Accounting Cycle

Flow of Accounting Information

Accounting Cycle

The events of each accounting period are recorded in a company's books and presented in the financial statements using the same process from period to period.

The accounting cycle, a step-by-step continuous process of accounting activities that keeps accounting records in order, begins with analyzing transactions and making journal entries. The accounting cycle then moves on to the steps of preparing the unadjusted trial balance and adjusting journal entries. The next step is to prepare the adjusted trial balance, which is an additional trial balance prepared by adding the adjusting journal entries to the unadjusted trial balance.

After the adjustments have been posted, the adjusted trial balance forms the foundation for creating the four major financial statements: income statement, statement of owner's equity, balance sheet, and statement of cash flows. The accounting cycle also serves other purposes beyond the production of those financial statements. The accounting cycle also helps management track inventory and manage costs in a timely manner. Finally, the accounting cycle is completed by posting closing entries and preparing the post-closing trial balance. The cycle then begins again with a new period.

An organization or business can maintain better controls over the consistency and accuracy of the accounting process by using the same operating conventions. Examples of such conventions include repeating the same steps in the accounting cycle, using similar account titles, and/or preparing similar financial statements—income statement, statement of owner's equity, balance sheet, and statement of cash flows.

The Accounting Cycle

Step-by-step accounting procedures are represented in the accounting cycle: analyzing transactions; journalizing entries; posting to ledger accounts; preparing unadjusted trial balance, adjusting entries, adjusted trial balance, and financial statements; closing accounts; and preparing post-closing trial balance.

Continuous Accounting Process

The flow of accounting information begins with actual economic events and allows for the capture, compilation, and movement of economic data from one period to the next. A consistent process enables stakeholders to understand and rely on an organization's financial status.
The flow of accounting information is a continuous process, as reflected in the accounting cycle, and contributes to the regular, systematic creation of accounting records and formal financial statements. It also allows for an orderly tracing of financial information from one accounting period to the next. When accountants are diligent about following the process, the organization's financial statements will be inherently comparable, consistent, and reliable over time. This allows the organization, its stakeholders, and the public to be better informed and able to make decisions based on the organization's financial performance. If a company is inconsistent with financial record keeping, analysis and good decision-making become difficult. The stability of the accounting process helps managers, investors, and other stakeholders more easily understand an organization's financial health. Before an organization's financial statements can be prepared, the accounting process begins with the unadjusted trial balance and moves through preparation of the adjusted journal entries until the adjusted trial balance is prepared.

Unadjusted Trial Balance

The unadjusted trial balance, a listing of all ledger accounts and their balances at any point in time, is the basic start for preparing an organization's four financial statements. Every company maintains a chart of accounts, which includes "buckets" for every type of money coming into and going out of the organization. Examples of ledger accounts include cash, accounts receivable, supplies, accounts payable, service revenue, utilities expense, and payroll expense. Each account holds the transactions related to that account. The unadjusted trial balance is a listing of all accounts and their respective balances.

Three steps are required prior to compiling the unadjusted trial balance. First, transactions such as receiving cash for providing services to customers, paying for utility expenses, and paying for employees' payroll are analyzed. The accounting staff must determine how to record the transactions in the company's books. Once that determination has been made for each transaction, individual entries are recorded in a journal, where they are summarized. From the journal, the information is transferred to the ledger, which contains every account and the related detailed transactions. The last step is transferring the balance of each ledger account to the unadjusted trial balance.

The unadjusted trial balance has three columns: account, debit, and credit. The debit column is to the left of the credit column. Each account's balance is recorded in either the debit or credit column. Both debit and credit columns are totaled at the bottom.

Unadjusted Trial Balance

The unadjusted trial balance lists every account with title and amount from the general ledger. The amounts (shown in red) are the adjusting journal entries that will be used to create the adjusted trial balance.

How to Prepare Adjusting Journal Entries

Preparing and posting regular journal entries is an important part of the accounting process, and the next step in the accounting cycle is recording adjusting journal entries. An adjusting journal entry is an entry prepared because of the passage of time or a change in circumstances, when no specific transactions have occurred. Adjusting journal entries are usually recorded at the end of an accounting period after preparation of the unadjusted trial balance. Ensuring that every completed transaction is entered into the accounting records in a timely fashion is a fundamental accounting concept known as completeness.

Adjusting journal entries can generally be categorized into two groups: accruals and deferrals. Adjustments are critical at month end because they ensure adherence to the matching principle, where revenues should be contemporaneously matched with the expenses that helped generate them. The use of adjusting journal entries results in more complete and accurate accounting records.

An accrual, as a category of an adjusting entry, recognizes the use (expense) or earning (revenue) associated with an event only before any cash is exchanged. An example of an accrual adjusting entry is recording service revenue when services are provided to customers who did not pay in cash, and therefore the transaction is recorded as an account receivable. Accruals typically look at events that have happened in the past but have not been accounted for in the records.

Suppose Blue Company provided consulting services worth $1,000 to Johnson Company, a customer, on December 31. Johnson did not pay for the consulting until January 15 of the following year. Because the services were performed in December, Blue Company must record the service revenue and the account receivable at December 31. The adjusting entry would include a debit to accounts receivable and a credit to service revenue.

Accrual Adjusting Journal Entry

Date Account Debit Credit
12/31/2018 Accounts receivable $1,000
Service revenue $1,000

Deferrals, or adjusting entries, recognize the use or earning associated with an event only after the exchange of cash. Examples of adjusting entries classified as deferrals consist of recognition of depreciation expense or interest expense, an accounting concept that spreads significant asset costs over the time period during which the asset will be useful, as well as the conversion of unearned revenue to earned revenue. Deferrals typically look back at a prior journal entry and adjust for changes to that account that happened during the accounting cycle.

For example, on January 1, 2018, Renner Company purchased a new printer to be used in its office. The cost of the printer, $1,200, is recorded in the equipment account in the ledger. The accountant estimates the printer will be useful for three years. The most common method of recording depreciation is the straight-line method, which divides the cost of the asset by the number of years of useful life. In this example, divide $1,200 by three years to arrive at $400 depreciation per year. The adjusting entry to record one year of depreciation on December 31 would include a debit to depreciation expense and a credit to the accumulated depreciation, a contra asset account, which is a unique type of account to offset the cost of an existing asset to adjust the asset account to its book value.

Deferral Adjusting Journal Entry

Date Account Debit Credit
12/31/2018 Depreciation expense $400
      Accumulated depreciation $400

Adjusted Trial Balance

Once the adjusting entries are posted to the ledger, they are added to the unadjusted trial balance to arrive at the adjusted trial balance. The adjusted trial balance summarizes the first five steps of the accounting cycle: analyze transactions, journal entries, ledger accounts, unadjusted trial balance, and adjusting entries. It is important to recognize that the adjustment process may require changes to existing account balances and may also require creation of new accounts. If an account requires adjustment but is not currently part of the unadjusted trial balance, it should be created and reflected in the adjusted trial balance.

At the point in time when the adjusted trial balance is prepared, all ledger accounts have been finalized and include the initial transactions and any necessary accrual and deferral adjusting journal entries that occurred during the accounting period. Financial statements will be prepared based on the accurate adjusted trial balance amounts.

Adjusted Trial Balance for Sky Company

Adjustments from the adjusting journal entries (shown in red) are added to the unadjusted trial balance to arrive at the adjusted trial balance. Equality of debits and credits is maintained. The adjusted trial balance is the complete financial picture for preparing financial statements.