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Running a business

The accounting cycle defined and explained

The accounting cycle is the collective process of recording and processing a business’s financial transactions – from when the transaction first occurs, to how it’s recorded in the financial statements and, eventually, closed. It’s called a cycle because the workflow is circular – moving from one accounting period to the next. The full cycle is made up of nine steps which in the past were worked out manually and recorded in journals. Today, most accountants use cloud-based accounting tools to process a lot of these steps simultaneously. If you’re planning a career in accounting, it’s a good idea to get your head around basics.

1 Transactions

The cycle starts with transactions. So, every time a sale is made, a product is returned, an asset is purchased, or a debt is paid, the cycle begins. Each financial activity that involves the exchange of a business’s assets is considered a transaction.

2 Journal entries

The journal lists transactions and other financial events in chronological order. This records amounts debited, amounts credited, the date of each transaction, and its explanation. When debiting or crediting an account the amounts should always balance.

3 Posting from the journal to the ledger

The information contained within the journal is then posted to the general ledger, where you can find changes made to each account from past transactions and their current balances. The ledger is used to create a business’s financial statements.

4 Trial balance

This is when all account balances are arranged into a single report and the accuracy of credits and debits checked. The accounts are typically listed as they appear in the ledger. Total debit should equal total credits.

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5 Adjusting entries

Adjusting entries takes into account accruals and deferrals that have altered the final balances of accounts on the general ledger at the end of the accounting period. These adjustments are made to ensure reported results are aligned with the actual financial position of the business before financial statements are prepared.

6 Adjusted trial balance

After making the last-minute adjustments, an adjusted trial balance is prepared. Like the trial balance, this is to confirm the credits and debits match after adjusted entries are made. The adjusted trial balance is the most accurate record of a business’s financial activities.

7 Financial statements

Using the adjusted trial balance, the balance sheet, income statement, and cash statement are prepared. These will be used to show the business’s financial results, condition, and cash flow.

8 Closing entries

Here, temporary accounts are closed (or reduced to zero) to prepare the accounts for the next period of transactions. All temporary accounts are moved to a permanent account.

9 Post-closing trial balance

The final step of the accounting cycle is to check the credits and debits match after closing entries are made. This balance should only contain permanent accounts since temporary accounts are already closed. The accounting cycle ensures financial statements are prepared accurately and are a true reflection of a business’s financial position. Master the steps of the accounting cycle and you’ll have a strong foundation for the rest of your career.

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