Financial Accounting - Accounting Cycle

 

FINANCIAL ACCOUNTING

Accounting Cycle

 

Introduction

Accounting cycle refers to the sequence of accounting activities (i.e. a series of accounting activities performed in a sequential order) undertaken in an organisation during a specific accounting period in order to ascertain the cumulative effect of all the transactions, occurred throughout the same accounting period, in the form of profit or loss (surplus or deficiency in the case of non-profit organisations) made / suffered during the period and in the form of increase or decrease in the value of assets and liabilities including cash and bank balances during the same accounting period.

 

The accounting activities in the most standard sequential order can be given as follows:

 

A. Regular day-to-day activities:

1. Identification of transactions,

2. Preparation of accounting vouchers,

3. Journalising,

4. Ledger posting,

 

B. Year-end / Period-end activities:

5. Balancing of ledger accounts,

6. Preparation of trial balance,

7. Passing of adjustment journal entries,

8. Preparation of final accounts,

9. Preparation of cash flow statement, and

10.    Preparation of report of all the accounting results pertaining to the accounting period.

 

Identification of transactions

A transaction is a particular type of event with respect to a business unit which can be expressed in terms of money and which brings change in the financial position of the business unit. (Financial position here implies the status of the assets, liabilities, and owners’ equity of an organisation, as reflected in its balance sheet. It is also known as financial condition.) A transaction involves transfer of something of value between two or more entities. In other words, in every transaction, there is a movement of value from one entity to another. Here are some examples of transactions:

 

1.       Mr. Devendra Munot started business with capital (brought in cash) Rs 5, 00,000

2.       Purchased machinery for Rs 1, 50,000

3.       Purchased materials for Rs 50,000

4.       Paid salaries Rs 20,000

5.       Paid carriage inward Rs 5,000

6.       Paid carriage outward Rs 7,000

7.       Paid electricity bill Rs 4,000

8.       Paid telephone bill Rs 1,200

9.       Paid insurance premium Rs 1,800

10.    Sold goods for Rs 1, 50,000

11.    Purchased goods from Mr. Anil Dave for Rs 40,000

12.    Paid rent Rs 15,000

 

Preparation of accounting vouchers

Accounting vouchers are the written documents containing the analysis of the business transactions for accounting and recording purpose. These are documentary evidence in support of transactions. Features of accounting vouchers are as follows:

1. It is a written document.

2. It is prepared on the basis of evidence of the transaction.

3. It contains an analysis with respect to which account is to be debited and which is to be credited.

4. It is prepared by an accountant and countersigned by the authorised signatory.

 

Classification of accounting vouchers

Primarily, accounting vouchers may be classified as cash vouchers and non-cash vouchers. Cash vouchers may again be classified as debit vouchers and credit vouchers.

 

Debit vouchers (also called payment vouchers)

These vouchers are prepared for recording of transactions involving cash payments only. Cash payments in the business are made on account of –

i.         Revenue expenses like salaries, wages, commission, etc. paid in cash,

ii.        Cash purchases of goods,

iii.      Cash purchases of assets,

iv.      Payment to creditors,

v.       Repayment of loans,

vi.      Drawings of cash by proprietors,

vii.    Advances to suppliers and employees, etc.

 

In all cash payments, one aspect is cash and the other is either

a)       The party to whom the payment is made, or

b)       An expense, or

c)       An item of property/fixed asset for which the payment is made.

 

                           A format of debit voucher may be as follows:

FIRM’S NAME
DEBIT VOUCHER
Voucher No.:                                                                   Date:
Debit Account
SL. No.	Account name	Amount (Rs)	Narration (Explanation)
Authorised by:                                  Prepared by:

 

Credit vouchers (also called receipt vouchers)

These vouchers are prepared for recording of transactions involving cash receipts only. Cash receipts in the business are accepted on account of –

i.         Cash sales of goods,

ii.        Cash sales of assets,

iii.      Revenue incomes like interest, rent, etc. received in cash,

iv.      Cash receipts from debtors,

v.       Loans taken,

vi.      Cash withdrawn from bank,

vii.    Receipts of advances, etc.

 

In all cash receipts, one aspect is cash and the other is either

a)       The party from whom cash is received, or

b)       An income, or

c)       An item of property/fixed asset on sale of which cash is received.

 

                       A format of credit voucher may be as follows:

FIRM’S NAME
CREDIT VOUCHER
Voucher No.:                                                                  Date:
Debit Account:
Amount:
Credit Account
SL. No.	Account name	Amount (Rs)	Narration (Explanation)
Authorised by:                                 Prepared by:

 

Non-cash vouchers (also called transfer/adjustment vouchers)

These vouchers are prepared for recording of all non-cash transactions of the business involving –

i.         Credit purchases of goods,

ii.        Credit purchases of assets,

iii.      Credit sales of goods,

iv.      Credit sales of assets,

v.       Return of goods sold,

vi.      Return of goods purchased,

vii.    Depreciation of fixed assets,

viii.   Bad debts, etc.

 

A format of non-cash voucher may be as follows:

FIRM’S NAME
NON-CASH VOUCHER
Voucher No.:                                                            Date:
Amount:
Debit Account
SL. No.	Account name	Amount (Rs)	Narration (Explanation)
Credit Account
SL. No.	Account name	Amount (Rs)	Narration (Explanation)
Authorised by:                                Prepared by:

 

 

Journalising

Journalising is the process of accounting through which the transactions of a business unit are recorded in the journal books from the vouchers. A journal book is also known as a day book or a book of original/prime entry or a subsidiary book. A medium size business enterprise generally maintains the following types of journal books:

1. Cash book – to record all cash transactions;

2. Sales day book – to record credit sales of goods;

3. Purchases day book – to record credit purchases of goods;

4. Sales return day book – to record sales returns of goods;

5. Purchases return day book – to record purchases returns of goods;

6. Bills receivable day book – to record bills receivable;

7. Bills payable day book – to record bills payable;

8. Petty cash book – to record petty cash payments; and

9. Journal proper (also known as “General journal”) – to record all such transactions which cannot be recorded in any of the above eight journal books, e.g. credit purchases of fixed assets, credit sales of old and obsolete fixed assets, credit purchases of stationery, depreciation of fixed asset, etc. Journal proper is also used for making opening entries, closing entries, transfer entries, adjustment entries and rectification entries.

 

Important definitions

Goods:  Goods are those things which are purchased for sale in course of regular business operation as the main business activity in order to earn revenue on continuous basis. Goods are also referred to as items forming part of the stock-in-trade of a business unit.

Fixed Assets: Fixed assets are those things which are purchased for use in the business in order to facilitate carrying out of the regular business operation efficiently and effectively. Although assets are not purchased for sale, they may be sold when they are old and obsolete. As per AS − 10 “Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.”

 

             Standard format of sales day book

Sales day book

Date	Particulars	Outward Invoice No.	L.F.	Details (Rs)	Amount (Rs)
				×××	×××
				×××	×××
				×××	×××
				×××	×××
	TOTAL				×××

   L.F. = Ledger Folio

 

             Standard format of purchases day book

Purchases day book

Date	Particulars	Inward Invoice No.	L.F.	Details (Rs)	Amount (Rs)
				×××	×××
				×××	×××
				×××	×××
				×××	×××
	TOTAL				×××

 

               Standard format of sales return day book

Sales return day book

Date	Particulars	Credit Note No.	L.F.	Amount (Rs)	Remarks
				×××
				×××
				×××
				×××
	TOTAL			×××

 

                  Standard format of purchases return day book

Purchases return day book

Date	Particulars	Debit Note No.	L.F.	Amount (Rs)	Remarks
				×××
				×××
				×××
	TOTAL			×××

 

                Standard format of journal proper

Journal proper

Date	Particulars	L.F.	Debit (Rs)	Credit (Rs)

 

Ledger posting

Ledger posting is the process of accounting through which entries are made into the individual ledger accounts in the different ledger books from the different journal books. A ledger book is also known as a principal book. Most of the business organisations usually maintain the following three types of ledger books:

1. Debtors’ ledger: It is also known as sales ledger. It contains the personal accounts of all those to whom goods have been sold on credit (separate accounts are opened and maintained for each separate customer). The total of the balances of all the customers’ accounts will give “sundry debtors” for the trial balance and the balance sheet.

2. Creditors’ ledger: It is also known as purchases ledger. It contains the personal accounts of all those from whom goods have been purchased on credit (separate accounts are opened and maintained for each separate supplier). The total of the balances of all the suppliers’ accounts will give “sundry creditors” for the trial balance and the balance sheet.

 

3. General ledger: All the accounts other than the individual debtors’ accounts and individual creditors’ accounts are opened and maintained in this ledger book. For example, all the real accounts such as land, building, plant, machinery, furniture, motor vehicles, office equipments, cash, etc. are opened in the general ledger. Similarly, all the nominal accounts such as sales, purchases, sales returns, purchases returns, salaries, wages, rent, rates, taxes, insurance premium, carriage, discount allowed/received, commission allowed/received, bad debts, depreciation, etc. are opened in the general ledger. Capital account and drawings account of the proprietor and the bank account are also opened in the general ledger.

 

Standard format of a ledger account

Dr                                        Title of account                                                    Cr

Date	Particulars	J.F.	Rs	Date	Particulars	J.F.	Rs

    J.F. = Journal Folio

 

 

Important notes regarding ledger posting

JOURNAL BOOK	LEDGER BOOK
Sales day book	Posting to individual debtor’s account is made on the same day when the transaction takes place, for the amount of the transaction.
	Posting to the sales account is made at the end of each month, with the amount of total credit sales for the same month.
Purchases day book	Posting to individual creditor’s account is made on the same day when the transaction takes place, for the amount of the transaction.
	Posting to the purchases account is made at the end of each month, with the amount of total credit purchases for the same month.
Sales return day book	Posting to individual debtor’s account is made on the same day when the transaction takes place, for the amount of the transaction.
	Posting to the sales returns account is made at the end of each month, with the amount of total sales returns for the same month.
Purchases return day book	Posting to individual creditor’s account is made on the same day when the transaction takes place, for the amount of the transaction.
	Posting to the purchases returns account is made at the end of each month, with the amount of total purchases returns for the same month.

 

Ledger postings from all the other journal books to all the respective ledger accounts in the different ledger books are made on the same day when the transactions take place, for the relevant amount of the transactions.

 

Balancing of ledger accounts

Balancing is the process of identifying the difference between the total of the two sides of a ledger account at the end of the accounting period and putting the amount of difference on the shorter side of the account. If the total of the debit side of an account is greater than the total of the credit side of the account, the balance is called debit balance, whereas, if the total of the credit side of an account is greater than the total of the debit side of the account, the balance is called credit balance.

 

Preparation of trial balance

A trial balance is a five-column schedule listing the names and balances of all the accounts in the ledger and cash book. The listing is usually done in the order in which they appear in the ledger. Last two columns are used for listing the balances of different accounts. The debit balances are listed in the left-hand column and the credit balances in the right-hand column. The total of the two columns should agree. A format of trial balance may be as follows:

 

Trial Balance of........................................... as on......................

Sl. No.	Heads of Account	L.F.	Debit (Rs)	Credit (Cr)
	Total

 

Important notes regarding trial balance

1. If all transactions are correctly recorded in the ledger accounts and if the balances of the ledger accounts have also been computed correctly, the debit and credit columns of the trial balance should agree.

2. The trial balance is not part of the ledger. It is a statement of debit and credit balances in the ledger at a particular date.

3. A trial balance ensures the arithmetical accuracy in maintaining the books of account (i.e. in journalising, ledger posting and balancing of ledger accounts).

4. Errors of principle, errors of complete omission and compensating errors are not revealed by the trial balance.

5. The trial balance facilitates the preparation of final accounts (i.e. trading account, profit and loss account and the balance sheet) at the end of the accounting year.

 

Passing of adjustment journal entries

After the trial balance is prepared some adjustment journal entries may be required to be passed before the final accounts are prepared -

1.   For recording those transactions which have not been entered into the books of account due to mistake or inadvertence or some unavoidable reasons;

2.   For rectifying some mistakes/errors which might have cropped up any time during the accounting year but have come to light only after the trial balance is prepared; and

3.   For making closing entries in order to prepare the final accounts at the end of the accounting year.