Chapter 04: Process & Base of Accounting
TOPIC 01: PROCESS OF ACCOUNTING
The accounting process is a series of logical steps followed to identify, record, classify, summarize, and report financial transactions of a business. It typically involves the following steps:
1. Identification of Transactions:
Only monetary transactions those that can be expressed in terms of money are recorded in accounting. Every transaction must be supported by source documents.
E.g., Cash memo, Invoice, Bill, Pay-in-slip, Cheque, Salary Slip. A document which provides evidence of the transaction is called the Source Document.
2. Preparation of Vouchers:
Based on the details from the source document, a voucher is prepared. A voucher is an internal document used to authorize and record a transaction, indicating which accounts are to be debited and credited.
- Recording in Books of Original Entry:
Transactions are first recorded in the Journal, also known as the book of original entry or primary book. Journalizing involves recording transactions chronologically, showing the accounts to be debited and credited, and a brief explanation (narration).
- Posting to Ledger:
After journalizing, transactions are classified and transferred to the Ledger. The ledger is the principal book of accounts, where separate accounts are maintained for each type of asset, liability, capital, revenue, and expense.
E.g., Cash Account, Bank Account, Sales Account, Purchases Account, Salary Account, Rent Account). This step is called posting.
- Preparation of Trial Balance & Financial Statements:
At the end of an accounting period, the balances of all ledger accounts are extracted to prepare a Trial Balance.
The trial balance is a statement that lists the debit and credit balances of all accounts to check the arithmetical accuracy of the posting and balancing of ledger accounts.
- It serves as a basis for preparing financial statements.
- Financial Statement is the final step in the accounting process.
- Based on the balances in the trial balance, the financial statements are prepared.
These typically include:
Trading and Profit & Loss Account (or Income Statement): Shows the profit earned or loss incurred during an accounting period.
Balance Sheet: Presents the financial position (assets, liabilities, and capital) of the business on a specific date.
Bases of Accounting
This refers to the methods used to record and recognize revenues and expenses. The two primary bases are:
(1). Cash Basis of Accounting:
Under this method, revenues are recorded only when cash is received, and expenses are recorded only when cash is paid.
Credit transactions are generally not recorded until cash is exchanged.
Outstanding expenses, prepaid expenses, accrued income, and unearned income are typically not accounted for.
Suitability: Often used by professionals like doctors, lawyers, and non-profit organizations.
Advantages: Simple to understand and apply.
Disadvantages: Does not show the true profit or loss of a period as it ignores outstanding/accrued items.
Violates the matching principle of accounting.
Example: acquisition of goods will have to be treated as expenses of the period in which payment is made instead of the periods in which benefits are derived from them.
- Not recognized by the Companies Act, 2013, and generally not accepted under Generally Accepted Accounting Principles (GAAP) for most businesses.
(2)Accrual Basis of Accounting:
Under this method, revenues are recorded when they are earned whether cash is received or not, and expenses are recorded when they are incurred or become due whether cash is paid or not.
Records both cash and credit transactions.
Properly accounts for outstanding expenses, prepaid expenses, accrued income, and unearned income.
Suitability: Most commonly used by businesses and companies.
Advantages:
- Provides a more accurate picture of the true profit or loss for a specific period.
- Adheres to the matching principle and other accounting principles.
- Recognized by the Companies Act, 2013, and generally accepted under GAAP.
- Facilitates better financial analysis and decision-making.
Disadvantages: Can be more complex to apply due to the need for adjustments for outstanding and accrued items.
(3) Hybrid or Mixed Basis of Accounting:
A combination of both cash and accrual bases.
Typically, revenue and assets are recorded on a cash basis, while expenses and liabilities are recorded on an accrual basis.
This basis is rarely used and is not generally accepted.
Distinction between Cash & Accrual Basis of Accounting:
| Basis | Cash Basis Accounting | Accrual Basis Accounting |
| Revenue Recognition | Recorded only when cash is received. | Recorded when earned, regardless of when cash is received. e.g., when goods are delivered or services are rendered |
| Expense Recognition | Recorded only when cash is paid. | Recorded when incurred or become due, regardless of when cash is paid. e.g., when a bill is received, even if not yet paid. |
| Credit Transactions | Generally not recorded until cash is exchanged. | Recorded e.g., Accounts Receivable for sales on credit, Accounts Payable for purchases on credit. |
| Matching Principle | Does not follow the matching principle. | Follows the matching principle. |
| Accuracy of Profit/Loss | May not show the true profit or loss for a period, as it ignores outstanding revenues and expenses. | Provides a more accurate picture of true profit or loss for a period, as it accounts for all revenues earned and expenses incurred. |
| Financial Health | May give a misleading picture of financial health at any given moment, as it doesn’t reflect what’s owed to or by the business. | Provides a more comprehensive and realistic view of financial health, including assets like accounts receivable and liabilities like accounts payable. |
| Complexity | Simpler to use and maintain. | More complex, requiring adjustments for accrued and deferred items. |
| GAAP Compliance | Generally not compliant with GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). | Compliant with GAAP and IFRS, making it the standard for most businesses. |
| Suitability | Often used by small businesses, sole proprietors, or individuals with simple operations and mostly cash transactions e.g., freelancers, small service providers. | Required for larger businesses, corporations, and publicly traded companies, especially those that deal with credit transactions, inventory, or have significant receivables/payables. |
| Balance Sheet | Does not reflect Accounts Receivable or Accounts Payable, so the balance sheet may not be complete. | Reflects Accounts Receivable and Accounts Payable, giving a more complete balance sheet. |