Process of Accounting Transactions

The accounting cycle is an essential, standardized process that follows eight steps to track, record, and analyze all financial activity within a business. It begins when a financial transaction occurs and ends with the issuance of financial statements and the closing of the books for a given accounting period.

How the Accounting Cycle Works

The accounting cycle is primarily managed by the accounts receivable or accounts payable team, full-cycle bookkeepers, or accountants. These individuals are responsible for recording financial transactions, closing the books at the end of each accounting period, and preparing financial statements. They must also adhere to internal controls and separation of duties to ensure accuracy, accountability, and transparency.

8 Steps of the Accounting Cycle

The accounting cycle follows a structured, eight-step process that ensures that all financial activities are properly recorded and reported. These steps are:

1. Identifying and Recording Transactions

The first step in the accounting cycle involves identifying and recording financial transactions as they occur. Every transaction—whether it's a sale, purchase, expense, or other financial activity—must be documented in detail, including the date, amount, and nature of the transaction.

2. Preparing Journal Entries

Once transactions are identified, they are recorded in journal entries. Each transaction is entered into the journal in chronological order, and it includes both the debit and credit entries that reflect how the transaction affects the company's financial accounts.

3. Posting to the General Ledger

After journal entries are prepared, they are posted to the general ledger. The general ledger is the master record that tracks all the company’s financial accounts, such as assets, liabilities, equity, income, and expenses. Each account in the ledger reflects the cumulative activity from the journal entries.

4. Generating an Unadjusted Trial Balance Report

At the end of the accounting period, an unadjusted trial balance is generated. This report lists all general ledger accounts and their balances to ensure that total debits equal total credits. It serves as a preliminary check before any adjustments are made.

5. Preparing Worksheets

After the unadjusted trial balance is prepared, worksheets may be created to organize and review the data. Worksheets help accountants adjust balances, correct any errors, and ensure that financial information is accurate before proceeding to the next steps.

6. Preparing Adjusting Entries

Adjusting entries are made to account for accrued expenses, deferred revenues, and other adjustments that ensure financial records are accurate for the reporting period. This step ensures that income and expenses are recorded in the proper period, according to the accrual basis of accounting.

7. Generating Financial Statements

After all adjusting entries are completed, financial statements are prepared. These include the income statement, balance sheet, statement of cash flows, and statement of shareholders' equity. These statements provide a comprehensive summary of the company’s financial performance and position for the accounting period.

8. Closing the Books

The final step is closing the books. This process involves closing temporary accounts (such as revenues and expenses) and transferring their balances to permanent accounts (such as retained earnings). Once the books are closed, the accounting cycle starts over for the next period.

Why Is the Accounting Cycle Important?

The accounting cycle is critical for businesses and organizations as it helps ensure that all transactions are accurately recorded and financial statements are properly prepared. By following a standardized process, businesses—whether small or large—can efficiently manage their financial activities and close their books at the end of each period.

Here are some reasons why the accounting cycle is important:

Consistent Financial Reporting: The accounting cycle ensures that businesses follow a consistent method for recording and reporting financial transactions, making it easier to generate accurate and timely financial statements.
Financial Statement Analysis: The financial information generated through the accounting cycle allows for in-depth financial analysis, which helps business owners, managers, and other stakeholders assess the company’s performance and make informed decisions.
Accountability and Process Management: The accounting department often uses a detailed checklist that outlines tasks to be completed during each accounting cycle. Assigning responsibilities, setting deadlines, and documenting completion improves accountability and ensures that the process is managed effectively.
Audits and Reviews: CPA firms can review or audit the financial statements, examining the underlying transactions and records to verify the accuracy of account balances. This helps ensure the reliability of the company’s financial data.
Stakeholder Analysis: Stakeholders, including management, the Board of Directors, lenders, shareholders, and creditors, can analyze the financial results for the accounting cycle period to make decisions about the future of the business.

In summary, the accounting cycle provides a structured framework for managing financial transactions, preparing accurate financial statements, and ensuring that businesses comply with legal and regulatory requirements.