The full accounting cycle is a complete process, beginning with the initial recording of business transactions and culminating in the preparation of financial statements, readying the books for the next cycle. It's a standardized way to ensure financial accuracy and transparency.
The Steps of the Accounting Cycle
Here's a breakdown of each step in the accounting cycle:
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Identifying Transactions: This involves recognizing and documenting economic events that affect the company's financial position. Source documents like invoices, receipts, and bank statements are crucial in this step. The key is determining whether an event should be recorded and what accounts are affected.
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Recording Transactions in a Journal: Once identified, transactions are recorded in a journal, a chronological record of all business activities. This is usually done using double-entry bookkeeping, where each transaction affects at least two accounts. For example, a sale on credit would debit Accounts Receivable and credit Sales Revenue.
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Posting to the General Ledger: The information from the journal is then transferred (posted) to the general ledger. The general ledger organizes all transactions by account. It provides a summary of all activity for each account, making it easier to prepare financial statements.
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Preparing the Unadjusted Trial Balance: At the end of the accounting period (e.g., month, quarter, year), an unadjusted trial balance is prepared. This is a list of all accounts and their balances at a specific point in time. Its purpose is to verify that the total debits equal the total credits. If they don't match, there's an error that needs to be corrected.
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Analyzing the Worksheet and Making Adjustments: This step involves identifying and making necessary adjustments to the accounts. Adjustments are made for items like accrued revenues, accrued expenses, deferred revenues, deferred expenses, and depreciation. A worksheet is often used to organize these adjustments before they are formally recorded.
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Preparing Adjusting Journal Entries: Based on the analysis in the previous step, adjusting journal entries are formally recorded in the general journal. These entries ensure that revenues and expenses are recognized in the correct accounting period (matching principle).
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Preparing the Adjusted Trial Balance: After posting the adjusting journal entries, an adjusted trial balance is prepared. This trial balance reflects all adjustments made and is used to ensure that debits and credits are still equal after the adjusting entries.
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Preparing Financial Statements: The adjusted trial balance is then used to prepare the financial statements, which are the primary output of the accounting cycle. The typical financial statements include:
- Income Statement: Reports the company's financial performance (revenues, expenses, and net income or loss) over a specific period.
- Balance Sheet: Presents a snapshot of the company's assets, liabilities, and equity at a specific point in time.
- Statement of Cash Flows: Shows the movement of cash both into and out of the company during a specific period.
- Statement of Retained Earnings: Shows changes in retained earnings during the accounting period.
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Closing the Books (Closing Entries): At the end of the accounting period, closing entries are made to transfer the balances of temporary accounts (revenues, expenses, and dividends) to retained earnings. This process prepares the accounts for the next accounting period by resetting the temporary account balances to zero. Permanent accounts (assets, liabilities, and equity) are not closed.
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Preparing a Post-Closing Trial Balance: After closing entries are posted, a post-closing trial balance is prepared. This verifies that all temporary accounts have been closed and that the debits and credits in the permanent accounts still balance.
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(Optional) Reversing Entries: Reversing entries are optional and are typically used to simplify the recording of certain transactions in the next accounting period, particularly accruals.
The accounting cycle is a fundamental process that ensures the accuracy and reliability of financial information. By following these steps, businesses can maintain accurate records and produce reliable financial statements for decision-making.
