What is Accounting Cycle?
The accounting cycle is the process of accepting, recording, sorting, and crediting payments made and received within a business during a particular accounting period. Companies generally balance their books each quarter and then again at year-end, though others may prefer to settle the books every day or every week – that’s a lot of work, but it can be done if you choose to.
Based on the transactions recorded as part of the accounting cycle, financial statements such as cash flow reports, profit and loss statements, and balance sheets can be prepared. Once all the business accounts have been balanced, they are closed out for that period and new ones created for the next accounting period.
Steps in the Cycle
Depending on whom you talk to, the accounting cycle can have anywhere from seven to nine steps, based on how detailed each step is.
- Financial transactions occur, such as selling inventory, buying raw materials, or making lease payments, for example.
- Those transactions are noted in the appropriate financial journal, depending on what the money was spent on or originated from. Debits are used to indicate money spent and credits are used for money that is received.
- The transactions are then posted to the account in the general ledger, which is the list of all the business’ financial accounts, that it impacts, such as rent or wages or marketing.
- At the end of the accounting period, you run a trial balance to see if all the numbers balance. Frequently, they won’t, so adjustments are necessary.
- The next step is trying to find the cause of the imbalance and correcting it.
- Once the accounts are balance, financial statements are prepared.
- At the end of the period, the books are closed out and new revenue and expense accounts created with zero balances. These are used for the next accounting period.
The Trouble with Balancing
The accounting cycle’s purpose is to ensure that all the money coming into or going out of a business is accounted for. That’s why balancing is so critical.
However, errors are frequently made when recording entries, leading to an incorrect trial balance that needs to be adjusted so that debits and credits match. The most common reasons for an account imbalance include:
- Forgetting a transaction
- Posting a transaction to the wrong account
- Posting a transaction as a debit instead of a credit, or vice versa
- Duplicate postings
- Posting the wrong amount
Once discovered, the error is easily corrected.