The accounting cycle is a system of recording, processing, summarizing and communicating all financial transactions in a consistent way. It starts when a transaction occurs, and ends with its representation on financial statements. Once the cycle concludes, steps are taken to begin the next accounting cycle. This signals the start of the next fiscal period.
The accounting cycle can help the business in catching transaction errors. It can also help measure and compare profitability from the end of one fiscal period to another. This is because income and expense accounts are closed (and zeroed out) at the end of a fiscal period, rather than accumulating in succeeding periods. Compliance with accounting regulations, along with tax and other governmental regulations, depends on successful application of the accounting cycle within an organization.
Timing of the Accounting Cycle
Organizations typically complete the accounting cycle at the end of each fiscal period (usually at the end of the month). At year-end, the accounting cycle may take longer to complete as management and outside accountants spend extra time checking the completeness and accuracy of the financial statements.
Accounting cycles can be monthly, quarterly or yearly. It depends on the company’s needs. However, the “fiscal year” is defined as any time the accounting period runs for a full 12-month period. This could be a calendar year, or it could be any other 12-month period.
The SEC requires publicly traded companies file quarterly financial statements. That means these companies will structure their accounting cycles accordingly. These companies also must file annual tax forms with the IRS. So, all public companies have yearly accounting periods to meet those requirements too.
Steps of the Accounting Cycle
The steps of the accounting cycle are illustrated in the diagram and described below.
An organization must identify and capture every financial transaction into the accounting system. Transactions are recorded (posted) using the double-entry bookkeeping system, where at least one account is debited, and one account is credited.
Example: When it occurs, a $500 cash sale is entered in the journal chronologically with all other transactions. In this instance, the $500 cash sale would most likely be a $500 Debit to the company’s Cash account and a $500 Credit to the company’s Sales Revenue account.
2. Ledger Accounts
The general ledger (G/L) is a group of accounts that reflects changes to the balances, based on transaction recorded. Once all transactions are posted to the ledger, the balances of each account can be determined.
Example: Besides the $500 cash sale listed above, the same company during the same period has an additional $300 cash sale and a $200 cash refund. Thus, in the G/L for that period, the summary of Cash transactions would be a Debit of $600. However, the company’s Sales Revenue account would probably record a single Credit to Sales Revenue of $800.
That said, companies often record refunds differently. In this instance, the company could record a $200 Debit in a “contra account” called Returns and Allowances. This “contra account” means the account has a debit balance offsetting a regular revenue account.
3. Unadjusted Trial Balance
All account balances from the ledger are arranged in a report. All the debit balances are added and compared to the total of all the credit balances. The sole purpose of this report is to confirm that total debits equal total credits. It does not validate that the journal entries posted are correct.
Example: If, in addition to the period’s Cash transaction of $600 recorded above, the company has recorded:
- $1,000 of Credit sales—logged as a $1,000 Debit to Accounts Receivable and a $1,000 Credit to Sales Revenue, and
- a $500 purchase of inventory from a vendor, logged as a $500 Credit to Accounts Payable and a $500 Debit to Inventory
Then the company has:
- Debit balances of $600 in Cash
- $200 in Returns and Allowances
- $1,000 in Accounts Receivable, and
- $500 in Inventory
Simultaneously, the company has Credits of $1,800 in Sales Revenue and $500 in Accounts Payable. Both Debits and Credits now add up to $2,300 each.
4. Adjusting Journal Entries (AJEs)
These journal entries are prepared as an application of the accrual basis of accounting. This means income earned but not received, and expenses incurred, but not yet paid, are not yet reflected in the Unadjusted Trial Balance. AJEs are prepared for revenue accrual or deferral, expense accrual, expense prepayments, depreciation and allowances.
Example: At the beginning of the calendar year, the company pays its entire year’s rent of $48,000 ($4,000 per month). Then, the original journal entry was a $48,000 Debit to Rent Expense and a $48,000 Credit to Cash.
At the end of the monthly accounting period, however, the AJE would be $44,000 Debit to Prepaid Rent and $44,000 to Rent Expense. This shows that only $4,000 worth of rent was used in January. For the 11 remaining accounting periods in the year, there will be a $4,000 Debit to Rent Expense and a $4,000 Credit to Prepaid Rent.
5. Adjusted Trial Balance
Once all AJEs are posted, the Adjusted Trial Balance is created. This again tests that all debits equal all credits before the financial statements are generated.
Example: If the Trial Balance example above was for January, all the figures from that period would be added to the additional figures from the accounting period (the entire month of January). All AJEs for the month would be taken into account as well. The goal is that Debits and Credits in the G/L equal one another and cancel each other out.
6. Financial Statements
Reports generated include the income statement, balance sheet, cash flow statement, statement of changes in equity and notes to the financial statements. The financial statements are the “scorecard,” as they report on the company’s financial health to its readers.
Example: If your income statement shows Total Revenues of $500,000 and Total Expenses of $250,000, your net income is $250,000 ($500,000 – $250,000).
Let’s assume your business started the year with a Retained Earnings balance of $100,000. The Adjusted Trial Balance would have listed this $100,000 in Retained Earnings. At the end of the year, however, as long as your company didn’t pay any dividends, you add your net income of $250,000 to your Retained Earnings, and you now have $350,000 of Retained Earnings. This is used to prepare your Balance Sheet.
7. Closing Entries
Temporary accounts (i.e., income statement accounts) are zeroed out to an income summary account. Then, they are closed to the appropriate equity account on the balance sheet to prepare for the next fiscal period. Temporary accounts include all income, expense and withdrawal accounts. Balance sheet accounts are not closed.
Example: For each fiscal year, your accountant Debits the total revenue of all your accounts and makes a corresponding Credit to Retained Earnings. All expense accounts will also be Credited with a corresponding Debit in Retained Earnings. Retained Earnings will then show either a net income or a net loss for the fiscal year.
8. Post-Closing Trial Balance
This is the last step in the accounting cycle. Debits and credits for only the balance sheet accounts are tested to ensure they equal out. This trial balance consists only of balance sheet accounts, as all temporary accounts have been closed.
Example: The accuracy of journal entries can be checked by comparing the financial statements’ numbers from Steps 6 and 7.
How to Successfully Complete the Accounting Cycle
Implement best practices to ensure successful completion of all the accounting cycle stages.
Use general accounting best practices
- Develop standardized accounting procedures to build consistency into the performance of each step within the accounting cycle. For example, ensure every sales and expense transaction posted to the G/L has a valid source document to support it. These source documents should be physically stored and/or backed up on the cloud. Retention should be based on IRS prescribed record holding periods.
- Implement and maintain strong internal controls. Segregation of duties, physical counts (of assets), periodic reconciliations and approval authority will help reduce the risk of fraud and other material misstatements of assets and liabilities.
- Consider outsourcing parts of the accounting function to specialized accounting and finance outsourcing service providers. This would allow your internal team to focus on more strategic and value-added tasks.
- Close the books and issue financial statements at least quarterly. This enables management to determine profitability and investigate significant or unusual variances from prior periods (or from approved budgets).
Set your people up for success
- Hire staff who have the appropriate level of accounting/bookkeeping expertise you need. Be sure you have the right combination of accuracy, efficiency and knowledge.
- Regularly meet with accounting team members to listen to their insights. They may have ideas to automate or eliminate unnecessary tasks within the accounting cycle. They may also have ideas for collaborating with other departments to further speed up the fiscal month-end close.
- Establish deadlines for the completion of each step in the accounting cycle and make adherence mandatory. Executive management depends on the timely generation of financial statements to make decisions. Additionally, compliance with regulatory and banking rules dictate that financial statements be made available within a set time period.
Use the right technology
Cloud-computing technology has become more common and affordable. It can make timely recording of transactions, performance of account reconciliations, maintenance of the G/L and generation of financial statements much more efficient than the more traditional, manual accounting processes.
If you have staff that are proficient in Excel, there are many calculations that can be performed automatically. These include generating accrual/deferral journal entries, reconciliation schedules to support G/L balances, account roll-forwards, and timely management reports for analytical analyses.
Create a reporting package
Establishing a reporting package that is updated after the adjusted trial balance has been generated is a great way to ensure trial balance accounts are accurate. This package should contain supporting schedules, reconciliations and notes for each balance sheet account total. Examples of items to be included are:
- Bank reconciliations
- Detailed A/R aging report
- Schedule of prepaid and other assets
- Physical to book inventory schedule and valuation
- Schedule of fixed assets and depreciation
- Detailed A/P aging report
- Schedule of accrued and other expenses
- Loan amortization schedules
Prior to issuing financial statements and closing out the accounting cycle, review the reporting package. Check that all account balances are properly reconciled to the adjusted trial balance. You may uncover issues that need to be investigated further. These might include unusual or significant reconciling items, missing or incorrectly calculated accruals or deferrals, or old outstanding balances that should be written off.
Establish an easily accessible set of permanent files
Files to maintain (and update as necessary) include:
- Corporate documents: articles of incorporation; corporate charter, shareholder agreements; meeting minutes, etc.
- Permits and licenses
- Insurance policies
- Loan and lease documents
- Key customer and supplier contracts
- Employee files
Having a detailed and well-maintained set of permanent files can help management investigate underlying assumptions to G/L balances such as loan rates for calculation of outstanding debt and interest expense, insurance premiums used to establish the prepaid expense balance, and customer/supplier contracts that specify prices paid, payment terms, etc.
Get accurate, reliable accounting support
If all this work seems overwhelming and impossible to accomplish, there are experts available who can identify strategies to strengthen your organization’s performance throughout the accounting cycle.
At Paro, we leverage our proprietary AI technology to build flexible, focused teams of remote experts that help companies solve problems and drive growth. Our laser focus on finance allows us to quickly identify experts across the U.S. with the right mix of skills, credentials and experience to achieve each company’s specific goals. Learn more about our accounting services and request a consultation to get one step closer to better manage your accounting and ensure accuracy across the entire cycle.