If you’ve ever misplaced your wallet, you know what it’s like to lose track of your finances. But for a business, having orders go missing or unbalanced books can cause significantly bigger problems than losing a bit of cash and a couple of credit cards. To ensure that a business’s records are accurate and properly tracked, many accountants – or business owners running their own books – recommend these eight steps to follow a transaction all the way through closing the books. This is known as the accounting cycle.
What Is the Accounting Cycle and Why Is It Important?
The accounting cycle, also known as the “record to report” (R2R) process, breaks down a business’s accounting process into eight steps, starting with a transaction and going through the end of a financial period. By optimizing the steps of the accounting cycle, businesses can have confidence that their financial statements and the data contained within are accurate, up to date, and effectively organized. Businesses with an efficient accounting cycle can also quickly identify trends to forecast future revenue more accurately and quickly catch any mistakes or fraud.
It’s important to remember that while these eight steps may seem simple, each step can require a significant amount of time and attention from the accounting staff. Because of the error-prone minutiae of the accounting cycle, many companies now turn to automated financial software to handle some – if not most – of the tasks involved.
Let’s dive into the accounting cycle’s eight steps.
The 8 Steps of the Accounting Cycle
1. Identify Transactions.
The accounting cycle starts every time a business makes a financial transaction, such as incoming sales from customers or outgoing payments to vendors. This stage of the cycle begins with a source document, such as a vendor invoice, employee expense report, deposit record, and many more. If a transaction is not properly identified, incorrect values can continue through the rest of the cycle and create headaches for accounting staff when accounts need to be balanced.
2. Record the Transaction.
Small companies may be able to record transactions in sales journals or simple spreadsheets, but as they grow, many switch to accounting programs to automate the error-prone and time-consuming process of data entry – especially if data needs to be entered into multiple general ledger (GL) accounts. (See step 3 for more on the GL.) Every transaction must be recorded. These transactions are often initially recorded in the accounts payable or accounts receivable subledgers or by direct journal entry into the GL. However a business chooses to record its transactions, it’s important that the records are comprehensive and organized. If accountants can’t read and understand the records, they will not be able to accurately carry the figures through the rest of the accounting cycle.
Many accountants run trial balances weekly or monthly because catching these errors quickly is important – especially for errors in customer invoicing or vendor bills.
3. Post to the General Ledger.
Once transactions are recorded and approved, they are transferred, aka posted, to the GL. The GL is the business’s overall record of financial transactions, organized by accounts. Because the GL provides a big-picture look at a business’s finances, sometimes summaries that combine larger sets of transactions are posted to the GL. For example, all sales may be listed individually in the accounts receivable subledger as invoices are generated, but the GL could be updated weekly with a cumulative total so it isn’t cluttered with unwieldy lists of every sale made.
4. Run a Trial Balance.
When the end of the accounting period approaches, often monthly, accountants run a trial balance on the unadjusted accounts – i.e., unbalanced debits and credits. This acts as a test run to make sure that everything lines up and nothing is unaccounted for. For example, if a salesperson accidentally sold a $900 appliance for $800, revenue may not match accounts receivable. If the figures don’t match – i.e., balance – adjustments will need to be made further down the accounting cycle.
5. Analyze the Worksheet.
If the trial balance doesn’t reveal any discrepancies and looks complete, accountants can skip steps 5 and 6 and create their financial statements. But if the totals don’t balance, analyzing the worksheet will help the accounting team find where the discrepancy lies. Many accountants run trial balances weekly or monthly because catching these errors quickly is important – especially for errors in customer invoicing or vendor bills. It can be difficult to get money from customers or vendors from miscalculated discounts or refunds for overpayments, and that will only become more difficult over time. For the previous step’s appliance example, a customer isn’t going to be happy to receive a $100 bill several months after the appliance was installed.
6. Make Adjustments and Run Again.
Once the errors are found, they need to be adjusted. This could be as simple as adding a $100 adjustment to correct a recording error or may involve more complex accounting adjustments, such as depreciation of assets or spreading out yearly bills. For example, a company may pay a yearly retainer fee to a consultant but spread out the expense in monthly increments in its books. These “monthly expenses” might not show up in accounts payable or the cash flow that month but are important to show an accurate picture of costs. Once adjustments are made, the trial balance is run again, called the adjusted trial balance. Adjustments and trial runs continue until it is accurate.
7. Create Financial Statements.
Now that all the books are balanced, accountants can create the financial statements. Public companies must follow specific guidelines, while a private business’ statements may vary with its needs. The three primary statements generated at this time are the income statement, balance sheet, and cash-flow statement. These reports show internal analysts and managers data to inform efficiency fixes, costs reductions, and revenue increases. They are also used to show external parties – such as investors, lenders, or the public – a business’s financial strength.
8. Close the Books.
The financial period eventually comes to a close – whether it be a month, quarter, year, or whatever period your business uses – and all that is left to do is close the books and conclude the accounting cycle. This resets temporary accounts found on the income statement, which tracks profits and losses over a given period. Those temporary accounts are then folded into cumulative or permanent accounts like retained earnings, which are found on the balance sheet, signifying the end of the current financial period. And tomorrow, the cycle will start all over again, back at step one.
The Takeaway
The accounting cycle is a sequence of steps that generates a company’s books and records. But within each step are opportunities for improvements that range from creating a more effective sales recording process to implementing accounting software that can automatically generate financial statements and close the books. By taking a step-by-step approach to analyzing the accounting cycle, businesses can optimize the entire workflow, speeding up the financial recording process and giving decision makers more accurate and up-to-date data to help them make better financial decisions.
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