Summary of the Accounting Process

4.1 INTRODUCTION

If the accounting process is to provide the users of accounting information with reliable, timely reports, transactions during the accounting period must be recorded promptly and accurately.  This transaction should be classified, summarized and presented to users using financial statements.  These financial statements convey useful information to internal and external users.  And both groups of users make various types of decision using this information.

 

4.2 THE ACCOUNTING PROCESS

The accounting process can be described as a set of procedures used in identifying, recording, classifying, and interpreting information related to the transactions and other events of a business enterprise.  The accounting process consists of three major parts:

1. the recording of transactions during an accounting period.
2. the summarizing of information at the end of the period.
3. The preparation of financial statements.

During an accounting period business transactions and events are recorded as they occur, and at the end of each period the accounting records are summarized in order to prepare financial statements.  After an unadjusted trial balance is prepared, adjusting entries are required to bring the accounting records up to date.  When the accounting records have been made as complete, accurate and up – to – date as possible, accountants prepare financial statements reflecting the financial position and the results of operations.

 

Business transactions and other events cause changes in the assets, liabilities and owners’ equity of a business enterprise.  Transactions and events may be classified into two broad groups:

1. External transactions and events – exchange of resources and obligations between the reporting firm and outside parties.

E.g. Purchase of goods.

           Sales of goods

1. Internal events – events within the firm that affect its resources or obligations.  Examples are recognition of depreciation and amortization of Long – lived assets, the recognition of estimated doubtful accounts expense, and the use of inventory for production

 

Transactions are often accompanied by a source document, generally a paper record that describes the exchange, the parties involved, the date and the birr amount.  Examples are sales invoices, freight bills, and cash register receipts.  Certain events (such as the accrual of interest) are not signaled by a separate transaction or source document. Recording these transactions requires reference to the underlying contract supporting the original exchange of resources.  Source documents are essential for the initial recording of transactions in a journal and are also used for subsequent tracing and verification, for evidence in legal proceedings, and for audits of financial statements.

 

4.3.2. Double – Entry System

The standard accounting model for accumulated data in a business enterprise consists of the double – entry system based on the basic accounting equation.  Double – entry system is a system of accounting in which each transaction affects and is recorded in two or more accounts with equal debits and credits.

The double – entry system has various advantages:

1. It gives built – in controls that automatically call attention to many types of errors and after assurance that once assets are recorded, they will not be forgotten or overlooked.
2. facilitates the preparation of a complete set of financial statements as frequently as desired.

 

 4.3.3 Accounting Period

To be useful, information must reach decision makers frequently and promptly.  Otherwise, problems cans arise and opportunities can be missed while they wait for the information.  To provide frequent and prompt information, accounting systems are designed to produce periodic reports at regular intervals.  As a result, the accounting process is based on the time period principle.  According to this principle, an organization’s activities are identified with specific time periods, such a month, a quarter, or a year.  Then, the financial statements or other reports are prepared for each reporting period.  The time periods covered by the reports are called accounting periods.  Most organization use one year as their primary accounting period.  As a result, they prepare annual financial statements.  However, nearly all organizations also prepare interim financial reports that cover one or three months of activity.

The annual reporting period is not always the same as the calendar year ending December 31.  In fact; an organization can adopt a fiscal year consisting of any 12 consecutive months.  Companies that do not experience much seasonal variation in sales volume within the year often choose the calendar year as their fiscal year.  On the other hand, companies that experience major seasonal variations in sales often choose a fiscal year that corresponds to their natural business year.  The natural business year ends when sales activities are at their lowest point during the year.

 

4.3.4 Accounting Cycle

The accounting cycle is a complete sequence of accounting procedures that are repeated in the same order during each accounting period.  The cycle in a traditional manual system (and with modifications in a computerized system includes the following steps:

1. Recording business transactions and events in the journal.
2. Classifying data by posting from the journals to the ledger.
3. summarizing data from the ledger in an unadjusted trial balance (first pair of columns in the worksheet)
4. Adjusting, correcting, and updating recorded data; completion of the worksheet.
5. summarizing adjusted and corrected worksheet data in the form of financial statements.
6. closing the accounting records (normal accounts) to summarize the operations of the accounting period
7. preparation of a post – closing trial balance.
8. Reversing certain adjusting Entries to facilitate the recording process in the subsequent accounting  period.

When these steps are completed, the cycle begins again for the next accounting period.

 

Financial reporting on an annual, quarterly, or monthly basis requires accountants to summarize the operations of a business enterprise for a specific time period.  The two types of end – of period adjusting entries are those (1) to apportion prepayment of expenses and revenue, and (2) to record accrued expenses and revenue.  Transactions that were recorded during an accounting period in balance sheet or income statement ledger accounts may affect two or more periods, and an end – of – period adjustment may be needed.  Some financial events not recognized on a day – to – day basis must be recorded through adjusting entries at the end of the period to bring the accounting recorded up to date.  If one should choose to record depreciation expense daily or to accrue interest expense daily, no adjustment for depreciation or interest expense would be needed at the end of the accounting period.

Note that every adjusting entry effects both a balance sheet and an income statement account.  This characteristic of adjusting entries reflects their dual purpose: (1) to measure all assets and liabilities accurately, and (2) to measure net income correctly by matching expired costs (expenses) with realized revenue.

 

   4.4.1 Apportionment of Recorded Costs and Revenue

Costs that will benefit more than one accounting period frequently are incurred.  These costs must be apportioned between periods in a manner that approximates the usefulness derived from the goods and services in the realization of revenue; this apportionment process is a necessary step under the matching principle to determine net income of each period.  Recording periodic depreciation expense is an example of a cost – apportionment adjusting entry.  Cost apportionment also is involved in accounting for all types of prepayments’ However, the adjusting entry will vary depending on the accounting procedure followed in recording the original transaction.  To illustrate assume that office supplies are acquired during the accounting period at the cost of Br.5000.  At the end of the period a physical inventory reveals that supplies on hand cost Br.550. At the time the supplies were acquired, the Br.5000 may have been debited to an asset account or an expense account.  The required adjusting entry for each approach is :

A) Prepayment debited to asset account.                                                                                                                                                                                                                                 The adjusting entry required is to transfer the expired portion of the cost to an expense account

              Office supplies expense……….4450

                           Office supplies……………….4450.

B) Prepayment debited to expense account.

 The adjusting entry required is to transfer the unexpired portion of the cost to an asset account.

           Office supplies expense………550

                  Office supplies Expense………….550.

    Under either approach, the final result is the same.       

When a business enterprise receives payment for goods and services before the goods are delivered or the services are performed, a liability exists until performance takes place.

If cash is received, the original transaction maybe recorded by a credit to either a liability account or a revenue account.  For example, assume that customers paid Br. 500,000 for magazine subscriptions during the current accounting period; however, Br. 75,000 represented payments for magazines to be delivered in subsequent periods. The adjusting entries for each of the two methods of recording cash receipts are:

A) Liability account credited on receipts of cash.

      The required adjusting entry to record the earned revenue for the period is

               Unearned subscriptions………425,000

                          Subscriptions revenue…………425,000

B) Revenue account credited on receipt of cash

     The required adjusting entry to transfer the unearned revenue to a liability account is

                 Subscriptions revenue…………..75,000.

                         Unearned subscriptions………….75,000.

Under either approach, the adjusted amount of the liability is Br. 75,000 and the adjusted amount of the revenue is Br. 425,000

     4.4.2 Accrual Of Unrecorded Expenses And Revenue

The incurring of certain expenses is related to the passage of time. These expenses generally are not recorded until payment is made, unless the end of an accounting period comes before the required date of payment.  Interest and salaries are typical of the expenses that accrue with the passage of time and are recorded only when paid, except when the end of a period occurs between the time the expense was incurred and the payment is due.  In order to measure expenses accurately for a period, an adjusting entry is necessary to record the accrued expense and the corresponding liability.

For example, assume that interest of Br. 18,000 on a Br. 400,000 note payable is paid on March 1 and September 1 of each year.  If expenses and liabilities are to be reported accurately on December 31, the following year end adjusting entry is required:

Interest Expense……….12,000

            Interest Payable………..12,000

Revenue that has been realized but not recognized at the end of an accounting period. For example, revenue that is realized on assets leased to others or on interest – bearing loans seldom is recognized until the cash is received, except at the end of a period.  In order to measure accurately the results of operations under the matching principle, revenue is recognized in the period earned.  For example, assume that rent totaling Br.625 that has been realized but not collected for the month of December has not been recorded.  The following adjusting entry on December 31 is required to measure the assets and revenue accurately:

          Rent receivable ……… 625

                Rent revenue……………625

 

     4.4.3 Valuation of Accounts Receivable

A policy of making sales on credit almost inevitably results is some accounts receivable that are uncollectible.  To achieve a satisfactory matching of revenue and expenses, the estimated expense arising from sales on credit should be recorded in the accounting period in which sales occur.  This estimate of probable expense from the granting of credit requires an end – of – period adjusting entry to revise the valuation originally assigned to accounts receivable.  For example, if doubtful accounts expense estimated at Br. 2,500 ,the following adjusting entry is made:

Doubtful Accounts expense………2,500

            Allowance for Doubtful Accounts………2,500

 

     4.4.4 Closing Revenue And Expense Accounts

Revenue and expense ledger accounts are closed at the end of each accounting period by transferring the balance of these ledger accounts to a summary ledger account, Income summary. Revenue and expense accounts are extensions of owners’ equity and are used to measure periodic net income. Once this information has been summarized, the revenue and expense have served their purposes and the net increase or decrease in owners equity is transferred to an appropriate owners’ equity ledger account.  Thus, the closing of the revenue and expense accounts keeps separate the operating results of each period.

After all revenue and expenses (including the cost of goods sold) have been closed, the balance of the income summary ledger account indicates the net income or net loss for the year.  A credit balance in the Income summary account indicates a profitable year and an increase in owners’ equity;.  The Income summary account is closed by transferring its balance to the Retained earning (capital) account.

 

     4.4.5 Closing Inventories And Related Ledger Accounts

When the periodic inventory system is used, the journal entry to establish the cost of goods sold and the ending inventory balance for the accounting period may be viewed as an adjusting entry; however, because there may be little need for a ledger account for cost of goods sold, the adjusting and closing entries for inventories may be combined.  This procedure is accomplished by closing the beginning inventory, ending inventory purchases, and all related ledger accounts to the income summary account.  At this point, the balance in the Income summary account represents the cost of goods sold for the period.       

 

To illustrate, assume the following for 1990 beginning inventory, Br.80,000; purchases, Br.275,000; Freight –in, Br- 40,000 purchases returns and allowances, Br. 2,500; ending inventory , including applicable freight – In, Br. 60,000.  The journal Entry to close the accounts and to record the ending inventory is:

Inventory (ending)………………………..…….60,000

Purchases Returns and Allowances……… .2,500

Income summary………………………………332,500

            Inventory (beginning)……………………………80,000

            Purchases………………………………………..275,000

            Freight – In……………………………………… 40,000

To close beginning inventory, and net purchase for the period, and to record ending inventory.

Some merchandising enterprises prefer to use a separate ledger account, cost of goods sold, to summarize the merchandising accounts when the periodic inventory system is used. The journal entry (which may be viewed as an adjusting entry) reflecting cost of goods sold in a separate ledger account is

          Inventory (ending)………………………60,000

         Purchases Returns and Allowances…2,500

         Cost of goods sold…….……………… 332,500

                        Inventory (beginning)………………..80,000

                        Purchases……………………………275,000

                        Freight – in………………………….. 40,000

When the perpetual inventory system is used, cost of goods sold is debited and Inventory is credited during an accounting period as sales are made.  An adjusting entry may be required if the carrying amount of inventory differs from the amount determined by physical count.  At the end of the period, cost of goods sold is closed to income summary, along with other revenue and expense accounts.

 

   4.5.1. Correcting Entries

Correcting entries are not considered adjusting entries because their function is to correct errors of omission or commission.  For example, the failure to record a transaction would be rectified by a journal entry as it should have been made originally; the improper recording of a transaction requires a journal entry to ensure that ledger accounts are stated properly.

When an error is made in one accounting period but discovered in a subsequent period, the effect of the error on the net income of the earlier periods is closed to the Retained earnings ledger account.  When an error is discovered in the period in which the error occurs, but before the accounting records are closed, revenue and expense accounts may require correction and the Retained earning account generally is not affected.

For example, assume that the following two errors were made in 1990 and were discovered at the end of the year when the worksheet for the year was being prepared:

1. A purchase of merchandise for Br. 500 cash was erroneously recorded by a debit of Br. 50 to cash.
2. An acquisition of equipment for cash of Br. 4000 on April 1, 1990 was recorded as a purchase of merchandise.  The equipment had an economic life of 10 years with no residual value, and was depreciated by the straight-line method for 9 months in 1990.  The required correcting entries are as follow:

 

   4.5.2 Reversing Entries

After the accounting records have been adjusted and closed at the end of an accounting period, reversing entries may be made on the first day of the next period.  The purpose of the reversing entries is to simplify the recording of routine transactions by disposing of the accrued items (assets and liabilities) that were entered in balance sheet accounts through adjusting entries.  A reversing entry, as the name implies, is the exact reverse of an adjusting entry.  It consists of the same ledger accounts and birr amounts as the adjusting entry, but the debits and credits are reversed, and the date is the beginning of the next period.

When policies of using reversing entries are adopted, the following general rules are followed.

1. When an adjusting entry affects an asset or a liability account that normally is not used during an accounting period, a reversing entry is required. Thus, adjustments to accrue revenue and expenses are reversed because asset and liability accounts such as Rent Receivable and Interest payable are not used in the normal course of accounting during a period.  Similarly, if payments for insurance and supplies during a period are recorded in expense accounts, or if revenue received in advance during a period is recorded in revenue accounts, the adjusting entries would have to be reversed because asset and liability accounts normally not used during the period would be affected by the adjusting entries.
2. When an adjusting entry adjusts an asset or liability account that normally is used to record transactions during a period, no reversing entry is required.

 

To expedite the accounting cycle, many firms use a worksheet as a mechanical aid.  A worksheet is a multi column work space that provides an organized format for performing several end – of – period accounting cycle and for preparing financial statements before posting adjusting journal entries.  It also provides evidence, for audit trail purposes, of an organized and structured accounting process that can be more easily reviewed than other methods of analysis.

Use of worksheet is optional.  The worksheet is not part of the basic accounting records.  Worksheets assist with only a portion of the accounting cycle.
 

   4.6.1. Worksheet for a manufacturing Enterprise

The procedures for preparing worksheet for a manufacturing enterprise are similar to those used for a merchandising enterprise.  The addition of a pair of columns to summarize the manufacturing operation is the major difference. 

The following data are the basis for the adjusting entries included in the worksheet for Addis Company for the year ended December 31,1990.

       Illustration of work sheet for a manufacturing enterprise

The procedures for preparing a work sheet for manufacturing enterprise are similar to those used for merchandising enterprise.  The addition of a pair of columns to summarize the manufacturing operation is the major difference.  These columns allow for one more step in the classification of the data.  The adjusted trial balance; which is an optional step, is omitted from this illustration.

The following data are the basis for the adjusting entries included in the worksheet for Addis manufacturing company for the year ended December 31 1990

1. Doubtful accounts expense for 1990 is estimated to be Br. 3,000.
2. A three – year insurance policy was acquired on July 1,1989 at a cost of Br 1,800.  The insurance expense is allocated to other factory costs and other general expenses in a 4:1 ratio.
3. The wages accrued since the last pay period is direct labor Br. 1,800 and paid on the last day of each month.
4. Interest of Br. 1,125 has accrued on notes payable.
5. Depreciation expense for the plant assets is computed by the straight – line method based on the following information.
   

        f. The power bill for December has not been received as of December 31,1990 Based on past experience, the cost applicable to December is estimated to be Br 1,450.  All heat, light, and power costs relate to the factory.

        g. An inventory of factory supplies on December 31 1990 indicates that supplies costing Br. 850 are on hand.

        h. The income taxes expense for 1990 is estimated at Br. 3,500

        i. Inventories on December 31, 1990 are as follows.

                 Finished goods………………….Br. 41,500

                 Goods in process…………………26,350

                 Raw material……………………….12,650

                              MANUFACTURING COMPANY
                                         Work sheet
                              Ended December 31,1990

Work sheet and year – end procedures – The journal entries for closing the manufacturing ledger accounts, for adjusting the inventory balances, for closing the revenue and expense accounts, and for closing the dividends account are illustrated below.

                                   ADDIS MANUFACTURING COMPANY

                                                 Closing Entries

                                            December 31,1990

Raw material inventory (Dec. 31,1990)………………....12,650

Good-in-process inventory (Dec,31 1990).. ……………26,350

Purchase return and Allowance………………………… 4,000

Cost of Finished good manufactured……………………434,770

            Raw material inventory (Jan 1,1990)………………………16,000

            Good in process inventory (Jan.1,1990)…………………..21,000

            Raw material purchase………………………………………125, 000

            Freight – in……………………………………………………. 3,500

            Direct labor cost………………………………………………194,300

            Indirect labor cost……………………………………………..73,550

            Heat, light and power…………………………………………13,750

            Other factory cost………………………………………………14,630

            Deprecation of building………………………………………..3,000

            Deprecation of machinery and equipment…………………13,000

            Deprecation of furniture and fixture………………………….40

To record cost of Good manufactured and ending inventory of row material and good in process

Finished Goods inventory (Des 31,1990)………….41,500

Cost of good sold…………………………………….441,270

            Cost of finished good manufactured………………434,770

            Finished good inventory (Jan 1, 1990)……………..48,000

To record ending finished goods inventory and cost of good sold

Sales……………………………………….633,600

            Cost of Good sold………………………441,270

            Sales return and allowance………….. 3,600

            Advertising Expense………………........35,000

            Sales salaries expense……………...…42,000

            Delivery expense………………......…….8,000

            Administrative salaries expense………50,000

            Office salaries expense…………………20,000

            Telephone and Telegraph expense……1,800

            Other general expense  ……………….  2,920

            Interest expense………………………….4,500

            Doubtful account expense……………....3,000

            Deprecation of Building…………………....360

            Deprecation of furniture and fixture…... .  750

            Income tax expense ……………………..  3,500

            Income summary ………………………..16,900

To close Revenue and Expense accounts
 

Income summary……….…16,900

            Retained earning…………..16,900

To close income summary account
 

Retained Earnings……….. 6,000

            Dividends…………………6,000

To close dividends account.

 

4.6.2. Statement Of Cost Of Finished Foods Manufactured

The cost of goods completed during an accounting period is summarized in a statement of cost of finished foods manufactured.  The information for this statement is taken from the manufacturing columns of the worksheet.

Addis Company Statement of cost of finished foods manufactured For the year ended December 31, 1990 Goods in process inventory (January 1,1990)……………………………Br. 21,000 Raw material used             Raw material inventory (Jan.1,1990……………………..Br. 16,000             Raw material purchases (net)…………………………….124,500             Cost of raw materials available for use………………….140,500             Less: Raw material inventory (Dec 31, 1990) ………….12,650             Cost of raw material used…………………………………127,850 Direct labor costs …………………………………………………..194,300 Factory overhead costs……………………………………………..117,970               Total manufacturing costs…………………………………………… 440,120 Total cost of goods in process during 1990 ……………………………….  461,120 Less: Goods in process inventory (Dec 31,1990) ……………………….    26,350 Cost of finished gods manufactured ……………………………………….  434,770

 

The accounting process can be described as a set of procedures used in identifying, recording, classifying, and interpreting information related to the transactions and other events of a business enterprise.

The first step in the accounting cycle is analysis of transactions and selected other events.  The purpose of this analysis is to determine which event represent transactions that should be recorded.  Two criteria must be met before an event can be considered a transaction and included in the accounting process.  The event must be capable of being objectively measured in financial terms and it must affect the financial position of the enterprise.

Events can be classified as external or internal. External events are those between the enterprise and other entities, whereas internal events relate to transactions totally within the enterprise being accounted for.

Once an event has been identified as a transaction, it must be recorded in the journals, sometimes referred to as the book of original entry.  The second step in the accounting cycle involves transferring amounts entered in the journal to the general ledger.  The ledger is a book that usually containe a separate page for each account.  Transferring amounts from a journal to the ledger is called posting.

The third step in the accounting cycle is the preparation of a trial balance.  A trial balance is a list of all open accounts in the general ledger and their balances.  Preparation of adjusting journal entries is the fourth step in the accounting cycle.  Adjusting entries are entries made at the end of the accounting period to bring all accounts up to date on an accrual accounting basis so that correct financial statements can be prepared.  After adjusting entries are recorded and posted, an adjusted trial balance is prepared.  This trial balance serves as a basis for the preparation of financial statements.

After financial statements have been prepared, nominal accounts should be reduced to zero in preparation for recording the transactions of the next period.  This closing process requires recording and posting closing entries.

A third trial balance may be prepared after the closing entries are recorded and posted.  This post – closing trial balance shows that equal debits and credits have been posted properly to the income summary account.

Preparation and posting of reversing entries is the final step in the accounting cycle.  A reversing entry is made at the beginning of the next accounting period and is the exact opposite of the adjusting entry made in the previous period.

A work sheet serves as an aid to the accountant in adjusting the account balance4s and in preparing the financial statements.  The worksheet provides an orderly format for the accumulation of information necessary for preparation of financial statements.  Use of worksheet does not replace any financial statements, nor does it alter any of the steps in the accounting cycle.