The accounting process is a sequence of processes that starts with analyzing and journalizing transactions and ends with the preparation and interpretation of financial statements. This whole process is also called the accounting cycle.
Because all the steps involved in the accounting process (from the analysis of transactions to the preparation of financial statements) take place during each accounting period.
The steps in the accounting cycle are as follows:
The steps are done in the order presented above, although the methods of performing the steps vary from business to business.
For example, the details of a sale may be entered by scanning bar codes in a grocery store, or they may require an in-depth legal interpretation for a complex order from a customer for an expensive piece of equipment.
Steps in the Accounting Process:
Identify Transaction & Events
The first step in the accounting process is to identify the transactions and events which can be measured in monetary terms.
Suppose, you go to a gift shop and buy some gifts for your brother and make a cash payment of Rs. 1500. Purchase of the gifts for cash is an example of a transaction, which involves a reciprocal exchange of two things:
- payment of cash,
- delivery of the gifts
Hence, the transaction involves this aspect, i.e. Give and Take. Payment of cash involves give aspect and delivery of gifts is a take aspect.
Thus, business transactions are exchanges of economic considerations between parties. The transaction could be a cash transaction or a credit transaction.
When the parties settle the transaction immediately by making payment in cash or by cheque, it is called a cash transaction. In credit transactions, the payment is settled at a future date as per agreement between the parties.
All business transactions and events which are of financial nature (i.e. expressed in terms of money) are recorded in the books of accounts.
Some examples of transactions and events are :
- Sale (cash or credit)
- Buy (cash or credit)
- Receive money
- Return goods
- Depreciation on fixed asset
We use the double-entry system of bookkeeping for recording the financial transactions and events of business. It is only the is a scientific system of accounting.
According to it;
- Each transaction must be recorded with at least one debit and one credit, and
- The total amount of the debits must equal the total amount of the credits.
Remember: Total debits = Total Credits
The second step in the accounting process is to obtain appropriate source documents for the transactions. A document that provides evidence of the transactions is called the Source Document or a Voucher. Business transactions are usually evidenced by appropriate documents such as Cash memo, Invoice, Sales bill, Pay-in-slip, Cheque, Salary slip, etc. For example;
When buying products, a business gets an invoice from the supplier. When borrowing money from the bank, a business signs a loan agreement, a copy of which the business keeps.
When preparing payroll checks, a business depends on salary rosters and time cards. All of these business forms serve as sources of documents for accounting purposes.
Under no circumstances may any entry be made in the records without a source document to substantiate the entry. But sometimes, there may be no documentary for certain items as in case of petty expenses.
In such a case, the voucher may be prepared showing the necessary details and got approved by the appropriate authority within the firm.
A specific source document is used for every type of transaction. It is also important to distinguish between an original and a duplicate source document.
Examples of source documents used under accounting process:
- receipt – for cash received
- cash slip or cash register slip – for goods sold cash
- cheque – for payment of something (cash)
- invoice – credit purchase invoice for credit purchases
- credit sales invoice – for credit sales
- credit note issued – for goods returned to us
- credit note received – for goods returned by us.
Recording Transactions in the Journal
The third step in the accounting process is to record the transactions in the appropriate journal. The book in which the business transactions are recorded for the first time is called journal. The source document, as discussed earlier, is required to record the transaction in the journal.
The journal is subdivided into a number of subsidiary journals. The purpose of a subsidiary journal is to summarise transactions of the same type.
The following subsidiary journals are applicable:
- General Journal (GJ)
- Cash Receipts Journal (CRJ)
- Cash Payments Journal (CPJ)
- Debtors Journal (DJ)
- Creditors Journal (CJ)
- Debtors Allowance Journal (DAJ)
- Creditors Allowance Journal (CAJ)
- Petty Cash Journal (book) (PCJ)
The process of recording transactions in the journal is called journalizing. The entry in the journal is called a journal entry.
All business transactions are first recorded in the journal through journal entries in chronological order.
The basic journal entry format is
We apply the rules of debit and credit for making journal entries for transactions.
The following is a useful method for analyzing and journalizing transactions:
- Carefully read the description of the transaction to determine whether an asset, a liability, an owner’s equity, a revenue, an expense, or a drawing account is affected.
- For each account affected by the transaction, determine whether the account increases or decreases.
- Determine whether each increase or decrease should be recorded as a debit or a credit.
- Record the transaction using a journal entry
You can apply the golden rules of accounting to make journal entries because it simplifies the rules of debit and credit of the double-entry system.
Post to General ledger accounts
The fourth step of the accounting process is to post the transactions from journals to general ledger accounts. The ledger is the principal book of the accounting system. A ledger is the collection of all the accounts, debited or credited, in the journal proper and various special journals.
After recording the transactions in the journals or subsidiary books then the same transactions are posted to individual accounts in the general ledger.
A General ledger account is in the shape of a ‘T’ which has a left‐hand side, called the debit side, and a right‐hand side called the credit side.
An account is debited when an amount is entered on the left‐hand side and credited when an amount is entered on the right‐hand side.
The purpose of a general ledger account is to determine a balance for each account in the records. An account is opened for every item, whether it is an asset, liability, income or expense, and the balance is determined for every account.
A balance is determined by calculating the difference between the debit side and the credit side of each account. The left-hand side of an account represents the debit side, and the right-hand side, the credit side.
For example, a Cash Account showing Debit balance:
Pre-adjustment trial balance
A trial balance is a statement that shows the balances, or total of debits and credits, of all the accounts in the ledger.
Trial balance is an important statement in the accounting process as it shows the final position of all accounts and helps in preparing the financial statements i.e. Income statement and Balance sheet.
The trial balance is a tool for verifying the arithmetical accuracy of debit and credit amounts.
We can verify the arithmetical accuracy of posting of debit and credit amounts into the ledger accounts by preparing a trial balance.
Pre- adjustment trial balance represents a summary of all the debit and credit balances in the general ledger before any adjustments are made to these balances. It includes income, expense, and income and expense accounts.
The steps in preparing a trial balance are as follows:
List the name of the company, the title of the trial balance, and the date the trial balance is prepared.
List the accounts from the ledger, and enter their debit or credit balance in the Debit or Credit column of the trial balance.
Total the Debit and Credit columns of the trial balance.
Verify that the total of the Debit column equals the total of the Credit column.
An adjustment is not a transaction that occurs, in other words, two parties are not involved.
The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process.
The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries.
All adjusting entries affect at least one income statement account and
one balance sheet account.
Thus, an adjusting entry will always involve a revenue or an expense account and an asset or a liability account.
Examples of adjustments:
- calculation of depreciation
- provision for credit losses
- other adjustments.
Adjusting entries are made in the general journal and the journal description acts as the source document. The entries in the general journal are posted to the general ledger account.
Four basic types of accounts require adjusting entries as shown below.
- Prepaid expenses
- Accrued revenues
- Unearned revenues
- Accrued expenses
Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid. Prepaid expenses become expenses over time or during normal operations.
Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received. Unearned revenues become earned revenues over time or during normal operations.
Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received. Fees for services that an attorney or a doctor has provided but not yet billed are accrued revenues.
Accrued expenses are unrecorded expenses that have been incurred and for which cash has yet to be paid. Wages owed to employees at the end of a period but not yet paid are an accrued expense.
Post-adjustment trial balance
A post-adjustment trial balance is prepared after making all the necessary adjusting entries. It represents the final balances of all general ledger accounts and includes income, expense, asset and liability accounts.
The adjusted trial balance verifies the equality of the total debit and credit balances before the financial statements are prepared.
Closing entries are made using the general journal. All income and expense accounts are closed so that no balances remain in these accounts and a clean start can be made during the next financial year.
Income and expense accounts that influence gross profit close off against the trade account. All other income and expense accounts close off against the profit or loss account.
The final trial balance
After all the closing entries have been made, the only balances that remain in the general ledger are assets, liabilities, and the profit or loss as calculated in the profit or loss account.
The final trial balance, therefore, consists of a summary of those balances that remain in the general ledger after all the closing entries have been made.
The statement of profit or loss
The income statement is referred to by various names, such as the statement of profit and loss, the statement of income, statement of operations, statement of earnings, or others.
Whatever name is used, its purpose is the same:
To provide users of the financial statements with a measurement of a reporting entity’s results of operations over a period of time.
The reporting period covered by the income statement can be a month, quarter, half-year or year.
But generally, the reporting period of the income statement is of one year.
Proft for the period is the excess of income over expenses for that time. If expenses for the period exceed income, a loss is incurred.
The heading of the statement of profit or loss and other comprehensive income always reads as follows:
‘‘Statement of profit or loss of … for the year ended … 20XX’’
The purpose of the statement of profit or loss and other comprehensive income is to determine the gross and net profit of the business concern for a specific period.
Only income and expenses appear in the statement of profit or loss and other comprehensive income.
The statement of financial position
Financial position refers to a company’s economic resources and the claims against those resources at a particular time. The balance sheet is one of the basic financial statements that tells about the financial position of a company. It is more formally referred to as the statement of financial position.
The balance sheet reports the financial position of an entity at a specific point in time. The financial position is reflected by the assets of the entity, its liabilities or debts, and the equity of the owner.
A balance sheet has two sides:
- Liabilities & Owners’ Equity
Note that the two sides of the balance sheet are always equal.
The accounting equation shows the financial position as Assets = Liabilities + Owner’s Equity.
Analysis and interpretation
The final step in the accounting cycle is the analysis and interpretation of the information contained in the financial statements. This is done by calculating ratios and comparing the figures in the financial statements with those of other concerns or budgets previously drawn up.
Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows:
- Horizontal analysis
- Vertical analysis
- Common-sized statements
The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis. Each item on the most recent statement is compared with the same item on one or more earlier statements in terms of the following:
1. Amount of increase or decrease
2. Percent of increase or decrease
When comparing statements, the earlier statement is normally used as the base year for computing increases and decreases
The percentage analysis of the relationship of each component in a financial statement to a total within the statement is called vertical analysis. Although vertical analysis is applied to a single statement, it may be applied on the same statement over time.
This enhances the analysis by showing how the percentages of each item have changed over time.
In the vertical analysis of the balance sheet, the percentages are computed as follows:
1. Each asset item is stated as a percent of the total assets.
2. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.
In a common-sized statement, all items are expressed as percentages, with no dollar amounts shown.
Common-sized statements are often useful for comparing one company with another or for comparing a company with industry averages.
Other Analytical Measures
Other relationships may be expressed in ratios and percentages. Percentage analysis and ratio analysis have been developed to provide an efficient means by which a decision-maker can identify important relationships between items in the same statements and trends in financial data.
Percentages and ratios are calculated in order to reduce the financial data to a more understandable basis for the evaluation of the financial condition and past financial performance of the entity.