Understanding the 8 Steps of the Accounting Cycle and the Role They Play in Your Business
The accounting cycle, often called the month-end close by accounting and FP&A teams, is an 8-step process that takes place on a monthly basis. Because of the well-established steps of the accounting cycle, the process serves as a critical checks and balances exercise for businesses and helps leadership solve major accounting problems today. It verifies that all transactions are correct, ensures anything missing is recorded, and illustrates how each line item flows through to financial statements. Ultimately, the accounting cycle steps paint a picture of a business’s financial health on a regular basis, giving leadership the chance to adjust as necessary.
Although the steps of the accounting cycle are standardized, there are many ways to approach the processes within those steps. No two companies will have exactly the same accounting cycle, but the steps of the accounting cycle are put in place to serve certain purposes. Today, more and more companies are examining the accounting cycle in hopes of making it smoother, reducing the amount of time it takes, and automating some of the manual processes involved.
Completing the accounting cycle isn’t seen as a fun or simple activity, but with the right understanding of each of the accounting cycle steps, it becomes abundantly clear why it’s so important. If you’ve ever wondered, “What is the accounting cycle?” then you’re in the right place. If you’d like to revamp the accounting cycle used by your organization, keep reading. If you want to know why it matters, this guide is for you.
What is the Accounting Cycle?
The accounting cycle provides a clear guide for the recording, analysis, and final reporting of a business’s financial activities. Bringing together the month’s work from accounts payable, accounts receivable, payroll, accounting, and finance, the accounting cycle results in a complete financial picture of the prior month. Usually, there will be month-end closes on a monthly basis, quarterly closes on a quarterly basis, and of course, an annual close at the end of every fiscal year.
The accounting cycle is used as the foundation for all financial accounting metrics in an organization. When a month ends, the accounting team is responsible for completing the 8 steps of the accounting cycle. Downstream accounting processes rely on an airtight accounting cycle every month. Getting an accurate read on financial metrics starts with the accounting cycle; ensuring audit trails are reliable requires the completion of the accounting cycle; and making business decisions relies on the outputs of prior accounting cycles.
How Does the Accounting Cycle Work?
For simplicity purposes, we’ll discuss an accounting cycle that follows a monthly calendar timeline. Usually, the month is split up into weeks. Weeks 1 and 2 of, let’s say, April, will be spent completing the accounting cycle for March, depending on how long your organization takes to complete the steps of the accounting process. The process itself happens in a domino-like order. The first step is critical to complete before starting the second step, and so on.
Depending on the complexity of your organization, the number of people involved in the close process will vary widely. Everyone involved should be detail-oriented, methodic, and familiar with the entire accounting process. If your organization is held privately, you may have some flexibility with when the month-end process finishes, as well as more freedom in how to complete it. For public companies, it’s important to abide by GAAP standards and reporting processes.
The 8 Steps of the Accounting Cycle
Every single transaction your company makes within an accounting period needs to be recorded and assessed in the accounting cycle. Operating expenditures, revenue from different sources, payroll expenses, and everything in between must go through the 8 steps of the accounting cycle.
At the beginning, the accounting cycle is a bunch of fragmented transactions and pieces of accounting information, but by the end of all of the accounting cycle steps, you’ll have a clear picture of your business’s financial standing.
The 8 steps of the accounting cycle are:
- Identify transactions
- Record journal entries
- General ledger posting
- Finalize the unadjusted trial balance
- Worksheet outputs
- Complete adjusting journal entries
- Create financial statements
- Close the books
Each step plays an important role in the accounting process; be sure to invest the time and resources needed to make each step successful.
The first of the accounting cycle steps is to identify every transaction that takes place within the given period. When money comes in or goes out, even if it’s for something small like a business lunch, it needs to be recorded for audit and tracking purposes. All customer invoices paid, outgoing vendor payments, and other transactions should be included in this step. The transactions are tracked within your accounting or bookkeeping system and ultimately feed into the journal entry preparation process in step 2.
Record Journal Entries
With all the transactions in place, you can move to the creation of journal entries that encompass each transaction. Journal entries will impact different accounts depending on whether the transaction was an expense, revenue, or other line item. If your organization uses double-entry accounting, you’ll need to balance the debits and credits across your accounts. Be sure to check the approval requirements for journal entries of different sizes; most will require the signature of the preparer and the approver, but if they are large dollar amounts, a second approver could be required.
Completing the accounting cycle would be impossible without the 3rd accounting cycle step: GL posting. After all the journal entries are complete, it’s critical that they are posted to their corresponding general ledger accounts. Some GL accounts are accounts receivable, cash, R&D expenses, and service revenue. Today, GL posting can usually be automated with many different types of accounting software tools. To get to the core of “what is the accounting cycle?” we must be able to reconcile the general ledger, and this step is responsible for that.
Unadjusted Trial Balance
All transactions are accurate in your accounting system, journal entries have been created and posted, and the general ledger is updated…now what? At this stage, all accounting processes call for the analysis of the unadjusted trial balance. Showcasing all account balances at this stage in the close process, the trial balance is the best way to identify errors in the close process, allowing your accounting team to fix any issues in the following steps.
If the trial balance highlights discrepancies, a worksheet allows accounting teams to go a layer deeper and figure out exactly where the discrepancies originated. In some cases, adjusting journal entries will need to be made to tie out the account balances correctly. Relying on advanced technologies like Nanonets can streamline this process, cutting down on the amount of time your employees spend digging into accounting errors.
Adjusting Journal Entries
With the worksheet’s detailed look into imbalances in hand, your accounting team can begin inputting the necessary adjusting journal entries for that month. Just like in step 2, these journal entries require review and approval prior to posting. Once all of the adjusting journal entries are completed, check the debits and the credits on the adjusted trial balance report as a final verification.
Create Financial Statements
The main financial statements are the income statement, the cash flow statement, and the balance sheet. Each of them requires upstream input from the above accounting cycle steps. The 8 steps of the accounting cycle feed directly into financial statement preparation. Once prepared, the financial statements can be used for analytical purposes, garnering financial insights, and gauging overall company performance. Since each financial statement focuses on a different aspect of the business, they are all needed for accurate reporting across the function.
Close the Books
At the end of the accounting cycle, accounting teams will close the books on a specified date. The last step in the 8 steps of the accounting cycle prohibits anyone from making further changes, entering new journal entries, or adjusting final account balances. It locks in the snapshot in time for the given period, allowing your team to pivot to the next fiscal month or year.
What is the Purpose of Accounting Cycles?
Now we know the answer to “What is the accounting cycle?” but to further contextualize this process and all accounting processes related to it, we must assess the overall purpose of the accounting cycle steps.
Cumulatively, the accounting cycle steps ensure the accuracy of a business’s financial reporting capabilities. Every business decision relies on financial statements, which come from the accounting cycle. If accounting errors are left alone for too long, they could seriously impact your ability to function as a business, and even worse, they could result in legal or regulatory issues down the line.
Accounting Cycle Automation
The accounting function is a prime candidate for robotic process automation; with the accounting cycle steps and many other repetitive tasks that come around on a weekly, monthly, or even quarterly basis, accounting leaders shouldn’t hesitate to invest in automation software.
In some parts of the function, such as accounts payable, implementing automation software and reinforcing best practices could save your employees many hours each week. It has even been proven to reduce the cost of processing invoices! With the extra time available, your team’s focus can shift from completing the accounting cycle to strategic planning, building business relationships, and investing in next-generation analytical capabilities.
Imagine a world where your month-end close process took 2-3 days instead of 7-10. With automation software, that world is possible, and in it, your employees will be happier, your organization will stay ahead of its competition, and the monetary benefits will be recognized in the long term. Invest in accounting and finance automation now or fall behind in your industry – the choice is yours.