Defining Key Terms You Need to KnowWe understand that navigating the financial side of your business can be confusing, especially because there are a lot of complex processes involved, along with vague technical terms. To get started, we’ll break down some of the technical jargon used in accounting so that the different aspects of the accounting cycle are easier to understand. Accountant– Accountants are the individuals who analyze your business’s financial information and help you use it to preserve the health of your business. Accountants aren’t required to have a degree, but many have a master’s degree. Accounting Period– An accounting period is established in order to create structure for how financial information for the business is recorded and analyzed. This might be monthly, quarterly, or annually. Businesses often follow a monthly or annual accounting period and have the option to follow a fiscal year or calendar year when it comes to their accounting cycle. Accounting Records– A collection of the original documentation of business transactions, journal entries, ledgers, as well as supporting documentation that is used to produce the financial statements for a given period. Adjusting Entries– Adjusting entries are made at the end of the accounting period to make necessary changes that ensure reports are accurate and up-to-date. Assets– Items that are considered company resources, including stocks, cash, equipment, and property that have future economic value. Balance Sheet– A financial statement that shows income and expenditures during a specific period, including assets, liabilities, and equity. Bank Statements– A monthly document that is issued by a bank detailing the transactions relevant to a specific bank account. Bookkeeper– A bookkeeper is the individual in charge of maintaining all the financial accounts related to your business. They will keep all of your information organized and accounted for. Bookkeepers only need a high school diploma to practice. However, they will often have an associate degree and certification. Credit (CR)– A credit is a type of accounting entry that denotes an increase in a liability or equity account or a decrease in an asset or expense account. In double-entry accounting, credits are always listed on the left side. Debit (DR)– A debit is an accounting entry that is used to record an increase in an asset or expense account or a decrease in a liability or equity account. In double-entry bookkeeping, debits are always recorded on the right side. Double-Entry Bookkeeping– A bookkeeping method that tracks every transaction with two entries — a “debit” and “credit.” By recording transactions using double-entry accounting, you can more clearly see if funds are being transferred to or from an account. Equity– The amount of funds that have been invested in a business by the owner(s) plus any retained earnings. It can be calculated as the difference between the total assets and liabilities on the balance sheet. Financial Statements– Records of a business’s financial activities, financial health, and cash flow. The most commonly used aspects of financial statements include the balance sheet, income statement, and statement of cash flows. Invoice– A document that provides information about a payment that is owed. Common aspects of an invoice include an invoice number, identification information, date of shipment or delivery, description of the items purchased, payment terms, and the total owed. Journal– Where individual transactions are listed. This information is later transferred over to the ledger. Journal Entries– The logging of a transaction in the business’s accounting journal. Ledger– The database (or physical book) that contains the accounting records for a business. The general ledger is a summary of all your business accounts on an on-going basis. Typically, you will refer back to the general ledger to compare transactions across different accounting periods. Liabilities– Debts the business is responsible for paying. Posting– Transferring information from the journal to the ledger. Transactions– A transaction is any incoming or outgoing money. For example, this may include a sale or return as well as a payment to a lender.
What is the Accounting Cycle?Now, let’s get down to the reason you’re here, learning what the accounting cycle is. This eight-step system is used by businesses to record transactions and establish accurate and consistent financial documents for each period. Typically, businesses use the 12-month calendar tax year or a 12-month fiscal year. Here’s how you can put the accounting cycle into practice using the double-entry method: Note: Using the double-entry accounting is highly recommended. The only exception is when generating your income statement.
The 8 Steps of the Accounting CycleIn most cases, there will be eight steps in the accounting cycle. However, it isn’t a hard and fast rule, and you can modify the cycle to your needs when necessary.
Step 1: Identify & Analyze TransactionsYou will need to account for all transactions that have taken place over the period. This includes all expenses and revenue, which should be documented using receipts and invoices. You will want to hold onto all source documentation for these transactions. It is important that when you’re reviewing your transactions that you only include those that specifically pertain to the business. If you’ve taken out a personal loan for an expense that’s not related to your business activities, it shouldn’t be recorded.
Step 2: Record TransactionsYou record your transactions by creating journal entries. While most transactions will be recorded in the general journal, recurring transactions, such as bills that you pay every month, usually have their own separate journal. When recording your transactions, remember:
- Each transaction should be added in chronological order, creating a running list.
- You will need to make two entries for every transaction.
- All business transactions should be converted into debits or credits to ensure they are put under the right accounts.
- Make sure to add a note under each recorded transaction providing insight as to what it was and why it was recorded as either a debit or credit. This will make it much easier when you need to go back and review your journals.
- It’s easier to go through the period adding transactions as they occur. Otherwise, you will have to set aside a large chunk of time to go back and identify each transaction. This can leave more room for error.
Understanding the Relationship Between Debits & CreditsHaving a clear understanding of how debits and credits interact with one another is critical for accurate bookkeeping. So, let’s boil it down quickly for those who are not particularly familiar with this aspect of accounting:
- A debit and credit are needed for every transaction for the affected accounts to be in balance. This means that the total of debits and credits for a transaction must be equal to one another.
- Using debits and credits to balance accounts is critical to creating financial statements.
- These accounts normally contain a debit balance: Expenses, assets, and dividends.
- When a debit is added to these accounts, they will increase. When a credit is added, they will decrease.
- These accounts normally contain a credit balance: Liabilities, revenues, and equity.
- When a credit is added to these accounts, they will increase. When a debit is added, they will decrease.
Step 3: Post Journal Entries to the General LedgerEach journal entry is organized and posted to the appropriate account in the general ledger. Examples of the different types of accounts of your business may have include cash, capital, expense, inventory, and accounts payable. Here, the closing balance of each of the accounts will be transferred, which is what you’ll use when calculating the unadjusted trial balance.
Step 4: Calculate the Unadjusted Trial BalanceAs previously mentioned, debits and credits should balance. To check for errors, you should use an unadjusted trial balance. To get the unadjusted trial balance, total up all the debits and separately total all the credit entries. Do they match? If not, you may have made an error when recording your transactions for the period. With that said, you may just need to make some adjusting entries to account for incongruencies. Note: This step is designed to ensure that credits and debits match. However, while debits and credits may be equal to one another, that does not necessarily mean that no errors have occurred.
Step 5: Create Worksheet & Make Adjusting EntriesFor any instance where there is uncollected income or an unpaid expense, you need to create an adjusting entry. You’ll also need to make an adjusting entry for any mistakes that were made. For example, if you forgot to record a transaction or used the wrong numbers, create a worksheet to record your adjustments. There are four types of adjustments you can make:
- Deferrals– Deferred revenue is money that has been received in advance for services. A deferred expense is one that has been paid but will be reported in future periods.
- Accruals– Accrued revenue is income that wasn’t received and recorded until after services were provided. An accrued expense is one that will be paid in a later accounting period.
- Missing Transactions– These adjustments are used for transactions that were missed. It may be something you bought for your business but used personal funds for that needs to be accounted for now.
- Tax– Tax adjustments account for tax deductions that you will be able to write off in a future period.
Step 6: Adjust Trial BalanceWhen calculating the adjusted trial balance, you want the debits and credits to be equal. Once they are, you can move forward with posting the entries in the ledger. If debits and credits still don’t match, you will need to go back and review your books once more to determine where the oversight was made.
Step 7: Generate Financial StatementsYou can now use this information to generate your financial statements for this period. You should take time to review your financial statements to determine which business activities are helping your bottom line and where improvements need to be made. To get an accurate picture of the health of your business, you should review the:
- Income statement
- Statement of changes in equity
- Balance sheet
- Statement of cash flows
- Footnotes of the financial statements
Step 8: Close Your BooksAt the end of the period, the balances for temporary accounts (income, expenses, and withdrawals) are closed out to the retained earnings account or the income summary account. Then, the accounting cycle starts over again. Once the books for a period are closed, you should file all pertinent information and destroy any remaining documents you do not need to hold onto. Since most businesses now use accounting software, all this information should be securely stored for you.
Why is Accurate Bookkeeping Important?So, now you know what the accounting cycle is and how it works, but you’re probably still wondering, why is it important for your business? It’s the best method for achieving accurate bookkeeping which is invaluable to your business.
Financial Health & PlanningUsing the accounting cycle to balance your books is a proven method for ensuring all the money earned and spent by your business is properly recorded. This process identifies errors early on, improves bookkeeping accuracy, and can help you generate important financial statements for your business, such as cash flow reports and balance sheets. Accurate financial records are one of the most important factors for monitoring the health of your business and plays a critical role in decision-making. So much so that even a small miscalculation can have a domino effect on the health of your business if it is not caught in time.
Tax PurposesEnsuring that your bookkeeping is conducted in a timely and accurate manner is critical to your business. Every business, no matter how small, is expected to uphold the highest accounting and tax reporting standards. Failure to do so could result in tax penalties. To protect your business, especially in the case of audits, it’s important to make sure you’re employing the accounting cycle correctly. Still, many small business owners take it upon themselves to take the risk and handle their own bookkeeping and accounting. However, for some, hiring a professional to perform these duties might be a better decision in the long run.
Should You Consider Professional Services?Now that you understand how the accounting cycle works and the impact it can have on your business, you may be reconsidering your decision to handle it on your own. It’s especially important to consider hiring a professional as your business grows. At some point, it’s too much for you to handle on your own with all your other responsibilities as a small business owner.
Do You Need a Bookkeeper or Accountant?So, what kind of help do you need? You might start out by hiring a bookkeeper or an accountant, but eventually, you will need both. Didn’t realize there was a difference? Let us explain…
When to Hire a BookkeeperA bookkeeper is the person who will manage your daily business transactions. They will be responsible for tracking them and recording them, so you don’t have to. This is a good start to ensuring that all of your bookkeeping is done correctly. Plus, it frees up your time to focus on the other demands of your business. Some of their key responsibilities include maintaining and balancing your ledgers and accounts, producing invoices, and completing payroll. However, they can’t perform the same duties as an accountant.
When to Hire an AccountantUnlike a bookkeeper, an accountant doesn’t manage your day-to-day transactions. Instead, they’re focused on the big picture. They’ll be responsible for preparing your financial statements, analyzing operational costs and other key data, provide advice you’ll need to make big decisions, and complete your business’s income tax returns. They can also help with business plans and legal advice—two functions that make them invaluable as your business becomes more complex. An accountant is essential to help ensure your business’s longevity, especially if you’re not financially savvy. If you can take on the extra expense, it can be beneficial to bring on these services as soon as possible.
Bundle Bookkeeping & Accounting ServicesBut what if we told you that you don’t have to go through the trouble of sourcing both positions on your own? At Community Tax, we offer packages that allow you to conveniently pair bookkeeping and accounting services, including but not limited to:
- Account reports
- Adjusting journal entries
- Annual payroll tax returns
- Quarterly tax returns
- Form W-2 and Form 1099 prep
- Customized financial reporting
- Sales and use returns
- Form 940 and Form 941 filings and amendments
- State and local payroll filings
- Poster compliance update service
- Application for agency ID’s SUI and SIT
- Individual and corporate tax returns