The accounting cycle is the step-by-step process businesses use to record transactions and turn them into accurate financial statements. Below, we’ll discuss the key stages—journal entries, posting to the general ledger, preparing a trial balance, making adjusting entries to align with GAAP, and closing the books.
This concept is a core part of fundamental investing.
Recording Transactions
The cycle begins when transactions are recorded in the journal. Transactions are then posted into ledgers, which record the transactions in each account. Account balances are aggregated into a general ledger. The general ledger is comprised of all the firm’s accounts and provides a quick reference for the balances of those accounts.
Preparing the Trial Balance
At the end of the accounting period, the accountant prepares a trial balance, which lists the period-ending balances in the general ledger.
The accountant reviews the trial balance and makes sure that the total debit balance equals the total credit balance.
Adjusting Entries
The accountant then makes any adjusting entries to the trial balance. Adjusting entries are made to bring the accounts in-line with accounting requirements, such as Generally Accepted Accounting Principles (GAAP). The accountant then prepares and reviews the final trial balance.
Preparing the Financial Statements and Closing the Books
If the final trial balance is satisfactory, the company’s accountant uses the account balances to prepare the income statement and balance sheet. The accountant will then “close the books.” This involves shifting balances from temporary accounts (revenue and expenses) to the financial statements. Temporary accounts begin each period at zero and thus must be “closed” each period.
Computerized Accounting Systems
With computerized accounting software, many of these steps are aggregated. However, it still helps to know the steps in the full accounting cycle.
Example of the Accounting Cycle
A company wants to prepare financial statements for the calendar year.
The process beings throughout the year when the company records business transactions in the accounting journal. These transactions are then posted to individual accounts in the ledger.
At the end of the accounting period, the accountant prepares a trial balance using the balances from the ledger accounts. If the trial balance shows that total debits equal total credits, the accountant proceeds to make any necessary adjusting entries.
After the adjusting entries are recorded, the accountant prepares the adjusted trial balance and then prepares the financial statements.
Finally, the accountant makes closing entries to the income and expense accounts so that those accounts begin the next accounting period with a zero balance.
Key Takeaways
- The accounting cycle is a series of steps used to convert accounting transactions into financial statements.
- Transactions are first recorded in journals and then posted to ledger accounts.
- At the end of the accounting period, accountants prepare a trial balance to verify debit and credit equality.
- Adjusting entries are made to ensure accounts comply with accounting standards such as GAAP.
- After adjustments are made, the books are closed and financial statements are prepared.