Accounting Mechanics

ACCOUNTING MECHANICS

The Accounting Cycle

Accounting Cycle refers to a series of steps in the accounting system applied to

 Measure business activities in the form of transactions

 Transform these transactions into financial statements
 Communicate useful information to decision makers

Steps in the Accounting Cycle

1. From various source documents, Transactions are ascertained (note: Transactions are different
from Events)
2. Business Transactions are recorded in the Journal. This is also referred as– Journalizing
transactions. Actually transactions are classified into Cash and/or Bank, Sales, Sales Return,
Purchase, Purchase Return, Bills Receivable or Bills Payable & All Others; accordingly they
are recorded into separate types of Journal. (Each Journal Entry affects at least two Ledger
accounts.)
3. Each transaction from the Journal is posted to the ledger accounts. After all transactions are
posted into Ledger, ledgers accounts are balanced and Trial Balance is Prepared.
4. Ledger Accounts are analyzed for Deferrals & Accruals and Adjustment Entries are recorded in
Journal and then posted into the respective Ledger Accounts. After all Adjustment Entries are
made accountants prepare Adjusted Trial Balance.
5. The Ledger Accounts (Temporary Accounts – this is discussed in depth in later part of this
reading material), which are to appear in the Income Statement, are closed by Passing Closing
Entries. Post-closing Trial Balance is prepared
6. Financial statements are prepared.
Since all the Temporary Accounts are closed by transferring their year end balances to
Profit & Loss A/c – after which the balance of Temporary Accounts becomes zero – the
net effect of such closure is shown in the Profit & Loss A/c.
The Post-Closing Trial Balance has only the Permanent Accounts which appear in the
Balance Sheet; so Balance Sheet is nothing but a better presentation of the Post Closing
Trial Balance.

Is it necessary to complete all 6 steps in the accounting cycle? Yes.

 All six steps must be accomplished to complete the accounting cycle. However,
 The order of these steps can vary somewhat depending on the system in place.

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Two Account Types

Transactions are recorded in Financial Accounting using Accounts. There are separate accounts for
each item of Asset, Liabilities, Income, Expenses, Gains and Losses. You can think of each account as
a separate file in which all transactions affecting that account will appear. All names of accounts are
typically followed by the suffix “A/c” or Account. We can classify all accounts into 2 Types –
depending upon their nature.
Permanent Accounts Temporary Accounts
They appear Balance sheet Appear in Income statement
Relate to Various Assets & Liabilities Relate to Income, Gain, Expenses & Losses
Their end-of-period balances are c/f Their end of period Balance is reset to Zero.
(Carried Forward) to the next period. So end of period balance is NOT c/f.
No Closing Entries at the end of the Closing Entries are passed to reset their
accounting period are passed, since their balance to Zero. (since they are closed to
balance is not reset to zero. Profit & Loss A/c)
Opening Balance: Begin each period with Zero Opening Balance: Begin each
the previous periods Closing balance. accounting period with a zero balance.
Referred as Personal or Real Accounts by Referred as Nominal Accounts by
accountants. accountants

It is a good practice to include a description – such as Income, Expense, Gain, Loss, Asset or Liability
– in the name of each account. (Though not all accountants follow this, but it’s a good practice for
beginners, and we will follow it in our study).

 Assets: Loans & Advances (Asset) A/c, Prepaid Insurance Expenses (Asset).
 Liability: Loans (Liability) A/c, Income Tax Payable (Liability) A/c
 Expenses: Insurance Expenses A/c, Interest Expense A/c
 Income: Interest Income A/c, Dividend Income A/c
 Losses: Loss by Fire A/c, Loss on Sale of Equipments A/c
 Profits or Gains: Profit on Sale of Equipments A/c
This is a good practice since it can eliminate confusion whether a particular item is an expense or
income, loss or gain, asset or liability. For example note the following items

 Interest is an Expense when it is paid, however it is an Income when it is received. Same is the
case with Dividends
 Bank Balance is an Asset when the bank owes us money (when we have deposited more than
we have withdrawn), however it is a Liability when we owe money to the Bank because we
availed overdraft facility (that is we have borrowed money or withdrawn more money than we
have deposited).

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Debit & Credit Balance

To understand what results in Debit (Dr) or Credit (Cr) Balance, we can have a rule of thumb. We can
say as follows:

 Anything we acquire which will result in paying cash or something in lieu of cash has Debit
Balance.
Asset Accounts have Debit Balance.
Expense Accounts have Debit balance.
Loss Accounts have Debit Balance.
 Anything we acquire by receiving cash or something instead of cash has Credit Balance.
Liability Accounts have Credit balance
Income Account have Credit Balance
Profits or Gain Accounts have Credit Balance

Accounts related to Assets, Expenses & Losses have Debit Balance. (We must pay cash for buying
assets or acquiring goods or service consumed). That is why

 All Assets appear on the Debit Side (or Asset Side) of the Balance Sheet.
 All Expenses & Losses appear on the Debit Side (or Expense / Loss Side) of the Income
Statement.
Accounts related to Liabilities, Income & Gains have Credit Balance. (We receive cash for income /
selling goods/ rendering a service, or when taking a borrowing / issuing shares / undertaking a
liability). That is why

 All Liabilities appear on the Credit Side (or Liability Side) of the Balance Sheet
 All Income, Revenue, Profits Or Gains appear on the Credit Side (or Income / Profit Side) of
the Income Statement.

We can also say that Debit Balance and Credit Balance are opposites. So

 Debit Balance can be considered as Negative Credit Balance, and similarly,

 Credit Balance can be considered as Negative Debit Balance.

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Rules for Debiting & Crediting an A/c while recording a Transaction

When an account (Asset or Expense or Loss) with Debit Balance has to

 Increase, we Debit that Account

 Decrease, we Credit that Account
When an account (Liability, Income, Profit or Gain) with Credit Balance has to

 Increase, we Credit that Account

 Decrease, we Debit that Account

Question: When does an A/c Increase? When does an A/c Decrease?

Answer: When we have More of it. When we have Less of it.

E.g.1. Assets Received Cash from Account Receivables (A/R).

IncreaseDebit Cash (Asset) has increased A/R (Asset) has decreased
DecreaseCredit Cash (Asset) A/c is Debited A/R (Asset) A/c is Credited

E.g. 2. Liabilities Equity Shares (Liability) are given in exchange of Bonds.

IncreaseCredit Equity Shares (L) has increased Bond (Liability) has decreased
DecreaseDebit Equity Capital A/c is Credited Bonds (Liability) A/c is Debited

E.g. 3. Expenses Salary Expenses Paid by Cheque.

IncreaseDebit Salary Expense has increased Bank Balance has decreased
DecreaseCredit Salary Expense A/c is Debited Bank (Asset) A/c is Credited

E.g. 4. Incomes Dividend Income Receive by Cheque

IncreaseCredit Bank Balance has Increased Dividend Income has increased
DecreaseDebit Bank (Asset) A/c is Debited Dividend Income A/c is Credited

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Types of Journal Entries

Normal Entries in Primary Books

As & when transactions occur we pass Normal Journal Entries either in the Journal or the respective
Primary Books.
Cash Book for all Cash & Bank related transactions
1. All Cash or Bank related transactions are recorded in Cash Book – in Computerized Accounting
Softwares all such transactions are passed thru Cash or Bank or Contra Voucher (Note: Contra
involving both Cash A/c & Bank A/c).
Other Primary Books for Non Cash Transactions
2. All Credit Sales Transactions are entered in Sales Day Book – in Accounting Softwares all such
transactions are passed thru Sales Voucher.
3. All Sales Return Transactions are entered in Sales Return Book – in Accounting Softwares all
entries are passed thru Sales Return Voucher.
4. All Credit Purchase Transactions are entered in Purchase Day Book – in Accounting Softwares all
entries are passed thru Purchase Voucher.
5. All Purchase Return Transactions are entered in Purchase Return Book – in Accounting Softwares
all entries are passed thru Purchase Return Voucher.
6. All Bills Accepted by Customers are entered in Bills Receivable Book – there may or may not be a
type of voucher for this in Accounting Softwares; when it does not exist, then we record them thru
Journal (General – Miscellaneous) Voucher.
7. All Bills Raised by Suppliers are entered in Bills Payable Book – there may or may not be a type of
voucher for this in Accounting Softwares; when it does not exist, then we record them thru Journal
Voucher.
8. All Other Transactions are entered in Journal Proper – in Computerized Accounting Softwares all
such transactions are passed thru Journal Voucher.

Closing Entries
Closing Entries are the Journal entries made at the end of an accounting period. Its purpose is to clear
revenue, expense, and dividend accounts (Temporary accounts) of their balances; thereby it helps
Summarize a period's revenues and expenses
This is required since Temporary Accounts (Revenue and expense accounts) must begin each new
period with zero balances for the income statement to present the activity of the next single period.

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For Passing Closing Entries:

 All Temporary Accounts with Debit Balance, are Credited with the closing balance and Profit
& Loss A/c is Debited with the same amount
All Expense & Loss related Accounts have Debit Balance. So in order to close them we
Credit each Expense A/c and Debit “Profit & Loss A/c”.
Example Computer Hiring Expenses A/c has Debit Balance, when we are passing
closing entry, we will Credit (Opposite of Debit), the Computer Hiring Expenses A/c
and Debit (same as the balance of Computer Hiring Expenses A/c before this closing
entry) P&L A/c, both with the same amount as the closing balance of the Computer
Hiring Expenses A/c.
 All Temporary Accounts with Credit Balance, are Debited with the closing balance and Profit
& Loss A/c is Credited with the same amount
All Income & Gain related Accounts have Credit Balance. So in order to close them
we Debit each such Income A/c and Credit P&L A/c.
Example Sales Account has Credit Balance, when we are passing closing entry, we will
Debit (Opposite of Credit) Sales A/c and Credit (same as the balance of Sales A/c
before this closing entry) P&L A/c, both with the same amount as the closing balance of
the Sales A/c.