Accounting and Finance · 3 min read
Accounting Cycle
The accounting cycle represents the systematic process of recording, classifying, and summarizing financial transactions. This cycle repeats each accounting period.
Step 1: Analyze Transactions
Every business transaction must be analyzed before recording. Source documents provide evidence of transactions. Common source documents include invoices, receipts, bank statements, purchase orders, and contracts. Each transaction affects at least two accounts, maintaining the accounting equation: Assets = Liabilities + Owner's Equity.
Step 2: Journalize Transactions
The general journal serves as the book of original entry. Journal entries record transactions in chronological order. Each entry includes the date, accounts affected, debit and credit amounts, and a brief explanation. Debits are recorded first, followed by credits indented below. Total debits must equal total credits in every entry.
Debit rules: Increases in assets, expenses, and dividends are debited. Decreases in liabilities, equity, and revenues are debited.
Credit rules: Increases in liabilities, equity, and revenues are credited. Decreases in assets, expenses, and dividends are credited.
Step 3: Post to the Ledger
Posting transfers journal entries to individual ledger accounts. The general ledger contains all accounts used by the business. Each ledger account shows the running balance. Posting references connect journal entries to ledger accounts for audit trails.
Step 4: Prepare Trial Balance
The trial balance lists all ledger accounts and their balances at a specific date. Debit balances appear in one column, credit balances in another. Total debits must equal total credits. A balanced trial balance does not guarantee accuracy—errors of omission, commission, or principle may exist.
Step 5: Prepare Adjusting Entries
Adjusting entries update accounts at period end to reflect accrual accounting. These entries ensure revenues are recorded when earned and expenses when incurred, regardless of cash flow timing.
Prepaid expenses represent payments made before expenses are incurred. Adjusting entries transfer expired portions to expense accounts. Unearned revenues represent cash received before services are performed. Adjusting entries recognize revenue as it is earned.
Accrued expenses are incurred but not yet paid or recorded. Common examples include wages payable, interest payable, and utilities payable. Accrued revenues are earned but not yet received or recorded. Examples include interest receivable and fees earned but not billed.
Depreciation adjustments record the periodic allocation of asset costs. The entry debits depreciation expense and credits accumulated depreciation.
Step 6: Prepare Adjusted Trial Balance
After posting adjusting entries, a new trial balance verifies that debits still equal credits. This adjusted trial balance serves as the basis for financial statements.
Step 7: Prepare Financial Statements
The income statement reports revenues, expenses, and net income for a period. Revenue minus expenses equals net income or net loss. The income statement follows a specific order: revenues, cost of goods sold (for merchandising companies), gross profit, operating expenses, operating income, other revenues and expenses, and net income.
The statement of owner's equity reconciles the beginning and ending equity balances. Beginning equity plus net income minus withdrawals equals ending equity. For corporations, this statement shows retained earnings changes.
The statement of cash flows reports cash inflows and outflows from operating, investing, and financing activities. Operating activities relate to the company's primary business operations. Investing activities involve buying and selling long-term assets. Financing activities involve transactions with owners and creditors.
Step 8: Journalize and Post Closing Entries
Closing entries transfer temporary account balances to permanent accounts. Revenue accounts are closed to Income Summary. Expense accounts are closed to Income Summary. Income Summary is closed to Owner's Capital or Retained Earnings. Drawing accounts are closed to Owner's Capital.
After closing entries, all temporary accounts have zero balances. Only permanent accounts (assets, liabilities, equity) carry balances forward.
Step 9: Prepare Post-Closing Trial Balance
This final trial balance verifies that the ledger is in balance after closing entries. Only permanent accounts appear on this trial balance.
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