​​When accounting talks about "month end close," what does that even mean?

I know this question has been stuck with you for months... shoot years.

Well today, we're going to answer it.

Buckle up because this is going to be a "fun" little peak into the accounting process.

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Demystifying Accounting: The Accounting Cycle

 ​Last week​ we talked about the roles of the different people in the accounting department.

This week we’re going to zoom out from the roles and talk about the process/cycle as a whole.

When people think of accounting, they think of a few things:

1. Tax
2. Transactions
3. Reporting

These are great and definitely a part of Accounting.

But the general sense I get is “what do you people even do?!?” Hopefully, you have a clearer sense of that after last week’s newsletter, but I think the cycle really brings that all together.

You see, the cycle of accounting is what keeps everything rolling. It’s a love/hate relationship for those of us in accounting. We love it because it keeps things organized, but we hate it because it can be relentless.

Family issues? Busy on other things? Just want to take a vacation? Well, if you have a limited team… too bad. Time doesn’t stop. You just have to keep delivering.

This cycle is split into 3 phases:

1. Daily & weekly work
2. Monthly closing of the books
3. Irregular work

The daily and weekly work is mainly made up of transaction work. This is dealing with AR and AP and bank accounts and making sure things are running smoothly.

Then you have the monthly closing of the books. This work is done once a month, but often bleeds over into other areas of the month too. For companies who are locked in, closing can happen in just days. For others, this can take weeks. 15 days seems pretty standard, but I’ve seen teams that take months.

The key with a longer close is assuring you have intermediate deadlines which allow you to deliver mostly correct numbers to the right teams in the business.

 

The irregular work is the stuff that comes less frequently but is just as essential.

Here is the rub: the daily/weekly work never stops. It doesn’t matter what is going on with monthly close or the auditors. The daily stuff still has to be done.

And this is where the juggling act comes in.

So today, we’re going deep into the cycle. The daily and weekly work is mostly ignored in this, as we focus on the monthly close cycle.

Within this Monthly Close Cycle, you have 7 steps:

1. Analyze & enter transactions
2. Create recurring journal entries
3. Reconcile & review all accounts
4. Prepare adjusting journal entries
5. Review Financials & make adjustments
6. Close the books
7. Share Financials

After these steps, we’ll address the irregular items that impact the cycle but aren’t consistent on a month-to-month basis.

Let’s dig in.

Analyze & enter transactions

This is the step that everyone understands.

Charges are made. Invoices are sent and money received. Accounting is responsible for making sure this is all done in a timely and accurate fashion.

This work is done on a daily/ongoing basis and the foundation of all things accounting.

The financial records are only as good as the underlying transactions, so it’s important you have a good team and process handling these transactions.

When dealing with transactions, it’s important that Accounting:

1. captures and files all related documentation
2. gets an understanding of the purpose
3. codes/categorizes it appropriately

All of this should be done in a timely manner and ideally in a way that allows weekly or daily account balances.

The first key is assuring all banking transactions are recorded, as that allows for an up-to-date understanding of cash.

Next is managing account balances where budgets are important to teams or departments within the business.

Create recurring journal entries

Every transaction in a business is a journal entry. That invoice, receipt, bill, payment, etc. But those are attached to transactions that often hit the bank account and hit other “journals” in the course of regular business.

But, in this case, we’re specifically talking about the entries required for compliance with accounting rules.

These can happen on any cadence but are most often monthly or annually. Some examples of transactions that would fall under this are:

1. Prepaid expenses
2. Depreciation & amortization
3. Accrued revenue & expenses

In Cash Basis Accounting, not many of these entries are needed. But as you start using Accrual Basis Accounting, the list of these transactions can grow increasingly long.

The point of these entries is to accurately record revenue, expenses, and obligations (assets or liabilities) on a monthly basis, instead of as cash comes out of the bank account.

Pay your insurance bill upfront? This is recorded as a prepayment and expensed via journal entry over the whole life of the policy.

This helps more accurately reflect the profitability of the business on a month-over-month basis.

When recording these journal entries, it’s important the process is documented so the entries are done consistently. If periods aren’t comparable, gleaning insights from financial statements is extremely hard.

Reconcile & review all accounts

Does anyone still keep a checkbook ledger for their bank account? I still remember my mom showing me how to balance my personal bank account using that ledger as a child.

Today things look much different, but there are times I wish for the simpleness of that process. Instead, I’m trying to understand why my accounts don’t balance and how the bank sync feeding into my budgeting app didn’t work.

I have no doubt the ledger would be much quicker, but then I’d lose my cool charts.

But within the simpleness of the checkbook ledger was the concept of reconciliation. You recorded all transactions to the ledger then compared the ledger balance to your bank statement. When they didn’t match, you’d look through the transactions to see what you missed.

In much the same way, Accounting is responsible for reconciling bank accounts (and other Balance Sheet accounts) to make sure things “match.”

You match your internal accounting records to the external statements you receive and when they match you’re done.

This helps identify discrepancies and match records. Sometimes you’ll enter something wrong or not enter it at all.

“Final” reconciliations are done monthly, but many accounting departments do these on a weekly or daily cadence.

This process will sometimes even include a validation of backup data to ensure policies are being followed.

Prepare adjusting journal entries

After reconciliations are done, all transactions are theoretically in the system.

This is where accounting typically has a checklist of things to review.

Some examples of adjusting journal entries are:

1. Writing off bad debt
2. Adjustments for missing transactions: These are bills or items you know have been accrued but haven’t received. If you were missing a bill for insurance or from a loan, you could do an adjusting journal entry to record it until you actually received it.
3. Adjusting inventory based on counts: Some businesses do regular counts of inventory. When those counts don’t match the balance on the books, adjustments are done to “true-up” the balance.
4. Allocating expenses to different departments: Say you want to “charge” departments for overhead expenses. You would determine how you’re going to allocate and in this case we’ll use employee headcount. We’d total up all overhead expenses and divide it by the headcount of each department. We’d then do a journal entry allocating those expenses based on that calculation.

Some businesses will delay the “recurring journal entries” to this point as well, but it’s strictly a preference.

Review Financials & make adjustments

Once adjusting entries are done, it’s time to run the Financial Statements.

The most common statements are:

1. Income Statement
2. Balance Sheet

The Statement of Cash Flow is often overlooked but should be used more, especially for businesses running on Accrual Accounting.

Businesses will often lump other reporting into this as well. Examples of this would be:

1. AR & AP Aging Reports
2. Department specific spends
3. Transaction detail reports by account
4. Bank Statements & Reconciliation backup

At this stage, you’re focused on running the reports in their final form and reviewing them with a fine-tooth comb for accuracy.

It’s embarrassing to have to change reporting after it’s presented, so Accounting tries to avoid this at all cost.

Just like in the other steps, there is often a checklist of things to review.

Examples of items on that list would be:

1. Verify revenue is within the expected range
2. Review Gross Margins for reasonableness
3. Ensure Balance Sheet “balances”
4. Validate calculations of key KPIs
5. Look for unusual drops or spikes in any account
6. Review Interest & Notes Payable accounts for accuracy
7. Confirm reconciliations are complete and no old transactions outstanding
8. Spot-check documentation for inclusion and accuracy

This list can get long and will be super specific. Things will often get added to this list as you run into issues over the months/years to make sure the previous mistakes aren’t repeated.

Close the books

Once you have confidence the books are accurate, it’s time to close the books.

This means zeroing out temporary accounts (an example would be “Ask My Accountant” in Quickbooks) and locking the period so no changes can be made to transactions in the period.

“Back in the day” this required manual adjustments from Net Income to Retained Earnings and other similar things, but most accounting software handles all this for you now.

During the close process, there is typically a “packet” put together of all the checklists and backup related to the close to create a clean and tidy resource if ever needed in the future.

With electronic close, this has sometimes gotten more informal, but I still like to create this same “packet” electronically as it creates one source of truth for everything in that month.

The packet will include:

1. Final Financial Statements
2. Trial Balances (unadjusted, adjusted, & close)
3. Supporting Schedules (AR & AP Aging, Fixed Asset Schedule, Inventory Schedule, Asset/Liability Detail Schedules, etc)
4. Reconciliation Reports
5. Journal Entry records and backup
6. Backup Documentation (Checklists used in the process, Approvals, supporting documents, etc)

Share Financials

This is not really a step unto itself, as it’s technically part of closing the books.

But I share this separately because the “sharing” process can be done differently based on the business you’re in.

Sometimes it’s just an email to the owner and/or leadership.

Other times it’s a meeting and presentation.

And others it’s sending specialized reports to different departments and managers.

Outside the Cycle

Outside of the Accounting cycle there are still other functions that happen and connect to the cycle.

I’ve not created a comprehensive list here, as different businesses can have different needs.

Instead, I’ll share some examples of functions that “plug-in” to the Accounting Cycle:

1. Tax
2. Audit
3. Payroll
4. Banking
5. Inventory Management
6. Budgeting & Forecasting

Each of these has its own requirements and cadences, but they all impact Accounting.

For example, with Tax, you’ll have:

1. annual tax filings
2. quarterly estimated payments
3. monthly or even weekly misc taxes due

For Audit, you could be required to do this annually based on the type of business you have. This means each year you have to build a period of time for your team members to be able to assist the external audit partner with document requests. This can also impact how you go about your day-to-day work if you’re addressing previous requests from auditors.

Banking can have monthly, quarterly, or annual requirements with debt agreements depending on the complexity and overall leverage portfolio of the business.

It’s key that you have the right team members to deal with these special needs. Sometimes that means hiring special people to do the whole job or making current employees get training to allow them to perform or assist with these tasks.

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What did you learn based on the breakdown of the Accounting Cycle today? Will it change the way you approach anything in your business?

Reply to this email and let me know!

Next week we wrap up this series by talking about processes and procedures in accounting.

Have questions about that or any of the previous things we’ve discussed in this series? Let me know. I’ll respond to all of them!