By Anastasia Hinojosa
Updated July 1, 2021 | Published February 4, 2020
Updated July 1, 2021
Published February 4, 2020
Anastasia Hinojosa is an experienced financial accountant with degrees from Texas A&M-Corpus Christi and Columbia University. She has worked in the healthcare field for over ten years.
By learning the necessary processes and terminology of accounting, you gain fundamental knowledge of a company’s finances. In this article, we discuss the eight steps of the accounting cycle process with examples and explain how it differs from a budget cycle.
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The accounting cycle is a series of steps used by an accounting department to document and report a company's financial transactions. The cycle follows financial transactions from when they occur to how they affect financial documents. The accounting cycle happens every accounting period or reporting period for which financial documents are prepared.
The final step—the closing process—can occur as a “soft close” throughout the fiscal year, but a “hard close” only happens at the end of the fiscal year.
A “soft close” closes the general ledger for that accounting period so that new journal entries can’t be booked. This occurs so that financial documents can be prepared for that period without the account balances changing.
The hard close process moves transactions from temporary accounts—accounts on the income statement—to permanent accounts, which are accounts on the balance sheet. This process is important as it guarantees precision and accuracy throughout a company's fiscal years.
Related: Accounting: Definitions and Specializations
The accounting cycle consists of eight steps that accountants should follow to record transactions and check for data accuracy. Steps one through seven occur every accounting period—regardless of length—while step eight only occurs at the end of the fiscal year:
The first step in the accounting cycle is to analyze events to determine if they are “transactions” and what their impact is. Transactions include any company purchases that were made, debts paid, debts acquired or revenue acquired from sales. Events that are not considered transactions include creating purchase orders and signing contracts. Transactions are the starting point from which the rest of the accounting cycle will follow.
Example: A company receives $300 in sales on their software products. This is the starting point of the accounting cycle for this transaction.
Read more: 7 Effective Methods for Analyzing Data
The next step in the accounting cycle is to record these financial transactions as journal entries. This should be done by following a chronological order. You need to understand the impact of the transaction—from step one—to create the journal entry.
A journal entry has a debit and a credit which relates to how a transaction affects different accounts. Whether an account is debited or credited is determined by how the balance of that account is tracked.
For example, cash and receivable accounts have debit balances—increased with debits, decreased with credits—and revenue accounts have credit balances—increased with credits, decreased with debits. The person entering the transaction data into the journal entries must make sure that the debits and credits are balanced.
Example: The $300 transaction is entered based on the date it occurred to align with the chronological order of the other transaction entries. A $300 cash sale will involve a Debit of $300 to Cash and a Credit of $300 to Sales Revenue.
Related: What Is Debit vs. Credit in Accounting?
A ledger account is a collection of all journal entries that debit or credit that account. The general ledger is the master set of all ledger accounts. The general ledger keeps track of a company's entire financial activity. When you post to the general ledger, you record a summary of the activity for each ledger account.
Example: If today’s transactions included a cash sale of $300, a cash sale of $200 and a cash refund of $100, then the summarized Cash transactions would be a debit of $400. Companies differ in how they track refunds, but let’s assume the summarized Sales Revenue transactions would be a credit of $500 with a summary of a debit of $100 recorded in Sales Returns and Allowances—a “contra account,” which means it offsets a regular revenue account and has a debit balance.
Read more: Accounting Ledger vs. Journal: What’s the Difference?
At the end of each accounting period, a company's accounting department should enter the data from the ledger accounts into a trial balance. This trial balance is also called “the unadjusted trial balance” because it is prepared before adjusted entries—step six—being entered.
The unadjusted trial balance is prepared so that accountants can catch any errors that may have occurred during the initial stages of the accounting cycle. A trial balance is considered successful if the debit account balances equal the credit account balances. Even if the unadjusted trial balance is balanced, you must conduct step five as other errors may have occurred.
Example: To keep this simple, let’s prepare a trial balance for one day while ignoring Cost of Goods Sold. To prepare the trial balance, you need to compile data from all ledger accounts. Let’s say the company also had $700 in credit sales—a debit of $700 to Accounts Receivable and a credit of $700 to Sales Revenue—and bought $200 of inventory on credit from a vendor—a credit of $200 to Accounts Payable and a debit of $200 to Inventory.
Taking into account the information from before, you have debit balances of $400 (Cash), $700 (Accounts Receivable), $200 (Inventory) and $100 (Sales Refunds and Allowances). You have credit balances of $1,200 (Sales Revenue) and $200 (Accounts Payable). This gives you total debits of $1,400 and total credits of $1,400. Real trial balances will involve numerous accounts.
Related: What Is a Trial Balance? How To Prepare a Trial Balance (With Examples)
This step is required when the debits and credits of a trial balance are not equal. The transaction data entered into past journal entries must be reviewed to find the error. Another error may include posting to the wrong accounts. For this error, debits and credits will equal, but an accountant will notice unusual account activity or balances. To fix these errors, you will need to enter journal entries to reverse the incorrect entries and enter the correct ones.
Example: If the accountant conducts a trial balance and finds that there are $900 in debits and $1,200 in credits, they must go through previous journal entries to identify the missing $300 amount. Most accounting software will not allow unbalanced journal entries to post; however, to manually find these types of errors, you can either look at entries individually or compare corresponding accounts—like Accounts Receivable and Sales Revenue—to try to find obvious mistakes.
Related: 7 Accounting Tasks and Duties
This step requires the usage of the matching principle to organize company transactions into the appropriate accounting periods. Adjustments are grouped into Deferrals and Accruals. Using the matching principle, accountants can examine deferrals and accruals to determine if they will be factored into a company's total revenue or unearned revenue for the fiscal period. A common deferral is a prepaid expense—for example, rent—and a common accrual is a payable expense such as salary and wages.
Example: In January, the company pays $12,000 in rent for the whole year ($1,000 a month). The original journal entry was a $12,000 debit to Rent Expense and a $12,000 credit to Cash. At the end of the accounting period (in this case, a month), the adjusting entry would be an $11,000 debit to Prepaid Rent and an $11,000 credit to Rent Expense. This reflects that only $1,000 of rent was actually used in January. For the remaining eleven accounting periods, the adjusting entry will be a $1,000 debit to Rent Expense and a $1,000 credit to Prepaid Rent.
The accountant could also have done two journal entries in January: (1) a $12,000 debit to Prepaid Rent and a $12,000 credit to Rent Expense, and (2) a $1,000 debit to Rent Expense and a $1,000 credit to Prepaid Rent. Entry #1 fixes the incorrect entry while Entry #2 records the correct transaction. Technically, as long as the net effect is that, as of January 31, $11,000 is in Prepaid Rent and only $1,000 is in Rent Expense, then either method is fine.
Read more: Accrual vs. Deferral: Definitions and Differences
Once all adjusting entries are completed and you ensure the debits and credits still balance, then you can prepare the Adjusted Trial Balance as well as the financial statements. Financial statements are prepared in this order: Income Statement, Statement of Retained Earnings, Balance Sheet and Statement of Cash Flows.
Once the Adjusted Trial Balance is finalized, the balance for each account is reported on the Income Statement, the Statement of Retained Earnings or the Balance Sheet. No individual account from the Adjusted Trial Balance will be on more than one of these. The Adjusted Trial Balance does list the beginning balance for Retained Earnings, but this specific number only appears at the beginning of the Statement of Retained Earnings and not directly on the Balance Sheet.
The order that you prepare the financial documents is important because the net income from the Income Statement will be used to prepare the Statement of Retained Earnings, and the ending balance on the Statement of Retained Earnings will be used to prepare the Balance Sheet. The Statement of Cash Flows is prepared last because it uses information from the first three statements.
Example: Let’s say your income statement shows Total Revenues of $1000 and Total Expenses of $500. Your Net Income is Total Revenues - Total Expenses = $500. This $500 is moved to Retained Earnings at the end of the fiscal year during the closing process.
Let’s say your beginning Retained Earnings balance is $200. The Adjusted Trial Balance would list this $200 balance for Retained Earnings. For the Statement of Retained Earnings, you start with the $200. You add $500 from net income. Assuming the company did not pay dividends, the ending balance for Retained Earnings is $700.
The ending balance for Retained Earnings is then used to prepare the Balance Sheet. It will appear under the Equity section.
The Statement of Cash Flows takes information from the other statements to characterize cash flows as “inflows” or “outflows.” These flows are then categorized as Operating, Investing, or Financing.
The last stage of the accounting cycle is the closing of temporary accounts. Accounts that appear on the Income Statement are temporary accounts that are closed out—also referred to as “zeroed out”—at the end of the fiscal year. The balances from these accounts are moved to permanent accounts on the Balance Sheet. The main purpose of zeroing out the income statement accounts is to allow for revenues and expenses to be tracked anew each fiscal year.
During the fiscal year, you can also do a “soft close.” If you prepare financial statements monthly, then February’s books will be closed during the beginning of March, which will prevent new journal entries from being entered with a February post date. If you prepare financial statements quarterly, then you may keep the books open for three months at a time. Soft closes do not permanently close the books, so entries can still be entered after close with management’s approval. Temporary accounts are not zeroed out for soft closes.
Example: At the end of the fiscal year, the accountant will debit the total of all revenue accounts with a corresponding credit to Retained Earnings. The accountant will also credit the total of all expense accounts with a corresponding debit to Retained Earnings. The net effect to Retained Earnings should equal the net income—an overall increase to Retained Earnings—or net loss—an overall decrease to Retained Earnings—for the fiscal year. You can check the accuracy of your journal entries by comparing the numbers to the financial statements that you prepared in step seven.
Read more: Understanding the Steps of the Accounting Cycle
The accounting cycle and budget cycle differ in their timing and focus. The accounting cycle records and reports past company transactions, whereas the budget cycle analyzes the direction and aspirations of a company to project future transactions.
Another way to differentiate between these terms is to consider the accounting cycle as part of a process that allows a company to share its financial documents with external stakeholders, whereas the budget cycle is part of a process used internally among company officials to determine the costs associated with future company activities.
Related: Learn About Being a CPA (Certified Public Accountant)
One accounting cycle happens every accounting period. The accounting period is defined as the time period for which financial documents are prepared. This could be monthly, quarterly or yearly depending on the company's needs. A fiscal year is the company's tax reporting year, which can be a calendar year or any 12-month period. If the accounting period is a year, then it can also be called a “fiscal year.”
For example, the government uses a fiscal year of October 1 to September 30. For the government, Fiscal Year 21 (usually denoted as FY21) runs from October 1, 2020 to September 30, 2021. If the government uses monthly accounting periods, then Period 1 of FY21 would be October 2020. Period 4 of FY21 would be January 2021. If the accounting period is quarterly, Q1 of FY21 would cover October 1, 2020 to December 31, 2020. Q4 of FY21 would cover July 1, 2021 to September 30, 2021.
Companies may use more than one accounting period, but it is important to remember that the accounting period is reporting transactions for that time period only. For example, the SEC requires publicly traded companies to file financial statements quarterly, so these companies will have quarterly accounting periods to meet this requirement. Companies must also file yearly tax forms with the IRS, so these companies will have yearly accounting periods to meet this requirement.
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