Small business is all about the bookkeeping.
While accounting software can lighten some of the load through automation and record keeping, there are processes that business owners can use to organize their accounting process and make it more efficient.
One in particular is the accounting cycle.
What is the accounting cycle?
The accounting cycle is an invaluable workflow map that formalizes the process of recording, classifying, and summarizing a company’s financial transactions during a fiscal year.
The accounting cycle is a continuous flow of work, and an accountant follows each of the steps as they unfold throughout the year rather than doing them all at once. This further ensures accuracy because transactions are less likely to be forgotten or incorrectly recorded from memory.
The process of the accounting cycle will be different depending on whether an accountant uses a single entry or a double entry accounting system.
A partly unique accounting system is used by businesses using cash accounting and will focus on inflows and outflows cash flow.
A double entry accounting system is the basis of accrual accounting, which is more complicated than a single part but also more precise. More than one account is managed in a double-entry accounting system, and it takes a bit more accounting knowledge to use this type of balance sheet.
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All of the steps in this cycle are necessary for double-entry accounting systems. However, one-time accounting only requires steps 1, 2, and 8.
Some experts have slight differences in the order of their steps, number and title. However, the general flow, content and purpose are still the same. As long as it is followed correctly, slight changes in the order of the steps will not impact the overall process.
1. Identify business transactions
Identifying your business transactions is the first step. Include only transactions directly related to the financial activities of your business.
These transactions can include activities such as expenses, purchases, income, and debt repayment. Any inflow or outflow of money to or from your business will likely count as a transaction.
The use of documents such as receipts and invoices helps identify business transactions; make sure you keep them to streamline the process of identifying transactions.
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2. Record transactions in the journal
After identifying a business transaction, record it in a dedicated journal, sometimes called the original entry book. This journal should be organized chronologically starting with the transactions at the beginning of the fiscal year.
For single-part accounting, an entry will be either a debit for inbound transactions or a credit for outgoing operations. For example, an invoice would be a debt entry, but a payroll expense would be a credit entry.
If bookkeepers use a double-entry bookkeeping system, they list two transactions for each entry, a debit and a credit. These inputs must be equal, but opposite values, resulting in a balance.
3. Post transactions in the general ledger
After you record the transaction in a journal, record the transaction in the general ledger, also called the final entry book. The general ledger is a summary of the accounts of a company. General ledger entries are changes made to each of your accounts, and transactions are posted to the impacted account.
The general ledger can be a physical document, but it is much more common for businesses to use software to act as a general ledger.
This part of the process is not necessary for businesses using a single entry account system since there is only one managed account. Your journal, or cash book, is already serving as a general ledger.
4. Calculate the trial balance
At the end of an accounting period, calculate a trial balance. An accounting period can be a month, a quarter or a year, depending on the preference of the business.
The trial balance is an accuracy test to verify that a business’s credit and debit entries are equal.
Calculate the trial balance by adding all debit balances and all credit balances. Check that the two totals are the same. If not, there may be an error somewhere in your records or they may require input adjustments.
5. Adjust the inputs
An accountant may also have to record accrued liabilities and deferrals in their records.
Accrued expenses are income or expenses that have been incurred but not previously recognized. Deferrals are receipts for payments made in advance or for future expenses.
6. Adjust trial balance (worksheet)
If the debit total and the credit total on a trial balance are unequal, the accountant will need to adjust their entries and look for errors which are then tracked on a spreadsheet.
Some accountants choose to adjust their entries after adjusting the trial balance. This is a matter of preference, and as long as the trial balance is re-checked after posting accruals and deferrals, their order does not matter.
7. Prepare financial statements
After an accountant has adjusted their journal entries and trial balance, they can use their updated accounts to create financial statements.
These statements include income statements that compare the profits and losses during the accounting period. They also include cash flow statements that detail the cash flow in and out of the business. Balance sheets can also show a company’s progress by explaining its assets, liabilities and equity.
The statements themselves are a good measure of performance over the period. Your business can review these statements and use them as the basis for targets for the new accounting period.
8. Close the books
The closing of the books of the company ends the financial activity of the accounting period and the transactions that occur after the closing of the books will be recorded in the following accounting period.
The income and expense accounts are zeroed and closed because they are only intended for a single accounting period so that a business can track its profit and loss between periods. The only accounts not closed are the balance sheet accounts since they show the financial position of a company at a given time.
After the books for an accounting period are closed, companies should start setting up their accounting for the upcoming period.
Accounting cycle vs budget cycle
Although they may look the same, the accounting cycle and the budget cycle are different. The accounting cycle focuses on financial events that have already occurred and ensures that they have been recorded correctly. The budget cycle, on the other hand, focuses on planning for a company’s financial future.
Why is the accounting cycle important?
While that sounds like a ton of record keeping, sticking to an accounting cycle is crucial for businesses. Here are a few reasons why.
Efficiency – Having a formalized process and tools for financial record keeping ensures that accountants have a clear roadmap to follow when recording information, which streamlines the process and makes it less subject to errors
Internal analysis – Reports that can be generated at the end of an accounting cycle provide valuable insight into a company’s performance, both within a period and between accounting periods. This information allows companies to locate the most profitable processes and practices.
Management of time – Bookkeepers and accountants find it easier to plan their schedules over a period when a formalized accounting cycle is in place, because they know in advance what responsibilities they will be called upon to assume.
Compliance – Rigorous financial record keeping is a necessity to stay in compliance with government regulations and taxes. Businesses must disclose their financial records and then calculate and pay their taxes. Even well-meaning companies can do it incorrectly, leading to government audits and potential fines. To avoid this, consider using governance, risk and compliance software.
Accounting software can be a valuable asset in the process of the accounting cycle. Find out how free accounting software can help your business manage your finances on a budget in 2019.