Financial Accounting Cycle
The accounting cycle is a series of steps setting out the procedures required for a typical small business to collect, record, and process its financial information.
The accounting cycle will vary from business to business and the procedures involved may change, for example, the accounting cycle for a service business might differ from the accounting cycle of a manufacturing business, the but the general steps to explain the accounting cycle remain the same.
The accounting cycle has ten basic steps, which can be seen in the illustration shown below. A PDF version of this diagram is available at the bottom of the page.
Flow Chart of Accounting Cycle
To explain the accounting cycle we have set out the ten steps involved in the flow chart diagram below.
|Step 1||→||Step 2|
|Identify and analyze transactions||Journal entries for transactions|
|Step 10||Step 3|
|Post closing trial balance||Post journals to ledgers|
|Step 9||Step 4|
|Closing entries||Prepare an unadjusted trial balance|
|Step 8||Step 5|
|Prepare financial statements||Prepare worksheet|
|Step 7||←||Step 6|
|Adjusted trial balance||Record adjusting journal entries|
Steps in Accounting Cycle
Step 1: Identify and Analyze Transactions
The accounting cycle starts by identifying the transactions which relate to the business. The business is a separate entity to the owner, so only business transactions should be included.
Having identified the transactions, each one now needs to be analyzed to determine which accounts in the bookkeeping records are affected. Each transaction must be supported by a relevant accounting source document such as sales and purchases invoices, debit and credit notes, petty cash vouchers, payroll reports etc.
Step 2: Journal Entries for Transactions
The journal entries are recorded in a journal sometimes referred to as a daybook.
The journals are also known as the books of original entry as they are the first time the transactions are recorded and entered into the accounting system.
Step 3: Post journals to ledgers
The journals are used to post to the subsidiary and general ledgers (sometimes referred to as the book of final entry). The general ledger has an account for each type of transaction e.g. rent expense, accounts receivable control, fixed assets etc. The general ledger is sometimes divided into the nominal ledger for income and expenses, and the private ledger for assets and liabilities.
All postings to the ledgers are double entry postings and therefore must balance which every debit having an equal and opposite credit entry.
Step 4: Prepare an unadjusted trial balance
At the end of each accounting period, the balances on the accounts of the general ledger are listed to produce a trial balance. At this stage the total debits on the trial balance should equal the total credits.
This unadjusted trial balance is used solely to check the total of the debit and credit entries, to ensure the accounting records balance and that the arithmetic is correct. If the trial balance does not balance correcting entries should be made in the ledgers until it does.
Step 5: Prepare worksheet
A 10 column worksheet is prepared and the unadjusted trial balance is transferred to the first two columns.
Step 6: Record adjusting journal entries
Adjusting entries such as accruals, prepayments, and depreciation entries are prepared to ensure that income and expenditure is allocated to the correct accounting period, this means that the accounting records are completed on an accruals basis and are in compliance with the matching principle.The adjusting entries are entered in the next two columns of the worksheet and at this stage, are not entered into the accounting records.
Step 7: Adjusted trial balance
When all adjusting entries have been completed an adjusted trial balance is prepared in the next two columns of the worksheet.
Step 8: Prepare financial statements
The financial statements can now be prepared from the adjusted trial balance. Items relating to the income statement are transferred to the next two columns and items relating to the balance sheet are transferred to the final two columns.
Step 9: Closing entries
Closing entries are carried out in the accounting ledgers. Closing entries are posted and temporary income and expenditure accounts are closed and their balances transferred to an income and expenditure summary account.
The summary account is in turn closed to transfer the profit or loss for the period to the balance sheet retained profits account. Balance sheet or permanent accounts are not closed, but the balance is carried forward to the next accounting period.
Step 10: Post closing trial balance
A post closing trial balance is drawn up to ensure that the debits and credits balance for the start of the new accounting period.
The post closing trial balance is a list of balances after the closing entries have been made. At this stage the temporary income and expenditure accounts have been closed and set to zero, so only the balance sheet accounts are listed on the post closing trial balance. The accounting cycle starts again with the new opening balance sheet account balances.
The accounting cycle diagram is available for download in PDF format by following the link below.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.