FINANCIAL ACCOUNTING

Complete Accounting Cycle

Week 02 (Lecture: 01 Class Session)

Instructor: Farhan Bajwa

2 2.1 Accounting Processes:

Instractor: Farhan Bajwa

3 2.1 Accounting Processes:
 Processes of Generating Financial Information (3 processes)
 1. Recording
Meaning
All business transactions which are of financial nature (i.e. expressed in terms of money) are
recorded in the books of accounts.

Purpose
A businessman cannot keep in his memory all the business activities carried out by him. Hence,
there is a need for keeping track of such activities in a separate record.

Basis of All transactions must be evidenced by supporting documents like Sales Invoice, Purchase Bill,
Recording Receipts, Pay Slip, etc. (These are called Vouchers)

The Books in which primary entry is made is called “Journal”, which is further sub–divided into
Relevant
A/cs Book several
Subsidiary Books for Sales, Purchases, Cash & Bank, etc. according to the nature and size of the
business.

Checkpoint
It is to be noted that Accounts is concerned with only FINANCIAL Transactions. Accounting will
not record non–financial transactions in its books.

Salary paid to Manager will be recorded in the books of accounts.

But, good health of the Manager, even if it is of great use to the business, has no financial
Example character and no economic value, and therefore, will not be considered in Accounting.
Instractor: Farhan Bajwa
4 2.1 Accounting Processes:
 Processes of Generating Financial Information (3 processes)
 2. Classifying
Meaning
Classifying involves grouping transactions of a similar nature at one place, such that information will be
compressed and presented in useable form.
Purpose
While the process of recording ensures that all financial transactions are recorded, one cannot make any
observations unless all the transactions are grouped together under different categories.

Basis Classification is based on the transactions recorded in the Journal / Subsidiary Books.

The book containing the classified information of transactions is called “Ledger”. Each page in the Ledger is called
Relevant as “Folio”. In each folio (Page No.), an individual Account Head and all transactions relating to that Account Head
is recorded / posted.
A/cs Book

Checkpoint Ledger can be prepared only after the preparation of Journal / Subsidiary Books

At recording stage, all transactions are normally recorded chronologically (i.e. date–wise).
Assuming a businessman made 10 sale transactions (out of which 6 are on credit), paid telephone charges, rent etc.,
Example
received payments from 3 debtors in a week, it is not possible to ascertain the exact position of each item unless
they are grouped as “Sales A/c, Telephone Charges A/c, Rent A/c, Debtors A/c etc.”
This will help in finding out Total Sales (Cash and Credit sales) / Expenditure / Amounts due from debtors etc.

Instractor: Farhan Bajwa

5 2.1 Accounting Processes:
 Processes of Generating Financial Information (3 processes)
 3. Summarizing

Meaning
This involves presentation and preparation of the classified information in a manner
useful to the internal and external users of Financial Statements.

Accounts
Books It involves preparation of Trial Balance, and Financial Statements therefrom, viz. (i)
Profit and Loss Account
(used to find out profits / losses for the business), (ii) Balance Sheet (used to
ascertain the financial position), and (iii) Cash Flow Statement (used to determine
the factors for increase or decrease in cash & bank balances)

Basis Summarizing is based on the classified transactions presented in Ledger

Instractor: Farhan Bajwa
6 2.1 Accounting Processes:
 Processes of Usage of Financial Information (generated through above 3 processes)
 4. Analyzing
Meaning Analysis involves methodical classification of the data given in the Financial
Statements.
Nature of Analysis is concerned with the determining the relationship between the items in the
process Profit and Loss Account and Balance Sheet (i.e. Ratio Analysis). Thus, it provides the
basis for interpretation.

Further, analysis involves comparing current year figures with the previous year
figures

Basis Financial Statements generated above in summarizing

Net Profit Ratio – The Sales and Net Profit is compared to find out the % of Net Profit
earned on Sales. This helps to ascertain how much sales have to be achieved, to
Example make specified net profits.
For Eg. If NP Ratio is 20% on sales and a businessman wants to achieve net
profits of ` 20 Lakhs in a year, then he must make a sale of ` 100 Lakhs (20 Lakhs
Instractor: Farhan Bajwa

/ 20%) during that year.

7 2.1 Accounting Processes:
 Processes of Usage of Financial Information (generated through above 3 processes)
 5. Interpreting:

Meaning Drawing observations from the items in the financial statements and also from
relationships determined in analyzing process
Purpose The recorded financial data is analysed and interpreted in the manner that will
enable the data users to make a meaningful judgment about the financial
condition and profitability of the business operation.
Nature of Financial Statements are interpreted to explain what had happened, why it had
process happened and what is likely to happen under specified conditions.
Based on analysed information, interpretation shall be done.

Basis Financial Statements generated in summarizing process and relationships

determined in Analyzing process.
Assuming the NP ratio for 2011 is 20% on sales, whereas it was 15% in
2010. Similarly the expenses ratio for 2011 is 80% on sales, whereas it
Example
was 85% in 2010.
This means the profit has increased mainly due to decrease in expenses. (so the
increase is not due to increase in sales)
Instractor: Farhan Bajwa
8 2.1 Accounting Processes:
 Processes of Usage of Financial Information (generated through above 3 processes)
 6.Communicating:

Meaning
It is concerned with the transmission of summarised, analysed and interpreted
information to the end user to enable them to make rational decisions.

Modes This is done through preparation and distribution of Accounting Reports, which
includes Profit and Loss Account and Balance Sheet, additional information in the
form of Accounting Ratios, Graphs, Diagrams, Funds Flow Statement, etc.

Instractor: Farhan Bajwa

9 2.2 Systems of Accounting:
 Cash Accounting
 Accrual Accounting

 Accrual Basis Accounting vs. Cash Basis Accounting

Cash Basis Accounting Accrual Basis Accounting

Revenue is recorded when payment is received. Revenue is recorded immediately.

Cash flow is managed in real time. Cash flow is managed by checking accounts
receivable against accounts payable.

Provides a point-in-time picture of a business's Gives a more accurate picture of the longer-term
cash flow. state of a business.

Instractor: Farhan Bajwa

10 2.2 Systems of Accounting:

 The Advantages of Cash Based Accounting

 The Advantages of Accrual Accounting

Instractor: Farhan Bajwa

11 2.2 Systems of Accounting:

 What it means to “record transactions”

 The effects of cash and accrual accounting

 The effect on cash flow
 The effect on taxes
 The effect on Expense and Revenue

 Which Method Should Your Business Use?

Instractor: Farhan Bajwa

12 2.3 Types of Accounts Used in Accounting:

 1. Personal accounts

 2. Real accounts

 3. Nominal accounts

Instractor: Farhan Bajwa

13 2.4 Complete Accounting Cycle:

 A Process from Recording Information to Presenting Financial Information:

 Accounting Cycle Steps

 Initial & Simple Part of Accounting Cycle:
 Adjustments and Adjusted Trial balance:
 Final & End of Period’s Step of Accounting Cycles
 Activities after Preparation of Financial Statements:

Instructor: Farhan Bajwa

14 2.4 Complete Accounting Cycle:
 Accounting Cycle Flow Chart
Let’s take a look at how Paul starts his accounting cycle below.
 Financial transaction occurs
 General Journal Entries
 General Ledger / T-Accounts
 Unadjusted Trial Balance
 Adjusting Entries
 Adjusted Trial Balance
 Financial Statements
 Check accuracy of worksheets
 Closing Entries
 Post-Closing Trial Balance
 Reversing Entries
Instructor: Farhan Bajwa
15 2.4 Complete Accounting Cycle:

 1. Financial Transaction Occurs:

 The first step in the accounting cycle is a transaction that takes place.

 Example: A company receives $300 in sales on their software products. This

is the starting point of the accounting cycle for this transaction.

 Accounting identifies transaction and event, which can be expressed in

term of money and bring change in the financial position of a business unit.

Instructor: Farhan Bajwa

16 2.4 Complete Accounting Cycle:

 2. General Journal Entries:

 Journal entries are the first step in the accounting cycle and are used to record
all business transactions and events in the accounting system.

 For example, when the company spends cash to purchase a new vehicle, the
cash account is decreased or credited and the vehicle account is increased or
debited.

How to Make a Journal Entry

 Identify Transactions
 Analyze Transactions
 Journalizing Transactions

Instructor: Farhan Bajwa

17 2.4 Complete Accounting Cycle:

 Example:
 We are following Paul around for the first year as he starts his guitar store called Paul’s
Guitar Shop, Inc. Here are the events that take place.

 Entry #1 — Paul forms the corporation by introducing Capital (common Stock) 10,000
shares of $1 par stock.

Instructor: Farhan Bajwa

18 2.4 Complete Accounting Cycle:

 3. General Ledger / T-Accounts

 A general ledger is a book or file that bookkeepers use to record all relevant
accounts.

 The general ledger tracks five prominent accounting items: assets, liabilities,
owner’s capital, revenues, and expenses.

 A T-Account format graphically shows the debits on the left side of the T and the
credits on the right side.

 This system allows accountants and bookkeepers to easily track account

balances and spot errors in journal entries.

Instructor: Farhan Bajwa

19 2.4 Complete Accounting Cycle:

 T-Account Format Explained

 How to Post Journal Entries to T-Accounts or Ledger Accounts

Instructor: Farhan Bajwa

20 2.4 Complete Accounting Cycle:

 Example
 Let’s post the journal entries that Paul’s Guitar Shop,
Inc. made during the first year in business to the
ledger accounts.

 As you can see, all of the journal entries are posted

to their respective T-accounts. The debits for each
transaction are posted on the left side while the
credits are posted on the right side.
 The account balances are calculated by adding
the debit and credit columns together. This sum is
typically displayed at the bottom of the
corresponding side of the account.

Instructor: Farhan Bajwa

21 2.4 Complete Accounting Cycle:

 4. Unadjusted Trial Balance

 An unadjusted trial balance is a listing of all the business accounts that are
going to appear on the financial statements before year-end adjusting
journal entries are made. That is why this trial balance is called unadjusted.

 This is the third step in the accounting cycle. After the all the journal entries
are posted to the ledger accounts, the unadjusted trial balance can be
prepared.

Instructor: Farhan Bajwa

22 2.4 Complete Accounting Cycle:

 Format
 An unadjusted trial balance is displayed in three
columns: a column for account names, debits,
and credits. Accounts with debit balances are
listed in the left column and accounts with
credit balances are listed on the right.

 Example
 After Paul’s Guitar Shop, Inc. records its journal
entries and posts them to ledger accounts, it
prepares this unadjusted trial balance.

Instructor: Farhan Bajwa

23 2.4 Complete Accounting Cycle:

 5. Adjusting Entries
 Adjusting entries, also called adjusting journal entries, are journal entries made at
the end of a period to correct accounts before the financial statements are
prepared.

 This is the fourth step in the accounting cycle. Adjusting entries are most
commonly used in accordance with the matching principle to match revenue
and expenses in the period in which they occur.

 Types of Adjusting Entries

 Prepayments
 Accruals
 Non-cash expenses
Instructor: Farhan Bajwa
24 2.4 Complete Accounting Cycle:
 5. Adjusting Entries

 Prepaid expenses or unearned revenues – Prepaid expenses are goods or services

that have been paid for by a company but have not been consumed yet.
Insurance is a good example of a prepaid expense.

 Accrued expenses and accrued revenues – Many times companies will incur
expenses but won’t have to pay for them until the next month. Utility bills are a good
example.

 Non-cash expenses – Adjusting journal entries are also used to record paper
expenses like depreciation. These expenses are often recorded at the end of period
because they are usually calculated on a period basis.

Instructor: Farhan Bajwa

25 2.4 Complete Accounting Cycle:

 Example
 Following our year-end example of Paul’s Guitar Shop, Inc., we can see that his
unadjusted trial balance needs to be adjusted for the following events.
 — Paul pays his $1,000 January rent in December.

Instructor: Farhan Bajwa

26 2.4 Complete Accounting Cycle:

 6. Adjusted Trial Balance

 An adjusted trial balance is a listing of all company accounts that will appear
on the financial statements after year-end adjusting journal entries have
been made.

 Format
 An adjusted trial balance is formatted exactly like an unadjusted trial
balance. Three columns are used to display the account names, debits, and
credits with the debit balances listed in the left column and the credit
balances are listed on the right.

Instructor: Farhan Bajwa

27 2.4 Complete Accounting Cycle:

 Preparation
 There are two main ways to prepare an adjusted trial balance.
 Reinitiate Trail Balance after Adjustments: You could post accounts to the
adjusted trial balance using the same method used in creating the
unadjusted trial balance.
 Make Adjustments in Unadjusted Trail Balance: Change those accounts in
unadjusted trail Balance which used in adjusting entries.
 Note that only active accounts that will appear on the financial statements
must to be listed on the trial balance. If an account has a zero balance,
there is no need to list it on the trial balance.

Instructor: Farhan Bajwa

28

Thanks

Instructor: Farhan Bajwa