The Accounting Cycle

I was browsing an accounting book a while back and came across the description and a diagram of “the accounting cycle.” Having started my CPA career in the “old days”, I could understand the cycle part of the term. Accounting really had a cycle of steps that went like this:

Step 1: Create source document. A source document was and still is your basic invoice, check, receipt, etc.

Step 2: You would take the source document and analyze the transaction then determine where to record the specific transaction. It might be the cash journal or the purchases journal depending on the transaction. Whatever the transaction represented, it was recorded by a bookkeeper using pen and paper with a calculator and eraser within arm’s reach.

Step 3: Record the transaction in a journal. A journal was a specific type of book with lined pages and several columns across the pages where you would record every transaction, generally in date order, then at the end of the month, add all the numerical entries and summarize the totals of each column, and “balance the totals.” This was the start of a monthly ritual, a cycle, of “closing the books.” Steps 4 through 7 below is the process known as closing the books.

Accounting Ledger

Step 4: Next the summary totals of each journal were entered into another book with paper sheets with printed lines and columns called a general ledger. Normally each page of the general ledger was “indexed” with an account number where the summary total for each category of columns in the different journals were posted at the end of each month. The indexed accounts were titled to represent either an asset, liability, equity, income or expense account such as “sales”, “cost of goods sold” or “rent expense.” The general ledger was then balanced to make sure the debits equaled the credits.

Step 5: The bookkeeper would then take the general ledger totals and prepare a “trial balance”. The trial balance was the beginning stages of the preparation for the monthly or annual financial statement. However, there was generally one more step needed before the bookkeeper would use trial balance to prepare the balance sheet and income statement.

Step 6: Before a financial statement could be prepared, certain final items needed to be recorded or transactions reclassified. These adjustments were made by preparing final “adjusting journal entries”. These adjusting journal entries would be necessary to record accounting entries like depreciation of assets. The bookkeeper would then balance the trial balance to make sure the debits equaled the credits. Bookkeeping took quite a lot of balancing at the end of each month.

Step 7: Finally the bookkeeper would prepare a financial statement so the owners and managers knew how much profit or loss the business generated the previous month.

The above described the accounting cycle using a manual bookkeeping system.

Today, with computers and accounting software, this is the equivalent of the accounting cycle.

Step 1: Create the transaction document in QuickBooks.

Step 2: Immediately print financial statement on demand.

That describes what most people believe the accounting cycle is today when using computers. How wrong they are! But that is why inaccurate financial statements and accounting records proliferate the business environment.

Although computers and accounting software have eliminated, or at least compressed the mechanics of creating a source document (like a check or invoice) and simultaneously posting that transaction through the system to a financial statement format, it did not remove the need for training in bookkeeping or accounting to produce accurate accounting records. The accounting cycle in the computer age still requires training to correctly analyze the business transaction and the understanding of how financial statements are created and the why of adjusting journal entries. Without this knowledge and understanding and skill, bad business decisions are made and loans are denied and business value is decimated.

If you don’t understand bookkeeping, or if your bookkeeper doesn’t understand bookkeeping, you need help. There is a lot more to preparing useful and accurate financial statements backed by a well-organized and correct set of books than installing QuickBooks or some other accounting software on your computer. That belief really is a myth.