Understanding the Accounting Cycle and its Steps
The Accounting Cycle
The accounting cycle is a series of activities that begins with a transaction and ends with the closing of the books at the end of the fiscal year. Because this process is repeated each reporting period, it is referred to as the accounting cycle and includes these major steps:
The Accounting Process
- Identify the transaction or other recognizable event.
- The transactions should have a source document such as a purchase order or invoice.
- Analyze and classify the transaction. This step involves quantifying the transaction in monetary terms (e.g. dollars and cents), identifying the accounts that are affected, and whether those accounts are to be debited or credited. (Rules of debits and credits).
- Record the transaction by making entries in the appropriate journal, such as the sales journal, purchase journal, cash receipt or disbursement journal, or the general journal. Such entries are made in chronological order.
Post general journal entries to the ledger accounts.
The above steps are performed throughout the accounting period as transactions occur or in periodic batch processes. The following steps are performed at the end of the accounting period:
- Prepare the trial balance to make sure that debits equal credits. The trial balance is a listing of all the ledger accounts, with debits in the left column and credits in the right column. At this point, no adjusting entries have been made. The actual sum of each column is not meaningful; what is important is that the sums be equal. Note that while out-of-balance columns indicate a recording error, balanced columns do not guarantee that there are no errors. For example, not recording a transaction or recording it in the wrong account would not cause an imbalance.
- Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include:
- Posting of the wrong amount,
- Omitting a posting,
- Posting in the wrong column, or
- Posting more than once.
Adjusting Process
- Prepare adjusting entries to record accrued, deferred, and estimated amounts. (Prepaids, Depreciation, Accrued expenses, Accrued revenues, Unearned revenues)
- Post adjusting entries to the ledger accounts.
- Prepare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found.
- From the Adjusted trial balance, prepare the financial statements.
- Income statement: Prepared from the revenue, expenses, gains, and losses.
- Balance sheet: Prepared from the assets, liabilities, and equity accounts.
- Statement of owner’s equity (retained earnings for corporations): Prepared from net income and drawing information.
- Cash flow statement: Derived from the other financial statements using either the direct or indirect method. (Principles II)
Closing Process
- Prepare closing journal entries that close temporary accounts such as revenues, expenses, drawings, gains, and losses. These accounts are closed to a temporary income summary account, from which the balance is transferred to the owner’s capital account (retained earnings account for corporations). Any dividend (corporations) or drawing (owner’s withdrawals) accounts also are closed to capital.
- Post closing entries to the ledger accounts.
- Prepare the post-closing trial balance to make sure that debits equal credits. At this point, only the permanent accounts appear since the temporary ones have been closed. Correct any errors.
- Prepare reversing journal entries (optional). Reversing journal entries often are used when there has been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting period. By reversing the adjusting entry, one avoids double-counting the amount when the transaction occurs in the next period. A reversing journal entry is recorded on the first day of the new period. For example, accrued expenses such as payroll-related entries.