What Is the Accounting Cycle?
The accounting process follows very specific guidelines and includes an accounting cycle flowchart. The accounting cycle consists of ten steps from identifying what is a transaction to recording the transaction appropriately to reconciling your trial balance.
The purpose of the accounting cycle, if followed correctly, is to achieve accurate financial statements that show the true state of your business, it’s profits or losses. Any business that fails to follow the accounting cycle could find they are lost in a wave of numbers that make no sense along with inaccurate data.
Tools In the Accounting Cycle
Many things can go wrong if the accounting cycle is not followed. If you’ve ever applied for any sort of business loan or credit, you were probably asked to produce a reconciled balance sheet and income and expense statement. If your accounting cycle isn’t followed correctly, both of these documents will be incorrect. The worst part may be when the banker or financial company realizes your information is incorrect, which is not only embarrassing, but it can become a huge headache to correct.
To help understand better what tools you need in the accounting cycle, here’s a quick breakdown:
- General Ledger – The general ledge is a place where most journal entries are made.
- Specific Journals – Journals can also be specific such as a sales journal and cost of sales journal.
- Controlled Schedules – Schedules that are controlled are usually those that need to keep track of something such as inventory, receivables and payables.
- Trial Balance – The trial balance is a compilation of all the data obtained from your ledgers, journals, and schedules. In a correct trial balance, all the debits and credits pulled from your ledgers, journals, and schedules must be equal.
- Income and Expense Statement – This clearly shows your sales revenues, less variable and fixed expenses to state your profit or loss.
- Balance Sheet – The balance sheet is considered a snap shot of your business at any given point in time and contains summary accounts of your assets, liabilities, owner equity, and net profits or losses.
Beginning with first defining everything that is a transaction and posting or recording it in the appropriate way and time, enables the accounting cycle to be accurate and tested.
To further aid you in understanding the accounting cycle, download a Sample Accounting Cycle Flowchart which can be found in our Accounting Media Gallery. The accounting flowchart shows a clear explanation on why transactions need to be identified, the posting stages, debits and credit, and when journal entries should be made. The flowchart also shows when adjusting journal entries are needed, the importance of reconciling the trail balance, implementing closing entries and running your final financial reports for the accounting period.
What Could Go Wrong?
Let’s say you own a flower shop. Here are some examples of what happens when the accounting cycle is not followed:
- Missed Journal Entries – Say you have two flower suppliers and receive inventory on two separate days. You do well with your first round of inventory and make the appropriate debits to inventory and credits to cash that paid for the inventory or accounts payable if you owe the supplier, but what if you didn’t record the inventory from the second shipment? Not only would you be able to quickly see how much flower inventory you had, if you needed to pay for that inventory you wouldn’t realize you owed your supplier money if you didn’t credit your accounts payables. This could cause understating your true inventory on the balance sheet as an asset and falling behind in paying your inventory supplier, possibly losing that supplier.
- Ineffective Reconciliation – If you don’t balance your cash in bank account each and every month, you can lose track of actual cash. The cash amount that appears on your financial statements could be incorrect. Failing to reconcile your accounts receivables could result in businesses that owe you money going beyond the set period you agreed on for payment. If you don’t reconcile accounts payables, you could be late paying your vendors.
- Incorrect Trial Balance – If you don’t record your transactions and reconcile accounts accordingly, your trial balance will be incorrect. A trial balance at the start of the accounting cycle has a beginning balance, debits and credits for transactions posted throughout the accounting period, and an ending balance. If you add up all your debits and credits and they don’t match, the numbers that pull from the trial balance to your income and expense statement and eventually your balance sheet will be inaccurate.
- Missed Income & Expenses – If you fail to record sales and cost of sales and other expenses incorrectly, you don’t really know how much profit you made. What if you made a profit but the income and expense statement didn’t show that due to inaccurate posting? Not only would the income and expense statement show a loss, so would your balance sheet.
- Erroneous Balance Sheet – If your income and expense statement is incorrect because your trial balance was incorrect, your balance sheet may show items like over or understated assets, inaccurate liabilities, owner equity problems, and even misstated profits. You need to reconcile your balance sheet and understand balance sheet limitations.
Making the Accounting Cycle Work
Because the world of financial accounting can be not only tedious but also hard to grasp, there are some things you can do to stay on track.
- Invest in an Accounting System – There are many affordable accounting software systems available to businesses of all sizes. Accounting programs like Quickbooks and Peachtree are affordable especially if you purchase only the modules you need based on the size of your business. For example, if you only have 3 employees, you could probably skip the payroll module and manually post your payroll.
- Hire a Bookkeeper – If you are lost in the accounting world, your financial records will show it. Consider the time you’ll save if you hire a bookkeeping that does understand what happens if the accounting cycle is not followed. Set up some interviews; you may even be able to find a bookkeeping that has worked in your field of business.
- Accounting Classes – Whether you find accounting classes online, at your local community college or even economic development center, you can gain much knowledge and understanding even if you hire a bookkeeper. Imagine being able to talk and speak about accounting effectively as well as explaining to banks or lenders exactly what consists in all of your financial statements.
Now that you know what happens when the accounting cycle is not followed, keep in mind the importance of following the accounting cycle, hiring some expert help, and educating yourself in the world of financial accounting. You’ll not only understand what all your numbers mean, but also who you owe, who owes you and what your true profits are each month.