Special Offer for Chartered Accountant

Tally Automation
Apr 25, 2024

Financial Well-Being Begins Here: Explaining the Accounting Cycle

Nishtha Arora



Ever Wonder What Makes a Business Healthy? Imagine your business as a human body. Just like you need regular checkups to stay healthy, businesses need a system to monitor their financial well-being. That's where the accounting cycle comes in – it's the foundation for understanding a company's financial health.

Think of it as a step-by-step process that tracks all the money coming in (sales, investments) and going out (expenses, payments). By following this cycle, businesses can not only see how they're doing financially but also make informed decisions about the future.

In this blog post, we'll be discussing the accounting cycle. We'll break down each step into easy-to-understand pieces, so even if you're new to accounting, you'll walk away with a clear picture of how it works. And who knows, maybe you'll even impress your friends with your newfound financial knowledge!

Understanding the Steps of the Accounting Cycle

Let's dive into the eight steps of the accounting cycle!

We'll start by understanding the foundation: identifying transactions and recording them.

Step 1: Identifying the Money Flow (Those Business Dealings)

Imagine your business is a busy marketplace. Every time a customer buys something (sale!), you receive money. That's a transaction! Transactions are any financial event that affects your business's money. This could include:

  • Sales: When you sell a product or service and receive payment (cash, credit card, etc.).

  • Purchases: When you buy something your business needs, like office supplies or inventory.

  • Payments: When you pay a bill, an employee's salary, or any other business expense.

  • Investments: When you put money into something that will hopefully grow your business (think buying new equipment).

The key here is to catch all the financial activities, big or small. They're all pieces of the puzzle that show how your business is doing financially.

Step 2: Recording the Transactions (The Journal - Your Business Diary)

Now that you've identified all the financial dealings, it's time to write them down! Think of this as your business diary, but instead of your deepest thoughts, you're recording your money flow. This record-keeping tool is called a journal.

The journal chronologically lists every transaction, like a timeline of your business's financial activity. Each entry includes details like the date, the amount involved, and the accounts affected by the transaction. But don't worry, we'll break down those "accounts" in a later step.

Here's the interesting part: transactions have two sides – a debit and a credit. Don't panic, these aren't scary monsters! They're simply ways to categorize where the money is coming from (debit) and where it's going (credit). We'll explore these concepts further in the next section.

By the end of this step, you'll have a clear picture of all your business transactions neatly recorded in your journal. Easy so far, right? Let's move on to understanding how debits and credits work in the next section.

Step 3: Posting to the Ledger (Central Hub)

Imagine your business diary (the journal) is filled with exciting stories (transactions) about your money coming in and going out. Now you need a central filing cabinet to organize these stories by category. That's where the general ledger comes in!

The general ledger is the heart of the accounting cycle. It acts as a central repository for all your financial transactions, categorized into different accounts. Think of these accounts as folders in your filing cabinet, each holding information about a specific type of financial item. Here are some common account types:

  • Assets: These are things your business owns, like cash in the bank, inventory, or equipment.

  • Liabilities: These are your business's debts, like money owed to suppliers or outstanding loans.

  • Equity: This represents the owners' investment in the business.

  • Revenues: This is the income your business earns from sales of products or services.

Expenses: These are the costs your business incurs, like rent, salaries, or supplies.

By recording each transaction in the appropriate account within the general ledger, you organize your financial information for easy access and analysis.

Step 4: Trial Balance (Making Sure the Books Balance)

After a busy shopping spree (recording transactions), it's always a good idea to check your receipts (transactions) to ensure you haven't missed anything. That's exactly what the trial balance does in the accounting cycle.

A trial balance is a simple report that lists all the accounts in the general ledger along with their ending balances (total debits and credits for each account). The main purpose of the trial balance is to verify if the total debits across all accounts equal the total credits. Why? Because in the world of accounting, debits and credits should always balance each other out – it's like a giant financial seesaw!

If the debits and credits don't match, it means there's an error somewhere in your records. Don't worry, this happens! The trial balance helps you identify these errors so you can fix them before moving forward.

Step 5: Adjustments and Worksheets (Getting the Full Picture)

So far, we've been recording transactions as they happen. But what about income you've earned but haven't received payment for yet, or expenses you've incurred but haven't paid for? This is where adjustments come in!

Imagine you owe your employees a salary for the last few days of the month, but haven't paid them yet. That unpaid salary is an expense your business has incurred, even though it's not reflected in your current records. Adjustments help us account for these "unrecorded" income and expenses to get a more accurate picture of the company's financial performance.

Two common types of adjustments are:

  • Accruals: Income earned but not yet received (like unpaid salaries) or expenses incurred but not yet paid (like utilities for the current month).

  • Prepayments: Expenses already paid for but not yet used (like office supplies you purchased this month but will use next month).

By making these adjustments, we ensure our financial statements reflect all the company's financial activity, not just the transactions that have already been recorded.

Step 6: Financial Statements (The Story of Your Business)

Now that we have a clear picture of all the financial activity (thanks to adjustments!), it's time to tell the story of your business through financial statements. These are like the final reports at the end of a movie – they summarize the company's financial health and performance. There are three main financial statements:

  • Income Statement: This statement tells you how much profit (or loss) your business made during a specific period. It basically shows your revenue (income from sales) minus your expenses (costs of running the business).

  • Balance Sheet: Think of this as a snapshot of your business's financial position at a specific point in time. It lists all the assets (what you own) and liabilities (what you owe) along with the owner's equity (investment in the business).

  • Cash Flow Statement: This statement keeps tabs on the money coming into and going out of your company. It shows how you're generating cash (through sales), using cash (to pay expenses), and investing cash (in equipment or inventory).

By analyzing these financial statements, you gain valuable insights into the financial health of your business, identify areas for improvement, and make informed decisions about the future.

Step 7: Closing the Books (Wiping the Slate Clean)

Imagine you're done recording all your business transactions for a specific period (month, quarter, year). Now it's time to close the books and start fresh for the next period. But before you do a victory dance, there's one more step!

In the accounting cycle, we categorize accounts into two main types: temporary and permanent.

Temporary accounts: These accounts track your business's income and expenses during a specific period. Think of them as income and expense buckets that you empty out at the end of each period. Examples include revenue, salaries, and rent expenses.

Permanent accounts: These accounts hold balances that carry over to the next accounting period. They reflect the ongoing financial health of your business. Examples include assets, liabilities, and owner's equity.

Closing the books involves transferring the balances from all temporary accounts (like revenue and expenses) into a permanent account called retained earnings. Retained earnings represent the cumulative profits your business has earned over time, minus any dividends paid to owners.

By closing the temporary accounts, we essentially reset them to zero for the next period. This ensures that the income statement only reflects the income and expenses for that specific period, and doesn't include any leftover balances from previous periods.

Step 8: Repeating the Cycle (The Financial Journey Continues)

Congratulations! You've successfully navigated the eight steps of the accounting cycle. But wait, it doesn't end here! The accounting cycle is a continuous process. Once you close the books for one period, you start all over again for the next period. This repetitive process ensures you have up-to-date financial information to make informed decisions for your business.

Think of it like tracking your fitness journey. You wouldn't just weigh yourself once and call it a day. You track your progress over time to see how your efforts are paying off. Similarly, the accounting cycle helps you monitor your business's financial health over time, allowing you to identify trends, adjust strategies, and ultimately achieve your financial goals.

Benefits of Understanding the Accounting Cycle (Why This Matters)

So, you've conquered the eight steps of the accounting cycle – high fives all around! But what does understanding this process actually do for you and your business?

Here's why familiarizing yourself with the accounting cycle is a win-win situation:

Financial Literacy Boost:

The accounting cycle isn't just for accountants anymore. By understanding the basics, you gain valuable financial literacy. You'll be able to interpret financial statements, track your business's performance, and make informed decisions about your money – whether you're a business owner or just managing your personal finances.

Data-Driven Decisions:

Imagine making important business choices based on guesses or hunches. Not ideal. The accounting cycle equips you with accurate financial data. This data becomes the foundation for making informed decisions about everything from pricing strategies and inventory management to investments and future growth plans. No more flying blind – you'll have the financial information you need to chart a clear course for success.

Early Warning System:

Financial troubles can sneak up on you if you're not paying attention. The accounting cycle acts as an early warning system. By analyzing financial statements regularly, you can identify potential financial issues early on, before they snowball into bigger problems. This allows you to take timely corrective actions and keep your business on track.

Building Block for Accounting Knowledge:

The accounting cycle is the foundation for further accounting knowledge. Once you grasp these core concepts, you can delve deeper into specific areas of accounting, like bookkeeping, tax preparation, or financial analysis. Understanding the cycle opens doors to a wider world of financial expertise.

In short, understanding the accounting cycle empowers you to take control of your financial well-being, be it for your business or yourself.

Conquered the Accounting Cycle and Hungry for More?

Here's some extra info to keep you going:

  • Accounting Software to the Rescue: The eight-step cycle might seem daunting at first, but fear not! Technology is here to help. Accounting software automates many tasks, like recording transactions, generating reports, and even keeping track of those pesky adjustments. This frees you up to focus on analyzing the data and making strategic decisions.

  • The Accountant: Your Financial Partner: Even with software, there's no substitute for a qualified accountant. Accountants bring their expertise to the table, ensuring your financial records are accurate and compliant with regulations. They can also provide valuable insights and guidance based on their experience, helping you navigate complex financial situations and maximize your business's potential.

Remember, the accounting cycle is a powerful tool for understanding your financial health. By embracing it, you can gain control of your finances and pave the way for a successful future!

You May Find This Useful:

  1. Accounting For Startups: Guide For The First-Gen Business Owners
  2. The Ultimate Guide to Time-Saving in Accounting with Suvit

Recent Blogs