The term "accounting cycle" sounds like a no-brainer. If you run a business, you must go through the cycle.
But there's a good reason why businesses must know how to do it: It records, classifies, and audits business transactions during a specific accounting period. If it's done incorrectly, there's room for error, fraud, and lost cash.
But when done correctly, this process keeps the business's transactions organized and provides a birds-eye view of ensuring the debits and credits are in balance.
What is the accounting cycle?
The accounting cycle refers to the process of recording financial transactions and reporting activity within a business.
The process starts with analyzing incoming and outgoing transactions like purchases and sales. It ends with preparing financial statements, like the balance sheet, income statement, and cash flow statement.
These three financial statements are fundamental to accounting and proper business bookkeeping. Together, they can provide both a birds-eye and in-depth view of your business's financial health and habits.
Businesses only need to conduct the eight-step accounting cycle at the end of a fiscal or calendar year when books must be closed out. This is called the end of the accounting period.
There are two ways to manage the accounting cycle: Through single-entry or double-entry accounting. But given the amount of technology businesses rely on to operate, single-entry accounting has become outdated.
Almost all businesses now use double-entry accounting, which requires extra steps and guarantees more accurate data.
The importance of double-entry bookkeeping
Double-entry bookkeeping refers to recording transactions twice — once in the Debit column and once in the Credit column. This clear recording makes it easier for business leaders, lenders, and potential investors to see how healthy cash flow is compared to liabilities, like debts and bills.
This method also helps prevent errors and fraud through frequent checks and balances. It also leaves a clearer paper trail, which is essential for audits. For example, if the IRS flags what they deem suspicious, you could easily trace it back to your ledger to double-check its accuracy.
The 4 aspects of the accounting cycle
Before diving into the eight steps of the accounting cycle, it's helpful to understand the parent aspects — accepting, recording, sorting, and crediting:
Your bookkeeper should "accept" every transaction to ensure that it is accurate and it was purposely placed.
If a transaction is accepted, then it can be recorded. If it was an error, you should reach out to the customer or vendor to remove or replace it.
Record essential information from the transaction, such as the transaction date, amount, customer name, and other information determined by the business needs.
Sales are documented as invoices, payments as receipts, and adjustments as both a credit and a refund.
Sorting transactions is when transactions are listed in a journal post to an accounting ledger that is categorized into assets, liabilities, revenues, expenses, and equity.
Transactions posted to the accounting ledger must also be accurate and balanced, which is why double-entry accounting is necessary.
Crediting is where you'll make adjustments. All adjustments, debits, and credits should be factual, or you risk repercussions such as false revenue amounts, which could lead to later tax reporting and payment issues.
The 8 steps of the accounting cycle
There are eight steps in the accounting cycle. While this might look intimidating at first, it quickly becomes muscle memory the more you do it. Some steps are straightforward and won't take more than a few minutes.
The steps of the accounting cycle are:
- Identify transactions
- Record journal entries
- Post to the general ledger
- Prepare an unadjusted trial balance
- Adjust journal entries
- Prepare financial statements
- Close the books
If you don't have the time to learn these steps or want to spend money on an in-house bookkeeper, then you might be better off with an AP and AR automated software that can do the entire accounting process for every transaction within moments.
Step #1: Identify transactions
The accounting cycle starts with identifying the transactions. There are many transactions throughout a single accounting cycle, and a business has to record each one correctly.
Say that a small LLC, Ray's Custom Signs, is nearing the end of its accounting cycle. It's time to go through the various transactions that Ray's Custom Signs saw over the past quarter, including sales and expenses, like supplies and delivery costs. Ray will check each transaction and confirm its accuracy.
Step #2: Record transactions in journal entries
With each confirmed transaction, you have to record them in journal entries. Journal entries contain specific information relevant to the transaction, such as the date, transaction number, amount, description, and which accounts are affected.
Step #3: Post to the general ledger
After you've recorded the transaction in a journal entry, you'll post them to the general ledger.
The general ledger is the official record of the accounting period, tracking account balances, cash flows, and debit balances within accounting periods. Without the ledger, business owners could not generate reporting, prepare to submit financial statements, and do financial analysis for their day-to-day operations.
Step #4: Calculate an unadjusted trial balance
This step occurs in the second half of the accounting cycle after the period ends and you've already identified, recorded, and posted your transactions.
An unadjusted trial balance ensures that total debits equal total credits. If they are, then nothing is there are no errors. You must go back and find what's incorrect if they're not.
Finding the unadjusted trial balance identifies any anomalies or errors before moving forward. Once you have an adjusted trial balance, you can go on to the next step to double-check.
Step #5: Analyze the worksheet
An accounting worksheet is an essential tool that determines the accuracy of your financial statements during an accounting period. So, if any entries need to be corrected, this step will identify which ones and how.
If you use the accrual accounting method, this step will also ensure whether or not your revenue and expenses are accurate. You can adjust any issues in the next step.
Step #6: Adjust journal entries
If any entries need to be adjusted, you should make a note explaining the adjustment. For example, if you're adjusting a bill you paid, you'll make a note to refer to the reconciling bank statement that cites a different amount.
After you've adjusted the necessary entries, check the ledger and see if your debit and credits are equal. If you want to triple-check your work, you can produce an adjusted trial balance report, which will cite all the notes and changes made.
Step #7: Create financial statements
By now, you know that the accounting cycle helps produce three critical financial statements:
- Income statement
- Balance sheet
- Cash flow statement
Depending on whether or not it's applicable, you may also produce an owner's equity statement.
You need to pull all the information from the steps you've conducted for this accounting cycle and plug them into these documents. The U.S. Securities and Exchange Commission (SEC) requires that all public companies provide annual and quarterly reports that encompass data from all these documents.
The good news is most accounting software can do this for you automatically.
Step #8: Close the books
The accounting cycle ends with closing the books, typically occurring at the end of a fiscal or calendar year. But, doing this monthly or quarterly is not uncommon.
Unfortunately, "closing the books" is not as simple as it sounds. Properly closing your books requires a few steps because the goal is to return the balance of your temporary accounts to zero, meaning you need to identify your permanent vs. temporary accounts. A chart of accounts can help manage and differentiate these accounts.
Permanent accounts are the ones found on your balance sheet, like assets, liabilities, and equity, which may include accounts payable, accounts receivables, inventory, retained earnings, and equity.
You must transfer the balance of these accounts to the next accounting period so they can remain the same. After all, just because it's the end of your accounting period doesn't mean you automatically get rid of any debt.
Temporary accounts are your revenue, expense, and dividend accounts, which may include earned interest, utilities, rent, and sales returns. These can be closed at the end of each accounting period because you're ready to begin tracking a new month, quarter, or year of business.
That's why they must be set back to zero by transferring the balance into permanent accounts. At the end of your accounting period, you'll have an Income Summary account, which receives all the temporary income and expense accounts. So, for example, your transfer might look like this:
- Revenue → Income Summary
- Expense → Income Summary
After you've transferred your income and expenses into the Income Summary account, you'll close that and move it to the Retained Earnings account, which is a permanent account.
How the accounting cycle differs from the budget cycle
The budget cycle is similar to the accounting cycle in that it tracks permanent accounts and their financial transactions. However, the accounting cycle focuses on historical transactions, while a budget focuses on future transactions.
When your bookkeeper records a debt payment you've made to a lender, they will go through an eight-step process that ensures the amount was correct, the payment was made, and the amount is accurately reflected in the books. This is part of the accounting cycle.
When it's the end of the quarter, and it's time to create a new budget for the next quarter, you need to look at historical data and predict what kind of budget your business can comfortably abide by. Through preparation, approval, execution, and evaluation, you'll learn if you need to cut down or if you can expand. This is part of the budget cycle.
Advantages and drawbacks of the accounting cycle
Without the accounting cycle, you put your business at risk for fraud, poor performance, and insufficient cash flow.
Although the accounting cycle is like the heartbeat of monitoring your business's financial health, there are drawbacks worth noting, such as the fact that it can't answer everything.
- The accounting cycle provides transparency. The best part about using the accounting cycle is that you know everything is accounted for. There is less room for mistakes and fraud, which happens more often when double-entry accounting isn't used.
- The accounting cycle has controls in place. "Controls" refers to the checks and balances in accounting that ensure the accounting cycle is accurate and ethical. Accounting controls are unique procedures that help ensure validity in transactions.
- The accounting cycle helps business leaders scale. Business managers rely on the financial statements from the accounting cycle to identify trends, create budgets, and ultimately, decide whether or not they can scale. They're also essential documents to present to lenders and investors.
- The accounting cycle is sensitive and time-consuming. Accounting is a specialized skill, and while accounting principles can be simple to understand, it still takes a detail-oriented person to perform the accounting cycle. The best way to mitigate the difficulty is to use accounting software to manage your transactions.
- The accounting cycle requires controls. Accounting controls are necessary to reduce fraud because accountants, managers, or salespeople can easily manipulate and record transactions for personal gain in the accounting process. You can avoid this by implementing auditing controls and relying on automation to automate controls.
Simplify your accounting cycle with BILL
The accounting cycle comprises many moving parts that build up the financial statements you need to track your business performance. It keeps records of every transaction that goes through your business.
From small LLCs to megalith corporations, all businesses use some form of the traditional accounting cycle. Small business owners (SBOs) might manage it via Excel sheets or by hand with a traditional ledger. But, it's much easier to record, track, and analyze using automated accounting software.
Accounting software can make managing your accounting period easy for your business. BILL helps businesses like yours automate accounts receivables, accounts payables, and payment receipts. Learn more at BILL today.