The accounting cycle is the comprehensive, step-by-step process that businesses use to identify, analyze, and record their financial transactions. It is a systematic framework that ensures all financial activities are captured, processed, and reported in a consistent and logical manner over a specific accounting period, such as a month, a quarter, or a year. This structured approach is fundamental to bookkeeping and accounting, providing a clear pathway from the initial transaction to the creation of comprehensive financial statements. By following this cycle, a company ensures its financial records are accurate, complete, and compliant with prevailing accounting standards.
This eight-step process transforms raw financial data, like invoices and receipts, into meaningful financial reports. It begins with the identification of a transaction and moves through recording it in a journal, posting it to a ledger, creating a trial balance, making adjustments, and finally, preparing the financial statements and closing the books. Each step builds upon the last, creating an organized and verifiable trail of a company’s financial history. Understanding this cycle is essential for maintaining financial integrity, supporting management decisions, and meeting regulatory obligations.
The Purpose of the Accounting Cycle
The primary purpose of the accounting cycle is to create accurate and reliable financial statements. These statements—the income statement, balance sheet, and cash flow statement—are the final output of the entire process. They provide a clear and standardized summary of a company’s financial performance and position. Stakeholders, including management, investors, lenders, and regulators, rely on this information to make informed decisions. Without the structured process of the accounting cycle, financial data would be chaotic, unreliable, and unusable for these critical purposes.
Beyond just creating reports, the cycle serves several key functions. It ensures that all financial transactions are properly recorded and classified, maintaining a complete record of business activities. This systematic process promotes compliance with financial regulations, such as Generally Accepted Accounting Principles (GAAP). It also facilitates internal control by creating a verifiable audit trail, which helps safeguard assets and deter fraud. Ultimately, the cycle translates the complex daily activities of a business into a coherent financial narrative, supporting strategic planning, budgeting, and overall financial management.
Why is the Accounting Cycle Important?
The importance of the accounting cycle lies in its ability to produce consistent and accurate financial information. For a business of any size, from a small sole proprietorship to a large multinational corporation, tracking financial inflows and outflows is critical. The cycle provides the necessary structure to do this effectively. It ensures that no transaction is overlooked and that all entries are balanced and correct. This accuracy is the bedrock of financial integrity, building trust with investors, creditors, and other external parties who rely on the company’s financial data.
This process is also vital for internal decision-making. Managers need timely and accurate financial reports to understand the company’s performance, assess its financial health, and make strategic choices. The cycle provides the data needed to analyze profitability, manage cash flow, and control expenses. It helps answer critical questions: Is the company profitable? Can it pay its bills? Where is the money being spent? By following the cycle, a business creates a reliable feedback loop that guides its operations and strategy toward its financial goals.
Step 1: Identify Transactions
The first and most fundamental step in the accounting cycle is the identification of financial transactions. A financial transaction is any economic event that affects the company’s financial position—that is, it causes a change in its assets, liabilities, or owner’s equity. Not every business event is an accounting transaction. For example, hiring a new employee is an important event, but it only becomes a financial transaction when that employee works and earns a wage, creating a liability for the company. Identifying these specific events is the starting point for all accounting.
Transactions can include a wide variety of activities, such as making a sale to a customer, purchasing inventory from a supplier, paying an employee’s salary, or taking out a bank loan. Each of these events must be identified as it occurs. This identification process relies on source documents, which are the original records that provide evidence a transaction has taken place. These documents are the raw data of the accounting system and are essential for accuracy and verifiability.
The Role of Source Documents
Source documents are the physical or electronic proof that a financial transaction has occurred. They are the triggers for the accounting cycle. Without a source document, there is no objective evidence for a transaction, and it should not be recorded in the accounting system. These documents are critical for maintaining an audit trail, which allows accountants, managers, and auditors to trace a transaction from its origin through the financial statements. This verifiability is a key principle of good accounting and internal control.
Common examples of source documents include sales invoices sent to customers, purchase orders for buying goods, supplier invoices, cash register tapes, checks, bank statements, and employee time cards. For example, a supplier invoice provides evidence of a purchase and the amount owed, triggering the recording of an expense or an asset and a corresponding liability. An accountant or bookkeeper must collect, organize, and review these source documents daily to ensure all transactions are identified and ready for the next step in the cycle.
The Basic Accounting Equation
As transactions are identified, they are analyzed in the context of the basic accounting equation: Assets = Liabilities + Owner’s Equity. This equation is the foundation of the double-entry bookkeeping system and must remain in balance after every single transaction. Assets are the resources the company owns, such as cash, equipment, and inventory. Liabilities are what the company owes to others, like loans or accounts payable. Equity represents the owner’s claim on the assets after all liabilities have been paid.
Every transaction has a dual effect on this equation. For instance, if a company purchases a $1,000 computer (an asset) with cash (another asset), the transaction increases one asset (equipment) and decreases another (cash). The equation remains balanced. If the company instead bought the computer on credit, it would increase an asset (equipment) and increase a liability (accounts payable). The equation still remains in balance. Analyzing transactions through this lens is a key part of the identification step, preparing the data for the journal entry.
Cash Basis vs. Accrual Basis Accounting
The timing of when a transaction is identified and recorded depends on the accounting method a business uses: cash basis or accrual basis. Under the cash basis method, transactions are recorded only when cash is actually received or paid. This method is simpler and is often used by small businesses. For example, a sale is recorded only when the customer’s payment is received, not when the service is performed. An expense is recorded only when the bill is paid, not when the expense is incurred.
In contrast, the accrual basis of accounting is required by GAAP for most companies. Under this method, transactions are recorded when they occur, regardless of when cash changes hands. Revenue is recognized when it is earned, even if the customer hasn’t paid yet. This is captured in an account called accounts receivable. Expenses are recognized when they are incurred, even if the bill hasn’t been paid. This is captured in accounts like accounts payable or wages payable. This method provides a more accurate picture of a company’s profitability during a specific period.
The Accounting Period
The accounting cycle is performed over a specific, defined length of time known as an accounting period. This period allows a company to divide its economic life into smaller timeframes to produce regular financial reports. The most common accounting period is one year, which serves as the basis for annual financial statements and tax reporting. This fiscal year does not have to be the same as the calendar year; many companies choose a fiscal year-end that aligns with their natural business cycle, such as after their busiest season.
For internal management purposes, businesses typically run the accounting cycle over shorter periods as well. Monthly and quarterly accounting periods are common, as they provide managers with more timely financial information to monitor performance and make adjustments. At the end of each of these periods—whether it be a month, a quarter, or a year—the accounting cycle is completed. The steps are followed to produce financial statements for that specific period, and then the cycle begins all over again for the next period.
Step 2: Record Transactions in a Journal
After a financial transaction has been identified and verified with a source document, the second step in the accounting cycle is to record it in a journal. The journal, often called the “book of original entry,” is a chronological, day-by-day log of all the company’s financial transactions. Recording transactions in a journal is the first time they are formally entered into the accounting system. This process is called making a journal entry, and it provides a complete and detailed record of each transaction in one place.
The journal entry contains several key pieces of information: the date of the transaction, the specific accounts affected, the amounts to be debited and credited, and a brief description or reference to the source document. This chronological record is crucial for maintaining an audit trail. If a question arises later about a specific transaction, an accountant can go back to the journal for the specified date and find the complete entry, which then points to the original source document. This creates a clear, verifiable, and organized history of all business activities.
The System of Double-Entry Bookkeeping
Modern accounting is built on the foundation of the double-entry bookkeeping system. This system is directly linked to the basic accounting equation (Assets = Liabilities + Equity) and mandates that every single transaction must affect at least two accounts. This dual-effect concept is what ensures the accounting equation always remains in balance. For every transaction, a journal entry is created that has two sides: a debit and a credit. The core rule of double-entry bookkeeping is that for every entry, the total amount of the debits must equal the total amount of the credits.
This system provides a powerful self-checking mechanism. If the debits and credits for a journal entry do not balance, the accountant immediately knows a mistake has been made. This prevents many types of errors from entering the accounting records. This system is far more robust than single-entry accounting, which is similar to simply managing a checkbook. Single-entry only tracks cash in and cash out, but it fails to capture other important financial elements like assets, liabilities, or the full scope of revenues and expenses.
Understanding Debits and Credits
Debits (Dr.) and credits (Cr.) are the tools used to record the dual effect of a transaction in the double-entry system. It is a common misconception that “debit” means increase and “credit” means decrease. This is not true. A debit is simply an entry on the left-hand side of an account, and a credit is an entry on the right-hand side. Whether a debit or credit represents an increase or a decrease depends entirely on the type of account being affected.
The rules for debits and credits are derived from the accounting equation. For assets, which are on the left side of the equation, a debit increases the account, and a credit decreases it. For liabilities and equity, which are on the right side, the rule is reversed: a credit increases the account, and a debit decreases it. This opposing relationship is what keeps the equation balanced. For example, getting a cash loan increases an asset (cash) with a debit and increases a liability (loan payable) with a credit. The equation remains in balance.
Debits and Credits for Temporary Accounts
The rules for debits and credits extend to the temporary accounts that are part of owner’s equity: revenues, expenses, and dividends. Revenues, such as sales, increase the company’s net income, which in turn increases owner’s equity. Since equity is increased with a credit, revenues are also increased with a credit. Expenses, such as rent or wages, decrease net income and owner’s equity. Therefore, expenses are increased with a debit, as a debit reduces the equity side of the equation.
Similarly, dividends (or owner’s withdrawals) are payments made from profits to the owners. This distribution of income reduces the owner’s claim on the company’s assets (owner’s equity). Therefore, the dividend or withdrawal account is increased with a debit, just like an expense account. Remembering these “normal balances” is key. Assets, expenses, and dividends all have a normal debit balance (they are increased with a debit). Liabilities, equity, and revenues all have a normal credit balance (they are increased with a credit).
Examples of Common Journal Entries
Let’s illustrate with some examples. Imagine a company performs a service for a client and is paid $500 in cash. The transaction is identified from a sales receipt. The journal entry would affect two accounts: Cash (an asset) and Service Revenue (a revenue). To increase the asset Cash, you debit it for $500. To increase the revenue account Service Revenue, you credit it for $500. The entry is balanced: total debits ($500) equal total credits ($500).
Now, imagine the company pays its $200 utility bill. The source document is the utility bill and the check payment. This transaction increases an expense (Utility Expense) and decreases an asset (Cash). To increase the expense account Utility Expense, you debit it for $200. To decrease the asset Cash, you credit it for $200. Again, the entry is balanced. One final example: the company buys $1,000 of supplies on credit. This increases an asset (Supplies) and increases a liability (Accounts Payable). The journal entry is a debit to Supplies for $1,000 and a credit to Accounts Payable for $1,000.
Step 3: Posting to the General Ledger
After transactions are chronologically recorded in the journal, the third step in the accounting cycle is posting. Posting is the process of transferring the debit and credit information from the journal entries to their respective individual accounts in the general ledger. While the journal provides a chronological history of all transactions, the general ledger provides a summary of all transactions affecting a single account. It is often called the “book of final entry” because it aggregates the data into a usable format.
For example, all the individual journal entry debits and credits to the “Cash” account throughout the month are posted to the “Cash” account in the general ledger. This allows a business to easily find the current balance of its cash account at any time. In manual accounting systems, this was a tedious and error-prone process. In modern computerized accounting systems, this step is performed instantly and automatically as soon as the journal entry is saved. The system posts the data to the correct ledger accounts in the background.
The Structure of the General Ledger
The general ledger is essentially a collection of all the individual accounts for a business. It can be visualized as a large binder, with a separate page for every single account. Each account in the ledger tracks its own balance. These accounts correspond to the chart of accounts, which is a list of all accounts a company uses, organized by type: assets, liabilities, equity, revenues, and expenses. The general ledger is the central repository for all accounting data.
A common tool used to visualize a ledger account is the T-account. It is a simplified graphic representation that shows the account name at the top, with a “T” shape below it. The left side of the “T” is for all debit entries, and the right side is for all credit entries. At the end of the period, the accountant totals the debits and the credits and subtracts the smaller side from the larger side to find the account’s ending balance. This balance is what will be used in the next step of the accounting cycle.
General Journal vs. Special Journals
In our discussion, we have focused on the general journal, which is a flexible, all-purpose journal where any type of transaction can be recorded. However, many businesses also use special journals to improve efficiency. Special journals are designed to record a specific type of high-volume transaction. This saves time because the accountant does not have to write out the full account details for every single entry. Instead, they just enter the date, amount, and other key details.
The most common special journals are the sales journal (for all sales on credit), the cash receipts journal (for all cash received), the purchases journal (for all purchases on credit), and the cash payments journal (for all cash paid out). Transactions that do not fit into any of these special journals (like adjusting entries or the purchase of an asset for a note payable) are recorded in the general journal. At the end of the period, the totals from the special journals are posted to the general ledger, rather than posting each individual transaction.
Step 4: The 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 the accounting system is mathematically in balance. The unadjusted trial balance is an internal document, not a formal financial statement. It is a simple, two-column list of all the accounts in the general ledger and their final balances—either debit or credit—at a specific point in time, typically the end of the month or year.
The primary purpose of this document is to verify that the fundamental rule of double-entry bookkeeping has been maintained throughout the period. That is, it checks to see if the total of all debit balances in the ledger equals the total of all credit balances. If the two totals match, the ledger is “in balance.” This provides a degree of confidence that the posting process was done correctly before the company moves on to the more complex step of making adjustments.
How to Prepare an Unadjusted Trial Balance
The process of preparing an unadjusted trial balance is straightforward. First, you need the ending balance for every account in the general ledger. For each account, you determine its “normal balance.” Asset, expense, and dividend accounts will normally have a debit balance. Liability, equity, and revenue accounts will normally have a credit balance. You then create a worksheet with three columns: one for the account names, one for debit balances, and one for credit balances.
You then list every single account from the general ledger down the first column. In the appropriate second or third column, you write the final balance of that account. For example, the “Cash” balance would be placed in the debit column, while the “Accounts Payable” balance would go in the credit column. Once all account balances have been listed, you sum up the debit column and sum up the credit column. If the accounting process has been free of mathematical errors, these two totals will be exactly the same.
The Purpose of the Trial Balance
The core purpose of the unadjusted trial balance is to detect mathematical errors that may have occurred during the journaling and posting steps. If the total debits do not equal the total credits, it is a clear signal that a mistake has been made. This allows the accountant to find and correct the error before the financial statements are prepared, which saves a significant amount of time and prevents inaccurate reporting. It acts as a crucial checkpoint, validating the integrity of the general ledger data.
It is important to understand what “unadjusted” means. This trial balance is prepared before any end-of-period adjusting entries have been made. This means it does not yet reflect transactions that have occurred but have not been recorded, such as incurred wages or the use of prepaid rent. The balances shown are based purely on the daily journal entries. This “unadjusted” report serves as the starting point for the adjustment process, which is the next key phase of the accounting cycle.
Common Errors a Trial Balance Can Detect
When the debit and credit columns of the unadjusted trial balance do not match, the accountant must play detective to find the error. The difference between the two totals can often provide a clue. For example, if the difference is divisible by 9, it often indicates a transposition error, where two digits were swapped (e.g., $54$ was written as $45$). If the difference is a round number like $100$ or $1,000$, it might suggest a posting error where an entry was posted to the wrong column.
Other common errors include: only posting one half of a journal entry (e.S., posting the debit but forgetting the credit), posting the same entry twice, or incorrectly calculating an account balance in the ledger. The process of finding the error involves re-calculating the account balances, checking the posting from the journal to the ledger for each entry, and verifying the original journal entries to ensure they balanced. This meticulous process is necessary to restore the balance and move forward in the cycle.
Limitations of the Trial Balance
A perfectly balanced unadjusted trial balance is a good sign, but it is not a guarantee that the financial records are completely free of errors. This is a critical limitation that accountants must understand. A trial balance can balance even when significant errors exist. The report only proves that total debits equal total credits; it does not prove that the transactions were recorded correctly.
For instance, if a $500 journal entry for a utility bill was accidentally debited to “Rent Expense” instead of “Utility Expense,” the trial balance would still balance. Both are expense accounts with debit balances, so the totals are unaffected, but the reported expenses are incorrect. Similarly, if a transaction was omitted entirely—never journalized or posted—the trial balance would not reveal the error, as both the debit and credit parts are missing. A journal entry posted for the wrong amount (e.S., $100$ instead of $1,000$ for both the debit and credit) would also go undetected.
An Example of an Unadjusted Trial Balance
Let’s imagine a small business has the following account balances at the end of its first month: Cash: $5,000 (Debit), Accounts Receivable: $2,000 (Debit), Supplies: $500 (Debit), Equipment: $10,000 (Debit), Accounts Payable: $1,500 (Credit), Owner’s Capital: $12,000 (Credit), Service Revenue: $7,000 (Credit), and Rent Expense: $3,000 (Debit). The accountant would list these in the trial balance worksheet.
The debit column would list: Cash $5,000$, Accounts Receivable $2,000$, Supplies $500$, Equipment $10,000$, and Rent Expense $3,000$. The total of the debit column would be $20,500$. The credit column would list: Accounts Payable $1,500$, Owner’s Capital $12,000$, and Service Revenue $7,000$. The total of the credit column would also be $20,500$. Since the totals match, the accountant can be confident that the ledger is mathematically in balance and can proceed to the next step: making adjusting entries.
The Trial Balance as a Starting Point
The unadjusted trial balance is not just a proofreading tool; it is also the primary source document for the next major step in the accounting cycle. This step involves creating a worksheet to analyze and record adjusting entries. The worksheet is an internal spreadsheet that starts by listing all the accounts and their balances directly from the unadjusted trial balance. From this starting point, the accountant will add columns for the adjustments, which will then lead to a new set of balanced numbers in a column called the “adjusted trial balance.”
Without the unadjusted trial balance, the process of making end-of-period adjustments would be chaotic. The accountant would have no clear, consolidated list of account balances to work from. By first ensuring the ledger is mathematically sound, the accountant can then focus on the more complex, conceptual work of making adjustments to properly reflect all revenues and expenses for the period under the accrual basis of accounting. This organized progression is essential to the logic of the cycle.
The Need for Adjusting Entries
After the unadjusted trial balance confirms that debits equal credits, the accounting cycle moves to one of its most critical phases: making adjusting entries. This step is the heart of accrual basis accounting. The unadjusted trial balance contains data from daily transactions, but it does not reflect economic events that have occurred over time but have not yet been recorded. For example, the company has used up a month’s worth of prepaid rent, or its employees have earned a week’s worth of wages that have not yet been paid.
Adjusting entries are internal journal entries made at the end of an accounting period to “adjust” the accounts to their correct balances. Their purpose is to ensure that the company’s financial statements accurately reflect its financial position and performance. Specifically, they are needed to uphold two key accounting principles: the revenue recognition principle, which states that revenue should be recorded when it is earned, and the matching principle, which states that expenses should be recorded in the same period as the revenues they helped generate.
Step 5: The Worksheet
Before formally recording adjusting entries, many accountants use a multi-column worksheet. This is an optional but highly useful internal tool, especially for complex businesses. The worksheet is a spreadsheet that helps organize the data for the entire end-of-period process. It starts by listing all accounts and their balances from the unadjusted trial balance. Then, it has a pair of columns for the adjusting entries, followed by a pair for the “adjusted trial balance,” and finally, columns to sort those balances into the income statement and the balance sheet.
This worksheet allows the accountant to “pencil in” and test the adjustments, ensuring everything still balances before committing the entries to the formal accounting records. It provides a clear, consolidated view of the entire adjustment process, from the starting numbers to the final figures that will be used to create the financial statements. It is a planning and organization tool that significantly reduces the risk of errors during this complex and crucial stage of the accounting cycle.
Step 6: Adjusting Journal Entries
Once the adjustments have been calculated, often on the worksheet, they must be formally recorded in the general journal as adjusting journal entries. These are just like any other journal entry: they require a date (always the last day of the period), the accounts affected, and balanced debit and credit amounts. After being journalized, these entries are then posted to the general ledger, updating the account balances. The new, corrected balances form the “adjusted trial balance.”
There are two main categories of adjustments: deferrals and accruals. Deferrals are for transactions where cash was paid or received in advance of the revenue being earned or the expense being incurred. Accruals are for transactions where revenue has been earned or an expense has been incurred, but the cash has not yet been exchanged. A third category involves estimates, like depreciation. Every adjusting entry will always affect at least one income statement account (a revenue or an expense) and one balance sheet account (an asset or a liability).
Type 1: Deferrals (Prepaid Expenses)
Prepaid expenses are assets that are paid for in cash upfront but are not used or consumed immediately. They represent a future benefit. Common examples include prepaid rent, prepaid insurance, and office supplies. When the cash is first paid, an asset account is debited (e.g., “Prepaid Insurance”) and cash is credited. At the end of the accounting period, an adjusting entry is needed to reflect the portion of the asset that has been “used up” or expired. This amount is now an expense.
For example, imagine a company pays $1,200 for a one-year insurance policy on January 1. On that day, it debits “Prepaid Insurance” for $1,200 and credits “Cash” for $1,200$. At the end of January, one month of the insurance has expired. The company must make an adjusting entry. It will debit “Insurance Expense” for $100$ ($1,200 / 12 months) and credit the asset “Prepaid Insurance” for $100$. This correctly matches the $100$ expense to January and reduces the prepaid asset’s balance to $1,100$, reflecting the remaining 11 months of coverage.
Type 2: Deferrals (Unearned Revenues)
Unearned revenues, also known as deferred revenues, represent a liability. This occurs when a company receives cash from a customer before providing the service or product. The company has an obligation, or liability, to perform that service in the future. When the cash is received, the company debits “Cash” and credits a liability account called “Unearned Revenue.” This is not yet revenue because it has not been earned.
For example, on March 15, a magazine company receives $120$ from a customer for a one-year subscription. It debits “Cash” for $120$ and credits “Unearned Subscription Revenue” for $120$. At the end of March, the company has fulfilled one month of its obligation. It must make an adjusting entry to recognize the portion of the revenue it has now earned. It will debit the liability “Unearned Subscription Revenue” for $10$ ($120 / 12 months) and credit “Subscription Revenue” for $10$. This correctly records $10$ of revenue in March and reduces the liability to $110$.
Type 3: Accruals (Accrued Expenses)
Accrued expenses are expenses that the company has incurred during the period but has not yet paid for or recorded. These are often “silent” transactions that do not have a specific source document like a bill. A common example is employee wages. Imagine a company pays its employees every Friday. If the accounting period ends on a Wednesday, the employees have worked for Monday, Tuesday, and Wednesday, but they won’t be paid until Friday. The company has incurred an expense and a liability that must be recorded.
If the employees earned $3,000$ for those three days, the company must make an adjusting entry on Wednesday, the last day of the period. It will debit “Wages Expense” for $3,000$ and credit a liability account called “Wages Payable” for $3,000$. This entry correctly matches the wage expense to the period in which the work was performed, and it accurately shows on the balance sheet that the company owes $3,000$ to its employees. Other examples include accrued interest on a loan and accrued utilities.
Type 4: Accruals (Accrued Revenues)
Accrued revenues are revenues that the company has earned by providing a service or product but has not yet billed for or received cash for. Just like accrued expenses, these transactions may not have a source document yet. For example, a consulting firm might perform work for a client throughout the month, billing them only when the project is complete. If the accounting period ends before the project is done, the firm has earned revenue that must be recorded.
If the firm has completed $5,000$ worth of consulting work by the end of the month that has not yet been billed, it must make an adjusting entry. It will debit an asset account called “Accounts Receivable” for $5,000$ (representing the right to collect that money) and credit “Consulting Revenue” for $5,000$. This entry correctly applies the revenue recognition principle, recording the revenue in the period it was earned, even though the cash has not been received.
Type 5: Estimates (Depreciation)
Some adjusting entries are not based on a specific transaction but on an estimate. The most common example is depreciation. Long-term assets, like buildings, equipment, and vehicles, lose value and wear out over time as they are used to generate revenue. The matching principle requires that the cost of this asset be allocated as an expense over its useful life, rather than being expensed all at once when it is purchased. This allocation process is called depreciation.
For example, a company buys a delivery van for $30,000$ with an estimated useful life of 5 years. Using the simple straight-line method, the annual depreciation expense is $6,000$ ($30,000 / 5 years), or $500$ per month. At the end of each month, the company must record this. It will debit “Depreciation Expense” for $500$ and credit a special asset account called “Accumulated Depreciation” for $500$. “Accumulated Depreciation” is a contra-asset account, meaning it reduces the book value of the asset on the balance sheet. This process continues for all 5 years of the asset’s life.
Creating the Adjusted Trial Balance
After all the adjusting journal entries from the previous step have been journalized and posted to the general ledger, the account balances are updated. The next logical step is to prepare an adjusted trial balance. This document is an internal report that is prepared in the exact same way as the unadjusted trial balance. It lists all the accounts in the general ledger and their new, adjusted balances. Its purpose, once again, is to verify that the total of all debit balances still equals the total of all credit balances after the adjustments.
This step is a crucial final check before creating the formal financial statements. If the columns in the adjusted trial balance do not match, it means an error was made in one of the adjusting entries (e.g., the debit did not equal the credit, or it was posted incorrectly). This must be fixed before proceeding. Once it is balanced, the adjusted trial balance becomes the single, definitive source of data for preparing the income statement, the statement of retained earnings, and the balance sheet.
Step 7: Preparing Financial Statements
With a balanced adjusted trial balance in hand, the company is finally ready to prepare its financial statements. This is the seventh and most crucial step in the accounting cycle, as it represents the main output and purpose of the entire process. These statements are the formal reports that communicate the company’s financial performance and position to external stakeholders, such as investors, lenders, and regulators, as well as to internal management. The statements must be prepared in a specific order because data from one statement flows into the next.
The typical order of preparation is: 1) The Income Statement, 2) The Statement of Retained Earnings (or Statement of Owner’s Equity), and 3) The Balance Sheet. The Cash Flow Statement is also a primary financial statement, but its preparation is a more complex process that often uses data from all the other statements. The adjusted trial balance provides all the necessary figures for the first three statements in a clean, organized format.
The Income Statement
The first statement prepared is the income statement. This report, also known as the profit and loss (P&L) statement, summarizes the company’s financial performance over a period of time (e.g., for the month ended, for the year ended). Its purpose is to show the company’s profitability. Its formula is simple: Revenues – Expenses = Net Income (or Net Loss).
To create the income statement, you take all the revenue and expense accounts directly from the adjusted trial balance. All the revenue accounts are listed first and totaled to get “Total Revenues.” Then, all the expense accounts are listed and totaled to get “Total Expenses.” Finally, total expenses are subtracted from total revenues. If the result is positive, the company has a “Net Income.” If it is negative, it has a “Net Loss.” This net income or loss figure is the “bottom line” and is a critical measure of the company’s success during the period.
The Statement of Retained Earnings
The second statement prepared is the statement of retained earnings (for a corporation) or the statement of owner’s equity (for a sole proprietorship). This report shows the changes in the equity section of the balance sheet over the same period of time as the income statement. It acts as a bridge, connecting the income statement to the balance sheet. Its formula is: Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings.
The preparation begins with the “Beginning Retained Earnings” balance, which is the ending balance from the previous period. Then, the “Net Income” (or net loss) is added. This number flows directly from the bottom line of the income statement that was just prepared. Next, any “Dividends” (or owner’s withdrawals) paid out to owners during the period are subtracted. This dividend amount is taken from the adjusted trial balance. The final result is the “Ending Retained Earnings,” which will be used in the next statement.
The Balance Sheet
The third and final statement prepared in this sequence is the balance sheet. This report, also known as the statement of financial position, provides a snapshot of the company’s financial health at a specific point in time (e.g., as of December 31). It is the detailed expression of the basic accounting equation: Assets = Liabilities + Owner’s Equity. The “balance” sheet gets its name from the fact that both sides of this equation must always be equal or in balance.
To create the balance sheet, you take all the asset, liability, and equity accounts from the adjusted trial balance. Assets are listed first, typically broken down into current assets (like cash and accounts receivable) and long-term assets (like equipment). These are totaled to get “Total Assets.” Then, liabilities are listed, broken into current (like accounts payable) and long-term (like loans payable), and totaled. Finally, the equity section is listed. This includes common stock and the “Ending Retained Earnings” balance, which flows directly from the statement of retained earnings.
Verifying the Balance Sheet
After all the accounts are listed, the accountant calculates “Total Liabilities” and “Total Owner’s Equity.” These two are added together to get “Total Liabilities and Owner’s Equity.” This final number must be exactly equal to the “Total Assets” number. If they are not equal, an error has been made somewhere in the preparation of the statements or in the adjusted trial balance. The fact that the net income from the income statement flows to the statement of retained earnings, which in turn provides the ending retained earnings for the balance sheet, creates a self-contained, interlocking system.
The balance sheet is a critical tool for assessing a company’s solvency (ability to pay long-term debts) and liquidity (ability to pay short-term bills). It shows stakeholders exactly what the company owns (its assets) and what it owes (its liabilities), as well as the owner’s stake (equity). Preparing this statement correctly is a major milestone in the accounting cycle, signifying that the bulk of the reporting work is complete.
The Cash Flow Statement
The fourth primary financial statement is the cash flow statement. This report is often prepared after the balance sheet, as it requires information from both the income statement and the comparative balance sheets (this period’s and last period’s). The purpose of the cash flow statement is to show the movement of cash in and out of the business over the period. This is crucial because a company can be profitable on the income statement (due to accrual accounting) but still have no cash, a condition that can lead to bankruptcy.
The statement is broken into three distinct sections. The “Operating Activities” section shows cash generated from or used in the main business operations, essentially converting net income from an accrual basis to a cash basis. The “Investing Activities” section shows cash used for or received from buying and selling long-term assets, like equipment or property. The “Financing Activities” section shows cash received from or paid to owners and lenders, such as from issuing stock, paying dividends, or taking out a loan.
Interrelation of Financial Statements
It is impossible to overstate how interconnected the financial statements are. The accounting cycle is designed to produce this set of interlocked reports. The “Net Income” from the income statement is a required component to calculate “Ending Retained Earnings” on the statement of retained earnings. The “Ending Retained Earnings” from that statement is then a required component to complete the “Owner’s Equity” section of the balance sheet.
Furthermore, the “Cash” balance shown on the balance sheet at the end of the period must be the same number that the cash flow statement calculates as the ending cash balance. The income statement and balance sheet provide the starting numbers for the operating activities section of the cash flow statement. This interconnectedness ensures that the statements are all in agreement and are derived from the same set of balanced, adjusted data. This coherence is the ultimate goal of the accounting cycle.
Step 8: Closing the Books
After the financial statements have been prepared and distributed to management and other stakeholders, the final step in the accounting cycle is to close the books. This is a crucial bookkeeping and data management step that is performed at the end of the accounting period (e.S., December 31 for an annual period). The closing process prepares the accounting system for the next period. It involves making a set of journal entries, known as “closing entries,” to formally close out all the temporary accounts and transfer their data to a permanent account.
The primary purpose of closing the books is twofold. First, it resets the balances of all temporary accounts to zero, giving them a clean slate to begin accumulating data for the next period. Second, it formally transfers the net income (or net loss) and any dividends for the period into the retained earnings account. This updates the retained earnings balance to match the amount reported on the balance sheet and statement of retained earnings, ensuring the accounting equation remains in balance.
Temporary vs. Permanent Accounts
To understand the closing process, one must first understand the difference between temporary and permanent accounts. Temporary accounts, also known as nominal accounts, are accounts that track financial activity over a single accounting period. At the end of the period, their job is done, and they must be reset. The temporary accounts are all revenue accounts, all expense accounts, and the dividends (or owner’s withdrawal) account. The financial statements, particularly the income statement, are essentially just a summary of these temporary accounts.
Permanent accounts, also known as real accounts, are accounts that carry their balances forward from one period to the next. Their balances are cumulative and are not reset at the end of the period. The permanent accounts are all the balance sheet accounts: all asset accounts (like Cash, Equipment), all liability accounts (like Accounts Payable, Loans Payable), and the main equity accounts (like Common Stock and Retained Earnings). The ending balance of one period becomes the beginning balance of the next.
The Closing Process Using “Income Summary”
The traditional method for closing the books involves using a special, temporary “clearing” account called “Income Summary.” This account is created and used only during the closing process and will have a zero balance before and after. The process follows four distinct steps.
First, all revenue accounts are closed. Since revenue accounts have a normal credit balance, an entry is made to debit each individual revenue account for its balance and credit the “Income Summary” account for the total. This brings all revenue accounts to zero. Second, all expense accounts are closed. Since expense accounts have a normal debit balance, an entry is made to credit each individual expense account for its balance and debit “Income Summary” for the total. This brings all expense accounts to zero.
The Final Closing Steps
At this point, the “Income Summary” account holds the net income or loss for the period. If there was a net income, “Income Summary” will have a credit balance (since revenue credits were larger than expense debits). If there was a net loss, it will have a debit balance. The third step is to close the “Income Summary” account to “Retained Earnings.” To close a net income (a credit balance), you debit “Income Summary” and credit “Retained Earnings.” This entry formally moves the period’s profit into the company’s cumulative equity.
The fourth and final closing entry is to close the “Dividends” account. The dividends account has a normal debit balance and is not an expense, so it was not closed with the other expense accounts. It is closed directly to “Retained Earnings” because dividends are a distribution of earnings, not a cost of doing business. The entry is a debit to “Retained Earnings” and a credit to “Dividends,” which reduces the retained earnings balance and resets the dividends account to zero.
The Post-Closing Trial Balance
After all closing journal entries have been journalized and posted to the general ledger, the accounting cycle has one final, optional-but-highly-recommended checkpoint. This is the post-closing trial balance. As its name suggests, it is another trial balance prepared after all the closing entries are complete. Its purpose is to verify two things: first, that total debits still equal total credits, and second, that all temporary accounts (revenues, expenses, dividends, and income summary) have been successfully reset to a zero balance.
The post-closing trial balance will only list the permanent (balance sheet) accounts: assets, liabilities, and the final, updated equity accounts (common stock and the new ending retained earnings balance). If any temporary accounts appear on this list with a balance, or if the debit and credit columns do not match, an error was made during the closing process. This report provides final assurance that the books are clean, balanced, and ready for the new accounting period to begin.
The Start of a New Cycle
The preparation of the post-closing trial balance marks the official end of the accounting cycle for one period and the simultaneous start of the next. The balances in the permanent accounts on the post-closing trial balance become the beginning balances for the new accounting period. On the very first day of the new period, the company will begin at Step 1: Identifying Transactions. An invoice for a new sale or a bill for a new expense will be received, and the entire eight-step process will start all over again.
This cyclical nature is the most important concept to understand. The accounting cycle is not a linear process that is done once and finished. It is a continuous, repeating loop that a business performs every single accounting period, whether it be monthly, quarterly, or annually. This disciplined repetition is what ensures that a company’s financial data is always being captured, processed, and reported in a timely, accurate, and consistent manner.
Conclusion
There is one final, optional step that some companies perform after the closing process, called “reversing entries.” These entries are made on the very first day of the new accounting period and are the exact opposite of certain adjusting entries made in the prior period. Specifically, they are used for any accrued expenses or accrued revenues. For example, the adjusting entry for accrued wages was a debit to Wages Expense and a credit to Wages Payable. The reversing entry on day one of the new period would be a debit to Wages Payable and a credit to Wages Expense.
This may seem counterintuitive, but it simplifies bookkeeping in the new period. By making this reversing entry, the accountant doesn’t have to worry about the accrued portion when the payroll is actually paid. They can just record the entire payroll payment with a simple, normal journal entry (a debit to Wages Expense and a credit to Cash). The reversing entry has already handled the portion that was expensed in the prior period. It is purely a mechanical convenience to simplify future data entry.