In order for businesses to look back on how they did in the past, they need to follow a certain set of steps to verify that their financials are accurate. These steps are commonly referred to as the accounting cycle because, after each accounting period has ended, businesses repeat the same basic steps.
The goal of the accounting cycle steps is to ensure that every cent that changed hands during the accounting period is accounted for properly and reflected in a company’s financial statements. Financial statements serve as the ultimate historical record for a business, and the stakes are high for getting them right. Outside parties like banks, investors, and the IRS will look at your financial statements to decide things like whether to give you a loan or whether you paid the right amount in taxes.
You can think of the accounting cycle as a checklist that needs to be completed at the end of the accounting period. When all steps are checked off, you can move on to the next accounting period with a clean slate.
An accounting period can be a month, quarter, or year depending on how often your business needs financial reports.
Before we go through each step of the cycle and the accounting terms associated with each, it’s important to remember that this process originated when accountants completed these steps by hand in physical ledgers and journals. We’ll highlight which of these steps now happen behind the scenes thanks to computers, but we’ll go through each so that you’ve got a full understanding of the process.
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Accounting Cycle Steps
Depending on who you ask, there can be anywhere from six to nine steps in the accounting cycle. Some prefer to consolidate a few steps into one, but it’s really a matter of personal preference. For simplicity’s sake, we’ll start by showing you the long version of the accounting cycle, with each step broken out clearly.
Step one: gather together all the information you have on every transaction that took place during the period. Hopefully you or your bookkeeper are doing this throughout the period instead of waiting until the month ends and scrambling to find receipts.
Remember that when you recognize income and expenses depends on the type of accounting you use. If you run on cash accounting, you’ll look for every time that cash changed hands during the period. If you’re using accrual accounting, you’ll only recognize financial transactions when incurred.
In the old days, recording a transaction meant writing down the transaction in the appropriate journals. These journals, or “books,” are how bookkeeping got its name. According to double-entry accounting, each transaction should be recorded as both a credit and debit in separate journals.
Now, as long as you classify the transaction in your accounting software, the rest will happen more or less automatically.
Post to General Ledger
Another hallmark of bygone days is the general ledger. The general ledger was a master list of all transactions. If a fire broke out in your back office, this would be the thing to save. After recording a transaction in the appropriate journals, you would also add it to the general ledger.
Thanks to the magic of the internet and automation, the general ledger now lives in the background of the accounting cycle today. It’s transitioned from a physical book to a part of the cloud, and accountants don’t really have to touch it.
Calculate Unadjusted Trial Balance
The first three steps of the accounting cycle can (and should) take place throughout the accounting period. Calculating the unadjusted trial balance is the first step that can only take place once the period has ended and all transactions have been identified, recorded, and posted to the general ledger.
Creating an unadjusted trial balance is akin to checking your homework. Because every transaction is recorded as a debit and a credit, the goal of this step is to ensure that your total debit balance and total credit balance are equal. If not, something was missed or misclassified. It’s normal to discover anomalies at this stage. Invoices that you expected to be paid (but weren’t) can throw it off. Payments that you expected your vendors to collect (but didn’t) can also cause issues.
Whatever the case, an unadjusted trial balance simply shows you all your debits and credits in a table. And if they don’t add up to the same amount, you can use this table to begin investigating why.
Make Adjusting Journal Entries
This step simply resolves any anomalies that are found. First, you identify what is causing the debits and credits to be misaligned. Then you make journal entries to fix them.
Create an Adjusted Trial Balance
Next up, time to double check your work one last time with the help of an adjusted trial balance. This table shows your unadjusted trial balance, your adjusting entries, and your adjusted amounts. It’s the final step before creating financial statements, so it’s worth triple checking everything.
Create Financial Statements
Your financial statements are the biggest deliverable you’ll receive as a result of the accounting cycle. The income statement and balance sheet are accurate records of what happened in your business over the last accounting cycle. (The cash flow statement isn’t mandatory, but we recommend making one of those, too.)
They’re important documents for anyone outside your business who needs to be able to compare your business to others (investors, lenders, etc.), but they’re also incredibly valuable to business owners. Knowing how to read and interpret your financial statements can help you stay on top of your business’ finances and strategize for growth.
Make Closing Entries
The last step in the accounting cycle is making closing entries and preparing your business for the upcoming accounting cycle. This means closing out temporary accounts like revenue and expenses and folding them into permanent accounts, like retained earnings.
Once this final step is complete, you can start the whole process over again.
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The Accounting Cycle & Technology
We’ve pointed out areas where technology has pushed some aspects of the accounting cycle into the background. In other words, while those steps are still happening to a degree, automated accounting has made them less relevant to accountants and business owners who don’t need to take direct action for those steps to be completed.
If we were to look at the accounting cycle through the lens of an accountant today, the process would look a little different. For example, the general ledger doesn’t exist in the same form today, so there’s no need to post transactions to it.
Even the idea of adjusting trial balances is simplified. Though the process is mostly the same, accounting software can help identify variances and prompt users to help reconcile them without creating explicit trial balances.
The accounting cycle reflects the rules and processes that all businesses must follow in order to have accurate numbers, so it’s important to know all steps—even those going on behind the scenes. However, as technology and accounting continue to mix, the accounting cycle continues to become much less manual and significantly faster.
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