The Financial Accounting Cycle

The Financial Accounting Cycle

1. Analysis of Business Transactions

  • Definition: This step involves examining what transactions have occurred in a business.

    • Key Questions:

    • What happened?

    • Which accounts are affected?

    • How is the accounting equation affected?

  • Source Documents:

    • These are documents that provide information about a business transaction and initiate the accounting process.

    • Examples: Purchase invoices, sales invoices, cheque stubs, cash register tapes, and corporate minutes' book.

    • Purpose: Source documents serve as objective evidence of transactions and can verify the accuracy of accounting records. They are typically filed for future reference.

2. Journalizing Business Transactions

  • Definition: The process of entering transactions into a journal.

  • Journal Entry Components:

    • Date of transaction.

    • Title of each affected account.

    • Amounts involved.

  • Types of Journals:

    • Special or Subsidiary Journals: Used for specific types of transactions.

    • Sales Journal: For credit sales.

    • Purchases Journal: For credit purchases.

    • Cash Book: For recording all cash receipts and payments.

    • General Journal: Used for transactions not recorded in special journals. Each entry is followed by a narration, describing the transaction briefly.

3. Posting Transactions to Ledger Accounts

  • Definition: Posting is the process of transferring debits and credits from the journal to the corresponding ledger accounts.

  • Ledger Types:

    • Corresponding special ledgers may exist for special journals and are supplemented by a General Ledger (GL).

    • Control Account: A summary account in the GL that aggregates data from subsidiary ledgers (e.g., Sales Ledger Control Account).

4. Trial Balance

  • Definition: A trial balance is a list of all accounts and their balances extracted from the ledgers.

  • Functions:

    • Checks the arithmetical accuracy of ledger postings.

    • Assists in preparing financial statements.

  • Note: The trial balance (TB) is an internal document, not a formal statement.

5. Closing Process

  • Objective: The closing entries reduce all nominal or temporary accounts to zero balances:

    • Steps:

    1. Close all revenue accounts to the Income Summary.

    2. Close all expense accounts to the Income Summary.

    3. Close the Income Summary to the Owner’s Equity Account.

    4. Close drawings to the Owner’s Equity/Capital Account.

6. Post-Closing Trial Balance

  • Definition: This provides a listing of all real/permanent accounts after closing entries have been made.

  • Purpose:

    • Ensures that total debits equal total credits before the new accounting period begins.

    • Composed solely of balance sheet accounts.

Adjustments

  • Rationale: The trial balance may exclude certain revenue and expense transactions that were omitted during the accounting period.

  • Accrual Accounting: Requires adjusting entries at period end to update accounts related to revenues and expenses.

    • These adjustments adhere to the realization and matching principles.

  • Every Adjusting Entry:

    • Involves recognition of revenue or expenses.

    • Affects both the income statement (revenue and expenses) and the balance sheet (assets and liabilities).

Types of Adjusting Entries

  1. Prepaid Expenses:

    • Definition: Advance payments for expenses not yet incurred.

    • Examples: Rent, insurance, electricity.

    • Journal Entries:

      • At Payment: Debit Prepaid Expense Account and Credit Cash.

      • When Expense Incurred: Debit Expense Account and Credit Prepaid Expense.

    • Balance Sheet Treatment: Prepaid expenses are classified as current assets.

  2. Prepaid Revenue (Unearned/Deferred Revenue):

    • Definition: Cash collected in advance for services to be performed in future accounting periods.

    • Journal Entries:

      • When Cash Received: Debit Cash and Credit Unearned Revenue.

      • When Income Earned: Debit Unearned Revenue and Credit Revenue Earned.

    • Balance Sheet Treatment: Shown among current liabilities.

  3. Accrued Expenses:

    • Definition: Amounts due for expenses incurred but not yet paid by the end of the accounting period.

    • Journal Entries: Debit Expense Account and Credit Expense Payable (e.g., Rent Payable).

    • Balance Sheet Treatment: Reflected as current liabilities.

  4. Accrued Revenue:

    • Definition: Revenue earned but not yet received or collected during the accounting period.

    • Journal Entries: Debit Accounts/Revenue Receivable Account and Credit Revenue Earned Account.

    • Balance Sheet Treatment: Recognized as a current asset.

  5. Depreciation:

    • Definition: The allocation of a fixed asset's cost over its economic useful life.

    • Causes: General wear and tear, technological changes, or obsolescence.

    • Notable Exception: Land is not subject to depreciation.

    • Purpose: To appropriately match revenues and expenses according to the accruals/matching concept.

    • Considerations:

      • Capitalized cost of the fixed asset.

      • Economic useful life of the asset.

      • Residual value of the asset (book value at the end of its useful life).

    • Physical vs. Economic Life:

      • Physical life relates to how long the asset remains intact.

      • Economic life defines how long the asset effectively aids in earning revenue, potentially impacted by technological advancements.

Methods of Depreciation

  • Common Method: Straight-line method.

    • Assumption: The fixed asset depreciates uniformly over its useful life.

Calculation:

  • Annual Depreciation: \text{Annual Depreciation} = \frac{\text{Depreciable Value}}{\text{Economic Useful Life}}

  • Depreciable Value: \text{Depreciable Value} = \text{Capitalized Cost of FA} - \text{Residual Value}

Example Calculation

  • Scenario: Black Ltd. purchases a motorcar for $750,000 on January 1, 20-; estimated useful life is 5 years and a residual value of $58,000.

    • Annual Depreciation Calculation:
      \text{Annual Depreciation} = \frac{750,000 - 58,000}{5} = 138,400

  • Journal Entry for Depreciation:

    • Debit: Depreciation Expense: Motor Car $138,400.

    • Credit: Accumulated Depreciation: Motor Car $138,400.

  • Financial Statement Treatment:

    • Depreciation expense appears in the income statement alongside other expenses.

    • Accumulated depreciation is reduced from the fixed asset's cost on the balance sheet, indicating it as a contra-asset account.

    • The difference between the asset cost and accumulated depreciation is called the net book value (NBV) or carrying value of the asset.

The Accountant Worksheet

  • Definition: A columnar form that consolidates all necessary information for adjusting entries and financial statement preparation.

  • Characteristics: Not a financial statement, and not formally part of the accounting system. Provides a tool during the accounting period-end.

  • Preparation Steps:

    1. Prepare the unadjusted trial balance.

    2. Make adjustments for accruals and deferrals.

    3. Prepare the adjusted trial balance.

    4. Extend adjusted balances to the income statement and balance sheet columns: revenues and expenses to the income statement; assets, liabilities, and capital accounts to the balance sheet.

    5. Complete the worksheet.

  • Final Figure: The balancing figure on the income statement indicates net income.

    • If total debits exceed total credits, this results in a net loss.

    • If total credits exceed total debits, this represents a net profit.

    • Transfer this net figure to the balance sheet, which should balance at this close of the accounting period.