The Accounting Cycle Explained: 5 Simple Steps

The accounting cycle is a must-know for all bookkeepers. It divides the entire process of a bookkeeper’s work into multiple steps. Though accounting software can help, small business accountants working on the books with less technical support should still know and use these processes manually. 

While other versions of the accounting cycle cover more detail, in this article, we’ll bring you an overview of the standard process that includes the five main steps needed to ensure the integrity of a company’s accounting process.

What is the accounting cycle?

The accounting cycle is a straightforward process for carrying out a company’s financial activities. It provides step-by-step directions for recording, examining, and analyzing a company’s financial activities.

The accounting cycle duration will vary depending on the reporting requirements. In general, most business owners strive to close their books on a monthly basis. On the other hand, some may prefer completing the accounting cycle on a quarterly or annually basis. 

What is the purpose of the accounting cycle?

The accounting cycle’s primary goal is to ensure that all the money coming into or going out of a business is accounted for and all financial records are accurate. While preparing financial reports, the accountant will examine accounting entries and processes to be aware of the business’s financial position day-by-day. 

Each step in the accounting cycle works as a check and balance along the way, preventing errors and inaccuracies from occurring in the previous step. Thus, the accounting cycle is an indispensable base or stepping stone for creating financial statements.

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What are the five steps of the accounting cycle?

Step 1 – Collect and analyze transactions

The first step of the accounting cycle is to collect documents of your business transactions, like receipts, invoices, bank statements, etc., for the current accounting period. These documents contain raw financial data that will then be entered into your accounting system before being converted into something meaningful.

You need to keep details of every transaction, including the date, amount, and location. Then, you’ll break down (or analyze) the purpose of each transaction. For example, if you received a receipt from Target, you’ll need to clarify if it was office supplies. If you received a gasoline bill, was it for the company vehicle? It’s essential to collect as detailed information as you can. 

Step 2 – Posting transactions to the general ledger

In the next step, you’ll use the general ledger to record all financial information gathered in step one. The ledger is a comprehensive, detailed list showing all your company’s transactions and how they affect each of its individual accounts. 

The ledger includes various journal entries, which chronologically document all of a company’s financial transactions. Journal entries must follow the rules of double-entry accounting. Whenever a transaction occurs, it must be recorded in the journal entries in two sections: a debit (to state what it’s going towards) and a credit (to state where your money is coming from).

After converting all of your business transactions into debits and credits, it’s time to move them into your company’s ledger. Keep in mind that uploading journal entries to the ledger as soon as possible helps ensure that the business’s records are always up to date. 

Step 3 – Preparing an unadjusted trial balance

You’ll prepare an unadjusted trial balance after posting transactions to the general ledger. The unadjusted trial balance gathers all of these totals together and calculates the total credits and debits in each of your business’s accounts. From that, you can determine individual account balances.

Here’s what an unadjusted trial balance looks like: 

The Accounting Cycle
Example of an unadjusted trial balance (Source: Wikiaccounting)

According to the double-entry accounting rules, all of a business’s credits must be equivalent to the total debits. If the sum of the debit balances isn’t equivalent to the sum of the credit balances, it means that either the step of recording or posting journal entries is incorrect. 

If you do bookkeeping with accounting software, this usually indicates that you entered information incorrectly. The process of searching for and fixing these errors is called correcting entries.

Step 4 – Preparing adjusting entries at the end of a period

You’ll prepare adjusting entries after you’ve finished correcting entries. Adjusting entries ensure that your financial statements only include data that is relevant to the time period you’re working on. There are four main types of adjustments, including deferrals, accruals, tax adjustments, and missing transaction adjustments.

Deferrals are revenues and expenses that have been received or paid in advance but have not yet been earned or used. For example, unearned revenue is money received for goods that have yet to be delivered.

Accruals are unpaid income and expenses that have not yet been recorded through a standard accounting transaction. For example, rent paid at the end of the month is an incurred expense, even though a business can occupy the premises at the beginning of the month if the rent is not yet paid.

  • Tax adjustments help you address expenses that lower your tax liabilities like depreciation and other tax deductions. For example, if you have spent a lot of money on new equipment, you may be able to deduct a portion of the cost this year. Once a year, your CPA will most likely guide you through the process.
  • Missing transaction adjustments allow you to account for financial transactions that you may have overlooked when bookkeeping, such as business purchases made on your personal credit card.

Step 5 – Preparing an adjusted trial balance

After posting all of your adjusting entries, it’s time to create an adjusted trial balance. This adjusted trial balance takes all of your adjusting entries into account.

The main purpose of the adjusted trial balance is to prove that all of your ledger’s credits and debits balance after all adjustments. Once you finish this step, you have all the information you need to start preparing your company’s financial statements!

The bottom line

Understanding the accounting cycle helps bookkeepers and small business owners simplify their accounting processes, and makes financial performance analysis more consistent, accurate, and efficient.

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