The Accounting Cycle Explained: Mastering Your Financial Records

Accounting and bookkeeping aren't just about complying with the requirements of your bank, investors, or even the IRS. They're the backbone of financial management, ensuring your company's financial transactions are accurately recorded, monitored, and reported.

This process is known as the accounting cycle, and it involves several crucial steps, each playing a critical role in providing stakeholders with the information needed to make informed decisions.

Photo by Mike Hindle on Unsplash

Whether you've just started a business and need to figure out how to record transactions or have been in business for decades but need to fine-tune the process for preparing financial statements, this article explains the accounting cycle and highlights how it can empower your business to thrive in today's competitive marketplace.

What Is the Accounting Cycle?

The accounting cycle is a set of processes designed to capture and organize a company's financial transactions over a specific accounting period—typically a month, quarter, or year.

The goal is to produce financial statements that accurately reflect the company's financial status and performance. Those financial statements might be used to prepare tax returns, get a loan, communicate with shareholders or investors, or be reviewed by management to keep a finger on the pulse of the business.

The accounting cycle may include several professionals, depending on the size of your company and the purpose of the financial statements. For example, you may have an in-house accounting team, hire professional accountants or bookkeepers, or have an independent auditor report on your financial statements.

The Steps of the Accounting Cycle

Now, let's look at the steps involved in the accounting cycle.

Step 1: Identify and Record Transactions

The first step in the accounting cycle is identifying and collecting data from transactions and events that affect the financial statements. This includes sales, purchases, payments, and receipts.

Once identified, these transactions are recorded chronologically in the double-entry accounting system, where every transaction impacts at least two accounts: a debit and a credit. Double-entry bookkeeping helps ensure the company's books are accurate.

This step in the accounting cycle used to be highly time-consuming. However, modern accounting software makes recording transactions much more manageable. For example, your accounting software can connect to your business bank accounts and credit cards to automatically identify transactions and use machine learning to classify those transactions correctly.

Step 2: Preparing Journal Entries

Every financial transaction doesn't go through the business checking account, so the next step in the accounting cycle is to make adjusting journal entries to get these transactions into the accounting software.

Journal entries are made to account for accruals, deferrals, depreciation, amortization, and other items not yet recorded. These entries are essential for adhering to the matching principle of accounting, ensuring expenses and revenues are recognized in the correct period.

These adjusting entries are posted to the general ledger and categorized into accounts.

Step 3: Prepare the Trial Balance

At the end of an accounting period, you prepare a trial balance to test whether debits and credits are equal. A trial balance shows the ending balance for all accounts without details of every transaction impacting that balance. With double-entry accounting, your total debits should equal your total credits. If they're not equal, you know a mistake has been made somewhere, and you'll need to review each account for the required adjustments.

You can also use the trial balance to perform a high-level review of your company's financial position. For example, if you notice that accounts receivable, which should have a debit balance, has a credit balance, you can review the activity in that account.

Step 4: Prepare Reconciliations and Workpapers

Reconciliations are crucial for ensuring the integrity and accuracy of your company's financial statements. The reconciliation process involves comparing your internal financial records to external records or physical assets to verify the accuracy of transactions and ending balances.

For example, when you reconcile your business checking account, you compare the ending cash balance and all transactions that impacted the cash accounting during the accounting period to the statement provided by your bank. If you notice any discrepancies, such as missing deposits, bank fees that aren't reflected on your books, or stale checks that haven't cleared, you can take steps to resolve them.

Ideally, you will perform a reconciliation for every balance sheet account monthly. You can run an adjusted trial balance report once you're confident all account balances are correct.

Step 5: Create Financial Statements

You (or your accountant) use the adjusted trial balance report to prepare the financial statements, including the income statement, balance sheet, statement of owner's equity, and cash flow statement. These documents provide a comprehensive overview of the business's financial position and results of operations.

You may need to submit financial statements to your bank to comply with loan covenants or provide them to shareholders or investors.

Step 6: Closing the Books

Closing the books refers to finalizing the financial information for the accounting period. This might include essentially "locking" the prior period to ensure employees cannot post transactions to that accounting period without authorization.

At the end of the fiscal year, you also return the balance of income statement accounts to zero by making closing journal entries. This essentially moves the balance in all temporary accounts (i.e., revenue and expense accounts)—to permanent accounts (i.e., equity and retained earnings), allowing for a clean start in the next accounting period.

The accounting cycle starts all over again in the new accounting period.

The Benefits of Timely and Accurate Accounting

The six steps of the accounting cycle are important because they help businesses organize their financial records and prepare financial statements. But it's not just a compliance exercise. It can also help you better manage your business.

Here are some benefits of having a systematic accounting process:

·       Proactive management. With real-time financial data, you can anticipate trends, identify opportunities, and mitigate risks before they escalate. This forward-looking approach is invaluable in today's fast-paced business world.

·       Informed decision-making. Accurate accounting provides a clear picture of a business's financial health, enabling you to make informed decisions regarding investments, cost-cutting, and growth strategies.

·       Compliance and trust. Staying on top of accounting ensures compliance with laws and regulations, building trust among investors, creditors, and the wider community.

·       Efficiency and cost savings. An organized accounting cycle streamlines financial management, reducing the likelihood of errors and the costs associated with correcting them.

Optimize Your Accounting Cycle with Slate

Understanding and effectively managing the accounting cycle is crucial for any business. When you start out, recording transactions, making journal entries and preparing a balance sheet and income statement might be simple. But as your business grows, the number of financial transactions you need to account for and the potential for errors grows along with it.

That's where reliable accounting software and trustworthy accounting support can come in handy.

If the complexity of the accounting cycle seems daunting, or if you're struggling to keep up with the demands of accurate financial reporting, schedule a call with Slate. Our team of experts is dedicated to providing the support you need to stay on top of your accounting, allowing you to focus on what you do best—growing your business.