What is the Accounting Cycle and Why Is It Important?
What is the Accounting Cycle?
The accounting cycle is an 8-step process of recording all of the necessary transactions for a business during an accounting period until those transactions are finalized into the business’s financial statements, and then the books are closed. It is the basic process of completing a company’s bookkeeping tasks. This cycle happens every accounting period, which for most businesses is monthly. Still, some companies decide to perform the cycle quarterly or annually. While many accounting software on the market will perform some steps automatically, it is crucial to understand each step and how it affects your financial records.
Why is the Accounting Cycle so important?
The accounting cycle ensures that your financial data is accurately tracked, recorded, and analyzed. This standardized process is essential because it helps business owners and nonprofit organizations generate financial information to perform critical analysis and manage the business more effectively. Most businesses have a dedicated accounting team that will turn the accounting cycle into a monthly close checklist. This checklist ensures that each step in the accounting cycle has successfully been completed by its respective responsible party and by the assigned deadline.
Steps in the Accounting Cycle
Step 1: Identify and Record Transactions
The first step in the accounting cycle is to identify and record your business’s transactions during the given accounting period. These transactions are usually a business’s payments, sales, and purchases. A business may have hundreds of transactions or just a couple. Still, every transaction that happens must be recorded. Most businesses utilize some sort of accounting software that will assist with transaction recording. A business could link its bank account with accounting software, like Quickbooks, and usually be able to record the bulk of the business’s transactions. Accurate recordkeeping is essential to the statements later produced in this cycle. The creditability of a business’s financial data starts here.
Step 2: Record Journal Entries
For those transactions that aren’t payments, sales, and purchases, journal entries are usually performed. Journal entries can be used to import payroll data, record depreciation, or amortize prepaid expenses. A business may want to use accompanying worksheets for any non-automatic journal entry that has to be recorded. A worksheet will provide backup support and could be extremely useful during a CPA review or audit.
Step 3: Post Transactions
Depending on your accounting system, this step may happen automatically. After all of the transactions from Step 1 and the journal entries from Step 2 have been recorded, they must be posted to the business’s general ledger. The general ledger is a business’s giant summary report that lists every transaction into sub-ledger accounts. Those uniquely labeled accounts detail a business’s five account types: assets, liabilities, equity/net assets, revenue, and expenses.
Step 4: Prepare Trial Balance
This step takes all the post transactions and turns them into an unadjusted trial balance. The trial balance is a summary sheet listing every sub-ledger account a business has with its respective credit or debit balance. Each month, this report should be analyzed to look for errors. When using double-entry bookkeeping, the total debits and total credits should match. The five accounting types mentioned above have a normal debit or credit balance, so a quick glance at a business’s trial balance could tell you a lot. For example, suppose you see a normal debit balance account, like a cash account, showing up on the credit side. In that case, you know you need to do some investigating. This step is also the time to reconcile your trial balance with your spreadsheets/backup documentation. For example, if your business has prepaid expenses, you should have support on a spreadsheet or somewhere showing how you arrived at that amount. While every general ledger account may not have a spreadsheet as supporting documentation, you should be able to support every transaction with some backup.
Step 5: Record Adjusting Entries
After preparing the trail balance, you should use it to perform reconciliations to ensure that all general ledger accounts are accurate. If any discrepancies are found, a business must record adjusting journal entries. This step also allows you to see if there is unearned revenue, accrued revenue, or expenses that may need to be adjusted.
Step 6: Review Adjusted Trial Balance
At this point, you are just giving your trial balance another review before compiling your financial statements. This step may seem unnecessary because you literally just looked at the trial balance and corrected everything. However, you wouldn’t believe how many people still need to make additional adjustments. It can be really easy to make an adjusting journal entry to correct a mistake and then actually make that mistake bigger.
Step 7: Prepare Financial Statements
Once all of your adjustments for the period are in, you can start preparing your financial statements. A business’s financial statements give the reader a summary of the business’s activities and performance. The main three financial statements that a business would prepare are the income statement (statement of activities for a nonprofit organization), the balance sheet (statement of financial position for a nonprofit organization), and the cash flow statement.
Step 8: Close the Books
Finally, after all the transactions have been recorded, the data is analyzed for accuracy, adjustments have been made, and financial statements have been prepared; the accounting department can close the books. This process involves “locking” the data from this accounting period so it cannot be edited. There are two types of close: a soft close and a hard close. A soft close is when the accounting department has an internal cut-off deadline for any transactions to be recorded or edited in an accounting period. While the books aren’t technically closed by the accounting system, it is understood that a prior accounting period cannot be altered. A soft close is usually done so that internal financial reports can be prepared, and it is understood that the result may be immaterially inaccurate. A hard close is when an accounting department closes the books officially by setting a close date in the accounting system, usually for the end of the fiscal year. At this point, temporary accounts on the income statement (or statement of activities) are zeroed out, and any surplus or net loss is carried over into retained earnings (or to net assets account). The completion of this step starts a new cycle, and you go back to step 1.