Accounting Cycle: Definition and How It Works

What Is the Accounting Cycle?

The accounting cycle is the process of identifying, analyzing, and recording a company's accounting events. It is a standard eight-step process that begins with the occurrence of a transaction and concludes with its inclusion in the financial statements.

The key steps in the eight-step accounting cycle include recording journal entries, posting to the general ledger, calculating trial balances, making adjusting entries, and creating financial statements.

KEY TAKEAWAYS

• The accounting cycle is a process designed to make financial accounting of business activities easier for business owners.

• The first step in the eight-step accounting cycle is to record transactions using journal entries, ending with the eighth step of closing the books after preparing financial statements.

• The accounting cycle generally comprises a year or other accounting period.

• Accounting software today mostly automates the accounting cycle.

How the Accounting Cycle Works

The accounting cycle is a methodical set of rules to ensure the accuracy and conformity of financial statements. Computerized accounting systems and the uniform process of the accounting cycle have helped to reduce mathematical errors. Today, most software fully automates the accounting cycle, which results in less human effort and errors associated with manual processing.

Steps of the Accounting Cycle

There are eight steps to the accounting cycle.

1. Identify Transactions: An organization begins its accounting cycle with the identification of those transactions that comprise a bookkeeping event. This could be a sale, refund, payment to a vendor, and so on.

2. Record Transactions in a Journal: Next come recording of transactions using journal entries. The entries are based on the receipt of an invoice, recognition of a sale, or completion of other economic events.

3. Posting: Once a transaction is recorded as a journal entry, it should post to an account in the general ledger. The general ledger provides a breakdown of all accounting activities by account.

4. Unadjusted Trial Balance: After the company posts journal entries to individual general ledger accounts, an unadjusted trial balance is prepared. The trial balance ensures that total debits equal the total credits in the financial records.

5. Worksheet: Analyzing a worksheet and identifying adjusting entries make up the fifth step in the cycle. A worksheet is created and used to ensure that debits and credits are equal. If there are discrepancies, then adjustments will need to be made.

6. Adjusting Journal Entries: At the end of the period, adjusting entries are made. These are the result of corrections made on the worksheet and the results from the passage of time. For example, an adjusting entry may accrue interest revenue that has been earned based on the passage of time.

7. Financial Statements: Upon the posting of adjusting entries, a company prepares an adjusted trial balance followed by the actual formalized financial statements.

8. Closing the Books: An entity finalizes temporary accounts, revenues, and expenses, at the end of the period using closing entries. These closing entries include transferring net income into retained earnings. Finally, a company prepares the post-closing trial balance to ensure debits and credits match and the cycle can begin anew.

Timing of the Accounting Cycle

The accounting cycle is started and completed within an accounting period, the time in which financial statements are prepared. Accounting periods vary and depend on different factors; however, the most common type of accounting period is the annual period. During the accounting cycle, many transactions occur and are recorded.

At the end of the year, financial statements are generally prepared, which are often required by regulation. Public entities are required to submit financial statements by certain dates. All public companies that do business in the U.S. are required to file registration statements, periodic reports, and other forms to the U.S. Securities and Exchange Commission. Therefore, their accounting cycle revolves around reporting requirement dates.

The Accounting Cycle Vs. Budget Cycle

The accounting cycle is different than the budget cycle. The accounting cycle focuses on historical events and ensures incurred financial transactions are reported correctly. Alternatively, the budget cycle relates to future operating performance and planning for future transactions. The accounting cycle assists in producing information for external users, while the budget cycle is mainly used for internal management purposes.

‍