8 Accounting Cycle Steps: An Easy Layman’s Guide

Every organization needs to keep track of its financial status. That is the role of bookkeeping or accounting. It is one of the fundamental processes for any legal organization. However, some people might be unfamiliar with how the accounting steps work. Or the jargon of accounting might seem confusing to them. 

A simple way of looking at accounting is a set of definite steps accountants take to record and balance a company’s business transactions. So, let us explain the accounting cycle, accounting steps, and process of accounting with examples in more detail.

What is Accounting Cycle?

The Accounting Cycle refers to the eight-step process that a company’s bookkeeper must follow to complete the bookkeeping tasks of the company. It is a guide to all the steps in the accounting process that the accountant or bookkeeper has to take.

The Accounting Cycle applies to one full accounting period. As the name suggests, it is a cyclical process. The stages of accounting have to be gone through from beginning to end in every accounting period. It helps the organization stay on track with its recording, analysis, and financial reporting of business transactions.

How Does The Accounting Cycle Work?

The Accounting Cycle begins with identifying and recording financial transactions and ends with consolidated statements of all such transactions in the given accounting period.

The Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) dictate how the accounting cycle’s steps operate. While US companies follow GAAP rules and regulations, IFRS is observed in many countries internationally.

Currently, most businesses use accounting software to manage their accounting cycle steps. Financial software, especially automated ones, is highly efficient and accurate. They save organizations time and money. However, it is still essential to check the process thoroughly. Besides, some small businesses might still keep their books the traditional manual way.

Organizations often customize or modify the eight steps in the accounting process based on their business model, accounting procedures, or legal requirements. However, the overall process of accounting remains broadly similar and can be explained through the accounting cycle steps.

What Are The Accounting Cycle Steps?

The accounting cycle process is a highly standardized and systematic one. Because the same accounting cycle steps are followed by companies worldwide, it becomes easier to do business globally. The basic accounting cycle has eight steps in the accounting process from end to end. Here is a detailed look at the accounting cycle steps.

Step 1: Transactions

The first step in the accounting steps is to recognize valid transactions. All organizations perform multiple transactions throughout the year. These transactions can be for inflow of money (e.g., sales) or outflow (e.g., salaries). It is critical to identify these transactions clearly for recording in the organization’s books.

Transactions that bring in money are called Credit Transactions. Credit transactions include sales, borrowings, interest received, etc. Transactions where money flows out, are called Debit transactions. Some examples of Debit Transactions are salaries, debt repaid, expenses on furniture, etc.

You can use Accounting software to keep track of the debits and credits easily. There are many useful accounting programs available. You can choose one based on your organization’s size, nature, budget, and unique needs.

Step 2: Journal Entries

Once you have identified the transactions clearly, the next step in the accounting cycle process is to record these debits and credits accurately. Organizations record financial transactions through Journal Entries. In organizations, financial transactions apply to all things. Even buildings, furniture, or goods/services produced are accounted for in terms of money.

Most organizations follow the double-entry accounting method to record transactions. In this bookkeeping system, each transaction gets both a Credit and a Debit entry. The debits and credits are made in different accounts belonging to the company. The logic behind the two entries is that one account is receiving the money that another account is spending.

For example, when an organization makes a sale of $10,000. In this case, the organization gets money in exchange for an inventory of goods or services. So, the Inventory account of the organization is debited $10,000, and the organization’s Revenue account is credited $ 10,000. 

Or, say, a company buys computers worth $25000 in cash. In this case, the record books would record a Debit transaction of $25,000 in the Cash account and a Credit transaction of the same value in the Electronic Assets account.

Two points need to be remembered while making Journal Entries. First, the entries are made in chronological order. Second, each transaction’s Debit and Credit entries must tally or balance. Transactions can be recorded through an actual physical journal entry or accounting software.

The type of accounting method you use determines when transactions are recorded. For accrual accounting, transactions are recorded at the time of sale. Whereas for cash accounting, transactions are recorded when you receive or pay cash. It is notable here that GAAP requires public companies to use accrual accounting in almost all cases.

Step 3: Posting to General Ledger (GL)

The General Ledger (GL) is the master document where an organization posts all the transactions. Once a transaction is recorded, it is posted to the General Ledger, which contains records of all the accounts of the organization.

The difference between the second and third steps is that you would only make entries to individual accounts in the second step. Say, you make a Credit entry to the Furniture account and a Debit entry to the Bank account. When checking the journal entries, you would have access to only the Furniture account or Bank account at a time. Therefore, you would have only a partial view of the accounts.

In this step of the accounting process, you would post to both the relevant accounts in the General Ledger. So you can access both accounts together. Then you will be able to see if the transactions are balanced. Since the basic accounting cycle needs to balance all the accounts, posting to the GL is a critical step toward that goal.

A General Ledger allows the organization’s bookkeepers to monitor the company’s financial position conveniently, as they can see the account balances. For example, they can easily check how much cash is available by checking the Cash account. These days, there is often no need to keep a separate manual GL, as most organizations use accounting tools.

 

Step 4: Trial Balance

The Trial Balance or Unadjusted Trial Balance is the step at which you would calculate the unadjusted balances in each account.

It is the first of the steps at the end of the accounting period. It is called “Unadjusted” because you would not be making adjustments and corrections at this step. This step is only for checking whether the accounts balance or not. Any corrections are made in subsequent steps.

This step is crucial as many accounting mistakes can be identified when preparing the Trial Balance. For instance, you might discover that your Inventory or Revenue accounts are not balanced. In later steps, you would analyze the account books, identify why these accounts are unbalanced, and rectify those issues.

Or, your total of Debit transactions is more than the total of Credit transactions. This imbalance hints at an accounting mistake since all Debit and Credit transactions should balance. Further analysis can discover the exact issue.

The accounting period at the end of which the Trial Balance is prepared can be monthly, quarterly, or yearly, depending on the regulations and company policy. Due to the use of accounting software, this step has become easier and smoother.

Step 5: Worksheet

The next step is moving all the entries to a Worksheet to analyze and identify the accounting errors indicated in the previous step. This step becomes necessary only when the Unadjusted Trial Balance does not tally.

In this step, the organization’s bookkeeper needs to closely examine and analyze all the recorded transactions to identify where mistakes have been made. This step leads to making the required corrections and adjustments.

For example, the Trial Balance might show more Credit balance than Debit. Analyzing the data in a Worksheet, the bookkeeper might discover that a certain transaction was mistakenly posted only on the Credit side but not on the corresponding Debit side. Or you might find that a certain transaction was posted on both sides, but human error led to an extra 0 at the end of the figure during Credit entry.

The advantages of accounting software ensure such errors are significantly reduced. So, quite often, the Trial Balance matches straight away, and this step is unnecessary.

Step 6: Adjusting Entries

Once the accounting errors have been identified and analyzed, the bookkeeper makes adjustments to balance the entries. This step follows the previous two steps. It is also needed if the Trial Balance does not tally. By the end of this step, the organization’s books are properly balanced.

Adjustments refer to making changes in the journal entries to correct mistakes. For example, if an amount is written incorrectly, the bookkeeper would adjust the entries by adding a journal entry. Say, if an amount is reported as $100 instead of $500, the accountant would make an adjusting entry for $400. This step is especially important when using accrual accounting.

Using accounting software can reduce the need for adjusting entries. However, some errors might still slip through, and this step can take care of those errors. Generally, human error in data entry or other manual interventions is often responsible in such cases. Proper staff training and data entry automation can reduce such errors to an extent.

Step 7: Financial Statements

Once the accounts have been balanced, an organization prepares several financial statements. These financial statements include the Income statement, Balance Sheet, and Cash flow statement. These financial statements summarize the organization’s financial performance during the accounting period.

The Income Statement (also called the Profit & Loss/P&L or Revenue and Expense statement) contains details of the company’s revenues, expenses, profits, and losses. The Balance Sheet is a record of the company’s Assets and Liabilities + Equity, which need to be in balance. Finally, the Cash flow statement records the company’s cash inflow and outflow during the accounting period.

Companies might release other financial statements too, but these three are the most significant. If you use accounting or financial software for creating financial statements, it might be programmed to generate these statements automatically once the previous steps are complete.

Step 8: Closing

The last step of the accounting cycle is Closing the books. The closing process involves wrapping up accounting activities for the accounting period. Closing statements that help to understand the organization’s performance during this period are generated at this time.

During Closing, the Revenue and Expenses accounts are closed, but the Balance Sheet is not. This is because the former are temporary accounts only valid for the accounting period. At the beginning of every accounting cycle, they are at zero. Any Net Loss or Net Gain moves to the Balance Sheet. The Balance Sheet reflects the Assets and Liabilities of the company, which are ongoing. 

After the organization closes its books for a particular accounting cycle, it starts the process for the next accounting cycle. The next accounting period begins from Step 1 again. Manual Closing of books can be a cumbersome and difficult process prone to mistakes. Using automated accounting software makes it easier and more accurate.

Examples That Explain The Accounting Cycle

It is easy to explain the process of the accounting cycle with examples, as examples can help you to see how the accounting steps apply to your business. Let us look at the steps of the Accounting Cycle with the example of ABC Inc., a company owned by a person named X.

1. Transactions

   Some examples of transactions could be:

   • X buys machinery worth $100,000
   • X spends $10,000 on salaries.
   • X sells $30,000 worth of goods.

   There would be many other such transactions for ABC Inc. during the accounting period (e.g., one year) with both inflow and outflow of money.

2. Journal Entries

   The transactions above can be entered into various journals like this:

   • Debit – Bank Account; Credit – Plant & Machinery Account
   • Debit – Bank Account; Credit – Salaries Account
   • Debit – Inventory Account; Credit – Sales Account

   Similarly, all the transactions will be entered into journals via double-entry bookkeeping.

3. Posting

   When these journal entries are posted to the GL, the Bank Account might have transactions worth $100,000, $ 10,000, and $ 40,000. Similarly, the Sales Account might have twenty transactions; the Salaries Account might have twelve transactions, etc.

4. Trial Balance

   While preparing the trial balance, Mr. X’s accountant might find that the Debit side of the books is $15,000 more than the Credit side.

5. Worksheet

   ABC Inc.’s bookkeeper would analyze all the transactions carefully. Say, they find that the Salaries Account has total Credits worth $120,000 but total Debits worth $135,000. This discrepancy could explain why the Trial Balance did not tally. There might be other such errors in the records also.

6. Adjusting entries

   Having discovered the source of the mismatch in the accounts, Mr. X’s bookkeeper would make an adjusting entry for $15,000. Since the Debit side is higher, the accountant will make the adjusting entry on the Credit side to balance the two sides.

   The accountant will make similar entries for all errors discovered in Step 5. If the Debit side is higher, they will make an adjusting entry on the Credit side. If the Credit side is higher, they will make an adjusting entry on the Debit side.

7. Financial Statements

   The bookkeeper will prepare several financial statements for ABC Inc. These financial statements include the Balance Sheet, P&L or Income Statement, and Cash Flow Statement for ABC Inc. Samples of these financial statements are given below.

8. Closing

   Since the accounting period for ABC Inc. is one year, at the end of that annual accounting period, the accountant will close out the books for that accounting year. Assuming that ABC Inc.’s accounting year started on 1st January 2022, their books would be closed on 31st December 2022. The next accounting cycle for ABC Inc. will begin on 1st January 2023. And the next accounting period will be for the calendar year 2023.

Final Words

The Accounting Cycle is a systematic process that helps accountants or bookkeepers manage the accounts and finances of companies more easily. In this post, we have tried to explain the accounting cycle and the steps in the accounting process simply. Our Layman’s Guide will help you to check your steps in the accounting process thoroughly, even if you use accounting software.