Understanding the 8 steps in the accounting cycle

Business leaders rely on a company’s financial statements when deciding what strategy to pursue or where to invest to drive growth. But why do they feel secure relying on those statements to begin with? In the financial management world, the accounting cycle serves as the backbone for maintaining accurate financial records. Understanding the full cycle is how business leaders follow and comply with accounting principles and make informed decisions. Businesses follow the accounting cycle to record the transactions that make up their financial statements and reports—it underpins the entire accounting system that powers small businesses and multinational enterprises alike.

The accounting cycle not only streamlines the process of recording and analyzing financial transactions but also plays a pivotal role in financial reporting and tax preparation. In this article, we’ll unpack the accounting cycle, how it works, and why companies that follow it benefit from increased accuracy, transparency, and consistency in their financial reporting. We’ll also take a deep dive into each step of the process. 

What is the accounting cycle?

The accounting cycle is a step-by-step process that organizations use to identify, record, and analyze all of their financial transactions during a specific period. This systematic approach helps ensure that financial data is accurately captured and that financial statements reflect the company's true financial position.

You can think of the accounting cycle as the foundation of sound financial management because it captures the essential data that comprises all of the essential reports decision-makers, investors, and lenders use to understand the company’s financial position. By following the accounting cycle, companies can also maintain consistency in their bookkeeping practices and meet regulatory requirements.

Purpose and importance of the accounting cycle

The primary purpose of the accounting cycle is to provide a structured method for recording financial activities, from the initial transaction to the final financial statements. Having a systematic process helps businesses make sure that all of their financial transactions are accurately recorded, analyzed, and reported within the specified accounting periods. The accounting cycle is also essential for:

• Ensuring compliance with accounting principles and standards.
• Providing accurate financial data for decision-making.
• Facilitating efficient financial reporting and tax preparation.
• Enhancing the transparency and reliability of financial statements.

What makes the accounting cycle so important is that it provides consistency. The process standardizes how companies report their overall financial health and capture and record information about money spent and money earned. Leaders can plan and strategize confidently, knowing that their choices align with the business’ true position, and investors can compare apples to apples when evaluating opportunities.

A standardized accounting cycle also means regulators can more easily identify patterns or spot anomalies. Ferreting out impropriety becomes more straightforward when all companies must follow the same process to prepare their financial statements.

Example: Regulators reviewing the financial statements for Widgets.io notice a sudden spike in revenue. Because the company follows the standard accounting cycle, auditors are able to identify the source as an error in recording deferred revenue rather than any impropriety.

8 steps of the accounting cycle

Understanding the rationale behind each of the accounting cycle steps can also help you develop a system for thorough and efficient accounting. Let's delve into each step of the accounting cycle to understand how they contribute to accurate financial management—below, we’ll review each action item with an example. 

Step 1. Identify transactions

In the first step of the accounting cycle, businesses identify all financial transactions that have occurred during the accounting period. Transactions are more than just sales of goods and services—they include sales made to customers, purchases from vendors, payments received, expenses paid, and debts incurred. Transactions can be cash or credit transactions and must be supported by source documents such as invoices, bills, cash receipts, and bank statements. Proper identification ensures that no financial activities are overlooked, providing a comprehensive view of the company's financial position.

For most businesses, this is a continuous process since transactions occur regularly—often multiple times per day. To simplify and streamline the process of identifying transactions and collecting documentation, many businesses use automated systems that link their company bank account with their point-of-sale technology or specialized accounting software. 

Example: Morgan works as a bookkeeper for Acme, Inc. and manages its accounting cycle. Acme’s payment processor offers point-of-sale technology that automatically syncs with the company’s accounting software to record purchases. The accounting software also automatically monitors and records payments from the company bank account. To identify transactions, Morgan reviews bank statements, payment records, and copies of invoices received by the accounting department.

Step 2. Record transactions in the journal

Once you’ve identified all possible transactions, you’ll need to record them as journal entries. If your business uses double-entry accounting, be sure that every debit has a corresponding credit in a subledger account. For example, when a company makes a sale on credit, the accounts receivable account is debited, and the sales revenue account is credited. 

Example: Morgan reviews the company’s invoices, purchase records, bank statements, bills, and other documents against the transactions recorded in the accounting software. During one period of two days, Acme’s bank account did not sync properly, and the software failed to record three payments made to vendors. Morgan updates the records and does a final check of the journal entries. 

Be aware that the specific accounting method your business uses influences when you record transactions. Most businesses use accrual accounting, which records transactions as they occur, regardless of whether money changes hands. In cash accounting, you record a transaction when the company actually receives or makes a payment.

No matter which accounting method you use, accurate journal entries are a must for reliable financial reporting.

Step 3. Post to the general ledger 

After verifying your journal entries, the next step is to post them to the company’s general ledger, which contains all of the company's accounts. Each account in the ledger reflects the account balance, showing the cumulative total of debits and credits for that account. For instance, when an expense is recorded, it is posted to the corresponding expense account in the ledger. The general ledger serves as the central repository for all financial data—the company’s source of truth for all things finance—which helps facilitate preparation of financial statements.

Some companies may still reconcile journal entries and the general ledger by hand; however, most accounting and bookkeeping software automates this process to save time and reduce the risk of error.

Example: Morgan submits the journal entries to Alex, Acme’s financial controller, for review and approval. Alex confirms the accuracy of the entries and approves them for posting. Morgan prompts Acme’s accounting software to record the transactions in the company’s general ledger.

Step 4. Prepare an unadjusted trial balance

At the end of the accounting period, an unadjusted trial balance is prepared by listing all accounts from the general ledger along with their balances. The purpose is to verify that the total debits equal total credits; in other words, that the books are in balance. This step helps detect any recording errors that may have occurred during the bookkeeping process. If the debits and credits are not equal, the bookkeeper needs to analyze the ledger and journal entries to identify and correct discrepancies.

Example: Acme, Inc. follows a monthly accounting cycle. On the 1st of each month, Morgan runs a report summarizing debits and credits from the previous month. One month, Morgan notices that the credit balance exceeds the debit balance. To understand why, they will need to create a worksheet.

Finance professionals use the term “unadjusted trial balance” to refer to this calculation because it’s a first attempt at balancing the books. You’re literally taking a trial run at reconciling all of the transactions, and you haven’t yet made corrections, or “adjusted” the entries to harmonize inflows and outflows.

Step 5. Analyze worksheet

In this step, accountants prepare a worksheet to analyze the unadjusted trial balance and determine necessary adjustments. This involves lining up all of a company’s debits and credits in a single spreadsheet and reviewing each transaction individually for accuracy and completeness, making sure that revenues and expenses are recognized in the correct period according to accrual accounting principles. It’s a painstaking process, but specialized software can sometimes help by generating the spreadsheet or flagging anomalies in your financial data for further investigation. 

Adjustments may include accruals, deferrals, depreciation, and corrections of errors. Accurately analyzing worksheets is an essential part of preparing reliable financial statements.

Example: Morgan begins by listing all accounts from the unadjusted trial balance in a two-column spreadsheet. One column lists credits, and the other lists debits. Because credits outweigh debits, Morgan focuses on over-recorded credits or potentially missing debit entries. After reviewing the data, Morgan realizes that the unadjusted trial balance doesn’t reflect prepaid insurance expenses from the previous month.

Step 6. Make adjusting entries

Once you’ve located the source of any discrepancies, you’ll prepare new entries to the general ledger to reflect changes to previously recorded entries. 

Adjusting entries are made to update the accounts for revenues earned and expenses incurred that have not yet been recorded, as well as to add necessary context to debits or credits that may occur in one period but have long-term effects that impact reporting in later cycles. This includes adjustments for accruals, deferrals, depreciation, and other allocations. Adjusting journal entries ensure that the financial statements reflect the company's true financial position under the accrual accounting method.

Example: To adjust the journal entry, Morgan calculates the portion of prepaid expenses used during the previous month. Acme initially recorded $1,200 in prepaid insurance for the entire year, meaning the company should record a $100 monthly expense. Morgan records a debit of $100 in the Insurance Expenses entry and a credit of $100 in Prepaid Insurance to accurately reflect Acme’s financial position.

You can also use adjusting journal entries to record any manual entries or capture accruals and deferrals from the period that weren’t captured before journal entries were posted to the general ledger.

Step 7. Prepare financial statements

After making adjusting entries, an adjusted trial balance is prepared. If your general ledger shows an equal balance of debits and credits after you record adjusting entries, it’s time to move on to accounts preparation.

The adjusted trial balance is then used to generate financial statements, including the income statement, balance sheet, and cash flow statement. These statements provide insights into the company's financial performance and position.

Example: After entering the adjustments, Morgan prepares an adjusted trial balance that includes the prepaid insurance debits and credits. The adjusted trial balance now shows matching total balances of debits and credits, which means Morgan can begin preparing financial statements. They start with the income statement, which includes the $100 Insurance Expense, followed by the balance sheet, which lists the $1,200 in PrePaid Insurance as an asset. 

Step 8. Close accounts

The final step in the accounting cycle? Closing the books. Start by transferring temporary accounts, like revenue and expense accounts, to permanent accounts, like retained earnings, so you start fresh with a zero balance for the next accounting period. Next, you can run a post-closing trial balance to double-check that only permanent accounts like assets, liabilities, and equity carry over. Finally, record a closing entry in the general ledger. Closing the books finalizes the accounting cycle and prepares the company for the next period.

Example: To prepare for the next accounting cycle, Morgan transfers Acme’s temporary accounts to retained earnings and records them as equity in the balance sheet. They also run a post-closing trial balance to confirm that the temporary accounts now reflect a zero balance and that only permanent accounts remain. 

If your business follows a longer accounting cycle and only closes its books once a year or once a quarter, it can help to prepare a checklist of the important steps to follow and documents to collect. Especially for larger organizations dealing with extensive payroll obligations or large quantities of inventory, consolidating the information you’ll need to close the company accounts takes time, and a checklist can eliminate last-minute scrambling for key documents.

Accounting cycle timing

The accounting cycle is typically completed on a monthly, quarterly, or annual basis, depending on each company’s business needs and reporting requirements. Factors influencing the timing include company size, industry standards, and regulatory obligations. 

Depending on its operational needs or reporting requirements, your business can experiment with monthly, quarterly, or annual accounting cycles to see what works best, or simply choose an accounting cycle timing that fits your needs.

A small business that transacts with a limited number of repeat customers might report quarterly, while a larger company that records numerous transactions and needs to keep a close eye on cash flow might complete cycles monthly. Larger organizations may complete the full cycle more frequently to provide timely financial data to stakeholders—or publicly traded companies typically follow an annual cycle to align with mandatory SEC and investor reporting deadlines. 

Company resources and infrastructure can also impact the timing of a business’s accounting cycle. Smaller organizations that don’t use specialized reporting software or rely on an outside bookkeeper might not have the budget or personnel to support monthly reports. On the other hand, a multinational company with a dedicated internal finance team and external accounting help can likely afford to report every month if the business needs frequent updates.

Simplify expense management with Rippling

A slipshod spend management system hamstrings finance teams’ ability to gauge cash flow and keep costs down. It can also stymie efforts to stay on top of the business’ overall financial health. Rippling consolidates all of your company’s finances—from payroll and benefits to corporate cards and expense management–giving you an up-to-date view of cash flow across your company and offering unprecedented control over spending patterns. Rippling expense management also gives you real-time visibility over purchasing patterns for simplified budgeting and forecasting. 

With Rippling you can: 

• Automatically route expenses and bills to the right approver every time. 
• Flag out-of-policy spending with hyper-custom policies, like by vendor or value, for further review. 
• Close the books faster with AI-powered transaction categorization and integration with your accounting systems.

Accounting cycle FAQs

What are the benefits of the accounting cycle?

The accounting cycle provides a structured approach to managing financial transactions, ensuring that all financial data is accurately recorded and reported. Benefits include:

• Improved accuracy and transparency in financial reporting
• Better budgeting and forecasting
• Enhanced compliance with accounting principles and tax regulations
• Streamlined bookkeeping processes
• Better financial reporting and analysis capabilities

What is the difference between the accounting process and the accounting cycle?

The accounting process refers to the overall procedures involved in recording, classifying, and summarizing financial transactions. The accounting cycle is a specific sequence of steps within the accounting process that ensures financial statements are accurate and complete for each accounting period. Essentially, the accounting cycle is a part of the broader accounting process.

What Is the difference between the accounting and budget cycles?

The accounting cycle focuses on recording and reporting historical financial data for a specific period, whereas the budget cycle involves planning and forecasting future financial activities. While the accounting cycle deals with actual transactions and prepares financial statements, the budget cycle sets financial goals and allocates resources for upcoming periods. Both cycles are essential for comprehensive financial management but serve different purposes.

How does double-entry accounting fit into the accounting cycle?

Double-entry accounting is the foundation of modern bookkeeping and is integral to the accounting cycle. It requires that every financial transaction affects at least two accounts, with debits equaling credits. This system ensures the accounting equation (Assets = Liabilities + Equity) remains balanced. By recording transactions using double-entry bookkeeping, companies can maintain accurate general ledgers and produce reliable financial statements.

What is the role of adjusting entries in accrual accounting?

Adjusting entries are crucial in accrual accounting as they ensure that revenues and expenses are recognized in the period in which they occur, regardless of when cash is exchanged. These entries adjust the account balances for items like accrued expenses, accrued revenues, prepaid expenses, and depreciation. By making adjusting journal entries, companies can produce accurate adjusted trial balances and financial statements that reflect their true financial position.

Why is the general ledger important in the accounting cycle?

The general ledger is a central component of the accounting system, containing all the accounts used to record financial transactions. It provides a complete record of all financial activities, showing the account balances for assets, liabilities, equity, revenues, and expenses. By maintaining an up-to-date general ledger, companies can prepare accurate trial balances, adjust entries as needed, and generate financial statements. The general ledger ensures that debits and credits are properly accounted for, making it essential for accurate bookkeeping.

This blog is based on information available to Rippling as of December 3, 2024.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.