“The accounting cycle is the sequence of procedures used to keep track of what has happened in the business and to report the financial effect of those things” (Service Automation, Inc., n.d., para. 1). In addition, the accounting cycle is designed to trace every transaction that causes the trade of one asset for another between a business and other entities (i.e., employees or investors) (Herron, 2000). In the end, the accounting cycle is very important because if it is used properly, this cycle will make it much easier to put together its financial statements in a more timely and precise fashion (Wild, Larson & Chiapetta, 2007, p. 148).
Multiple Ways to Approach the Accounting Cycle
Let us take a look at the specific steps of the accounting cycle. Please remember throughout our examination that the accounting cycle is an extremely complicated process. Although there is a basic flow to the accounting cycle, the actual actions necessary to complete the cycle can vary from one business to another since there is not just one single way to approach the accounting cycle (Herron, 2000; QuickMBA, 2007, Wild et al, 2007, p. 148). To simplify things, I will use one single interpretation to explain the accounting cycle (Wild et al, 2007, p. 148).
Step 1 of the Accounting Cycle
First, this cycle opens with the analysis of all transactions (Wild et al, 2007, p. 148-149). Before transactions are written in the journal (journalized), they are first examined to see if they actually are required to be placed in the journal. If a transaction does not involve the exchange of assets, it does not need to be journalized (Herron, 2000). However, if a transaction must be journalized, the business needs to generate (or have someone outside the company create) a source document to serve as concrete evidence that the transaction did occur and that it is the type of transaction the company claims (Service Automation, Inc., n.d.; Wild et al, 2007, p. 49). Checks and purchase orders are both fine examples of source documents (Herron, 2000).
Step 2 of the Accounting Cycle
After the first step of the accounting cycle is finished, the transactions can be journalized in either the general journal or a special journal (QuickMBA, 2007). Since current accounting is a dual-entry system, every transaction that is journalized, must be recorded as a debit and an equal, corresponding credit (Herron, 2000). All of a business’s open accounts are tracked in a journal, so not a single financial transaction is missed. Furthermore, all transactions are journalized in the order they occur (Wild et al, 2007, p. 49, 148).
Next, we will discuss the third step of the accounting cycle. During this step, all of the debits and credits that have been journalized in the company’s various journals must then be transferred to the ledger. In the ledger, these debits and credits are divided by the accounts they affect and recorded in a T-account for each company account. This record is often created in electronic format for easier reference when the business has to produce its regular set of financial statements (Herron, 2000; Wild et al, 2007, p. 49, 148-149).
Step 4 of the Accounting Cycle
Now, we can move on to step four of the accounting cycle. Once all the credits and debits have been transferred to the ledger, the business will need to create a trial balance to check that all the debits and credits are still in balance (Service Automation, Inc., n.d.; Wild et al, 2007, p. 148). If the number of credits and debits in the ledger do not equal each other during the trial balance, then somewhere along the line, a transaction was not recorded correctly (Herron, 2000). If this is the case, the business will need to go back and retrace the steps of the accounting process (sometimes all the way back to how the transactions were journalized) until the error or errors have been discovered and subsequently corrected, for the accounting cycle cannot continue until everything is balanced (Wild et al, 2007, p. 63-64).
Step 5 of the Accounting Cycle
After the trial balance has been successfully completed, it may be necessary to add on any additional credits and debits that may have occurred while the trial balance was being created, analyzed, and possibly fixed. All accrued and/or deferred transactions must be properly journalized and posted. Only then will the account balances correctly record the business’s actual current finances (Service Automation, Inc., n.d.; QuickMBA, 2007; Wild et al, 2007, p. 94-95).
Step 6 of the Accounting Cycle
Of course, once the journals and ledger are adjusted to include these additional transactions, the trial balance will also need to be adjusted (Herron, 2000). Just as in step 4, all credits and debits must be transferred from the adjusted ledger to the trial balance (Wild et al, 2007, p. 148). And just like before, the new trial balance will need to be analyzed to make sure the credits and debits balance. If not, the company will have to go retrace its steps again and check how the additional transactions were journalized and transferred to the ledger to discover the error (or errors) that have thrown the trial balance off. This is exceptionally important because this is the last safeguard before the business uses its financial records to produce its required set of financial statements (Herron, 2000).
Next, we have the seventh step of this cycle: creating the company’s financial statements. All the information that is necessary to complete this step can be found in the final trial balance, since it simply summarizes the data found in the adjusted ledger (Wild et al, 2007, p. 103, 148). Fundamentally, the accounts and balances listed on the final trial balance are essential to creating each of the four financial statements: the balance sheet, the income statement, the statement of cash flow, and the statement of owner’s equity (Service Automation, Inc., n.d.). However, the data provided by the final trial balance must be sorted and used correctly in the right financial statement or statements. Otherwise, these financial statements will be worthless (Wild et al, 2007, p. 137).
Step 8 of the Accounting Cycle
As many of you may already know, once a business completes its financial statements, this indicates the completion of that particular accounting period. It is a common mistake to assume that the accounting cycle ends at this point. Nevertheless, we still have three more steps to cover before the cycle is finally completed. First, let us examine step eight. Ultimately, this step of the cycle helps prepare the business’s financial records for the next accounting period by closing any temporary accounts the business might have opened during the previous period (QuickMBA, 2007; Wild et al, 2007, p. 148). To understand this step of the accounting cycle, you must be aware of how accounts work within a business. The majority of accounts will go into the next accounting period with a running balance, since these figures will continue to be relevant in the new period. However, there are a handful of accounts that are only opened during a single accounting period to track certain business transaction during that particular period, not over the life of the business (Herron, 2000). Consequently, each of these types of accounts must be closed after each accounting period and opened anew to be useful. Expense accounts, revenue accounts, and withdrawal accounts are all types of these temporary accounts (Wild et al, 2007, p. 145).
Once these temporary accounts have been closed, the procedures used to complete step 8 must be checked for errors, as well. As a result, a business will then create a post-closing trial balance in step 9 to ensure that the total debits equal the total credits and that every one of the temporary accounts truly has a balance of zero (Wild et al, 2007, p. 148).
Step 10 of the Accounting Cycle
The tenth and final step of this cycle calls for the company to “reverse certain adjustments in the next period” (Wild et al, 2007, p. 148). This step is actually not a required part of the accounting cycle. However, businesses may opt to complete this extra step because it makes accounting for the next period much simpler. Adjusting entries from previous periods cause abnormal balances for the next period. Therefore, whenever a business must record its first transaction for the new period, it must both fix the abnormal balances, as well as document the transaction, all in one entry. In the end, reverse entries automatically compensate for these adjusting entries, allowing the balances to begin straightforward when the first transaction occurs (Wild et al, 2007, p. 148, 157).
References:
Herron, T. L. (2000). Overview of the accounting cycle. Retrieved June 1, 2008, from University of Montana-Missoula, School of Business Administration Web site: http://www.business.umt.edu/faculty/herron/courses/ACCT655_01/overview.htm
QuickMBA. (2007). The accounting cycle. Retrieved June 1, 2008, from http://www.quickmba.com/accounting/fin/cycle/
Service Automation, Inc. (n.d.). The accounting cycle. Retrieved June 2, 2008, from http://www.servicedispatch.com/docs/theaccountingcycle.htm
Wild, J. J., Larson, K. D., & Chiapetta, B. (2007). Fundamental accounting principles (18th edition). Boston: McGraw-Hill/Irwin.
