Managing a small business is challenging. But if you can produce accurate accounting information, you can make better decisions and grow your business. When it comes to accounting, many business owners don’t know where to start. They need a roadmap that provides the steps required to create useful accounting data and financial statements. The accounting cycle is that roadmap.
What is the Accounting Cycle?
Accounting is the process of gathering information on business activity, posting transactions, and producing financial statements. The accounting cycle is a series of steps, completed in a specific order, that ends with a set of accurate financial statements. If you don’t follow each step in the cycle, you won’t produce accurate financial data.
Why is the Accounting Cycle Important?
The accounting cycle can help you account for all financial transactions, protect assets from loss or theft, and report financial results to stakeholders. Small businesses often operate on narrow profit margins, and access to cash may be limited. These businesses have less room for error. Following the accounting cycle can help the business owner stay on track.
It protects your assets from theft
Assets are resources—vehicles, machinery, equipment—you use to generate sales and profits. Businesses must invest in asset purchases and maintenance. Without assets, businesses can’t operate. The accounting cycle protects assets from loss and theft. Imagine when a retail store purchases inventory, for example.
An accountant reviews the vendor’s invoice and the shipping receipt before increasing the inventory balance in the accounting records. Source documents support each accounting transaction, which reduces the risk of theft.
It helps you report financial results to stakeholders
Business owners may keep stakeholders informed for a variety of reasons. Stakeholders include employees, investors, creditors, regulators, and vendors. Investors want to know if the business is generating profits and that the business’s value is increasing. Creditors need to know if the company is generating enough cash to repay a loan. Vendors want to know if the business will continue to order goods and services and that the business can pay invoices on time.
The accounting cycle requires accountants to review the general ledger and the trial balance before using the information to create the financial statements. When a business owner can generate reliable financial statements, they can maintain good relationships with stakeholders.
How to Implement Each Step in the Accounting Cycle
Every business should have a formal procedures manual that documents each step in the accounting cycle. The manual outlines each accounting task, how often the business must complete each task, and who is responsible for each task. Using a manual clarifies each process and reduces the risk of confusion.
Let’s look at an example. Outfield Sporting Goods follows the six steps in the accounting cycle.
1. Gather source documents
A source document is generated when an event happens in your business. Source documents include a receipt for a purchase or an invoice sent to a client.
On May 5, Outfield purchased $3,000 in leather materials to make baseball gloves. Their accountant reviewed the vendor’s invoice and the shipping receipt, which verifies that Outfield received the materials.
2. Determine the financial impact
Next, Outfield’s accountant must decide how the event impacts the accounting records. In this case, the inventory-material account increases by $3,000, and cash decreases by $3,000.
3. Post a journal entry
Outfield’s accountant records events the accounting records using journal entries. The journal entry includes the date, debit or credit, account number, account title, dollar amount, and a description of the transaction. The accountant enters this journal entry into the accounting system:
Debit account #3100 inventory-material $3,000 (increase)
Credit account #1000 cash $3,000 (decrease)
(Purchase of leather material for cash)
4. Review the general ledger
The general ledger is a record of every transaction posted to the accounting records. Accountants review the general ledger frequently to verify that transactions posted correctly. General ledger transactions are organized by account number.
In the Outfield example, the inventory-material account will list the $3,000 debit (increase) on May 5. Similarly, the cash account will include the $3,000 credit (decrease) on the same date.
5. Generate the trial balance
The trial balance is a listing of each account and the current account balance. After reviewing the general ledger, the accountant generates a trial balance, which includes the inventory-material and cash balances. Accountants often make adjusting entries to the trial balance before generating the financial statements.
6. Produce financial statements
Generate financial statements—including the balance sheet, income statement, and cash flow statement—from the trial balance. Here is a brief explanation of each financial statement.
Monitor assets and liabilities with balance sheets
The balance sheet summarizes a company’s financial position as of a specific date. It’s a financial statement that subtracts assets from liabilities to determine equity:
Assets – liabilities = equity
Most business owners focus on the income, or profit and loss, statement.
Assess profitability using the income statement
An income statement reports a business’s profit or loss over time—typically, a month or year. It’s a financial statement that subtracts revenue from expenses to determine net income or profit:
Revenue – expenses = net income
Net income increases equity in the balance sheet. Many business owners focus on the balance sheet and income statements. But the cash flow statement is equally important.
Determine cash generated for business operations with a cash flow statement
The statement of cash flows reports cash inflows and outflows over time. Accountants or business owners can separate cash flow into three activities: operating, investing, and financing. The ending balance in the cash flow statement must equal the cash balance in the balance sheet.
Putting a System in Place
As your business grows, so will the number of people who complete accounting tasks. Typically, bookkeepers post accounting transactions. Accountants, on the other hand, supervise bookkeepers and produce financial statements.
Creating an accounting process requires a significant time investment. Consider purchasing accounting software to work more efficiently and minimize errors. If you set up an effective process and understand the accounting cycle, you’ll produce financial information that you can analyze quickly. Use the financial statements to make more informed decisions and grow your business.