The 8 Steps in the Accounting Cycle

Bookkeeping can be daunting. There are various tasks to juggle, and getting it wrong could have serious implications.

Fortunately, established processes exist to help businesses and entrepreneurs accurately record and report financial activities. One of them is the accounting cycle. This eight-step repeatable guide is a basic checklist of what to do during each accounting period. All phases are covered, from identifying and recording transactions to checking for discrepancies, making adjustments, and creating financial statements. We take you through these important steps below.

What Is the Accounting Cycle?

The accounting cycle is an eight-step guide to ensure the accuracy and conformity of financial statements. It walks companies and their accountants through each of the bookkeeping tasks that must be completed every accounting period to track transactions, starting with their identification and ending with creating financial statements and closing the books.

This guide breaks down the accounting process into easy-to-follow steps that are repeatable every time a new accounting period begins. They are standardized for use across all types of business. The accounting cycle is compatible with technology and can be implemented by companies using accrual or cash accounting and double or single-entry accounting. In the case of the latter, some steps can be ignored.

The length of each cycle depends on how often a company chooses to analyze its performance or is required to lay out its accounts. Some companies have monthly internal accounting periods. Others report quarterly or annually.

Once an accounting period ends, a new one begins, and the process starts over again.

Step 1: Identifying Transactions

The accounting cycle begins by identifying transactions. All transactions must be accounted for, whether they involve a sale, refund, inventory order, debt payoff, asset purchase, or other activity.

The necessary information includes transaction dates and monetary figures paid or received. Sales data is logged automatically for companies using point of sale (POS) technology.

Step 2: Recording Journal Entries

After a transaction is identified, a record of it needs to be created. This is done through a journal entry. The journal functions as a running record of a business’s financial transactions. It states the date of each transaction, how much money was involved, and the accounts affected.

The timing for recording transactions depends on whether the company uses accrual or cash accounting. With cash accounting, transactions are recorded when cash changes hands. With accrual accounting, journal entries are made when a good or service is provided rather than when it is paid for.

When recording transactions, remember to keep them in chronological order and, if using double-entry accounting, which most businesses do, make two entries each time. For every transaction, there must be a credit and a debit. A credit in one account offsets a debit in another, so all credits must equal the sum of all debits.

Step 3: Posting to the General Ledger

Once a transaction is recorded as a journal entry, it should be posted to an account in the general ledger, which is an old-fashioned term for a record-keeping system for a company’s financial data.

In the general ledger, all accounting activities are summarized and sorted into one of the following subcategories: assets, liabilities, owners’ equity, revenues, and expenses. This makes it easier to track finances and identify, for example, how much cash a company has or how much it’s spending or owes.

Step 4: Preparing a Trial Balance

After all transactions are logged in the general ledger, the next step is to make sure the entries balance out, meaning total debits equal total credits. This is done by building a trial balance.

A trial balance is a bookkeeping worksheet that compiles the balances of ledgers into debit and credit account columns. With the data laid out this way, it’s easy to see if the numbers match up. If they don’t and there are more debits than credits or vice versa, there’s an error.

The trial balance is usually created at the end of the accounting period, whether monthly, quarterly, or annually.

Step 5: Analyzing the Worksheet

In this phase, worksheets are investigated for any discrepancies.

If the debts and credits on the trial balance don’t match, the person keeping the books must get to the bottom of the error and adjust accordingly. That’s not the only analysis required. Even if the trial balance is balanced, there still may be errors, such as missing transactions or those classified incorrectly.

Step 6: Making Adjustments

If any discrepancies are spotted, adjustment entries must be made to remedy them. Companies using accrual accounting need to account for accruals, deferrals, and estimates, such as an allowance for doubtful accounts.

Accruals occur when payment is made after a good or service is delivered, while deferrals occur when the payment is executed before the good or service is delivered.

With cash accounting, the transaction is recorded when the payment is made. With accrual accounting, the log date is the date the service is provided, received, or earned.

Of course, not all goods or services are provided in a day. Often, an assignment or service can stretch over weeks or months. When a transaction starts in one accounting period and ends in another, an adjusting journal entry is required to ensure it is accounted for correctly.

Step 7: Generating Financial Statements

Once all the necessary entries and adjustments for the accounting period have been made, it’s time to generate financial statements. These formal records of a company’s financial activities must follow a specific template. In most cases, a company’s financials are communicated in the following three statements:

•  Balance sheet: This is where a company’s assets, liabilities, and shareholder equity are reported. The balance sheet says what a company owns and owes, as well as the amount invested by shareholders at a specific time.
• Income statement: This is where a company reports its revenue, income, and expenses over a set period. From this, it’s possible to determine whether it made a profit or a loss.
• Cash flow statement: This details how cash entered and left the business during the reporting period.

Step 8: Closing the Books

After the financial statements are completed, it’s time to close the books. This can be a good time to reflect and compare the firm’s performance with other periods and peers. Further analysis could reveal areas for improvement and highlight where the company has done well.

The closing of the books also marks the start of the next accounting period. The cycle is complete, and it’s time to begin the process again, starting with step one.

The Bottom Line

A business’s financial activities need to be accurately recorded and reported not only for internal use but also to meet legal and regulatory requirements. The accounting cycle, an eight-step guide on the various bookkeeping phases, helps make that daunting task more manageable.

The accounting cycle is adaptable to different accounting methods, such as accrual or cash accounting, and can be partially automated through software. It starts by identifying transactions and creating a proper record of them in the ledger, then shifts to checking for errors and making necessary adjustments before generating financial statements and closing the books.