The Accounting Cycle; An Ultimate Guide

Introduction

When we talk about accounting cycle, we normally refer the 10 steps process in accounting from the analyzing, then record those transactions until the preparation of Financial Statements and reversing entry where necessary. In this article, we will go in detail about each of the 10 steps plus examples. So what are those steps in the accounting cycle?

So let’s start.

The Accounting Cycle, 10 Steps Process

The accounting cycle consists of 10 steps. We will list the accounting cycle steps in the proper order as below:

  1. Analyzing transactions and source documents
  2. Journalizing transaction (Journal Entries)
  3. Summary or post into General Ledger (GL)
  4. Prepare Unadjusted Trial Balance
  5. Journalizing adjustment entries
  6. Prepare Adjusted Trial Balance
  7. Prepare Financial Statements
  8. Closing entries
  9. Post-Closing Trial Balance
  10. Reversing entry

The above are the full cycle of accounting that each accountant should be aware of.

This can be summarized into the accounting flow chart as below:

Accounting Cycle, 10 Steps Process

In practice, step 3, 4, 6, 7 and 9 are often automatically generated by computerized accounting system.

Now you know the 10 steps of the accounting cycle. Below are the detail explanation as well as examples of each step.

So let’s dive in.

Step 1: Analyzing Transactions and Source Documents

The first step of the accounting cycle is to analyze business transactions and the relevant source documents. This is the starting point of accounting. Before we record any transactions, as an accountant or bookkeeper, they need to analyze those transactions first. This analyzing is done by looking at the source documents. They shall need to look at the nature of each transactions and how to record it.

Each accountant or bookkeeper shall understand the key principle of Debits (left hand side) and Credits (right hand side) when they analyze transactions. If they don’t understand the rule of Debits and Credits and incorporate in the analyzing process, they won’t be able to record transactions correctly. This rule is difference for assets, liabilities, equity, revenues and expenses.

Below are the rule of Debits and Credits that accountant or bookkeeper should know and apply in their analyzing transactions process.

Assets

For asset, its balance should be on Debit side. Thus, any increase shall be recorded on Debit side and if it decreases, we shall record it on Credit side.

Liabilities

For liability, its balance should be on Credit side. Therefore, any increase shall be recorded on Credit side and vice versa.

Owner Equity or Shareholder Equity

Equity has its balance on Credit side. Normally, the increase comes from additional investment or injection of capital. We shall record such increase on Credit. The decrease normally comes from the withdrawal from the owner; thus such decrease shall be recorded on Debit.

Revenues/Gains or Incomes

Revenues or incomes/gains have balance on Credit. Thus, any increase in revenue shall be recorded on credit side and vice versa.

Expenses/Losses

Expenses/losses have balance on debit. Therefore, any increase in expense shall be recorded on debit side and vice versa.

To be easy to memorize, let see the acronyms as below:

“D.E.A.L and G.I.R.L.S for the increase and decrease of each accounts.” according to AccountingCoach.

Increase on Debit is called (D.E.A.L). This come from the word below:

D. Drawing or withdrawal and Dividend

E. Expenses

A. Assets

L. Losses

In contrast, the increase on Credit is called (G.I.R.L.S). This come from the word below:

G. Gain

I. Income

R. Revenues

L. Liabilities

S. Stockholder’s Equity or owner Equity

Below is the summary in T-Account for such increase and decrease:

T-Account for Accounting Equation
T-Account for revenues and expenses

In short, Assets and Expenses/Losses increase on Debit while Liabilities, Equity and Revenues/Gains/Incomes increase on Credit.

Step 2: Journalizing Transactions (Journal Entries)

Journalizing transactions is the second step among the 10 steps of the accounting cycle. After analyzing transactions considering the source of documents and the rule of Debits and Credits. Accountant or Bookkeeper shall need to record those transactions in Journal. In the old fashion of accounting while paper work is used, accountant or bookkeeper shall maintain a Journal Book; a book where all transactions have been recorded.

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The template might be difference from one entity to another; however, the concept remains the same. The Journal should contains Journal number, account number, account name, the double entries of each transaction as well as the narrative or description of each transaction. Below is the simple sample Journal:

GENERAL JOURNAL
    Page 1
DateAccount Titles and ExplanationPRDebitCredit
     
1-Jan-19Cash      30,000 
       Capital       30,000
 (To record investment by owner)   
     
3-Jan-19Supplies        3,000 
      Cash         3,000
 (To purchase supplies for cash)   
5-Jan-19Office Equipment 5,500 
      Cash  5,500
  (To record purchase of office equipment)   
     

In a computerize accounting, or a modern accounting world, we no need to maintain such Journal Book. In each off- the-shelf software or advanced tailored application, the Journal has been built and the format is difference from one system to another.

Step 3: Posting to General Ledger

After each accountant or bookkeeper records transactions in the Journal, the next steps of the accounting cycle is summarizing them into General Ledger. Each account in the chart of account has its own separate ledger. General Ledger commonly has two forms, Balance Column Account and T-Account.

Below are the two for of General Ledger:

  • Balance Column Account:

In this form, General Ledger is a tabular. At the top, there are information on account name and account number and following by the next heading the date, explanation or narrative, PR, Debit, Credit and Balance. You can see the sample of Balance Column Account as follow:

General Ledger in the form of Balance Column Account
  • Ledger in the form of T-Account

The word T-Account is because the ledger derive from letter “T”. At the top left corner is Debit (Dr.) and the top right corner is Credit (Dr.). Then for the title of the account is at the middle following by account number.

T-Account Format

The T-Account form is very common for academic or illustration purpose as it is easy and convenience.

Balance Column Account is very common in the computerized system. There might be some additional features or a little bit difference in formatting in each computerized system; however, some basic information is the same as per the tabular above.

Step 4: Prepare Unadjusted Trial Balance

The fourth steps of the accounting cycle is preparing the Unadjusted Trial Balance. The Unadjusted Trial Balance consists of the summary of each account balance. Commonly, Trial Balance is presented in both side, Debit and Credit. At the end, the total Debit shall equal total Credit. If it does not balance, there should be some errors or problems. Thus, each accountant or bookkeepers shall investigate and correct it.

However, in some accounting software, the trial balance is shown only one column. The Debit and Credit side are presented in one column together. Assets and Expenses are presented as positive balance while liabilities, equity and revenues are presented as negative balance. Thus, the sum of all accounts together shall be zero.

Below is the basic illustration of Unadjusted Trial Balance for both one column and two column Unadjusted Trial Balance:

Two column Unadjusted Trial Balance:

Unadjusted Trial Balance in two columns format

One column Trial Balance:

Unadjusted Trial Balance for one column format

Step 5: Journalizing Adjustment Entries

Next step after preparing the Unadjusted Trial Balance is to journalize the adjustments. There are some prepaid expenses and accruals that we shall need to make adjustments at the end of the accounting period.

Therefore, the adjusted journal entries are prepared in order to recognize expenses and revenues that incurred or earned but have not been recognized in the accounting book.

For the detail of the adjustments, you can refer to previous articles on how to account for amortization of prepaid expenses and accounting for accrued expenses. These two articles cover all aspect of adjustments that we shall made for this step of the accounting cycle.

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For illustration purpose, let’s assume that the below expenses have not been adjusted yet by an accountant of ABC Co.

  • ABC Co has not recorded depreciation of office equipment of US$950 for December 20×9.
  • ABC Co has not recorded depreciation of computer equipment of US$1,425 for December 20×9.
  • Rent expense for December 20×9 has not been amortized. The amount for December 20×9 is US$5,000
  • Insurance expense for December 20×9 has also not been amortized. The amount for December 20×9 is US$1,250
  • ABC Co has not received utility bill as at 31 December 20×9. From past experience, the utility expense is approximately US$1,000 per month.

Thus, based on the above, information, ABC Co shall need to make the adjustment entries as follow:

 DebitCredit
 US$US$
Depreciation – Office Equipment950
Accumulated Depreciation – Office Equipment     950
Depreciation – Computer Equipment1,425 
Accumulated Depreciation – Computer Equipment 1,425
Rent Expense5,000 
Prepaid Rent 5,000
Insurance Expense1,250     5,700
Utility Expense1,000 
Accrued Expenses1,000
   

Step 6: Prepare Adjusted Trial Balance

After making or journalizing relevant adjustments, the next step is to prepare the Adjusted Trial Balance. In the Adjusted Trail Balance, all revenues and expenses have been accounted for fully. Thus it is time for an entity to prepare the Financial Statements. Below is the illustration of Adjusted Trial Balance continuing from step 4 above. Going further, we will use only two column Trial Balance for illustration purpose.

Adjusted Trial Balance

Step 7: Prepare Financial Statements

Once a trial balance has been prepared, the next step of the accounting cycle involves the preparation of financial statements. In this step, we are able to prepare all the main four types of financial statements. These are Income Statement or Profit and Loss Statement, Balance Sheet or Statement of Financial Position, Statement of Changes in Equity and Statement of Cash Flow. In practice, there are also disclosure notes to support the figures in the Financial Statements as well as the significant accounting policies and procedures which play a vital role in preparing the Financial Statements.

For illustration purpose, we will show only Income Statement and Balance Sheet. For other statements such as Statement of Changes in Equity, and Statement of Cash Flow, please refer to another article on Type of Financial Statements. In that article, there are more detail about the preparation of Financial Statements.

After ABC Co has prepared its Adjusted Trial Balance, it is time to prepare the Financial Statements. Below are the preparation of both Income Statement and Balance Sheet.

Here is the profit or loss statement for income statement for ABC Co after all adjustments have been made.

Income Statement

Below is the Balance Sheet or Statement of Financial Position after all adjusting entries have been made.

Balance Sheet

Step 8: Closing Entries

In practice, we can perform the closing process on the monthly basis or on annual basis depends on the preference of each entity. Some companies, they prefer to perform the closing on the annual basis which is at the end of the accounting period.

In this step, it involves the transfer of all temporary accounts to retained earnings. In accounting, there are two types of account; Permanent Account and Temporary Account. Permanent accounts refer to all of the assets, liabilities as well as share capital or share premium. All these accounts usually are shown in the Balance Sheet.

In contrast, temporary accounts are those accounts mostly found in the Income Statements except the dividend or withdrawal account.

In the closing process, we shall need to close or transfer all temporary accounts to retained earnings. Before transferring to retained earnings, we commonly use income summary account as a temporary account for the closing process for all revenues and expenses accounts. In order to illustrate this closing process, let’s take the extract of all Profit and Loss accounts plus retained earnings and withdrawal of ABC Co as follow:

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 DebitCredit
 US$US$
Retained Earnings          114,000
Repair Service Revenues         222,800
Interest Revenue              7,500
Depreciation – Office Equipment         13,300 
Depreciation – Computer Equipment         19,950 
Salary and Wage Expenses         75,000 
Rent Expense        55,000 
Insurance Expense         15,000 
Utility expense         12,000 
Other operating expenses         15,000 
Interest Expense           5,700 
Income tax expense           5,000 

The closing process involves four steps as follow:

  • Step 1: Closing all revenue accounts:

This involves transferring all revenue accounts to income summary account. Commonly all revenue accounts have balance at Credit. Thus to close all revenue accounts, we need to record them on Debit as follow:

 DebitCredit
 US$US$
Repair Service Revenues222,800
Interest Revenue7,500   
Income Summary230,300
  • Step 2: Closing all expense accounts:

In this step, it involves the transferring all expenses accounts to income summary account. As all expense accounts have balance on Debit; thus to close all these accounts, we need to record them on Credit as follow:

 DebitCredit
 US$US$
Income Summary215,950
Depreciation – Office Equipment   13,300
Depreciation – Computer Equipment   19,950
Salary and Wage Expenses   75,000
Rent Expense    55,000
Insurance Expense     15,000
Utility expense    12,000
Other operating expenses     15,000
Interest Expense5,700
Income tax expense 5,000
  • Step 3: Closing income summary account:

In this step, we would need to transfer the Income Summary account to retained earnings. The Debit or Credit of Income Summary account depends the difference between step 1 and step 2 above. If the balance of such account in step 1 is higher than that in step 2, that means the net balance would be on Credit. Thus to close this, we shall need to record on Debit and vice versa.

In the case of ABC Co above, the sum of step 1 is greater than step 2; thus the closing entries in the step would be as follow:

 DebitCredit
 US$US$
Income Summary (230,300 – 215,950)14,350
Retained Earnings14,350
  • Step 4: Closing dividend or withdrawal (If an entity is sole proprietorship or partnership):

In the final step of closing process, we shall need to transfer all balance of dividend or withdrawal account to retained earnings. The dividend or withdrawal has its balance on Debit; thus to close this account, we need to record on Credit and other correspondent entry to retained earnings.

In the case of ABC Co above, there is no dividend nor withdrawal. Therefore, the amount will be zero. However, for illustration purpose, please see the entry with nil balance as follow:

 DebitCredit
 US$US$
Retained EarningsNil
Dividend/WithdrawalNil

After we perform all these four steps process of closing, all balance of revenues, expenses as well as dividend or withdrawal would be zero and those balances are transferred to retained earnings account.

Step 9: Post-Closing Trial Balance

In this step, it involves the preparation of trial balance that contains only permanent accounts. This is because all temporary accounts have been closed to zero in step 8 above.

Thus, after the closing process, the Post-Closing Trial Balance of ABC Co would be as follow:

Post-Closing Trial Balance

As you can see, the Post-Closing Trial Balance consists of only permanent accounts in the Balance Sheet. All temporary accounts have been transferred to retained earnings after the closing process.

Step 10: Reversing Entries

This is an exceptional step and also the last step of the accounting cycle. In some case, it requires to have a reversal entries. For example, when an entity record any accruals but such entity has not received nor issued invoices. Thus, such entity shall need to reversal that entry at the beginning of the following period and then record actual invoices instead.

In some computerized accounting systems, there is an option where each accountant or bookkeeper is able to choose or tick so that such entry will be automatically reversed in the following period. This would help a lot in practice to avoid so many manual work. This would ensure that there is no chance of missing such reversal.

For example, ABC Co has recorded accrued utility expense at the end of 31 December 20×9. ABC Co has not received the utility bill yet as of 31 December 20×9. From past experience, ABC Co normally incur the utility expense of US$1,000 per month. However, on 5 January 202x, ABC Co receive the utility bill with the actual amount of US$1,200.

Thus, in the adjustment process in step 5 above, ABC Co shall need to record the accruals at the end of 31 March 20×9 as follow:

 DebitCredit
 US$US$
Utility expense1,000
Accrued expense1,000

If there is option to choose auto reverse in the accounting system of ABC Co, this entries would be reversed automatically in early January 202x. However, if not, each accountant shall need to reverse manually and then record the actual utility bill. The entries would be as follow:

 DebitCredit
 US$US$
Accrued expense1,000
Utility expense1,000

Then the new entries would be as follow to record the actual bill:

 DebitCredit
 US$US$
Utility expense1,200
Cash or Account Payable1,200

Thus, in January 202x, the additional utility expense is $200 as result of under accruals in December 20×9.

Conclusion

Accounting cycle consists of the 10 important steps that are very important in order to manage and present financial information. As an accountant and bookkeeper, they shall need to understand clearly about these steps process.

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