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2018

Understanding Accounting Cycle

UnderstandingAccounting Cycle

Maintaining Books of accounts of an organisation is a systematic process involving well defined steps. Such process involve recording, classifying and summarizing of economic transactions carried out by a business during a particular accounting period. The ultimate purpose of maintaining books of accounts is to generate useful information about entity's financial position. Hence, the end result of an accounting cycle is generation of Financial Statements like Profit & Loss Account (aka Income Statement) and Balance Sheet. In this article we shall understand each step involved in accounting cycle of an entity.

Duration of Accounting Cycle:

Books of accounts are maintained based on Time Period Principle. This requires that accounting cycle must be followed over a specific time period known as accounting period. Accounting period is normally one financial year. Hence, accounting cycle is repeated every financial year. Accounting cycle starts with recording transactions and ends with preparation of final accounts.

Major Steps in Accounting Cycle:

An Accounting Cycle consists of following steps:

  1. Acquiring Source Document for transactions.
  2. Analyzing and Recording Transactions via Journal Entries.
  3. Posting Journal Entries to Ledger Accounts.
  4. Preparing Trial Balance.
  5. Passing adjustment entries at the end of the period.
  6. Preparing Adjusted Trial Balance.
  7. Preparing Financial Statements.

 

Step 1: Acquiring Source Document for transactions: Having determined which transactions are to be recorded in the books of accounts, we must acquire the source document as a proof of respective transaction. No transaction can be recorded in the books of accounts without sufficient supporting documents. An invoice, a receipt note, a delivery note, receipt voucher, refund voucher, debit note, credit note etc. can act as supporting document for a transaction.

Transactions:

Date Particulars Amount Source Document
01/04/2018 Open business bank account and deposited personal cash 1,00,000 Bank Statement
02/04/2018 Withdrew cash as working capital 50,000 Bank Statement
03/04/2018 Goods purchased from ABC Co. Ltd. on credit 1,00,000 Invoice
04/04/2018 Goods sold to XYZ Co. Ltd. on credit 2,00,000 Invoice
05/05/2018 Paid Office Rent by Bank 25,000 Invoice

 

Step 2: Analyzing and Recording Transactions via Journal Entries:

After acquiring source documents, the next step is to record the transaction in the books of accounts. It is done through passing appropriate Journal Entry in respective voucher type. Following points must be kept in mind while passing journal entries:

  1. Journal Entry must be passed as per rules prescribed in Double Entry Book Keeping system.
  2. Ledgers involved in a journal entry must be determined.
  3. In a journal entry appropriate ledgers involved in the transactions must be determined.
  4. After determining the ledgers involved, determine type of ledgers i.e. Personal, Real or Nominal.
  5. Now decide which ledgers are to be debited and which are to be credited based on golden rules of accounts.
  6. Pass journal entry for the transaction.

Golden Rules of Accounting

Type of Account Debit and Credit Rules
Personal Account Debit the receiver
Credit the giver
Real Account Debit what comes in
Credit what goes out
Nominal Account Debit the expenses and losses
Credit the Incomes and Gains

 

Classification of Ledgers involved in above transactions:

Ledger Name Type of Ledger
Capital A/c Personal
Bank A/c Personal
Cash in Hand Real
Purchase A/c Real
ABC Co. Ltd. Personal
Sales A/c Real
XYZ Co. Ltd. Personal
Office Rent Nominal

 

Journal Entries in the books of accounts of Munimji Training & Placement Pvt. Ltd.

Date Particulars L.F. Debit Credit
01/04/2018 Bank A/c                                                           Dr. 1,00,000
To Capital A/c 1,00,000
02/04/2018 Cash in Hand A/c                                                Dr. 50,000  
To Bank A/c 50,000
03/04/2018 Purchase A/c                                                      Dr. 1,00,000  
To ABC Co. Ltd. A/c 1,00,000
04/04/2018 XYZ Co. Ltd. A/c                                                Dr. 2,00,000
To Sales A/c 2,00,000
05/04/2018 Office Rent                                                        Dr. 25,000
To Bank 25,000

Step 3: Posting journal entries to ledger accounts: After passing Journal entries for transactions, the next step in accounting cycle is to post individual journal entries into respective ledger accounts. An account is created for each ledger involved in journal entries. Then, amounts are posted to respective ledgers accounts. (Please refer to below example.)

Step 4: Preparing Trial Balance: A trial balance is a list of the balances of ledger accounts of a business at a specific point of time usually at the end of a period such as month, quarter or year. An trial balance is the one which is created before any adjustments are made in the ledger accounts. The preparation of a trial balance is very simple. All we have to do is to list the balances of the ledger accounts of a business.

The trial balance proves that the books are in balance or that the debits equal the credits. From the trial balance, a company can prepare their financial statements. After the financials are prepared, the month end adjusting and closing entries are recorded (journalized) and posted to the appropriate accounts. After those entries are made, a post-closing trial balance is run. The post-closing trial balance verifies the debits equal the credits and that all beginning balances for permanent accounts are in place.

Closing Entries:

Closing entries are passed in order to transfer closing balances of all nominal ledgers to P&L A/c. Closing entries are passed at the end of accounting cycle normally on 31st March every year. In closing entries, all expense ledgers are credited and P&L a/c is debited. While all income ledgers are debited and P&L a/c is credited.

Particulars L.F. Debit Credit
P&L A/c Dr. 1,00,000
To Purchase A/c 1,00,000
Sales A/c  Dr. 2,00,000
To P&L A/c 2,00,000
P&L A/c Dr. 25,000
To Office Rent 25,000

Bank A/c:

Date Particulars Debit Date Particulars Credit
01/04 To Capital A/c 1,00,000 02/04 By Cash-in-hand 50,000
By Office Rent 25000
By Balance C/F 25000
1,00,000 1,00,000

 

Capital A/c

Date Particulars Debit Date Particulars Credit
01/04 By Bank A/c 1,00,000
To Balance C/D 1,00,000
1,00,000 1,00,000

 

Cash-in-Hand

Date Particulars Debit Date Particulars Credit
02/04 To Bank A/c 50,000
By Balance C/F 50,000
50,000 50,000

 

Purchase A/c

Date Particulars Debit Date Particulars Credit
03/04 To ABC Co. Ltd. 1,00,000
By P&L A/c 1,00,000
1,00,000 1,00,000

 

ABC Co. Ltd. 

Date Particulars Debit Date Particulars Credit
03/04 By Purchase 1,00,000
To Balance C/F 1,00,000
1,00,000 1,00,000

 

XYZ Co. Ltd.

Date Particulars Debit Date Particulars Credit
04/04 To Sales A/c 2,00,000
By Balance C/F 2,00,000
2,00,000 2,00,000

 

Sales A/c

Date Particulars Debit Date Particulars Credit
04/04 By XYZ Co. Ltd. 2,00,000
To P&L A/c 2,00,000
2,00,000 2,00,000

 

Office Rent A/c

Date Particulars Debit Date Particulars Credit
05/04 To Bank A/c 25,000
By P&L A/c 25,000
25,000 25,000

 

Trial Balance as on 31st March 2019

Particulars Debit Credit
Capital A/c 1,00,000
Bank A/c 25,000
Cash in Hand 50,000
Purchase A/c 1,00,000
ABC Co. Ltd. 1,00,000
Sales A/c 2,00,000
XYZ Co. Ltd. 2,00,000
Office Rent 25,000
Total 4,00,000 4,00,000

 

Step 5: Preparing Adjustment Entries at the End of the Period: Adjusting entries are journal entries recorded at the end of an accounting period to adjust income and expense accounts so that they comply with the accrual concept of accounting. Their main purpose is to match incomes and expenses to appropriate accounting periods.

Types
There are following types of adjusting entries:
1. Accruals:
These include revenues not yet received nor recorded and expenses not yet paid nor recorded. For example, interest expense on loan accrued in the current period but not yet paid.
2. Prepayments:
These are revenues received in advance and recorded as liabilities, to be recorded as revenue and expenses paid in advance and recorded as assets, to be recorded as expense. For example, adjustments to unearned revenue, prepaid insurance, office supplies, prepaid rent, etc.
3. Non-cash:
These adjusting entries record non-cash items such as depreciation expense, allowance for doubtful debts etc.

Step 6: Preparing adjusted trial balance: An Adjusted Trial Balance is a list of the balances of ledger accounts which is created after the preparation of adjusting entries. Adjusted trial balance contains balances of revenues and expenses along with those of assets, liabilities and equities. Adjusted trial balance can be used directly in the preparation of the statement of changes in stockholders' equity, income statement and the balance sheet. However it does not provide enough information for the preparation of the statement of cash flows. The format of an adjusted trial balance is same as that of unadjusted trial balance.

Step 7: Preparing Financial Statements: A set of financial statements is a structured representation of the financial performance and financial position of a business and how its financial position changed over time. It is the ultimate output of an accounting information system and has following components:

1. Profit & Loss Account (Income Statement): It lists all incomes / gains and expenses / losses earned / incurred by a business during an accounting period.
2. Balance Sheet: It is a statement containing all Assets and Liabilities of the business.

In the Books of Munimji Training and Placement Pvt. Ltd.

Profit & Loss Account for FY 2018-19

Particulars Debit Particulars Credit
To Purchase 1,00,000 By Sales 2,00,000
To Office Rent 25,000
To Net Profit 75,000
2,00,000 2,00,000

Note: Profit represents Credit balance of P&L A/c. While Loss represents Debit Balance of P&L A/c.
Note: Net Profit / Loss in P&L A/c is transferred to Reserve and Surplus A/c on liability side of balance sheet by passing following journal entry. Hence, P&L account is also closed.

 Date Particulars  Debit  Credit
In case of Profit
31/03/2019 P & L A/c  Dr. 75,000
To Reserve & Surplus A/c 75,000
In case of Loss
 31/03/2019

Reserve & Surplus A/c   Dr. 

 75,000
 To P & L A/c 75,000 

 

Balance Sheet as on 31st March 2019

Liabilities Amount Assets Amount
Capital 1,00,000 Bank A/c 25,000
Reserve & Surplus 75,000 Cash-In-hand 50,000
Sundry Creditors Sundry Debtors
ABC Co. Ltd. 1,00,000 XYZ Co. Ltd. 2,00,000
Total 2,75,000 Total 2,75,000

  • With preparation of P&L and Balance sheet the one accounting cycle for FY 2018-19 ends. The closing Balances for FY 2018-19 shall act as opening balance for FY 2019-20.

 

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