The accounting process that begins with analyzing and journalizing transactions and ends with the preparation and interpretation of financial statements is called the accounting cycle.
Because the series of steps involved in the accounting process (from transactions to financial statements) takes 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
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 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
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 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)
Post 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
This 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
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.
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.
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 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
The heading of the statement of financial position always reads as follows:
‘‘Statement of financial position of … at … 20XX’’
Only assets and liabilities appear in the statement of financial position, which is the balance of these accounts at a specific date.
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.