Financial statements are vital to business owners. Without them, you wouldn’t be able to plan expenses, secure loans, sell your business, etc. But how are financial statements created? They are created through the accounting cycle (Also referred to as 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 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).
Accounting Cycle Step 1: Record and Analyze Transactions
Record and Analyze Transactions
In the 1st step of the accounting cycle, you’ll gather records of your business transactions—receipts, invoices, bank statements, etc.—for the current accounting period. Recording entails noting the date, amount, and location of every transaction. These records are raw financial information that needs to be entered into your accounting system to be translated into something useful. After recording, every transaction needs to be analyzed to discover the purpose of each transaction.
Accounting Cycle Step 2: Post Transactions to the Ledger
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.
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. 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.
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.
Accounting Cycle Step 3: Prepare an Unadjusted Trial Balance
Prepare an Unadjusted Trial Balance
At the end of the accounting period, an unadjusted trial balance is prepared.
The 1st 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.
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.
Accounting Cycle Step 4: Preparing Adjusting Entries at the End of the Period
Prepare Adjusting Entries at the End of the Period
Once you’ve made the necessary corrections, it’s time to adjust the 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 4 main types of adjustments (Deferrals, Accruals, Missing Transaction, Tax)
- Deferrals have to do with money you spent before seeing any resulting revenue (e.g., buying office supplies for future use) or cash you received before delivering a service or good (e.g., an advance payment from a client).
- 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 3 weeks ago, or the invoice from your supplier you haven’t sent money for.
- Missing transaction adjustments help you account for the financial transactions you forgot about while bookkeeping—items like business purchases on your personal credit. You’d add them in here.
- 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.
Accounting Cycle Step 5: Prepare An Adjusted Trial Balance
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.
Accounting Cycle Step 6: Prepare Financial Statements
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.
Once you’ve created an adjusted trial balance, financial statements can be assembled.
- 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.
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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.
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.
Focus on your business and let Arbo take care of your books! Sign up now for easy bookkeeping, tax services, and financial insights.
