Accounting Cycle

What Is an Accounting Cycle?

An accounting cycle is the set of steps a company follows to record its financial transactions for a reporting period and turn them into finished financial statements. It begins when a transaction occurs and ends when the books are closed and ready for the next period. Because the same steps repeat each period, the process is called a cycle.

For example, a company sells goods on credit in one month. The sale is recorded as revenue and as an amount owed by the customer. When the customer pays later, cash increases and the amount owed decreases. Each of these events passes through the same recording steps.

The Main Steps

The steps are usually carried out in this order:

• Identify and analyze transactions using source documents such as invoices and receipts.
• Record each transaction as a journal entry in the general journal, with debits and credits that equal each other.
• Post the journal entries to the individual accounts in the general ledger.
• Prepare an unadjusted trial balance to check that total debits equal total credits.
• Record adjusting entries for items such as accrued expenses, unearned revenue and depreciation, so that income and expenses fall in the period they belong to.
• Prepare an adjusted trial balance.
• Prepare the financial statements, including the income statement and balance sheet.
• Close the temporary revenue and expense accounts, moving their balances into retained earnings.
• Prepare a post-closing trial balance to confirm the ledger is ready for the next period.

Some companies also make reversing entries at the start of a new period to simplify routine recording.

Why It Matters to Investors

Investors rarely see the cycle itself, but its results appear in the annual and quarterly reports they read. Following the steps in order helps ensure that revenue and expenses are recorded in the periods in which they occur, which makes reported profit and asset values more comparable from one period to the next.

The quality of the cycle also affects how much confidence readers can place in the numbers. Financial statements that are restated, or that are released late, may indicate problems with the recording process. Investors often review the auditor's report and the notes to the financial statements for information about how the books were prepared.