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1.03 – Understanding The Accounting Cycle
Bookkeepers work through a series of tasks known as the accounting cycle. It’s called a cycle because the process is continuous: entering transactions, processing them through the accounting system, closing the books at the end of the period, and then starting over for the next period.
The Accounting Cycle: An Overview
The accounting cycle consists of eight fundamental steps:
- Transactions: Financial transactions initiate the process. These can include sales, returns, purchases of supplies, debt settlements, or deposits and payouts to the company’s owners. All sales and expenses must be recorded.
- Journal Entries: Each transaction is recorded in the appropriate journal in chronological order. The journal, also known as the book of original entry, is the first place a transaction is listed.
- Posting: Transactions are posted to the affected accounts in the General Ledger, which summarizes all the business’s accounts.
- Trial Balance: At the end of the accounting period (monthly, quarterly, or yearly), a trial balance is calculated to ensure that total debits equal total credits.
- Worksheet: Often, the initial trial balance reveals discrepancies. Errors are identified and corrected through adjustments, which are tracked on a worksheet. Adjustments may also account for asset depreciation and allocate one-time payments (like insurance) across relevant periods. After adjustments, a new trial balance ensures the accounts are balanced.
- Adjusting Journal Entries: Once the trial balance is correct, any necessary corrections are posted to the affected accounts. Adjustments are only made after identifying all needed corrections.
- Financial Statements: With the corrected account balances, the balance sheet and income statement are prepared.
- Closing: The books are closed for revenue and expense accounts, resetting their balances to zero for the new accounting period. Asset, Liability, and Equity accounts carry over their balances since these accounts reflect ongoing financial status.
Why Zero Balances Matter
For effective financial tracking, revenue and expense accounts must start each period with zero balances. This allows for clear month-to-month, quarter-to-quarter, and year-to-year profit or loss assessments. In contrast, asset, liability, and equity accounts carry over balances from one cycle to the next, reflecting the business’s ongoing financial position.
