Our goal with this post is to provide you with an understanding of the 7 steps of the accounting cycle.
Understanding the accounting cycle is crucial for effective financial management and business decision-making.
What is the Accounting Cycle
The accounting cycle is a well-established process consisting of 7 essential steps.
Its purpose is to meticulously track, record, and analyse all financial activities and transactions that occur within a business.
The transaction initiates the process, which concludes with issuing financial statements and closing books.
It provides businesses with a structured framework for managing their financial records effectively.
Step 1 – Analysing and Recording Transactions
Step 2 – Posting Journal Entries to General Journal
Step 3 – Post transactions to general ledger
Step 4 – Unadjusted Trial Balance
Step 5 – Making Adjusting Entries
Step 6 – Generating Financial Statements
Step 7 – Closing books
Step 1: Analysing and Recording Transactions
Ensuring accurate recording of each transaction in the company’s books is essential as companies have numerous transactions throughout the cycle.
Companies must record expenses, sales revenue, debt payments, and customer cash.
Companies need clear guidelines and procedures for recording transactions to keep accurate transaction records. This includes proper categorisation and documentation and checks and balances to catch errors.
Process of accounting with examples:
Throughout this post, we will use an example for each stage of the accounting cycle using the fictional company “Artisan Clay”:
Step 1: Let’s consider a small boutique pottery store called “Artisan Clay.” Imagine that Artisan Clay makes a sale of 10 ceramic mugs for £20 each on August 5, 2023.
Step 2: Posting Journal Entries to General Journal
The second stage of the accounting cycle involves the process of journalising transactions.
This step involves recording all financial activities. Whether in a physical ledger or an accounting software program.
The double-entry bookkeeping system records transactions. This system involves recording each transaction as a debit and a corresponding credit in two or more sub-ledger accounts.
Example
Step 2: Artisan Clay record in the Sales Journal:
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- Date: August 5, 2023
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- Account: Accounts Receivable (Customer)
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- Debit: £200
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- Account: Sales Revenue
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- Credit: £200
Step 3: Post transactions from the journal to the general ledger
The recorded journal financials now transfer to the ledger.
The general ledger displays the company’s accounts and changes resulting from business transactions.
Automated accounting systems have made it more convenient and easier to keep track of financial records. This has resulted in a decreased use of traditional general ledger accounts.
Example
Step 3: Artisan Clay record In the General Ledger:
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- Accounts Receivable Account (Customer):
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- Debit: £200
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- Sales Revenue Account:
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- Credit: £200
Step 4: Preparing an Unadjusted Trial Balance
Once all transactions have been identified, a trial balance is calculated.
It is called an ‘unadjusted’ balance as, during this stage, the trial balance has not yet reflected any needed adjustments. (Such as unbalanced debits and credits).
The unadjusted trial balance catches a lot of mistakes, ensuring that the total credit and debit balances are equal.
This balance is then carried forward for testing and analysis.
Correctly preparing an unadjusted trial balance helps you catch any discrepancies early. This allows you to make necessary adjustments before finalising financial statements.
This step is crucial in maintaining accurate records and ensuring financial integrity within an organisation’s accounting system.
Example
Step 4: Before adjustments
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- Accounts Receivable: £200
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- Sales Revenue: £200
Step 5: Preparing an Adjusted Trial Balance
During this stage, accountants will make adjustments to the trial balance if any errors are found. The goal is to ensure that the debits and credits are equal in the new trial balance.
You will use a worksheet to identify any discrepancies and make adjustments.
Example
Step 5: Artisan Clay realises they still have £50 worth of raw materials left at the end of the month. They adjust:
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- Date: August 31, 2023
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- Account: Inventory (Raw Materials)
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- Debit: £50
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- Account: Raw Materials Expense
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- Credit: £50
Step 6: Generating Financial Statements
Financial statements can be created once all the account balances are adjusted and corrected.
Financial statements are crucial accounting reports summarising a company’s activities and performance over a specific period. They are usually prepared on a monthly or quarterly basis to offer an accurate overview of the company’s financial state
These statements provide a snapshot of a company’s financial health and performance.
These are:
- Income statement
- Balance sheet
- Cash flow statement
- Posting closing entries
Example
Step 6: Artisan Clay uses the adjusted trial balance to prepare financial statements:
Income Statement:
Sales Revenue: £200
Raw Materials Expense: £50
Net Income: £150
Balance Sheet:
Assets:
Accounts Receivable: £200
Inventory: £50
Liabilities: £0 (Assuming no liabilities)
Equity: £250 (Starting equity + Net Income)
Step 7: Closing the Books for the Period
The books get closed at the end of the accounting cycle.
After making all the needed changes and reviewing them, it is important to transfer the balances of temporary accounts.
This process ensures that these accounts start fresh at zero balance for the new accounting period.
Closing the books this way is crucial for maintaining accurate financial records.
Example
Step 7: Artisan Clay closes the temporary accounts (revenue and expense accounts) and prepares the final financial statements:
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- Income Summary Account:
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- Debit: £200 (Transfer sales revenue)
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- Credit: £50 (Transfer raw materials expense)
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- Debit Balance: £150 (Net income)
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- Retained Earnings Account:
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- Debit: £150 (Transfer net income)
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- Credit: £0
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- Close Revenue and Expense Accounts:
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- Close Sales Revenue: £200
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- Close Raw Materials Expense: £50
Final Balance Sheet:
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- Assets:
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- Accounts Receivable: £200
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- Inventory: £50
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- Liabilities: £0
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- Equity: £400 (Starting equity + Net Income)
This example demonstrates how “Artisan Clay” goes through each stage of the accounting cycle. From analysing transactions to closing the books and preparing final financial statements.
Automating the Accounting Cycle Using Accounting Software
What is the impact of automation in accounting?
Automation software can have many benefits, such as saving time, preventing mistakes, and quickly accessing essential documents. Additionally, it can improve cash flow and visibility, increase efficiency during month-end closing, and enhance data accuracy.
What is automation in the accounting cycle?
Here’s how automation is applied to each stage:
1. Identify and Analyse Transactions
Automated systems can categorise and classify transactions based on predefined rules, reducing manual sorting.
2. Record Transactions in Journals
Accounting software captures transaction details and automatically records them in relevant journals.
3. Post Transactions to General Ledger
Software automatically transfers data from journals to the general ledger, ensuring accurate account balances.
4. Prepare Unadjusted Trial Balance
Automation compiles account balances from the general ledger, efficiently generating an unadjusted trial balance.
5. Make Adjusting Entries
Accounting software can suggest or apply adjusting entries based on predefined criteria, reducing manual calculations.
6. Prepare Adjusted Trial Balance
Automation updates account balances after adjusting entries, quickly producing an adjusted trial balance.
7. Generate Financial Statements
Automated software uses updated trial balance data to generate income statements, balance sheets, and cash flow statements.
8. Close Books and Prepare Closing Entries
Automated systems can handle closing entries transferring temporary account balances to retained earnings.
9. Post-Closing Trial Balance
Automation compiles post-closing balances for use in the next accounting period.
For more information on how accountants can use automated accounting software, check out a past post of ours here:
Conclusion- 7 steps of the accounting cycle
Understanding the 7 steps of the accounting cycle is vital for managing finances, making strategic decisions, and achieving business success.
To delve deeper into this topic and explore practical solutions, visit our accountancy page.
Find helpful resources, case studies, and expert insights that can assist you in achieving your goals of improving your business processes.
