Financial statements are critical to your business. Without them, you wouldn’t be able to do things like plan expenses, secure loans, or sell your business.
But how do they get created? Through the accounting cycle (sometimes called the “bookkeeping cycle”).
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?
In short, the concept of an accounting cycle makes sure that all of the money passing through your business is actually “accounted” for.
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Steps of the accounting cycle
There are lots of variations of the accounting cycle. 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:
- Analyze and record transactions
- Post transactions to the ledger
- Prepare an unadjusted trial balance
- Prepare adjusting entries at the end of the period
- Prepare an adjusted trial balance
- Prepare financial statements
Step 1: Analyze and record transactions
The first step in the accounting cycle is gathering records of your business transactions—receipts, invoices, bank statements, things like that—for the current accounting period.
This is the raw financial information that needs to be translated into something useful.
Step 2: Post transactions to the ledger
This involves recording all of the financial information we gathered in step one into the general ledger.
The ledger is made up of journal entries, a chronological list of all of a business’s transactions, written down according to the rules of double-entry accounting. This means that whenever a transaction occurs, two journal entries must be made, affecting at least two accounts: a debit and a credit.
If you buy a new MacBook Pro for your business, for example, your assets account will go up, and your bank account will go down.
Once you’ve converted all of your business transactions into debits and credits, it’s time to move them into your company’s ledger.
The ledger is a large, numbered list showing all your company’s transactions and how they affect each of your business’s individual accounts. 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.
Journal entries are usually posted to the ledger on a continuous basis, as soon as business transactions occur, to make sure 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
Next comes preparing an unadjusted trial balance, which happens at the end of the accounting period.
The first step to preparing an unadjusted trial balance is totaling up all the debits and credits in each of your company’s accounts, and calculating a total balance for each individual 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 January 31, 2018
|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 debits must equal all credits. If the sum of the debit entries in a trial balance doesn’t equal the sum of the credits, 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 that is 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 advanced payment from a customer).
Put another way, 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 didn’t immediately record at the time (such as a bill that you sent to the customer two weeks after giving them consulting services), or expenses you didn’t immediately pay for (e.g. rent you owe a landlord and haven’t paid yet).
Accruals make sure that the financial statements you’re preparing now take into account those future payments and expenses.
3. Missing transaction adjustments help you account for the 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 that tell you where your business’s 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.
After your CPA 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 gets it ready for the next accounting cycle.
There are other financial statements too. You can read more about them in our article How to Read Financial Statements.
The accounting cycle sounds like a lot of work, because it is. But the payoff is worth it: actionable financial insight 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.