The Accounting Cycle
What is the Accounting Cycle?
The Accounting Cycle helps you turn your raw financial information into financial statements that you can use to manage and grow your business. It explains the process of recording transactions, creating financial statements, and closing accounts for the next period. Once you close your books, the cycle starts again for the new year.
Depending on who you ask, the Accounting Cycle may have a different number of steps based on how you divide up the tasks, but they are all essentially the same. For the purpose of this post, we will use 8 steps to explain the accounting cycle.
1. Identify and Analyze Transactions
The Accounting Cycle begins with a transaction. This could be making a sale, paying a bill, running a payroll, etc. First, you need to gather the records of your business transactions and determine which accounts they belong too.
2. Record Journal Entries
After gathering information for your transactions, it’s time to make journal entries. These should include the date, description, the name and number of the account(s) affected, and a reference number. If you’re using the double-entry bookkeeping method, you will need to record a debit and corresponding credit for every transaction.
3. Post to the General Ledger
If you manually keep and update your books, the next step is to summarize your journal entries in the general ledger. While journal entries are recorded in chronological order, the general ledger is organized by account. However, if you use accounting software, many of them update the general ledger automatically when you input a journal entry.
4. Prepare an Unadjusted Trial Balance
At the end of each period, you should run a trial balance to ensure that your information is accurate and up-to-date. This will display the total debits in credits in all your general ledger accounts.
5. Make Adjusting Entries
After the unadjusted trial balance has been created, you may find there are adjustments that need to be made. This could include adjusting for taxes, balancing debits and credits if you found they aren’t equal, or adding a missed transaction. Here are the four main types of adjustments you may need to make to your trial balance:
Deferral: Get rid of any transactions that don’t belong to the current period for your trial balance.
Accruals: If you use accrual accounting, you want to consider future payments and expenses.
Missing transactions: While reconciling your accounts, you may come across a transaction you forgot to record.
Tax adjustment: Determine which tax deductions you need to make during that period.
6. Prepare Adjusted Trial Balance
After all these adjustments have been made, you get the adjusted trial balance. If you use accounting software, typically there won’t be an unadjusted and adjusted report, just a trial balance. This is because adjustments can be made in software in real-time so that they’re always up to date.
7. Prepare Financial Statements
At this point in the cycle, you can start creating financial statements using the trial balance. The three main financial documents are the Income Statement, Balance Sheet, and Cash Flow Statement. You can use the information from the asset, liability, and equity accounts on the report to create the balance sheet. The revenue and expense accounts provide the information you need for the income statement. While details from accounts that interact with the cash accounts can be used to prepare the cash flow statement.
8. Make Closing Entries
Closing your books means returning the balance of your temporary accounts back to zero. Temporary accounts include revenue, expense, and withdrawal/dividend accounts. You will need to make closing entries to transfer the balance to permanent accounts. These are made at the end of the accounting period and allows for a fresh start in the next period.
You’ve now completed the Accounting Cycle! Now what? Time to repeat it! As a business owner, you will need to go through the Accounting Cycle every year. Keeping up with the cycle can be a lot of work, but it's extremely important.
Need help keeping up with the Accounting Cycle? As bookkeepers, one of our main jobs is keeping the cycle running smoothly so you can focus on what you do best! If you need help, contact us or give us a call at (360) 756-5020.