A guide to understanding the accounting cycle from recording transactions to creating year-end accounting reports.
Do you own a small business and want to know how to keep track of your finances? That’s great! Regardless of size, the accounting cycle is an important part of any company. We’ve got you covered if you’re looking for help understanding it. In this blog post, we’ll go over 8 steps to help get things done on time and in order.
What is the Accounting Cycle?
All small businesses must produce financial statements to report their profit or loss in any period.
The financial reports are the Profit and Loss (Income Statement) and Balance Sheet. These reports are created by following the bookkeeping or accounting cycle.
The Accounting cycle is a step-by-step process a business follows to complete the accounts. It starts with the transactions and ends with the reports and closing year-end.
Several people might help complete the accounting cycle, including the business owner posting transactions, the bookkeeper and the accountant making adjustments and preparing financial statements.
How Long is the Accounting Cycle?
The cycle is generally for an accounting period of 12 months and will tie up with the financial year-end of the business.
The reason for 12 months is for business owners to submit the accounts to Companies House or Self-Assessment tax returns. Both of these require the books completed to obtain the figures.
The reporting dates will depend on the date registered at companies house or for the tax year for the self-employed.
A more significant business might complete the accounting cycle either monthly or quarterly. It will enable the management team to get accurate financial statements regularly.
How to Complete the Financial Cycle
There are several ways, including Excel bookkeeping templates, setting up spreadsheets or accounting software.
We have created a Cash Book template if you want to use Excel for a small business. More templates are available for other tasks, including; petty cash, business expenses, sales invoices, and cash flow statements.
You can also create spreadsheets yourself; many YouTube videos are available on how to do it.
One of the problems with using Excel is that it is harder to complete the trial balance, make adjusting entries and produce financial statements.
Accounting software is the best way to complete the company’s accounts.
In accounting software, you can set the accounting period, print all the financial statements, prepare the trial balance, adjust entries, and share information with bookkeepers and accountants.
Steps of the Accounting Cycle
Below are the 8 steps that businesses use:
1. Identify All Business Transactions
The first stage of the accounting cycle is the accounting source documents. These documents include sales invoices, point-of-sale transactions, bills, receipts, bank statements and supplier statements.
If you are a self-employed business, separating business transactions from personal ones is crucial. Opening a separate business bank account makes bookkeeping easier and is required for limited companies.
2. Record All Financial Transactions
The next step is to record the transactions in the accounting software. Add as much information as possible to the transaction, including date, amount, reference number, account code, and details.
In modern cloud accounting packages, the source documents can be uploaded to the software using a photo or PDF document. Automated software will also import the information; two such packages are Dext and Auto Entry.
Open bank feeds also make accounting much easier and reduce mistakes. When you look at software, check if your bank is included.
Posting each transaction creates a journal entry with debit and credit balances. These entries appear in date order in the accounts.
3. Posting to the General Ledger
The journal entries are posted to the general ledger. Each journal entry will have at least two entries, debits and credits, and balances on each side.
The journal may have more than two entries; an example is a supplier invoice for general business expenses, postage and VAT.
The general ledger is all the accounts that make up the chart of accounts.
4. Prepare an Unadjusted Trial Balance
A trial balance is a report in the accounting software that lists all the accounts and debit and credit totals. The total of the debits and credits will be equal.
The first trial balance is known as an unadjusted trial balance.
An example of a trial balance is below.
An advantage of an unadjusted trial balance is that a business owner, bookkeeper or accountant can see all the figures in one place. It is a great starting point to see any adjustments that are needed.
5. Prepare Adjusting Journal Entries
The trial balance is used to see if adjusting journal entries are needed. There are many reasons adjusting journal entries are completed, including:
Correcting any errors that have occurred; these might be wrong amounts or miss posted transactions.
Depreciation – Fixed assets are depreciated over several years and will use a depreciation method to calculate the amount for the period. Depreciation is posted on the balance sheet to reduce the assets and profit and loss as an expense.
Bad debts – If customers are unlikely to pay their bills, bad debt is needed in the accounts.
Stock – At the year-end, complete a stock check. It may have differences in quantities in stock or values. Make journal adjustments to correct the figures.
Accruals – Set up accruals for amounts not already included in the accounts. Examples of accruals are invoices not received from suppliers or work in progress on a job or product.
Prepayments – Any transactions paid for in advance will need a prepayment adjustment. An example is an insurance policy paid for a year but only two months related to the financial period.
Move the net income from the profit and loss to the retained earnings. These are closing entries that transfer from the temporary accounts to the permanent accounts.
You may have more adjusting entries; these are just some examples.
6. Create an Adjusted Trial Balance
An adjusted trial balance is produced after posting the journal entries to the accounts.
This trial balance will differ from the first as it includes all the adjustments.
It is then good practice to check it through again and see if further adjusting entries are required.
If there are any adjustments, a closing trial balance is created.
7. Prepare Financial Statements
Once the adjusted trial balance is agreed upon, the Company’s financial statements are prepared.
The main financial statements are the Profit and Loss (Income Statement) and the Balance Sheet. A business may also require a cash flow statement and a budget.
For Limited companies, these financial reports are the basis of creating the accounts for submission to Companies House. These statutory accounts are typically prepared and submitted by an Accountant. The reason for using an accountant is to ensure that the reports meet all the legal requirements.
For the Self-employed, the reports are used to calculate the revenue and expense for the self-assessment tax return. You can complete the self-assessment yourself, but using either a bookkeeper or accountant is recommended if you are unsure or need tax advice. There are calculators to see how much self-employed tax you owe.
8. Closing the Year-End
The final stage of the accounting cycle is to close the year-end accounts.
Some accounting software requires you to close the year-end, stopping any transactions accidentally posted to the incorrect year.
Others continue from year to year, and you continue to post the transactions.
This is the end of the accounting cycle, and the next cycle will start.
The Accounting Cycle Conclusion
The accounting cycle is the process of issuing or receiving source documents, creating an unadjusted trial balance, making adjustments, producing the year-end reports and closing the books.
The cycle is generally for a period of 12 months, but some companies will need monthly or quarterly.
Further reading on the accounting cycle is available at Investopedia.