Accounting Mechanics

Financial Accounting
Unit-2
 Accounting Process

 Accounting mechanism is used to

record the activities and
transactions that occur within a
business.
 The first general rule of accounting
mechanism is that every transaction
is recorded.
 The accounting process is a series of
activities that begins with a
transaction and ends with the
closing of the books.
 The accounting process includes
summarizing, analyzing and
reporting these transactions to
oversight agencies, regulators and
tax collection entities.
 The accounting cycle is, eight-
step process for completing a
company's bookkeeping
tasks.
 It provides a clear guide for
recording, analysis, and final
reporting of business's
financial activities.
 The accounting cycle is used
comprehensively through one
full reporting period.
Step 1: Identify Transactions
 The first step in the accounting cycle is identifying transactions.
 Companies will have many transactions throughout the accounting cycle.
Step 2: Record Transactions in a Journal
 The second step in the cycle is the creation of journal entries for each transaction.
 Point of sale technology can help to combine Steps 1 and 2, but companies must also track their expenses. 
Step 3: Posting
 Once a transaction is recorded as a journal entry, it should post to an account in the general ledger. 

Step 4: Unadjusted Trial Balance 

 At the end of the accounting period, a trial balance is calculated as the fourth step in the accounting cycle.
Step 5: Worksheet
 Analyzing a worksheet and identifying adjusting entries make up the fifth step in the cycle.
 A worksheet is created and used to ensure that debits and credits are equal.
Step 6: Adjusting Journal Entries
 In the sixth step, a bookkeeper makes adjustments.
 Adjustments are recorded as journal entries where necessary.
Step 7: Financial Statements
 After the company makes all adjusting entries, then it generates financial statements in the seventh step.
 For most companies, these statements will include an income statement, balance sheet, and cash flow statement.
Step 8: Closing the Books
 Finally, a company ends the accounting cycle in the eighth step by closing its books at the end of the day on the
specified closing date.
 Double Entry System

 The most scientific and reliable method of accounting is the Double Entry System.
 Every transaction involves two parties or accounts, one account gives benefit, and other receives it.
 It is called a dual entity of transaction.
 In every transaction, the account receiving benefit is debited, and the account giving benefit is
credited.
 The main principle of the double-entry system is that for every debit there is a corresponding credit
for an equal amount of money.
 For every credit there is a corresponding debit for an equal amount of money;
 i.e., for every transaction one account is debited for the amount of transaction and the other account
is credited with equal amount of money.
Assets = Liabilities + Owner's equity
Capital=Assets-Liabilities
Assets=Capital-Liabilities
 Journal Entries
 A journal entry is a record of the business transactions in the accounting books of a business.
 A properly documented journal entry consists of the correct date, amounts to be debited and
credited, description of the transaction with a unique reference number.
 7 Types of Journal Entries used in accounting
(i) Simple Entry
(ii) Compound Entry
(iii) Opening Entry
(iv) Transfer Entries
(v) Closing Entries
(vi) Adjustment Entries
(vii) Rectifying Entries

(I) Simple Entries:-Simple entries are those entries, which

are affected only two accounts, one account is related to
Debit and another account is related to credit.

(II) Compound Entries:

 Compound entries are those entries in which there are at
least two debits and at least one credit or at least one
debit and two or more credit items.
 Compound entries are recorded for those transactions
which are similar in nature and occur on the same day.
(III) Opening Entry:
 Opening entries are those entries which record
the balances of assets and liabilities, including
capital brought forward, from previous
accounting period.
 In the case of going concerns, there is always a
possibility of having balances of assets and
liabilities, including capital, which were lying
in the previous accounting year.
 To show true and fair view of the business
concern, it is necessary that all previous
balances are to be brought forward in the next
year by way of passing an opening entry.
(IV) Transfer Entries:

 Transfer entries are those entries through

which amount of an account are transferred to
another account.
 Usually, these entries are recorded for those
transactions when wrong booking has been
made in respect of any account.
(V) Closing Entries:
Closing entries are those entries through which the
balances of revenue and expenses are closed by
transferring their balances to the Trading Account or
Profit and Loss Account.

(VI) Adjustment Entries:

Adjusting entries are those entries through which
assets and liabilities are recorded at their true values
and revenues are matched with the expenses.

(VII) Rectifying Entries:

Rectifying entries are those entries which are passed to
make few corrections in the books of original entries
or some accounts in the ledger.
 Trial Balance
A trial balance is a bookkeeping worksheet in which the balance of all ledgers are compiled into debit
and credit account column, that totals are equal.
 Trial balance is a list of all the general ledger accounts contained in the ledger of a business.
 This list will contain the name of each nominal ledger account and the value of that nominal ledger
balance.
 Each nominal ledger account will hold either a debit balance or a credit balance.
 The purpose of a trial balance is to prove that the value of all the debit value balances equals the total
of all the credit value balances.
 If the total of the debit column does not equal the total value of the credit column, then there is an
error in the nominal ledger accounts.
 A company prepares a trial balance periodically, usually at the end of every reporting period.
 A trial balance is a listing of the ledger accounts and their debit or credit balances to determine that
debits equal credits in the recording process.
On the trial balance the accounts should appear in this order:
1. Assets,
2. Labilities
3. Equity
4. Dividends
5. Revenues
6. Expenses
  Here is a sample of adjusted trial
balance.
 Notice the accounts are listed in the
order described left.
 You might be wondering why it is
such a big deal to organize the trial
balance in this manner.
 The purpose of the trial balance is to
make life easier when preparing
financial statements.
 Look what happens when we divide
the trial balance by statement.

This is the same trial balance is color coded it.

 Orange section is for the accounts that will be used on the balance sheet.
 Blue is the statement of retained earnings
 Green is the income statement.
Because to organize the accounts, preparation of financial statements will be so much easier.
 Types of trial balances
There are three types of trial balances
i. Unadjusted trial balance,
ii. Adjusted trial balance
iii. Post- closing trial balance
The unadjusted trial balance is prepared before adjusting
journal entries are completed.
 This trial balance reflects all the activity recorded from day-
to-day transactions and analyze accounts when preparing
adjusting entries.
For example, if you know that remaining balance in prepaid
insurance should be $600, you can look at the unadjusted
trial balance to see how much is currently in the account.
 The adjusted trial balance is completed after the adjusting
entries are completed.
Trial balance has the final balances in all the accounts and is
used to prepare the financial statements.
 The post-closing trial balance shows the balances after the
closing entries have been completed.
This is your starting trial balance for the next year.
 Types of Accounts
 Real account is a general ledger account that
does not close at the end of accounting year.
 In other words, the balances in the real accounts
are carried over to become beginning balances
of the next accounting period.
 Real accounts are also referred to as permanent
accounts.

 Nominal accounts are general ledger accounts

that are closed at the end of each accounting
year.
 As a result, the nominal accounts are also
referred as temporary accounts.
 The closing process also means each nominal
account will start the next accounting year with
a zero balance.
  An accounting system is the system used to manage the
income, expenses, and other financial activities of a
business.
 An accounting system allows a business to keep track of
all types of financial transactions, including purchases
(expenses), sales (invoices and income), liabilities
(funding, accounts payable), etc.
 It is capable of generating comprehensive statistical
reports that provide management or interested parties
with a clear set of data to aid in the decision-making
process.
What an accounting system manages
Expenses: The amount of cash flows out of the company in exchange for goods or services from another
person or company are the expenses.
 With a manual system, it is necessary to manually enter, balance, and categorise each expense.
 Automatic accounting system can make quick entry, categorisation and balance of expenses.
Invoices: Creating professional invoice Today, such as Debtor allow for instant invoice creation with the
ability to customise and automatically track paid invoices and income.
Funding: All the business liabilities, whether accounts payable, bank loans taken to support the
business, or mortgages, etc.
 An accounting system keeps track of these liabilities as payable values and automatically updates
the balances as soon a payment is made and accounts are settled.
 Systems of accounting and its effect on financial statements
 Assets, liabilities, owner’s equity, revenue and expenses, the five main elements of accounting.
 Each affect on a financial statement differently.
 Each element affects a financial statement, depends on whether the accounting system is cash or
accrual basis accounting.
 Accounting transactions refer to any business activity that results in direct effect on
the financial status and financial statements.
 These three core statements are intrication of the business.
 Such transactions come in many forms, including: Sales in cash and credit to customers.
 While new or very small privately-held businesses may choose a cash basis accounting system.

 The majority of businesses, including public companies and many established privately-held
businesses, use accrual basis accounting.
 Although more complex, accrual basis accounting follows generally accepted accounting principles,
which for many public and privately-held businesses is an accounting requirement.
 On a typical income statement, a firm's expenses are deducted from its revenues to come up with the
firm's net profits or losses for that given period.
 Therefore, any transactions that have an effect on the firm's overall revenues or expenses will have a
direct effect on the income statement.
 Having a set of rules can increase accuracy and reduce the ambiguity that can trigger
aggressive reporting decisions by management.
 Compliance to GAAP helps to ensure transparency in the financial reporting process by standardizing
the various methods, terminology, definitions, and financial ratios.
 When expenses are accrued, means an accrued liabilities account is increased, the amount of
the expense reduces the retained earnings account.
 Thus, the liability portion of the balance sheet increases, while the equity portion declines.

Cash Payment
 Assets for the balance sheet include cash, inventory, accounts receivable and prepaid accounts.
 As the value of the assets increases, the equity in the business increases.
 The equity calculation on the balance sheet is directly impacted by the value of the company assets.
 Salary payable is classified as a current liability account that appears under the heading of current
liabilities on the balance sheet.
 All the general rules of accounting are also applicable to this account.