Accounting Process

The One Thing

The accounting process converts financially measurable business transactions into reliable financial information through documentary evidence, journalisation, ledger posting, trial balance preparation, and financial statements. Its foundation is the dual-aspect principle: every transaction affects at least two accounts, and total debits must equal total credits.

Definitions and Results

• Transaction: A financial event that can be measured in money and affects the assets, liabilities, capital, income, or expenses of a business.
• Source Document: Written evidence of a transaction, such as an invoice, receipt, cheque counterfoil, or bank advice.
• Voucher: A document prepared or obtained as proof and authorization for recording a business transaction.
• Accounting Equation: Assets = Capital + Liabilities.
• Journal: The book of original entry in which transactions are recorded chronologically using debit and credit rules.
• Narration: A brief explanation written below a journal entry to describe the transaction.
• Ledger: The principal book containing separate accounts for assets, liabilities, capital, income, and expenses.
• Posting: The process of transferring information from the journal or subsidiary books to the appropriate ledger accounts.
• Trial Balance: A statement listing the debit and credit balances of ledger accounts to check the arithmetical accuracy of bookkeeping.
• Cash Book: A book of original entry and a ledger account used to record cash and bank receipts and payments.
• Contra Entry: An entry involving both cash and bank, such as depositing cash into the bank or withdrawing cash from the bank for office use.
• Depreciation: The gradual and permanent decrease in the value of a fixed asset due to use, passage of time, wear and tear, or obsolescence.
• Straight-Line Method: A depreciation method under which an equal amount is charged every year.
• Written-Down Value Method: A depreciation method under which depreciation is calculated at a fixed percentage on the asset’s opening book value each year.
• Provision: An amount charged against profit to meet a known liability or expected loss whose exact amount or timing is uncertain.
• Reserve: An appropriation of profit retained in the business to strengthen financial position or meet future needs.
• Capital Reserve: A reserve created mainly from capital profits and generally not available for normal dividend distribution.
• Revenue Reserve: A reserve created from normal business profits and usually available for general business purposes.
• Traditional rules of debit and credit:

- Personal accounts: debit the receiver and credit the giver. - Real accounts: debit what comes in and credit what goes out. - Nominal accounts: debit expenses and losses and credit incomes and gains.

• Modern classification rules:

- Increases in assets and expenses are debited. - Increases in liabilities, capital, and income are credited. - The reverse applies to decreases.

• Trial Balance methods: A trial balance may be prepared using the total method, balance method, or total-cum-balance method.
• Cash Book columns: A cash book may be single-column, double-column, or triple-column. A triple-column cash book generally includes cash, bank, and discount columns.
• Depreciation formulas:

- Straight-Line Method: Annual Depreciation = (Cost of Asset - Estimated Residual Value) / Estimated Useful Life - Written-Down Value Method: Depreciation for the year = Opening Book Value × Depreciation Rate / 100 - Book Value of an Asset = Original Cost - Accumulated Depreciation

• Accounting period: The time span for which financial results are measured, commonly one year, although the exact period depends on the business and applicable rules.

Worked Methods

1. Applying the accounting process

The accounting process generally follows this sequence:

• Identify the business transaction.
• Prepare or collect the relevant voucher or source document.
• Record the transaction in the journal or appropriate subsidiary book.
• Post the information to the relevant ledger accounts.
• Prepare the trial balance from the ledger balances.
• Use the balances to prepare financial statements.

The process should be based on reliable documentary evidence so that accounting entries are complete, accurate, and verifiable.

2. Recording transactions using debit and credit rules

For each transaction:

• Identify the accounts affected.
• Classify the accounts as personal, real, or nominal, or apply the modern classification rules.
• Determine which account is debited and which is credited.
• Record the date, accounts affected, debit amount, credit amount, and narration in the journal.
• Confirm that the total debit equals the total credit.

Every transaction has a dual aspect. Therefore, total debits must equal total credits.

3. Posting and balancing ledger accounts

After journalisation:

• Transfer each debit entry to the debit side of the relevant ledger account.
• Transfer each credit entry to the credit side of the relevant ledger account.
• Total both sides of the account.
• Find the difference between the two totals.
• Bring down the balance to the next accounting period.

The journal records transactions chronologically, whereas the ledger classifies them account-wise for analysis and balancing.

4. Preparing a trial balance

To prepare a trial balance:

• Extract the debit and credit balances from the ledger accounts.
• List the debit balances in the debit column.
• List the credit balances in the credit column.
• Total both columns.
• Compare the totals.

Agreement of the totals provides an arithmetical check that total debits equal total credits. The trial balance may be prepared by the total method, balance method, or total-cum-balance method.

However, agreement does not prove that all errors are absent. Complete omission, compensating errors, and some errors of principle may remain undetected.

5. Recording cash and bank transactions

Using the cash book:

• Record cash receipts on the debit side.
• Record cash payments on the credit side.
• Record bank receipts and payments in the bank column where applicable.
• Record discounts in the discount column when using a triple-column cash book.
• Record a transaction involving both cash and bank as a contra entry.

Examples of contra entries include depositing cash into the bank and withdrawing cash from the bank for office use.

Cash cannot normally have a credit balance. A bank column, however, may show a credit balance when there is an overdraft.

6. Calculating depreciation under the Straight-Line Method

Under the Straight-Line Method:

• Determine the cost of the asset.
• Deduct the estimated residual value.
• Divide the resulting amount by the estimated useful life.
• Charge the equal annual amount each year.

The formula is:

Annual Depreciation = (Cost of Asset - Estimated Residual Value) / Estimated Useful Life

This method charges an equal amount every year. Depreciation should be charged systematically over the useful life of the asset and should be based on a consistent method.

7. Calculating depreciation under the Written-Down Value Method

Under the Written-Down Value Method:

• Determine the asset’s opening book value.
• Apply the fixed depreciation rate.
• Divide by 100.
• Deduct the depreciation from the opening book value to determine the closing book value.
• Use the closing book value as the basis for the following year.

The formula is:

Depreciation for the year = Opening Book Value × Depreciation Rate / 100

The book value is calculated as:

Book Value of an Asset = Original Cost - Accumulated Depreciation

Depreciation is a non-cash expense. It reduces accounting profit and the carrying amount of the asset but does not involve an immediate cash payment. It applies the matching principle by charging the cost of a fixed asset to the periods that benefit from its use.

8. Distinguishing provisions and reserves

To account for a provision:

• Identify a known liability or expected loss.
• Recognize the amount as an expense before determining net profit.
• Estimate the amount even though its exact amount or timing is uncertain.

Examples include:

• Provision for doubtful debts.
• Provision for discount on debtors.
• Provision for taxation.

The provision for doubtful debts is generally calculated on the adjusted amount of debtors after considering relevant bad debts and other adjustments.

To account for a reserve:

• Determine the profit for the period.
• Appropriate part of the profit after profit has been determined.
• Retain the amount in the business for strengthening its financial position or meeting future needs.

Reserves may be:

• Specific reserves, created for a particular purpose.
• General reserves, created without a specific purpose.

A capital reserve is created mainly from capital profits and is generally not available for normal dividend distribution. A revenue reserve is created from normal business profits and is usually available for general business purposes.

Provisions follow the prudence principle by recognizing expected losses or liabilities. Reserves represent retained profits set aside for strengthening the business or meeting future requirements.

Where It Goes Wrong

• Ignoring documentary evidence: Transactions must be supported by source documents or vouchers, such as an invoice, receipt, cheque counterfoil, or bank advice.
• Applying only one side of a transaction: Every transaction has a dual aspect, so total debits must equal total credits.
• Confusing journalisation with posting: The journal records transactions chronologically, while posting transfers information to the appropriate ledger accounts.
• Treating trial balance agreement as conclusive: Complete omission, compensating errors, and some errors of principle may remain even when the trial balance agrees.
• Misreading cash and bank balances: Cash receipts belong on the debit side and cash payments on the credit side; cash cannot normally have a credit balance, although a bank overdraft may produce a credit balance in the bank column.
• Confusing depreciation, provisions, and reserves: Depreciation is a non-cash expense; a provision is charged before determining net profit for an expected loss or liability; a reserve is generally appropriated after profit has been determined.

What Gets Asked

This material supports questions requiring students to:

• State and apply the accounting equation: Assets = Capital + Liabilities.
• Arrange the accounting process in the correct sequence from transaction identification to financial statements.
• Identify suitable source documents and vouchers for business transactions.
• Apply traditional and modern rules of debit and credit.
• Prepare journal entries containing the date, accounts, amounts, and narration.
• Explain the distinction between journal recording, ledger posting, and ledger balancing.
• Prepare a trial balance using the total method, balance method, or total-cum-balance method.
• Explain why agreement of a trial balance does not detect every accounting error.
• Prepare or interpret single-column, double-column, and triple-column cash books.
• Record contra entries for depositing cash into the bank or withdrawing cash from the bank for office use.
• Calculate depreciation using the Straight-Line Method.
• Calculate depreciation using the Written-Down Value Method.
• Determine the book value of an asset using Original Cost - Accumulated Depreciation.
• Explain why depreciation is a non-cash expense and how it applies the matching principle.
• Distinguish between a provision and a reserve using the timing of recognition in relation to net profit.
• Identify examples of provisions, including provision for doubtful debts, provision for discount on debtors, and provision for taxation.
• Calculate provision for doubtful debts using the adjusted amount of debtors after relevant bad debts and other adjustments.
• Distinguish between capital reserves, revenue reserves, specific reserves, and general reserves.
• Explain the importance of consistency in accounting methods and the role of the accounting period in measuring financial results.