What is the Accounting Cycle? Steps and Defintion

Companies must ensure that their books are balanced and that they accurately reflect all financial activity that occurred during an accounting period before closing the books. The accounting cycle, an eight-step procedure that helps firms maintain track of their financial activities by documenting, classifying, and evaluating all transactions to verify that each one is accounted for, accomplishes this. Handling each step of the accounting cycle manually can be time-consuming, difficult, and error-prone. Automating the procedure improves efficiency while lowering the chance of misrepresentation.

What Exactly Is the Accounting Cycle?

The accounting cycle is a multistep process that firms employ to establish an accurate record of their financial status, which is summarised on financial statements. Companies will record their financial transactions in a journal during the cycle's many stages, transfer the facts into a general ledger, examine the entries, and ensure the books are balanced and error-free before generating financial statements and closing the books for the period.

The amount of time it takes a corporation to complete the accounting cycle is determined by various factors, including the volume of transactions, the use of automated accounting software, and the kind of financial close. A hard close is a comprehensive method of closing the books that ensures all information is correct and marks the conclusion of financial activity for an accounting period. A soft closure is similar to a solid estimate and is often utilised for internal management reporting rather than for public or investor use. Ideally, a company will do a "continuous closure," dispersing the effort throughout the accounting period rather than waiting until the end. This leads in a faster closing, regardless of whether the goal is a weekly soft close or a quarterly hard close.

Accounting Cycle Explanation

The accounting cycle consists of eight phases that firms must take to guarantee that their books are balanced so that they can be closed and reset for the next accounting period, when the cycle will begin again. The accounting cycle, which is often the realm of an accounting team or bookkeeper, begins with a business event, or transaction. The following processes include data analysis and, if necessary, changes. The sequence concludes with the creation of standardised reports that reflect the company's financial performance and aid in the guidance of internal and external decision-making.

The Accounting Cycle's Purpose

The accounting cycle's principal goal is to maintain track of all financial operations that occur throughout a certain accounting period, whether monthly, quarterly, or annually. In a nutshell, the accounting cycle ensures that every dollar that enters or exits the different general-ledger accounts is recorded.

Some steps in the accounting cycle are more laborious than others, but each is designed to allow bookkeepers or accountants to thoroughly review their work before progressing. This is especially important at the end of the accounting cycle, when financial statements are generated and the books are reset.

What Are the Accounting Cycle's Eight Steps?

The accounting cycle's purpose is to create an accurate report of a company's financial status. The eight steps of the accounting cycle are listed below.

When a transaction happens, the accounting cycle begins and ends when a corporation closes its books at the end of an accounting month.

1. Recognize and analyse transactions.

The first phase in the accounting cycle is to identify and analyse all transactions that occurred during the accounting period, such as expenses, debt payments, sales revenue, and customer cash received. Companies go through every transaction that affects their financials during this initial stage, though this should be an ongoing phase for companies that are always creating client invoices, buying product, paying bills, making payroll, and receiving cash.

Assume a tiny business that offers custom picture frames - let's call it Picture Perfect - sells a £350 frame to a customer. This is the beginning of the accounting cycle.

2. Keep a log of your transactions.

The next stage is to record the specifics of all financial transactions as journal entries in chronological sequence, whether in a physical book or in an accounting computer. Each transaction in double-entry accounting is recorded as a debit and matching credit in two or more subledger accounts. The exact timing of the transaction is determined by whether the company selects the accrual accounting approach (as most do) or the cash accounting method.

When Picture Perfect issues an invoice in its billing system for the £350 transaction, the transaction is recorded (at its most basic) as a £350 debit in the AR subledger and a £350 credit in the revenue subledger.

3. Enter transactions into the general ledger.

Journal entries are uploaded to the general ledger after they have been recorded and approved. The general ledger (GL) is the central record and summary of all financial transactions by account.

On the same day that Picture Perfect sold the £350 frame, it also sold two £200 frames. The amount of the three sales is specified in the AR subledger and sent to the GL.

4. Calculate the unadjusted trial balance.

A trial balance reflects the closing balances of all accounts in the GL at the end of an accounting period. At this time, the trial balance does not reflect any adjustments that must be made if problems, such as imbalanced debits and credits, are discovered. That is why it is referred to be "unadjusted."

5. Review the worksheet.

By lining up debits and credits from numerous accounts in a single spreadsheet, this stage identifies any errors or abnormalities that may have happened up to this point. If the numbers do not balance, a bookkeeper or accountant must verify the transaction data put into the journal and make necessary adjustments.

6. Correct errors in journal entries.

This is a continuation of the previous two steps. If an error occurs, it must be fixed and recorded as an adjusting diary entry that reflects a change to an earlier recorded journal entry. This step also includes human adjustments, such as accruals for expenses incurred that did not make it into the AP system before the account was posted to the GL, or reconciling items discovered during the account reconciliation process.

It doesn't take long for Picture Perfect's bookkeeper to notice the error: the £350 frame transaction was incorrectly recorded as £250. To fix the error, he makes an adjusting journal entry for £100.

7. Make financial statements.

Financial statements can be generated after adjustments have been made and account balances have been adjusted. Financial statements are accounting reports that summarise a company's operations and results over a specific time period, such as monthly or quarterly. The income statement, balance sheet, and cash flow statement are the three most important financial statements produced by businesses.

8. Put the books away.

This is the final stage of the accounting cycle, where the accounting period is locked in. When the books are closed, temporary accounts on the income statement, such as revenue and expenses, are reset to zero balances, which means they do not roll over to the following accounting period. The income statement's net income or loss is transferred to the retained earnings account, which is a balance-sheet permanent account that continues over to the next period. It should be noted that the resetting of accounts to zero does not apply to a gentle close.