A Beginner’s Guide to the Accounting Cycle
Accurate and reliable financial information is key to making the right decisions that drive your business forward. The more standardized your procedure for gathering and analyzing the data, the more reliable that information becomes.
That’s where the accounting cycle comes in. Following the accounting cycle provides you a fixed set of steps that ensure you have the best possible financial data.
Below, we’ll explain what the accounting cycle is and then explore each step within the cycle so you can more effectively carry out your accounting tasks.
What is the Accounting Cycle?
The accounting cycle is a set of rules governing a company’s accounting process over an accounting period (most often, one month). The “cycle” part of the term comes from the fact that you perform this process every accounting period to ensure consistency in gathering and reporting financial data.
The accounting cycle generally consists of eight steps, although some firms may split one of the later parts into two separate steps. Thus, we’ve laid out the process in nine steps below.
In today’s world of cloud accounting and automation, accounting software solutions handle many of the manual tasks involved in the accounting cycle.
Why is the Accounting Cycle Important?
The goal of the accounting cycle is to ensure every dollar you accurately account for every dollar you earn or spend.
See, you can’t make the right business decisions without assurance that your financial information is as accurate and reliable as possible.
Without a standardized process for gathering, recording, and reporting on your financial information, you could end up with unreliable financial statements. Financial statements are the authority on your past financial performance, so getting them right is of the utmost importance.
Additionally, a standardized accounting cycle saves you (or your bookkeepers/accountants) time and energy. They don’t have to think as hard about what to do during their day-to-day life when they simply have to follow specific steps.
The 9 Steps to the Accounting Cycle
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Identify Your Transactions:
Transactions occur whenever your business does anything that might impact the final financial statements. For example, acquiring a new piece of equipment or selling inventory to customers on credit are transactions.Without financial transactions, there’s no accounting to do. So the first step in the accounting cycle is to identify all your transactions.
This happens throughout an accounting period. It also goes hand-in-hand with the next step in the cycle.
Transactions occur whenever your business does anything that might impact the final financial statements. For example, acquiring a new piece of equipment or selling inventory to customers on credit are transactions.
Without financial transactions, there’s no accounting to do. So the first step in the accounting cycle is to identify all your transactions.
This happens throughout an accounting period. It also goes hand-in-hand with the next step in the cycle.
- Record Your Transactions
During the accounting period, you must record every transaction you identify in its proper journal.
Back in the day, there were separate journals for accounts payables, accounts receivables, fixed assets, and so on. For example, if you bought inventory on credit, you’d enter that transaction in your accounts payable journal.
Today, accounting software solutions have these journals and make it much easier to record the data in the right places. The hardest part is selecting the right accounts and making sure there aren’t any typos when you enter the dollar figures. - Post to the General Ledger
The general ledger, or GL for short, is essentially the master ledger for your business. It breaks down the details of all your transactions by account.
Once again, knowing the intricacies of the GL isn’t as vital as it used to be.
In the past, you’d first enter transactions in their proper journals, then make a journal entry in the GL.
Today, however, most software solutions push transactions from individual journals to the GL automatically. You still need a basic understanding of the GL, but there’s much less work involved in updating it. - Create Unadjusted Trial Balance
Once the end of the accounting period arrives, you generate an unadjusted trial balance.
For reference: a trial balance is a list of all your accounts and their balances. The purpose of a trial balance is to make sure your total debits and credits across all accounts in your chart of accounts are equal.
You’ll then move onto the next step to actually make sure everything equals out. - The Worksheet
If debits and credits aren’t equal, that’s quite normal. Most organizations have some imbalance due to data entry errors, missed transactions, and so on.
During the Worksheet stage, you’ll create a worksheet to hunt down and take note of these imbalances in your trial balance.
Even if you have no errors — which is fairly uncommon — there’s some work to do before creating your financial statements and closing the books. - Make Adjusting Entries
After looking through the worksheet, you’ll create adjusting journal entries to make your debits and credits equal.
First, you’ll likely make some adjusting entries to correct any errors. For example, an invoice you thought had you paid might not have been recorded somehow. You’d make an entry to fix that.
Whether or not you have errors, you’ll also need to account for accruals and deferrals.
For example, say it’s December 28th, 2021. You prepay $6,000 in insurance for a six-month period beginning January 1 of 2022. You’d make the journal entry debiting Prepaid Insurance and crediting Cash.
Then, each month of those six months, during the Adjusting Entries part of the cycle, you’d make an adjusting entry debiting Insurance Expense and crediting Prepaid Insurance to recognize the deferred expense.
This is just one example, of course. You’d do the same thing for all other accrued and deferred revenues and expenses. - Create Adjusted Trial Balance
Upon finishing your adjusting entries, you’ll generate your adjusted trial balance to double-check your work. Total debits and credits across all accounts should now be equal.
If they don’t, you can repeat the previous and current steps as necessary until things are equal. - Generate Financial Statements
Your financial statements are the result of your hard work during the accounting cycle. They provide you key information regarding your business’s financial health.
You’ll generate an income statement and a balance sheet at the minimum. The former details your financial performance over the period, while the latter displays your financial position for a specific point in time (aka right now).
Cash flow statements aren’t mandatory here, but they can supplement the two main financial statements — especially if you have lenders or investors that are curious about your business’s financial standing. Cash flow statements are helpful for your own analysis as well. - Close the Books
Finally, you close out the accounting period at the end of a specified day near the end of said accounting period. Revenues and expenses are closed, zeroed out, and their balances are transferred to the proper permanent accounts, such as retained earnings.
After closing the books, the cycle begins again.
Well, actually, the monthly closing for the last cycle may occur during the first few days of the next cycle. Therefore, you may be closing the last cycle’s books while identifying and recording transactions for the current cycle.
Accounting: A Continuous Cycle
The accounting cycle standardizes the process of gathering and presenting financial information for accountants and business owners alike. By following the nine steps of the accounting cycle, you’ll have more reliable financial data to make vital business decisions.
Today, accounting software like ZarMoney automates a decent chunk of this process — from posting journal entries to generating financial statements and more.
Try ZarMoney free for 14 days to see how it can help you through the accounting cycle!
