The Accounting Cycle: Every Step Explained

What Is the Accounting Cycle?

The accounting cycle is the sequence of steps a business follows to record, classify, and summarize transactions during an accounting period. It starts when a transaction occurs and ends when the books are closed for the period.

Every business — from a one-person shop to a multinational — follows this same cycle. The complexity varies, but the logic is identical.

The cycle has eight steps. Each one feeds into the next. Skip a step or do it wrong, and everything downstream breaks.

Step 1: Analyze Transactions

Before recording anything, you need to understand what happened. Not every business event is a transaction.

A transaction must: - Involve a measurable financial exchange - Affect at least two accounts - Be supported by a source document (invoice, receipt, contract)

Example: Al-Noor Consulting signs a SAR 120,000 contract for a 12-month engagement. Is this a transaction? Not yet — no service has been delivered and no cash has changed hands. When the first monthly payment of SAR 10,000 arrives, that's the transaction.

Source documents matter. The invoice, bank deposit slip, or purchase order is what proves the transaction happened. In an audit, no document means no evidence.

Step 2: Record Journal Entries

Each transaction gets recorded as a journal entry — a debit-and-credit pair that keeps the accounting equation balanced.

Example: Al-Noor receives the first SAR 10,000 payment from the contract above.

The journal is the book of original entry. Every transaction starts here before going anywhere else. Entries are recorded in chronological order, with a brief description of each transaction.

Step 3: Post to the General Ledger

Posting transfers each journal entry to the affected accounts in the general ledger. The ledger organizes transactions by account rather than by date.

After posting the entry above: - The Cash ledger shows a SAR 10,000 debit - The Service Revenue ledger shows a SAR 10,000 credit

Why not just use the journal? Because when you need to know the total Cash balance or total Revenue for the period, you don't want to scan through hundreds of journal entries. The ledger groups everything by account.

In practice, accounting software posts automatically. But understanding this step matters because it's how account balances are built.

Step 4: Prepare the Unadjusted Trial Balance

A trial balance lists every account and its balance. The unadjusted version is prepared before adjusting entries.

If debits don't equal credits, there's a posting error somewhere. A balanced trial balance doesn't guarantee accuracy — you could have debited the wrong account — but an unbalanced one guarantees a mistake.

Step 5: Record Adjusting Entries

Adjusting entries are where accrual accounting comes to life. They ensure revenue is recorded when earned and expenses when incurred, regardless of cash timing.

Four categories of adjustments:

1. Prepaid expenses (deferrals): You paid in advance; now you've used part of it. *Al-Noor paid SAR 18,000 for 12 months of rent. After 3 months, SAR 4,500 has been used.*

2. Unearned revenue (deferrals): A client paid in advance; now you've earned part of it.

3. Accrued expenses: An expense has been incurred but not yet paid (utilities, interest).

4. Accrued revenue: Revenue has been earned but not yet billed or received.

Adjusting entries never involve the Cash account. If cash moved, it was already recorded in Step 2.

Step 6: Prepare the Adjusted Trial Balance

After posting adjusting entries, you prepare a new trial balance that reflects the true account balances for the period.

This adjusted trial balance is what you use to build financial statements. Every number on the income statement and balance sheet comes directly from this document.

If an adjusting entry was missed — say, you forgot to accrue SAR 3,000 of salary expense — the trial balance will still balance, but net income will be overstated by SAR 3,000 and liabilities will be understated by the same amount. The statements would be wrong even though they look correct.

Step 7: Prepare Financial Statements

From the adjusted trial balance, you prepare three core statements in this order:

1. Income Statement — Reports revenue and expenses for the period. The bottom line is net income (or net loss).

2. Statement of Changes in Equity — Shows how equity changed during the period. Net income from the income statement flows in here, along with owner investments and withdrawals.

3. Balance Sheet — Reports assets, liabilities, and equity at a specific date. The ending equity from the statement above flows into the balance sheet.

The order matters because each statement feeds into the next. You can't prepare the balance sheet without knowing net income.

Step 8: Close the Books

Closing entries reset temporary accounts (revenue, expenses, dividends) to zero so they're ready for the next period.

Why? Revenue and expense accounts track activity for a single period. If you earned SAR 90,000 this year and don't close the accounts, next year's revenue would start at 90,000 instead of zero.

The closing process: 1. Close all revenue accounts to Income Summary (debit Revenue, credit Income Summary) 2. Close all expense accounts to Income Summary (debit Income Summary, credit Expenses) 3. Close Income Summary to Retained Earnings 4. Close Dividends to Retained Earnings

After closing, only permanent accounts (assets, liabilities, equity) have balances. The cycle is complete — and it starts over with the next transaction.

Want to practice the full cycle? Accountery walks you through transactions, journal entries, adjustments, and financial statement preparation with instant feedback at every step.