The Accounting Process
The accounting process is made up of all the steps taken by a company in preparing its financial accounts for a period. As the accounting process is completed on a regular basis, for each reporting period, it is also often referred to as the accounting cycle. The process can be seen to be made up of a number of activities which are carried out for each transaction the company undertakes. In this case, a transaction is defined as anything which has a material effect on the assets, liabilities, income and expenses of a company. For example, the purchase of stock for cash is a transaction as it results in a reduction in the company’s level of cash and an increase in the level of inventory. Be aware that there can be misleading transactions, which do not have an effect on the company’s accounts. For example, taking cash from the bank to refill the petty cash reserve will not be counted as a transaction, as the total amount of cash does not change. It is important to be aware of these distinctions.
The major steps in the accounting process for each transaction are:
1. The transaction is identified, and verified as an accounting transaction as discussed above
2. All source documents associated with the transaction, including the original invoice and the receipt, need to be located and checked
3. The transaction needs to be analysed; the monetary value needs to be determined; and the affected accounts need to be identified. For example, if a company takes out a long term loan, the value of the loan needs to be debited to the cash account and credited to the long term debt account
4. The transaction then needs to be recorded in the journal accounts. The journal accounts record all information about a certain aspect of the business: there will be a journal for sales, purchases, cash, trade receivables, depreciation, long term debts and all other accounting data. Note that, under double entry bookkeeping conventions, conventions, each transaction must be recorded in two journals, hence the phrase double entry
5. The transaction is then posted to the general ledger, which includes all transactions in chronological order, together with the relevant amount and the journals to which is was debited and credited. This ledger forms a vital part of the audit and tracking process
Once the accounting period is over, the accounting process can be completed for that period. This involves ten further steps:
6. The trial balance needs to be prepared. The trial balance involves adding the transactions in all journal accounts and combining all the journal accounts to ensure that the total debit balance equals the total credit balance. Under double entry bookkeeping rules, ever transaction is recorded as a debit in one account and a credit in another, so if the total value of debits does not equal the total value of credits then some transactions have not been recorded correctly. However, it is important to note that even if the total value of debits and credits are equal, this does not mean the accounts are correct as some values may have been recorded incorrectly. For example, Enron recorded significant amounts of financial losses as long term debts taken on by its special purpose entities (a type of subsidiary). Therefore, whilst Enron’s trial balance showed no discrepancies, the accounts were not a fair representation of the company’s financial situation. Part of the auditor’s role is to check the trial balance and also check that transactions have been posted to the correct journals.
7. If there are any discrepancies in the trial balance, these need to be corrected. These errors can include incorrect addition, transactions being posted to the wrong column, transactions not being posted in two accounts, and the wrong amounts being posted. It is important for accounting students to understand how these errors can come about and how they can be resolved.
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8. Adjusting entries need to be made to the journals to record any cost accruals, deferred income, and estimations used in the accounts. This is part of the prudence concept, which requires companies to recognise costs as soon as they are likely to be incurred, even if the transaction has not taken place yet, and income only when it is certain, for example if a customer has paid for a product but may decide to return it in the next accounting period
9. These adjusting entries now need to be posted to the ledger accounts.
10. Prepare and correct the adjusted trial balance, which is the same as the trial balance but including any corrections and adjustments from steps 7 to 9.
11. The financial statements can then be prepared and the journals can be closed. As part of this, the financial statements need to be drawn up and the closing balances from the accounts transferred to the relevant part of the statement. For example, the closing balance of the cash journal needs to be entered into the balance sheet and the closing balance from the revenue account needs to be transferred to the income statement. The following accounts need to be prepared from the following journal accounts:
Income statement – all journals related to revenue, expenses, gains, and losses.
Statement of retained earnings – the total post tax profits less any dividends paid
Balance sheet – all journals related to assets, liabilities, and equity accounts as well as any earnings retained
Cash flow statement - derived from the cash journal and any other financial statements related to cash based transactions
12. The closing balances from the temporary accounts need to be transferred to a temporary income summary statement which will be used to prepare the retained earnings account. Temporary accounts include revenue, expenses and dividends paid, since these accounts will not carry over to the next year
13. The closing entries from all accounts need to be posted to the ledger accounts.
14. The after closing trial balance needs to be prepared, again making sure that debits and credits are equal. This is a key part of the audit process for the financial statements and again any errors need to be corrected.
15. Reversing entries should be prepared for any accruals or deferrals. Any accruals or deferrals that were including in the current period need to be reversed out in the following period to ensure that there is no double counting in the following period when the transaction actually occurs. For example, if a company has accrued £100 of electricity bills in its current financial statements, it will need to reverse this accrual in the following period. Otherwise, when the final electricity bill is paid, the £100 will be recorded twice, causing double counting.
An important part of producing the financial statements is a sound understanding of what constitutes a debit and a credit. This can be particularly confusing given that transactions must be recorded as debits and credits. A useful mnemonic for remembering the difference is:
GIRLS love CREDIT cards, but DEBIT cards are a better DEAL
Whilst this may not win you many female friends, it can help you to remember that:
Gains, Income, Revenue, Liabilities and Shareholder’s equity increase when credited
Dividends, Expenses, Assets and Losses increase when debited
Therefore sales of £200 are a debit to cash, which is an asset and increases, and a credit of £200 to sales which are revenue and also increase. Similarly, a purchase of £100 of stock would be a credit to cash, which decreases, and a debit to inventory, which is an asset and increases.