Small business is all about bookkeeping.
While accounting software can take some of the load off through automation and record keeping, there are processes business owners can employ to organize their accounting process and make it more efficient.
One in particular is the accounting cycle.
What is the accounting cycle?
The accounting cycle is an invaluable workflow map that formalizes the process of recording, classifying and summarizing a business’ financial transactions across a fiscal year.
The accounting cycle is a continual workflow, and a bookkeeper follows each of the steps as they happen across the year rather than doing them all at once. This further ensures accuracy since transactions are less likely to be forgotten or recorded incorrectly from memory.
8 steps of the accounting cycle
The accounting cycle process is going to look different depending on if a bookkeeper is using a single-entry or double-entry bookkeeping system.
A single-entry accounting system is used by businesses using cash-basis accounting and will focus on incoming and outgoing cash flow.
A double-entry accounting system is the basis for accrual accounting, which is more complicated than single-entry but also more accurate. More than one account is handled in a double-entry bookkeeping system, and it requires slightly more accounting knowledge to utilize this type of balance sheet.
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All of the steps in this cycle are necessary for double-entry bookkeeping systems. However, single-entry accounting only requires steps 1, 2, and 8.
Some experts have slight differences in the order of their steps, how many there are and how they title them. However, the general flow, content and aim are always the same. As long as it is followed correctly, slight changes in the order of steps won’t impact the overall process.
1. Identify business transactions
Identifying your business’ transactions is the first step. Only include transactions that are directly related to your company’s financial activities.
These transactions can include activities like expenses, purchases, revenue and debt payoff. Any influx or outflux of money to or from your company will likely count as a transaction.
Using documents like receipts and invoices helps in identifying business transactions; be sure to hold on to them to streamline the transaction identification process.
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2. Record transactions in the journal
After you’ve identified a business transaction, record it in a dedicated journal, sometimes called the book of original entry. This journal should be organized chronologically starting with transactions from the beginning of the fiscal year.
For single-entry bookkeeping, an entry will either be a debit for incoming transactions or a credit for outgoing transactions. For example, an invoice would be a debt entry, but a payroll expense would be a credit entry.
If bookkeepers are using a double-entry bookkeeping system, they list two transactions for each entry, one debit and one credit. These entries must be equal, but opposite values, resulting in balance.
3. Post transactions to the general ledger
After recording the transaction in a journal, record the transaction in the general ledger, also called the book of final entry. The general ledger is a summary of a business’ accounts. The entries in the general ledger are changes made to each of your accounts, and transactions are posted to the account impacted.
The general ledger can be a physical document, but it’s far more common for businesses to utilize software to serve as their general ledger.
This part of the process is not necessary for businesses using a single-entry account system since there is only one account being handled. Your journal, or cash book, already serves as a general ledger.
4. Calculate the trial balance
At the end of an accounting period, calculate a trial balance. An accounting period can be a month, a quarter, or a year, depending on the business’ preference.
The trial balance is a test of accuracy to check that a business’ credit and debit entries are equal.
Calculate the trial balance by adding all debit balances together and all credit balances together. Check to make sure the two totals are the same. If they aren’t, there may be an error somewhere in your records or they may require entry adjustments.
5. Adjust entries
A bookkeeper may also have to account for accruals and deferrals in their records as well.
Accruals are revenues or expenses that were incurred, but were not previously recorded. Deferrals are receipts of payments made in advance or upcoming expenses.
6. Adjust trial balance (worksheet)
If the debit total and credit total on a trial balance are unequal, the bookkeeper will have to adjust their entries and search for errors that are then tracked on a worksheet.
Some bookkeepers choose to adjust their entries after they adjust the trial balance. This is a matter of preference, and as long as the trial balance is checked again after accounting for accruals and deferrals, their order does not matter.
7. Prepare financial statements
Once a bookkeeper has adjusted their entries and trial balance, they can use their up-to-date accounts to create financial statements.
These statements include income statements which compare profits and losses across the accounting period. They also include cash flow statements which detail money’s flow in and out of the company. Balance sheets can also show a company’s progress by explaining its assets, liabilities and equity.
The statements themselves are a good measure of performance across the period. Your business can review these statements and use them for the basis of goals in the new accounting period.
8. Close the books
Closing the business’ books concludes financial activity for the accounting period, and transactions that occur after books have been closed will be counted in the next accounting period.
Revenue and expense accounts are zeroed and closed since they are only intended for a single accounting period so a business can track their profit and loss between periods. The only account that remains unclosed are balance sheet accounts since they indicate a business’s financial position at a given time.
Once books for an accounting period are closed, businesses should start setting up their accounting for the upcoming period.
Accounting cycle vs budget cycle
Although they may resemble each other, the accounting cycle and budget cycle are different. The accounting cycle focuses on financial events that have already happened and ensures they have been recorded correctly. The budget cycle, on the other hand, focuses on planning for the financial future of a business.
Why is the accounting cycle important?
While it seems like a ton of record keeping, adhering to an accounting cycle is crucial for businesses. Here are a couple of reasons why.
Efficiency — Having a formalized process and tools for financial record keeping ensures that bookkeepers have a clear roadmap to follow when recording information, which streamlines the process and makes it less prone to error
Internal analysis — The reports that can be generated at the end of an accounting cycle give precious insight into a business’ performance, both within a period and between accounting periods. These insights allow companies to locate which processes and practices are the most profitable.
Time management — Bookkeepers and accountants have an easier time planning their schedules across a period when a formalized accounting cycle is in place since they know ahead of time what responsibilities they’ll be handling.
Compliance — Strict financial record keeping is a necessity in staying compliant with government regulations and taxes. Businesses must disclose their financial records then calculate and pay their taxes. Even well-intentioned businesses can do this incorrectly, leading to government audits and potential fines. To avoid this, consider using governance, risk and compliance software.
Accounting software can be a valuable asset in the accounting cycle process. Learn how a free accounting software can help your business manage your finances on a budget in 2019.