As a small business owner, you’ve likely had a crash course in accounting 101, learning everything from how to track business expenses, to learning about the different types of accounting.
But along with the accounting process and the various accounting terms, you should also take a bit of time to learn more about the accounting cycle.
Here are the steps in the accounting cycle:
- Step 1: Transactions
- Step 2: Record journal entries
- Step 3: Post journal entries to the general ledger (G/L)
- Step 4: Run unadjusted trial balance
- Step 5: Make adjusting entries
- Step 6: Prepare an adjusted trial balance
- Step 7: Run financial statements
- Step 8: Close the books
- Step 9: Begin the next accounting cycle
Overview: What is the accounting cycle?
The accounting cycle is considered a bookkeeping basic and is a a step-by-step process performed by accountants to ensure that all financial transactions are properly recorded. Starting from the initial financial transaction, the accounting cycle makes the entire financial process simpler, and helps to ensure that you don’t overlook any of the processes.
Thanks to accounting software, much of this cycle is automated, so you no longer have to post in separate journals, or wait to post to the general ledger (G/L). But even though the cycle is automated, it’s important to understand each of the steps, and why each is necessary.
At the end of the month, you’ll run your financial statements, and then start all over again, hence the term ‘cycle.’
The steps in the accounting cycle
Depending on where you look, you can find the accounting cycle described in 4 steps, 5 steps, even 10 steps.
However, the general consensus is that there are 8 steps in the accounting cycle, 9 if you count the beginning of the cycle. If you use accounting software, you’ll find that many of these steps, such as entering transactions and posting them to the G/L, have been consolidated into a single step.
It’s important to note that many of the steps in the accounting cycle are for those using the accrual accounting method. If your business uses the cash accounting method, you can still follow the cycle, but you can eliminate some of the steps such as adjusting entries.
Step 1: Transactions
The first step in the accounting cycle begins immediately after closing your books for the previous month.
The new cycle starts as you begin to organize all of your financial transactions. This can include coding your accounts payable to the correct account, writing an invoice, reviewing receipts, creating an expense report, and paying your employees.
Once this initial review has been completed, and your transactions have been coded properly, you can move on to the next step in the accounting cycle.
Step 2: Entering transactions
Once you’ve prepared your transactions, you can start posting them. If you’re manually entering your bookkeeping transactions, you’ll need to enter them in separate journals. Common journals used by bookkeepers and accountants include:
- Cash receipts
- Cash disbursements
The purpose of these journals is to provide the details of the balance that you will later transfer to the G/L. In other words, if you end up recording $150 in payments from your customers, your cash receipts journal will provide the details for each of those payments, while the G/L will only reflect the $150 total.
|12-31-19||Zebra Print Toys||25.00||25.00||25.00|
|Total for December||150.00||75.00||75.00||150.00|
If you’re using accounting software, this process is automated, which will save you a tremendous amount of time and significantly reduce the chance of errors.
Step 3: Posting to the general ledger
Once your transactions have been entered for the month, you will then need to post the totals from your subsidiary journals to your general ledger. This step is unnecessary if you’re using accounting software, which I highly recommend. However, if you’re not, or if your accounting software does not automatically post to the G/L, you would post your entries to the G/L at this point.
Step 4: Preparing an unadjusted trial balance
A trial balance provides you with a list of all of your general ledger account balances, with each account displaying a debit or a credit balance. The reason you run a trial balance at this point is to ensure that your debits and your credits are in balance.
If they’re not, you will have to return to your subsidiary ledgers to find the error.
Step 5: Make adjusting entries
Once you’ve reconciled your bank statement, you will likely have a few adjusting entries to make. This is the point where you would also make any depreciation entries and enter payroll or other expense accruals.
Step 6: Run an adjusted trial balance
After you’ve fixed any out-of-balance issues and entered any late entries or accrual entries, you’ll want to run an adjusted trial balance. This will give you the most up-to-date balances for all of your general ledger accounts.
Step 7: Prepare financial statements
Your adjusted trial balance plays a large role in creating your month-end financial statements. At a minimum you should run three reports:
- Income statement
- Balance sheet
- Statement of cash flows
You can run as many supplementary reports as you wish, but these three are a necessity.
Step 8: Closing the books
When you close your books for the current accounting cycle, you zero out both the revenue and expense account balances.
This zero balance will carry over to the start of the next accounting period, and is done in order to show both revenue and expenses for a set period of time, which can only be done if you start with a zero balance for each accounting period.
Step 9: Begin the next cycle
Congratulations, you’ve completed your first accounting cycle. While much of this detail is completely automated if you’re using accounting software, you now understand the accounting cycle from beginning to end.
Using the accounting cycle for your finances
Even if you’re a small business, and even if you use cash accounting, it can be beneficial to use the accounting cycle.
The accounting cycle helps to ensure that your balances are accurate, that you haven’t skipped over one of the processes, and that your financial statements represent the true financial health of your business.
Like everything else about bookkeeping and accounting, the accounting cycle is a process that can help you categorize and enter your transactions properly. Using the accounting cycle also helps to ensure that you and your accountant both have a complete and accurate overview of the financial health of your business.
Even small businesses would benefit from using the accounting cycle in their business, and if you are using accrual accounting, it’s an absolute must.
The Motley Fool owns shares of and recommends Intuit. The Motley Fool owns shares of Xero. The Motley Fool has a disclosure policy.