Accounting Cycle Explained for Dummies

What is the accounting cycle?

Basically, the accounting cycle is the process that divides the responsibilities and duties of bookkeepers and accountants in eight-steps, starting with ‘identifying transactions’ and ending with ‘closing the books’ for a specific accounting period.

Nowadays, most of the eight steps are executed through accounting software programs.

The accounting cycle periods will vary according to a business’s reporting needs, being monthly, quarterly, or annually.

Once an accounting cycle ends, a new cycle starts, performing the eight-step process all over again.

The accounting cycle enables bookkeepers and accountants to ensure precision and accuracy during the accounting process.[1]

The eight steps of the accounting cycle

The accounting cycle comprises the following eight steps:

Step 1: Identify transactions

The first step in the accounting cycle is to identify financial transactions that occur. If there were no financial transactions, there would be no need for an accounting cycle.

Financial transactions are also referred to as economic events that can be measured in terms of money.

Businesses will have numerous financial transactions throughout an accounting cycle. The number of transactions will depend on the type and the size of the business.

Transactions can include, among others, the following:

• Purchase of materials, services, or supplies for business activities.
• Sale of goods (cash or credit), or services to customers.
• Acquisition of assets such as plant and machinery, vehicles, and equipment.
• Any expenses incurred.
• Debt payoffs.
• Salaries and wages paid to employees.

Source documents, such as invoices, receipts, contracts, depreciation schedules, and bank statements, are proof that the transactions have taken place.

Step 2: Journal entries

The next step in the accounting cycle is to record the financial transactions in the appropriate accounting journals of the business. The journal entries should be done in chronological order, debiting one or more accounts, and crediting one or more accounts, ensuring that the debits and credits are in balance.

Recording a transaction in a journal is also referred to as journalising the transaction.

Journals are also known as ‘books of original entry,’ because it is the first place where a transaction is recorded. Examples of accounting journals are:

• General journal.
• Cash journal.
• Sales journal.
• Purchase journal.

Although, in this day and age, the concept of accounting journals is only applicable to manual record-keeping because computerised accounting systems no longer refer to any of the accounting journals but record all the financial transactions in a central database.

Step 3: Posting

In the third step in the accounting cycle, the journal entries are posted to the accounts in the general ledger (GL).

The general ledger is described in different ways, such as:

The general ledger:

• is not viewed as a book of original entry,
• provides a summary of all accounting activities by individual accounts, keeping track of all the financial activities of a business, and
• is the main accounting record for a business.

The cash account, indicating how much cash is available, is one of the most commonly referenced accounts in the GL.

Step 4: Trial balance

The fourth step in the accounting cycle is to prepare a trial balance at the end of the accounting period (which may be monthly, quarterly, or annually). The trial balance is prepared by totalling the debits and credits from the general ledger accounts, ensuring the debits equal the credits.

A trial balance is considered successful when all the debit and credit balances of all the general ledger accounts are indeed in balance.

This step is necessary in order to detect any errors and inaccurate entries that may have taken place during the initial stages of the accounting cycle.

At this stage, the trial balance is still an unadjusted one. An adjusted trial balance is prepared in step 6 after all the adjusting entries have been recorded.

Step 5: Worksheet

When step 4 of the accounting cycle indicates that the general ledger accounts are not in balance, bookkeepers or accountants must look for errors and discrepancies in order to correct them, which are performed in step 5 of the accounting cycle.

These corrections are called adjustments, which are tracked on a worksheet, ensuring that debits and credits are equal.

Step 6: Adjusting journal entries

The adjustments made on the worksheet are recorded in the appropriate accounting journals as adjusting entries at the end of an accounting period.

In addition to correcting any errors, adjusting entries may be used to match revenues and expenses when using the accrual accounting method, adjusting revenues and expenses to the accounting period in which they actually occurred.

Adjusting entries are also used to address the following issues:

• Accrued expenses – expenses that should be reported in the accounting period but have not yet been reported or paid.
• Accrued revenues – revenues that should be recorded in the accounting period but have yet not been reported, nor has the money been received.
• Prepaid expenses – a type of asset on the balance sheet, resulting from advanced payments made by a business for goods or services to be received in the future.
• Deferrals – money received that should be recorded as income (revenue) in a later accounting period.
• Depreciation.

Adjusting entries are important because a transaction may influence revenues or expenses beyond the current accounting period.

An adjusted trial balance is created after all the adjusting entries for the accounting period have been posted to the general ledger accounts. The trial balance is not a financial statement but an internal document that provides financial information to prepare the financial statements.

Step 7: Financial statements

The penultimate step in the accounting cycle is the preparation of the financial statements, compiled from balances obtained from the adjusted trial balance.

Financial statements include the following statements:

• The Balance Sheet, also known as the Statement of Financial Position.
• The Income Statement.
• Cash Flow Statement.
• Statement of Changes in Equity, also referred to as Statement of Retained Earnings.

Step 8: Closing the books

In the final step in the accounting cycle, all the revenue and expense accounts (income statement accounts) are closed and zeroed out. Net income is transferred to retained earnings.

Balance sheet accounts (assets, liabilities, and owner’s equity) are not closed because their closing balances are the opening balances for the next accounting period.

Finally, a post-closing trial balance is created to ensure debits and credits are equal, enabling bookkeepers and accountants to start a new accounting cycle.

[1] Refer to the article ‘Accounting Explained for Dummies,’ for more information about accounting.