Accounting is the process of recording financial transactions pertaining to a business. The accounting process includes summarizing, analyzing, and reporting these transactions to oversight agencies, regulators, and tax collection entities. The financial statements used in accounting are a concise summary of financial transactions over an accounting period, summarizing a company’s operations, financial position, and cash. Regardless of the size of a business, accounting is a necessary function for decision making, cost planning, and measurement of economic performance measurement.
Process of Accounting:
1. Identify the Transaction
Identifying the business transaction is the initial step in the process of accounting. The business entity has to identify financial and monetary transactions. Therefore, only those transactions that are monetary is recorded. Also, the transactions that belong to the business are to be recorded, and not the personal transactions of the owner are included in the books of accounts of the business.
2. Recording of the Transactions in the Journal
After identifying the transactions, the second step of the accounting process is to create the Journal entry for every accounting transaction. The point of the recording of transactions is based on the policy followed by the entity for accounting, i.e., accrual basis or cash basis of accounting. In the accrual basis of accounting, the revenues and expenses are recorded in the books of the entity in the period when they are earned and incurred respectively, regardless of the actual cash receipt and payment. However, in the case of cash accounting, the transactions are recorded only when the actual cash is received/paid. In a dual entry system, every transaction affects at least two accounts, i.e., one account is debited, and another account is credited. For example, if the purchases are made in cash, then the purchases account will be debited (purchases increases), and the cash account is credited (cash decreases).
3. Posting in the Ledger
After recording the transaction in the Journal, the individual accounts are then posted in the general ledger. This helps the owner/accountant to know the balance of each account individually. For example, all the debits and credits of the bank account are transferred to the ledger account, which helps to know the increase and decrease in bank balance during a period, and finally, we can determine the ending bank balance from it.
4. Unadjusted Trial Balance
The trial balance of the company is prepared to check whether the debits are equal to the credits or not. Basically, trial balance’s main purpose is to identify the errors, if any, made during the above process. Trial balance reflects all the balances of accounts at the given point of time. After the preparation of the trial balance, it is checked that the total of all credits is equal to the total of all debits, and if the total is not the same, then an error is to be identified and corrected. There can be other reasons for error also, but still, firstly, an accountant tries to locate the error from prepare preparing the trial balance, and also trial balance helps to know the balances of all accounts in a summarized form.
5. Adjusting Journal Entries
When the accrual basis of accounting is followed, some of the entries are to be made at the end of the accounting year, such as entries of expenses that may have been incurred but are not booked in the Journal and entries of some income that may be earned by the business but are not yet recorded in the books. For example, the interest amount on a fixed deposit is earned each year, but it is accumulated in the fixed deposit amount. This interest income is to be recorded in the books of accounts yearly because the interest is earned yearly, no matter the amount will be received together after the maturity of the fixed deposit.
6. Adjusted Trial Balance
After all the adjusting entries are made, again, a trial balance is to be prepared before preparing the financial statements to check that all the credits are equal to the debits after the adjustment entries are made.
7. Preparation of Financial Statements
After all the above steps are completed, the financial statements of the company are prepared to know the actual financial position, the profitability position, and the cash flow position of the business. The statements that are prepared for knowing the above positions are a statement of profit and loss for knowing the profitability position, the balance sheet for getting the financial position, and the cash flow statement to know the changes in cash flows from the three activities of the business (operating, investing and financing activities).
8. Closing Entries
Finally, the accounting cycle ends with this step. These entries transfer the temporary account balances to a permanent account. The temporary accounts are the accounts whose balances ends in a single accounting year such as sales, purchases, expenses, etc. These balances are first transferred to the income statement and then to the permanent account, i.e., the profit/loss is transferred to retained earnings account. It should be cleared that only temporary accounts are closed not the permanent ones (accounts that are balance sheet accounts such as fixed assets, debtors, inventory, etc.). After closing entries are made, the trial balance is again prepared to check that the debit is equal to the credit, and the accounting cycle starts again with the beginning of another accounting year.