Winning business owners know financial management is one of the most critical factors in a company's success. An accounting cycle is one of the best ways to keep track of your business's finances. It creates simple, organized financial data that external parties – such as investors – can easily interpret.
The accounting cycle tracks each transaction from the moment of purchase until the date it's added to a financial statement. This eight-step process, usually completed through accounting software, is a great way to get more time in your day to focus on growing your business while protecting your assets from theft. By maintaining the accounting cycle consistently, you will notice balance discrepancies at a glance.
Here's a look at the accounting cycle and its eight-step process.
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What is the accounting cycle?
The accounting cycle is an organized set of steps used to identify and maintain records of transactions made within your company. This process is used to document, categorize and summarize each transaction your business makes during a given time period. The process begins when a transaction takes place and ends with a completed financial statement. [Related: Accounting Mistakes That Cost Small Businesses Significant Growth]
You can automate the accounting cycle's steps with accounting software, thus reducing common mistakes that arise when financial data is manually processed. A bookkeeper often manages the entire accounting cycle process for you.
An accounting cycle's timeframe can vary based on factors unique to each business, but most business owners choose to start a new accounting cycle annually.
How does the accounting cycle work?
The accounting cycle begins with a bookkeeper or accountant documenting your business's financial transactions. Once the accounting period ends, the books are closed, and financial statements are created detailing the information captured. These financial statements are then shared with company stakeholders and government entities.
The process is generally separated into a series of eight to 11 steps. Here is a breakdown of the eight-step cycle.
8 steps of the accounting cycle
The exact accounting cycle steps may vary by a company's individual needs. However, the following process for tracking activity and creating financial statements doesn't change.
1. Identify the transactions.
The first step of the accounting cycle is identifying each transaction that creates a bookkeeping event. Bookkeeping events are sales, refunds, vendor payments and any other financial transactions that take place in your business.
In accounting, the transaction types are cash, noncash and credit events. You can identify transactions through invoices, receipts and other documents that record activity within your business.
2. Record the transactions.
Next, each transaction should be documented as a journal entry. Also known as a "book of original entry," this is the book – or spreadsheet – where all transactions are initially recorded.
Each entry should list details about every transaction in chronological order. If your company uses double-entry accounting, the details include a debit and credit for each transaction. This makes it easier to track how events affect your finances.
3. Post the transactions.
After transactions are entered in the journal, they should be posted to your general ledger. Posting occurs when the initial entries are added to the general ledger. The general ledger functions as a summary of all business transactions balanced using debits and credits.
Transactions posted to the general ledger should be separated into five categories:
- Assets
- Liabilities
- Capital
- Expenses
- Income
These categories make it easy to find transactions quickly. However, if debits and credits aren't balanced, it's a sure sign your financial statements won't be accurate.
4. Prepare a trial balance.
Once journal entries are posted to designated general ledger accounts, it's time to prepare an unadjusted trial balance. The unadjusted balance is used to analyze account balances to ensure that the debit and credit totals in the ledger accounts are correct.
To create an unadjusted trial balance, list all general ledger account balances before adjusting entries for your financial statement. You can use the trial balance to create basic financial statements without sorting through the general ledger. While these balances can be manually listed, the trial balance process is built into many accounting software systems.
5. Fix any errors.
This is a crucial step when you've found that the debits and credit of your trial balance aren't equal. To locate the error, compare the information in question to previous journal entries on the spreadsheet.
One common error is posting to the incorrect account. When this happens, debits and credits are equal, but the activity for the account may seem unusual. This is the time to make the necessary adjustments.
6. Add the adjusting entries.
As you get closer to the end of the accounting period, you'll need to add adjusting entries – or end-of-period adjustments – to your journal. These entries ensure your accounts reflect the correct expenses and revenues for the accounting period.
Include prepayments, accruals and noncash expenses in these entries. This step is especially important when you list transactions that impact more than one accounting period.
7. Create your financial statements.
Now that your adjusting entries are posted, create an adjusted trial balance and complete your financial statements. The adjusted trial balance should list all ending balances for your general ledger accounts.
Once the adjusted trial balance is complete, it's time to create your financial statement or annual report. In your financial statement, list information in a simple, organized format. Tax authorities, employees and other parties interested in understanding your business's financial position will review the information in your financial statement.
The three major types of financial statements – or accounting reports – are the balance sheet, income statement and cash flow statement. These statements explain a company's financial standing and serve as an indicator of operational performance.
8. Close the books.
After you prepare your financial statement, it's time to end the accounting period. At the end of each period, you'll use closing entries to finalize your expense and revenue records.
The closing entry process involves transferring your net income into retained earnings. When earnings are transferred, all temporary accounts should be closed.
The final step is to document the post-closing trial balance to review debits and credits before beginning the next accounting period. Since this step zeroes out your revenue, the post-closing trial balance would only include balance sheet accounts.
When does an accounting cycle begin and end?
The accounting cycle timeframe is based on an accounting period you select based on your company's needs. During the chosen accounting period, financial statements are created and shared. To ensure compliance, it's common for business owners to end each accounting period annually.
On the other hand, some business owners opt for accounting periods of three or six months. Guidelines from the International Financial Reporting Standards (IFRS) allow the accounting period to span 52 weeks. This time period is known as the fiscal year.
Accounting software and the accounting cycle
Accounting software is an excellent way to save time and effort by automating the entire accounting cycle. As your business grows, you may find you need more than one employee to handle all the accounting cycle steps for your company. The best accounting software is an investment that can save you money in the long run.
You'll want to choose accounting software based on your business's current needs. For example, if your organization generates many invoices, consider an accounting software solution that can keep up with the pace, like FreshBooks. Read our FreshBooks review for more information.
However, if you're focused on inventory management because of your growing sales team, OneUp would be an excellent choice. Read our in-depth OneUp review to learn more.
Even if you choose to hire an accountant or bookkeeper to oversee the accounting cycle for your business, accounting software can simplify their duties. They can use accounting software to record business transactions and automatically generate financial statements.
By computerizing most of your accounting cycle steps, you'll drastically reduce the chance of costly errors in your financial statements.