Chapter 4: The accounting process and transaction analysis

JoHo summary: Accounting: What the numbers mean (9th edition 2010)

Chapter 4: The accounting process and transaction analysis

In order to understand how various transactions influence the financial reports and to make sense of the information in the financial statements, it is necessary to understand the mechanical operation of the accounting process.

4.1 The accounting process The accounting process starts with transactions (economic exchanges between entities, processed and displayed in the financial statements) and culminates in the annual report.

Annual reports result from accounting (procedures for sorting, classifying and presenting the effects of a transaction) and reporting (the selection of alternative methods for displaying the effects of certain transactions) processes.

The balance sheet equation: a mechanic key. Accounting procedures for registering transaction are built on the framework of the balance sheet equation.

? Assets = Liabilities + Owner's Equity

We can rewrite the balance sheet equation, by adding revenues and expenses: ? Assets = liabilities + invested capital ? retained earnings ? Assets = liabilities + invested capital ? retained earnings (beginning of period) + revenues ? expenses.

Revenues and expenses of the income statements are subsections of the retained earnings that are separately registered as the net income. The net income for a fiscal period is then added to the retained earnings from the beginning of the fiscal period, in the process of determining the income at the end of the fiscal period.

Bookkeeping jargon and procedures. Due to the complexity of most business operations and the frequent need to refer to transactions in the past, the accounting system developed to make it easier to follow mutations.

Transactions are recorded initially into a journal entry. A journal entry is day-to-day chronological list of transaction. After that, the transactions are booked into a general ledger.

The general ledger is a large field with a column for each asset, liability item, equity category and there is an account for each category.

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JoHo summary: Accounting: What the numbers mean (9th edition 2010)

A chart of accounts is used as an index for the general ledger account and each is numbered, so that the booking of regular journal entry is easier.

For several years, the same calculating format has been used, namely the T accounts. One side of the T keeps track of the debits and the other side keeps track of the depreciations. The account balance at any moment in time, is the difference between the previous balance plus the debits minus the depreciation.

The left side of the T-account is called the debit side and the right side is called the credit-side.

The essence of the accounting process is that transactions are analyzed to determine which assets, liability or category of equity is affected and how it is affected.

Accounting procedures include the introduction of an account for each asset, liability, equity component, income and expense. These accounts can be display by a D of debit side on the left and the C of credit sight on the right.

The transactions are recorded in journal entry formats. The journal entry is the source of the amounts registered on an account. The closing balance of an account is the positive difference between the debit and credit amounts that are registered on the account, including the opening balance.

Asset accounts and expenditure accounts normally have a debit balance. Increases in assets are noted as debit posts on these accounts and decreases in assets as credit posts.

Liabilities, equity and income amounts normally have a credit balance.

Assets

Debit

Increase

+

Regular balance

=

Liabilities

+

Equity

Credit

Decrease

-

Debit

Decrease

-

Credit

Increase

+

Regular balance

Debit

Decrease

-

Credit

Increase

+

Regular balance

Revenues are increases in equity and therefore normally have a credit balance and the credit items will increase.

Expenses are decreases in equity, so will spending accounts normally have a debit

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JoHo summary: Accounting: What the numbers mean (9th edition 2010)

balance and will increase with debts.

The debit or credit behavior accounts for assets, liabilities, equity, income and expenses that can be summarized as followed:

Account name Debit side

Normal balance: ? Assets ? Expenses

Debit post rises: ? Assets ? Expenses

Debit post declines: ? Liabilities ? Equity ? Revenues

Credit side Normal balance:

? Liabilities ? Equity ? Revenues

Credit post rises: ? Liabilities ? Equity ? Revenues

Credit post declines: ? Assets ? Expenses

The format of the journal entries has the following characteristics: ? The date is recorded to provide a cross reference to transactions. ? The name of the accounts, which is debited and the amount are on the left of the name of the account that is credited and the amount. ? The abbreviations Dr. and Cr. Are used for debit and credit.

Date

Dr. Account name Cr. Account name

Amount

Amount

A requirement for the journal entry is that the total of the debit amounts is equal to the total of the credit amounts.

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JoHo summary: Accounting: What the numbers mean (9th edition 2010)

The following diagram illustrates the accounting process: Transactions registered in Journal submitted into General Ledger.

Understanding the effects of transactions on the financial statements. T-accounts and journal entries are models used by accountants for explaining and understanding the effects of transactions on the financial statements.

An alternative to the T-account and the model of journal entries that is useable for everyone, is the horizontal financial account relationship model as discussed in chapter 2. The horizontal model is an easy and useful way to understanding the effect of a transaction on the balance sheet.

Balance Sheet

Income statement

Assets = liabilities + owner's equity

Net income = revenues - expenses

The key to using this model is to balance the balance sheet.

For a transaction that affects both the balance sheet as the income statement, the balance sheet will be in equilibrium when the effect on equity is included in the income statement.

In the horizontal model, the account number is entered under the appropriate category of the financial statement and the dollar effect of that transactions on that account is entered with a + or ? sign under the account name.

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JoHo summary: Accounting: What the numbers mean (9th edition 2010)

Suppose the owners of a company make an investment of $30. This is how it is entered in the horizontal model:

Balance sheet

Income statement

Assets = liabilities + owner's equity

Net income = revenues - expenses

Cash + 30

Invested capital +30

Suppose: the company makes a transaction and pays $12 for advertising. The financial overview now looks like this:

Balance sheet

Income statement

Assets = liabilities + owner's equity

Cash - 12

Net income = revenues - expenses

Advertising costs - 12

The horizontal model can be abbreviated to the following single equation: ? Assets = liabilities + owner's equity + revenues ? expenses.

Adjustments. After the end of the accounting period, accountants normally make a summary of every adaption on the account balance to maintain a good image of the accrual accounting in the financial reports. Adjustments result in income and revenue that are reported in the correct fiscal period.

There are two types of adjustments. ? Accrued liabilities: transactions for which no money is received or paid, but the effect of which is included into the accounts in order to match the revenues with the expenses and for an accurate presentation of financial statements.

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