Business leaders should always look to the past and to the future. The future holds new initiatives, growth (hopefully), and new work to be done. The past holds the key to understanding how the company has performed. A careful analysis of the past can help entrepreneurs make strategic and tactical decisions for the future of the company. The accounting cycle produces financial statements that provide important information for executives. To get good financial reports, one should understand the basics of the accounting cycle.
Step 1: Identify and Analyze Transactions
For the purposes of the accounting cycle, a transaction is an economic event that is quantifiable in terms of money. Any time money changes hands, that is a transaction to be recorded and analyzed such as purchases, payments, or writing off bad debts.
Analyze past transactions to understand your businesses reporting needs. From that, you will develop a chart of accounts by which you will classify every transaction. While every step is important, this step determines what information you will get from your financial reports at the end of the process. If your transactions are classified poorly, your financial reports will give you less useful information about the company.
Step 2: Record Transactions
When accounting was done by hand, this was two steps. First, the transaction would occur and then someone would write down the transaction in a journal. Automated point-of-sale systems do both at the same time. The moment you sell a product, the computer records the sale as a transaction and journalizes that transaction. Recorded in chronological order, each journal entry should have this information:
- Explanation of the transaction
- Debits and credits (due to double-entry accounting) to the appropriate accounts
When a business expands into global markets, their accounting system must adapt for different currencies. Financial records should always denominate transactions in a single currency, usually the home country’s currency, regardless of what currency by which the transaction happened. If an American company takes a payment in Euros (the transaction currency), the accountants will record the transaction in dollars (the accounting currency).
Review journal entries to ensure they are an accurate and faithful representation of the transaction that they are recording. Journal entries should be reviewed by another person to ensure accuracy and help prevent fraud.
Step 3: Enter Transactions in the General Ledger
At regular periods, transactions move from the journal to the general ledger. The difference between a general ledger and a journal is how they organize transactions. The journal organizes transactions chronologically while the ledger clusters like transactions together according to the chart of accounts. Automated accounting systems can record transactions directly from the point of sale to the general ledger.
Step 4: Trial Balance
Before one prepares final reports, an accountant will create a trial balance. This is a list of all the company’s accounts at any given time. The trial balance gives the accountant a chance to check whether the debits and credits for each account match. If not, there is an error somewhere in the ledger.
If there is an error in the general ledger, the accountant creates a temporary adjusting account to make the debits and credits match. The account is temporary because it remains only until someone finds and corrects the error in the ledger. When all this is done, the accountant creates the adjusted trial balance.
Step 5: Prepare Financial Reports
Financial reports are the goal of the accounting process. They are meant to provide useful and relevant information about the company’s past performance to help influence future decisions. There are five statements that comprise the financial reports of any company:
- The statement of financial position, or a balance sheet, shows the assets, liabilities, and equity of a company
- The statement of financial performance, or income statement, shows the income and expenses for a given period
- The statement of changes in equity includes more detail on the equity portion of the balance sheet
- The cash flow statement shows the movement of cash into and out of the company
- The notes to the financial statements contain helpful notes to explain and expand upon sections of the financial statements.
Differences in the Global Accounting Cycle
While accounting cycles generally remain the same no matter where you do business, there are two major standards for accounting in the world that determine how you record and report transactions: Generally Accepted Accounting Principles, or GAAP, and International Financial Reporting Standards, or IFRS. The United States uses GAAP, while most other countries, about 120 of them, use IFRS.
The major difference between the two standards is GAAP is rules-based and IFRS is principles-based. This means there could be different interpretations of IFRS principles vs. GAAP which has very specific rules.
If you’re new to global expansion and accounting management, consider working with a trusted partner that can help you navigate any arising complications. Our team of international business experts is ready and willing to help. Reach out to us today!