The Accounting Cycle. Report. Rinse. Repeat. Traditionally, an accounting cycle refers to the processes and procedures performed to record a company’s transactions. The cycle starts with a transaction, moves through the creation of financial statements, and ends with a closeout.
There are, of course, a number of other steps in between. Why is it a cycle? Because after the last step is completed, the whole process begins again. Though a lot of the steps are now invisible thanks to accounting software, it’s important to know what the steps are and what actually happens even if software is doing all the work.
The Accounting Cycle
The complete traditional accounting cycle can be summed up in eight basic steps. Accountants:
1. Record transactions in the daily journals
2. Post journal entries to the appropriate ledgers
3. Prepare a trial balance of all general ledger accounts
4. Create a working trial balance, complete with adjusting entries
5. Enter those adjusting entries into the general journal, and then post them to the general ledger
6. Prepare a set of financial statements
7. Close out the temporary accounts
8. Create a post-closing trial balance
Knowing the steps, and what order to take them in, is essential to the accounting process. Taking those steps, and getting into the meat of the numbers, is when the work really begins.
TAKING THE STEPS
You probably record transactions, which is the first step in the accounting cycle, every day. When you break it down, this step involves recognizing what counts as a transaction, identifying all the details pertinent to that transaction, and then recording those details in a journal. A journal is a sort of transaction diary.
Before the use of accounting software became widespread, those journal entries would be periodically posted to ledgers, which are books containing pages for each specific account.
This is step two. So if a journal entry included the cash account, eventually that part of the transaction would be posted to the cash account’s ledger page (sort of like a check register). With accounting software, this happens automatically, as soon as the journal entry gets recorded.
Step three, the trial balance (which we discuss in more detail later on in this section), is a way to make sure everything has been posted correctly. As the name of this step suggests, it’s basically a test to see if the accounts balance. To create this report, you list all the accounts in the ledger along with their ending debit or credit balances; then you add up all the debits and all the credits.
If the total debits equal the total credits, the accounts balance; if not, there’s a mistake somewhere. In the presoftware days, bookkeepers would pull their hair out trying to find the mistakes that knocked the trial balance out of whack. Now, software does this automatically, and it virtually never allows the accounts to be out of balance.
Step four working trial balance brings adjustments into play. Sometimes, those adjustments simply correct errors. Other times, they account for things that haven’t been recorded yet because of timing. For example, if the accounting period ends on a Tuesday, but your company pays its employees on Friday, you’d have to adjust the payroll expenses to capture two days’ worth of employee pay (for Monday and Tuesday) in the period that’s ended.
Finally, adjusting entries in this fourth step are used to account for periodic depreciation and amortization expense. These adjustments were traditionally recorded in a working trial balance until everything was correctly accounted for and in balance.
Step five simply formalizes the adjusting entries made in the working trial balance. In this fifth step those entries get recorded in the journal, and then are posted to each relevant account in the ledger.
Step six is one of the most important for business owners: creating a set of financial statements. The three primary financial statements are:
1. The balance sheet
2. The statement of profit and loss
3. The statement of cash flows
Together, these financial statements sum up all of the activity for the period, and offer a detailed picture of the company’s current state.
Steps seven and eight wrap up the accounting cycle. First, all temporary accounts get zeroed out, and their net total gets folded into an equity account called retained earnings. This is done to accurately capture the activity of the accounting period. Once all the closing entries have been recorded and posted, step eight comes into play: The post-closing trial balance is created to ensure all the accounts are still in balance.
After that end of period wrap up, there’s a clean accounting slate to go forward, into the next period. Then the accounting cycle begins all over again.
On top of that, there are some individual accounts that merit special ledgers. Accounts receivable and accounts payable both hold summary information for a lot of underlying accounts. Accounts receivable includes everything your customers owe you, and accounts payable includes everything you owe to your suppliers. Chances are, though, that your company has a lot of different customers and uses at least a few different vendors. For each, you have to track the individual account balance so you know at a glance which customers owe how much money, and how much you owe to each supplier. That gets extremely cumbersome if it is all squished into the general ledger accounts.
For that reason, both accounts receivable and accounts payable have special subledgers. Where the general ledger holds detail information for each separate account, the subledgers hold the detail data for each customer and vendor account. Rather than posting specific transaction information to the general ledger, transactions involving accounts payable and accounts receivable first get posted to the special subledgers. Then, a summary entry is made to the general ledger accounts.
Accounting software does use these special journals and ledgers, but all of the transaction recording is done instantly and simultaneously. For example, your accounting software maintains a customer ledger so you can track payments from each customer.