Introduction to the Accounting Cycle
by Robert Goldstein, on Jan 15, 2019
Accounting is the language of communicating the financial health of an organization to owners, management, employees and other key stakeholders (customers, creditors, banks, shareholders, etc.). Properly applied, accounting provides relevant information (in the form of financial statements) to the owners and executive management team, so that they can make appropriate decisions for running the business. The accounting cycle is the means for ensuring that these financial statements provide timely, relevant and accurate information needed to guide the decision-making process.
The accounting cycle is a system of recording, processing, summarizing and communicating all financial transactions of an entity, in a uniform and consistent manner. It starts when a transaction occurs, and concludes with its representation on the financial statements. At this time, the cycle concludes and steps are taken to begin the next accounting cycle, signaling the start of the next fiscal period.
The accounting cycle can aid the organization in catching transaction errors. Moreover, profitability can be measured and compared from the end of one fiscal period to another, because income and expense accounts are closed (and zeroed out) at the end of a fiscal period, rather than continuing to accumulate in succeeding periods. Compliance with accounting, along with tax and other governmental regulations, also depends on successful application of the accounting cycle within the organization.
Organizations typically complete the accounting cycle at the end of each fiscal period (typically at the end of the month. At year-end, the accounting cycle may take longer to complete as an organization’s management and outside accountants spend extra time performing a final check on the completeness and accuracy of the financial statements.
Stages of the Accounting Cycle
Below are the steps of the accounting cycle, as illustrated in the diagram and briefly described below.
Journal Entries. Every financial transaction of an organization needs to be identified and captured into the accounting system. Transactions are recorded (posted) using the double-entry bookkeeping system, whereby at least one account is debited, and one account is credited.
Ledger Accounts. The general ledger (G/L) is a group of accounts that reflects changes to the balances, based on transaction recorded. Once all transactions are posted to the ledger, the balances of each account can be determined.
Unadjusted Trial Balance. All account balances from the ledger are arranged in a report; all the debit balances are added and compared to the total of all the credit balances. The sole purpose of this report is to validate that total debits equal total credits. It does not validate the correctness of the journal entries posted.
Adjusting Journal Entries (AJEs). These journal entries are prepared as an application of the accrual basis of accounting, whereby income earned but not received and expenses incurred, but not yet paid, have yet to be reflected in the Unadjusted Trial Balance. AJEs are prepared for revenue accrual or deferral, expense accrual, expense prepayments, depreciation and allowances.
Adjusted Trial Balance. Once all AJEs are posted, the Adjusted Trial Balance is generated to once again test that all debits equal all credits, prior to generating the financial statements.
Financial Statements. Reports generated are comprised of the following: income statement: balance sheet; cash flow statement; statement of changes in equity; and notes to the financial statements. The financial statements are the “scorecard,”as they report on the entity’s financial health to its readers.
Closing Entries. Temporary accounts (i.e. income statement accounts) are zeroed out to an income summary account and then closed to the appropriate equity account on the balance sheet, in preparation for the next fiscal period. Temporary accounts include all income, expense and withdrawal accounts. Balance sheet accounts are not closed.
Post-Closing Trial Balance. The last step in the accounting cycle, as debits and credits for only the balance sheet accounts are tested to ensure that they equal. This trial balance consists of balance sheet accounts only as all temporary accounts have been closed.
Best Practices to Follow
Navigating the steps in the accounting cycle can be a daunting task, especially for a growing business, as its accounting function can quickly evolve from a shoebox and a checkbook to a more sophisticated accounting system. Here are some areas to work on that will ensure successful completion of the various steps of the accounting cycle.
Develop standardized accounting procedures to build consistency into the performance of each step within accounting cycle. For example, ensure that every sales and expense transaction posted to the G/L has a valid source document to support it, (i.e. purchase order, invoice, bill of sale). These source documents should be physically stored and/or backed up on the cloud. Retention should be based on IRS prescribed record holding periods.
Implement and maintain strong internal controls. Segregation of duties, physical counts (of assets), periodic reconciliations and approval authority will help reduce the risk of fraud and other material misstatements of assets and liabilities.
Wherever possible and practical, consider moving non-critical, time-consuming aspects of the accounting function to specialized accounting and finance outsourcing service providers, allowing the accounting team to focus on more strategic and value-added tasks. The two-fold result is that the accounting department’s productivity increases, while the outsourced activities are performed to a higher quality and accurate fashion.
Close the books (thus completing the accounting cycle) and issue financial statements at least quarterly, so that management can determine profitability and investigate significant or unusual variances from prior periods (or from approved budgets). This type of analysis can uncover potential errors in accounting entries booked during the period under review. By addressing errors and other accounting issues on an interim basis, the amount of time needed at year-end to track down these same issues can be greatly reduced, which can speed up the year-end closing process.
Make sure that you hire staff who have the appropriate level of accounting/bookkeeping expertise needed. Proficiency in Excel is a plus also. Cross-train and continue to develop the skills of the accounting team, so that they can step in to perform any of the steps of the accounting cycle. Regularly meet with accounting team members to listen to their insights for automating or eliminating unnecessary tasks within the accounting cycle. They may also have ideas for collaborating with other departments to further speed up the fiscal month-end close.
Management should establish deadlines for the completion of each process in the accounting cycle and make adherence mandatory. Executive management depends on the timely generation of financial statements to make decisions. Additionally, compliance with regulatory and banking rules dictate that financial statements be made available within a set time period. Create and communicate a work calendar to all employees and make sure that delays are immediately brought to the attention of management. (There are numerous workflow solution software packages that aid in this effort.)
Cloud-computing technology has become more pervasive (and affordable). It can facilitate the timely recording of transactions, performance of account reconciliations, maintenance of the G/L and generation of financial statements in a much more efficient manner than the more traditional (and manually intensive) accounting processes. Batch processing (which is greatly aided through accounting software) enables the aggregation, consolidation and processing of invoices, receipts and checks at the end of a week or period, instead of one at a time.
If you have staff that are proficient in Excel, there are many calculations that can be performed automatically to generate: accrual/deferral journal entries; reconciliation schedules to support G/L balances; account roll-forwards; and timely management reports for analytical reviews and analyses. Technology not only keeps your data safe, but it also allows people from remote locations to access data and work on it, lending more flexibility to employees, who can work from home.
A great way to ensure that trial balance accounts are proper and accurate is to establish a reporting package that is updated after the adjusted trial balance has been generated. This package should contain supporting schedules, reconciliations and notes for each balance sheet account total. Examples of items to be included are:
- Bank reconciliations
- Detailed A/R aging report
- Schedule of prepaid and other assets
- Physical to book inventory schedule and valuation
- Schedule of fixed assets and depreciation
- Detailed A/P aging report
- Schedule of accrued and other expenses
- Loan amortization schedules
Prior to issuing financial statements and closing out the accounting cycle, management should review the reporting package to ensure that all account balances are properly reconciled to the adjusted trial balance. During this process, management may uncover issues that need to be investigated further, such as unusual or significant reconciling items; missing or incorrectly calculated accruals or deferrals; and old outstanding balances that should be written off.
Reviewing the reporting package on a regular basis reduces the risk of financial statements being materially misstated. A thorough review by management can also shorten the year-end audit or review, as questions or concerns posed by outside accountants or regulators can be addressed quickly.
It would be wise to establish a set of permanent files that can easily be accessed (stored locally or in the cloud) by ownership, management, outside accountants and other stakeholders. Files to maintain (and update as necessary) include:
- Corporate documents: articles of incorporation; corporate charter, shareholder agreements; meeting minutes, etc.
- Permits and licenses
- Insurance policies
- Loan and lease documents
- Key customer and supplier contracts
- Employee files
Having a detailed and well-maintained set of permanent files can help management investigate underlying assumptions to G/L balances such as: loan rates for calculation of outstanding debt and interest expense; insurance premiums used to establish the prepaid expense balance; and customer/supplier contracts that specify prices paid, payment terms, etc.
Accounting Cycle Takeaways
Organizations are transforming the role of their internal finance function, from a nuts-and-bolts, data gathering, report preparing and document managing tactical role, into a role that is viewed as more consultative in nature. The CFO and accounting team are being called upon to provide more analytical and strategic guidance, to help shape the organization’s future.
If all this work seems overwhelming and impossible to accomplish, don’t panic. Paro’s team of freelance accountants and consultants can help you identify strategies to strengthen your organization’s performance of the accounting cycle.
Implementation of these practices will lead to a more efficient and effective completion of the accounting cycle; errors will be minimized; issues will be addressed in a timely fashion; financial statements will be issued more quickly; and most importantly, precious time will be returned to owners and management, so that they can spend it analyzing results and planning for the future.