The accounting cycle is a process of calculating, recording, and classifying financial transactions during an accounting period, which can be quarterly, annually, or for any other time period. Often a public company will align its accounting cycles with when its financial statements are due.
Let’s learn more about the common steps in an accounting cycle and how they are completed to provide regular snapshots of a company’s financial situation.
Definition and Examples of the Accounting Cycle
The accounting cycle is a process used to document and report on all financial transactions during an accounting period, which is commonly quarterly or annually. Usually, an accounting cycle is managed by a bookkeeper, who may use accounting software to make the process simpler.
An accounting cycle consists of several steps in which a business documents and reports on financial transactions. The number and type of steps can vary from business to business, but they all follow each transaction from its occurrence through each part of the accounting process to the production of financial documents.
Financial transactions can include paying for or receiving cash for goods, paying employees, or putting money into your business either directly or through loans. The accounting cycle process results in the preparation of accurate financial statements at the end of each period and at the end of the fiscal year. The accounting cycle process essentially is how businesses systematically record their business events in an organized, chronological way to present to others through financial statements.
For example, Johnson & Johnson (JNJ) releases quarterly financial statements that can be reviewed by analysts, investors, potential investors, and others. These reports include financial statements that contain the company’s revenue and profit, among many other key financial metrics for that particular quarter. The step-by-step process the company used to produce the statements to generate the report is its accounting cycle.
How the Accounting Cycle Works
The exact steps in an accounting cycle can vary according to a company’s reporting needs, with some businesses following, for example, seven steps while others may follow nine steps. Here are some common key steps:
- Identify and analyze: Examine receipts, invoices, and other documents to analyze transactions and their impact on accounts.
- Record: Log your transactions in a journal, applying a debit or credit using either a single or double-entry journaling system. If you are using a cash-accounting system, you will record your transactions as soon as money is received or paid.
- Post journal entries: Record the journal entries in the appropriate general ledger accounts. The general ledger includes entries related to all your business accounts, so this step will help you monitor your cash flow accurately.
- Prepare an unadjusted trial balance of your accounts: In an ideal world, your accounts will be balanced at this point. Check that the accounts are indeed balanced and do not have errors that would need adjustments.
- Make any necessary corrections: Make adjustments and record them as journal entries. You may, for example, have to account for deferrals (prepaid expenses) or accruals (expenses billed but not yet paid).
- Prepare an adjusted trial balance: Ensure that the company books are balanced after posting adjusted entries.
- Generate financial statement: Once adjusting entries are completed, a company can then generate financial statements including an income statement, balance sheet, cash flow statement, and statement of owner’s equity.
- Close books: The accounting cycle ends with the closing of the books on the last day of the accounting cycle. That process includes closing expenses and revenue to the income summary account; closing the income summary account to the owner’s capital account; and losing withdrawals to the owner’s capital account
The resulting financial reports will allow you to see how your cash is moving and how much money is available to you at any given time, among other financial metrics. Once an accounting cycle closes, a new one begins.
Why the Accounting Cycle Is Important
The accounting cycle is a critical part of running a business because it provides a way to comprehensively understand how a business is performing. When bookkeepers break down complex financial information into clear categories and step-by-step calculations, they can ensure more accuracy.
Even a small business may have multiple employees to pay, equipment to buy, customer receipts to process, and overhead costs to pay. A business may be financed by a combination of bank loans, family investments, or a business owner’s personal money.
Each aspect of your business must be properly accounted for so you can:
- Carefully track financial trends
- Analyze financial trends such as revenue growth and profitability
- Create necessary financial reports for the IRS, regulators, investors, and others
- Make financial decisions about the business, including managing expenses and optimizing profits
- The accounting cycle is a process that yields a comprehensive report on a company’s financial performance.
- Businesses complete the accounting cycle once each accounting period, which can be quarterly, annually, or other durations, depending on regulatory requirements.
- The accounting cycle helps businesses, analysts, and investors analyze key financial metrics with financial statements such as income statements and balance sheets.
- The length of an accounting cycle will vary from company to company.