Module 2: Accounting Cycle .com



FINANCIAL REPORTING, STATEMENTS AND ANALYSISModule 2: Accounting CycleLearning Outcome: Identify various processes in accounting cycle leading to trial balanceAccounting ProcessBooks of AccountsJournalCash BookBank Reconciliation StatementPreparation of Trial BalanceThe AccountAn account is an individual accounting record of increases and decreases in a specific asset, liability, or owner’s equity item. For example, a company may have separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue, Salaries and Wages Expense, and so on. An account consists of three parts: (1) a title, (2) a left or debit side, and (3) a right or credit side. Because the format of an account resembles the letter T, it is referred a T-account. Debits and CreditsThe term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease, as is commonly thought. For example, the act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account.When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits.Debit and Credit ProcedureUnder the double-entry system, the dual (two-sided) effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions and also helps to ensure the accuracy of the recorded amounts as well as the detection of errors. If every transaction is recorded with equal debits and credits, the sum of all the debits to the accounts must equal the sum of all the credits.DR./CR. PROCEDURES FOR ASSETS AND LIABILITIESRevenues and Expenses- The purpose of earning revenues is to benefit the owner(s) of the business. When a company recognizes revenues, owner’s equity increases. Therefore, the effect of debits and credits on revenue accounts is the same as their effect on Owner’s Capital. That is, revenue accounts are increased by credits and decreased by debits.Expenses have the opposite effect. Expenses decrease owner’s equity. Since expenses decrease net income and revenues increase it, it is logical that the increase and decrease sides of expense accounts should be the opposite of revenue accounts. Thus, expense accounts are increased by debits and decreased by credits.Double Entry SystemThere are numerous transactions in a business concern. Each transaction, when closely analysed, reveals two aspects. One aspect will be “receiving aspect” or “incoming aspect” or “expenses/loss aspect”. This is termed as the “Debit aspect”. The other aspect will be “giving aspect” or “outgoing aspect” or “income/gain aspect”. This is termed as the “Credit aspect”. These two aspects namely “Debit aspect” and “Credit aspect” form the basis of Double Entry System. The double entry system is so named since it records both the aspects of a transaction.Classification of Accounts and Debit- Credit RulesClassificationCharacteristicsExamplesDebit-Credit RulesPersonal AccountAccounts of persons or firms with whom the firm enters into dealings. Personal accounts include both natural persons’ accounts and artificial persons’ accounts. Personal accounts may be ‘representative personal accounts’.Capital accounts (owner’s account), trade receivables (amount due from customers), trade creditors (amount due to suppliers), bank account and insurance companies’ account. Examples of representative personal accounts are outstanding expenses account, unexpired insurance account and interest received in advance account.Debit the receiver and credit the giver.Real AccountAccounts of properties under the control of the firm.Land, Building, Furniture and Fixtures, Stock, Goodwill and Trade Marks.Debit what comes in and credit what goes out.Nominal AccountAccounts of revenue, gains, expenses and losses.Purchases, sales, operating expenses, discount received, discount paid, commission received and insurance premium paid.Debit expenses and losses and credit revenue and gains.Accounting CycleThe JournalCompanies initially record transactions in chronological order (the order in which they occur). Thus, the journal is referred to as the book of original entry. For each transaction, the journal shows the debit and credit effects on specific accounts. A journal is often referred to as Book of Prime Entry or the book of original entry. If a transaction is omitted from recording in the primary book, the transaction will not have any reflection in the subsequent accounting process. Therefore, recording in primary books is an essential step in accounting process. Companies may use various kinds of journals, but every company has the most basic form of journal, a general journal. Typically, a general journal has spaces for dates, account titles and explanations, references, and two amount columns.The journal makes several significant contributions to the recording process:1. It discloses in one place the complete effects of a transaction.2. It provides a chronological record of transactions.3. It helps to prevent or locate errors because the debit and credit amounts for each entry can be easily compared.1 The date of the transaction is entered in the Date column.2 The debit account title (that is, the account to be debited) is entered first at the extreme left margin of the column headed “Account Titles and Explanation,” and the amount of the debit is recorded in the Debit column.3 The credit account title (that is, the account to be credited) is indented and entered on the next line in the column headed “Account Titles and Explanation,” and the amount of the credit is recorded in the Credit column.4 A brief explanation of the transaction appears on the line below the credit account title. A space is left between journal entries. The blank space separates individual journal entries and makes the entire journal easier to read.5 The column titled Ref. (which stands for Reference) is left blank when the journal entry is made. This column is used later when the journal entries are transferred to the ledger accounts.The steps involved in journalisation of transactions are as follows:Identify a transactionIdentify the elements of the transactionApply the ground rule of journalisation to confirm the dual effect.Journalise, i.e. record in the primary booksThe LedgerLedger is the main book or principal book of account. The entries into ledger accounts travel through the route of journal and subsidiary books. The ledger book contains all accounts viz. assets, liabilities, incomes or gains, expenses or losses, owner’s capital and owner’s equity. The ledger is the book of final entry and hence is a permanent record. There is a systematic way in which transactions are posted into a ledger account. Once the transactions are posted for an accounting period, the ledger accounts are balanced (i.e. the difference between debit side and credit side is calculated). These balances are used to ultimately prepare the financial statement like Profit and Loss A/c and Balance Sheet.Format of LedgerLedger AccountDr. Cr.DateParticularsJ.F.Amount (Rs.)DateParticularsJ.F.Amount (Rs.)Cash BookIt records daily cash (including bank) receipts and payments. Its unique feature is that it serves the purpose of both a book of prime entry and a book of secondary entry. In other words, the cash book is a journal as well as a ledger. The simplest form of cash book is a single column cash book which records only cash (no bank) receipts and payments. The double column cash book has two amount columns on either side-one for cash and the other for bank. If a business unit has more than one bank account, a separate column should be devoted to each bank account. The highest form of cash book is a triple column cash book- one column for cash, the second column for bank and the third column for discount.Specimen of Triple Column Cash BookDr. Cr.ReceiptsPaymentsDateParticularsL.F.CashBank DiscountAllowedDateParticularsL.F.CashBankDiscount ReceivedBank Reconciliation StatementA bank reconciliation statement is prepared as on a particular date to reconcile the balances as per the cash book and as per the bank statement as on that date by identifying the causes of the difference and showing their impact. Causes of DifferenceCheques issues to suppliers not yet presented for payment.Cheques deposited to the bank for collection.Cheques received by the bank directly not yet intimated.Insurance premium paid by the bank as per standing instructions not yet intimated.Dividend received by the bank directly.Bank charges not yet intimated.Cheques dishonoured but not yet intimated.It is worthwhile to note here that in the cash book all receipts are debited and all payments are credited. But the bank maintains your account in the reverse way. That is, if a cheque or cash is received by the bank on your behalf the same will be credited in your account and the payments will be debited in your account. Thus, the debit balance in the cash book will mean that your receipts are greater than payments. The bank statement will show the same as credit balance. Similarly, the credit balance in the bank column of the cash book would mean a negative balance (called overdraft), and the bank statement will show the same as a debit balance.Format of Bank Reconciliation The format of Bank Reconciliation Statement when bank balance as per cash book is taken as the starting point. Bank Reconciliation Statement as on………………….ParticularsAmount (Rs.)Amount (Rs.)ABalance as per Cash Book***BAdd:Cheques issued but not presented for payment***Interest credited by bank but not recorded in cash book***Debtors directly paid into bank but not recorded in cash book***Wrongly credit by banker***Collections by banker as per customer standing instructions***Total B***C(Total A + B)***DLess:Cheques deposited but not credited by the bank***Dishonoured cheques appeared in the pass book but not entered in the cash book***Bank charges as per pass book***Wrong debit by banker***Payments as per standing instructions***Total (D)***Balance as per pass book (C- D)***Trial Balance A trial balance is a list of accounts and their balances at a given time. Customarily, companies prepare a trial balance at the end of an accounting period. They list accounts in the order in which they appear in the ledger. Debit balances appear in the left column and credit balances in the right column. The trial balance proves the mathematical equality of debits and credits after posting. In the trial balance, the closing balances of the accounts in the general ledger are shown along with balances from the cash book. As the primary and secondary books are maintained on the double entry concept, the balances in the trial balance must tally.The steps for preparing a trial balance are:1. List the account titles and their balances in the appropriate debit or credit column.2. Total the debit and credit columns.3. Prove the equality of the two columns.Purpose- The purpose of preparing trial balance is not only to check the arithmetical accuracy of ledger balances, but also to have an overview of the operations of the business as on a particular date. A trial balance is prepared not only at the year-end but also weekly, monthly, quarterly and half yearly. These interim trial balances are used as control steps. A trial balance is not a part of books of account. It is drawn as a separate statement, and this becomes the source document for preparing external financial statements, i.e. profit and loss account and the balance sheet. A trial balance consists of all the elements of financial statements- assets, liabilities, equity, income and expenses.Trial BalanceAs at…………S.No.Ledger AccountsL.F.Dr. AmountCr. Amount(Total or Balance)(Total or Balance)Rules of Preparing the Trial BalanceFollowing rules should be taken into care:The balances of all (i) assets accounts (ii) expenses accounts (iii) losses (iv) drawings (v) cash and bank balances are placed in the debit column of the trial balance.The balances of all (i) liabilities accounts (ii) income accounts (iii) profits (iv) profits are placed in the credit column of the trial balance. ................
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