Accurate books and records are the foundation of a healthy business, and it all starts with the accounting cycle.
The accounting cycle is a process for recording, classifying, and reporting business transactions for a specific accounting period. When done correctly, it helps prevent errors, fraud, and lost cash.
It also keeps the business's transactions organized and provides a birds-eye view of the business’s financial position and results of operations.
This article explains what the accounting cycle is, the steps involved, and how following these steps can elevate your bookkeeping and financial reporting.
What is the accounting cycle?
The accounting cycle is the process of recording financial transactions and reporting activity within a business.
The process starts with analyzing incoming and outgoing transactions like purchases and sales. It ends with preparing financial statements, like the balance sheet, income statement, and cash flow statement, and closing the books.
Businesses need to conduct the eight-step accounting cycle for each accounting period. That accounting period might be a month, a quarter, or a fiscal or calendar year.
There are two ways to record transactions during the accounting cycle: Through single-entry or double-entry accounting. Most reputable accounting software uses double-entry accounting. As a result, single-entry accounting has become outdated.
The importance of double-entry bookkeeping
Double-entry bookkeeping refers to recording every transaction in at least two accounts — a Debit on one side and a Credit on the other. This recording system provides a system of checks and balances in the company’s books and helps prevent fraud and errors.
It also leaves a clearer paper trail, which is essential for audits. For example, if the IRS flags a tax deduction they deem suspicious, you can easily trace the number back to your ledger to double-check its accuracy and provide support for the write-off.
The 4 aspects of the accounting cycle
Before diving into the eight steps of the accounting cycle, it's helpful to understand the parent aspects — accepting, recording, sorting, and crediting:
Accepting
Your bookkeeper should "accept" every transaction to ensure that it is accurate and it was purposely placed.
If a transaction is accepted, you can move on to recording it in the company’s books. If it was an error or looks suspicious, you should reach out to the customer or vendor to remove or replace it.
Recording
Recording documents essential information from the transaction, such as the transaction date, amount, customer name, and other information the business needs.
You document sales with invoices, payments with receipts, and adjustments with credits and refunds.
Sorting
During the sorting process, you organize transactions into accounts in an accounting ledger. Those accounts are categorized into assets, liabilities, revenues, expenses, and equity.
Double-entry accounting helps ensure all transactions posted to the accounting ledger are accurate and balanced.
Crediting
Crediting is where you'll make adjustments to accounts in your general ledger. For example, if you receive a payment from a customer, you need to make sure that payment was properly credited to their accounts receivable balance. All adjustments, debits, and credits should be factual, or you risk errors in your financial statements, which could lead to later tax reporting and payment issues.
The 8 steps of the accounting cycle
There are eight steps in the accounting cycle. We’ll explain each of them in detail.
The steps of the accounting cycle are:
- Identify transactions
- Record journal entries
- Post to the general ledger
- Prepare an unadjusted trial balance
- Make adjusting journal entries
- Prepare an adjusted trial balance
- Issue financial statements
- Close the books
These steps might seem intimidating at first, but remember, most businesses use accounting software that handles the entire accounting process for every transaction within moments.
Step #1: Identify transactions
The accounting cycle starts with identifying the transactions. There are many transactions throughout a single accounting cycle, and a business has to record each one correctly.
Let’s consider an example to see how identifying transactions happens in the real world.
Ray's Custom Signs is nearing the end of its accounting cycle. It's time to go through the various transactions the business saw over the past quarter, including sales and expenses, like supplies and delivery costs. Ray reviews his sales journal, bank account statements, and credit card statements for the quarter, checking each transaction and confirming its accuracy.
Because Ray uses software that automates his financial workflows, these transactions automatically sync into his accounting software.
Step #2: Record journal entries
Every transaction has a corresponding journal entry. Journal entries contain specific information relevant to the transaction, such as the date, transaction number, amount, description, and which accounts are affected.
Ray’s accounting system creates journal entries for his bank and credit card transactions automatically.
Step #3: Post to the general ledger
After you've recorded the transaction in a journal entry, you'll post them to the general ledger.
The general ledger is the official record of the accounting period. It includes beginning balances for each account, all transactions impacting those accounts during the accounting period, and each account’s ending balance. Without the ledger, business owners couldn’t generate reports, prepare financial statements, or analyze the results of their day-to-day operations.
Since Ray’s Custom Signs uses accounting software, creating a general ledger is as easy as running a report in the system.
Step #4: Prepare an unadjusted trial balance
This step occurs in the second half of the accounting cycle after the period ends and you've already identified, recorded, and posted your transactions.
An unadjusted trial balance is a report with two columns: debits on one side and credits on the other. When you generate a trial balance, you ensure total debits equal total credits. If they balance, you’re in good shape. If your trial balance isn’t balanced, you must go back through your transactions to find and correct the error before moving forward.
Step #5: Make adjusting journal entries
While accounting software automates many transactions, you may still need to make journal entries for non-routine transactions like depreciation, prepaid expenses, accrued expenses, and unearned revenue.
If you need to make any adjusting journal entries, you should include a note explaining the adjustment. For example, if you're adjusting a bill you paid, you'll make a note to refer to the reconciling bank statement that cites a different amount.
Ray’s Custom Signs needs to make journal entries to record depreciation for the period and accrue payroll expenses for hours his employees worked, for which they’ll be paid at the first payroll run in the next accounting period.
Step #6: Prepare an adjusted trial balance
Once you make adjusting journal entries, you run a trial balance one more time. This is the adjusted trial balance because it reflects all the adjusting journal entries. Make sure total debits equal total credits. If your trial balance doesn’t balance, you need to go back through your transactions to find and correct the error.
This is also a good opportunity to perform a quick analysis of the numbers.
Ray prints out his trial balance and quickly scans the ending balance for each account, looking for any irregularities or unexpected balances. For example, Ray notices a large ending balance in prepaid rent when he knows he hasn’t yet paid rent for the coming month. He investigates and realizes he forgot to make an adjusting journal entry to move last month’s rent from prepaid expenses to rent expense. Once Ray makes that entry, he re-runs the trial balance.
Step #7: Issue financial statements
By now, you know that the accounting cycle helps produce three critical financial statements:
- Income statement
- Balance sheet
- Cash flow statement
These three financial statements are fundamental to accounting and proper business bookkeeping. Together, they provide insight into a business’s financial position, results of operations, and cash flow.
You may also produce an owner's equity statement, Which shows changes in the value of all equity accounts belonging to the company’s owners or shareholders.
You pull all the information from the previous steps in the accounting cycle and plug them into a financial statement template.
Small businesses might issue financial statements to track performance and make decisions. The U.S. Securities and Exchange Commission (SEC) requires public companies to provide annual and quarterly reports encompassing data from all these documents.
The good news is most accounting software can do this for you automatically.
Step #8: Close the books
The accounting cycle ends with closing the books, typically occurring at the end of a month, quarter, or fiscal or calendar year.
The goal of closing the books is to return the balance of your temporary accounts to zero, meaning you need to identify your permanent vs. temporary accounts. A chart of accounts can help manage and differentiate these accounts.
You’ll find permanent accounts on your balance sheet. They include:
- Assets like cash, accounts receivable, inventory, and equipment
- Liabilities like accounts payable and notes payable
- Equity like retained earnings
The ending balance of these accounts becomes the beginning balance for the next accounting period. This makes sense because you don’t lose all of your cash or automatically get rid of debt just because it's the end of your accounting period.
Temporary accounts include:
- Revenue like sales and interest income
- Expenses like utilities, rent, and payroll
- Some equity accounts like owner draws or dividends paid to shareholders
You close these accounts at the end of each accounting period because you're ready to begin tracking a new month, quarter, or year of business.
Closing temporary accounts involves transferring the ending balance into permanent accounts. At the end of your accounting period, you'll have an Income Summary account, which receives all the temporary income and expense accounts. So, for example, your transfer might look like this:
- Revenue → Income Summary
- Expense → Income Summary
After you've transferred your income and expenses into the Income Summary account, you'll close that account, moving the balance to Retained Earnings, which is a permanent account.
Closing the books also locks in the prior period transactions so people can’t change those balances without proper authorization.
How the accounting cycle differs from the budget cycle
The budget cycle is similar to the accounting cycle in that it tracks financial transactions. However, the accounting cycle focuses on historical transactions, while a budget focuses on future transactions.
When your bookkeeper records a debt payment you make to a lender, they go through an eight-step process that ensures the amount was correct, the payment was made, and the amount is accurately reflected in the books. This is part of the accounting cycle.
When it's the end of the quarter and it's time to create a new budget for the next quarter, you need to look at historical data and predict your revenue and expenses for the next quarter. Through preparation, approval, execution, and evaluation, you'll learn if you need to make cuts or expand. This is part of the budget cycle.
Advantages and drawbacks of the accounting cycle
Without the accounting cycle, you put your business at risk for fraud, poor performance, and insufficient cash flow.
Advantages
Here are a few advantages of following the accounting cycle for your business.
- The accounting cycle provides transparency. The best part about using the accounting cycle is that you know everything is accounted for. There’s less room for mistakes and fraud, which happens more often when businesses don’t use double-entry accounting.
- The accounting cycle has controls in place. "Controls" refers to the checks and balances in accounting that ensure the books and records are accurate and follow appropriate accounting standards. Accounting controls are unique procedures that help ensure validity in transactions.
- The accounting cycle helps business leaders scale. Business managers rely on the financial statements from the accounting cycle to identify trends, create budgets, and ultimately, decide whether or not they can scale. They're also essential documents to present to lenders and investors.
Drawbacks
Although the accounting cycle is like the heartbeat of monitoring your business's financial health, there are drawbacks worth noting.
- The accounting cycle is sensitive and time-consuming. Accounting is a specialized skill, and while accounting principles can be simple to understand, it takes a detail-oriented person to perform the accounting cycle. The best way to simplify your bookkeeping is to use accounting tools with built-in automation features to track and categorize your transactions.
- The accounting cycle requires controls. Internal controls are necessary to reduce fraud because accountants, managers, or salespeople can easily manipulate and record transactions for personal gain. You can avoid this by implementing internal controls and automating some controls.
Simplify your accounting cycle with BILL
The accounting cycle includes many moving parts that build the financial statements you need to track your business performance and file tax returns. It keeps records of every transaction that goes through your business.
From small LLCs to large corporations, all businesses use some form of the traditional accounting cycle. Small business owners might manage it via Excel sheets or by hand with a traditional ledger. But, it's much easier to record, track, and analyze financial results using automated accounting software.
Ready to streamline your accounting workflows? BILL Spend & Expense simplifies capturing, supporting, and recording transactions by doing the heavy lifting for you, and it even syncs with most popular accounting software platforms.
Learn how BILL’s expense management software can help you automate accounts receivables, accounts payables, and payment receipts by signing up today or requesting a demo.
