Every business needs to keep a close eye on its accounts. To do so, you will need to have a smooth accounting cycle in place. Find out everything you need to know with our guide to the meaning of the accounting cycle.
What is the accounting cycle?
The accounting cycle, sometimes known as the bookkeeping cycle (and not to be confused with the billing cycle), is the sequence of events that need to be completed for a transaction to be fully incorporated into a company's yearly finances. There are several steps to the accounting cycle. From the start of any transaction, there are between five and six processes that need to be completed before the seventh and final step: closing the books for the year. By looking at the accounting cycle, you can get a full overview of the accounting process used by a business. Generally speaking, the process will be more or less the same for any company.
What's the point of the accounting cycle?
The accounting cycle is like a checklist to help your business close the books for each financial period. To do this, you must follow the bookkeeping cycle steps to create correct financial statements. Almost anything you plan to do with your business, from forecasting expenses to selling the business altogether, will require financial statements. The cycle ensures thorough and correct creation of these documents.
How to draw the accounting cycle
Your business's finances may be a mystery to most people outside of the accounting department, but it is always a good idea to have everyone clued up on the basic steps. The bookkeeping cycle steps may also be referred to as the accounts payable cycle. The eight steps can be summarised as follows:
Adjustments or worksheet (sometimes split into two steps)
But what does each of these bookkeeping cycle steps mean? Let's take a closer look at each part of the accounting cycle.
Transactions are the first step of the accounts payable cycle. This can include items like raw materials, rent, sales revenue, or expenses.
The transactions must be noted in the financial journal in the order in which they were made. Debits mark the money which has been spent, and credit indicates money that has been received. An account must be debited at the same rate that another is credited so that they balance. So, if you buy a new piece of machinery for your warehouse, your bank account (debit) will go down, and the value of your assets will increase. All transactions must be marked as either credit or debit before you can move onto step three of the accounting cycle.
Transactions must be posted to the account of the general ledger (GL). This provides an overview of the accounting process in the company. Keeping a GL up to date can be done manually or via an automated process. The important thing is to make sure it always reflects your business's most current state, as it is the ultimate tool for checking your company's finances.
4. Trial balance
At the end of every accounting period (usually quarterly, although this can also be a monthly or annual process), a trial balance is run. This ensures that credit and debit are balanced. However, it's relatively common for errors to creep in, which is why step five (worksheet and adjustment) of the accounting cycle is so important. To run a trial balance, add up all credits and debits. According to the rule of double-entry bookkeeping, the final figures should be the same. If this process is also automated, be aware that the cause of the imbalance may be a human error during input rather than the figures themselves.
5. Worksheet and adjustment
Arguably one of the most vital steps in the bookkeeping cycle, the bookkeeper must correct any imbalances and track them in a worksheet. These adjustments usually fall into one of two categories:
Deferrals: Revenues or expenses that were not recorded, i.e., advanced payment for undelivered work.
Accruals: Receipts of payment or assets that have not been recorded, i.e., late payment for delivered work.
Adjusting entries can be tricky. Expenses should be reported when they are incurred, not when they are actually paid. That means that interest on payment should still be factored into the balances even if it isn't due yet. You can also make tax adjustments here, for example, writing off part of your new machinery cost.
After these bookkeeping cycle steps, you may wish to run another trial balance following your adjustments.
6. Financial statements
Financial statements are the penultimate step in the accounting cycle. Essentially, once everything is balanced, you can begin preparing your statements. This includes the income statement, balance sheet, and cash flow statement.
Finally, the revenue and expense accounts are closed for this accounting period, and new ones opened at zero balance, completing the accounting cycle.
Do financial statements have to close?
Yes, they do. This is an essential part of the accounts payable cycle as it completes the accounting overview for the period. So, if you want to see how your business fared in Q1, your financial statement will reflect Q1 alone. Q2 will have its own statement.
What if my financial statements are incorrect?
Financial statements are a critical document for your business, and you must make sure they are accurate. Potential investors, banks, and the ATO will look closely at your financial statements. Untruthful or inaccurate financial statements could lead to severe repercussions, including fines and penalties.
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