The 8 Step Accounting Cycle – A Definitive Guide

The accounting cycle provides the necessary information for your business to function

The accounting cycle is the summary of bookkeeping duties that transform raw financial transactions into proper financial statements. It is marked by eight processes that a bookkeeper goes through to make sure every transaction is documented. The goal of the accounting cycle is to create a balance sheet, among other financial statements, that provide a summary of a business’s financial situation at a given time.

In addition, recording financial transactions allow a bookkeeper to illustrate a companies financial situation accurately. Without an organized, documented sheet of transactions, or worse yet, erroneous or missing information, your company may be sailing into uncharted waters.

Every business will have differing needs, and thus may have account cycles with more or fewer steps. One crucial factor determining this alteration is if they want the bookkeeper to do single-entry accounting or double-entry accounting.

What is the Difference Between Single-Entry Accounting and Double-Entry Accounting?

While single-entry and double-entry accounting are separate ways of recording transactions, double-entry is the industry standard.

Single-entry accounting records transactions in a journal, but does not specify credit or debit in other accounts. Double-Entry accounting requires documenting transactions in both debit and credit accounts.

What is Single-Entry Accounting?

An example of a journal that bookkeepers use in the accounting cycle

Single-entry accounting records inward and outward cash flow in a journal. This journal records income, expenses, and transaction details to calculate the remaining balance at the end of a period. Specific information recorded in a single entry book would be the following.

Date

The date that the transaction is processed.

Description of transaction

Context brings information with it, which is why journal entries include descriptions of transactions. Descriptions of transaction document the details involving the product or service sold, time of purchase and product type.

Transaction Value

Transaction value refers to the monetary value exchanged. The amount of money processed.

Balance

Balance is how much money you have after a transaction. Depending on if the transaction is income or an expense, the balance may increase or decrease.

A financial statement is created at the end of the period. It details all of the transactions for a given period, which leads to the final balance. With this, you see exactly where the money goes, and how well your business is doing. Typically, automated software and mercantile technology like cash registers and debit machines record single-entry information.

Tools For Recording Information

Originally, transaction information was recorded on paper in a book called a ledger or journal. This was done by hand, and by memory. However, we are no longer in the 1800s, and technology has made simple bookkeeping tasks like recording transaction formation easier through automation.

Most companies now record transactional data through the use of debit machines and cash registers, which also provide source documents. Additionally, there are automated tools like Sage and Quickbooks that bookkeepers use extensively.

Programs like Sage and Quickbooks are tools that make data entry much easier, while also running calculations in the background. As such, bookkeepers use these in order to maintain perfect results. In bookkeeping, any errors can mean drastic consequences, which is why any help is necessary.

Accounting Cycle Key Terms

There are some key terms used to describe facets and processes of the accounting cycle that need to be defined. The following all apply to bookkeeping in general, but also apply to the accounting cycle in particular.

Account

An account refers to a record in the general ledger representing the transactions occurring in a specific area of the business. An easy example would be the cash account, which records every transaction that impacts the total amount of money a business has.

Debit

Debits are recorded on the lefthand side of a t-chart in bookkeeping. This facet records debit transactions. The debit is defined as anything that increases assets and expenses while decreasing liability, revenue, and equity. Typically, debit means an increase or gain of something.

Credit

Credit is on the right side of a t-chart and records transactions that increase liability, revenue, and equity, while decreasing assets and expenses. Credit does the opposite of a debit, in other words. A simple way of understanding credit is that it usually signifies loss, or owing to a third party.

Source Documents

Anytime a transaction is made which involves spending or receiving money, a paper is created. Some standard source documents include receipts, bills, invoices, statements, and cheques.

What is Double-entry Accounting?

The double-entry system records one transaction in two separate accounts. These two accounts are known as ‘credit’ and ‘debit’ individually, and both have to add up to the same amount. The principle that defines this principle is called the ‘accounting equation,’ used as an error-detection system. The formula dictates that an error occurs if the total credit account balance does not equal the debit account balance, and vice versa.

It is for this reason that this system is preferred since double-entry methods automatically balance the books.

What is the Accounting Equation?

‘Balancing the books’ is a term that comes from the accounting equation

Assets = Liability + Equity

The accounting formula has three truths to it, which are that;

Entries always affect two accounts
There are debit and credit accounts
The total debits and credits will always balance and be equal

What is an Asset?

An asset in the accounting equation represents the total of what a business owns. Types of Assets are,

Cash
Accounts Receivable
Inventory
Equipment
Property and Land
Investments

All of these represent what the business owns.

What are Equity and Liability?

Equity and liability combine to make up‘what the business owes to third parties, shareholders, and the business owner. Specifically, liabilities refer to money owed to third parties, while equity is money owed to the shareholders and the business owner respectively. Types of Equity include,

Stockholder share
Owner’s Equity
Retained Earnings

Likewise, types of liabilities are,

Accounts payable
Loans Payable
Wages Payable
Taxes Payable

Another way of describing equity would be the amount of money left after selling a business’s assets and returning shareholder money. All of this data is recorded and imputed to help create the balance sheet, which objectively shows how well the company is running.

Double-entry example: You buy an orange for 5 $. The company now has a 5 $ asset of 1 (orange), which also reflects as 5$ in equity. Both sides of the equation are equal to 5 $, which means it is balanced, and nothing is wrong.

Benefits of Double-Entry

Provides a much more accurate view of the business

Double-entry bookkeeping tracks both credit and debit accounts, which provide a detailed image of how the business is functioning.

Single-entry bookkeeping only reveals a transaction in one account. Still, it does not account for the fact that one transaction can affect multiple parts of a business. More prominent corporations and banks exclusively use this system for this reason. It allows them to track every expense and source of income back to its source.

Using a similar allegory from before, a bookkeeper is like a cartographer, and the financial statement is like the map.

Error Detection

One key benefit of recording both credit and debit for each transaction is that the ledger remains ‘balanced’ at all times since the equation states that ‘Assets = Liabilities + Equity’ both debit and credit accounts are required add up to the same amount.

Consequently, if one of these accounts does not add up to the same amount, then there is an error somewhere in the calculations. Double-entry accounting thus serves as an error detection screen that makes sure everything is accounted for.

Preserves Audit Trail

Since every transaction in double-entry bookkeeping is entered in credit and debit accounts, these transactions have the same date and code. Thus, even in the event of an error, there is a traceable trail that has been documented. This is called an audit trail and allows for every transaction to be traced back to its source.

The Eight Step Accounting Cycle

The accounting cycle is critical because it measures the financial health of a business

There are eight steps to the accounting cycle, each of which performs a function that culminates as a financial statement.

Identifying Transactions

The first step of the accounting process involves identifying transactions. Bookkeeping as practice documents and records where transactions come from. Logically then, the data that is being recorded needs to be located and marked before any further steps can be taken.

The job of the bookkeeper is first to track all transactions within a given period. This data is recorded in the form of source documents, which are receipts and invoices.

Record Transactions

The second part of the accounting process involves bookkeeper recording data in a journal entry. A journal entry includes the date of transaction, the accounts affected, and a matching debit and credit amount in double-entry bookkeeping.

Posting

Posting occurs after journal entries have been made, where the same information is transferred to a general ledger. The general ledger records all transactions as separate accounts. Essentially, the general ledger summarizes the financial state of a particular account, detailing where the money is coming from, and where it is going.

Unadjusted Trial Balances

After the general ledger is posted, an unadjusted trial balance is produced at the end of a period. A trial balance shows the untested balances for each separate account. This step is further tested in future actions to confirm whether the amounts stated or indeed correct.

Worksheet

In this step of the process, a worksheet is created to determine whether the accounts balance properly. Remember, the accounting equations states that both credit and debit account balances must be equal. If there is a difference in final adjusted balances, then there is something wrong.

Adjust Journal Entries

Adjustments may need to be made based on accruals, which are revenues or expenses that occurred after the initial recordings have been made.

Financial Statements

When the trial balances are checked, and any new revenues or expenses are accounted for, the updated data can then be turned into financial statements. There are three main types of financial statements businesses use: the balance sheet, income statement, and cash flow statement.

Types of Financial Statements

Balance Sheet

The balance sheet represents the same information that the accounting formula does. In other words, it displays what the company owes and what it owns. It provides a quick summary of the financial situation of a company at a given period.

Income Statement

An income statement measures profit over a specified period. Income statements display revenue minus expenses and losses.

Cash Flow Statement

Cashflow statements record the cash inflows that a company receives from its operations and other sources of income. This statement measures the overall value of the company through operations, investment, and financing.

Closing the Books

Closing the books finalizes and stops the recording of information for a specified period. Accruals can occur in previous steps, which upset the balance of the last sheets, confusing the process. That is why closing the books stops recording information at a designated time. The data for a particular period remains accurate.