Following the 8 steps of the accounting cycle is essential for maintaining comprehensive and accurate books. You can use them to efficiently manage finances, collect data for more informed decisions, and comply with regulations. Read our guide to understand each of the accounting cycle steps and learn how to implement them effectively.
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What is the Accounting Cycle?
The accounting cycle is an eight-step process that businesses use to record and analyze their finances. It begins with identifying and recording transactions and ends with checking the balance, publishing statements, and closing the books.
Businesses follow these eight steps over the fiscal year which runs from October 1st to September 30th. Some also run internal accounting cycles for shorter periods, typically months or quarters. We call these internal cycles because they focus on in-house financial management and don’t usually involve external stakeholders.
What are the 8 Steps in the Accounting Cycle?
In this section, we’ll outline all the steps of the accounting cycle, their best practices, and the advantages of using this system. Here’s a quick overview of the stages:
- Identify the Transactions
- Record the Transactions
- Post to General Ledger
- Prepare Trial Balance
- Analyze the Worksheet
- Adjust Journal Entries
- Create Financial Statements
- Close the Books
1. Identify Transactions
The first step involves examining your accounts and identifying any transactions that affect your finances. While this isn’t an exhaustive list, you’d typically consider:
- Sales revenue
- Employee payroll
- Business expenses like rent and utilities
- Payments to suppliers
- Assets you’ve purchased
Most businesses now use accounting software to automatically record transactions and rule out the possibility of human error. You can integrate your bookkeeping software with point-of-sale terminals to capture revenue as it comes in. Likewise, you can usually connect your bank accounts to record ingoings and outgoings.
2. Record Transactions
Once you’ve identified transactions, you can document them in a journal. It’s standard practice to use the double-entry method whereby you record all financial activities as both a debit in one account and a credit in another.
For example, if you purchase $100 worth of office supplies, you might debit this amount in Assets and credit it in Accounts Payable.
What is the purpose of journals in the accounting cycle when you also have a general ledger? The journal allows you to record transactions as they occur, in chronological order, in more detail. On the other hand, you organize the ledger by accounts, not dates.
You have to choose between cash or accrual accounting to document your financial activities. The cash method records immediate cash flow whereas the accrual one records transactions, regardless of whether the money has changed hands.
There are pros and cons to each method. Although cash accounting is simpler, accrual accounting gives you more oversight of your financial health. Some company types are required to use accrual accounting by the IRS (Internal Revenue Service).
3. Post to General Ledger
After you’ve recorded your financial activities in the journal, you can transfer them to your general ledger. You need to add each transaction to the relevant account. For example, if you have a sale, you can put it into Accounts Receivable in your ledger.
Most accounting software automatically records and categorizes transactions in a digital general ledger.
4. Prepare Trial Balance
You can calculate a trial balance at the end of the fiscal year. This amount represents your closing balance for all your general ledgers before you’ve checked them for accuracy.
If any credit and debit amounts are different, you know you’ve made a mistake somewhere in your books.
You can skip the fifth and sixth steps if your credit and debit amounts match across all of your accounting trial balances.
5. Analyze the Worksheet
Where there are discrepancies, you need to analyze your books to look for missing or incorrect records. You can use the difference between the credit and debit amount to guide you. For example, if you notice your expenses are $500 higher on the credit side, you know there may be an unrecorded cost of the same amount.
Perhaps you’ve been using cash accounting but your business is required to use the accrual method. If so, you can post adjusted entries to meet IFRS (Internal Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles) guidelines.
Essentially, you ensure you’ve recorded any money earned or charges incurred within the fiscal period. If you’ve got a bill, for example, you would record it even if you don’t pay after you’ve closed the books.
6. Adjust Journal Entries
After finding the source of any discrepancies, you can add the adjusted entries to your general ledger. The credit and debit amounts across all general ledgers should now match.
You can also account for any transactions regardless of cash flow if you have to use accrual accounting. The aim is to accurately represent your financial position in your books at the end of the fiscal year.
7. Create Financial Statements
Now you have all the data you need, you can use it to create financial statements. There are three main types:
- Income statement: Summarize your revenue and expenses over a period to show your overall profit or loss.
- Cash flow statement: Track your cash flow across three main categories, operating, investing, and financing.
- Balance sheet: State your company’s assets, liabilities, and equity.
External stakeholders can look at these documents to check your financial performance. With the new information, they can decide how they want to continue engaging with your business. For instance, investors may decide they’d like to increase their stake in the company due to its profitability that year.
8. Close the Books
As you end the fiscal year, you transfer all these records to your permanent accounts. Then you can return the balance across all your books to zero.
After you’ve closed the books, it’s challenging to reopen them and make edits. You should ensure you’ve finalized everything before you move on to the next period.
You’re not finished with the paperwork, though. You’ll use the financial records to complete your tax returns and analyze your performance among other tasks.
Why is the Accounting Cycle Important?
Completing all the steps in the accounting cycle ensures you keep comprehensive and accurate financial records. As a result, you’ll find the following benefits:
- Regulatory compliance: Keeping accurate financial records makes it easier to comply with local and federal regulations. For example, you can avoid a penalty of up to 20% of your business income for an incorrect tax return.
- Greater oversight: Having clear and accurate records gives you more insight into how your company is performing. You can make more informed financial decisions.
- Lower risk of illegal activity: With more oversight into your business, you’re more likely to notice discrepancies caused by theft or fraud.
- More consistency: Standardizing the process also streamlines your workflow. Any staff involved in accounting have a clear process to follow so they’ll be more efficient at bookkeeping tasks. You’ll also find it easier to check and edit your books when you’re all following the same steps.
According to a study by Xero, more and more businesses are standardizing accounting with the help of software and consulting services. This means following the accounting steps isn’t just a strategic necessity but essential to remaining competitive.
The accounting cycle is key to your organization’s financial success. As well as providing a straightforward process to record and analyze your transactions, it helps you streamline bookkeeping tasks. Nowadays, you can also use accounting software to automate most of the process and simply run checks. Even those with limited bookkeeping experience can master the eight steps to improve their financial management.