In a previous blog, we talked about the three types of small business accounting. One of them was financial accounting, and for this type, you must follow the steps of the accounting cycle. However, before you do that, you should set up the accounting system.
To review, the steps of the accounting cycle are:
- Record financial transactions
- Transfer financial transactions
- Classify financial transactions
- Trial balance and adjusting entries
- Preparation of financial statements
In this blog, we will explain how to set up your accounting system to be used in the accounting cycle for a small business.
Related Post: 3 Types of Small Business Accounting
Set Up the Chart of Accounts
A chart of accounts is an index of all the accounts where your business files financial information. In the chart of accounts, you should create a numbering system for each category so you can keep it organized, and they should be listed in chronological order.
There are five categories to use on a chart of accounts:
- Assets
- Liabilities
- Owner’s Equity
- Revenue
- Expenses
Keep Source Documents of a Transaction
Always keep source documents of your transactions, so you can have evidence that a transaction occurred. This could be invoices, canceled checks, receipts, purchase orders, and other documents.
Set up Journal Entries
That brings us to creating journal entries. These entries are stated in debits and credits. Journal entries should be entered as soon as your business makes a transaction. The entries should be classified by their account, set up in the chart of accounts.
Set Up the General Ledger
At the end of the accounting cycle, you must transfer the journal entries to the general ledger. The entries are listed in a summary form, where the debits and credits are separated into their separate accounts according to the chart of accounts.
Prepare the Trial Balance
After you transfer the journal entries to the general ledger, you can prepare the trial balance. For this, you total out the debits and credits to make sure they are balanced for the current accounting period.
Adjust Entries in the Journal
After preparing the trial balance, you should adjust the revenues and expenses in the journal entries to the accounting period to which they actually occurred. There are five types of adjustments: accrued revenues, accrued expenses, prepaid expenses, and depreciation. These adjustments will impact your final monthly balance.
Prepare the Financial Statements
Now you can prepare the financial statements. Take the information from the accounting journal and the general ledger and use those to develop the following statements in this order:
- Income statement
- Statement of retained earnings
- Balance sheet
- Statement of cash flows
Create the Closing Entries
At the end of the accounting cycle, you can now create the closing entries. This is when you create journal entries to set the balance of temporary accounts to zero so you can begin the next accounting period. You should close the following accounts:
- Revenue
- Expenses
- Drawing accounts
These accounts should remain open because their ending balances are the beginning balances for the next accounting period:
- Assets
- Liabilities
- Owner’s Equity
Now that you know the many parts of your accounting system, you can begin your accounting cycle for your small business.
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