When a customer makes a purchase or your business pays a bill, the transaction is processed during the accounting cycle. “Accounting cycle” means the step by step procedure of recording and processing accounting information. Each accounting cycle lasts for one time period, typically a month, quarter or year.
Initial Steps: Recording and Posting
The accounting cycle begins when the account gathers documents like receipts and invoices. She then analyzes and classifies them. Transactions are recorded as journal entries. Suppose daily sales include cash transactions of $500 plus credit extended to customers for another $1,200. The journal entry would look something like this:
- Date Account Debit Credit
- May 1 Cash $500
- Accounts Receivable $1,200
- Sales receipts $1,700
Each journal entry is posted to a ledger. This may be a general ledger. In this example, the day's sales are posted to the sales ledger. The preceding steps -- analyzing, recording and posting accounting events -- take place throughout the accounting period.
Unadjusted Trial Balance
At the end of the accounting period, an account draws up an unadjusted trial balance. The debit balances in ledgers are added up. Likewise, the credit balances are summed. For example, the credit entries posted in the sales ledger are added up. The sum is then added to credit totals from other ledgers. The debit and credit figures should match. If they don't, it shows there is an error. Accountants also check ledgers for mistakes that don't cause an imbalance in the debit and credit totals
Adjusted Trial Balance
The next step in the accounting cycle is producing an adjusted trial balance. Some entries are made only at the end of the accounting period. Usually this is necessary to make sure amounts are debited or credited in the correct accounting period. Suppose a store hires a delivery company to handle increased volume during the Christmas season. The delivery firm agrees to bill the business after the current accounting period ends on December 31. An adjusting entry is made so the expense incurred is recorded during the current accounting period. After such adjustments are made, the account draws up the adjusted trial balance.
Preparing Financial Statements
Accountants prepare a set of financial statements for each accounting period. Once the adjusted trial balance is finished, accountants use the information to prepare a balance sheet, income statement and statement of shareholders' or owners' equity. For instance, suppose total sales for May come to $51,000. This amount is entered on the income statement under Revenues.
Winding Down the Accounting Cycle
After financial statements are prepared, three final steps in the accounting cycle are carried out:
- Closing out accounts. Some accounts, such as sales or revenues and expenses, are temporary. This means the balances are transferred to permanent accounts like retained earnings or owners' equity. The result is that temporary accounts end with a zero balance, ready for the next accounting cycle.
- Preparing a post-closing trial balance. This final trial balance serves as a last check to insure accuracy.
- Reversing entries. Some firms find it useful to add one last step to the accounting cycle. When an adjusted trial balance is prepared, entries are made such as adjustments for services received that won't be paid for during the current accounting period. To avoid a duplicate entry when payment is eventually made, the account can reverse the adjustment made earlier.