10. accounts used to accumulate information from one fiscal period to the next.

The accounting cycle is a collective process of identifying, analyzing, and recording the accounting events of a company. It is a standard 8-step process that begins when a transaction occurs and ends with its inclusion in the financial statements.

The key steps in the eight-step accounting cycle include recording journal entries, posting to the general ledger, calculating trial balances, making adjusting entries, and creating financial statements.

Key Takeaways

• The accounting cycle is a process designed to make financial accounting of business activities easier for business owners.
• The first step in the eight-step accounting cycle is to record transactions using journal entries, ending with the eighth step of closing the books after preparing financial statements.
• The accounting cycle generally comprises a year or other accounting period.
• Accounting software today mostly automates the accounting cycle. 

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Accounting Cycle

How the Accounting Cycle Works 

The accounting cycle is a methodical set of rules to ensure the accuracy and conformity of financial statements. Computerized accounting systems and the uniform process of the accounting cycle have helped to reduce mathematical errors. Today, most software fully automates the accounting cycle, which results in less human effort and errors associated with manual processing.

Steps of the Accounting Cycle

There are eight steps to the accounting cycle.

1. Identify Transactions: An organization begins its accounting cycle with the identification of those transactions that comprise a bookkeeping event. This could be a sale, refund, payment to a vendor, and so on.
2. Record Transactions in a Journal: Next come recording of transactions using journal entries. The entries are based on the receipt of an invoice, recognition of a sale, or completion of other economic events.
3. Posting: Once a transaction is recorded as a journal entry, it should post to an account in the general ledger. The general ledger provides a breakdown of all accounting activities by account.
4. Unadjusted Trial Balance: After the company posts journal entries to individual general ledger accounts, an unadjusted trial balance is prepared. The trial balance ensures that total debits equal the total credits in the financial records.
5. Worksheet: Analyzing a worksheet and identifying adjusting entries make up the fifth step in the cycle. A worksheet is created and used to ensure that debits and credits are equal. If there are discrepancies then adjustments will need to be made.
6. Adjusting Journal Entries: At the end of the period, adjusting entries are made. These are the result of corrections made on the worksheet and the results from the passage of time. For example, an adjusting entry may accrue interest revenue that has been earned based on the passage of time.
7. Financial Statements: Upon the posting of adjusting entries, a company prepares an adjusted trial balance followed by the actual formalized financial statements.
8. Closing the Books: An entity finalizes temporary accounts, revenues, and expenses, at the end of the period using closing entries. These closing entries include transferring net income into retained earnings. Finally, a company prepares the post-closing trial balance to ensure debits and credits match and the cycle can begin anew.

Timing of the Accounting Cycle

The accounting cycle is started and completed within an accounting period, the time in which financial statements are prepared. Accounting periods vary and depend on different factors; however, the most common type of accounting period is the annual period. During the accounting cycle, many transactions occur and are recorded.

At the end of the year, financial statements are generally prepared, which are often required by regulation. Public entities are required to submit financial statements by certain dates. All public companies that do business in the U.S. are required to file registration statements, periodic reports, and other forms to the U.S. Securities and Exchange Commission. Therefore, their accounting cycle revolves around reporting requirement dates.

The Accounting Cycle Vs. Budget Cycle

The accounting cycle is different than the budget cycle. The accounting cycle focuses on historical events and ensures incurred financial transactions are reported correctly. Alternatively, the budget cycle relates to future operating performance and planning for future transactions. The accounting cycle assists in producing information for external users, while the budget cycle is mainly used for internal management purposes.

An accounting period is an established range of time during which accounting functions are performed, aggregated, and analyzed. An accounting period may consist of weeks, months, quarters, calendar years, or fiscal years. The accounting period is useful in investing because potential shareholders analyze a company’s performance through its financial statements, which are based on a fixed accounting period.

Key Takeaways

• An accounting period is a span of time that covers certain accounting functions; it can be either a calendar or fiscal year, but also a week, month, or quarter, for example. 
• Accounting periods are created for reporting and analyzing purposes, and the accrual method of accounting allows for consistent reporting. 
• Accrual accounting is governed by two important principles: revenue recognition and matching.
• The revenue recognition principle states that revenue should be reported when it is earned, rather than when the cash is received.
• The matching principle states that an expense should be reported in the same accounting period as the revenue generated by the expense.

How an Accounting Period Works

There are typically multiple accounting periods currently active at any given point in time. For example, assume the accounting department of XYZ Company is closing the financial records for the month of June. This indicates the accounting period is the month (June), although the entity may also wish to aggregate accounting data by quarter (April through June), half year (January through June), or an entire fiscal year.

Accounting periods are useful to analysts and potential shareholders because it allows them to identify trends in a single company's performance over a period of time. They can also use accounting periods to compare the performance of two or more companies during the same period of time.

Accounting Period Types

A calendar year with respect to accounting periods indicates that an entity begins aggregating accounting records on the first day of January and subsequently stops the accumulation of data on the last day of December. This annual accounting period imitates a basic 12-month calendar period. 

An entity may also elect to report financial data through the use of a fiscal year. A fiscal year arbitrarily sets the beginning of the accounting period to any date, and financial data is accumulated for one year from this date. For example, a fiscal year starting April 1 would end on March 31 of the following year. The federal government has a fiscal year that runs from October 1 to September 30, while many nonprofits have a fiscal year that runs from July 1 to June 30.

Financial statements, such as the income statement and balance sheet, identify the accounting period in their headers. The income statement includes a company's revenue and expenses from the entire accounting period. The header will identify the time range in the heading with a statement such as, “...for the year ended Dec. 31, 20XX.” Meanwhile, the balance sheets gives a snapshot of a company's assets, liabilities, and equity at a specific point in time, i.e. the end of the accounting period. The header will identify the last date of the accounting period, for example, "as of June 30, 20XX."

Requirements for Accounting Periods

There are two main accounting rules that govern the use of accounting periods, the revenue recognition principle and the matching principle. The accrual method of accounting encompasses these two principles.

Accrual method of accounting

Accounting periods are established for reporting and analysis purposes. In theory, an entity hopes to experience consistency in growth across accounting periods to display stability and an outlook of long-term profitability. The method of accounting that supports this theory is the accrual method of accounting.

The accrual method of accounting requires an accounting entry to be made when an economic event occurs regardless of the timing of the cash element in the event. For example, the accrual method of accounting requires the depreciation of a fixed asset over the life of the asset. This recognition of expenses over numerous accounting periods enables relative comparability across the periods as opposed to a complete expense when the item was paid for.

Revenue recognition principle

An important accounting rule used in the accrual method of accounting is the revenue recognition principle. The revenue recognition principle states that revenue should be recognized when the money is earned, not when the cash changes hands. For example, a company may earn revenue prior to receiving cash if it allows customers to make purchases on credit. At the time of service or upon transferring a good to the customer, the company will recognize both revenue and an accounts receivable.

Important

If a company hasn't earned revenue when cash is received, it will need to set up a deferred revenue account which indicates the revenue has not yet been earned.

Matching principle

A primary accounting rule relating to the use of an accounting period is the matching principle. The matching principle requires that expenses are reported in the accounting period in which the associated revenue is reported. For example, the period for which the cost of goods sold (COGS) is reported will be the same period in which the revenue is reported for the same goods.

Using the example of depreciation from above, the depreciation and subsequent spread of expense over multiple periods better matches the use of fixed assets with its ability to generate revenue. If a company were to expense an expensive machine in the year of purchase, it still has a long time to generate revenues for the business. That would be a mismatch of revenue and expense. However, by spreading the expense over the useful life of the fixed asset, it better matches the expense to its related revenue.

Is an Accounting Period Always 12 Months?

No, an accounting period can be any established period of time in which a company wishes to analyze its performance. It could be weekly, monthly, quarterly, or annually.

What Are the Two Types of Annual Accounting Periods?

A calendar year is the typical year everyone is accustomed to. It runs from January 1 to December 31. A fiscal year, on the other hand, can consist of any annual period selected by a company.

What Happens at the End of an Accounting Period?

At the end of an accounting period, a company will close out the period. After all closing entries are made, the company will be ready to run its financial reports for that accounting period. Closing a period may take days, weeks, or even months into the next accounting period, and two periods can run simultaneously as the previous period is closed out.

The Bottom Line

Whatever the length of an accounting period—whether monthly, quarterly, or by fiscal year, for example—during that time span a company performs, aggregates, and analyzes accounting functions. For investment purposed potential shareholders can analyze that company’s performance through its financial statements, which are based on a fixed accounting period, and analysts can compare its financials to those of other companies during the same time period.

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