accounting process
Accounting Process
Accounting is used for gaining quantitative information about the finances. The accounting process includes a sequence of activities that involve recording the income and expenditure of an organization. This Buzzle article will give you an overview of the accounting cycle and explain it with the help of an illustration.
"It sounds extraordinary, but it's a fact that balance sheets can make fascinating reading." Mary, Lady Archer
Every company has an accounts or finance department that looks after its accounting details. An accounting department is the backbone of every business. It records all the business transactions, and keeps a track of the incomes and expenses of the business. The accounting department also helps to determine the correct financial position and standing of the business. For a systematic and accurate recording of transactions, accounting is important.
The purpose of accounting is recording all the transactions honestly and accurately in the 'Books of Accounts'. The accounting process can be defined as "the process that begins when the transaction takes place and ends when the transaction is recorded in the books of accounts". It includes a series of steps that are used to analyze and record the business transactions for a particular period.
The accounting process, also known as the accounting cycle process, includes the steps mentioned below. In order to follow these steps, you will need to know about the accounting principles and concepts. Here is a diagram of the accounting cycle along with its explanation for facilitating easy understanding.
The first step in the accounting cycle involves identifying a transaction or event, and finding the source documents for it. Remember that the owners should not include personal transactions like expenses, loans, asset gains, investments, etc. in the business. Analyze which accounts a particular transaction is affecting and determine its amount. Business transactions may include buying supplies from vendors, selling goods to customers, payment of labor cost, salary of employees, etc. You will then have to prepare the source documents of the transaction like the invoice, purchase order, receipts, payment slips, etc. These source documents are also stored as a record of the transaction history.
You will have to then record the relevant entries in the journal, according to their nature. A journal is called the 'Book of Original Entry' because the transactions are recorded in a chronological order. Also, transactions are recorded in the journal using a double-entry system. An entry occurs in at least two accounts out of which one is debited and the other is credited. Sometimes special journals are used for transactions which take place frequently like purchases, sales, etc. The transactions which cannot be entered in special journals are recorded in the general journal.
The next step you will have to undertake is transferring the journal entries into the appropriate ledger accounts. It is also known as the 'Book of Final Entry'. These accounts are represented by T-accounts which mark the debits on the left and the credits on the right side. It is a collection of accounts, and contains the financial information of many accounts. This information is based on past transactions of these accounts and their current balances. Each transaction impacts the subsidiary ledgers and a collective sum is seen in the general ledger.
The next step is preparing a trial balance. It summaries the general ledger account balances showing debit and credit columns. It is created to ensure that the debit amount is equal to the credit amount. If any discrepancy is found in the amounts, it hints at an error in the posting of original transactions. Hence, it must be corrected immediately. It may so happen that you may have posted an entry or amount wrongly, and might have even forgotten to post an entry in the first place. You will have to identify and rectify the errors by making the correct entries. Even when the columns get balanced, there may be a possibility of an error. So you will have to check all the entries again.
You will have to then make adjusting entries in order to record the accrued and deferred amounts. These are additional adjusting entries which may not be generated directly through the source documents. This may include expenses or incomes which had taken place but were not recorded in the books. For example, depreciation expenses will have to be recorded periodically for items like equipment, business vehicles, etc. Such adjusting entries are also posted in the journal and the general ledger.
Next, prepare the adjusted trial balance on the basis of the addition and subtraction of the entries. This will help you to understand if the debits and credits are equal. This should be made before because it will form a basis for the financial statements. If you find any errors, correct them immediately.
Now that all your accounts are updated, trial balance is adjusted, and the debit and credit columns tally, you should prepare the financial statements. The financial statements will include an Income Statement (Statement of Financial Performance), Balance Sheet (Statement of Financial Position), Cash Flow Statement, Statement of Retained Earnings and Notes to Financial Statements.
This step includes closing of temporary accounts like expenses, revenues, dividend, gains, losses, owner's drawing accounts, etc. For this you will have to close the journal entries. These balances are then transferred to the retained earnings account or the income summary account. It is reflected in the appropriate capital account on the balance sheet. Thus, it leaves the accounts empty with a zero balance to enter the transactions for the new accounting period. Closing entries are only made for temporary accounts and not for permanent accounts or balance sheet accounts.
For the last step in the accounting cycle, you will have to prepare the post-closing trial balance or a final trial balance on the basis of the closing journal entries. It is undertaken to ensure that the debits and credits are equal. As the temporary accounts are already closed, it only contains the real or permanent accounts. You can then go ahead and correct errors, if you find any.
There can be a slight alteration in the above-mentioned process. Financial statements can be made before the adjusting entries. Also, some companies add another step after the final trial balance. It is known as the 'reversing entries' step. Reversing entries is undertaken if an accrual or deferral entry was recorded earlier and needs to be adjusted in order to avoid a double entry. It is recorded on the first day of the new financial period. All the accountants follow the same sequence, except in case of the reversing entries. This is an optional step which may or may not be followed. The process of accounting is framed, based on the basic accounting concepts and principles followed in the business world. Those who understand the importance of accounting follow these processes accurately.