The accounting procedure, from start to finish, follows what is called an accounting cycle. This article will give you an idea of what happens in the accounting process and reaffirm the importance of record keeping. If you are not familiar with any of the terminology or is still in the early stages of learning about accounting, you may have to re-read this article.
The Accounting cycle is a series of steps in recording an accounting event from the time a transaction occurs to its reflection in the financial statements. These steps in the accounting cycle provides means of organising and keeping track of financial transactions.
Stage 1. Analyse Business Transaction
This is the transaction identification process. A business may carry out many activities that do not represent business transactions. The processing of accounting data begins with an economic transaction. Each transaction must be analysed in terms of its effect on the components of the basic accounting equation. The question must be asked: Has the financial position (assets, liabilities and shareholders equity) of the company changed? If yes, this is a business transaction and must be recorded.
Where two or more parties engage in an exchange of goods or services for some form of consideration, a business transaction has taken place. Evidence of this happening is the receipt or some form of a source document. Common examples of source documents include:
– Sales receipt
– Purchase invoice
– Debit/credit memorandum
– Copy of a contract entered into
– Cancelled cheque
– Billing statement
– Correspondence containing other financial information
There are a multitude of source documents, varying in type and format used to record significant data. It is these which become the basis for data input to the accounting process.
Stage 2. Journalise the Transactions
After transactions are classified they are then entered in the books of original entry (also called Journals). The Journals or books of original entry give a chronological (day-to-day) record of business transactions. Examples of books of original entries are:
- Sales Journal (Sales Day Book) – Used to record credit sales
- Purchases Journal (Purchases Day Book) – Used to record credit purchases
- Return Inward journal – Used to record sales returns
- Return Outwards Journal – Used to record purchases returns
- Petty Cashbook – Used to record small purchases and other payment that you do not want crowding the cashbook.
- Cashbook – Used to record cash transactions (sales or purchases)
- The Journal or General Journal – This is a chronological (day-to-day) record of business transactions. For each transaction the journal shows the debit and credit effects on specific accounts. The contributions of journal to the recording process are:
It discloses in one place the complete effect of a transaction
- It provides chronological record of transactions
- It helps to prevent or locate errors since the debit and credit amounts of each entry can be readily compared
Stage 3. Posting to Ledger Accounts
Posting involves transferring debits and credits from the journals to the ledger accounts. Double entry (where entries are divided into debits and credits) is the method of recording transactions, which allows a check on accuracy of the recording. This system is based on the concept that business can be described by a number of variables or accounts, each describing an aspect of business in monetary terms. Each transaction has a ‘dual effect’. Double entry bookkeeping is governed by the accounting equation. At any time the following must be true:
Asset = liabilities + capital
A = L + C
Stage 4. Prepare a Trial Balance
A Trial Balance is a list of all debits and credits in the ledger accounts and their balances at any given time.
The Primary purpose of the trial balance is:-
1. To prove the mathematical accuracy of the debit and credit posting
2. Uncover errors in journalising and posting
3. In addition, it is useful in the preparation of financial statements
Limitations of the Trial Balance
There are numerous errors that may exist in a trial balance, whereby both sides still balance despite this.
Stage 5. Adjusting entries
Adjusting entries are made at the end of the accounting period to ensure that revenues are reported when earned and expenses are reported when incurred. Every adjusting entry involves the recognition of either revenue or expenses. Revenue and expenses represent changes in owner’s equity. However, owner’s equity cannot change by itself, there must also be a corresponding change in either assets or liabilities (as per accounting equation noted above). Thus every adjusting entry affects both the Income Statement account (revenue or expense) and the Balance Sheet account (asset or liability). Rarely if ever do adjusting entries include an entry to cash. Adjusting entries are based on the concept of accrual accounting.
Stage 6. Adjusted Trial Balance
This is prepared after all adjusting entries have been journalised, posted and the affected accounts balanced. It shows the balance of all the accounts, including those that have been adjusted at the end of the accounting period. Its purpose is to prove equality of total debit and credit balances.
Stage 7. The Financial Statements
The financial statements can be prepared directly from the adjusted trial balance. They are used to report the financial position of the business. Financial Statements include: –
- The Balance Sheet
- Retained Earnings Statement
- Income Statement
- Cash flow Statement
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Stage 8. Making Closing Entries
Here the balances of the temporary (nominal) accounts are brought to zero. These are the temporary owners equity accounts, revenue, expenses and withdrawals – these accounts only accumulate data for one year at a time.
A. Revenue accounts – closed into Income Summary account
B. Expense accounts – closed into profit and loss
C. Drawing account – closed into Owner Capital account
Stage 9. Prepare Post-Closing Trial Balance
After all the temporary accounts have been closed, then the focus is turned to the real accounts and these include assets, liabilities and capital accounts. These balances remain open. The preparation of a post closing trial balance is to prove that debits and credits are equal after closing the ledger.
Stage 10. Reversing entries
The reversing entries are made at the beginning of the next accounting period and is the exact opposite of adjusting entries made in the previous period.
a. It is the last step done after closing entries but dated the first day of the next accounting year
b. It reverses/nullifies the Adjusting entries for Accruals and Accrued Revenue
c. Its purpose is a self-correcting mechanism for the next/new accounting year
Accounting is not an area to be feared and you do not have to understand all of it but especially when you run your own business it is good to have some idea.
I will be posting more articles about this topic in the future so please feel free to check back later.