Companies need to make sure their books are balanced and that they reflect all financialactivity that occurred during an accounting period before the books are closed. This isaccomplished through the accounting cycle, an eight-step process that helps businesses keeptrack of their financial activities by documenting, sorting and analyzing all transactionsto ensure that each one is accounted for. When handled manually, each step of the accountingcycle can be time-consuming, tedious and prone to error. Automating the process increasesefficiency and reduces potential risks of misstatement.
What Is the Accounting Cycle?
The accounting cycle is a multistep process used by businesses to create an accurate recordof their financial position, as summarized on their financialstatements. During the cycle’s various stages, companies will record theirfinancialtransactions in a journal, transfer the details into a general ledger, analyze the entries and makesure the books are balanced and error-free before generating financial statements andclosing the books for the period.
The amount of time it takes a company to advance through the accounting cycle depends onseveral factors, including the volume of transactions, whether it uses automated accountingsoftware and the type of financial close. A hard close is a thoroughapproach to closing the books, ensuring that all information is accurate and marking the endof financial activity for an accounting period. A soft close is more like a solid estimate,typically used for internal management reporting, not for the public or investor purposes.Ideally, a business will engage in a “continuousclose,”spreading the workload across the course of the accounting period, rather than waiting untilits end. This results in a faster close, regardless of whether the target is a weekly softclose or a hard close at the end of a quarter.
Key Takeaways
- The accounting cycle is an eight-step process companies use to identify and record theirfinancial transactions.
- Before companies can close their books, transactions must be balanced and devoid oferrors.
- Once the accounting cycle is completed, financial statements can be generated.
Accounting Cycle Explained
The accounting cycle comprises eight steps businesses follow to ensure that their books arebalanced so they can be closed and reset for the next accounting period, when the cyclebegins again. Typically, the domain of an accounting team or bookkeeper, the accountingcycle begins with a business event, or transaction. Ensuing steps include data analysis andadjustments, if necessary. The sequence culminates in the preparation of standardizedreports that reflect the company’s financial performance and help guide internal andexternal decision-making.
The Purpose of the Accounting Cycle
The main purpose of the accounting cycle is to keep track of all financial activities thatoccur during a specific accounting period, be it monthly, quarterly or annually. In short,the accounting cycle verifies that every dollar going into or out of the variousgeneral-ledger accounts is reported.
Some steps in the accounting cycle are more tedious than others, but each one is set up toenable bookkeepers or accountants to diligently check their work before proceeding. This isespecially crucial for the final steps of the accounting cycle, when financial statementsare created and the books are reset.
What Are the 8 Steps of the Accounting Cycle?
The goal of the accounting cycle is to develop an accurate account of a company’sfinancialposition. Below are the eight steps of the accounting cycle.
- Identify and analyze transactions.
- Record transactions in a journal.
- Post transactions to a general ledger.
- Determine the unadjusted trial balance.
- Analyze the worksheet.
- Adjust journal entries and fix any errors.
- Create financial statements.
- Close the books.
1. Identify and analyze transactions.
The first step in the accounting cycle is to identify and analyze all transactions madeduring the accounting period, including expenses, debt payments, sales revenue and cashreceived from customers. During this initial stage, companies go through every transactionthat affects their financials, though this should be an ongoing step for companies that arecontinuously creating customer invoices, buying inventory, paying bills, making payroll andcollecting cash.
Say, for example, a small business that sells custom picture frames — let’sname itPicture Perfect — sells a customer a $350 frame. This marks the accountingcycle’sstarting point.
2. Record transactions in a journal.
The next step is to record the details of all financial transactions, in chronological order,as journal entries, whether in an actual book or in an accounting program. With double-entryaccounting, each transaction is recorded as a debit and corresponding credit in twoor more subledger accounts. Exactly when the transaction is recorded depends on whether thebusiness prefers the accrual accountingmethod (as most do) or the cash accountingmethod.
When Picture Perfect generates an invoice for the $350 transaction in its billing system,the transaction is recorded (at its simplest) as a $350 debit in the AR subledger and asa $350 credit in the revenue subledger.
3. Post transactions to general ledger.
Once journal entries are recorded and approved, they are posted to the general ledger. The GLis the master record and summary of all financial transactions, broken down by account.
On the same day Picture Perfect sold the $350 frame, it sold another two frames for $200apiece. The total of the three sales is detailed in the AR subledger and posted to theGL.
4. Determine unadjusted trial balance.
Closing balances of all the accounts in the GL at the end of an accounting period arereflected in a trial balance. At this point, the trial balance doesn’t reflect anyadjustments that need to occur if errors — i.e., unbalanced debits and credits —are caught.That’s why it’s considered “unadjusted.”
Picture Perfect adds up the amounts of debits and credits, confident that the totals willbalance.
5. Analyze the worksheet.
This step identifies errors and anomalies that may have occurred up until this point bylining up debits and credits from various accounts in a single spreadsheet. If the numbersdon’t balance, a bookkeeper or accountant will need to review the transaction dataenteredinto the journal and adjust entries accordingly.
Picture Perfect’s bookkeeper pours himself a coffee, puts on his reading glasses andgetsto work. He compares the balance of debits to credit and is surprised to find a $100discrepancy.
6. Adjust journal entries and fix errors.
This step is a continuation of the two previous steps. If an error was made, it has to becorrected and recorded as an adjusting journal entry that reflects a change to a previouslyrecorded journal entry. Additionally, manual adjustments are recorded in this step, such asaccruals for expenses incurred that didn’t make it into the AP systembefore that account was posted to the GL, or for reconciling items uncovered during theaccount reconciliation process.
It doesn’t take long before Picture Perfect’s bookkeeper discovers themistake: The $350frame sale was mistakenly entered as $250. He creates an adjusting journal entry for$100 to correct the error.
7. Create financial statements.
Once adjustments are made and account balances have been corrected, financial statements canbe created. Financial statements are accounting reports that summarize a company’sactivities and performance for a defined period of time, such as monthly or quarterly. Thethree key financial statements that companies generate are the income statement, the balancesheet and the cash flow statement.
Picture Perfect’s bookkeeper is satisfied that the company’s financialstatements areaccurate and properly reflect its financial health.
8. Close the books.
This is the final stage of the accounting cycle, locking in the accounting period. Closingthe books resets temporary accounts on the income statement, such as revenue and expenses,to zero balances, meaning that they don’t carry into the next accounting period. Netincomeor loss from the income statement is transferred to the retained earnings account, which is apermanent account on the balance sheet that carries over to the next period. Of note, theresetting of accounts to zero doesn’t apply to a soft close.
Picture Perfect’s bookkeeper clears off his desk and gets ready for the next day,when hestarts working on the new accounting period.
Customizing the Accounting Cycle
While the steps of the accounting cycle are typically the same for most companies, a businessmust be consistent in its approach should it decide to do anything differently. One surefireway to achieve that is by using automated accounting software that can be customized tohandle the cycle in any way that works best for any given company.
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Accounting Cycle vs. Budget Cycle
The accounting cycle and the budget cycle are separate processes. The accounting cycleapplies to transactions that have already occurred, from the moment they take place untilfinancial statements are generated and the books are closed. The budget cycle looks at abusiness’s future expenses to determine how to allocate its funds and not spend morethan ithas available.
Accounting Cycle Timing
The accounting cycle kicks in the moment a sale is made. Thus, it’s a continuousprocess thatculminates at the end of an accounting period — which can be a month, quarter orfiscal year— only to start again when a new period begins the following day. Automated accountingsoftware accelerates the cycle so that accounting staff have to focus only on analysis andpossible adjustments, therefore cutting costs, saving time and ensuring the accuracy offinancial statements.
Automate the Accounting Cycle With Financial Software
As a business grows, its number of daily financial transactions increases — as does thepotential for errors, if recording each transaction manually. NetSuite’s CloudAccounting Software automates and simplifies every step of the accounting cycle,from creating journal entries all the way to creating financial statements that reflect thebusiness’s profitability, net worth and solvency. The software manages accountspayables andreceivables, provides real-time dashboards and reporting capabilities, generates anddisseminates financial statements in compliance with accounting regulations, and acceleratesthe financial close process. This automation saves accounting teams and bookkeepers time,reduces business costs and ensures more accurate financial reporting.
The accounting cycle is a series of steps that begins the moment a transaction is made andculminates when a business closes its books at the end of an accounting period. Fromrecording journal entries and posting to the general ledger to calculating a trial balanceto analyzing results and correcting errors to issuing financial statements, each and everystep in the cycle is essential to ensure the highest level of accuracy. Automationeliminates the need for a significant amount of manual intervention, therefore expeditingthe process so businesses can close their books with confidence.
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Accounting Cycle FAQs
What is a “soft close?”
A “soft close” takes place when companies want to close their books quickly butnotdefinitively, such as for internal management reporting purposes. It’s generallyunderstoodthat results may be materially inaccurate, unlike a “hard close,” wherecompanies take amore rigorous approach to ensure that reporting and eventual financial statements areaccurate and that the books can be closed for an accounting period.
What is the purpose of the accounting cycle?
The accounting cycle is an effective way for companies to systematically record all financialtransactions during an accounting period. The eight-step cycle helps companies make suretheir financial information is correct before they close their books and then reset them forthe next accounting period.
What is the difference between a journal and ledger?
A journal is one of the first steps in the accounting cycle, where details of every financialtransaction are recorded. A general ledger is the “master” document thatsummarizes thetransactions and the company’s financial position.
