Without financial statements, business owners would be lost. They are crucial for things like planning expenses, securing loans, or even selling the business. You may run a business without understanding how a financial statement is created. They are part of the accounting cycle, which may also be referred to as a bookkeeping cycle or the accounting process. The accounting cycle is a series of steps through which all your company’s raw financial data is converted into financial statements.
Purpose of the Accounting Cycle
Working through the accounting cycle properly ensures your company’s financial statements are accurate, consistent, and also conform to the official financial standards. (IFRS and GAAP) Essentially, the accounting cycle accounts for all money flowing through your business. Even small businesses benefit from a professional bookkeeper. A bookkeeper or accountant makes sure a business remains healthy by keeping records and as well as producing financial statements.
Accounting Cycle Steps
The accounting cycle has numerous variations depending on cash and accrual accounting methods. Some accountants work through as many as 10 steps, but here, we broke them down into six essential steps.
Step 1: Analyze and Record Transactions
The first step in the accounting cycle is gathering all business transactions in the current accounting period. This includes gathering things like invoices, receipts, and bank statements. All of this raw financial information is entered into the accounting system so it can be translated into useful statements.
An accountant records all the information including the date, location, and amount of each business transaction. Once recorded, they analyze the purpose of each transaction. Every receipt and invoice contains information about business finances. Each piece is noted including office supplies on an Office Depot receipt or an oil change for a company vehicle. The accounting cycle needs these bits of information to create an accurate account.
Step 2: Post Transactions to the Ledger
Accountants and bookkeepers use a general ledger to track and record financial information gathered in the first step. A ledger is a large, numbered list whether hardcopy or online, containing all the transactions made by your company. The ledger contains all the necessary information about each transaction including an entry for each debit and credit. Accountants must determine how to classify each transaction – debit or credit. Once that is done, then the accountant enters the data into the ledger. They also must post journal entries in the ledger as soon as the transaction is complete. This quick action ensures the books remain up to date. Some businesses use software that posts transactions automatically.
Step 3: Preparing an Unadjusted Trial Balance
When the accounting period ends, accountants prepare an unadjusted trial balance. They add up the credits and the debits in each of the company’s accounts. They use these totals to calculate each account’s individual balance. The benefit of an unadjusted trial balance is having all the totals in one place. The total credits need to equal the sum of the debits. If these two totals are not equal, an error has occurred somewhere. For those using accounting software, it usually means the mistake occurred with information being input into the program. Correcting entries is the term used for searching and fixing these types of errors.
Step 4: Prepare Adjusting Entries at End of Period
Once the accountant corrects entries, they make adjustments. They check the entries to ensure your financial statements contain only information relevant to a specific time frame. There are four main types of adjustments.
- Deferrals: Money the business spent before receiving revenue.
- Accruals: Revenue from unpaid invoices.
- Tax adjustments: Once a year adjustment such as accounting for depreciations.
- Missing transaction adjustments: Missed entries like a purchase for your business on your personal account.
Step 5: Prepare an Adjusted Trial Balance
After posting adjusted entries, an account creates another trial balance. The bookkeeper also takes any previous adjustments into account. The new balance is called the “adjusted trial balance.” The new balance proves all the ledger’s debits and credits balance once the adjustments are made. Once this step is completed, you have the information needed to prepare financial statements.
Step 6: Prepare Financial Statements
The final step in the accounting cycle is to prepare financial statements. They tell you where your money is presently, and the road it took to get there. Having a financial statement is the biggest reason to go through the steps in the accounting cycle. Financial statements use the compiled information.
- First, your accountant prepares an income statement that contains all the revenue and expense sections from the trial balance.
- A balance sheet lists assets, liabilities, and the owner’s equity in the business.
- The cash flow statement shows how cash enters and leaves the business.
Once you, a bookkeeper, or a CPA prepare all the financial statements, you’ll make one more round of adjustments. This action closes out the temporary accounts. Now it’s time to get ready for the next accounting cycle.
Closing the Books of an Accounting Cycle
As a business transitions into a new accounting cycle, it’s time to close the books. For most businesses, closing the books signals the end of a fiscal year. Closing the books means tying up loose ends and resetting the balances (revenue and expense balances), so the new year starts fresh. To do this, an accountant makes “closing entries,” Closing entries offset balances in both expense and revenue accounts. Everything goes back to zero essentially. The remaining balances reflect the profit or loss for the year. For this, accountants use the term, “retained earnings.”
The accounting cycle sounds like a lot of work, right? That is because it is. But in the end, it is worth it since it offers you actionable financial insights. Many business owners handle their own finances and accounting cycles. But hiring a bookkeeper relieves you of a lot of work so you can focus on your business.