The accounting cycle is one of the most important behind-the-scenes, back-office actions a company manages. At the same time, it’s also often one of the most overlooked. Outside of a small cadre of accounting professionals and the CFO, few executives or managers understand the importance of the accounting cycle to business health. Fewer still recognize the accounting cycle’s depths, let alone the step-by-step process by which business record and reconcile financial transactions.
Ultimately, neglecting the accounting cycle at an executive or managerial level is a massive misstep. While products or services drive the accounting cycle, rather than the other way around, understanding the cycle’s nuances and how it fits into your company’s holistic health is an important step in ensuring longevity and – critically – avoiding costly mistakes or the risk of falling afoul of regulatory overseers.
A Step-by-Step Look at the Accounting Cycle
The accounting cycle starts with diligently logging each transaction your firm executes. The process ends with a total look at the firm’s financial activity at the end of the predetermined timeframe. The accounting cycle typically encompasses quarterly and annual activities. However, for startups or smaller companies, more frequent touchpoints are often beneficial to gauge whether your financial strategy is working accurately. To that end, here’s how the accounting cycle plays out along each of its eight steps.
Each time you make a sale, spend cash on production or allocate money into your marketing budget, you must enter the transaction in your financial journal. Diligent bookkeeping is key to this process. Even the smallest operations typically have hundreds of transactions throughout a single accounting cycle. Luckily, tech tools and innovations serve to automate much of these processes, but this first step still demands human oversight. If you mess up the accounting cycle at the beginning, you’ll pay in time and (possibly) money when you try to clean up the books.
At the same time you’re logging transactions, you must account for their effect on your balance sheet through ledger accounts. As cash flows in and out, your net balance fluctuates. Maintaining an accurate ledger is therefore critical in forecasting and projecting future cash flow and accurately budgeting future periods.
Unadjusted Trial Balance
After logging transactions, Step 3 is the first audit process a company undertakes within the accounting cycle. Instead of validating transactional legitimacy or accuracy, building an unadjusted trial balance simply ensures that your total outflow (debit) matches your total inflow (credit).
Adjusting Journal Entries
This is a key step in accrual accounting, the most common business accounting technique. Because businesses typically rely on accounts payable and receivable as part of their financial transactions, journal entry adjustment ensures that unearned income and unpaid expenses are reflected properly.
Adjusted Trial Balance
Next, your bookkeeper or accounting team used the adjusted journal entries to assess their impact on your balance sheet and net balance. This sets the stage for the next step, financial statement generation. This is the step in which executives or management directly involve themselves in the accounting cycle.
Now, your accounting team takes a slew of reconciled and adjusted transactions to generate the financial statement trifecta. These include your balance sheet, income statement, and statement of cash flows. Depending on your firm’s size and capital structure, they’ll also generate your changes in equity statement. Also, notes required to understand the statements’ details and nuances are generated.
Next, temporary accounts or accounts created for accounting cycle convenience (like income statement accounts) get zeroed out and reflected on the appropriate financial statement. This prepares your accounting team for the next period’s accounting cycle. These accounts include income, expense, and withdrawal accounts but not balance sheet accounts.
Post-Closing Trial Balance
Now you’re done with this accounting cycle and prepared to begin again. The post-closing trial balance is a final check on accuracy. This step focuses only on your balance sheet, to ensure all appropriate accounts are closed and positioned to renew upon the next accounting cycle.
The Accounting Cycle Never Ends
Even though the accounting cycle is a discrete eight-step series, it never truly ends. Prudent financial management is a long game. Effective managers and executives know and empathize with the burden their bookkeeping undertakes to ensure financial accuracy across the enterprise.
To that end, effective executives empower their accounting teams and ensure that accounting procedures are standardized, internal controls are established and complied with, and closely read all associated financial statements.
The lattermost point is most critical, as understanding your firm’s financial health is as important as bringing a product to market – but remember, understanding each of the accounting cycle’s steps can go a long way to better guiding the financial ship, even if the financial statements are the most impactful part of the process.