The accounting cycle is the fundamental, step-by-step process that businesses use to record, analyze, and report their financial transactions. It is a systematic, structured approach that ensures all bookkeeping tasks are completed in a logical order, leading to the creation of accurate and reliable financial statements. This cycle provides a clear guide for a company to manage its financial activities, starting from the moment a transaction occurs and ending with the reporting of those activities. By following this process, a business can maintain a precise record of its financial position and performance.
This cycle is repeated for each accounting period, which could be a month, a quarter, or a year. The entire process encompasses all the core components of bookkeeping, including the initial recording of journal entries, the use of T-accounts and ledgers, the application of debits and credits, and the necessary adjustments. Each step is carefully tracked to ensure the final financial statements are accurate, compliant, and useful for decision-making.
The Purpose of the Accounting Cycle
The primary purpose of the accounting cycle is to create accurate and timely financial statements. These statements, such as the income statement and balance sheet, are the main output. They provide vital information to both internal and external stakeholders. Internal users, like management, use these reports to make informed decisions about budgeting, investments, and operational efficiency. External users, such as investors, creditors, and regulatory bodies, rely on these statements to assess the company’s financial health, profitability, and creditworthiness.
Another key purpose is to ensure compliance with accounting standards, such as the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). The standardized process of the accounting cycle helps a company maintain consistency and transparency in its financial reporting. It also facilitates the implementation of internal controls, which act as safeguards against errors, fraud, and mismanagement. This systematic oversight contributes to the overall integrity of the company’s financial data.
The Accounting Period Concept
The accounting cycle operates within a defined timeframe known as an accounting period. This is the specific period for which the financial statements are prepared. The most common accounting period is one year, which culminates in the preparation of annual financial statements. However, to make more timely decisions, most businesses also complete the accounting cycle on a more frequent basis, such as monthly or quarterly. This allows management to monitor the company’s performance and financial position throughout the year.
The concept of a defined period is essential for the matching principle, which we will discuss later. It allows a business to measure its revenues and its corresponding expenses for that specific timeframe, leading to an accurate calculation of net income or loss. At the end of each accounting period, the cycle is completed, the books are closed, and the process begins anew for the next period. This cyclical nature is what gives the process its name.
The Bedrock: Double-Entry Bookkeeping
The entire accounting cycle is built upon the principle of double-entry bookkeeping. This system, which has been in use for centuries, requires that every single financial transaction be recorded in at least two different accounts. This method ensures that the accounting equation always remains in balance. The fundamental accounting equation is: Assets = Liabilities + Equity. The double-entry system ensures that this equation holds true for every transaction.
For every transaction, there is a “debit” entry in one account and a corresponding “credit” entry in another account. The total amount of the debits for a transaction must always equal the total amount of the credits. This dual-entry system provides a self-checking mechanism. If the debits do not equal the credits at any point, it signals that an error has been made. This is a core concept that is essential for maintaining the accuracy of the financial records throughout the accounting cycle.
Understanding Debits and Credits
To understand double-entry bookkeeping, one must understand the rules of debits and credits. A debit is an entry made on the left side of an account, and a credit is an entry made on the right side. Whether a debit or a credit increases or decreases an account’s balance depends on the type of account it is. For asset and expense accounts, a debit increases the balance, and a credit decreases it.
Conversely, for liability, equity, and revenue accounts, a debit decreases the balance, and a credit increases it. This may seem complex at first, but it is the mechanism that keeps the accounting equation in balance. For example, when a company buys equipment (an asset) with cash (another asset), it debits the equipment account (increasing it) and credits the cash account (decreasing it). The equation remains balanced.
Accrual Basis vs. Cash Basis Accounting
There are two primary methods for recording transactions within the accounting cycle: accrual basis accounting and cash basis accounting. The choice between these two methods significantly impacts when transactions are recorded. Under cash basis accounting, transactions are recorded only when cash is actually received or paid. It is a simple method, similar to managing a personal checkbook, but it can provide a misleading picture of a company’s financial health.
Accrual basis accounting, on the other hand, records transactions when they occur, regardless of when the cash is exchanged. Revenue is recorded when it is earned, not when the customer pays. Expenses are recorded when they are incurred, not when the bill is paid. This method is required by GAAP for most companies because it provides a much more accurate representation of a company’s profitability and financial position for a given period. The accounting cycle, particularly the adjustment process, is designed to support accrual accounting.
Why Accrual Accounting Is Crucial
The accrual method is critical because it upholds the matching principle. This principle dictates that expenses should be “matched” to the revenues they helped generate within the same accounting period. For example, if a company makes a sale in December but does not pay its sales staff their commission for that sale until January, the commission expense must be recorded in December. This matches the expense (commission) with the revenue (the sale).
If the company used the cash basis, the revenue would be recorded in December (if the customer paid) but the expense would be recorded in January (when paid). This would make December’s profit look artificially high and January’s profit artificially low. The accrual basis and the adjusting entries in the accounting cycle correct for these timing differences, ensuring that the financial statements are an accurate reflection of the company’s performance for the period.
An Overview of the Eight Steps
The accounting cycle can be broken down into eight key steps that are followed in order for each accounting period. The first step is to identify all financial transactions. The second step is to record these transactions in a journal. The third step is to post the journal entries to the general ledger. The fourth step is to calculate an unadjusted trial balance.
The fifth step is to analyze the trial balance on a worksheet and determine the necessary adjusting entries. The sixth step is to record these adjusting journal entries. The seventh step is to prepare the financial statements using the adjusted account balances. The final and eighth step is to close the books, resetting temporary accounts and preparing the system for the next accounting cycle to begin. This series will explore each of these steps in detail.
Step 1: Identify Financial Transactions
The first step of the accounting cycle is the identification of all financial transactions. A financial transaction is any event that has a monetary impact on the financial position of the business and can be reliably measured. This is the starting point for all accounting; if a transaction is not identified, it cannot be recorded, and the financial statements will be incomplete. Businesses engage in numerous activities, but only those that affect the accounting equation (Assets = Liabilities + Equity) are recorded.
Companies experience a wide variety of transactions, such as making a cash sale, purchasing inventory on credit, paying an electricity bill, or receiving a loan from a bank. Each of these events changes the company’s assets, liabilities, or equity. For example, paying an employee’s salary is a transaction because it decreases the company’s cash (an asset) and decreases its equity (via an expense). This identification step requires a clear understanding of the company’s operations and what constitutes a recordable event.
The Role of Source Documents
Transactions are not identified out of thin air. They are evidenced by source documents, which are original paper or electronic records that support and detail a transaction. These documents are the proof that a transaction occurred and provide the necessary information for recording it, such as the date, the amount, and the parties involved. Source documents are a critical component of the accounting cycle and are essential for internal controls and external audits.
Common examples of source documents include sales invoices, purchase orders, supplier bills, cash register tapes, bank statements, and employee timecards. For example, when a company purchases office supplies on credit, the supplier provides a bill, or invoice. This invoice is the source document that provides all the information needed to record the transaction: the date, the amount, the supplier’s name, and the items purchased. The accounting department gathers and analyzes these documents to begin the recording process.
The Chart of Accounts
Before any transaction can be recorded, the company must have a structured list of all its accounts. This list is called the chart of accounts. It is a customized blueprint or index of every account in the general ledger, organized by account type. The chart of accounts typically assigns a unique number to each account, making it easier to locate and manage them within an accounting system.
The accounts are organized in the same order they appear in the financial statements: assets, liabilities, equity, revenues, and expenses. For example, asset accounts might be numbered in the 1000s (e.g., 1010 for Cash, 1100 for Accounts Receivable), liabilities in the 2000s (e.g., 2010 for Accounts Payable), and so on. This structure ensures consistency in recording transactions. When a transaction is identified, the accountant refers to the chart of accounts to select the specific accounts that are affected.
Step 2: Record Transactions in a Journal
After a transaction has been identified from a source document and the affected accounts are determined, the second step in the accounting cycle is to record it in a journal. A journal is the first place a transaction is officially documented in the accounting system. It is often called the “book of original entry” because it is where the entry originates before it is moved to any other record.
Transactions are recorded in the journal in chronological order, by date. This creates a complete and sequential history of all the company’s financial activities. This chronological record is extremely useful for reviewing the transactions that occurred on a specific day or for tracing an error back to its source. Each entry in the journal is known as a journal entry, and it contains all the information about the transaction.
Anatomy of a Journal Entry
A standard journal entry consists of several key components. First is the date of the transaction. Second is the account or accounts that will be debited, along with the corresponding debit amount. Third, listed below the debited accounts, are the account or accounts that will be credited, along with the corresponding credit amount. The credited accounts are typically indented to the right to visually distinguish them from the debited accounts.
Finally, a short description or narration of the transaction is often included below the entry to explain its purpose. For every journal entry, the fundamental rule of double-entry bookkeeping must be followed: the total debit amount must equal the total credit amount. This ensures that the accounting equation remains in balance with every single entry. Modern accounting software simplifies this process, but it is still following these fundamental principles.
Example: Journalizing a Cash Sale
Let us walk through a simple example. A company sells a product to a customer for $500 in cash on October 26. The accountant identifies this from the cash register tape. The two accounts affected are Cash and Sales Revenue. Following the rules of debits and credits, the Cash account (an asset) is increasing, so it must be debited. The Sales Revenue account (a revenue, which increases equity) is also increasing, so it must be credited.
The journal entry on October 26 would be: Debit: Cash $500 Credit: Sales Revenue $500 (To record cash sale of product) Here, the total debits ($500) equal the total credits ($500), and the accounting equation remains in balance (Assets increase, and Equity increases).
Example: Journalizing a Credit Purchase
Here is another common example. The company purchases $1,000 of office supplies from a vendor on credit. The source document is the invoice from the vendor. The two accounts affected are Office Supplies (an asset) and Accounts Payable (a liability). The Office Supplies account is increasing, so it must be debited. The Accounts Payable account, which represents money owed to a supplier, is also increasing, so it must be credited.
The journal entry would be: Debit: Office Supplies $1,000 Credit: Accounts Payable $1,000 (To record purchase of supplies on account) Again, the debits equal the credits. The accounting equation balances, as Assets increase (Office Supplies) and Liabilities increase (Accounts Payable) by the same amount.
The General Journal vs. Special Journals
While many businesses use a single general journal for all transactions, it can become cumbersome for companies with a high volume of similar transactions. To improve efficiency, many businesses use special journals in addition to the general journal. A special journal is designed to record a specific, repetitive type of transaction.
Common examples include a sales journal (for all sales on credit), a cash receipts journal (for all cash received), a purchases journal (for all purchases on credit), and a cash disbursements journal (for all cash paid). Transactions that do not fit into any of the special journals are recorded in the general journal. Using special journals streamlines the recording process and allows for a better division of labor within the accounting department.
Step 3: Posting to the General Ledger
Once transactions have been recorded in chronological order in the journal, the third step of the accounting cycle begins. This step is called “posting.” Posting is the process of transferring the debit and credit information from the journal entries to their respective accounts in the general ledger. While the journal provides a day-by-day history of all transactions, it does not show the balance of any single account.
The general ledger is the tool that consolidates all transactions for each individual account. For example, if a company has ten cash transactions during the month, the journal will show ten separate entries scattered among all other transactions. The general ledger, however, will have a single “Cash” account that collects all ten of these entries in one place. This allows the company to easily see the activity and, more importantly, the current balance of its cash.
What Is the General Ledger?
The general ledger is the central, master file of all accounts for a business. It can be thought of as a large, organized binder where every account (as listed in the chart of accounts) has its own separate page. Each page lists all the transactions that have ever affected that specific account. For example, the “Accounts Payable” page in the ledger will show every purchase made on credit and every payment made to suppliers.
This organization by account is what makes the general ledger the core of the company’s financial records. It provides a complete record of financial activity and the resulting balance for every asset, liability, equity, revenue, and expense account. In modern businesses, this is not a physical book but a database within an electronic accounting system. The system automatically posts journal entries to the general ledger, which saves time and reduces errors.
Understanding T-Accounts
The simplest way to visualize an account in the general ledger is by using a T-account. A T-account is an informal term for a tool used to represent an account. It is shaped like the letter “T,” with the account name written on top. The left side of the “T” is for all debit entries, and the right side is for all credit entries. This visual layout clearly separates the two sides of an account.
When a journal entry is posted, the debit amount is transferred to the left side of the appropriate T-account, and the credit amount is transferred to the right side of its corresponding T-account. After all transactions for a period have been posted, the accountant can easily “foot” the T-account by summing up all the debits and all the credits. The difference between the two totals is the account’s ending balance.
The Mechanics of “Posting”
Let’s follow one of our examples from Part 2. The company recorded a journal entry: Debit Office Supplies $1,000 and Credit Accounts Payable $1,000. The posting process involves two actions. First, the accountant goes to the “Office Supplies” account in the general ledger and enters a $1,000 debit. They would also note the date and a cross-reference to the journal page number for a clear audit trail.
Second, the accountant goes to the “Accounts Payable” account in the general ledger and enters a $1,000 credit, along with the date and journal reference. This process is repeated for every single journal entry made during the period. Once posting is complete, the journal’s chronological record has been fully reorganized into a ledger format that is sorted by account.
Subsidiary Ledgers and Control Accounts
For some accounts in the general ledger, a company may need more detail than a single balance provides. For example, the “Accounts Receivable” account in the general ledger shows the total amount of money owed to the company by all of its customers. However, it does not show how much each individual customer owes.
To manage this, companies use subsidiary ledgers. An accounts receivable subsidiary ledger would contain a separate account for each customer, tracking their individual purchases and payments. The main “Accounts Receivable” account in the general ledger is then called a “control account,” and its balance must equal the sum of all the individual balances in the subsidiary ledger. This keeps the general ledger clean and concise while providing necessary detail elsewhere.
Step 4: Unadjusted Trial Balance
After all journal entries for the period have been posted to the general ledger, the fourth step in the accounting cycle is to prepare an unadjusted trial balance. This is the first check to ensure that the books are “in balance.” The trial balance is a simple report that lists every single account from the general ledger and its current balance.
The balances are listed in two columns: a debit column and a credit column. Asset and expense accounts, which normally have debit balances, are listed in the debit column. Liability, equity, and revenue accounts, which normally have credit balances, are listed in the credit column. At the bottom of the report, the total of the debit column and the total of the credit column are calculated.
Purpose of the Unadjusted Trial Balance
The sole purpose of the unadjusted trial balance is to prove that the total debits in the general ledger equal the total credits. This is a mathematical check to verify that the double-entry bookkeeping system has been followed correctly up to this point. If the total debits do not equal the total credits, it immediately signals that one or more errors have been made during the journalizing or posting steps.
This step must be completed before the company can proceed with the rest of the accounting cycle. If the columns are not equal, the accountant must investigate and correct the errors. Common errors include posting a debit as a credit, transposing numbers (e.g., writing $54 as $45), or partially posting a journal entry (e.g., posting the debit but forgetting the credit).
What the Trial Balance Cannot Detect
It is critically important to understand the limitations of a trial balance. Just because the debits equal the credits does not mean the financial records are perfect. The trial balance cannot detect certain types of errors. For example, if a transaction was completely omitted and never journalized, the books would still balance, but they would be incorrect.
Similarly, if a journal entry was recorded for the wrong amount (e.g., a $1,000 sale was recorded as $100 for both the debit and the credit), the trial balance would still balance. If a debit was posted to the wrong asset account (e.g., “Equipment” instead of “Supplies”), the total debits would be correct, and the trial balance would not catch the error. This is why the unadjusted trial balance is only the first check, not the final one.
The Need for Adjusting Entries
The fourth step of the accounting cycle, the unadjusted trial balance, provides a list of account balances. However, these balances are not yet ready for creating accurate financial statements. This is because, under accrual accounting, many transactions occur over time and are not signaled by a single daily source document. For example, rent is paid in advance and “used up” daily, or employees earn wages every day but are only paid every two weeks.
The unadjusted trial balance does not reflect these time-based changes. Therefore, the fifth and sixth steps of the accounting cycle are dedicated to the adjustment process. This process ensures that all revenues that have been earned and all expenses that have been incurred are recorded in the correct accounting period. This is the mechanism that makes accrual accounting work.
Step 5: The Worksheet and Identifying Adjustments
The fifth step involves using a worksheet to analyze the unadjusted trial balance and identify any discrepancies or needed adjustments. An accountant’s worksheet is a multi-column spreadsheet used to organize the data for the end-of-period process. It pulls in the account names and their unadjusted balances. Then, it has columns for the proposed adjustments, the adjusted trial balance, and finally, columns to sort the balances into the income statement and balance sheet.
This worksheet is an internal tool, not a formal financial statement. It is a “scratch pad” that helps the accountant visualize the impact of the adjustments before formally recording them. By analyzing each account, the accountant determines which balances need tobe updated to reflect revenues earned and expenses incurred, ensuring they are recorded in the proper period.
The Matching and Revenue Recognition Principles
The adjustment process is driven by two of the most important principles in accounting. The first is the revenue recognition principle, which states that revenue must be recorded in the period in which it is earned, regardless of when the cash is received. If a company performs a service for a client in December but does not get paid until January, that revenue belongs to December.
The second is the matching principle. This principle states that all expenses incurred to generate revenue must be “matched” with that revenue in the same accounting period. For example, the cost of the supplies used to perform that December service is a December expense, even if the supplies were purchased in November. Adjusting entries are the tools used to enforce these two principles.
Step 6: Recording Adjusting Journal Entries
Once the necessary adjustments have been identified on the worksheet, the sixth step of the accounting cycle is to formally record them. This is done by creating and posting adjusting journal entries. These entries are recorded in the general journal just like any other transaction, and then they are posted to the general ledger, updating the account balances.
Adjusting entries will always affect at least one income statement account (a revenue or an expense) and one balance sheet account (an asset or a liability). They are a crucial step for ensuring that the company’s financial statements present an accurate and complete picture of its financial position and performance at the end of the period. There are four main types of adjustments.
Type 1: Accrued Revenues
Accrued revenues are revenues that have been earned by the company, but the cash has not yet been received, and the transaction has not yet been recorded. For example, a bank earns interest on a loan every single day, but it may only receive the cash payment from the borrower at the end of the month. At the end of the accounting period, the bank must make an adjusting entry to record the interest revenue it has earned but not yet collected.
The adjusting entry would be a debit to an asset account (like “Interest Receivable”) and a credit to a revenue account (like “Interest Revenue”). This entry increases the company’s assets (what it is owed) and its revenues, ensuring the income statement is accurate.
Type 2: Accrued Expenses
Accrued expenses are expenses that the company has incurred, but the cash has not yet been paid, and the transaction has not yet been recorded. The most common example is employee wages. If a company’s pay period ends a few days after the end of the accounting period, the employees have earned wages for the last few days of the month that have not yet been paid or recorded.
The company must make an adjusting entry to record this expense. The entry would be a debit to an expense account (like “Wages Expense”) and a credit to a liability account (like “Wages Payable”). This entry correctly records the expense in the period it was incurred (matching principle) and recognizes the liability the company owes to its employees.
Type 3: Deferred Revenues (Unearned Revenues)
Deferred revenues occur when a company receives cash from a customer before it has earned the revenue. The cash has been collected, but the service or product has not yet been delivered. When the cash is first received, the company records a liability called “Unearned Revenue.” This liability represents the company’s obligation to perform the service in the future.
For example, a magazine publisher receives $120 for a one-year subscription. At the end of the first month, it has earned one-twelfth of that amount. The company must make an adjusting entry to debit the “Unearned Revenue” liability account (decreasing it) and credit the “Subscription Revenue” account (increasing it) by $10. This gradually recognizes the revenue as it is earned.
Type 4: Deferred Expenses (Prepaid Expenses)
Deferred expenses, or prepaid expenses, are assets that are paid for in advance and are “used up” over time. When the company first pays for the item, it debits an asset account. Common examples include prepaid insurance, prepaid rent, and office supplies. For example, a company pays $1,200 for a one-year insurance policy. On the day of purchase, it debits “Prepaid Insurance” for $1,200.
This $1,200 is an asset because it represents a future benefit. At the end of each month, one-twelfth of that benefit has been used. The company must make an adjusting entry to debit “Insurance Expense” for $100 and credit “Prepaid Insurance” for $100. This entry correctly records the expense for the month and reduces the asset’s value on the balance sheet.
A Special Case: Depreciation
Depreciation is a specific type of deferred expense. It is the process of allocating the cost of a long-term tangible asset (like a building, machine, or vehicle) over its useful life. When a company buys a machine for $10,000, it does not record a $10,000 expense in the year of purchase. Instead, it records the machine as an asset and then spreads that cost over the several years it expects to use the machine.
The adjusting entry for depreciation is a debit to “Depreciation Expense” and a credit to a special account called “Accumulated Depreciation.” This is a “contra-asset” account, meaning it is an asset account with a credit balance that reduces the value of the related asset on the balance sheet. This process accurately matches the asset’s cost to the revenues it helps generate over its life.
The Adjusted Trial Balance
After the adjusting journal entries from Step 6 have been recorded in the journal and posted to the general ledger, the account balances are now up to date. However, before preparing the formal financial statements, accountants perform one more check. They prepare an adjusted trial balance. This is an internal report that lists all the accounts from the general ledger and their balances after the adjusting entries have been posted.
Just like the unadjusted trial balance, this report has a debit column and a credit column. The totals of both columns must be equal. If they are not, it means an error was made while recording or posting the adjusting entries. This is the final check to ensure the books are in balance before proceeding to the most critical step of the accounting cycle: creating the financial statements.
Step 7: Preparing Financial Statements
This is the seventh and most important step in the accounting cycle. The financial statements are the primary output and the entire purpose of the process. These formal reports summarize the company’s financial performance and position for internal and external stakeholders. The numbers used to prepare these statements are taken directly from the “Adjusted Trial Balance.” The statements are always prepared in a specific order because the output of one statement is needed as an input for the next.
The typical order of preparation is: first, the Income Statement; second, the Statement of Retained Earnings (or Statement of Owner’s Equity); and third, the Balance Sheet. A fourth report, the Cash Flow Statement, is also prepared, but it is often created using information from both the income statement and the balance sheets from the current and prior periods.
The Income Statement
The first statement prepared is the income statement. This report is also known as the “Profit and Loss Statement” or “P&L.” Its purpose is to show the company’s profitability over a specific period (e.g., “For the Month Ended October 31”). It answers the question, “How well did the company perform?” It is calculated by taking all revenue accounts from the adjusted trial balance and subtracting all expense accounts.
The formula is simple: Revenues – Expenses = Net Income (or Net Loss). If revenues are greater than expenses, the company has a net income. If expenses are greater than revenues, the company has a net loss. This “bottom line” number, net income, is one of the most-watched figures in business. It is also a critical piece of information needed to prepare the next financial statement.
The Statement of Retained Earnings
The second statement prepared is the statement of retained earnings. This report shows how the company’s equity changed over the same accounting period. It is the bridge that connects the income statement to the balance sheet. The statement starts with the retained earnings balance from the beginning of the period.
Next, it adds the net income for the period (the number that just came from the income statement). Then, it subtracts any dividends (or owner’s drawings) paid out to shareholders during the period. The final result is the ending retained earnings balance. The formula is: Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings. This ending balance is the number that will be used on the balance sheet.
The Balance Sheet
The third statement prepared is the balance sheet. Unlike the income statement, which covers a period of time, the balance sheet is a snapshot at a specific point in time (e.g., “As of October 31”). It answers the question, “What is the company’s financial position?” The balance sheet is a direct representation of the fundamental accounting equation: Assets = Liabilities + Equity.
The report lists all the company’s asset accounts and their balances from the adjusted trial balance. It then lists all the liability accounts. Finally, it lists the equity accounts, which include common stock and the ending retained earnings balance calculated on the statement of retained earnings. The defining characteristic of a balance sheet is that it must “balance.” The total assets must equal the total liabilities plus the total equity.
The Cash Flow Statement
The final statement is the cash flow statement. This report shows the movement of cash in and out of the business over the period. It answers the question, “Where did the company’s cash come from, and where did it go?” This is crucial because, under accrual accounting, net income is not the same as cash. A company can be profitable on paper but still run out of cash.
The statement is broken into three sections. The first section is “Cash Flows from Operating Activities,” which shows cash generated or used by the main business operations. The second is “Cash Flows from Investing Activities,” which includes cash spent on or received from selling long-term assets, like equipment. The third is “Cash Flows from Financing Activities,” which includes cash from taking out loans or paying dividends.
The Relationship Between the Statements
It is important to see how the statements are interconnected. The accounting cycle is designed to make them flow into one another. The net income calculated on the income statement is used to determine the ending balance on the statement of retained earnings. The ending retained earnings balance from that statement is then used to make the equity section of the balance sheet correct.
The cash flow statement is also connected. The net income from the income statement is typically the starting point for the operating activities section. The final line on the cash flow statement, the “Ending Cash Balance,” must match the “Cash” account balance reported on the balance sheet. This interconnectedness is a final check on the accuracy of the entire accounting cycle.
Step 8: Closing the Books
The final step in the accounting cycle is closing the books. This is a housekeeping process that is performed after the financial statements for the period have been prepared. The purpose of this step is to finalize all the accounting records for the current period and to prepare the accounting system for the next period. This process involves resetting the balances of certain accounts to zero.
At this stage, all financial activities for the period have been recorded, adjusted, and reported. Closing the books ensures that the data from the current period is not mixed with the data from the next period. This allows the company to measure the performance of the new period (e.g., the next month or year) from a clean slate. This is a critical step in maintaining the integrity of the accounting cycle.
The Purpose of Closing Entries
The process of closing the books is accomplished by recording and posting “closing entries.” The main purpose of these entries is to reset the balances of all temporary accounts to zero. Temporary accounts are accounts that track the financial activity of only one accounting period. They need to be zeroed out so they can begin accumulating data for the next period.
If these accounts were not reset, the income statement would be meaningless. For example, if the “Sales Revenue” account was not closed at the end of the year, its balance in the new year would include all sales from the previous year. This would make it impossible to determine the sales revenue for just the new year. Closing entries solve this problem by wiping the slate clean.
Temporary vs. Permanent Accounts
To understand closing entries, you must know the difference between temporary and permanent accounts. Temporary accounts, also called nominal accounts, include all of the accounts on the income statement (all revenue accounts and all expense accounts). The owner’s drawing account (or the corporation’s dividends account) is also a temporary account. These accounts are “temporary” because their balances are reset to zero at the end of the accounting cycle.
Permanent accounts, also called real accounts, are all of the accounts on the balance sheet. This includes all asset accounts, all liability accounts, and the main equity accounts (like common stock and retained earnings). These accounts are “permanent” because their balances are not set to zero. Instead, their ending balances from one period carry forward to become the beginning balances for the next period.
The Four Steps to Close the Books
The closing process is typically done in four distinct journal entries. To facilitate this, a special new temporary account called “Income Summary” is used. This account acts as a temporary holding “bucket” for all the revenues and expenses before their net amount is transferred to retained earnings.
The four steps are:
- Close all revenue accounts to the Income Summary account.
- Close all expense accounts to the Income Summary account.
- Close the Income Summary account (which now holds the net income or loss) to the Retained Earnings account.
- Close the Dividends (or Drawings) account to the Retained Earnings account.
Step 1: Closing Revenue Accounts
Revenue accounts normally have a credit balance. To bring their balance to zero, a closing entry must be made to debit each revenue account for its balance. The corresponding credit is made to the “Income Summary” account. For example, if a company has $100,000 in “Sales Revenue” and $5,000 in “Interest Revenue,” the entry would be:
Debit: Sales Revenue $100,000 Debit: Interest Revenue $5,000 Credit: Income Summary $105,000 After posting this entry, both revenue accounts will have a zero balance.
Step 2: Closing Expense Accounts
Expense accounts normally have a debit balance. To bring their balance to zero, a closing entry must be made to credit each individual expense account for its balance. The corresponding total debit is made to the “Income Summary” account. For example, if the company has $60,000 in “Wages Expense” and $20,000 in “Rent Expense,” the entry would be:
Debit: Income Summary $80,000 Credit: Wages Expense $60,000 Credit: Rent Expense $20,000 After posting this, all expense accounts will have a zero balance.
Step 3: Closing the Income Summary Account
After the first two steps, the “Income Summary” account now holds all the revenues and expenses. Its balance is the net income or loss for the period. In our example, it has a $105,000 credit (from revenues) and an $80,000 debit (from expenses), leaving a net credit balance of $25,000. This $25,000 represents the company’s net income.
The third closing entry transfers this net income into the “Retained Earnings” account. To close the Income Summary account (which has a $25,000 credit balance), we debit it. The entry is: Debit: Income Summary $25,000 Credit: Retained Earnings $25,000 This entry zeros out the Income Summary account and moves the period’s profit into equity.
Step 4: Closing the Dividends Account
The final closing entry deals with dividends (or owner’s drawings). The “Dividends” account tracks payments made to owners during the period and is not an expense. It normally has a debit balance. This account is closed directly to “Retained Earnings” because dividends are a distribution of earnings, which reduces equity.
If the company paid $10,000 in dividends, the entry to close the “Dividends” account would be: Debit: Retained Earnings $10,000 Credit: Dividends $10,000 This entry zeros out the Dividends account and reduces the Retained Earnings balance accordingly. After these four steps, all temporary accounts are zero.
The Post-Closing Trial Balance
After the closing entries are posted, the accountant will prepare one final report: the post-closing trial balance. This is the very last step of the entire accounting cycle. This trial balance lists only the permanent accounts (assets, liabilities, and equity) and their balances. All temporary accounts have been zeroed out, so they do not appear on this report.
The purpose of this report is twofold. First, it verifies that the total debits still equal the total credits after the closing entries have been made. Second, it serves as the final, confirmed list of account balances that will become the starting balances for the new accounting period. The balance sheet for the period just ended will match the post-closing trial balance exactly.
The Continuous Nature of the Accounting Cycle
The accounting cycle is not a one-time process but a continuous, repeating system that operates throughout a company’s existence. The very next day after the post-closing trial balance is confirmed and the books are closed for one period, a new accounting period begins. This seamless transition from one cycle to the next creates an unbroken chain of financial record-keeping that captures every transaction throughout the company’s life. The continuous nature of this process ensures that financial information is always current and that there are no gaps in the financial records. This perpetual cycle creates a rhythm in the financial operations of a business. Finance teams know that certain activities must occur at regular intervals: transactions must be recorded daily, adjustments must be made at period end, financial statements must be prepared on schedule, and books must be closed to begin anew. This predictable pattern brings order and discipline to financial management, preventing the chaos that would result if financial record-keeping were conducted haphazardly. The transition between accounting periods is both an ending and a beginning. While it marks the conclusion of recording and reporting for one period, it simultaneously initiates the process for the next. The permanent accounts carry their ending balances forward to become the opening balances of the new period, maintaining continuity in the financial records. Meanwhile, temporary accounts start fresh at zero, ready to accumulate new revenues, expenses, and dividends for the upcoming period. Understanding this continuous nature helps explain why consistency in accounting methods is so important. Since each cycle builds upon the results of previous cycles, any changes in accounting policies or procedures can create discontinuities that make financial comparisons across periods difficult or misleading. Companies typically maintain consistent methods from period to period, changing only when required by new accounting standards or when a different method would provide more relevant information.
Opening a New Journal for Each Period
When a new accounting period begins, one of the first practical steps is opening a new journal. While some computerized accounting systems maintain a single continuous journal file, the conceptual principle of starting fresh remains important. The new journal will record all transactions that occur during the new period, creating a chronological record specific to that timeframe. This practice helps organize financial information by period and makes it easier to review, audit, and analyze the activities of specific timeframes. Opening a new journal represents a clean slate for transaction recording. The journal pages are blank, waiting to capture the economic events that will unfold during the period. This fresh start is psychologically important for accounting staff, marking a clear demarcation between past and present. It reinforces the understanding that each accounting period is a distinct unit of measurement for financial performance and position, even though the business operations continue uninterrupted. The format and structure of the new journal typically remain consistent with previous periods, maintaining continuity in record-keeping procedures. The same types of information will be recorded: transaction dates, account names and numbers, debit and credit amounts, and explanations of each entry. This consistency in format makes the accounting records easier to use and understand, as anyone familiar with one period’s journal can readily navigate another period’s records. In manual accounting systems, the physical act of opening a new journal book or starting a new file is tangible and deliberate. In computerized systems, the transition may be less visible but equally important. The system may automatically begin a new period, carrying forward beginning balances and resetting temporary accounts. Regardless of whether the system is manual or automated, the principle remains the same: each period begins with a fresh journal ready to record new transactions.
Identifying Transactions in the New Period
As the new accounting period begins, the first substantive step in the accounting cycle repeats: identifying transactions that require recording. Business operations continue without pause from one period to the next, and economic events begin occurring immediately. Sales are made, expenses are incurred, assets are purchased, and liabilities are created. The accounting system must capture these events as they occur, ensuring that the financial records remain current and complete. Transaction identification requires vigilance and a thorough understanding of what constitutes an accounting transaction. Not every business activity requires a journal entry. Signing a contract might be significant for the business, but it typically does not require immediate accounting recognition until one party performs under the contract. Hiring an employee is important, but no transaction is recorded until the employee works and earns wages. Accountants must distinguish between events that affect the accounting equation and those that do not yet have financial impact. Source documents provide the evidence necessary for identifying and recording transactions. When a sale occurs, an invoice is created. When expenses are incurred, receipts or bills are generated. When cash is received or paid, bank statements or cash register tapes provide documentation. These source documents serve as the foundation for the accounting records, providing the details needed to create accurate journal entries. Implementing good document management systems ensures that all transactions are captured and properly supported. The timing of transaction recognition varies depending on the nature of the event and the accounting basis used. Under cash basis accounting, transactions are recognized when cash changes hands. Under accrual basis accounting, which most businesses use, revenues are recognized when earned and expenses when incurred, regardless of cash flow timing. This distinction is crucial because it affects when transactions appear in the accounting records and, ultimately, in the financial statements.
Recording Transactions Through Journal Entries
Once transactions are identified, they must be analyzed and recorded in the journal through journal entries. This process requires understanding the nature of each transaction and determining its effect on the accounting equation. Every transaction affects at least two accounts, maintaining the fundamental principle that assets equal liabilities plus equity. The accountant must determine which accounts are affected and whether each should be debited or credited. Creating accurate journal entries requires knowledge of account classifications and normal balances. Asset accounts normally carry debit balances and increase with debits. Liability and equity accounts normally carry credit balances and increase with credits. Revenue accounts are a subset of equity and also have credit balances. Expense accounts are technically reductions in equity but are structured to have debit balances. Understanding these relationships allows accountants to analyze transactions correctly and create proper journal entries. Each journal entry must include specific information to be complete and useful. The date of the transaction establishes when the event occurred and ensures transactions are recorded in the proper period. Account titles identify which accounts are affected. Debit and credit amounts show the financial impact on each account. A brief explanation describes the nature of the transaction, providing context for anyone reviewing the records later. This comprehensive information creates a clear audit trail. Journal entries range from simple to complex depending on the transaction. A cash sale might involve just two accounts: increasing cash and increasing sales revenue. Purchasing equipment might involve three accounts: increasing equipment, decreasing cash, and increasing notes payable if financing is involved. More complex transactions might affect many accounts, such as paying employees, which might involve wage expense, various withholding liabilities, and cash. Regardless of complexity, every entry must maintain the fundamental equality of debits and credits.
Conclusion
The speed and accuracy with which transactions are recorded significantly impacts the usefulness of financial information. Real-time or near-real-time recording ensures that financial reports reflect current business conditions. Delayed recording can result in financial statements that are outdated by the time they are prepared, reducing their value for decision-making. Modern accounting software has made it possible to record transactions almost instantaneously, dramatically improving the timeliness of financial information. Timely recording also reduces the risk of forgotten or omitted transactions. When transactions are recorded shortly after they occur, the details are fresh and source documents are readily available. If recording is delayed, documents may be lost, details forgotten, or transactions entirely overlooked. These omissions create gaps in the financial records that can distort financial statements and lead to poor decisions based on incomplete information. The principle of recording transactions in the period they occur is fundamental to accurate period-to-period comparisons. If transactions from one period are inadvertently recorded in another, both periods’ financial statements will be misstated. Revenues and expenses must be matched to the periods in which they occur to provide meaningful measures of performance. This matching principle is a cornerstone of accrual accounting and requires diligent attention to proper period cutoffs. Many businesses establish internal controls to ensure timely and accurate recording of transactions. Daily reconciliation procedures, regular review of source documents, and separation of duties are common controls. These procedures help ensure that all transactions are captured, recorded correctly, and posted to the appropriate accounts. Strong internal controls over transaction recording contribute to reliable financial reporting and reduce the risk of errors or fraud.