All business owners should be aware of the accounting cycle, a sequence of 8 phases used by an organization to detect, analyze, and record transactions and the company’s accounting operations.
What Is the Accounting Cycle?
Businesses must take specific actions to ensure that their financials are correct if they want to reflect on how they performed in the past. Because firms repeat the same fundamental activities after each accounting period ends, these actions are frequently referred to as the accounting cycle.
Ensuring that every dollar that changes hands throughout the accounting period is accurately accounted for and reported in a company’s financial statements is the aim of the accounting cycle steps. Correct financial accounts are crucial since they are the ultimate historical record of a company.
External parties like banks, investors, and the IRS will examine your financial accounts to determine whether to grant you a loan or if you paid the correct amount of taxes, among other things. The accounting cycle can be seen as a checklist that must be finished at the end of the accounting period. Once every step has been completed, you can start fresh with the following accounting period.
Why does the accounting process matter?
The accounting cycle is the cornerstone of your business’s accounting procedures; it establishes the standards for consistency and organization in your finances. Small enterprises may have slim profit margins and restricted access to capital.
These companies have fewer margins for error. By completing numerous duties at once, following the accounting cycle aids in organization, asset protection, and financial reporting, which keeps the business owner on schedule.
Let’s now explore this method in more detail.
- Failure to account for all financial transactions might lead to lost revenue or a potential discrepancy on financial statements.
- It keeps financial transactions orderly.
- It guards your possessions against theft.
- Businesses must spend money on the acquisition and upkeep of assets.
- Assets are necessary for a firm to function. By tracking your assets and income, the accounting cycle prevents theft and loss of support. It simplifies financial reporting. Before using the data to produce the financial statements, accountants must check the general ledger and the trial balance per the accounting cycle. Business owners can better understand and manage their company when they can produce trustworthy financial statements.
How the Accounting Cycle Works
A systematic set of guidelines known as the accounting cycle guarantees the accuracy and consistency of financial accounts. Mathematical errors have decreased thanks to computerized accounting systems and the standardization of the accounting cycle. Today’s software automates the accounting process, reducing the need for human intervention and the errors that come with manual processing.
Why is the accounting cycle important?
Because it provides businesses plan with a series of carefully thought-out phases to arrange the bookkeeping process, the accounting cycle is crucial. It aids you in avoiding the traps of subpar accounting procedures.
Without the cycle, businesses risk losing their bearings, treating their records improperly, and ultimately tainting their financial statements, which could paint an unfavorable picture of the company’s financial situation.
The accounting cycle’s eight steps
The complete accounting procedure entails, as we mentioned earlier, eight steps. Consider each step as a pillar that, when combined, provides a thorough picture of a company’s financial situation (similar to a company’s financial report card). Below are the specific steps of the accounting cycle.
1. Identify your transactions
To start, list your transactions. Bookkeepers or accountants must record the transactions over the accounting timeline. For instance, a marina that sells boats must record each transaction involving purchases of machinery, components, or services provided within the accounting period.
They will also want to note important information to simplify categorizing and executing actions.
Vital info to identify includes:
- Transaction dates
- Product prices
- Amounts paid
2. Document the trades.
Information storage, an essential stage in the accounting process, might occur at the point of sale (during the first step) or as a separate second step. Although this can be done manually, many businesses employ accounting software for a more effortless transaction and storage recall.
Several things to keep in mind when documenting transactions:
- Maintain chronological order of transactions
- When using credits and debits, they must always balance each other out
- Include essential notes for the accountant for easier reconciliation
- Luckily, accounting software can easily track all of this information for you.
3. Add transactional data to the general ledger.
Consider the general ledger as a summary page where all transactions are recorded and organized by category. The public ledger serves as the central repository for all transactional data recorded in journals and sub-ledgers.
4. Create the trial balance
At the end of the period, transactions must be balanced to move on to the fourth stage of the accounting cycle. Depending on the company, the accounting period can change (monthly, quarterly, or annually).
The trial balance reveals any disparities and gives the business information about the account balances. You will always discover differences when balancing your books because no accounting process is error-free.
5. Review the worksheet.
The worksheet analysis is possibly one of the accounting process’s trickiest tasks. It would help if you made the necessary corrections when the credits and debits from your transactions don’t balance (that is, one cancels the other).
6. Revision of journal entries
Making any necessary modifications to account for any accrual or deferral errors comes last before you prepare your financial statements. An example of an adjustment is a salary or bill paid later in the accounting period.
It takes an adjustment to get rid of the charge because it was initially recorded as an account payable when the expenditure happened.
7. Produce financial reports
In this step, we create financial statements from the trial balance, including the balance sheet, the income statement, and the cash flow statement. Here are some essential accounting formulas as well as a quick explanation of each financial information:
A balance sheet provides an overview of a company’s financial situation as of a particular date. It is a financial statement that calculates equity by deducting assets from liabilities:
- Assets – liabilities = equity
The most crucial part of the balance sheet is the profit and loss statement.
An income statement reports a business’s profit or loss over time—typically, a month or year. It’s a financial statement that subtracts revenue from expenses to determine net income or profit:
- Revenue – expenses = net income
Equity is raised on the balance sheet by net income. The balance sheet and income statements are frequently the focus of business owners. However, the cash flow statement is just as significant.
The cash inflows and outflows over time are shown in the statement of cash flows. Cash flow can be divided into three activities: operating, investing, and financing by accountants or business owners. The company’s cash balance on the balance sheet must match the ending balance in the cash flow statement.
8. End the accounting.
Any accountant can attest that it is incredibly satisfying to close the books finally. This occurs after each accounting period, signaling the start of the subsequent accounting cycle. Next, we restart step 1 of the accounting procedure.
Tips for successfully managing the accounting life cycle
Completing the accounting cycle can be difficult if documents and receipts are dispersed around your office. Utilize these five suggestions to increase your accuracy and speed.
Having good timing
Timing is essential for correctly implementing the accounting cycle, whether your accounting period is completed monthly, quarterly, or annually. Planning to align plans and dates with your accounting deadlines will boost output and outcomes.
Solve problems swiftly
The whole accounting cycle consists of 8 steps, which may seem relatively simple, but it also means that there are eight potential ways for your process to go wrong. Finding and fixing issues as they arise will ensure that your procedure is carried out more quickly and efficiently.
This can be achieved by establishing appropriate processes for each phase and adding checks and balances to identify undesirable errors.
Modify the process to fit your needs
Regarding accounting procedures, there is no one size fits all approach. Each sector, business, and team has its operating procedures. Early on, you might discover that your system needs to be adjusted to fit your accounting practices.
For instance, one person can be designated to handle transactions, as relying on two or more people may result in inconsistencies in the transactions that are recorded to the correct accounts. These circumstances can quickly result in an erroneous trial balance and increase the danger of your company’s accounts not being closed on time.
Prepare your group for success.
Give your personnel the resources they require to implement the accounting cycle successfully. This could be offering quarterly training on best practices, having regular meetings with your workers to identify their problems, or giving them the right accounting tools. Your staff will be more influential the better prepared they are.
Try accounting software to lighten the load.
Your job will be more accessible, and the workload associated with maintaining your books will be lessened if you use excellent solutions to automate accounting procedures.
A business accounting platform may automate and streamline various processes, while going digital with your process may seem intimidating at first; you’ll save a ton of time in the long run.
The Accounting Cycle’s Timing
Every accounting period has one accounting cycle. The accounting period for preparing financial records is known as the accounting period. Depending on the firm’s requirements, this can occur weekly, quarterly, or annually.
The company’s tax reporting year is a fiscal year, which can be a calendar year or any other 12-month period. The term “fiscal year” may also be used if the accounting period is a full calendar year. Although businesses may employ many accounting periods, it’s crucial to remember that each accounting period only reports transactions for that specific time frame.
For instance, since the SEC mandates publicly traded corporations to submit their financial statements quarterly, these businesses will use quarterly accounting periods to comply. Companies must also offer yearly tax returns to the IRS to comply with this obligation; these businesses must use annual accounting periods.
The number of employees that perform accounting duties will increase as your organization expands. Bookkeepers often post accounting transactions. On the other hand, accountants oversee bookkeepers and create financial statements.
Businesses and organizations utilize the accounting cycle to record transactions and create financial statements. The standardized accounting cycle procedure, supported by accounting systems, is crucial because it enables small and established organizations to close their books for the accounting period and provide financial data for managing the company’s finances and doing financial statement analysis.