Did you know that each and every accounting transaction passes through a predetermined cycle in your company’s books? Even though cloud accounting software make the entire bookkeeping process much smoother by automating the majority of your transactions, it’s still important to have a basic understanding of this cycle, called the accounting cycle (or the bookkeeping cycle) if you want to be in control of your company’s finances. The cycle starts with each individual transaction, and ends with the aggregation of all transactions at the end of each accounting period.
What is an Accounting Transaction?
First of all, what exactly is a transaction in accounting? Simply put, a transaction is any event that has an effect on your financial statements, and is recorded in your accounting records. The combination of all of your business’ accounting transactions can be organized and analyzed to give you, your shareholders, and any other interested outside party a picture of your company’s overall financial health and standing.
What are some examples of transactions that go through the accounting cycle? Selling goods to your customers, paying off an invoice, making a loan or insurance payment, and paying wages to employees are all examples of transactions that cycle through your company’s books.
First Steps: Recording Transactions
Once you’ve identified the transactions that need to be recorded during a particular accounting period (whether that’s a month, a quarter, or a fiscal year), you need to follow the proper steps to record them in your company’s books. Transactions can be recorded as chronological journal entries and then moved to the general ledger, or they can be recorded directly in the general ledger.
Trial Balance and Adjusting Entries
The next step in the cycle is to calculate your unadjusted trial balance, which is the first step you need to complete in order to prepare your financial statements. (More on that in a moment.) A trial balance is the closing balance of an account at the end of a given reporting period, and if you are doing your books manually, you may find that some of your accounts are not in balance at this stage. This means that an error has occurred at some point (like entering a debit when you meant to enter a credit, entering an amount more than once, or entering the wrong amount), which can usually be avoided by using online accounting software. (Hint, hint!)
Once you’ve identified any errors, you can make adjustments, or corrections, to the appropriate accounts. Besides accounting errors, adjustments may be made for the depreciation of assets or one-time payments that you have decided to allocate monthly in order to make your monthly revenues and expenses match more closely.
Now that your adjustments are done, you will be recalculating your trial balance, giving you the adjusted trial balance that you need to create your financial statements.
Preparing Financial Statements and Closing the Books
We recently posted about the primary financial statements, which include your balance sheet, your income statement, and profit and loss statement. These documents are vital not only to your own understanding of your company’s finances as a business owner, but will be of crucial help come tax time or in the event of an audit.
The final step in the cycle is closing the books for the given accounting period. If you’re using accounting software, then this step should be handled automatically. Otherwise, all temporary account balances (for example, the balances of your revenue and expense accounts) will be moved into an income summary and then into a retained earnings account. Zeroing out the balances of these accounts at the end of a given accounting period allows you to analyze your gains and losses on a month by month, quarter by quarter, or year by year basis much more easily.
Now you’re ready to calculate your post-closing trial balance and start the whole cycle over again!