Accounting Cycle Steps

Why This Matters

The accounting cycle isn't just a checklist—it's the systematic process that transforms raw business transactions into the financial statements you'll analyze throughout this course. Every concept you encounter in financial accounting, from revenue recognition to the matching principle to accrual accounting, gets operationalized through these steps. When exam questions ask you to trace an error, explain why accounts don't balance, or identify when revenue should be recognized, they're testing whether you understand how information flows through this cycle.

Think of the accounting cycle as the backbone of financial reporting reliability. Each step exists for a reason: to ensure accuracy, maintain the fundamental accounting equation ($\text{Assets} = \text{Liabilities} + \text{Equity}$), and produce statements that comply with GAAP or IFRS. Don't just memorize the order of steps—know why each step matters and what accounting principle it enforces. That's what separates students who ace FRQs from those who struggle.

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Capturing and Recording Transactions

These initial steps focus on getting economic events into the accounting system accurately. The goal is complete and accurate capture—nothing gets to the financial statements if it isn't properly identified and recorded first.

Identify and Analyze Transactions

• Source documents trigger this step—invoices, receipts, and contracts provide evidence that an economic event occurred and must be recorded
• The accounting equation ($\text{A} = \text{L} + \text{E}$) guides analysis; every transaction must keep this equation in balance
• Classification decisions happen here—determining whether something is an asset vs. expense or liability vs. revenue affects all downstream reporting

Record Transactions in the Journal

• Double-entry accounting requires every transaction to have equal debits and credits, creating a self-checking system
• Chronological order in the general journal creates an audit trail; each entry includes date, accounts, amounts, and a brief description
• Journal entries are the first formal record—errors here cascade through the entire cycle, making accuracy critical

Post Transactions to the Ledger

• The general ledger organizes by account rather than by date, allowing you to see the complete history of any single account
• Running balances are updated with each posting, showing the cumulative effect of all transactions on that account
• Cross-referencing between journal and ledger entries ensures nothing gets lost or duplicated during transfer

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Verification and Adjustment

These steps ensure the recorded data is accurate and reflects economic reality under accrual accounting. This is where the matching principle and revenue recognition come to life.

Prepare an Unadjusted Trial Balance

• Total debits must equal total credits—this mathematical check catches posting errors and transposition mistakes
• Does NOT guarantee accuracy—a balanced trial balance can still contain errors like omitted transactions or incorrect account classifications
• Lists all ledger accounts with their balances, serving as a snapshot before period-end adjustments

Prepare and Post Adjusting Entries

• Accruals and deferrals are the two main categories; accruals record earned/incurred items not yet in cash, deferrals allocate cash already exchanged
• The matching principle drives most adjustments—expenses must be recorded in the same period as the revenues they helped generate
• Common adjustments include depreciation, prepaid expenses, unearned revenue, and accrued wages; these appear frequently on exams

Prepare an Adjusted Trial Balance

• Incorporates all adjusting entries to show account balances that reflect the true economic position at period-end
• Debits still must equal credits—if they don't after adjustments, an error occurred in the adjusting entries
• Direct source for financial statements—the numbers on this trial balance flow directly into the income statement and balance sheet

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Financial Statement Preparation

This is the output phase—where all the recording and adjusting work becomes the reports that external users actually see. Financial statements are the end product of the entire cycle.

Prepare Financial Statements

• Three core statements are prepared: income statement (performance), balance sheet (position), and statement of cash flows (liquidity)
• Order matters—income statement first (to calculate net income), then statement of retained earnings, then balance sheet
• GAAP/IFRS compliance is required; these standards dictate presentation, classification, and disclosure requirements

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Closing the Period

Closing entries reset the books for the next period by zeroing out temporary accounts. This step enforces the periodicity assumption—the idea that business activity can be divided into discrete time periods.

Close Temporary Accounts

• Temporary accounts (revenues, expenses, dividends) are closed to retained earnings, transferring net income or loss to equity
• Permanent accounts (assets, liabilities, equity) are NOT closed—their balances carry forward to the next period
• The Income Summary account is often used as an intermediate step, collecting all revenue and expense balances before transferring to retained earnings

Prepare a Post-Closing Trial Balance

• Contains only permanent accounts—all temporary accounts should show zero balances after closing
• Verifies the closing process was completed correctly; debits must still equal credits
• Starting point for next period—these are the opening balances when the new accounting cycle begins

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Quick Reference Table

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Self-Check Questions

1. Which two steps in the accounting cycle specifically verify that total debits equal total credits, and what distinguishes their purposes?

2. If a company fails to record an adjusting entry for accrued wages, which financial statements will be misstated and in what direction?

3. Compare and contrast the unadjusted trial balance and the post-closing trial balance—what accounts appear on each, and when in the cycle is each prepared?

4. A transaction is recorded in the journal but never posted to the ledger. Will the trial balance still balance? Explain why or why not.

5. An FRQ asks you to explain why closing entries are necessary under the periodicity assumption. Which accounts are affected, and what would happen to the income statement if closing entries were skipped?