The accounting cycle is the process businesses use to track, record, and organize their financial transactions over a specific period—usually a month, quarter, or year. Think of it like a checklist that helps accountants ensure every financial activity is properly recorded, so at the end of the period, the business can see exactly how it’s performing.
In this post, we’ll break down the accounting cycle step-by-step in simple terms, with easy examples to make it all clear!
What is the Accounting Cycle?
The accounting cycle is a series of 8 steps that businesses follow to keep their financial records in order. These steps help ensure that all financial transactions are recorded accurately and that the financial statements (like the income statement and balance sheet) are complete and correct.
The cycle repeats each time the business prepares financial statements, which could be monthly, quarterly, or annually.
The 8 Steps of the Accounting Cycle
1. Identify Transactions
The first step is to identify any financial transactions that occurred during the accounting period. This includes anything that involves the business’s money, such as paying bills, receiving payments from customers, buying supplies, or taking out a loan.
Example:
If you run a coffee shop and buy $500 worth of coffee beans, that’s a transaction. Selling a $5 cup of coffee to a customer is another.
2. Record Transactions in the Journal (Journal Entries)
Once you identify a transaction, it needs to be recorded in the journal. This is often called journalizing. Here, you write down the details of the transaction, including the date, the accounts affected, and whether it’s a debit or credit.
Example:
When you sell a $5 cup of coffee, you would make a journal entry like this:
- Debit: Cash (because cash increases by $5)
- Credit: Revenue (because sales revenue increases by $5)
| Date | Account | Debit | Credit |
|---|---|---|---|
| Oct 1, 2024 | Cash | $5 | |
| Oct 1, 2024 | Revenue | $5 |
3. Post Transactions to the Ledger
After recording the transaction in the journal, the next step is to post it to the ledger. The ledger is a collection of all the accounts (such as Cash, Revenue, Expenses, etc.) and shows the running balance of each account.
Example:
The $5 from the coffee sale is posted to the Cash and Revenue accounts in the ledger, updating their balances.
4. Prepare the Trial Balance
Once all transactions are posted, you create a trial balance. This is a report that lists all the accounts and their balances, making sure that total debits equal total credits. If the debits and credits don’t balance, there’s an error somewhere, and you’ll need to find and fix it.
Example:
At the end of the month, if your total debits are $5,000 and your total credits are $4,995, something is wrong, and you’ll need to check for any missed or incorrect entries.
5. Make Adjusting Entries
Sometimes, not all financial activities are captured by the initial journal entries. For example, expenses like electricity might have been used but not yet billed. In this step, you record adjusting entries to account for these things.
Example:
If your coffee shop uses $100 worth of electricity in October but the bill hasn’t arrived yet, you would create an adjusting entry to reflect that expense.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Oct 31, 2024 | Utilities Expense | $100 | |
| Oct 31, 2024 | Accounts Payable | $100 |
This adjusting entry ensures that your records are up-to-date, even though you haven’t paid the bill yet.
6. Prepare Financial Statements
Now that all transactions and adjustments are recorded, you’re ready to create your financial statements. These include:
- Income Statement (shows your revenue and expenses to calculate profit or loss)
- Balance Sheet (shows your assets, liabilities, and equity)
- Cash Flow Statement (shows the movement of cash in and out of the business)
Example:
If your coffee shop earned $10,000 in revenue and had $8,000 in expenses, your income statement would show a profit of $2,000.
7. Make Closing Entries
At the end of the accounting period, you need to close temporary accounts like revenues and expenses to prepare for the next period. This means that you reset their balances to zero and transfer the net income (or loss) to the retained earnings account.
Example:
If your revenue account shows $10,000 and your expenses account shows $8,000, you’ll close them by transferring the $2,000 profit to the Retained Earnings account.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Dec 31, 2024 | Revenue | $10,000 | |
| Dec 31, 2024 | Retained Earnings | $2,000 | |
| Dec 31, 2024 | Expenses | $8,000 |
8. Prepare the Post-Closing Trial Balance
The last step is to create a post-closing trial balance. This is a final check to ensure that everything is balanced before starting the new accounting period. At this point, only permanent accounts (like assets, liabilities, and equity) should have balances, while temporary accounts (revenues, expenses) should be reset to zero.
Why is the Accounting Cycle Important?
The accounting cycle ensures that your financial records are:
- Accurate: It reduces the chances of errors by following a structured process.
- Organized: Every transaction is properly recorded and categorized, making it easy to prepare financial statements.
- Reliable: You can trust the financial data you’ve collected to make informed business decisions.
Real-Life Example: Running a Small Bakery
Let’s say you own a small bakery, and here’s how the accounting cycle might look for a typical month:
- Identify Transactions: You buy ingredients, pay employees, sell pastries, and receive payments from customers.
- Record Transactions in the Journal: Each sale and expense is recorded in the journal with a debit and credit.
- Post to the Ledger: The transactions are then posted to the bakery’s ledger, updating account balances for cash, inventory, revenue, etc.
- Prepare the Trial Balance: At the end of the month, you check to ensure your debits and credits are balanced.
- Adjust Entries: Maybe your bakery used electricity that hasn’t been billed yet, so you add an adjusting entry.
- Prepare Financial Statements: You generate your income statement, balance sheet, and cash flow statement to see how your bakery performed that month.
- Close the Accounts: You reset your revenue and expense accounts to zero and transfer your net profit to retained earnings.
- Prepare the Post-Closing Trial Balance: You double-check everything to ensure your books are balanced and ready for the next month.
Conclusion: Keeping Your Finances in Check
The accounting cycle is like a well-organized system that helps businesses manage their finances step-by-step. Whether you run a small coffee shop or a large corporation, following the accounting cycle ensures that every financial activity is properly recorded and nothing is overlooked. By completing this cycle, you’ll have accurate financial statements that provide valuable insights into your business’s performance, helping you make smarter decisions for the future.
Once you understand the process, the accounting cycle becomes a powerful tool for keeping your finances in check!
Photo by Nataliya Vaitkevich: https://www.pexels.com/photo/person-writing-on-white-paper-8927687/