As a small business owner, you can benefit from a basic understanding of how the accounting cycle works, even if you don’t perform your own bookkeeping duties.
Technically, any span of time for which you balance your books and prepare accurate financial statements can be called an accounting - or reporting - period.
But in most cases, it refers to the twelve months that make up your fiscal year.
Recording, managing, and reporting your company’s financial transactions is essential for staying organized and compliant, and for growing your business more efficiently.
Which brings us to the three main reasons why the accounting cycle has evolved as a way to summarize your company’s accounting periods:
Every accounting period ends by making any necessary adjusting entries, and closing out revenue and expense accounts.
Every accounting period begins by making any necessary reversing entries, and carrying over asset, liability, and owner’s equity balances.
Closing out and carrying over certain account balances is what allows you to measure your profits and losses year-over-year, and to view your financial status at a particular point in time.
The accounting cycle is an endless, circular workflow driven by identifying, recording, and analyzing your company’s financial transactions - from the time they occur, to their inclusion on your financial statements.
Depending on the nature of your business, there can be as many as 10 different stages in the accounting cycle. But for the purposes of this discussion, we’ll be looking at the 6 most common steps.
Every financial transaction your business conducts gets recorded as a journal entry in your accounting system or software. These transactions are tracked chronologically, and usually reflect events like:
Transaction records should always be backed up by appropriate source documents like purchase orders, canceled checks, receipts, invoices, and bank and financial statements.
As the main accounting framework for your business, the general ledger is a list or index of all of your company’s financial accounts. Every transaction you record as a journal entry also gets posted to this ledger.
Most businesses use a double-entry bookkeeping system to record transactions in their general ledger. The purchase of printer toner cartridges, for example, might result in a debit to your office supplies account, and a credit of the same amount to your cash or bank account.
Preparing a trial balance report at the end of the accounting cycle - by totaling each of your general ledger accounts - lets you confirm that debit entries equal credit entries. If your books show an imbalance, this is the time to track down any errors and make account adjustments to correct them.
Other adjustments might be required at the end of the reporting period to account for financial accruals or deferrals. Common adjusting entries reflect asset depreciation and the reallocation of annual expense payments (like business insurance, for example) to monthly amounts.
Adjusting entries posted to your accounting journal ensure that revenues and expenses get reported in the appropriate accounting periods. Running an adjusted trial balance afterward ensures debits and credits remain in balance.
Key financial statements produced at the end of the accounting cycle include your income statement, balance sheet, and cash flow statement – typically in that order. Data for these reports is gleaned from accounting journals and your general ledger.
The accounting period is closed out by zeroing the balances of temporary accounts like revenue, expenses, and drawing accounts.
Journal entries known as closing entries effectively move these balances into income summary accounts, and/or directly to the owner's equity account for sole proprietors, and the retained earnings account for corporations.
It’s important to recognize that many of the steps in the accounting cycle are accomplished effortlessly with the help of today’s bookkeeping software.
These programs will instantly generate financial statements, automatically prepare, record, and post-closing entries, and can even reverse designated adjusting entries at the start of each new accounting period.
But by understanding what’s going on behind the scenes, you’ll be in a better position to choose and upgrade your accounting data system, and to make the most of any decision-making tools it offers.
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