Disclaimer: Please note this article is not financial advice. The purpose of our blog is purely educational, so please consult a professional accountant or financial advisor before making any financial decision.
If you're ever thinking about creating your own bookkeeping system, you'll need the fundamental knowledge first. And there's no other accounting knowledge more fundamental than full-cycle accounting.
Before we introduce the concept of the accounting cycle, there's one thing you need to determine as your first order of business in the accounting facet of your business.
Determine Your Business's Reporting Period
Before setting up any bookkeeping or accounting system for your business, you must first determine your preferred accounting reporting period.
The accounting period spans twelve months in which business transactions are recorded. You have two options when choosing an accounting period.
Calendar - Your accounting period follows the year's calendar in chronological order. That means you start recording on January 1 and then finish the recording period on December 31. The calendar method is the default method used if you have no preferences.
Fiscal - Your accounting period is based on your preferred month. For example, If you choose your accounting period to start on April 1 of the current year, the ending period would be March 31 of next year. Big businesses and public accounting firms commonly use the fiscal year.
The chosen starting month can be arbitrary, or it can be based on multiple factors. For example, some choose their starting month strategically so that the ending month period would fall on a lean period. That way, they can focus more on the accounting part while the business is slow.
An accounting firm makes it their best practice to choose a fiscal period when the ending month falls on the tax-payment period, hitting two birds in one stone—create financial statements and pay appropriate taxes in one effort.
If you're not sure how your business behaves, it's okay to stick to the calendar period. Accounting periods can be changed in the future depending on your state's policy. Be sure to check with them if they will allow it. Either way, you must choose wisely. Accounting period changes may involve considerable paperwork.
The Accounting Cycle
Once you've determined your preferred accounting period, you'll need to know how the accounting cycle works. This is especially true if you're going to be the one doing your own books. You'll need to know that you're doing it accurately from start to finish, so you get a clear picture of how your business is doing. This fundamental knowledge will help you gain insights into how others work on your books in the long run. In addition, you'll be able to converse with them using the same accounting knowledge because you know how it works.
The accounting or bookkeeping cycle is a repeating process composed of several steps. Bookkeepers up to top accounting firms use it, no exceptions. It is a cycle because you will have to close the books at the end of your accounting period, open another one the following month, and start the process again. That said, the accounting cycle is composed of these steps:
Classifying business transactions
You will have to determine each transaction that your business can potentially conduct. Normally, your business transactions revolve around a few basic activities, such as sales and revenue, purchases of assets, business expenses, and accounts receivable—money owed to you. Then, you can create an "account" in your books that represent each transaction based on these transactions. For example, for sale, you'll have to create a "Sales" account to represent the amount you need to record as a sale. This is what is called your chart of accounts.
Journalizing
Once you've determined what's to be included in your chart of accounts, you can then proceed to record your business transactions using the double-entry method. A double-entry method records one transaction under two accounts - a debit account and a credit account. These transactions are what you call journal entries, or in simple terms, amount coming in and amount going out. This is important to get right as this will affect other accounting cycle steps.
Posting on a ledger
You will have another book apart from your bookkeeping journal, and it's called a general ledger. This serves as a tool to break down the amount that went in and out of a specific account. Like a journal, it also has debit and credit but is organized under the account rather than the transaction to see the total net value of each line item on the chart of accounts.
Creating an Unadjusted Trial Balance
At the end of the accounting period, or once a financial statement is needed, the accounting process moves to this step. First, you examine each of the accounts on the ledger and get the difference by subtracting the debit side to the credit side of each account. Then, you will record the net amount in a line item that represents it. Once all ledger accounts are calculated and recorded, the expected result should be equal amounts for both the debit and credit sides. If both sides have the same amount, there's no need for adjusting. Otherwise, you'll have to do the next step.
Pouring over accounting worksheet
You'll have to comb through the worksheet to find any discrepancies whenever a trial balance doesn't “balance.” This is equivalent to finding lost pennies.
Once you've determined where the error occurred and what transaction was misrecorded or unrecorded, you'll have to go back to your journal.
Creating adjusting entries
You'll have to enter the adjusting entries on your journal by creating an accounting transaction that balances the account in question on the accounting ledger. The transaction will have debit and credit amounts that would impact at least two accounts and should even out both sides of the trial balance.
The adjusted trial balance
Once you have recorded all adjusting entries, you will have to do another trial balance to ensure everything is in the proper place. That means going over the ledgers again and checking if all amounts are correct on both the debit and credit sides. Then, sum all the amounts on both sides. The net total should be balanced at this point.
Classifying each account
Once everything is balanced, you'll have to determine which accounts are classified as "Balance Sheet" accounts and which ones are "Income Statement" accounts. Again, this is in preparation for creating your financial statements for reporting purposes.
Closing books, opening new ones.
Once every account for each financial statement type is determined, it’s time to close the books. Basically, when closing the books, you'll have to change temporary accounts, also known as your "income statement" accounts, into something permanent that will reflect the balance sheet. In the new book, you will record these converted accounts as your first journal entry, so any ending amounts per account are carried over to the next accounting period.
The Accounting Cycle of Confusion
Accounting can be a tough concept, especially if you don't have time to put your one hundred per cent into learning it. This article will serve as your refresher or even your introduction to the full accounting cycle.
But if these accounting concepts create a loop of confusion, Unloop is here to help. Give us a call, and we'll help you with your bookkeeping needs, so you don't have to think too much about completing the accounting cycle.