Complete Guide to the Accounting Cycle: Steps, Timing, and Utility

What Is the Accounting Cycle?

The accounting cycle systematically tracks and records financial transactions from occurrence to inclusion in financial statements and closing of books. This eight-step process ensures accuracy, leveraging automation to minimize manual errors.

The key steps include recording journal entries, posting to the general ledger, calculating trial balances, making adjusting entries, and creating financial statements.

Understanding the Functioning of the Accounting Cycle 

The accounting cycle is a methodical set of rules that can help ensure the accuracy and conformity of financial statements. Computerized accounting systems and the uniform process of the accounting cycle have helped to reduce mathematical errors.

Today, most software automates the accounting cycle, reducing human effort and manual errors.

Detailed Walkthrough of the Accounting Cycle

There are eight steps to the accounting cycle.

1. Identify Transactions: An organization begins its accounting cycle with the identification of those transactions that comprise a bookkeeping event. This could be a sale, refund, payment to a vendor, and so on.
2. Record Transactions in a Journal: Next comes the recording of transactions using journal entries. The entries are based on the receipt of an invoice, recognition of a sale, or completion of other economic events.
3. Posting: Once a transaction is recorded as a journal entry, it should post to an account in the general ledger. The general ledger provides a breakdown of all accounting activities by account.
4. Unadjusted Trial Balance: After the company posts journal entries to individual general ledger accounts, an unadjusted trial balance is prepared. The trial balance ensures that total debits equal total credits in the financial records.
5. Worksheet: The fifth step is to create and analyze a worksheet of debits and credits to identify necessary adjusting entries, if there are discrepancies.
6. Adjusting Journal Entries: At the end of the period, adjusting entries are made. These result from corrections made on the worksheet and the passage of time. For example, an adjusting entry may involve interest revenue that has been earned over time.
7. Financial Statements: Upon the posting of adjusting entries, a company prepares an adjusted trial balance followed by the actual, formal financial statements.
8. Closing the Books: An entity finalizes temporary accounts, revenues, and expenses, at the end of the period using closing entries. These closing entries include transferring net income to retained earnings. Finally, a company prepares the post-closing trial balance to ensure debits and credits match and the cycle can begin anew.

When to Execute the Accounting Cycle

The accounting cycle is started and completed within an accounting period, the time in which financial statements are prepared. Accounting periods vary and depend on different factors. However, the most common type of accounting period is the annual period.

Many transactions are recorded during the accounting cycle. At the fiscal year's end, financial statements are prepared, often required by regulation.

For example, public entities are required to submit financial statements by certain dates. All public companies that do business in the U.S. are required to file registration statements, periodic reports, and other forms to the U.S. Securities and Exchange Commission. Therefore, their accounting cycles are tied to reporting requirement dates.

Distinguishing Between Accounting Cycle and Budget Cycle

The accounting cycle is different from the budget cycle. The accounting cycle focuses on historical events and ensures that incurred financial transactions are reported correctly.

Alternatively, the budget cycle relates to future operating performance and planning for future transactions. The accounting cycle provides information for external users, while the budget cycle is for internal management.

The Bottom Line

The accounting cycle is a fundamental process for accurately recording and reporting a company's financial activities. This eight-step cycle—from identifying transactions to closing the books—ensures financial statements reflect true financial health and compliance with regulations. With modern accounting software, many tasks are automated, reducing errors and increasing efficiency. Understanding and implementing this cycle empowers business owners to maintain precise financial records and make informed decisions.