Principles of Accounting

PRINCIPLES OF ACCOUNTING
3. Accounting Process, System & Accounting Cycle
Students’ Notes: This area covers the Accounting Cycle and related terms.

3.4 Complete Accounting Cycle:

A Process from Recording Information to Presenting Financial Information:
The accounting cycle is a series of steps starting with recording business transactions and leading up to
the preparation of financial statements. The sole purpose of recording transactions and keeping track of
expenses and revenues is turn this data into meaning financial information by presenting it in the form of
a balance sheet, income statement, statement of owner’s equity, and statement of cash flows at the end
of accounting period.

Accounting Cycle Steps

Initial & Simple Part of Accounting Cycle:
This cycle starts with a business event. Bookkeepers analyze the transaction and record it in the general
journal with a journal entry. The debits and credits from the journal are then posted to the general ledger
where an unadjusted trial balance can be prepared.
Adjustments and Adjusted Trial balance:
After accountants and management analyze the balances on the unadjusted trial balance, they can then
make end of period adjustments like depreciation expense and expense accruals. These adjusted journal
entries are posted to the trial balance turning it into an adjusted trial balance.
Final & End of Period’s Step of Accounting Cycles
Now that all the end of the year adjustments are made and the adjusted trial balance matches the
subsidiary accounts, financial statements can be prepared. After financial statements are published and
released to the public, the company can close its books for the period. Closing entries are made and
posted to the post closing trial balance.
Activities after Preparation of Financial Statements:
At the start of the next accounting period, occasionally reversing journal entries are made to cancel out
the accrual entries made in the previous period. After the reversing entries are posted, the accounting
cycle starts all over again with the occurrence of a new business transaction.

Accounting Cycle Flow Chart

Let’s take a look at how Paul starts his accounting cycle below.
1. Financial transaction occurs
2. General Journal Entries
3. General Ledger / T-Accounts
4. Unadjusted Trial Balance
5. Adjusting Entries
6. Adjusted Trial Balance
7. Financial Statements
8. Check accuracy of worksheets
9. Closing Entries
10. Post-Closing Trial Balance
11. Reversing Entries

Instructor: Farhan Bajwa

 Principles of Accounting

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.

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
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.

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.

T-Account Format Explained

The standard T-account structure starts with the heading including the account name. This section usually

Instructor: Farhan Bajwa

 Principles of Accounting

forms the top of the T. The left column is always the debit column while the right column is always the
credit column.

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

Once journal entries are made in the general journal or subsidiary journals, they must be posted and
transferred to the T-accounts or ledger accounts. This is the second step in the 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.

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.

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

 Principles of Accounting

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

There are three different types of adjusting journal entries as follows:
i. Prepayments
ii. Accruals
iii. Non-cash expenses

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.

Unearned revenues are also recorded because these consist of income received from customers, but no
goods or services have been provided to them.

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,
amortization, and depletion. These expenses are often recorded at the end of period because they are
usually calculated on a period basis.

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.

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.
Preparing an adjusted trial balance is the fifth step in the accounting cycle and is the last step before
financial statements can be produced.
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.

Preparation

Instructor: Farhan Bajwa

 Principles of Accounting

There are two main ways to prepare an adjusted trial balance. Both ways are useful depending on the site
of the company and chart of accounts being used.
You could post accounts to the adjusted trial balance using the same method used in creating the
unadjusted trial balance. The account balances are taken from the T-accounts or ledger accounts and
listed on the trial balance. Essentially, you are just repeating this process again except now the ledger
accounts include the year-end adjusting entries.
You could also take the unadjusted trial balance and simply add the adjustments to the accounts that have
been changed. In many ways this is faster for smaller companies because very few accounts will need to
be altered.
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.

7. Financial Statements
Preparing general-purpose financial statements; including the balance sheet, income statement,
statement of retained earnings, and statement of cash flows; is the most important step in the accounting
cycle because it represents the purpose of financial accounting.
In other words, the concept financial reporting and the process of the accounting cycle are focused on
providing external users with useful information in the form of financial statements. These statements
are the end product of the accounting system in any company. Basically, preparing these statements is
what financial accounting is all about.

What is Financial Statement?

Financial Statements represent a formal
record of the financial activities of an
entity. These are written reports that
quantify the financial strength,
performance and liquidity of a company.
Financial Statements reflect the financial
effects of business transactions and events
on the entity.
Four Types of Financial Statements

1. Statement of Financial Position / Balance

Sheet:
Statement of Financial Position, also
known as the Balance Sheet, presents the
financial position of an entity at a given
date. It is comprised of the following three
elements:
 Assets: Something a business owns
or controls (e.g. cash, inventory,
plant and machinery, etc)
 Liabilities: Something a business
owes to someone (e.g. creditors, bank loans, etc)
 Equity: What the business owes to its owners. This represents the amount of capital that remains
in the business after its assets are used to pay off its outstanding liabilities. Equity therefore
represents the difference between the assets and liabilities.
View detailed explanation and Example of Statement of Financial Position

Instructor: Farhan Bajwa

 Principles of Accounting

2. Income Statement:
Income Statement, also known as the
Profit and Loss Statement, reports the
company's financial performance in terms
of net profit or loss over a specified period.
Income Statement is composed of the
following two elements:
 Income: What the business has
earned over a period (e.g. sales
revenue, dividend income, etc)
 Expense: The cost incurred by the
business over a period (e.g.
salaries and wages, depreciation,
rental charges, etc)
Net profit or loss is arrived by deducting
expenses from income.
View detailed explanation and Example of
Income Statement

3. Cash Flow Statement:

Cash Flow Statement, presents the
movement in cash and bank balances over
a period. The movement in cash flows is
classified into the following segments:
 Operating Activities: Represents
the cash flow from primary
activities of a business.
 Investing Activities: Represents
cash flow from the purchase and
sale of assets other than
inventories (e.g. purchase of a
factory plant)
 Financing Activities: Represents
cash flow generated or spent on
raising and repaying share capital
and debt together with the
payments of interest and
dividends.
View detailed explanation and Example of
Cash Flow Statement

Instructor: Farhan Bajwa

 Principles of Accounting

4. Statement of Changes in Equity:

Statement of Changes in Equity, also
known as the Statement of Retained
Earnings, details the movement in
owners' equity over a period. The
movement in owners' equity is
derived from the following
components:
 Net Profit or loss during the period as reported in the income statement
 Share capital issued or repaid during the period
 Dividend payments
 Gains or losses recognized directly in equity (e.g. revaluation surpluses)
 Effects of a change in accounting policy or correction of accounting error
View detailed explanation and Example of Statement of Changes in Equity

8. Check accuracy of worksheets / Accounting Worksheets:

An accounting worksheet is a tool used to help bookkeepers and accountants complete the accounting
cycle and prepare year-end reports like unadjusted trial balances, adjusting journal entries, adjusted trial
balances, and financial statements.

Format
The accounting worksheet is essentially a spreadsheet that tracks each step of the accounting cycle. The
spreadsheet typically has five sets of columns that start with the unadjusted trial balance accounts and
end with the financial statements.

Example
Here is what Paul’s Guitar Shop’s year-end would look like in accounting worksheet format for the
accounting cycle examples in this section.

Instructor: Farhan Bajwa

 Principles of Accounting

As you can see, the worksheet lists all the trial balances and adjustments side by side. During the
accounting cycle process, an accounting worksheet can be helpful to keep track of the different steps and
reduce errors.

9. Closing Entries:
Closing entries, also called closing journal entries, are entries made at the end of an accounting period to
zero out all temporary accounts and transfer their balances to permanent accounts. In other words, the
temporary accounts are closed or reset at the end of the year. This is commonly referred to as closing the
books.

Example:
In this example we will close Paul’s Guitar Shop, Inc.’s temporary accounts using the income summary
account method from his financial statements in the previous example.
There are three general closing entries that must be made.

Close all revenue and gain accounts

All of Paul’s revenue or income accounts are debited and credited to the income summary account. This
resets the income accounts to zero and prepares them for the next year.

10. Post-Closing Trial Balance:

The post-closing trial balance is a list of all accounts and their balances after the closing entries have been
journalized and posted to the ledger. In other words, the post-closing trial balance is a list of accounts or
permanent accounts that still have balances after the closing entries have been made.

Format
A post-closing trial balance is formatted the same as the other trial balances in the accounting cycle
displaying in three columns: a column for account names, debits, and credits.

11. Reversing Entries

Reversing entries, or reversing journal entries, are journal entries made at the beginning of an accounting
period to reverse or cancel out adjusting journal entries made at the end of the previous accounting
period. This is the last step in the accounting cycle.
Reversing entries are made because previous year accruals and prepayments will be paid off or used
during the new year and no longer need to be recorded as liabilities and assets. These entries are optional
depending on whether or not there are adjusting journal entries that need to be reversed.

Instructor: Farhan Bajwa

 Principles of Accounting

3.5 Glossary of Significant Terms Used:

Term Mea
ning
 It represents the set of activities which are regularly carried on by a person or an organization for
the
purpose of earning profits from such activities.
 For Example –
(i) A Tea shop owner regularly prepares tea and sells it in glasses to his customers.
(ii) Reliance Communications regularly sells mobile phones to the customers.
Business
 Profit Motive is involved in Business. (Note: The business may actually lead to losses. But motive is to
earn profits)
 Business may be
(i) Manufacturing – Purchasing Raw Materials, Converting them into Finished Goods and selling the
goods.
(ii) Trading – Buying Finished Goods and selling them as such without any conversion.
(iii) Service – Rendering services to clients Eg. Doctors, Chartered Accountants etc. (Note: No
Goods)
 Items / Products / Articles which are regularly traded by the businessman are called “Goods”.
 Eg. For a Mobile Shop owner, mobile phones are “goods”, as he regularly purchases and sells them.
Goods
 However, for the same mobile shop owner, if he purchases one motor bike for carrying the mobile
phones, then the motor bike is not considered as goods for him.
Cost /  It represents the amount actually spent or the liability actually incurred.
Historical  For eg. Assume that a land is purchased for `100 Lakhs, but its market value is ` 150 Lakhs. In this
Cost case, the Historical Cost is ` 100 Lakhs only.
(From Buyer’s angle) It refers to Buying of Finished Goods / Raw Materials by one person from
Purchases another person for consideration. [Note: Sale by one party is the purchase for another party.]
Finished It refers to the products manufactured by the manufacturer. For a trader, the goods purchased and
Goods sold by him are called finished goods.
Sales  “Sales” refers to “Transfer of ownership in goods from one person to another for a consideration”
(from the  Hence, 3 Conditions for sale are – (a) Transfer of Ownership (refer below) (b) Ownership must be in
goods
Term Mea
ning
angle of (refer above) (c) Consideration – Some money or money’s worth must be given by one person to another.
seller)  Transfer of Ownership: Ownership in goods is transferred when the risks of loss and rewards
relating to such goods are transferred.
 Example:
(i) Mr.X buys one Mobile phone from Mr.Y. When Mr.X comes out of Y’s shop, somebody stole the
mobile phone. In this case, the loss of mobile phone due to theft is to be borne by Mr.X
and NOT by Mr.Y.
(ii) However, if the same mobile phone is stolen when it is kept in the display of Mr.Y’s shop, then
Mr.Y shall bear the loss of mobile phone.
(iii) Thus in the above case, there is a transfer of risk of loss from Mr.Y to Mr.X after the purchase of
mobile phone. When there is transfer of risk, it is considered as transfer of ownership and hence
sale.
 Sale of properties other than goods: If items other than goods are sold (For eg. Motor Car),
then it is not considered as “Sales” for Accounting purposes. It is referred by the name of the
respective item. Hence, if mobile phone dealer sells motor car, it is NOT referred by the general
name of “Sales”, but is referred as “Motor Car Sold”.

Raw (Applicable only for manufacturing business) It refers to the base materials from which finished goods
are manufactured. [For Eg – Water Bottles are made from Plastics. In this case, water bottles are finished
Materials goods whereas plastics are raw materials.]. For a trader, there is no raw material as he does not produce
anything.

Instructor: Farhan Bajwa

 Principles of Accounting

 It refers to the balance Finished Goods / Raw Materials existing at the beginning or end of a
specified period.
 Closing Stock – Stock at the end of a specified period.
 Opening Stock – Stock at the beginning of the period.
Stock
 Example – Mr.A purchased 10,000 kgs of sugar in 2011. He sold 8,000 kgs throughout
2011. In this case, the stock on 31.12.2011 is 2,000 kgs of Sugar. This is closing stock on
31.12.2011.
On 01.01.2012, the above stock of 2,000 kgs is carried forward from 2011. This is Opening Stock on
01.01.2012.
(i) Technical Definition: An Asset is a resource controlled by the enterprise as a result of past events
and from which future economic benefits are expected to flow to the enterprise.
Assets
(ii) General Definition: Properties of the business / Amounts receivable from others by the business Eg.
Stock, Land, Building, Debtors etc. (Detailed Meaning in the next chapter)
Debtors Persons from whom the business has to receive money, due to credit sales made to them.
Liabilities Amounts payable by the business to outsiders and includes capital. For eg. Bank Loans, Expenses not yet
paid
Creditors Persons to whom the business has to pay money due to credit purchases made from them.
Capital Amount invested by the owner into the business
Drawings Cash / Goods drawn by the owner for his personal purposes. It decreases the capital.
Profits Incomes – Expenses
Income/ Amount receivable due to Sales / any other amount receivable arising out of the regular operations of the
Revenue business. For Eg. Interest, Commission etc. (Note: This excludes loan amounts received / amounts received
from debtors)
Amount spent to derive benefit for an accounting period. For Eg. Rent paid for the benefit of occupying a
Expenses
building for 12 Months.
Losses Amount spent but no benefit is derived / Amount not recoverable from debtors. For eg. Stocks lost due to
fire
It is Bank Account. However, in this account, the account holder is allowed to withdraw over and above
the existing balance. For Eg. Assume that Mr.A has a balance of ` 10,000 in his Bank Account. If he draws
Bank
a cheque for ` 15,000, normally it will be rejected by the bank. However, if the account has Overdraft
Overdraft facility, then the bank will pay ` 15,000 on the cheque, despite the insufficient balance.
It is in the nature of Current Liability
Equity Capital is otherwise called as equity.
Working
Current Assets Less Current Liabilities. Also called as “Net Working Capital”
Capital
Current It refers to the assets which are easily convertible into cash or cash equivalents within a single accounting
Assets period. For Eg. Bank, Debtors etc. (Refer Chapter A.2)

Term Mea
ning
Current It refers to the liabilities which are payable within the single accounting period. For eg. Creditors, Bank
Liabilities Overdraft etc. (Refer Chapter A.2)
Represents Long Term Assets which are expected to be used in the business for a longer period of time.
Fixed
They are meant for usage in the business for production / rendering of services etc. Eg. Machinery,
Assets
Building (Refer Chapter A.2)
The term “Disclosure” means that a statement describing the event / transaction (included the
amount involved) should be added to the financial statements as a note therein. (Disclosure is not same
Disclosure
as accounting. Accounting means Accounting Entries will be passed, whereas in disclosure, a mere
statement is given; Journal Entry not passed.)
It refers to the creation / existence of liability for expenses. For rent paid ` 12,000 for 12 months is
Incurred
otherwise called as “rent incurred”. Mere payment of advances is not considered as “incurred”.

Instructor: Farhan Bajwa

 Principles of Accounting

Inventory Technical term for “Stock”. It includes Raw Material Stock, Work in Progress and Finished Goods Stock
Gradual Decrease in the value of Fixed Assets due to wear and tear, use, passage of time,
Depreciation
obsolescence and other relater factors.
It refers to the transaction wherein the goods are delivered by the seller to the buyer on condition that
Hire the settlement has to be made in specified installments. On payment of the last installment, the goods
Purchase shall be treated as owned by the buyer. Till the last installment, the goods are owned by the seller. In
case of default of any installment, the seller can get back the goods delivered.
Liquidity Ability of the business to meet its Short–Term Liabilities. Current Assets > Current Liabilities
Solvency Ability of the business to meet its Total Liabilities. i.e. Assets > Liabilities
Window It means manipulating the financial statements to make them attractive viz. inflating the incomes,
Dressing suppressing the expenses, treating revenue expenditure as capital expenditure etc.
It refers to the notional gains arising due to increase in prices of stocks held in the business.

Holding For Eg. A has 10,000 Kgs of Steel in Stock. They are bought at ` 100/Kg. They are not sold for one
Gains month. At the end of one month, their market price is ` 180/Kg. In this case, if the stocks are sold at the
end of one month, then A can earn a profit of ` 80/Kg. This is not realized as sale is not actually made
and they are just kept in stock.
It is not realized and may be earned if some event happens. In the above case, if sale happened then `
Notional
80 is earned. Till the actual sale, it is only a notional profit.

Instructor: Farhan Bajwa