The accounting cycle is a step by step process of collecting, summarizing, recording, and presenting financial information. The Accounting process can be divided into 6 sub-processes as follows:
We’ll discuss all these processes in detail in this section for better understanding.
Process -1: Recording transactions through Journal Entries
Before explaining Journal Entries, we need to understand the concept of the Chart of Accounts.
Chart of Accounts
Chart of Accounts is a list of all general ledger accounts being used by a Company. The purpose of maintaining a chart of accounts is to keep things organized by specifying an account for each type of transaction and to avoid misclassifications while posting general entries.
In order to keep things simple, a predefined numbering scheme is used to differentiate between different categories of accounts. The most commonly used numbering scheme use prefix 1 for assets, 2 for liabilities, 3 for equity, 4 for incomes, and 5 for expenses. An example of a simple chart of accounts is as follows.
Account Number | Account Description |
---|---|
1010001 | Cash in hand |
1010002 | Cash at bank |
1020001 | Accounts Receivable |
1030001 | Fixed Assets |
2010001 | Accounts Payable |
2020001 | Short term running finance |
3010001 | Share Capital |
3020001 | Accumulated profit/Loss |
4010001 | Sale Revenue |
4020001 | Other income |
5010001 | Cost of goods sold |
5020001 | Salaries and wages |
5020002 | Utilities |
5030001 | Marketing Expenses |
Above is a simplified example. In practice, the chart of accounts would contain a lot of other accounts as well which will keep on adding as per defined numbering criteria.
Journal Entry
A journal entry is the set of information needed to document a business transaction. The minimum information required for a complete journal entry is as follows:
- Date of transaction
- Ledger accounts related to the transaction
- Account to be debited or credited
- Value of the transaction
Depending on the accounting system used, many additional facts can also be stored other than the basic details.
Journal entries under accrual and cash basis of accounting
As explained earlier, there are two bases for the recording of accounting transactions i.e. cash basis and accrual basis of accounting.
Under the cash basis, transactions are recorded as and when related cash flow occurs i.e. revenues are recorded when the amount is received while expenses are recorded when related amounts are actually paid.
While under an accrual basis, transactions are recorded at the time of occurrence in line with accrual concept. i.e. revenue is recorded at the time of sale of goods or rendering of services whether or not related amounts have been received. Similarly, expenses are recorded at the time when those are incurred irrespective of when they would be paid.
The example below explains the difference of accounting entries under the two accounting systems:
Comprehensive Example:
Consider the following transactions. We’ll use these as a continued example for explaining
1. | Jan1st: | Capital injected by shareholder–$800,000 |
2. | Jan5th: | Plant and machinery obtained through financing from bank – $700,000 |
3. | Jan10th: | Paid factory rent for two months – $ 50,000 |
4. | Jan10th: | Raw material purchased – $300,000 (50% on cash, 50% on credit) |
5. | Jan20th: | Sales made on credit basis – $ 450,000 |
6. | Jan25th: | Sales made on cash basis – $ 300,000 |
7. | Jan29th: | Amount recovered from credit customers – $ 350,000 |
8. | Jan30th: | Paid employees’ salaries – $60,000 |
9. | Jan30th: | Estimate of electricity bill for January – $ 55,000 (not paid yet) |
Now let’s post these transactions in the Journal.
Business ABC Journal For the month of January 2016 | ||||
---|---|---|---|---|
S.No | Date | Account Description | Debit | Credit |
1 | 1-Jan-16 | Bank Account | 800,000 | |
Share Capital | 800,000 | |||
(Capital injected by shareholder) | ||||
2 | 5-Jan-16 | Plant & Machinery | 700,000 | |
Long Term Loan | 700,000 | |||
(Purchase of plant and machinery through financing from bank) | ||||
3 | 10-Jan-16 | Prepaid Rent | 50,000 | |
Bank Account | 50,000 | |||
(Payment of factory rent for two months) | ||||
4 | 10-Jan-16 | Raw Material Inventory | 300,000 | |
Accounts Payable | 150,000 | |||
(Purchase of raw material) (50% on cash basis, 50% on credit basis) |
||||
5 | 20-Jan-16 | Accounts Receivable | 450,000 | |
Sales | 450,000 | |||
(Sale of goods on credit terms) | ||||
6 | 25-Jan-16 | Bank Account | 300,000 | |
Sales | 300,000 | |||
(Sale of goods on cash basis) | ||||
7 | 29-Jan-16 | Bank Account | 350,000 | |
Accounts Receivable | 350,000 | |||
(Recovery of amount from credit customers) | ||||
8 | 29-Jan-16 | Salaries expense | 60,000 | |
Bank Account | 60,000 | |||
(Payment of employees’ salaries) | ||||
9 | 30-Jan-16 | Electricity expense | 55,000 | |
Accrued Expenses | 55,000 | |||
(Booking of accrual for electricity expense) |
Compound Journal Entry
When two transactions of the same nature happen on the same date we can record a compound journal entry for both transactions as in case of entry number 4 in the table above. However, while posting compound entries it should be taken care of that the total of Debit and Credit columns is equal.
Process-2: Posting Journal Entries to General Ledger
General Ledger is the consolidated picture of all transactions related to a particular account head whether it is an asset, liability, equity, income or expense account.. A general ledger contains the following information:
- Date of transaction
- Folio number (reference to the accounting entry contained in Journal)
- Description of transaction
- Amount of transaction and it impact (Debit or Credit)
- Account balance after each transaction
A sample general ledger is shown below for reference:
Why general ledgers are prepared:
All accounting entries are chronologically recorded in the Journal and it is very difficult to extract and summarize in one place all the transactions pertaining to a specific head of account. To solve this problem, general ledgers are prepared for all accounts and all accounting entries are first entered in the Journal and are then posted to respective ledger account. As a result, we get a consolidated picture of transactions pertaining to a specific account head.
Continued Example:
General ledger of Bank Account based on our continued example would be as follows:
Business ABC Bank Account Ledger For the month of January 2016 |
|||||
---|---|---|---|---|---|
Date | Folio NO. | Description | Debit ($) | Credit ($) | Balance ($) |
Opening Balance | Debit 0 | ||||
1-Jan-16 | 1 | Capital injection by shareholder | 800,000 | Debit 800,000 | |
10-Jan-16 | 3 | Payment of factory rent | 50,000 | Debit 750,000 | |
20-Jan-16 | 4 | Purchase of raw material inventory | 150,000 | Debit 600,000 | |
25-Jan-16 | 6 | Sale of goods on cash basis | 300,000 | Debit 900,000 | |
29-Jan-16 | 7 | Recovery from credit customers | 350,000 | Debit 1,250,000 | |
29-Jan-16 | 8 | Payment of employees’ salaries | 60,000 | Debit 1,190,000 | |
Closing Balance | Debit 1,190,000 |
T accounts
T – Account is an alternate format of presenting the general ledger in which ledger is maintained in a T shaped format with debit and credit transactions separated on either side of the T. It is popular among accounting staff due to the ease of understandability.
Following steps must be considered while preparing ledger in T-Accounts format:
- Opening balance of ledger account is mentioned on left side in case of debit nature accounts (i.e. Assets and Expenses) or on the right side in case of Credit nature accounts (i.e. Equity, Liabilities)
- All Debit transactions are recorded on the left side of T partition
- All Credit transactions are recorded on the right side of T partition
- Closing balance is calculated by adding the net of debit and credit transactions to opening balance and is written on the opposite side to the one where opening balance was written. Alternatively, closing balance can also be calculated as the balancing figure on the respective side.
Below is the Bank Account Ledger in T Format based on data of example discussed earlier:
Business ABC Bank Account Ledger (T-Account) For the month of January 2016 |
|||||||
---|---|---|---|---|---|---|---|
Date | Folio NO. | Description | Amount | Date | Folio NO. | Description | Amount |
Opening Balance | 0 | ||||||
Jan 1 | 1 | Capital injection by shareholder | 800,000 | Jan 10 | 3 | Payment of factory rent | 50,000 |
Jan 25 | 6 | Sale of goods on cash basis | 300,000 | Jan 20 | 4 | Purchase of raw material | 150,000 |
Jan 29 | 7 | Recovery from credit customers | 350,000 | Jan 29 | 8 | Payment of employees’ salaries | 60,000 |
Closing Balance | 1,190,000 | ||||||
1,450,000 | 1,450,000 |
Process 3: Preparing the Trial Balance
Trial Balance is a list of all general ledger accounts and their closing balances at a particular date. In order to prepare financial statements, we need closing balances of all accounts, an information which can be obtained from individual ledger accounts but it is always good to prepare trial balance which summarizes all account balances at one place.
We have discussed earlier that in double entry book keeping debit and credit amount in every accounting entry is equal. As a result the total of debit and credit columns of trial balance should be equal. If it is not equal then either there was an error in recording of accounting entries.
The trial balance prepared from ledger balances is also termed as “Unadjusted Trial Balance”. Management may need to incorporate certain adjusting entries in it before using it for preparation of financial statements. An example of trial balance based on our continuing example from above would be as follows:
Business ABC Trial Balance As at January 31, 2016 |
|||
---|---|---|---|
Account Description | Type | Debit | Credit |
Share Capital | Equity | 800,000 | |
Long Term Loan | Liability | 700,000 | |
Accounts Payable | Liability | 150,000 | |
Accrued expenses | Liability | 55,000 | |
Plant & Machinery | Asset | 700,000 | |
Raw Material Inventory | Asset | 300,000 | |
Accounts Receivable | Asset | 3100,000 | |
Bank Account | Asset | 1,190,000 | |
Prepaid rent | Asset | 50,000 | |
Sales | Income | 750,000 | |
Staff salaries | Expense | 60,000 | |
Electricity expense | Expense | 55,000 | |
2,455,000 | 2,455,000 |
Note: The ‘type’ column is not part of trial balance rather it has been inserted here just for understanding purpose.
Process 4: Year/Period-end adjustments
Companies most often need to make some closing adjustments at year end or whenever they want to prepare financial statements. These may include following items:
Accruals |
As discussed earlier that under accrual basis of accounting, a business needs to recognize earned income whether or not received and to recognize expenses incurred whether or not paid. If business has not already recognized all accrued income or expenses as required under accrual concept then it must incorporate adjusting entries to that effect. Example:
Utilities expense (Debit) xxxx
Accrued receivable (Debit) xxxx |
Adjustments of prepaid expenses/ income |
Businesses do sometime make prepayments for expenses which might need to be adjusted at period end for the period expired. On the other hand a business may have received advance money against services which might need adjustment at period end. |
Non–cash items |
Other non-cash items may also require adjustments. Prime examples of such entries are depreciation and provision for doubtful debts. |
Incorporating above adjustments would give us the Adjusted Trial Balance which then can be used for preparing financial statements.
ContinuedExample:
We have already accrued electricity expense so let’s move on to other adjustments such as prepayments, depreciation and provisions. Assume following adjustments:
- Adjustment of prepaid rent for one month i.e. $ 25,000
- Adjustment for depreciation expense (assuming useful life of 5 years i.e. depreciation rate of 20%) (Depreciation for one month would be = Rs 700,000 x 20% x 1/12 = 11,667)
- Recognize a provision for doubtful receivables at the rate of 10% of outstanding receivables (i.e. $ 100,000) Provision for doubtful receivables would be = $ 100,000 x 10% = 10,000)
- Incorporate entry for recording consumption of raw material during the period. Consider that there is no closing inventory of raw material or finished goods and all items produced have been sold during the period.
Accounting entries for above adjustments would be as follows:
Business ABC |
||||
S. No |
Date |
Account Description |
Debit |
Credit |
1 |
31-Jan-16 |
Rent Expense |
25,000 |
|
|
|
Prepaid Rent |
|
25,000 |
|
|
|
|
|
|
|
(Adjustment of one month rent in prepaid rent account) |
|
|
2 |
31-Jan-16 |
Depreciation expense |
11,667 |
|
|
|
Accumulated Depreciation |
|
11,667 |
|
|
|
|
|
|
|
(Purchase of plant and machinery through financing from bank) |
|
|
3 |
31-Jan-16 |
Provisions A/c |
10,000 |
|
|
|
Provision against doubtful debts |
|
10,000 |
|
|
|
|
|
|
|
(Payment of factory rent for two months) |
|
|
4 |
31-Jan-16 |
Cost of Goods Sold |
300,000 |
|
|
|
Raw material inventory |
|
300,000 |
|
|
|
|
|
|
|
(Consumption of raw material inventory) |
|
|
The adjusted trial balance would be as follows:
Business ABC |
|||
Account Description |
Type |
Debit |
Credit |
Share Capital |
Equity |
|
800,000 |
Long Term Loan |
Liability |
|
700,000 |
Accounts Payable |
Liability |
|
150,000 |
Accrued expenses |
Liability |
|
55,000 |
Plant & Machinery |
Asset |
700,000 |
|
Accumulated Depreciation |
Provision |
|
11,667 |
Raw Material Inventory* |
Asset |
0 |
|
Accounts Receivable |
Asset |
100,000 |
|
Provision against doubtful receivables |
Provision |
|
10,000 |
Bank Account |
Asset |
1,190,000 |
|
Prepaid rent ** |
Asset |
25,000 |
|
Sales |
Income |
|
750,000 |
Staff salaries |
Expense |
60,000 |
|
Electricity expense |
Expense |
55,000 |
|
Rent expense |
Expense |
25,000 |
|
Depreciation expense |
Expense |
11,667 |
|
Provisions |
Expense |
10,000 |
|
Cost of goods sold |
Expense |
300,000 |
|
2,476,667 |
2,476,667 |
* Raw material inventory = 300,000 – 300,000 = NIL
** Prepaid Rent = 50,000 – 25,000 = 25,000
Process 5: Preparing financial statements
The next step in accounting cycle after incorporating the adjusting entries in trial balance is the preparation of financial statements. A complete set of financial statements includes:
- Balance Sheet
- Profit & Loss Account
- Cash flow statement
- Statement of changes in Equity
- Notes to the accounts
We will prepare the first 2 items i.e. Balance Sheet and Profit & Loss Account using the data from above.
Profit & Loss Account:
Profit & Loss Account summarizes the operational performance of a business over a period as it incorporates all “Income” and “Expense” nature accounts from adjusted trial balance. An example of profit & loss account based on above data is as follows:
BUSINESS ABC |
|
Profit & Loss Account |
|
For the month ended January 31, 2016 |
|
$ |
|
Sales |
750,000 |
Less: Cost of Goods Sold |
300,000 |
Gross Profit |
450,000 |
Less: Expenses |
|
Staff salaries |
60,000 |
Electricity expense |
55,000 |
Rent expense |
25,000 |
Depreciation expense |
11,667 |
Provisions (for doubtful receivables) |
10,000 |
161,667 |
|
Profit for the period |
288,333 |
Balance Sheet:
Balance Sheet shows the financial position of a business at a particular date as it incorporates all “Equity”, Liability” and “Asset” nature accounts from adjusted trial balance.
Balance sheet can be presented in two formats based on the accounting equation:
Format#1 Assets = Equity + Liabilities
Under this format, Equity and Liabilities are shown on one side while Assets are shown on the other side in a way that both sides are equal.
Format#2 Equity = Assets -Liabilities
Under this format, Equity is shown as net of assets and liabilities.
Examples of both formats are given below.
BUSINESS ABC |
||||||
$ |
$ |
|||||
EQUITY |
ASSETS |
|||||
Share Capital |
800,000 |
Plant & Machinery |
700,000 |
|||
Retained earnings |
288,333 |
Less:Accumulated dep. |
(11,667) |
688,333 |
||
1,088,333 |
||||||
AccountsReceivable |
100,000 |
|||||
LIABILITIES |
Less:Provision against doubtfulreceivables |
|||||
Long Term Loan |
700,000 |
(10,000) |
90,000 |
|||
Accounts Payable |
150,000 |
|||||
Accrued expenses |
55,000 |
Prepaid Rent |
25,000 |
|||
905,000 |
Cash at bank |
1,190,000 |
||||
|
||||||
1,993,333 |
1,993,333 |
BUSINESS ABC |
||
$ |
||
ASSETS |
||
Plant & Machinery |
700,000 |
|
Less: Accumulated Depreciation |
(11,667) |
688,333 |
Accounts Receivable |
100,000 |
|
Less: Provision against doubtful receivables |
(10,000) |
90,000 |
Prepaid Rent |
25,000 |
|
Cash at bank |
1,190,000 |
|
1,993,333 |
||
Less: LIABILITIES |
||
Long Term Loan |
700,000 |
|
Accounts Payable |
150,000 |
|
Accrued expenses |
55,000 |
|
905,000 |
||
NET ASSETS |
1,088,333 |
|
Share Capital |
800,000 |
|
Retained earnings |
288,333 |
|
1,088,333 |
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