February 19, 2018
As the backbone of all businesses, accounting is one of the most important tools that business owners use every day to make informed decisions.
And while most businesses today rely on accounting software like Xero and MYOB to produce their financial statements, having a basic understanding of how it all works is critical to business success.
Central to all accounting practices is the accounting cycle: A series of nine steps that all businesses complete each year – be it a sole trader, partnership or limited liability company.
How does this relate to my business, you ask? Read on as we talk you through the accounting cycle step by step.
What is the accounting cycle?
Every year businesses go through a series of nine steps to account for business income, expenses and the resulting profit or loss. Business transactions are recorded and at the end of the financial year income and expense accounts must be closed off while assets, liabilities and owner’s equity are carried forward to the next financial year to begin the cycle all over again.
The sole purpose of recording transactions and keeping track of expenses and revenue is to turn this data into meaningful financial information by presenting it in the form of a balance sheet, income statement, statement of owner’s equity, and statement of cash flows.
Let’s take a closer look at each of the steps:
1. Record Journal Entries
Journal entries are the first step in the accounting cycle and these are used to record all transactions and accounting events.
2. Post Entries to Ledger Accounts
Once the transactions are recorded in the general journal, they need to be posted to the ledger account. Ledger accounts categorize these changes into specific accounts to provide useful data for budgeting and planning – this is usually done by your accounting software. Posting entries is done throughout each accounting period.
3. Prepare Unadjusted Trial Balance
After the journal entries are posted to the ledger, the unadjusted trial balance can be prepared: A listing of all the business accounts that are going to appear on the financial statements before year-end adjusting journal entries are made. That is why this trial balance is called unadjusted.
4. Adjusting Journal Entries
Analyse the trial balance and make any end of period adjusting journal entries. These are made towards the end of each period to correct accounts before preparing the Financial Statements. There are three types of AJE: prepayments, accruals & non-cash expenses. Each of these adjusts income or expenses to match the relevant time period, basically dividing income and expenses into those that were used in the current period and deferring those that will be used in future periods.
5. Prepare Adjusted Trial Balance
This is a listing of all business accounts that will appear on the financial statements after the year-end adjusting journal entries have been made. Both the debit and credit columns are calculated at the bottom of a trial balance. These debit and credit totals must always be equal. If they aren’t equal, the trial balance was prepared incorrectly, or the journal entries weren’t transferred to the ledger accounts accurately.
6. Record Reversing Entries
Used to cancel temporary adjusting entries, reversing entries are journal entries made at the beginning of an accounting period to reverse or cancel out adjusting journal entries made at the end of the previous accounting period. Reversing entries are usually made to simplify bookkeeping in the new year. For example, if an accrued expense was recorded in the previous year, the accountant can reverse this entry and account for the expense in the new year when it is paid. The reversing entry erases the prior year’s accrual.
7. Prepare Post-Closing Trial Balance
This is a list of accounts that still have balances after the closing entries have been made and is the same as the accounts presented on the balance sheet because all of the income statement accounts have been closed and no longer have a current balance. The purpose of preparing the post-closing trial balance is to verify that all temporary accounts have been closed properly and the total debits and credits in the accounting system equal after the closing entries have been made.
8. Record Closing Entries
Made at the end of an accounting period to zero out all temporary accounts and transfer their balances to permanent accounts. In other words, the temporary accounts are closed or reset at the end of the year. This is commonly referred to as closing the books. Closing all temporary accounts to the income summary account leaves an audit trail for accountants to follow. The total of the income summary account after the all temporary accounts have been closed should be equal to the net income for the period.
9. Prepare Financial Statements
The final step in the cycle is the preparation of the financial statements including the balance sheet, income statement, statement of retained earnings, and statement of cash flows. Undoubtedly, this is the most important step in the accounting cycle because it represents the purpose of financial accounting. These statements are the end product of the accounting system in any company.
Please get in touch with our team of knowledgeable accountants if you’d like to find out more about the accounting cycle and how this would operate in your own business.