In the world of financial management, the accounting cycle plays a critical role as a foundational process that sets the stage for accurate and insightful decision-making. It’s a series of steps that takes raw financial data and turns it into useful reports.
Each step in the accounting cycle is important, ensuring that a company’s financial records not only meet regulatory standards but also give a complete picture of its financial activities. From entering financial data to creating reports, the accounting cycle provides a systematic way to keep financial records.
This article explores these steps in detail and explains their importance in promoting transparency, accountability, and informed decision-making in business. It also looks at how technology is making the accounting cycle more efficient and accurate by automating tasks and improving processes.
What is the Accounts Cycle?
The accounting cycle is a structured process that guides how a business records, analyzes, and reports its financial activities. It involves consolidating information from various departments like accounts payable, accounts receivable, payroll, and finance to create a complete financial picture for the previous month. This cycle typically includes monthly, quarterly, and annual closes to finalize financial records.
The accounting cycle is crucial for establishing the basis of financial accounting metrics within an organization. At the end of each month, the accounting team follows eight steps to complete the cycle. Other accounting processes depend on the accuracy of this cycle. It ensures reliable audit trails and provides the data needed for making informed business decisions based on past financial cycles.
How Does the Accounting Cycle Work?
The accounting cycle typically operates on a monthly timeline, divided into weeks. For example, the first two weeks of April might be dedicated to completing the accounting cycle for March, depending on the organization’s timeline. The process follows a sequential order, where each step is crucial and must be completed before moving on to the next.
The number of people involved in the accounting cycle can vary based on the organization’s complexity. It’s important for everyone involved to be detail-oriented, systematic, and knowledgeable about the entire accounting process. Private organizations may have more flexibility in completing the month-end process, while public companies must adhere to GAAP standards and reporting requirements.
What are the 8 Steps of the Accounting Cycle?
The accounting cycle is a series of steps that businesses take to record financial transactions and prepare financial statements. These steps ensure that financial records are accurate and that financial statements provide a true and fair view of the company’s financial position. Let’s take a closer look at each step:
1. Identify and Analyze Transactions
The first step in the accounting cycle is to identify and analyze all transactions that occur during the accounting period. These transactions include expenses, debt payments, sales revenue, and cash receipts from customers.
Companies use subsidiary ledgers or journals to systematically capture and document these transactions in their books. These transactions are then integrated into the financial statements. By employing the principles of double-entry bookkeeping, where each transaction is accompanied by balancing debits and credits, the organization ensures accuracy and completeness in its accounting system. This methodical approach is fundamental to maintaining the integrity of the accounting system.
2. Prepare Journal Entries
After identifying and analyzing transactions, the next step in the accounting cycle is to record these entries in the company’s journal. This process involves carefully documenting each transaction in chronological order, whether using physical books or accounting software. The recording follows the principles of double-entry accounting, where each transaction is entered as a debit in one or more accounts and a corresponding credit in two or more sub-ledger accounts. This ensures that the total debits equal the total credits, maintaining balance.
The timing of these recordings depends on the accounting method chosen by the company. Accrual accounting records transactions when they occur, providing a comprehensive overview of financial activities. On the other hand, cash accounting records transactions when cash changes hands. This systematic recording of financial transactions establishes a transparent chronological record and is crucial for the subsequent stages of the accounting cycle.
3. Post to General Ledger
Posting to the general ledger is the next step after recording and approving journal entries. The general ledger acts as the main record, summarizing all financial transactions by account.
Each transaction recorded in the journal is systematically posted to the corresponding account in the general ledger. This process provides a detailed breakdown of all accounting activities, helping track various company account finances. The general ledger is crucial for offering a consolidated view of financial data, ensuring accuracy and transparency in representing the organization’s financial standing.
4. Create Unadjusted Trial Balances
After journal entries are posted to individual general ledger accounts, the unadjusted trial balance is prepared to ensure that the total debits equal the total credits in the financial records. This step is crucial for maintaining accuracy. The unadjusted trial balance shows the closing balances of accounts without any adjustments, hence the term “unadjusted.” It serves as a preliminary check for errors and helps ensure that all transactions are accurately recorded in the general ledger.
The unadjusted trial balance provides insight into each account’s balance before adjustments and helps identify anomalies, such as missing or misaligned transactions. The trial balance is then used for additional testing and analysis in the next phases of the accounting cycle.
5. Analyze Worksheets to Find Anomalies
In the accounting cycle, the fifth step involves using worksheets to analyze and reconcile debits and credits. This helps identify and correct errors and discrepancies found in the trial balance. If there are mismatches between debits and credits, bookkeepers use worksheets to track adjustments needed to balance the accounts.
This process includes consolidating debits and credits from different accounts into a single spreadsheet for a thorough review. The analysis helps identify any necessary adjusting entries to ensure that total credit and debit balances match. This step is crucial for detecting errors and reconciling revenue and expenses, especially in accrual accounting. If any discrepancies are found, adjustments need to be made before preparing for the next steps in the accounting cycle.
6. Finalize Adjusting Journal Entries
Adjusting entries is a crucial step in the accounting cycle, usually done at the end of the accounting period to ensure accurate financial reporting. This step continues from earlier processes, correcting any errors found in the trial balance and worksheet analysis. Adjustments can include recording accrued expenses and reconciling items found during account reconciliation.
Once the adjusting entries are made and posted to the general ledger, the total debit balances are carefully compared to the total credit balances to ensure they match. This process helps maintain accounting accuracy. Finally, an adjusted trial balance report is generated and reviewed to confirm the effectiveness of the adjustments. This step is done just before preparing financial statements, marking the end of meticulous error correction and reconciliation to maintain the integrity of the financial data.
7. Generate Financial Statements
After adjusting entries are posted and the adjusted trial balance is prepared, the next step in the accounting cycle is to generate formal financial statements. These statements are based on the corrected account balances and provide a summary of a company’s financial activities and performance for a specific period, such as a month or a quarter.
The key financial statements typically include the income statement, balance sheet, and cash flow statement. These statements, along with others like the statement of owner’s equity, offer insights into the company’s financial status and performance.
The balance sheet shows the company’s assets, liabilities, and equity at a specific point in time, providing a snapshot of its financial position. The income statement summarizes the company’s revenues, expenses, and profits or losses over a period, showing its financial performance. The cash flow statement details the sources and uses of cash during the period, helping to monitor and project cash flow.
These financial statements are crucial for financial management, as they help in making informed decisions and developing growth strategies based on the company’s financial health and performance throughout the accounting cycle.
8. Close the Books
The final stage of the accounting cycle is closing the books, the main objective is to reset certain accounts on the income statement to zero. These accounts, such as revenue and expenses, show the company’s financial performance for a specific period, like a month or a year. Unlike accounts on the balance sheet, which reflect the company’s overall financial status at a certain point, income statement accounts need to be reset to start fresh for the next period.
To accomplish this, closing entries are made, which involve transferring the net income or loss from the income statement to the retained earnings account on the balance sheet. This retained earnings account carries over to the next period. It’s important to note that this process does not apply to something called a soft close.
Closing entries ensure that all revenue, expenses, and related entries for the accounting period are properly accounted for. After these entries are made, a post-closing trial balance is prepared to verify that debits and credits are balanced before starting a new accounting cycle. This entire process marks the end of one accounting cycle and the beginning of the next reporting period.
Why is the Accounting Cycle Important?
The accounting cycle is essential for businesses and organizations to record transactions accurately and prepare financial statements. This standardized process, often supported by accounting systems, helps in closing books for the accounting period and generating financial information for analysis and business management.
Businesses use a detailed accounting close checklist to ensure each step of the accounting cycle is completed. This checklist assigns responsibilities, sets deadlines, and documents completion times and approvals for each task. This helps improve accountability and process management.
CPA firms can review or audit financial statements during the accounting cycle, examining underlying financial transactions and accounting records to test account balances.
Stakeholders, including management, the Board of Directors, lenders, shareholders, and creditors, analyze the financial statement results for the accounting cycle period to make informed decisions.
What is the Accounting Cycle Period?
A business’s accounting period is determined by factors such as reporting obligations and deadlines. This period refers to the timeframe for preparing financial documents, which can range from monthly to annually. Companies choose their accounting periods based on their specific needs, opting for monthly, quarterly, or annual financial analyses.
Each accounting period reports transactions within that specific timeframe. If the accounting period covers a year, it is also known as a fiscal year. Publicly traded firms submit quarterly financial statements as mandated by the SEC, while annual tax filings with the IRS require yearly accounting periods.
Closing Thoughts
Investing in accounting automation software is a wise choice for companies looking to scale and overcome complexities. Many CFOs are turning to end-to-end automated solutions to streamline processes, especially as they expand into new markets and add new entities.
Imagine reducing your month-end close process from 7-10 days to just 2-3 days. Automation software can make this a reality, leading to happier employees, a competitive edge, and long-term financial benefits.
With Peakflo’s automated account reconciliation, closing the books becomes effortless. Your finance team no longer needs to spend weeks on month-end closing. Peakflo automates reconciliations and syncs the data to your accounting software seamlessly.
Integrating your accounting software with Peakflo is seamless and doesn’t disrupt your current finance process. You can say goodbye to errors and mismatches in bank statements and transactions.
