The Full Accounting Cycle for a Small Business With Inventory and 12 Employees

A Complete, Step-by-Step Guide From the First Day of the Year to the Next Year-End Close

Running a small business that employs staff and sells physical inventory requires far more than simply tracking money in and money out. Accounting is a continuous cycle, not a once-a-year event, and each step builds on the one before it.

This guide walks through the entire accounting cycle for a typical U.S. small business with:

• Approximately 12 W-2 employees

• Physical inventory (not drop-shipping)

• Payroll, sales tax, vendors, and operating expenses

• Accrual accounting (the standard for inventory businesses)

We begin immediately after year-end accounting has been completed and follow the business through the entire new year — day-to-day operations, monthly closes, quarterly requirements, internal controls, and preparation for the next year-end.

Nothing is skipped. Nothing is hand-waved.

Part 1: Starting the New Accounting Year After Year-End Close

Understanding Where the New Year Actually Begins

The accounting year does not start with January 1st activity — it starts after the prior year has been closed.

A proper year-end close means:

• All income and expenses for the prior year are finalized

• Inventory has been counted and adjusted

• Payroll is complete through the last pay period

• Bank and credit card accounts are reconciled

• Temporary accounts are closed

• Financial statements are final

Only once this is done can the new accounting cycle begin correctly.

Step 1: Carrying Forward Opening Balances

At the start of the new year, the balance sheet does not reset. Only income and expense accounts reset to zero.

Permanent Accounts That Carry Forward

These accounts roll forward automatically:

• Cash

• Accounts Receivable

• Inventory

• Fixed Assets

• Accounts Payable

• Accrued Expenses

• Payroll Liabilities

• Loans and credit lines

• Owner’s equity or retained earnings

The ending balances from December 31 become the opening balances for January 1.

If these balances are wrong, every report in the new year will also be wrong.

Step 2: Closing Temporary Accounts Properly

Before the new year begins, temporary accounts must be closed.

Temporary Accounts Include:

• Revenue

• Cost of Goods Sold

• Operating expenses

• Payroll expenses

• Interest expense

• Depreciation expense

These accounts are closed into retained earnings (or owner’s equity for pass-through entities).

If this step is skipped or done incorrectly:

• Profit carries into the next year

• Reports become distorted

• Tax reconciliation becomes difficult

Step 3: Verifying Inventory Carryforward

Inventory is often the largest and riskiest asset for businesses that sell goods.

At year-end:

• Physical inventory should have been counted

• Shrinkage, damage, and obsolescence adjusted

• Inventory valuation finalized

That final number becomes:

Beginning Inventory for the new year

This number will directly affect:

• Cost of Goods Sold

• Gross profit

• Cash flow

• Taxable income

Step 4: Confirming Chart of Accounts Structure

Before recording any new transactions, the chart of accounts should be reviewed.

Core Accounts for an Inventory Business

Assets

• Operating bank account

• Payroll bank account (if separate)

• Accounts receivable

• Inventory

• Prepaid expenses

• Fixed assets

• Accumulated depreciation

Liabilities

• Accounts payable

• Credit cards

• Sales tax payable

• Payroll tax liabilities

• Accrued wages

• Loans and notes payable

Equity

• Owner’s equity or retained earnings

Income

• Product sales

• Other operating income

Cost of Goods Sold

• Beginning inventory

• Purchases

• Freight-in

• Inventory adjustments

• Ending inventory

Operating Expenses

• Payroll

• Rent

• Utilities

• Insurance

• Marketing

• Repairs

• Professional fees

A clean chart of accounts ensures transactions are posted correctly from day one.

Step 5: Establishing the Day-to-Day Accounting Flow

With opening balances confirmed, daily operations begin.

Every accounting cycle revolves around five core transaction types:

1. Sales

2. Receipts of cash

3. Purchases

4. Payments

5. Payroll

Each must be recorded consistently and accurately.

Step 6: Recording Sales Transactions

Sales drive the business, but they also trigger multiple accounting events.

Cash vs Credit Sales

If sales are made:

• In cash → revenue and cash increase

• On credit → revenue increases, accounts receivable increases

Under accrual accounting, revenue is recorded when earned, not when paid.

Sales Tax Handling

For taxable sales:

• Sales tax collected is not income

• It is recorded as a liability

Example:

• $1,000 sale

• $82.50 sales tax collected

Accounting entry:

• Revenue: $1,000

• Sales tax payable: $82.50

Failing to separate sales tax from revenue leads to overstated income and tax problems later.

Step 7: Inventory Relief at the Time of Sale

When inventory is sold, two things happen simultaneously:

1. Revenue is recognized

2. Inventory is reduced and COGS is recognized

This is known as inventory relief.

Example:

• Item sold for $100

• Item cost $60

Accounting impact:

• Revenue: +$100

• COGS: +$60

• Inventory: −$60

This step is what connects inventory to profitability.

Step 8: Cash Receipts and Deposits

Cash received from customers must be:

• Recorded

• Deposited

• Matched to sales

Daily or batch deposits should be reconciled to:

• Point-of-sale systems

• Invoices

• Merchant processor reports

Delays or mismatches here often signal:

• Theft

• Recording errors

• System issues

Step 9: Purchasing Inventory

Inventory purchases are not expenses when bought.

They are assets until sold.

The Purchase Cycle

1. Purchase order issued

2. Inventory received

3. Bill entered

4. Vendor paid

Inventory increases when received — not when ordered and not when paid.

Freight and Landed Costs

Costs necessary to get inventory ready for sale (freight, customs, handling) should be added to inventory value, not expensed immediately.

This ensures:

• Accurate COGS

• Proper gross margin reporting

Step 10: Accounts Payable Management

Bills from vendors are recorded when incurred.

This creates:

• An expense or asset

• An accounts payable balance

Paying bills later reduces cash and A/P but does not affect profit at that time.

Poor A/P tracking leads to:

• Cash flow surprises

• Duplicate payments

• Missed discounts

Step 11: Payroll Setup and Cycle

Payroll is one of the most complex recurring accounting processes.

With 12 employees, payroll typically includes:

• Hourly and salaried wages

• Overtime

• Bonuses

• Employer payroll taxes

• Benefits

Each Payroll Run Creates:

• Wage expense

• Payroll tax expense

• Payroll liabilities

• Net pay cash outflow

None of this is optional or flexible.

Step 12: Recording Payroll Correctly

When payroll is run:

• Gross wages are expensed

• Withheld taxes are liabilities

• Employer taxes are additional expenses

Until payroll taxes are paid, they sit on the balance sheet as liabilities.

Mis posting payroll is one of the most common small-business accounting errors.

Step 13: Monthly Accounting Responsibilities

At the end of each month, the business must pause and close the books.

Monthly close is where accuracy is enforced.

Key monthly tasks include:

• Bank reconciliation

• Credit card reconciliation

• Review of A/R and A/P

• Inventory review

• Payroll liability reconciliation

Without monthly closes, errors compound silently.

Step 14: Bank and Credit Card Reconciliations

Every cash account must be reconciled to the bank statement.

This confirms:

• All deposits were recorded

• All payments were authorized

• No duplicate or missing entries exist

Reconciliations are not optional — they are the foundation of trust in the numbers.

Step 15: Inventory Monitoring During the Year

Inventory should not be ignored between year-end counts.

Ongoing monitoring includes:

• Spot counts

• Shrinkage review

• Obsolete inventory identification

• Pricing changes

Small issues become large write-offs if ignored too long.

Part 2: Adjustments, Controls, Reporting, and Preparing for the Next Year-End

Step 16: Monthly Accruals and Adjusting Entries

Accrual accounting requires that income and expenses be recorded when earned or incurred, not when cash moves. This is enforced through adjusting entries, typically recorded at month-end.

Common Monthly Accruals

Accrued Expenses

• Utilities incurred but not yet billed

• Professional fees

• Interest on loans

• Payroll earned but unpaid at month-end

Prepaid Expense Amortization

• Insurance

• Software subscriptions

• Rent paid in advance

Depreciation

• Equipment

• Vehicles

• Furniture

• Leasehold improvements

These entries ensure that each month’s financial statements reflect economic reality, not cash timing.

Skipping accruals causes:

• Overstated profits in some months

• Understated profits in others

• Poor decision-making by ownership

Step 17: Reviewing Accounts Receivable (A/R)

Accounts receivable must be reviewed monthly for:

• Outstanding balances

• Aging

• Collectability

Key A/R Tasks

• Identify invoices past due

• Follow up on collections

• Write off truly uncollectible balances

• Record allowance for doubtful accounts if needed

Unmanaged receivables create phantom profits — income recorded but never collected.

Step 18: Reviewing Accounts Payable (A/P)

Accounts payable review ensures:

• All bills are recorded

• No duplicate entries exist

• Cash requirements are predictable

Monthly A/P review prevents:

• Late fees

• Damaged vendor relationships

• Cash flow crunches

Step 19: Payroll Liability Reconciliation

Payroll does not end when paychecks are issued.

Each month, payroll liabilities must be reconciled:

• Federal withholding

• Social Security and Medicare

• Federal unemployment (FUTA)

• State unemployment

• Any state income tax (if applicable)

Liabilities should be reduced only when payments are made, not when payroll runs.

Failure here leads to:

• Payroll tax notices

• Penalties

• Interest

• Personal liability risk for owners

Step 20: Sales Tax Compliance Cycle

Sales tax is not an annual event — it is continuous.

Monthly or Quarterly Sales Tax Process

1. Track taxable vs non-taxable sales

2. Reconcile sales tax payable account

3. File sales tax returns

4. Remit collected tax to the state

Sales tax payable should always match:

• POS reports

• Sales summaries

• Filed returns

Sales tax errors are among the fastest ways to trigger audits.

Step 21: Quarterly Accounting Responsibilities

Quarter-end accounting builds on monthly discipline.

Key Quarterly Tasks

• Review financial statements

• File payroll tax returns (Forms 941)

• Pay estimated income taxes (if applicable)

• File sales tax returns (if quarterly)

• Evaluate inventory turnover

• Review gross margin trends

Quarterly reviews allow course correction before problems become unfixable.

Step 22: Internal Controls for a 12-Employee Business

Internal controls protect the business from:

• Errors

• Fraud

• Theft

• Misstatements

They do not require complexity — just consistency.

Practical Internal Controls

Cash Controls

• Separate deposit duties from reconciliation

• Require approval for refunds

• Limit access to bank accounts

Inventory Controls

• Restricted inventory access

• Periodic counts

• Adjustment approval procedures

Payroll Controls

• Time approval

• Separation between payroll processing and approval

• Review of payroll reports

Purchasing Controls

• Purchase order approval

• Vendor setup controls

• Dual authorization for large payments

Controls are not about distrust — they are about risk management.

Step 23: Understanding the Financial Statements

With disciplined accounting, the financial statements become reliable tools.

Income Statement (Profit & Loss)

Shows:

• Revenue

• Cost of goods sold

• Gross profit

• Operating expenses

• Net income

Inventory businesses must watch:

• Gross margin trends

• Payroll as a percentage of revenue

• Expense creep

Balance Sheet

Shows:

• What the business owns

• What it owes

• Owner’s equity

Key focus areas:

• Inventory valuation

• Payroll and sales tax liabilities

• Loan balances

• Retained earnings accuracy

A strong balance sheet signals stability.

Statement of Cash Flows

Explains why cash changed, even when profit didn’t.

Inventory purchases, debt payments, and owner draws often explain cash shortages despite profitability.

Step 24: Mid-Year Inventory Counts and Adjustments

Waiting until year-end to count inventory is risky.

Mid-year counts help:

• Catch shrinkage early

• Identify obsolete items

• Adjust pricing strategies

• Improve purchasing decisions

Inventory adjustments should always be:

• Documented

• Approved

• Reviewed for trends

Step 25: Identifying Common Accounting Errors Early

Common problems include:

• Expensing inventory purchases

• Misclassifying payroll liabilities

• Mixing personal and business expenses

• Ignoring sales tax accruals

• Skipping reconciliations

The longer errors persist, the more expensive they become to fix.

Step 26: Preparing for Year-End Accounting (Before December)

Year-end should never be a surprise.

Preparation begins months in advance.

Year-End Readiness Checklist

• Clean bank reconciliations

• Reviewed A/R and A/P

• Inventory counts scheduled

• Fixed asset list updated

• Loan balances confirmed

• Payroll reconciled through final pay period

Strong preparation reduces:

• Accounting costs

• Tax prep time

• Audit risk

Step 27: Year-End Inventory Count and Valuation

Inventory must be:

• Physically counted

• Reconciled to books

• Adjusted for damage or obsolescence

The final inventory value directly affects:

• Cost of Goods Sold

• Net income

• Taxable income

This is one of the most material steps in the entire cycle.

Step 28: Final Accruals and Adjustments

At year-end, additional adjustments are often required:

• Bonus accruals

• Interest accruals

• Professional fees

• Inventory write-downs

These ensure the year’s results are complete and accurate.

Step 29: Closing the Books

Once all entries are posted:

• Financial statements are finalized

• Temporary accounts are closed

• Retained earnings is updated

This officially ends the accounting year.

Only after this step does the next accounting cycle begin, returning us to Step 1.

Step 30: How the Accounting Cycle Ties Into Tax Strategy

Clean accounting enables:

• Accurate tax returns

• Proper inventory reporting

• Payroll tax compliance

• Legitimate deductions

• Strategic tax planning

Poor accounting leads to:

• Overpaid taxes

• Missed deductions

• IRS notices

• Stressful cleanups

Accounting is not separate from tax — it is the foundation of tax strategy.

Final Thoughts: Accounting Is a Continuous System

For a small business with employees and inventory, accounting is not bookkeeping — it is an operational system.

When each step in the cycle is handled correctly:

• Financial statements become reliable

• Cash flow improves

• Compliance risk decreases

• Decision-making strengthens

• Tax planning becomes proactive

When steps are skipped, problems compound quietly.

The accounting cycle never truly ends — it simply resets and begins again, stronger or weaker depending on how well it was managed.