What is Accounting Process? Stage, Transaction

What is Accounting Process?

The accounting process starts when any financial transaction is made in an organisation. The accounting process results in various financial statements, such as balance sheet, profit and loss account and other statements. Therefore, you can say that the main objective of this process is recording financial transactions systematically and accurately in the journal and process them to prepare the financial statements.

The process of financial accounting involves a number of steps. Let us understand the accounting process with the help of an example.

Stages in Accounting Process

The process of accounting starts with the identification of financial transactions. Next, it records the transactions in the books of accounts. Then the process classifies and summarises the information and prepares a trial balance and financial statements.

A brief description of the steps involved in the accounting process is as follows:

Identification of Financial Transactions

In this step, the business transactions that are financial in nature are identified. It should be noted that the financial transactions should have documentary evidence, such as invoices of purchases and sales, credit and debit notes, cash memo, pay-in-slips and payment vouchers.

Financial transactions result in monetary changes in the assets and liabilities of an organisation. Therefore, these changes are recorded in the journal, books of accounts.

Preparation of Vouchers

In this step, documentary evidences are prepared. This helps in notifying the business transactions. A voucher refers to an authorised consent of the payments made and provides information about the accounts that are to be debited or credited. After recording the payment entries in the voucher, they are next recorded in the journal.

Recording Entries in the Books of Original Entry

In this step, the financial transactions are recorded from the vouchers to the books of accounts or journals. You must note that the financial transactions are recorded in chronological order in these books. If the same type of transaction takes place a large number of times, then a subsidiary book can be maintained to record the credits. Subsidiary books are specialised books of original entry, and are discussed later in the chapter.

Posting to the Ledger

In this step, the recorded transactions are transferred from the journal books to the ledger. This process is called the ledger posting. Same type of entries of financial transaction collectively forms an account. In other words, in an account we put financial transactions that are classified as per their type.

For example, sales account contains entries of the product/services sold. The book in which the accounts are maintained is known as a ledger. Therefore, a ledger is a collection of accounts and also the principal book in double entry bookkeeping. Classification of transactions enables the organisation to get information related to total purchases, total sales, total expenses, creditors and debtors.

Preparation of Trial Balance and Financial Statements

In this step, a balance in each ledger account is determined and the trial balance is prepared. In the trial balance, the debit and credit balances of each account are put in their respective columns. The total of the debit balance and the credit balance must tally. This would indicate arithmetic accuracy. The financial statements are prepared with the help of the trial balance.

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Traditional Approach for Recording Transactions

According to the traditional approach, various accounts are classified as personal account, real account and nominal account.

Personal accounts are accounts that are related to persons, company, firms or organisations, with which the business is engaging in financial transactions. Personal account will mainly consist of accounts of debtors and creditors. Some examples for personal accounts are Rakesh account, ABC Pvt. Ltd. Account, creditors account, debtors account, etc.

Personal accounts are further divided into the following three sub-categories:

• Natural personal accounts are those accounts which are related to individual persons or human beings. For example, Rakesh account, Ramesh Account, Sohail account, etc.
  
  
• Artificial personal accounts are those accounts which are related to corporate bodies, institutions created by the law and these accounts are not related to living persons. For e.g. Private limited companies (Pvt. Ltd.), Limited liability partnerships (LLPs), limited liability companies (LLCs), banks, educational institutions, etc.
  
  
• Representative personal accounts are those accounts which represent an individual or a group of certain individuals directly or indirectly. For example, outstanding expenses account, advance expenses account, outstanding income account and advance income account.

Golden rule for personal accounts: Debit the receiver and credit the giver.

Real accounts refer to the accounts related to the assets and liabilities including capital accounts of owners. These accounts may be tangible or intangible in nature.

Real accounts are further divided into the following two sub categories:

• Tangible real accounts are those accounts which are related to those items that can be touch and feel. For example, building, plant and machinery, land, stock, etc.
  
  
• Intangible real accounts are those accounts which are related to intangible things that cannot be touch or feel. For example, goodwill, patents, trademarks, copyrights, etc.

Golden rule for real accounts: Debit what comes in and credit what goes out.

Nominal accounts are those accounts which exist in name only and do not have any physical form. Monetary transaction is involved behind every transaction in a nominal account. For e.g. sales account, purchase account, commission account, salary account, discount account, rent account, etc. Golden rule for nominal accounts: Debit all expenses and losses and credit all incomes and gains.

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Transaction Analysis

Every business organisation involves a large number of transactions on a daily basis, for example issue of shares, purchase of raw material, rent paid, wages paid, salary paid, sale of finished goods, etc. All these transactions lead to changes in three basic elements, which are assets, liabilities and share capital.

Transaction analysis provides a clear view of owner’s original investment by applying an accounting equation. Accounting equation shows the relationship between assets (valuable resources owned by organisation), liabilities (present obligations of organisation) and share capital (owners’ equity required to operate a business).

This relationship can be expressed by a mathematical equation, i.e. Assets = Liabilities + Capital. This mathematical equation must be balanced to match the assets and liabilities side of a balance sheet. Any transaction from accounting operations can be divided into the following parts:

We will further describe transaction analysis with the help of a series of transaction given below:

Transaction 1

ABC Ltd. Company starts business by issuing shares of ₹10 lakh.

Impact on Balance Sheet

• Assets side will increase with cash of ₹10 lakh.
• Liability side will increase with share capital of ₹10 lakh.

Transaction 2

Purchased machinery of ₹1 lakh for cash.

Impact on Balance Sheet

• Assets side will decrease with a cash of ₹1 lakh.
• Assets side will increase with the purchase of machinery of ₹1 lakh.

Transaction 3

Purchased raw material inventory on credit worth ₹1 lakh.

Impact on Balance Sheet

• Assets side will increase with the inventory of ₹1 lakh.
• Liabilities side will increase with creditors of ₹1 lakh.

Transaction 4

Sold finished goods inventory for cash ₹1 lakh.

Impact on Balance Sheet

• Assets side will increase with cash of ₹1 lakh.
• Assets side will decrease with inventory of finished goods sold for ₹1 lakh.

Transaction 5

Advance payment of ₹1 lakh received from customer.

Impact on Balance Sheet

• Assets side will increase with cash of ₹1 lakh.
• Liability side will increase with Advance income ₹1 lakh (income received but not earned).

Transaction 6

Cash payment made to creditors ₹1 lakh.

Impact on Balance Sheet

• Assets side will decrease with cash of 1 lakh – Liability side (Creditors) will decrease with 1 lakh.

Transaction 7

Patents amortise with ₹1 lakh.

Impact on Balance Sheet

• On Assets side, patents will decrease with the amount of ₹1 lakh.
• On Liability side, retained earnings will decrease with ₹1 lakh.

Transaction 8

10% Loan of ₹1 lakh acquired from bank.

Impact on Balance sheet

• Assets side will increase with cash of ₹1 lakh.
• Liability side will increase with ₹1 lakh as loan received from bank.

Transaction 9

Cash dividend of ₹10 thousand paid to shareholders

Impact on Balance Sheet

• On Assets side cash will decrease with ₹10 thousand.
• On liability side retained earnings will decrease with ₹10 thousand.