Small business owners need a simple way to complete bookkeeping tasks. The more organized the process, the easier it is, and following the accounting cycle is a tried-and-true way to stay on track.
What Is the Accounting Cycle?
The accounting cycle is the process of recording your business’ financial activities and looking back in time at the end of a designated period. The cycle includes several steps, starting when a transaction occurs and ending with a record of the transaction as a permanent part of a company's financial records. If you use accounting software, you can program dates for your accounting cycle. The software will generate reports based on the dates you select.
- The accounting cycle is a step-by-step process designed to make daily accounting activities easier for business owners.
- There are usually eight steps to follow in an accounting cycle.
- Accounting worksheets can help make sure all debit and credit balances are accounted for and no errors have been made.
Understanding the 8-Step Accounting Cycle
Full cycle accounting can be broken down into several steps, which you may be able to modify according to your needs. Many steps in the accounting cycle work best with accrual accounting. The double-entry accounting system allows you to cross-reference entries for accuracy.
You will begin the accounting period on a certain date, record entries, and close your books at the end of the period. However, it's not necessary to follow the steps that prescribe checking entries for debits and credits.
If you use a single-entry accounting, which is the case with cash accounting, you can still use the accounting steps.
8 Steps of an Accounting Cycle
The 8 steps in an accounting cycle, in order, are:
- Identify transactions: The first step in the accounting cycle is identifying the financial transaction, which includes any transaction involving the use or exchange of a company's assets. You only want to include transactions related to your company in your financial records. Use source documents to identify business transactions, such as receipts and invoices. Save these kinds of financial documents to support your records.
- Record transactions in a journal: The second step in the cycle is the creation of journal entries, where the financial transactions are listed in the appropriate journal in chronological order. Your journal should be a running list of financial activities, much like a checkbook. Be sure to keep your journal current by tracking transactions as they happen. If you use double-entry bookkeeping, record two entries for each transaction. Enter a debit for one account and a credit for another. The debit and credit should be equal.
- Posting: The transaction, which was recorded as a journal entry, is now posted to the appropriate account in the general ledger. The general ledger is also known as the book of final entry. General ledger entries track changes made to each account in your books. For example, if a customer paid for a product with cash, enter the transaction under the cash account in your books.
- Unadjusted trial balance: At the end of the accounting period, a trial balance is calculated as the fourth step in the accounting cycle. A trial balance tells a company if its books are in balance. Use an unadjusted trial balance to test if your debits and credits match. Note each account balance.
- Worksheet: The fifth step in the cycle is the creation of a worksheet, which a company uses to make any adjusting entries needed to balance the books created during the fourth step. Add all the debit balances and all the credit balances together. If the two totals are not the same, there might be an error in your books or an entry may need adjustment. For example, you may have earned interest on a bank account balance, but not recorded the interest in your books. Use an adjusted entry to recognize the interest in your books.
- Adjusting journal entries: The sixth step in the cycle is to post the adjusting journal entries. In this step, the adjusting entries tracked in a company's worksheet are posted to the correct accounts. This step acts as a test to ensure debits and credits match.
- Financial statements: After the company makes all adjusting entries, it then generates its financial statements in the seventh step.
- Closing the books: Finally, a company ends the accounting cycle in the eighth step by closing its books, effectively starting the accounting cycle over again with a zero balance. When closing the books, decide which processes are moving your business forward. Create a calendar for completing future tasks, file paperwork from the last period, and shred old documents.
The Bottom Line
The step-by-step process of the accounting cycle makes accounting easier for busy entrepreneurs, helping to take the guesswork out of how to handle accounting activities. It helps ensure consistency and accuracy, helps manage time and set goals, and generates the overall health of a company's finances.