Financial statements are critical to business owners. Without them, you wouldn’t be able to do things like plan expenses, secure loans, or sell your business.
But how are financial statements created? Through the accounting cycle (sometimes called the “bookkeeping cycle” or “accounting process”).
The accounting cycle is a multi-step process designed to convert all of your company’s raw financial information into financial statements.
What’s the purpose of the accounting cycle?
The proper order of the accounting cycle ensures that the financial statements your company produces are consistent, accurate, and conform to official financial accounting standards (such as IFRS and GAAP).
In short, an accounting cycle makes sure that all of the money passing through your business is actually “accounted” for.
If you need a bookkeeper to take care of all of this for you, check out Bench. We’ll do your bookkeeping each month, producing simple financial statements that show you the health of your business.
Steps of the accounting cycle
There are lots of variations of the accounting cycle—especially between cash and accrual accounting types. Some have eight, nine steps, or even ten steps. For simplicity’s sake, we’re going to divide it into six steps.
The six steps of the accounting cycle:
1. Analyze and record transactions 2. Post transactions to the ledger 3. Prepare an unadjusted trial balance 4. Prepare adjusting entries at the end of the period 5. Prepare an adjusted trial balance 6. Prepare financial statements
Step 1: Analyze and record transactions
In the first step of the accounting cycle, you’ll gather records of your business transactions—receipts, invoices, bank statements, things like that—for the current accounting period. These records are raw financial information that needs to be entered into your accounting system to be translated into something useful.
Recording entails noting the date, amount, and location of every transaction. Next, you’ll break down (or analyze) the purpose of each transaction. For example, if a receipt is from Walmart, was it office supplies? Restocking the office kitchen? Or maybe some stuff for the company vehicle? The details you provide are essential for step one.
Step 2: Post transactions to the ledger
Next, you’ll use the general ledger to record all of the financial information gathered in step one.
The ledger is a large, numbered list showing all your company’s transactions and how they affect each of your business’s individual accounts. Your accounts are how you bucket transactions. Here are some common examples.
The general ledger is like the master key of your bookkeeping setup. If you’re looking for any financial record for your business, the fastest way is to check the ledger.
The ledger is composed of journal entries, which list all of a business’s financial activity in chronological order. Journal entries must be recorded according to the rules of double-entry accounting (or double-entry bookkeeping). Whenever a transaction occurs, journal entries must be made in two parts: a debit and a credit.
Simply put, the credit is where your money is coming from, and the debit is what it’s going towards. If you buy some new business cards, for example, your marketing expense account is debited, and your bank account is credited. Or, if you receive a payment, your sales revenue is credited while your bank account is debited.
Once you’ve converted all of your business transactions into debits and credits, it’s time to move them into your company’s ledger.
Journal entries are usually posted to the ledger as soon as business transactions occur to ensure that the company’s books are always up to date.
If you use accounting software, posting to the ledger is usually done automatically in the background.
Step 3: Prepare an unadjusted trial balance
At the end of the accounting period, you’ll prepare an unadjusted trial balance.
The first step to preparing an unadjusted trial balance is to sum up the total credits and debits in each of your company’s accounts. These are used to calculate individual balances for each account.
An unadjusted trial balance brings all of these totals together in one place and looks something like this:
Mr. Magorium’s Wonder Emporium Trial Balance October 31, 2020
|Unearned consulting revenue||-||3,000|
|Mr. Magorium, capital||-||20,320|
|Mr. Magorium, withdrawals||300||-|
According to the rules of double-entry accounting, all of a company’s credits must equal the total debits. If the sum of the debit balances in a trial balance doesn’t equal the sum of the credit balances, that means there’s been an error in either the recording or posting of journal entries.
If you use accounting software, this usually means you’ve made a mistake inputting information into the system.
Searching for and fixing these errors is called making correcting entries.
Step 4: Prepare adjusting entries at the end of the period
Once you’ve made the necessary correcting entries, it’s time to make adjusting entries.
Adjusting entries make sure that your financial statements only contain information relevant to the particular period of time you’re interested in. There are four main types of adjustments: deferrals, accruals, tax adjustments, and missing transaction adjustments.
1. Deferrals have to do with money you spent before seeing any resulting revenue (e.g., buying office supplies that you will use in the future) or cash you received before delivering a service or good (e.g., an advance payment from a customer).
In other words, deferrals remove transactions that do not belong to the period you’re creating a financial statement for.
2. Accruals have to do with revenues you weren’t immediately paid for and expenses you didn’t immediately pay. Think of the unpaid bill that you sent to the customer two weeks ago, or the invoice from your supplier you haven’t sent money for.
Accruals make sure that the financial statements you’re preparing now take those future payments and expenses into account.
3. Missing transaction adjustments help you account for the financial transactions you forgot about while bookkeeping—things like business purchases on your personal credit. You’d add them in here.
4. Tax adjustments help you account for things like depreciation and other tax deductions. For example, you may have paid big money for a new piece of equipment, but you’d be able to write off part of the cost this year. Tax adjustments happen once a year, and your CPA will likely lead you through it.
Step 5: Prepare an adjusted trial balance
Once you’ve posted all of your adjusting entries, it’s time to create another trial balance, this time taking into account all of the adjusting entries you’ve made.
This new trial balance is called an adjusted trial balance, and one of its purposes is to prove that all of your ledger’s credits and debits balance after all adjustments.
Once you have an adjusted trial balance, you have all the information you need to start preparing your company’s financial statements!
Step 6: Prepare financial statements
The last step in the accounting cycle is preparing financial statements—they’ll tell you where your money is and how it got there. It’s probably the biggest reason we go through all the trouble of the first five accounting cycle steps.
Once you’ve created an adjusted trial balance, assembling financial statements is a fairly straightforward task.
First, an income statement can be prepared using information from the revenue and expense account sections of the trial balance.
A balance sheet can then be prepared, made up of assets, liabilities, and owner’s equity.
A cash flow statement shows how cash is entering and leaving your business. While the income statement shows revenue and expenses that don’t cost literal money (like depreciation), the cash flow statement covers all transactions where funds enter or leave your accounts.
After you, your CPA, or your bookkeeper prepares your company’s financial statements, they’ll make one more round of adjustments to close out your company’s temporary accounts, which resets the system and prepares it for the next accounting cycle.
Further reading: How to Read Financial Statements.
Closing the books
When transitioning over to the next accounting period, it’s time to close the books. This is typically done at the end of your fiscal year.
Closing the books ties up any loose ends and resets the balances of your temporary accounts (like revenues and expenses) so you can start the new year fresh. To do this, you make adjusting entries called “closing entries.”
Closing entries offset all of the balances in your revenue and expense accounts. Think of it as “resetting” the balances back to zero. You offset the balances using something called “retained earnings.” Essentially, this is the profit or loss for the year that is “retained” in your business.
For example, if a business sells $25,000 worth of product over the year, the sales revenue ledger will have a $25,000 credit in it. This credit needs to be offset with a $25,000 debit to make the balance zero.
The closing entry would look like this:
This process is repeated for all revenue and expense ledger accounts. Balance sheet accounts (such as bank accounts, credit cards, etc.) do not need closing entries as their balances carry over. They’re what’s called permanent accounts.
What’s left at the end of the process is called a post-closing trial balance.
The accounting cycle sounds like a lot of work because, well, it is. But the payoff is worth it: actionable financial insights into your business. Plus, a bookkeeper can take care of the accounting cycle for you so you can focus on what you do best. Here’s how to hire the right bookkeeper for your small business.
How Bench can help
Is keeping up with the accounting cycle taking up too much of your time? Win back hours each month by automating your bookkeeping. With Bench, you get access to your own expert bookkeeper to collaborate with as you grow your business. Our secure bank connections automatically import all of your transactions for up-to-date financial reporting without lifting a finger. Book review calls or send messages to get prompt answers to your questions so your financial health is never a mystery. Learn more.