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Chapter 4 Notes

This document outlines the accounting cycle which is used to record business transactions and prepare financial statements. It consists of 9 steps: 1) recording source documents, 2) preparing journal entries, 3) posting to ledgers, 4) preparing a trial balance, 5) making adjusting entries, 6) preparing an adjusted trial balance, 7) making closing entries, 8) preparing a post-closing trial balance, and 9) preparing the income statement and balance sheet. The accounting cycle ensures all transactions are recorded accurately and financial statements are prepared according to accounting principles.

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Lex Xu
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85 views

Chapter 4 Notes

This document outlines the accounting cycle which is used to record business transactions and prepare financial statements. It consists of 9 steps: 1) recording source documents, 2) preparing journal entries, 3) posting to ledgers, 4) preparing a trial balance, 5) making adjusting entries, 6) preparing an adjusted trial balance, 7) making closing entries, 8) preparing a post-closing trial balance, and 9) preparing the income statement and balance sheet. The accounting cycle ensures all transactions are recorded accurately and financial statements are prepared according to accounting principles.

Uploaded by

Lex Xu
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Chapter 4 – Record Keeping

4.1 – The importance of good records


 Complete and accurate records are important: they provide the observations and the history of the
organisation. Without knowing what has happened, investors and managers cannot make plans, evaluate
alternatives properly or learn from past actions.
 In today's complex business environment especially since organisations have be-come very large - the
number of events (or transactions, as we will call them) is much too great for anyone to keep track of
without keeping accurate re-cords (written or, these days, mostly on computer).
 Re-cords provide the basis for extrapolations into the future, the information for evaluating and rewarding
performance, and a basis for internal control over the existence and quality of an organisation's assets.
Record keeping, however, does cost money; therefore, records should be worth their cost.
 How complex and sophisticated to make one's re-cords is a business decision, much like decisions such
as how to price or market one's product.

4.2 – Financial accounting's transactional filter

4.3 – Accounting’s 'books' and records


The Accounting Cycle
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Step 1: Source documents
Accounting record-keeping depends upon sets of documents to show that transactions have occurred.
Such documents are kept so that the accounting records can be checked and verified to correct errors.
They also permit auditing and can be used if there is a dispute or to support income tax claims and other
legal actions. The transactions themselves reflect various events in operating a business.

Step 2: Prepare journal entries


Based on source documents, accounting transactions are recorded by preparing journal entries. Because
this is when the business event is first recorded by the accounting system, these basic transactional records
are often called books of original entry.
Consider the following transactions:

 A consulting company provides services to a client on 1 February and sends it an invoice (source
document) for $10 000.
 The company buys a motor vehicle for $30 000 on 3 February, paying $12 000 cash and owing $18
000 to be paid in two years.
These would be recorded as follows:

Step 3: Post to ledgers


Consider a situation where, during the month, thousands of journal entries were written, of which 20 per
cent included either a debit or credit to the cash account. If you were asked the balance of the cash
account at the end of the month, how would you find out?
One option is to get the opening balance, add on all debit entries affecting cash and deduct all credit
entries affecting cash.
But doing this is time-consuming, and it would be preferable to have a source that will give you the
balance of the account at any point in time. Such a source is a ledger.
Ledgers are books (or computer records) that have a separate page or account code for each individual
account referred to in the chart of accounts.
Each area or page contains a summary of all the transactions relating to that particular account and,
therefore, posted to it.
Here is an example of the 'cash at bank' ledger account for a company:

Each ledger account is really just a convenient summary of the entries affecting it. In turn, the balance
sheet is a summary of all the account balances.
The general ledger is the complete set of all the accounts (assets, liabilities, equity accounts, revenues and
expenses) that lie behind the financial statements.
For demonstration and analysis purposes, accountants and accounting instructors often use a simplified
version of a ledger account called a T-account, which includes only the debits and credits columns of the
account, without calculating the balance after every entry. A T-account version of the above cash account

example would look like this:

AN EXAMPLE ON LEDGERS
Let's start with a very simple example where the company has only two opening balances:

Step 4: Prepare a trial balance


A trial balance is a list of all the accounts and the balances of each of the accounts.
The aim is that the sum of the debit balances equals the sum of the credit balances.
Because the general ledger contains all the accounts, all of which came from balanced journal entries, it
must balance (sum of debit-balance accounts equalling sum of credit-balance accounts) and it leads to a
balanced balance sheet.
Because errors might have been made, a standard bookkeeping procedure is to check that the ledger does
balance by adding up al l the debit and all the credit account balances and making sure the two totals are
equal. There is always a little uncertainty that this will work, so the calculation is called a trial balance.
An example of a trial balance is shown in Exhibit 4.1.

Step 5: Prepare adjusting journal entries and post to ledgers


At the end of each accounting period, it is necessary to adjust the revenue and expense accounts (and the
related asset and liability accounts) to reflect expenses incurred but not yet paid, revenues earned but not
yet received, cash received from customers before the work being done, and the using up of assets, which
creates an expense (such as depreciation). It is al l about splitting an expense or revenue item across two
different accounting periods. For example, an insurance payment could be made in March 2019 covering
1 April 2019 to 30 March 2020. At 30 June 2019, accounts have to be adjusted to reflect that 25 per cent
of the payment is a 2019 expense and 75 per cent is a 2020 expense. Assuming that the payment for
insurance (say, $200 000) was put to an asset account in March (i.e. DR prepayments $200 000, CR cash
$200 000), at 30 June it is necessary to reduce the asset (prepayments) to reflect that part of the asset is
used up. Therefore:
Step 6: Prepare an adjusted trial balance
After all the adjusting entries have been made and posted to the ledger accounts, then another trial balance
called an adjusted trial balance can be prepared. Follow the same process as described previously in step
4.

Step 7: Prepare closing journal entries and post to ledgers


Closing entries formally transfer the balances of the revenue and expense accounts to a profit and loss (P
& L) summary, then to retained profits.
This step will occur at the end of the accounting period. Closing entries reset the revenue and expense
account balances to zero to begin recording these items for the next accounting period. Closing entries are
simple to prepare. The steps are outlined below:

 Revenue accounts have credit balances and are closed (reduced to zero) with debits to the revenue
accounts and a credit to the P & L summary account.
 Expense accounts have debit balances and are closed (reduced to zero), with credits to the expense
accounts and debits to the P & L summary account.
 The P & L summary account, which is simply a holding account, is then closed off to retained profits.
o If the P & L summary has a credit balance after closing off the revenues and expenses (i.e. a
profit has been made), the entry is debit P & L summary and credit retained profits.
o If the account has a debit balance (i.e. a loss has been made), the entry is a credit to P & L
summary and a debit to retained profits.
Step 8: Prepare a post-closing trial balance
A post-closing trial balance can now be prepared as follows:

Note that there are no revenue and expense accounts in the above post-closing trial balance as these
accounts have been closed off in the previous step. If there is a revenue or expense account listed, a
closing entry may have been missed; this should be resolved before preparing the financial statements.
Step 9: Prepare the financial statements
The items in the P & L summary account can be used as a basis for preparing the income statement, and
the items in the post-closing trial balance can be used to prepare the balance sheet. These statements are
shown in Exhibit 4.2.

4.4 – An illustrative example

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