What Is The Accounting Cycle?
To understand why accounting and bookkeeping are necessary for your business, you first need to understand what the accounting cycle is. The accounting cycle gives you an overview of how a business’s finances are recorded and analyzed. The accounting cycle provides the standard workflow and process that aligns with the Generally Accepted Accounting Principles (GAAP) established by the Financial Accounting Standards Board (FASB) in the United States. The accounting cycle consists of the following 8 steps:
Identifying Transactions
Journalizing Transactions
Posting Transactions to the General Ledger
Calculating the Unadjusted Trial Balance
Making Any Necessary Adjusting Entries
Calculating the Adjusted Trial Balance
Creating the Financial Statements
Creating the Closing Entries/Closing the Books
It seems simple enough, but completing the accounting cycle for a specific period of time can be complicated. Let’s dive into what is typically achieved in each step:
The first three steps, identifying transactions, journalizing transactions, and posting transactions to the general ledger, are often grouped into one step because they are typically done at the same time. When a bookkeeper starts working on a business’s books, they usually begin at the start of a specific time period, such as the 1st of the month. They will start reviewing the transactions the business made, and will make a journal entry to categorize the transaction to the correct account (for example, journalizing a large inventory purchase by debiting the inventory account, and crediting the cash or accounts payable account). Once all transactions are accurately identified and journalized, they will be posted to the general ledger as part of the permanent record in the business’s financial data.
The next step in the accounting cycle is to calculate the unadjusted trial balance. A trial balance is a ‘trial’ balance of all the accounts in the general ledger. The trial balance is calculated to ensure all accounts are accurate and balanced. The trial balance will list assets, liabilities, equity, dividends, revenue, and expenses (listed in that order). If all the debit accounts (assets, expenses, and dividends) equal all the credit accounts (liabilities, equity, and revenue), that is typically a good indication that the unadjusted trial balance is correct and does not need adjustments. However, adjustments are still required for things like accrued expenses and revenues, deferrals, and depreciations.
The fifth and sixth steps in the accounting cycle, making any necessary adjusting entries and calculating the adjusted trial balance, are also often grouped into one step. An accountant or CPA professional will review the business’s books and determine what adjustments need to be made. Typically, bookkeepers only journalize these adjusting entries and post them to the general ledger. Once the adjusting entries are made, an adjusted trial balance is calculated to ensure all errors have been fixed and no additional entries are needed.
After an adjusted trial balance is calculated, the financial statements can then be prepared. The four main financial statements are the income statement, the balance sheet, the statement of equity, and the statement of cash-flow. These financial reports will provide insight into the health of your business, and will help you create budgets and make future financial decisions. We’ll go into depth on each of these statements in future blog posts.
The final step in the accounting cycle is to create the closing entries and to ‘close the books’ for the current time period, also known as year-end or month-end close. This is done at the end of each fiscal year (year-end close), and will typically be done at the end of each month as well (month-end close). Closing entries are essentially journal entries that close each of the temporary accounts in the general ledger (like revenue and expenses), so that they are reset and have a zero starting balance for the next month or fiscal year (for example, recording the closing entry for the revenue account by debiting the service revenue account the remaining amount, and crediting the income summary the same amount).
All of these steps sound like a lot of work, because they are. However, they are extremely important in ensuring the accuracy of your financial records. This helps you budget and plan for the future, while also guaranteeing tax compliance.