What is the Accounting Cycle?

What is the Accounting Cycle?

Priyanka Tiku Tripathi
Priyanka Tiku Tripathi
Table of Contents
Table of Contents

One of the most crucial components to ensure that your business runs smoothly is its 'money.' After all, money is what allows you to buy and sell your goods, pay your employees, earn profits and maybe even end up going into loss.
How do you ensure that you are on top of your game with your money? You keep a record of it!

Businesswoman calculating finances with a calculator
Image: Shutterstock 

Without a financial record of your business, you will be unable to plan where your money comes from and where it goes. If you're unable to plan your finances, you're likely to be unaware of when you are losing it - and that is something nobody wants.

How do you plan your finances?

The process of keeping track of all your business transactions in an orderly manner is called bookkeeping. Making sense of your books, that is, preparing financial statements is called Accounting.
In simpler terms, knowing where your money is, comes under bookkeeping. Balancing your books gives you an idea of your assets, liabilities, revenue, expenses, and equity.
Sorting, analyzing, reporting, and comparing this data falls under Accounting. This gives you an idea of where you stand in terms of past performance as well as gives you inferences that can be used to plan your future performance. Financial statements are the basis from which banks give you loans, businesses partner with you, and investors, invest in you.

To get the accounting process right, you need to first know about the accounting cycle.

What is the Accounting Cycle?

Sometimes known as the bookkeeping cycle, the accounting cycle is a six-step process that results in the conversion of your business' financial information into financial statements. This process gets repeated every fiscal year.

Why do you need to follow the accounting cycle?

Following all the steps in chronological order is vital to ensure that your financial statements are accurate and keep an account of every single dime that has exchanged hands during the fiscal year. It also helps you to conform to the official standards for accounting.

What are the steps in the accounting cycle?
Although many people further expand the cycle up to ten steps, a six-step accounting cycle is simple and to-the-point.

 The six steps of an accounting cycle.
The six steps of an accounting cycle.

  1. Identify and record transactions
  2. Update transactions in the ledger
  3. Calculate the unadjusted trial balance
  4. End of Period adjustment
  5. Prepare an adjusted trial balance
  6. Create financial statements

Let's take them all step by step.
Step One: Identify and record transactions
This step requires a complete record of all business transactions - invoices, receipts, debts, acquisitions, bank loans, etc.

But don't wait until the last possible moment to identify such transactions. Keep a daily ledger of all deals taking during the fiscal year.

Step Two: Update transactions in the ledger

Now that you have all your daily records in front of you, it's time to transfer them, in chronological order, all into one place - the company's general ledger.The recommended procedure is using double-entry bookkeeping with at least two accounts - Debit and Credit.

Related: Doing your own bookkeeping: Balancing the books for beginners, startups, and entrepreneurs

Annual general ledgers 2009 - 2012

If you're using an online software like Deskera.com, these updates are done automatically for you.

Step Three: Calculate the unadjusted trial balance
While both step one and step two of the accounting cycle can be done during the fiscal period, as and when they happen, step three has to be done at the end.

Calculating the unadjusted trial balance is like reviewing your test before handing it over to the invigilator. It requires checking that all your 'debits' and all your 'credits' turn out equal.If it doesn't match, it is very common to discover anomalies here. More often than not, if a software doesn't balance your accounts, it would be due to an incorrect entry done.

Step Four: End of Period adjustment
Now that you know there are anomalies in your balance sheet, the next step is finding them and making adjusting entries to fix them. The process of finding and fixing the errors discovered is known as correcting entries.

Accruals, deferrals, tax adjustments, and missing transactions are the four types of adjustments that can be made.

Step Five: Prepare an adjusted trial balance
Once you have made your adjustments, it's time to create a new trial balance taking the adjusted balance into consideration. This step will also show your adjusting entries and your final adjusted balance.

Step Six: Create financial statements
Proceed to this step only after you triple-check your adjusted trial balance for smooth sailing. The last step of the accounting cycle is the most important. Financial statements are the essential documents required by people outside your organization to review it based on the previous years, as well as competitors.

A team analyzing the business financial statements
Image:Shutterstock|A team analyzing the business financial statements

If all your 5 steps have been done right, then preparing financial statements is pretty simple. It includes an income statement, a balance sheet, equity, and a cash-flow statement. However, the latter isn't compulsory.

The conclusion:

The accounting cycle may seem complicated but in the long run, it is for the best - you will get a financial insight into your business. You can also hire a bookkeeper or an accountant to take care of it for you. Online accounting is also a very convenient method for small businesses to save time, money, and effort while getting the desired results.

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