Accurate bookkeeping is a necessity for any business. Disorganized books can lead to bad decisions, failure to fulfill various obligations and sometimes even legal problems. That’s why today we will discuss the eight accounting cycle steps you can follow to ensure accuracy.
What Is the Accounting Cycle?
The accounting cycle is an eight-step process that accountants and business owners use to manage a company’s books throughout a particular accounting period—typically throughout the fiscal year (FY). The federal government’s fiscal year spans 12 months, beginning on October 1 of one calendar year and ending on September 30 of the next. FY 2023 starts on October 1, 2022 and ends on September 30, 2023.
It starts with recording all financial transactions throughout that accounting period and ends with posting closing entries to close the books and prepare for the next accounting period. It’s worth noting that some businesses also have internal accounting cycles that have a shorter accounting period. These internal accounting cycles follow the same eight accounting cycle steps and can last anywhere from one month to six months.
A shorter internal accounting cycle can make bookkeeping more manageable, especially when the company’s finances are complicated. However, businesses with internal accounting cycles also follow the external accounting cycle of the fiscal year.
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Why Is the Accounting Cycle Important?
The accounting cycle is critical because it helps to ensure accurate bookkeeping. Skipping steps in this eight-step process will likely lead to an accumulation of errors. If these errors aren’t caught and corrected, they can give you and your employees an inaccurate view of your company’s financial situation.
Moreover, if you have inaccurate information, you might inadvertently mislead your lenders, creditors and investors, which can have serious legal consequences. Finally, if your books are disorganized, you might provide inaccurate information when filing taxes. It can get you in trouble with the IRS.
8 Steps in The Accounting Cycle
There are eight accounting cycle steps. The first three steps are ongoing. You need to perform these bookkeeping tasks throughout the entire fiscal year.
Meanwhile, the remaining five steps are the bookkeeping tasks you do at the end of the fiscal year. Fortunately, nowadays, you can automate these tasks with accounting software, so doing all this isn’t as time-consuming as it might seem at first glance.
1. Identify Transactions
You need to identify all transactions that occur throughout the fiscal year. The best approach to do that is to create a system where every transaction is automatically captured because that prevents human error. Typically, companies integrate their accounting software with their payment processor and point-of-sale (POS) software to capture revenue.
However, you also need to capture expenses, which you can do by integrating your accounting software with your company’s bank account so that every payment will be charged automatically.
2. Prepare Journal Entries
Double-entry accounting, considered the standard accounting practice worldwide, requires recording each transaction with two journal entries: a credit entry and a debit entry. These words describe the source of the financial benefit (credit) and the destination of the financial benefit (debit).
Making two entries for each transaction means you can compare them later. If they don’t match, you will know there’s an error somewhere. All popular accounting apps are designed for double-entry accounting and automatically create credit and debit entries.
One thing to keep in mind here is that how you should record journal entries depends on whether you are using the cash accounting method or the accrual accounting method:
- Cash accounting. An accounting method that focuses on tracking the business’s cash flow—you record the financial transactions as the money comes in or goes out.
- Accrual accounting. An accounting method that focuses on tracking business transactions as they occur—even if the money exchange related to the transaction in question hasn’t happened yet.
Both of these methods have their advantages and disadvantages. We recommend reading our article on this subject so that you can choose the approach that makes the most sense for your business.
That being said, accrual accounting offers a more accurate picture of the financial state of any given business, which is why in some cases, companies are obligated by law to use this method.
3. Post Journal Entries to General Ledger
You need to post every journal entry to the general ledger. The general ledger is a central database that stores the complete record of your accounts and all transactions recorded in those accounts.
You post an entry to the general ledger by adding it to the relevant account. You can automate this with accounting software.
4. Calculate the Unadjusted Trial Balance
A trial balance is an accounting document that shows the closing balances of all general ledger accounts. You need to calculate the trial balance at the end of the fiscal year. The objective of the trial balance is to help you catch mistakes in your accounting.
The total credit and debit balance should be equal—if they don’t match, there’s an error somewhere. The unadjusted trial balance is the initial version of the trial balance that hasn’t been analyzed for accuracy and adjusted as needed.
5. Post Adjusting Journal Entries to General Ledger
If the total credit and debit balances don’t match, you need to figure out what’s missing, record those transactions and post these adjusting entries to the general ledger.
Also, if you have been using cash accounting but want to create a financial statement that meets IFRS or GAAP standards, you will need to post adjusting entries to bring your general ledger in line with accrual accounting.
6. Calculate the Adjusted Trial Balance
The result of posting adjusting entries should be an adjusted trial balance where the total credit balance and the total debit balance match.
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7. Prepare Financial Statements
Once you have the adjusted trial balance, you should use it to create your financial statements. Here are the three most popular types of financial statements:
- An income statement recaps the company’s revenues and expenses over the accounting period.
- A cash flow statement outlines the company’s cash inflows and outflows over the accounting period.
- A balance sheet summarizes what the company owns and owes at the accounting period’s end.
You can then show these financial statements to your lenders, creditors and investors to give them an overview of your company’s financial situation at the end of the fiscal year.
8. Post Closing Journal Entries To Close the Books
Finally, you need to post closing entries that transfer balances from your temporary accounts to your permanent accounts. That’s how you close the books for that fiscal year.
Bottom Line
Following the eight-step accounting cycle can help you accurately record all financial transactions, catch and correct errors and balance your books at the end of each fiscal year before you close them.
Frequently Asked Questions (FAQs)
What is the accounting cycle?
The accounting cycle is an eight-step process that accountants and business owners use to manage the company’s books throughout a specific accounting period, such as the fiscal year.
What are the eight steps of the accounting cycle?
- Identify transactions
- Prepare journal entries
- Post journal entries to the general ledger
- Calculate the unadjusted trial balance
- Post adjusting journal entries to the general ledger
- Calculate the adjusted trial balance
- Prepare financial statements
- Post closing journal entries to close the books
Is it necessary to follow the accounting cycle?
Yes. Following the accounting cycle is a standard practice that helps to ensure that all financial transactions are accounted for. Not following the accounting cycle would likely lead to an accumulation of bookkeeping errors, which could cause severe problems for your business.
Are bookkeeping and accounting different?
Bookkeeping focuses on recording and organizing financial data, including tasks, such as invoicing, billing, payroll and reconciling transactions. Accounting is the interpretation and presentation of that financial data, including aspects such as tax returns, auditing and analyzing performance.
