Introduction
Understanding the accounting cycle is essential for your business' survival. Without a way to track how the money moves, most businesses won't stay afloat.
The goal of an accounting cycle is to help companies organize and structure the financial activities carried out during a specific period. It shows how much money is spent and earned by recording, classifying and summarizing all the essential financial information.
Businesses with a successful accounting cycle can see an impact on how they:
- Plan expenses,
- Secure loans,
- ... or even sell their products and services.
But building or creating an efficient accounting process can be demanding, especially when starting from scratch. It requires consistent documentation, time, expertise and technology.
Because of these factors, each business's pathway to creating an accounting cycle is unique — but they'll still follow the same overall steps.
Let's explore the importance of the accounting cycle, how it works and how you can tap into modern-day accounting technologies to optimize the process.
TL;DR: What is the accounting cycle?
- The accounting cycle is a set of steps businesses use to record and process financial transactions.
- It includes identifying and analyzing transactions, recording them in a journal, posting to the general ledger, preparing trial balances, adjusting entries, creating financial statements, closing the books, and preparing a post-closing trial balance.
- The accounting cycle helps businesses track finances, generate reliable financial statements, make informed decisions, and detect errors or fraud.
- Optimizing the accounting cycle can be done through automation and effective documentation.
- Automation tools and software simplify and automate accounting processes, while effective documentation promotes consistency and aids in training.
What is the accounting cycle?
The accounting cycle is a set of steps businesses use to record and process financial transactions, including:
- Identifying and analyzing transactions.
- Recording transactions.
- Posting to the general ledger.
- Preparing trial balances.
- Adjusting entries.
- Creating financial statements.
- Closing the books.
- Preparing a post-closing trial balance.
How does the accounting cycle work?
The accounting cycle begins when a transaction occurs. The entire process can be broken down into eight or more steps, depending on who handles it.
Let's go through each step one by one.
Step 1: Identify and analyze the transactions
Step one is to analyze and identify the financial transactions within a specific accounting period. This involves reviewing source documents—invoices, receipts, bank statements, etc.—to determine the nature and impact of each transaction. This used to be a manual process, but accounting software can help you automate this task.
As an example, let's say Zenith Tech & Co. purchases inventory worth $10,000 from a supplier on credit. This is the start of the accounting cycle for that transaction.
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Step 2: Record the transactions in a journal
Now that you've identified the transactions, you need to record them chronologically in the general journal. The journal should record two accounts: credits and debits. Include the date, accounts affected and corresponding amounts for each entry.
Suppose you do not register an identified transaction. In that case, it's like the transaction never happened. So step two is necessary to help you reduce discrepancies later on.
Step 3: Post to the general ledger
Step three involves transferring the recorded transactions from the general journal to the general ledger. The general ledger is where all financial transactions are tracked and summarized.
Your general ledger should contain individual accounts for five separate categories:
- Asset.
- Liability.
- Equity.
- Revenue/income.
- Expenses.
Step 4: Prepare an unadjusted trial balance
An unadjusted trial balance is created by writing down all the account balances from the general ledger. The trial balance makes sure that debits are equal to credits.
Step 5: Make adjusting entries
The rule of bookkeeping states that for every credit entry, there must be a corresponding debit entry. Step five is where you check the entries and fix any errors. Adjusting entries keeps all accounts current and matches revenues and expenses to the accounting period. This includes accruals, deferrals, estimates, and corrections for errors.
Step five helps you avoid costly mistakes at the end of your financial calculations for the fiscal year. You can use accounting software to make this process easier and reduce the chances of errors.
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Step 6: Prepare an adjusted trial balance
After you've adjusted the entries, you'll prepare an adjusted trial balance. This trial balance reflects the updated account balances after making adjustments.
Step 7: Create your financial statements
Using the adjusted trial balance data, you can now go on to prepare the financial statements. There are three primary financial statements that all businesses prepare:
- The income statement shows your revenues and expenses incurred for the year.
- The balance sheet shows your assets, liabilities and equity.
- The cash flow statement outlines your cash inflows and outflows.
Other types of financial statements can be generated, but these are more important and accurately show the state of your company's finances.
Step 8: Close the books
Temporary accounts, such as revenue and expense accounts, are closed at the end of the accounting period. The balances of these accounts are transferred to the retained earnings or owner's equity account so you can start the next accounting period with zero balances.
Step 9: Prepare a post-closing trial balance
After closing the temporary accounts, you're ready to prepare a post-closing trial balance. The trial balance verifies that all the permanent accounts (e.g., assets, liabilities, equity) have the correct balances and that the accounting records are balanced.
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The accounting cycle in action
Let's walk through an example of the accounting cycle using a company called SilverBay Manufacturing:
1. Analyzing and identifying transactions
SilverBay Manufacturing purchases raw materials worth $50,000 from a supplier and pays in cash.
2. Recording journal entries
Journal Entry:
Debit: Raw Materials Inventory: $50,000
Credit: Cash: $50,000
3. Posting to the general ledger
The above journal entry is posted to the correct accounts in the general ledger. The debit of $50,000 is assigned to the "Raw Materials Inventory" account, and the credit of $50,000 is assigned to the "Cash" account.
4. Adjusting entries
At the end of the accounting period, SilverBay Manufacturing realizes that it has $5,000 worth of raw materials used in the production process that wasn't recorded before, so an adjusting journal entry is created to correct the error.
Adjusting Entry:
Debit: Work-in-Progress Inventory: $5,000
Credit: Raw Materials Inventory: $5,000
5. Preparing an unadjusted trial balance
An unadjusted trial balance is prepared to ensure that the total debits equal the total credits. It includes the balances of all the accounts before any adjustments.
6. Adjusted trial balance
After the adjusting entry, they're ready to prepare an adjusted trial balance. This trial balance includes the adjusted balances of all accounts, reflecting the effects of the adjusting entries.
7. Financial statement preparation
Using the adjusted trial balance, SilverBay Manufacturing is ready to prepare financial statements:
- An income statement showing revenues and expenses.
- A balance sheet presenting assets, liabilities and equity.
8. Closing entries
At the end of the accounting period, SilverBay Manufacturing closes its revenue and expense accounts, confident that they didn't carry any pending financial transactions into the next accounting cycle. All temporary accounts are now back to zero balance.
9. Post-closing trial balance
After the closing entries, a post-closing trial balance is prepared to ensure that only permanent accounts (e.g., assets, liabilities, equity) remain.
How is the accounting cycle different from the operating cycle?
So let's understand the difference between an accounting and an operating cycle. These two cycles often overlap, although they are different financial cycles.
The accounting cycle focuses on monitoring and recording financial transactions over a given period for internal and external reporting purposes. The accounting cycle is responsible for:
- Maintaining financial records.
- Generating financial statements.
- Ensuring compliance with accounting principles and standards.
The operating cycle documents the time and process it takes for a company to convert its resources (such as inventory) into cash.
The operating cycle involves a series of events that typically includes:
- Purchasing or manufacturing raw materials.
- Transforming them into finished goods.
- Selling them to customers.
- Collecting payment.
The operating cycle length varies across industries, and it can happen more than once during the same accounting cycle. It depends on how quickly a company can turn inventory and accounts receivable into cash, and how long the company can keep the cash before paying accounts payable and other accrued expenses.
Why is the accounting cycle important?
As mentioned earlier, the accounting cycle provides businesses with a structured and efficient approach to managing all their financial transactions.
The accounting cycle helps you achieve financial accountability and transparency by:
1. Accurately tracking and analyzing financial transactions
Tracking income, expenses, assets, liabilities, and equity allows every penny spent or received to be analyzed, recorded and accounted for.
You can identify trends, patterns, and anomalies in your financial data by recording and classifying transactions. This analysis can help identify areas of improvement, cost-saving opportunities, and potential risks. For example, a significant increase in expenses can indicate that you need to investigate and take action to control costs.
It also prevents situations where money gets missing or becomes untraceable in an organization.
2. Generating reliable & timely financial statements
Statements such as the balance sheet, income statement and cash flow statement provide a snapshot of your company's financial position and performance.
Managers can analyze these statements to assess profitability, liquidity, and solvency, which are vital factors in decision-making.
Financial statements make it easier to assess your current market position, giving investors and shareholders confidence or alerting them that all is not well financially.
3. Impacts decision-making
You can use the information generated through the accounting cycle to make informed business decisions.
Financial statements provide accurate and timely financial information, enabling you to stay on target with budgeting, investments, pricing, and cost management. This can make it easier to attract investors, obtain loans and meet regulatory requirements.
4. Detecting & preventing errors or fraud in financial records
A successful accounting cycle helps you avoid penalties or legal issues, for example, while filing taxes.
Optimizing your accounting cycle
There are several approaches to optimizing your business's accounting cycle. We will discuss two key ones—and if well executed, they might just be all you will need.
Automation
The more your business grows, the more it becomes to do the accounts manually. Accounting workflow software and tools reduce the risks of errors and help you work smarter.
Today, many accounting tools and software are built to simplify and automate all the processes involved in the accounting cycle, such as data entry, journal entry posting and report generation.
Technology has improved the automation of repetitive tasks like data entry and reconciliation. Accounting software and algorithms can now do these tasks quickly and accurately, freeing up time for strategic and analytical activities. This not only improves productivity but also reduces the risk of human error.
AI is also starting to play a role in the accounting cycle.
AI-powered systems can analyze financial data, identify patterns, and make predictions, allowing you to make more informed decisions.
For example, AI can help in fraud detection by flagging suspicious transactions. This not only enhances accuracy but also strengthens the overall integrity of financial reporting.
These tools will save you time and resources, improve efficiency and enhance the accuracy and timeliness of the financial reports you create.
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Effective documentation
Documentation is essential to get things done more efficiently. Rather than struggling to establish standardized processes and procedures for recording and reporting financial transactions, you can create clear and comprehensive documentation of accounting policies, procedures and guidelines as they apply to your business.
This promotes consistency, guides employees and aids in training new staff members, creating an opportunity for continuous learning that enhances your team's skills and knowledge. And in no time, you will realize you have been able to build a solid repository of information that you can trust will always get the job done.
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Now, manual documentation can seem like a long, tedious and "too-formal" process—especially if you run a small business. This is why we built Scribe to take the hard part out so you can create documentation on the go in minutes.
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Automating your accounting documentation
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