What is the accounting cycle and why is it relevant to your business?
Financial statements are basically the beating heart of every business. With the data they contain, you can understand how your business functions and what it needs to grow. Financial statements help you predict prospective cash growth, obtain loans or investors, ease the filing of tax returns and see the stability of your business.
The creation of these financial statements is a complex one. Its purpose is to convert every bit of financial information recorded by a bookkeeper into an assessable format. From this analysis, an accountant can help a business owner see where improvements to business practice can be made.
The production of financial statements is known as the accounting cycle – this article will detail what the accounting cycle is, and why it’s so important to your business.
So, lets start with the basics: why do we even need an accounting cycle?
The answer to this is a pretty simple one – for both legal and practical reasons, the accounting cycle ensures that you have recorded accurate and consistent financial statements. These statements must detail exactly where and how money has flowed through your business.
It’s extremely important that your financial statements reflect the reality of your business’ day-to-day transactions – otherwise you won’t have a clear idea of where your business is succeeding or failing!
Now you know why, lets move on to what!
The accounting cycle consists of eight main steps – this number varies depending on interpretation, but we think these eight are the most important and we didn’t want to miss out any you might need!
- A Transaction Takes Place
- Making Journal Entries
- Posting to the General Ledger
- Creating a Trial Balance
- Correcting the Trial Balance in the Worksheet
- Adjusting Entries
- Preparing the Financial Statements
- Closing your General Ledger
There are a lot of steps here, so bear with us and we’ll cover each one as best we can!
A Transaction Takes Place
This one is pretty self-explanatory. In the running of your business, financial transactions will be a common occurrence – whether you’re buying supplies, paying off debts or making money through sales. The occurrence of a transaction is the first step in any accounting cycle.
Making Journal Entries
This is where a bookkeeper comes in. A bookkeeper’s job is to keep track and record every single financial transaction your business does on a daily basis. These journal entries are always recorded in chronological order and, for most businesses, use the double-entry bookkeeping method. That means, for each transaction that occurs, the bookkeeper will show which account is credited and which account is debited.
Posting to the General Ledger
After the bookkeeper has recorded the transaction using a cloud accounting software or Excel, they then post these entries into the General Ledger. Simply put, the General Ledger summarises all the transactions that have been made into five different categories, depending on the corresponding account.
For example, revenue from sales is posted into the revenue account and expenses are posted into an expense account – for more information on the more complex accounts, take a look here at our article on the five account types.
Creating a Trial Balance
When the accounting period has come to an end – this is usually either monthly or annually – a trial balance is calculated based on the five main accounts. This is done by summing up the debits and credits for each account and then bringing them together in one place.
If you’re using the double-entry accounting method as we mentioned earlier, the total debits of each account must equal the total credits of each account. If they don’t match, the worksheet comes into play.
Correcting the Trial Balance in the Worksheet
If the trial balance shows that the debits and credits for your business don’t match, the bookkeeper must attempt to reconcile this issue. The bookkeeper will go through each account in order to find the errors that lead to the unmatched balances – these errors and corrections are recorded in the worksheet.
Once the accounting period has come to an end, the bookkeeper must go through their accounts and make adjustments to the general ledger – this can be for one of many reasons, such as correcting errors or recording acknowledging accounts receivables.
Preparing the Financial Statement
Back to the beating heart. Using all the correct information that the last two steps have accounted for, a financial statement can be made. These financial statements usually take one of four forms: statement of financial position; statement of change in equity; income statement; and a statement of cash flow.
From these financial statements, the accountant can analyse the behaviour of the business and make suggestions to the business owner as to how the business can maintain or improve its growth.
Closing your General Ledger
Closing your accounts ready for the next accounting period is an important final step of the cycle. It’s basically a spring-cleaning exercise. Specific details can be found here but simply put, revenue and account expenses are closed and returned to zero in anticipation of the new fiscal period.
Our Final Statement
There you have it! It’s certainly a lengthy process and by no means is it an easy one. If you plan on going at it alone, have a look at some of our other guides and see if you can pick up some useful information here and there.
The accounting cycle is an extremely important part of running your business; understanding how your business operates gives you a great insight into where you should focus your efforts to help stimulate growth.
You don’t have to go it alone: our professional bookkeepers and accountants can deal with all this financial administration so you can focus on the important part: running your business.