What is the Accounting Cycle?
Cycles are a great way to visualize processes that are repetitive in nature.
Think of the life cycle in its most simplistic form: from birth to child to teenager to adult to elderly to death.
Or the cycle of seasons: spring, summer, fall, and winter.
Certain qualities and activities are correlated with each stage of a cycle, and the Accounting Cycle is similar in this way. The goal of keeping well-organized books is to be able to provide stakeholders with accurate financial information about how the business is performing. The stages of the accounting cycle allow bookkeepers, accounts, and business owners to focus activities in preparation for financial review.
What are the stages of the accounting cycle?
Identify & Record Transactions
Calculate Unadjusted Trial Balance
Make Adjusting Entries
Calculate Adjusted Trial Balance
Create Financial Statements
The 5 stages come together to produce the financial data used to keep business owners abreast of their business activity over the span of months, quarters, or years, depending on how this information will be used to make business decisions.
Let’s go over each step in detail.
Stage 1: Identify & Record Transactions
When most people think of bookkeeping, they think of collecting receipts in shoeboxes or recording business expenses and income in bookkeeping software. This is the step that embodies those activities.
Stage 1 is all about gathering the documents that make up a business's transactions, whether it be receipts for office supplies, invoices for projects completed for freelance clients, or the forms for acquiring inventory.
Examples of the types of transactions that need to be recorded by a bookkeeper include:
Sales transactions
Cash, check, or credit card sales
Credit or cash purchases
Cash disbursements
Interest and depreciation
This information and evidence of the transaction (often in the form of receipts or invoices, for example) should be gathered and updated in bookkeeping software, such as QuickBooks, Wave, or Xero.
Each transaction will involve the debiting and crediting of accounts that make up the business’ Chart of Accounts. These accounts (e.g. “Accounts Receivable,” “Inventory,” “Owner’s draw,” “Supplies”) represent not only actual physical checking and credit accounts (such as “Cash”), but also abstract accounts that represent business activity.
At this stage, all transactions within a certain time period (such as a month, quarter, or year) need to be recognized in the general ledger.
Stage 2: Calculate Unadjusted Trial Balance
The trial balance is a tool that bookkeepers and accountants use to verify that each account from the Chart of Accounts is accurate. The reason why this test is categorized as “unadjusted” is because the books at this stage do not include adjusting entries (entries like depreciation, tax, etc.). The unadjusted trial balance is a preliminary step to make sure the accounts are balanced and accurate before making further changes.
Stage 3: Make Adjusting Entries
As mentioned in the last step, adjusting entries include a few specific, additional records of changes in account balances. This process further ensures that the bookkeeping records are in alignment with actual financial positions.
Some examples of adjusting entries include:
Accrued expenses
Depreciation
Deferred expenses
Prepaid expenses
Inventory adjustments
Often, accountants are responsible for calculating the appropriate adjustment amounts and bookkeepers take responsibility for adding these entries to the books.
Stage 4: Calculate Adjusted Trial Balance
Stage 4 is an identical process to stage 2, except that all entries are now accounted for, including adjusted entries. This is the final review of the business’ books and account balances. Performing this step helps to ensure that the resulting financial statements are accurate.
Stage 5: Create Financial Statements
In this final stage, the financial reports covering a specific period are generated. There are four main financial statements the help businesses and their stakeholders best understand the financial position of the company.
Income Statement - this report outlines the business’ revenues and expenses, highlighting the profit received during the period, as well as the expenses for business supplies and activities, such as salaries and rent. This statement is also known as the Profit & Loss Report
Balance Sheet - the balance sheet represents a snapshot in time (often a particular day) of the balance of all current accounts. It represents all of the ending period’s assets, liabilities, and equity.
Statement of Equity - this report shows the owner(s)’s current investment in the company at the end of the period, including the period’s net income and any deposits or withdrawals of owner equity.
Statement of Cash Flow - this statement highlights the uses of cash, as well as the income and outflow of cash, including the payment of past invoices for revenue received in other periods. It can also show expenses for future business activity. Statement of cash flow helps the business understand what cash is currently liquid and accessible.
With these statements prepared and finalized, business owners can analyze and use information from them to make decisions about strategy, finance, and performance efforts. Such a reflection often keeps a business fully aware of its financial health and capability.
Conclusion
Cycles provide a clear and intuitive way to visualize repetitive processes, and the accounting cycle is no different. Just as the life cycle progresses through predictable stages from birth to death, and the seasons rotate through spring, summer, fall, and winter, the accounting cycle follows a systematic sequence of steps. Each stage of the accounting cycle—from identifying and recording transactions to creating financial statements—ensures that financial information is accurate and up-to-date, enabling business owners and stakeholders to make informed decisions.
Ultimately, the accounting cycle is a powerful tool for maintaining financial clarity and accountability. By understanding and implementing each stage of this cycle, businesses can ensure that their financial practices are robust, transparent, and conducive to long-term success.
