Key Takeaways
- The accounting cycle encompasses a series of steps that is performed throughout the accounting period.
- The accounting cycle is divided into two phases: the recording phase and the summarizing phase.
Overview of the Accounting Cycle
The Accounting Cycle refers to the sequence of activities and procedures in the company’s accounting information system that are performed throughout the accounting period.
The accounting cycle encompasses all the necessary steps that a company does to prepare its financial statements. It starts with identifying business transactions that will be recorded in the accounting books and ends with the closing of those books.
The steps in the accounting cycle are done in the following order:
- Gathering of business source documents
- Analyzing and journalizing business transactions
- Posting journalized transactions to the ledger
- Preparing an unadjusted trial balance
- Journalizing and posting adjusting entries
- Preparing an adjusted trial balance
- Preparing the financial statements
- Journalizing and posting closing entries
- Preparing a post-closing trial balance
- Journalizing and posting reversing entries
These steps are repeated at the beginning of every accounting period. Nowadays, some of the steps in the accounting cycle occur simultaneously and automatically, thanks to the advent of accounting software. However, it’s still important for you to have a fundamental knowledge about the traditional steps in an accounting cycle of a manual accounting system to fully appreciate what goes behind the scenes when using a computerized accounting information system.
To easily understand the steps in the accounting cycle, let’s break them down into two phases: Recording Phase and Summarizing Phase
Recording Phase
The Recording Phase of the accounting cycle encompasses steps 1, 2 and 3 above. These first three steps are done multiple times during the entire accounting period as business transactions occur continuously. The recording phase requires the most time and effort because transactions have to be analyzed correctly and recorded accurately.
Summarizing Phase
The Summarizing Phase of the accounting cycle includes steps 4 through 9 above. These six remaining steps of the accounting cycle are done at the end of the accounting period. The summarizing phase is where the financial statements are generated by the business.
Step 10 which is the recording of reversing entries is an optional step that is done depending on the method used when recording adjusting entries. This step actually takes place at the beginning of the next accounting period but can still be considered as part of the previous accounting cycle.
The steps in the accounting cycle may vary from one business to another. Depending on the type of accounting information system used by your business, i.e. manual or computerized, some steps in the accounting cycle can be combined or omitted. However, the nature of the process remains the same regardless of the accounting information system being used.
Step 1: Gathering of business source documents
The accounting cycle starts with gathering of source documents that are used for every business transaction. Source Documents are original records that serve as evidence of transactions and events that have occurred in your company during an accounting period. They are retained and used for recording transactions, audit purposes and internal control.
Typical examples of source documents are invoices, cash receipts, cash register tape, bills, statement of accounts, checks, bank deposit slips, cash vouchers, promissory notes, debit notes, credit notes, estimates, quotes, purchase orders, sales orders, packing slips, delivery receipts, bank statements, and employee timesheets.
Source documents can either be in the form of a paper document or an electronic record. With the growth of e-commerce and business software, the use of electronic forms and documents became prevalent.
Step 2: Analyzing and journalizing business transactions
After gathering the source documents, your next step is to identify the transactions that will be entered in the accounting information system, and to collect data related to those transactions. These transactions, called Accounting Events, are recognized in the financial statements because they impact your company’s financial position, financial performance and cash flows during the accounting period. Examples of accounting events are as follows:
Events between your company and outside parties – this involves the exchange of resources and obligations with third parties outside of your business. An example is the sale of goods to your customers. Another example is taking out a loan from a bank to expand your business.
Internal events within your company that do not involve outside parties – these events include activities within your company that do not involve outside parties. Examples are payment of wages and salaries to employees, adjusting of inventory values to match physical count, and transfer of supplies from one department to another within the same company.
Economic and environmental events beyond your company’s control – this may include losses from lawsuits and losses due to natural disasters or theft.
As required by the monetary unit assumption, accounting events should be measurable in terms of money. Other events that do not affect the financial statements, such as signing of contracts and hiring of employees, are not considered as accounting events.
After you have identified the accounting events that occurred in your company during the accounting period, you need to analyze each transaction and determine the ledger accounts that will be affected by those transactions. Tools such as the T-account can be very useful when you’re making a preliminary analysis of transactions.
The next step after analyzing the transactions is to record them in the accounting journal. Journalizing is the process of recording transactions in the accounting journal using journal entries. The Accounting Journal is a chronological day to day record of transactions with references to source documents.
The most common accounting journal used by companies is the General Journal. Special Journals are also used for certain transactions that are repetitive in nature.
Step 3: Posting journalized transactions to the ledger
Posting to the ledger is the process of transferring the recorded transactions from the accounting journal to the appropriate accounts in the ledger. The General Ledger is an accounting record that stores the ledger accounts. These ledger accounts contain information about each financial transaction of the business and are the basis of the amounts needed to prepare the financial statements.
Under the posting process, the data that you have previously recorded in chronological format in the accounting journal is recorded again in the general ledger, but on a per account basis this time. The data posted from the journal to the ledger can increase or decrease the amounts of the affected account in the ledger, thus changing the account’s running balance in the process.
If your company has large amounts of transactions that could easily clutter up the general ledger, you can use a subsidiary ledger to store the details of each transaction. The total amounts of the recorded transactions in the subsidiary ledger throughout the period will then be posted to its corresponding control account in the general ledger at the end of the period. As a result, the balances of both subsidiary ledger and its control account in the general ledger should always match.
Step 4: Preparing an unadjusted trial balance
Recording transactions in the accounting journal and the general ledger takes place on a regular basis as your company operates throughout the accounting period. After all the accounting events are posted to the general ledger, the unadjusted trial balance is then prepared.
The Unadjusted Trial Balance is a list of all the accounts in the general ledger including their balances, listed in the order of assets, liabilities, equity, revenues, expenses, gains, and losses. Its preparation marks the beginning of the summarizing phase in the accounting cycle.
The purpose of the unadjusted trial balance is to prove the equality of the total debits and total credits of the accounts and to determine some errors that could have been made while recording transactions. In case an error is detected, journal entries can be prepared to correct the error.
Remember that the function of a trial balance in checking whether the total debits equal the total credits are virtually eliminated when using an accounting software. This is because the software does not allow an unbalanced entry of debit and credit amounts as the bookkeeper inputs a transaction in the software. Unbalanced means the debit and credit amounts in a journal entry are not equal.
Step 5: Journalizing and posting adjusting entries
Before you can prepare your company’s financial statements, some adjustments in the accounting books should be made first in the form of adjusting entries. The unadjusted trial balance that you have generated in the previous step is just the starting point for the preparation of adjusting entries.
Adjusting Entries are journal entries that are prepared to update and correct the amounts of some income and expense accounts for the related accounting period. These entries ensure that the financial statements are accurate and are prepared based on the accrual principle of accounting.
Adjusting entries are recorded in the general journal and then posted to the general ledger to update the balances of the related accounts. If you’re using a manual accounting system, a working paper or worksheet can be a useful tool to facilitate the preparation of adjusting entries, adjusted trial balance and financial statements.
Step 6: Preparing an adjusted trial balance
After recording and posting the adjusting entries to the ledger, the adjusted trial balance is prepared. The purpose of the Adjusted Trial Balance is to prove the equality of the total debits and total credits of the ledger accounts after including the effects of the adjusting entries. As I have mentioned above, checking the equality of debits and credits is virtually eliminated using an accounting software.
Like the unadjusted trial balance, the adjusted trial balance also lists all the account balances of every general ledger accounts. These balances are then used in the preparation of the financial statements.
Step 7: Preparing the financial statements
The adjusted trial balance is an important tool in the preparation of the financial statements. The account balances in the adjusted trial balance are brought forward to either the statement of financial position or income statement, depending on which financial statement the account will be reported.
The preparation of the financial statements is the peak or culmination of the accounting cycle. If your company uses an accounting software, you can easily generate the financial statements with just a few clicks. Furthermore, you can also design custom reports based on your financial information needs.
Step 8: Journalizing and posting closing entries
To bring the bookkeeping process for the accounting period to a close, your company needs to prepare and record closing entries in the general journal and general ledger. Closing Entries are journal entries that close the temporary or nominal accounts in your accounting records and reduce their balance back to zero. Its purpose is to prepare a fresh, new set of nominal accounts for the next accounting period.
Temporary or nominal accounts include the accounts in the income statement as well as the owner’s drawing account used by a sole proprietorship form of business. The balances of these accounts are closed and absorb by the following accounts:
- Owner’s capital account – for sole proprietorships
- Partner’s capital account – for partnerships
- Retained earnings account – for corporations
Closing the books allows your company to draw a separation line or boundary between the current accounting period and the next accounting period so that your business can start with a new set of temporary accounts that will measure a its financial performance for the upcoming period.
Step 9: Preparing a post-closing trial balance
After your company has closed its temporary accounts at the end of the reporting period, a post-closing trial balance will be prepared. A Post-closing Trial Balance is a trial balance that proves the equality of the total debits and total credits of the accounts after the closing entries are posted.
The difference between the post-closing trial balance and the adjusted trial balance on step 6 above is on the list of accounts being reported. A post-closing trial balance only reports permanent accounts or statement of financial position accounts in the ledger since these accounts are the only ones that have a remaining (non-zero) balance after the closing entries were posted. Temporary accounts are not shown anymore since their balances are reduced to zero due to the closing entries that were posted.
Let’s summarize the 3 forms of trial balance that were prepared throughout the accounting cycle.
- Unadjusted trial balance – prepared after all transactions during the accounting period have been posted to the general ledger. It reports both permanent and temporary accounts.
- Adjusted trial balance – prepared after the adjusting entries have been posted to the general ledger. It also reports both permanent and temporary accounts.
- Post-closing trial balance – prepared after the closing entries have been posted to the general ledger. It only reports the permanent accounts.
The preparation of the post-closing trial balance marks the end of the accounting cycle. A new accounting period begins and the accounting cycle starts over again.
Step 10: Journalizing and posting reversing entries
There’s an optional step in the accounting cycle that can be performed after the post-closing trial balance is prepared. This step, which involves the recording of reversing entries, is only done depending on the accounting policies and methods used by your company.
At the beginning of the new accounting period, reversing entries are prepared to simplify the analysis and recording of certain journal entries that will be prepared for that period. Reversing Entries are journal entries that reverses certain adjusting entries that were posted at the end of the previous accounting period.
Review Questions
- What is an accounting cycle?
- What is the difference between an adjusted trial balance and a post-closing trial balance?
- Why is there a need to close the balances of temporary accounts at the end of the accounting cycle?
- Before preparing the financial statements, why do companies need to record adjusting entries?
- What is the difference between the general journal and the general ledger?
