What is the Accounting Cycle?

The accounting cycle is the actions taken to identify and record an entity's transactions. These transactions are then aggregated at the end of each reporting period into financial statements. The accounting cycle is essentially the core recordation activities that an accounting department engages in on an ongoing basis, and constitute the primary job responsibilities of the typical bookkeeper or controller. A proper understanding of the accounting cycle provides you with a knowledge of the core activities of an accounting department.

How the Accounting Cycle Works

The accounting cycle is based on policies and procedures that are designed to minimize errors, and to ensure that financial statements can be produced in a consistent manner, every time. To make the cycle more robust, organizations incorporate a complete suite of control activities into the procedures. In addition, most businesses use accounting software to accumulate transactional data and convert them into financial statements. The use of software introduces a high degree of control over the accounting cycle, so that transactions can only be recorded if they are made in accordance with the rules set up within the software. This approach is also more efficient than a manual accounting system, requiring significantly less labor per transaction.

Related AccountingTools Courses

Accountants’ Guidebook

Bookkeeper Education Bundle

Bookkeeping Guidebook

Steps in 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 reporting period. The accounting cycle for individual transactions is noted below.

Step 1: Identify Transactions

Identify the event that is causing an accounting transaction. Examples of such events are buying materials, paying wages to employees, applying overhead to inventory and the cost of goods sold, selling goods to customers, providing services to customers, receiving payments from customers, and recognizing an expense. These are all key business activities that involve the generation of revenue and incurrence of expenses in support of revenue-generated activities.

Step 2: Prepare Business Documents

Prepare the business document associated with the accounting transaction, such as a supplier invoice, customer invoice, petty cash voucher, or cash receipt. Once prepared, a copy of the applicable document is stored as evidence in the firm’s archives; it may be stored electronically. These documents are needed as evidence for later examination by auditors, as well as to initiate transactions, such as the payment of an invoice.

Step 3: Identify Impacted Accounts

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. This level of standardization is needed to keeping the underlying accounting activities as efficient as possible.

Step 4: Record Transaction

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. These postings are needed for the next set of activities in the accounting cycle, as described next.

Components of the Period-End Accounting Cycle

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.

Step 1: Prepare Trial Balance

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 (an unbalanced 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, or entering an account as a debit instead of a credit (or vice versa).

Step 2: Add Adjusting Entries

Add accrued items, record estimates, and correct errors in the preliminary trial balance with adjusting entries. Examples of such items are recording expenses for supplier invoices that have not yet arrived, recording revenue for customer invoices that have not yet been billed, recording errors spotted in the month-end bank reconciliation, adjusting for transactions that were initially recorded in the wrong account, or accruing for unpaid wages earned.

Step 3: Prepare Adjusted Trial Balance

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.

Step 4: Prepare Financial Statements

Prepare the financial statements from the adjusted trial balance. The core elements of the financial statements are the balance sheet, income statement, statement of cash flows, statement of retained earnings, and accompanying disclosures (also known as footnotes). When the financials are only being reported internally, the income statement and balance sheet may be the only documents issued, since the statement of cash flows and disclosures are more commonly examined by outside parties.

Step 5: Close the Books

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. There are many closing activities, as detailed in our Closing the Books course.

Step 6: Prepare Post-Closing Trial Balance

Prepare and review a post-closing trial balance. This trial balance should contain zero balances for all temporary accounts.

Accounting Cycle Documentation

It is 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.

Accounting Cycle vs. Budget Cycle

The budget cycle is the planning process that a business goes through in order to derive a budget for the upcoming fiscal year. Thus, a key difference between the accounting cycle and the budget cycle is that the accounting cycle deals with transactions that have already occurred, while the budget cycle is forward-looking. Another difference is that the results of the accounting cycle are compiled for external users of a company’s financial statements, while the budget model derived from the budget cycle is primarily intended for internal use.