Accrue for unpaid wages earned
- Prepare an adjusted trial balance, which incorporates the preliminary trial balance and all adjusting entries. It may require several iterations before this adjusted trial balance accurately reflects the results of operations and the financial position of the business for which the information is being aggregated.
- Prepare the financial statements from the adjusted trial balance. The core elements of the financial statements are:
- Balance sheet
- Income statement
- Statement of cash flows
- Statement of retained earnings
- Accompanying disclosures (footnotes)
- Close the books for the reporting period. This step is handled automatically by an accounting computer system. If you are compiling accounting information manually, then closing the books involves shifting all temporary account balances (e.g., revenue, expenses, gains, and losses) into the income summary account, and shifting the balance from there to the retained earnings account.
- Prepare and review a post-closing trial balance.This trial balance should contain zero balances for all temporary accounts.
It is also useful to print out the key documents supporting the completed financial statements and store them in a binder. This can include all journals, as well as source documents for major journal entries, such as the depreciation calculations. This information provides backup information for the financial statements, and is of particular use when providing evidentiary matter to auditors.
The accounting cycle is also known as the bookkeeping cycle.