The accounting cycle is a series of activities that begins with a transaction and ends with the closing of the books. It is a process. Because this process is repeated each reporting period, it is referred to as the accounting cycle and starts with these five steps below. The first three steps can be thought of as the transaction. The fourth step is the journal and the fifth step is the ledger.
| 1. | Identify the transaction or other recognizable event. |
| 2. | Prepare the transaction's source document such as a purchase order or invoice. |
| 3. | Analyze and classify the transaction. This step involves quantifying the transaction in monetary terms (e.g. dollars and cents), identifying the accounts that are affected and whether those accounts are to be debited or credited. |
| 4. | Record the transaction by making entries in the appropriate journal, such as the sales journal, purchase journal, cash receipt or disbursement journal, or the general journal. Such entries are made in chronological order. |
| 5. | Post general journal entries to the ledger accounts. |
Once the above steps are performed, managers have access to various reports in their accounting software. This is highly advantageous. The above steps are performed throughout the accounting period as transactions occur or in periodic batch processes. The following steps are performed at the end of the accounting period:
6. |
Prepare the trial balance to make sure that debits equal credits. The trial balance is a listing of all of the ledger accounts, with debits in the left column and credits in the right column. At this point no adjusting entries have been made. The actual sum of each column is not meaningful; what is important is that the sums be equal. Note that while out-of-balance columns indicate a recording error, balanced columns do not guarantee that there are no errors. For example, not recording a transaction or recording it in the wrong account would not cause an equation imbalance. |
7. |
Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. |
8. |
Prepare adjusting entries to record accrued, deferred, and estimated amounts. |
9. |
Post adjusting entries to the ledger accounts. |
10. |
Prepare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found. |
11. |
Prepare the three financial statements. The Income Statement is prepared from the revenue, expenses, gains, and losses. The Balance Sheet is prepared from the assets, liabilities, and equity accounts. The Cash Flow Statement is derived from the other financial statements using either the direct or indirect method. |
12. |
Prepare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses. These accounts are closed to a temporary income summary account, from which the balance is transferred to the retained earnings account (capital). Any dividend or withdrawal accounts also are closed to capital. |
13. |
Post closing entries to the ledger accounts. |
14. |
Prepare the after-closing trial balance to make sure that debits equal credits. At this point, only the permanent accounts appear since the temporary ones have been closed. Correct any errors. |
15. |
Prepare reversing journal entries (optional). Reversing journal entries often are used when there has been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting period. By reversing the adjusting entry, one avoids double counting the amount when the transaction occurs in the next period. A reversing journal entry is recorded on the first day of the new period. |
Instead of preparing the financial statements before the closing journal entries, it is possible to prepare them afterwards, using a temporary income summary account to collect the balances of the temporary ledger accounts (revenues, expenses, gains, losses, etc.) when they are closed. The temporary income summary account then would be closed when preparing the financial statements.