The simplest question a Certified Public Accountant (CPA) can answer is “What is an accounting cycle?” But for small business owners, it’s a revelation. Streamlined accounting cycles prevent accounting mistakes and bring order, utility, and visibility to the financial side of your business.
Today, I’m going to give you a simple, six-step description of the accounting cycle and the steps to implement it as soon as possible.
The accounting cycle is a standardized, periodic process to identify, analyze, and record financial transactions.
So, that’s a pretty comprehensive definition in the heading above. But, when we use the word “periodic,” the question we’re led to is “What is the beginning and end of the accounting cycle?” Let’s use some bullet points.
- The accounting cycle begins when your business engages in a transaction.
- The accounting cycle ends when that transaction is recorded in your financial statement.
That’s fairly straightforward. But what is an accounting cycle in the context of a business year? Well, it’s the time between “transaction” and “financial statement.”
How long does the accounting cycle last?
The accounting cycle repeats every fiscal year. Again, pretty straightforward.
The steps of the accounting cycle are the same regardless of the accounting method you use.
Successful businesses properly manage each of the steps in the accounting period. First, let’s talk about cash vs. accrual accounting.
Cash accounting focuses on the actual payments that come in and go over a given accounting period, while accrual accounting covers a broader range of financial activities like bills you owe and money owed to you. Accrual accounting is more complex, but with the proper processes and people in place, it’s the more accurate method for seeing financial transactions over time.
I’ll be discussing the accounting cycle as it is practiced under the accrual accounting method, but you’ll take the same essential steps regardless of the accounting method you choose.
Step #1: Identify transactions.
Historically, accounting for every business transaction was a daunting task. But in 2024, we can use automation to record transactions accurately. Here are some top tips to streamline this process:
- Match all relevant documents to the impacted accounts, such as cash receipts, disbursements, and sales.
- Leverage automation tools to send transaction details directly to the general ledger, reducing errors and saving time.
The most important thing here is standardizing and organizing your transactions. By creating journal entries for routine transactions, such as depreciation or accrued wages, you can minimize errors and ensure consistency.
Step #2: Record transactions as journal entries and post journal entries in your general ledger.
We’ve identified our transactions, and now it’s time to record them using journal entries.
A journal can be on paper, organized in a spreadsheet, or managed inside of accounting software, but the function of a journal is to contain a running record of your business’s financial transactions. Your journal should contain the following items as entries:
- Receipt of an invoice or recognition of a sale
- Expenses
- Debts
- Liabilities
- Inventory
Remember to include the date of invoices and expenses, a description of each transaction, and the affected accounts. Where applicable, I recommend adding an additional entry that addresses tax implications.
Exactly how valuable is an organized journal?
Your journal is the cornerstone of accurate record-keeping because it is an objective document. There’s no room for misinterpretation, and that’s valuable in the accounting cycle, where complexity and risk of error increase with each step.
Consult your journal for clarity in decision-making, management, and performance.
- Reconcile accounts in the future.
- Give owners and management a clear picture of the day-to-day business activities.
- Gather information to produce performance metrics or evaluate the profitability of new ventures.
- Plan and prepare taxes with minimal risk of an audit.
Step #3: Post transactions from your journal to your general ledger.
Posting journal entries separates each transaction by account and produces a “trial balance.” Your trial balance is a method of verification for debits and credits, ensuring that the two values match. To simplify the process further, place debits and credits beside each other.
Here are the guidelines in bullet points:
- List debits and credits in the left and right columns, respectively.
- Compare the balances: Discrepancies indicate errors.
- Utilize accounting software to reduce the risk of mistakes common with manual entries, such as partial transactions or incorrect amounts.
Software and automation reduce mistakes, but you need to check in on the process and the people responsible because that’s what drives improvement. Software is just the labor.
Step #4: Adjust and correct journal entries.
Adjusting entries is often necessary to align your records with actual financial activity. This step involves recording accrued items, making estimates, and correcting errors identified in the unadjusted trial balance.
(Traditionally, we’d include a “worksheet” step. But this is an introduction for business owners, not accountants. So, we’re keeping the process lean.)
Adjusting journal entries can get tricky, so read these three steps closely.
- Collect all items associated with your trial balance report.
- Manage unpaid invoices by recording expenses for invoices yet to be paid and estimating revenue for services that still need to be invoiced.
- Correct the errors discovered during your reconciliation process.
In accrual accounting, we estimate bad debts or uncollectible accounts by recording them as expenses. This is the correct time to review and confirm depreciation on long-term assets.
Step #5: Prepare financial statements.
The adjusted trial balance report is your primary tool for preparing financial statements. Gather all financial information, and ensure that all the accounts are accurately adjusted for transactions during the accounting period.
- Generate financial statements for internal use by preparing a balance sheet and income statement that gives a concise overview of the company’s financial position and performance. These statements are used for internal management and decision-making.
- Prepare financial statements for stakeholders such as investors, lenders, and regulators. The cash flow statement and disclosures should provide a complete picture of the company’s financial health.
Once the financial statements are prepared, review and analyze them to ensure they tell the same story. Identify potential areas of concern or opportunities for improvement.
Step #6: Close the books.
Temporary accounts, including revenue, expense, and dividend accounts, are used to record a business’s financial activities within a specific accounting period.
At the end of this period, the balances in these accounts are transferred to the income summary or directly to retained earnings, resetting them to zero for the new period.
If you can answer “yes,” to the sentence below, it’s time to close the books.
“I can verify that the closing trial balance displays zero for all temporary accounts. All of my accounts are now ready to receive the data for the next accounting period.”
That’s where we want to be at the end of the accounting cycle.
Comprehensive documentation is the key to efficient accounting procedures.
Five core elements of your financial statements should include the following:
- Balance sheet.
- Income statement.
- Statement of cash flows.
- Statement of retained earnings.
- Any necessary disclosures.
Source documentation, such as receipts and journal entries, should be carefully filed alongside the relevant tax returns for at least seven years.
Start with solid processes for efficient, low-cost, and accurate accounting.
If you’re a growth-stage business with over $250K in annual revenue, now is the time to get your accounting cycle squared away. I can help.
Schedule a discovery call today, and we’ll get with your team and set up an enterprise-level process.
Talk soon,
Jeremy A. Johnson, CPA