Companies need to make sure their books are balanced and that they reflect all financial activity that occurred during an accounting period before the books are closed. This is accomplished through the accounting cycle, an eight-step process that helps businesses keep track of their financial activities by documenting, sorting and analyzing all transactions to ensure that each one is accounted for. When handled manually, each step of the accounting cycle can be time-consuming, tedious and prone to error. Automating the process increases efficiency 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 record of their financial position, as summarized on their financial statements. During the cycle’s various stages, companies will record their financial transactions in a journal, transfer the details into a general ledger, analyze the entries and make sure the books are balanced and error-free before generating financial statements and closing the books for the period.
The amount of time it takes a company to advance through the accounting cycle depends on several factors, including the volume of transactions, whether it uses automated accounting software and the type of financial close. A hard close is a thorough approach to closing the books, ensuring that all information is accurate and marking the end of 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 “continuous close,” spreading the workload across the course of the accounting period, rather than waiting until its end. This results in a faster close, regardless of whether the target is a weekly soft close 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 their financial transactions.
- Before companies can close their books, transactions must be balanced and devoid of errors.
- 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 are balanced so they can be closed and reset for the next accounting period, when the cycle begins again. Typically, the domain of an accounting team or bookkeeper, the accounting cycle begins with a business event, or transaction. Ensuing steps include data analysis and adjustments, if necessary. The sequence culminates in the preparation of standardized reports that reflect the company’s financial performance and help guide internal and external decision-making.
The Purpose of the Accounting Cycle
The main purpose of the accounting cycle is to keep track of all financial activities that occur 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 various general-ledger accounts is reported.
Some steps in the accounting cycle are more tedious than others, but each one is set up to enable bookkeepers or accountants to diligently check their work before proceeding. This is especially crucial for the final steps of the accounting cycle, when financial statements are 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’s financial position. 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 made during the accounting period, including expenses, debt payments, sales revenue and cash received from customers. During this initial stage, companies go through every transaction that affects their financials, though this should be an ongoing step for companies that are continuously creating customer invoices, buying inventory, paying bills, making payroll and collecting cash.
Say, for example, a small business that sells custom picture frames — let’s name it Picture Perfect — sells a customer a $350 frame. This marks the accounting cycle’s starting 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-entry accounting, each transaction is recorded as a debit and corresponding credit in two or more subledger accounts. Exactly when the transaction is recorded depends on whether the business prefers the accrual accounting method (as most do) or the cash accounting method.
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 as a $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 GL is 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 $200 apiece. The total of the three sales is detailed in the AR subledger and posted to the GL.
4. Determine unadjusted trial balance.
Closing balances of all the accounts in the GL at the end of an accounting period are reflected in a trial balance. At this point, the trial balance doesn’t reflect any adjustments 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 will balance.
5. Analyze the worksheet.
This step identifies errors and anomalies that may have occurred up until this point by lining up debits and credits from various accounts in a single spreadsheet. If the numbers don’t balance, a bookkeeper or accountant will need to review the transaction data entered into the journal and adjust entries accordingly.
Picture Perfect’s bookkeeper pours himself a coffee, puts on his reading glasses and gets to work. He compares the balance of debits to credit and is surprised to find a $100 discrepancy.
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 be corrected and recorded as an adjusting journal entry that reflects a change to a previously recorded journal entry. Additionally, manual adjustments are recorded in this step, such as accruals for expenses incurred that didn’t make it into the AP system before that account was posted to the GL, or for reconciling items uncovered during the account reconciliation process.
It doesn’t take long before Picture Perfect’s bookkeeper discovers the mistake: The $350 frame 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 can be created. Financial statements are accounting reports that summarize a company’s activities and performance for a defined period of time, such as monthly or quarterly. The three key financial statements that companies generate are the income statement, the balance sheet and the cash flow statement.
Picture Perfect’s bookkeeper is satisfied that the company’s financial statements are accurate and properly reflect its financial health.
8. Close the books.
This is the final stage of the accounting cycle, locking in the accounting period. Closing the 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. Net income or loss from the income statement is transferred to the retained earnings account, which is a permanent account on the balance sheet that carries over to the next period. Of note, the resetting 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 he starts 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 business must be consistent in its approach should it decide to do anything differently. One surefire way to achieve that is by using automated accounting software that can be customized to handle the cycle in any way that works best for any given company.
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Get Your Free GuideAccounting Cycle vs. Budget Cycle
The accounting cycle and the budget cycle are separate processes. The accounting cycle applies to transactions that have already occurred, from the moment they take place until financial statements are generated and the books are closed. The budget cycle looks at a business’s future expenses to determine how to allocate its funds and not spend more than it has available.
Accounting Cycle Timing
The accounting cycle kicks in the moment a sale is made. Thus, it’s a continuous process that culminates at the end of an accounting period — which can be a month, quarter or fiscal year — only to start again when a new period begins the following day. Automated accounting software accelerates the cycle so that accounting staff have to focus only on analysis and possible adjustments, therefore cutting costs, saving time and ensuring the accuracy of financial statements.
Automate the Accounting Cycle With Financial Software
As a business grows, its number of daily financial transactions increases — as does the potential for errors, if recording each transaction manually. NetSuite’s Cloud Accounting Software automates and simplifies every step of the accounting cycle, from creating journal entries all the way to creating financial statements that reflect the business’s profitability, net worth and solvency. The software manages accounts payables and receivables, provides real-time dashboards and reporting capabilities, generates and disseminates financial statements in compliance with accounting regulations, and accelerates the 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 and culminates when a business closes its books at the end of an accounting period. From recording journal entries and posting to the general ledger to calculating a trial balance to analyzing results and correcting errors to issuing financial statements, each and every step in the cycle is essential to ensure the highest level of accuracy. Automation eliminates the need for a significant amount of manual intervention, therefore expediting the 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 but not definitively, such as for internal management reporting purposes. It’s generally understood that results may be materially inaccurate, unlike a “hard close,” where companies take a more rigorous approach to ensure that reporting and eventual financial statements are accurate 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 financial transactions during an accounting period. The eight-step cycle helps companies make sure their financial information is correct before they close their books and then reset them for the 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 financial transaction are recorded. A general ledger is the “master” document that summarizes the transactions and the company’s financial position.