What Is the Accounting Cycle?

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.

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.

What Is the Accounting Equation?

The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity.

This straightforward relationship between assets, liabilities, and equity is considered to be the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the debit side has a corresponding entry (or coverage) on the credit side.

The accounting equation is also called the basic accounting equation or the balance sheet equation.

Understanding the Accounting Equation

The financial position of any business, large or small, is based on two key components of the balance sheet: assets and liabilities. Owners’ equity, or shareholders’ equity, is the third section of the balance sheet.

The accounting equation is a representation of how these three important components are associated with each other.

Assets represent the valuable resources controlled by the company, while liabilities represent its obligations. Both liabilities and shareholders’ equity represent how the assets of a company are financed. If it’s financed through debt, it’ll show as a liability, but if it’s financed through issuing equity shares to investors, it’ll show in shareholders’ equity.

The accounting equation helps to assess whether the business transactions carried out by the company are being accurately reflected in its books and accounts. Below are examples of items listed on the balance sheet.

Assets

Assets include cash and cash equivalents or liquid assets, which may include Treasury bills and certificates of deposit.

Accounts receivables list the amounts of money owed to the company by its customers for the sale of its products. Inventory is also considered an asset.

The major and often largest value asset of most companies be that company’s machinery, buildings, and property. These are fixed assets that are usually held for many years.

Liabilities

Liabilities are debts that a company owes and costs that it needs to pay in order to keep the company running.

Debt is a liability, whether it is a long-term loan or a bill that is due to be paid.

Costs include rent, taxes, utilities, salaries, wages, and dividends payable.

Shareholders’ Equity

The shareholders’ equity number is a company’s total assets minus its total liabilities. 

It can be defined as the total number of dollars that a company would have left if it liquidated all of its assets and paid off all of its liabilities. This would then be distributed to the shareholders.

Retained earnings are part of shareholders’ equity. This number is the sum of total earnings that were not paid to shareholders as dividends.

Think of retained earnings as savings, since it represents the total profits that have been saved and put aside (or “retained”) for future use.

Accounting Equation Formula and Calculation

$\text{Assets}=(\text{Liabilities}+\text{Owner’s Equity})$Assets=(Liabilities+Owner’s Equity)

The balance sheet holds the elements that contribute to the accounting equation:

1. Locate the company’s total assets on the balance sheet for the period.
2. Total all liabilities, which should be a separate listing on the balance sheet.
3. Locate total shareholder’s equity and add the number to total liabilities.
4. Total assets will equal the sum of liabilities and total equity.

As an example, say the leading retailer XYZ Corporation reported the following on its balance sheet for its latest full fiscal year:

• Total assets: $170 billion
• Total liabilities: $120 billion
• Total shareholders’ equity: $50 billion

If we calculate the right-hand side of the accounting equation (equity + liabilities), we arrive at ($50 billion + $120 billion) = $170 billion, which matches the value of the assets reported by the company.

About the Double-Entry System

The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet. 

Essentially, the representation equates all uses of capital (assets) to all sources of capital, where debt capital leads to liabilities and equity capital leads to shareholders’ equity.

For a company keeping accurate accounts, every business transaction will be represented in at least two of its accounts. For instance, if a business takes a loan from a bank, the borrowed money will be reflected in its balance sheet as both an increase in the company’s assets and an increase in its loan liability.

If a business buys raw materials and pays in cash, it will result in an increase in the company’s inventory (an asset) while reducing cash capital (another asset). Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting.

The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left side value of the equation will always match the right side value.

In other words, the total amount of all assets will always equal the sum of liabilities and shareholders’ equity.

The global adherence to the double-entry accounting system makes the account keeping and tallying processes more standardized and more fool-proof.

The accounting equation ensures that all entries in the books and records are vetted, and a verifiable relationship exists between each liability (or expense) and its corresponding source; or between each item of income (or asset) and its source.

Limits of the Accounting Equation

Although the balance sheet always balances out, the accounting equation can’t tell investors how well a company is performing. Investors must interpret the numbers and decide for themselves whether the company has too many or too few liabilities, not enough assets, or perhaps too many assets, or whether its financing is sufficient to ensure its long-term growth.

Real-World Example

Below is a portion of Exxon Mobil Corporation’s (XOM) balance sheet in millions as of Dec. 31, 2019:

• Total assets were $362,597
• Total liabilities were $163,659
• Total equity was $198,938

The accounting equation is calculated as follows:

• Accounting equation = $163,659 (total liabilities) + $198,938 (equity) equals $362,597, (which equals the total assets for the period)

What Are Accounting Policies?

Accounting policies are the specific procedures implemented by a company’s management team that are used to prepare its financial statements. These include any accounting methods, measurement systems, and procedures for presenting disclosures. Accounting policies differ from accounting principles in that the principles are the accounting rules, and the policies are a company’s way of adhering to those rules.

How Accounting Policies Are Used

Accounting policies are a set of standards that govern how a company prepares its financial statements. These policies are used to deal specifically with complicated accounting practices such as depreciation methods, recognition of goodwill, preparation of research and development (R&D) costs, inventory valuation, and the consolidation of financial accounts. These policies may differ from company to company, but all accounting policies are required to conform to generally accepted accounting principles (GAAP) and/or international financial reporting standards (IFRS).

Accounting principles can be thought of as a framework in which a company is expected to operate. However, the framework is somewhat flexible, and a company’s management team can choose specific accounting policies that are advantageous to the financial reporting of the company. Because accounting principles are lenient at times, the specific policies of a company are very important.

Looking into a company’s accounting policies can signal whether management is conservative or aggressive when reporting earnings. This should be taken into account by investors when reviewing earnings reports to assess the quality of earnings. Also, external auditors who are hired to review a company’s financial statements should review the company’s policies to ensure they conform to GAAP.

Example of an Accounting Policy

Accounting policies can be used to legally manipulate earnings. For example, companies are allowed to value inventory using the average cost, first in first out (FIFO), or last in first out (LIFO) methods of accounting. Under the average cost method, when a company sells a product, the weighted average cost of all inventory produced or acquired in the accounting period is used to determine the cost of goods sold (COGS). Under the FIFO inventory cost method, when a company sells a product, the cost of the inventory produced or acquired first is considered to be sold. Under the LIFO method, when a product is sold, the cost of the inventory produced last is considered to be sold.

In periods of rising inventory prices, a company can use these accounting policies to increase or decrease its earnings. For example, a company in the manufacturing industry buys inventory at $10 per unit for the first half of the month and $12 per unit for the second half of the month. The company ends up purchasing a total of 10 units at $10 and 10 units at $12 and sells a total of 15 units for the entire month. 

If the company uses FIFO, its cost of goods sold is: (10 x $10) + (5 x $12) = $160. If it uses average cost, its cost of goods sold is: (15 x $11) = $165. If it uses LIFO, its cost of goods sold is: (10 x $12) + (5 x $10) = $170. It is therefore advantageous to use the FIFO method in periods of rising prices in order to minimize the cost of goods sold and increase earnings.

The Bottom Line

Accounting policies are different from accounting principles, which are the accounting rules to which all accounting policies must conform. A company’s management team can choose specific accounting policies that are advantageous to the firm’s financial reporting. The team might use either conservative or aggressive accounting policies, which will determine how a company’s financial performance appears in a given year.

What Are Accounting Principles?

Accounting principles are the rules and guidelines that companies and other bodies must follow when reporting financial data. These rules make it easier to examine financial data by standardizing the terms and methods that accountants must use.

The International Financial Reporting Standards (IFRS) is the most widely used set of accounting principles, with adoption in 167 jurisdictions. The United States uses a separate set of accounting principles, known as generally accepted accounting principles (GAAP).

The Purpose of Accounting Principles

The ultimate goal of any set of accounting principles is to ensure that a company’s financial statements are complete, consistent, and comparable.

This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a period of time. It also facilitates the comparison of financial information across different companies. Accounting principles also help mitigate accounting fraud by increasing transparency and allowing red flags to be identified.

Comparability

Comparability is the ability for financial statement users to review multiple companies’ financials side by side with the guarantee that accounting principles have been followed to the same set of standards.

Accounting information is not absolute or concrete, and standards are developed to minimize the negative effects of inconsistent data. Without these rules, comparing financial statements among companies would be extremely difficult, even within the same industry. Inconsistencies and errors also would be harder to spot.

What Are the Basic Accounting Principles?

Some of the most fundamental accounting principles include the following:

• Accrual principle
• Conservatism principle
• Consistency principle
• Cost principle
• Economic entity principle
• Full disclosure principle
• Going concern principle
• Matching principle
• Materiality principle
• Monetary unit principle
• Reliability principle
• Revenue recognition principle
• Time period principle

The most notable principles include the revenue recognition principle, matching principle, materiality principle, and consistency principle. Completeness is ensured by the materiality principle, as all material transactions should be accounted for in the financial statements. Consistency refers to a company’s use of accounting principles over time.

Generally Accepted Accounting Principles (GAAP)

Generally accepted accounting principles (GAAP) are uniform accounting principles for private companies and nonprofits in the U.S. These principles are largely set by the Financial Accounting Standards Board (FASB), an independent nonprofit organization whose members are chosen by the Financial Accounting Foundation.

A similar organization, the Governmental Accounting Standards Board (GASB), is responsible for setting the GAAP standards for local and state governments. And a third body, the Federal Accounting Standards Advisory Board (FASAB), publishes the accounting principles for federal agencies.

Although privately held companies are not required to abide by GAAP, publicly traded companies must file GAAP-compliant financial statements to be listed on a stock exchange. Chief officers of publicly traded companies and their independent auditors must certify that the financial statements and related notes were prepared in accordance with GAAP.

Privately held companies and nonprofit organizations also may be required by lenders or investors to file GAAP-compliant financial statements. For example, annual audited GAAP financial statements are a common loan covenant required by most banking institutions. Therefore, most companies and organizations in the U.S. comply with GAAP, even though it is not a legal requirement.

International Financial Reporting Standards (IFRS)

The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS). These standards are used in more than 120 countries, including those in the European Union (EU).

The Securities and Exchange Commission (SEC), the U.S. government agency responsible for protecting investors and maintaining order in the securities markets, has expressed interest in transitioning to IFRS. However, because of the differences between the two standards, the U.S. is unlikely to switch in the foreseeable future.

However, the FASB and the IASB continue to work together to issue similar regulations on certain topics as accounting issues arise. For example, in 2014, the FASB and the IASB jointly announced new revenue recognition standards.

Since accounting principles differ around the world, investors should take caution when comparing the financial statements of companies from different countries. The issue of differing accounting principles is less of a concern in more mature markets. Still, caution should be used, as there is still leeway for number distortion under many sets of accounting principles.

The Bottom Line

Accounting principles are rules and guidelines that companies must abide by when reporting financial data. Whether it’s GAAP in the U.S. or IFRS elsewhere, the overarching goal of these principles is to boost transparency and basically make it easier for investors to compare the financial statements of different companies.

Without these rules and standards, publicly traded companies would likely present their financial information in a way that inflates their numbers and makes their trading performance look better than it actually was. If companies were able to pick and choose what information to disclose and how, it would be a nightmare for investors.