WEEK 7 to 12: FINANCIAL ACCOUNTING FOR BUSINESS Accounting Cycle ACCOUNTING CYCLE STEP 1: RECOGNISE & RECORD TRANSACTIONS EXTERNAL TRANSACTIONS INTERNAL TRANSACTIONS NON-TRANSACTIONAL EVENTS Involves an outside party Transformation of economic Not usually recorded, but may be Exchange of economic resources resources in the future and/or obligations E.g. Use of office supplies E.g. receiving an order form a E.g. Sale of Inventory & Purchase customer of Supplies SOURCE DOCUMENTS Prepared for every external transaction Support entries in accounting records Important element in control system Common sources documents include: Tax invoices Purchase order Cash register tape Credit card slips ACCURAL ACCOUNTING COMMONLY USED: provides more accurate updated records; transactions and events are recorded in the periods in which they met the revenue, expense, asset & liability criteria can occur before, as, or after cash has been received For example, an insurance company bills Company XYZ $600 every six months. If each bill is for six months of coverage, then under the accrual method, Company XYZ would record a $100 expense each month for the whole year. That is, Company XYZ would match the expense to the period in which it was incurred: $100 for January, $100 for February, $100 for March, and so on. CASH-BASED ACCOUNTING: records transactions and events only at the time of receipt/payment of cash i.e. no payables/receivables EXAMPLE OF ACCOUNTS BALANCE SHEETS ASSET ACCOUNTS LIABILITY ACCOUNTS EQUITY ACCOUNTS Current Current Non-Companies Cash at bank Accounts Payable Capital Accounts Receivables Unearned income Drawings/Withdrawals Other receivables Current Liabilities Prepaid Expenses Non-Current Non-Current Companies Land Mortgage payable Retained Earnings Buildings Dividends Plant/Equipment Revenues Gains - capital INCOME INCOME STATEMENTS EXPENSES Salary Expenses Electricity Expenses Rent expense Stationary expenses Etc. DOUBLE-ENTRY ACCOUNTING Each transaction must be analysed to determine: 1. What type of accounts are affected 2. By how much each item must be increased or decreased Important: Accounting equation must always remain in BALANCE!! 8 P a g e A C C G 1 0 0
DEBITS & CREDITS D A X = C I L DEBIT/Drawings Assets Expenses CREDIT/Capital Income Liabilities EXAMPLES OF TRANSACTIONS EXAMPLE 1. Owner pays capital 2. Buy inventory by cheque 3. Buy inventory by credit 4. Sale of inventory on credit 5. Sale of inventory on cash 6. Pay creditor 7. Debtors pay money owing by cheque 8. Owner takes out money 9. Owner pays creditor from private BALANCE SHEET A - L = OE Assets Liabilities Owner s Equity Double-entry effect cash at bank cash at bank inventory inventory inventory cash at bank cash at bank cash at bank accounts payable STEP 2: JOURNALISE TRANSACTION HOW DO YOU RECORD? A general journal has the following advantages: + Complete record of all transactions + Presented in chronological order + Useful for locating and reducing errors as debits & credits are shown together 2 or more accounts are affected by each transaction The DEBITS must = CREDITS The ACCOUNTING EQUATION must remain in balance capital inventory accounts payable accounts receivable cash at bank accounts payable accounts receivables capital capital STEP 3: POST TO LEDGER ACCOUNTS GENERAL LEDGER Collection of all individual accounts of an entity Organised in the order they appear in the balance sheet & income statement Each account has a specific identification number (Post Reference Number) Can vary from simple 2-digit number to complex alphanumeric system THE LEDGER ACCOUNT T-ACCOUNTS Convenient way to show individual accounts Illustrate effects of transactions on an account Still used in practices for quick calculations 9 P a g e A C C G 1 0 0
STEP 4: PREPARE TRIAL BALANCE Lists all ledger accounts/balances Debits & credits Total of columns must equal, therefore ledger balances LIMITATIONS: may balance but contain errors, doesn t balance = error, doesn t tell you what the error is 1. UNADJUSTED: reflects all activity recorded from day-to-day transactions and is used to analyse accounts when preparing adjusting entries 2. ADJUSTED: after adjusting entries are completed; has the final balances in all the accounts & is used to prepare the financial statements 3. POST-CLOSING: after closing entries are completed; starting trial balance for the next year; Income & Expense accounts have a ZRO BALANACE (closed) and therefore post-closing TB only includes ASSETS, LIABILITIES & EQUITY accounts STEP 2 (a): JOURNALISE ADJUSTING ENTRIES & POST TO ADJ. TB In some cases, the period in which cash is paid or received does not coincide with the period in which expense and income are recognised Therefore, some accounts must be adjusted on the last day on the accounting period to correctly recognise expenses and income not reflected in cash receipts or payments CLASSIFICATION OF ADJUSTING ENTRIES DEFERRALS Prepaid Expense Unearned revenue (Prepayments) Cost/expenses paid before they are Revenues that are collected/received but not consumed/expire yet earnt Initially recorded as an asset when paid Initially recorded as a liability when At the end of the period, the amount received consumed is expensed Recognised as revenue when earnt ASSET ACCOUNT prepaid expense Dr initial cost EXPENSE ACCOUNT LIABILITY ACCOUNT Unearned revenue Cr cash receipt EXPENSE ACCOUNT ACCURALS Accrued Expense Accrued Revenue (Unrecorded) Expenses incurred but not yet paid Revenue earned but not yet received Expense MUST be recognised along with a liability for future payment LIABILITY ACCOUNT - Expense Payable EXPENSE ACCOUNT *** Expenses have been incurred DEFERRALS EXAMPLE: Prepaid expenses Service performed NO ADJUSTING ENTRY WOULD BE NECESSARY Any unrecorded revenue earned needs to be recorded ASSET ACCOUNT Account receivable INCOME ACCOUNT *** Revenue has been earnt, but not yet received 10 P a g e A C C G 1 0 0
DEFERRALS EXAMPLE: Depreciation ALWAYS!!!! Dr Depreciation Expense Cr Accumulated Depreciation ACCRUALS EXAMPLE: Accrued Salaries ACCRUALS EXAMPLES: Accrued revenue 11 P a g e A C C G 1 0 0
- Once adjusting general journal entries have been made, adjustments are posted to the individual general ledger accounts - The general ledger balances are then posted to the ADJUSTED TRIAL BALANCE, which reflects all posted end-ofperiod adjusting entries STEP 5: PREPARE FINANCIAL STATEMENTS BALANCE SHEET Reports financial position of an entity at a SPECIFIC POINT IN TIME Shows A, L & OE in order of liquidity Represents the accounting equation 2 FORMATS: Account (A = L + OE) & Narrative (A L = OE) INCOME STATEMENTS (a.k.a. Statement of Financial Performance OR Profit & Loss Statement) Reports financial performance over a SPECIFIC TIME PERIOD Shows income & expenses Income > Expenses = PROFIT Income < Expenses = LOSS 12 P a g e A C C G 1 0 0
STATEMENTS OF CHANGES IN EQUITY 1. Capital Contributions (A L = OE) 2. Profit (I X = Profit) 3. Withdrawals 4. Final Capital (OE + Profit Withdrawals = F.OE) ACCOUNTING ASSUMPTIONS COMPARABILITY & CONSSISTENCY users can identify similarities/difference between 2 sets of economic data VERIFIABILITY different, independent observers can reach consensus that information faithfully represents what it claims to MATERIALITY extent to which info can be omitted, misstated or grouped with other information without misleading the statement users when they are making their economic decisions PERIOD ASSUMPTION life of entity can be broken up into equal time intervals. Profit is determined for particular periods of time in order to be comparable RELEVANCE Information is useful for decision making when it can influence economic decisions by users FAITHFUL REPRESENTATION info presented faithfully, without bias or undue error. Economic substance over form LAST STEP: CLOSED ENTRIES CLOSING ENTRIES Journal entries that effectively close all accounts at the end of the accounting period A special temporary account, PROFIT & LOSS ACCOUNT, is created to facilitate the closing process Income & expense accounts then begin the next accounting period with a ZERO BALANCE TEMPORARY ACCOUNTS Income statement & drawings accounts revenue, expenses & drawings Must be closed to set the account balance to ZERO BALANCE at the end of each accounting period PERMANENT ACCOUNTS Balance sheet accounts assets, liabilities & owners equity Ending balances carried forward to the next accounting period STEP 1: CLOSE ALL INCOME ACCOUNTS to the P&L SUMMARY ACCOUNT: Dr EVERY INCOME ACCOUNT Cr P&L SUMMARY STEP 3: CLOSE P&L ACCOUNT to the CAPITAL ACCOUNT: If PROFIT Dr P&L SUMMARY Cr CAPITAL If LOSS Dr CAPITAL Cr P&L SUMMARY STEP 2: CLOSE ALL EXPENSE ACCOUNTS to the P&L SUMMARY ACCOUNT: STEP 4: CLOSE DRAWINGS ACCOUNT to the CAPITAL ACCOUNT Dr P&L SUMMARY Dr CAPITAL Cr EVERY EXPENSE ACCOUNT Cr DRAWINGS END RESULT All income & expense accounts have nil balances The drawings account has a nil balance The capital account has either increased by the profit, or decreased by the loss & decreased by the drawings 13 P a g e A C C G 1 0 0