8 Steps of the Accounting Cycle
A guide to understanding the accounting cycle from recording transactions to creating year-end accounting reports.
Are you struggling to keep track of your small business finances? You’re not alone! Understanding the accounting cycle is crucial for businesses of all sizes. This simple guide breaks down the 8 essential steps, helping you stay organised, make informed decisions, and achieve financial success. Learn how to master the accounting cycle today!
What is the Accounting Cycle?
Every small business owner needs a clear picture of their financial health. That’s where the accounting cycle comes in! This essential process transforms your daily transactions into insightful financial reports like the Profit and Loss Statement and Balance Sheet.
Think of the accounting cycle as a roadmap, guiding you from recording sales and expenses to understanding your overall financial performance. It’s a collaborative effort, often involving the business owner, a bookkeeper, and an accountant, each playing a key role in ensuring accuracy and providing valuable insights.
By mastering the accounting cycle, you gain control over your finances, make informed decisions, and pave the way for business growth.
How Long is the Accounting Cycle?
The cycle is generally for an accounting period of 12 months and will coincide with the business’s financial year-end.
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.
Excel Bookkeeping
Easily track your income and expenses with our user-friendly cash book template. This template is perfect for small businesses that want to manage their finances efficiently. More templates are available for other tasks, including petty cash, business expenses, sales invoices, and cash flow statements.
While Excel offers flexibility, managing more complex accounting tasks like trial balances, adjusting entries, and generating financial statements can be challenging. Consider exploring dedicated accounting software if you’re looking for a more robust solution. It can automate these processes and provide a clearer picture of your financial health.
Accounting Software
While spreadsheets like Excel can be helpful for basic financial tracking, accounting software offers significant advantages that make it a recommended solution for most businesses, especially as they grow.
Several options include free and paid-for packages like QuickBooks, Xero, Sage or FreshBooks.
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
This first step involves identifying and analysing financial transactions as they occur. This includes sales, purchases, expenses, and any other event that impacts the business’s financial position. Gathering accounting source documents like receipts, invoices, and bank statements is essential.
Separating business transactions from personal ones is crucial for self-employed businesses. 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 using 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; Dext and Auto Entry are two such packages.
Open bank feeds also make accounting much easier and reduce mistakes. When you look at the 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.
The accounts include the balance sheet and profit and loss – assets, liabilities, equity, revenue, cost of sales and expenses.
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 for making any needed adjustments.
5. Prepare Adjusting Journal Entries
The trial balance is used to see if adjusting journal entries is needed. There are many reasons why adjusting journal entries is completed, including:
Correct 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 year-end, complete a stock check. Differences in stock quantities or values may exist. 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 temporary accounts to permanent accounts.
You may have more adjusting entries; these are just some examples.
6. Create an Adjusted Trial Balance
After posting the journal entries to the accounts, an adjusted trial balance is produced.
This trial balance will differ from the first as it includes all the adjustments.
It is then good practice to check it again and see if further adjusting entries are required.
If there are any adjustments, a closing trial balance is created.
7. Prepare Financial Statements
The Company’s financial statements are prepared once the adjusted trial balance is agreed upon.
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 for creating accounts for submission to Companies House. These statutory accounts are typically prepared and submitted by an Accountant. Using an accountant ensures 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
By diligently following the accounting cycle, businesses gain a comprehensive and accurate view of their financial health. This clarity helps informed decision-making, facilitates regulation compliance, and ultimately paves the way for sustainable growth and success. Whether you’re a small business owner or managing a large corporation, mastering the accounting cycle is essential
Further reading on the accounting cycle is available at Investopedia.
