Topic
X
3
The Accounting
Cycle
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Identify the steps involved in the accounting cycle;
2.
Explain the basic accounting equation;
3.
Analyse transactions; and
4.
Demonstrate the effect of transactions on an accounting equation
X INTRODUCTION
By now, you should be wondering how to prepare the financial statements
discussed earlier. Can you recall the definition of accounting or recall the four
components of accounting process? You need to be able to collect, identify,
measure and record before communicating the information to users in the form
of financial statements. This process describes the accounting cycle of a business.
In this topic, we will begin by introducing the accounting cycle to you. These are
the steps that will be repeated at every accounting period. We will then look at
the accounting equation, which is Assets equal Liabilities plus OwnerÊs Equity.
This equation will always remain in balance at all times. This is the basis of all
accounting as every transaction will have certain effects on the accounting
equations.
MYOB (Mind Your Own Business) is one of the many computer-based
accounting systems available in Malaysia. Many companies rely on an
accounting system to generate reports. An accounting package is an integral part
of a business in completing an accounting cycle, as highlighted by a chartered
accountant.
TOPIC 3
THE ACCOUNTING CYCLE W
41
„Having the right accounting system is essential for any business. It can save
time and money. Having the wrong one, however, can cost you hours in
inefficiencies and eat into your profits‰.
Tanya Parkyn
Chartered Accountant and the Director of Innovative Accounting Systems Pty.
Ltd
3.1
THE ACCOUNTING CYCLE
The accounting process begins with a transaction and ends with closing the
books at the end of a period. These steps are repeated at every accounting period
and are called the accounting cycle. It begins with the occurrence of the
transaction itself, analysing and recording the transactions in journals, posting it
to the ledgers and then preparing trial balance. At the end of the period,
adjusting entries are made, adjusted trial balance and financial statements are
prepared and then closing entries is done to prepare the temporary accounts for
the next periodÊs accounting cycle.
Figure 3.1: The accounting cycle
In this section, we will begin by looking at all of the steps in the accounting cycle
briefly.
3.1.1
Source Documents
At this stage information is gathered, generally in the form of source documents,
about transactions or events. Source documents are documents that provide
42
X TOPIC 3
THE ACCOUNTING CYCLE
proof that a transaction had actually occurred, and this is the basis of accounting
records. Examples of source document are sales invoice, purchase invoice, debit
note, credit notes, cheque and receipts. Controls on source document are
important to ensure accounting information is accurate and reliable.
At a minimum, each source document should include the data, the amount and a
description of the transaction. During an audit, source documents are used as
evidence that a particular business transaction occurred.
ACTIVITY 3.1
Look at a sample of sales or purchase invoice. Can you list down the
information is documented in this source document?
3.1.2
Transactions Analysis
Transactions are analysed; how each transaction affects the accounting equation
is looked into. At this stage the accounts affected by the transaction and how it is
affected (increased or decreased) will be identified.
3.1.3
Journalising
These transactions are then recorded in journals. A journal is also known as the
book of prime entry. It is a chronological record of transactions. Journal entries
will facilitate the posting of transactions to ledgers.
3.1.4
Posting
Records from the journal are then posted (transferred) to ledgers. Posting should
be done on timely basis, to ensure ledger is up to date.
3.1.5
Preparation of Unadjusted Trial Balance
At end of accounting period, the balance of all accounts of a business will be
listed in the trial balance.
TOPIC 3
3.1.6
THE ACCOUNTING CYCLE W
43
Adjusting Entries
At the end of an accounting period, adjusting entries are prepared to assign
revenues and expenses to the periods they are earned and incurred.
3.1.7
Preparation of Adjusted Trial Balance
Listing of all businessÊ accounts balances after adjustment entries are made.
3.1.8
Preparation of Financial Statements
The result of the business is communicated to users through financial statements.
Can you recall the financial statements that you have learned in Topic 1.6 earlier?
Income statement is prepared in order to report the financial performance of the
business. Balance sheet is prepared to report the financial position of the
business.
3.1.9
Closing Entries
At the end of an accounting period, all temporary accounts are closed. Revenues
and expenses are closed to income summary. Profit or loss is then transferred to
capital account. Drawings are also closed to capital account too.
The above mentioned stages are depicted in Figure 3.2 for quick reference.
44
X TOPIC 3
THE ACCOUNTING CYCLE
Figure 3.2: The stages involved in preparing the financial statement
Adapted from: Horngren (2004)
You will learn in detail all the steps of the accounting cycle. However, let us first,
look at the accounting equation. This is the most basic concept of the double
entry book keeping.
TOPIC 3
3.2
THE ACCOUNTING CYCLE W
45
ACCOUNTING EQUATION
Before we look at the accounting equation, you need to understand that all
economic events can be classified into three categories which are assets, liabilities
and ownerÊs equity.
Assets are resources that are owned by the entity. Land, properties, equipment,
motor vehicle, cash, receivables (debtors) are examples of assets. These assets are
expected to provide future economic benefits to the entity.
Liabilities are debts or obligation of the entity. Loans, bank overdrafts and
payables (creditors) are examples of liabilities. The liabilities are expected to be
cleared off by sacrificing the entityÊs assets.
OwnerÊs equity is the residual claim (rights) of entity assets. LetÊs say you
purchase a car using your own money and the car belongs to you. You can do
whatever you want with the car, even selling it. However, if you take a loan to
purchase a car, although you have the right to use the car, the ownership is not
yours, and the car is not yours until you pay off your loan. If you sell the car, the
loan amount will be deducted (settled) and the difference (the residual) will be
refunded to you.
To illustrate, let us look at this situation. You have decided to start a new
business. You only have RM5,000. So you asked your friend to lend you another
RM5,000. The business now has an asset (cash) of RM10,000 whereby only
RM5,000 belongs to you, and another RM5,000 belongs to your friend.
If you were to stop your business immediately, the business asset (cash) of
RM10,000 is not yours alone; you have to pay off your borrowings, and only the
balance belongs to you (residual claim).
The accounting equation is the fundamental of accounting. The equation presents
the resources of a business and the claim against those resources.
46
X TOPIC 3
THE ACCOUNTING CYCLE
Can you see the relationship between the assets of the business with liabilities of
the business and the ownerÊs equity interest? The relationships are presented in
the following basic accounting equation.
Figure 3.3: The basic accounting equation
All economic transactions in an entity will affect the equation, meaning they will
affect assets, liabilities or ownerÊs equity.
Although the items in the equations are affected (increased or decreased), the
equation will remain in balance at all times.
The basic accounting equations can be expanded to include items of ownerÊs
equity.
There are four items that can affect the ownerÊs equity, and they are:
Capital investments: they will increase ownersÊ equity.
Drawings: they will decrease ownersÊ equity
Revenues: they will increase the ownersÊ equity.
Expenses: they will decrease the ownersÊ equity.
TOPIC 3
THE ACCOUNTING CYCLE W
47
Figure 3.4: Transactions effect on ownerÊs equity
Hence the equations can be rewritten as:
Figure 3.5: The expanded accounting equation
The next section will look at the second step in the accounting cycle, analysing
transaction to determine how it affects the accounting equation.
ACTIVITY 3.2
You have a personal wealth of RM100,000, comprising of RM10,000 cash
and a car worth RM90,000. You had borrowed RM40,000 from your
parents to purchase the car. Can you write your accounting equation?
48
X TOPIC 3
3.3
THE ACCOUNTING CYCLE
TRANSACTION ANALYSIS
It is important for you to remember that the accounting equation must be in
equilibrium at all times. Business transactions must be analysed to see their
effects on the components of the equation.
The following are the steps that you can use to help you analyse business
transactions.
STEP 1:
Read and think about the transaction
STEP 2:
Identify components in the equations that are affected. Is it
Asset, Liability or OwnerÊs Equity?
STEP 3:
Identify the accounts and the effects. Decreased? Increased?
STEP 4:
Check the equation; it has to be balanced.
It is important for you to understand this analysis as it is the basis for preparing
journal entries for all transactions. Spend more time learning this section before
proceeding to another level.
We will see in detail how transaction analysis works by looking into the
following transactions of a service based business.
Table 3.1: Transactions of a Company
Date
Transactions
1st Sept. 2008
Sonic invested RM50,000 cash to start a photography business.
3rd Sept. 2008
Sonic purchased a photo processing machine costing RM1,000 cash.
5th Sept. 2008
Sonic withdrew RM10,000 cash for personal use.
6th Sept. 2008
Sonic borrowed RM20,000 cash from Digi Bank.
25th Sept. 2008
Sonic paid off RM5,000 of the bank loan.
26th Sept. 2008
Sonic provided professional photography service for a wedding;
RM2,000 cash was received and another RM1,000 will be received
within 14 days.
28th Sept. 2008
Sonic paid RM500 cash for his employeeÊs salary, RM300 cash for
utilities and RM200 cash for shop rental.
TOPIC 3
3.3.1
THE ACCOUNTING CYCLE W
49
Transaction 1: Initial Investment by Owner
Owner can contribute cash or other assets to the business as capital. For example
owner can bring his own motor vehicle into the business and this will be
considered as capital contribution by owner to the business. Capital
contributions by owner will increase both the business assets and ownerÊs equity.
Transaction
Basic
Analysis
Accounting
Equation
Accounting
Equation after
Transaction 1
1st Sept 2008, Sonic invested RM50,000 cash to start a
photography business Sonic Enterprise.
The asset (cash) has increased by RM50,000.
The ownerÊs equity (capital) has increased by RM50,000.
Assets
=
Liabilities
n Cash RM50,000
Assets
=
+
OwnerÊs Equity
n Capital RM50,000
Liabilities
+ OwnerÊs Equity
=
The equation remains in balance.
Figure 3.6: Transaction 1
3.3.2
Transaction 2: Purchase of Non Current Asset
To operate, most business must have non current assets (fixed assets) that will be
used to generate revenues. For example, a delivery van is needed to deliver
goods; a machine to produce products and so on. The purchase of such items can
either be on cash term or credit term. Paying cash for your purchase of non
current asset will see your cash asset decreases and your non current asset
increases. Purchasing non current assets on credit will see your non current
assets increased and your liabilities increased.
50
X TOPIC 3
Transaction
Basic
Analysis
THE ACCOUNTING CYCLE
3rd Sept. 2008, Sonic purchased a photo processing machine
costing RM1,000 cash.
The asset (cash) has decreased by RM1,000.
The asset (equipment) has increased by RM1,000.
Accounting
Equation
Assets
Accounting
Equation after
Transactions 1
&2
Assets
=
Liabilities
+
p Cash RM 1,000
=
OwnerÊs Equity
n Equipments 1,000
Liabilities
+
OwnerÊs Equity
Cash + Equipment
Capital
49,000
50,000
1,000
The equation remains in balance.
Figure 3.7: Transaction 1 to 2
3.3.3
Transaction 3: Withdrawals by Owners
It is normal for owner to take the business cash and use it for their personal
purpose. Business and owners assets are two separate things and need to be
accounted as so. If business cash are used for personal (owner) purposes, it is
considered as drawings by the owner. Drawings will reduce the ownerÊs equity
(capital) and asset (cash). It should be noted too, that any consumption of
business assets such as office supplies or stationeries for personal usages must be
recorded as drawings too.
TOPIC 3
Transaction
Basic
Analysis
THE ACCOUNTING CYCLE W
51
5th Sept. 2008, Sonic withdrew RM10,000 cash for personal
use.
The asset (cash) has decreased by RM10,000.
The ownerÊs equity (capital*) has decreased by RM10,000.
Accounting
Equation
Assets
Accounting
Equation after
Transactions 1,
2&3
Assets
=
Liabilities
+
OwnerÊs Equity
p Cash 10,000
=
p Capital * 10,000
Liabilities
+
OwnerÊs Equity
The equation remains in balance.
Figure 3.8: Transaction 1 to 3
Note: *
Withdrawals by owners are not recorded in the capital account directly but will
be recorded in an account called drawings. Drawings represent a reduction in
ownerÊs equity.
52
X TOPIC 3
3.3.4
THE ACCOUNTING CYCLE
Transaction 4: Borrowing Money
To finance business operations such as buying non current assets, office supplies,
paying employees sometimes the cash capital from owner is not enough.
Business can borrow money from another company, a person or a financial
institution to increase its available funds. This borrowing represents an
obligation to business to pay the principle amount plus interest charges.
Borrowing increases both assets (cash) and liabilities of a business.
Transaction
Basic
Analysis
Accounting
Equation
Accounting
Equation after
Transactions 1,
2, 3 & 4
6th Sept, Sonic borrowed RM20,000 cash from Digi Bank.
(In this example we will ignore the interest charges)
The asset (cash) has increased by RM20,000.
The liability (loan) has increased by RM20,000.
Assets
=
Liabilities
+
n Cash 20,000
Assets =
OwnerÊs Equity
n Loan 20,000
Liabilities
+
OwnerÊs Equity
=
The equation remains in balance
Figure 3.9: Transaction 1 to 4
3.3.5
Transaction 5: Repayment of Borrowings
Borrowings must be paid off. Repayment methods and amount varies according
to the loan agreement. For example borrower might pay only monthly interest
charges over the period of the loan and the whole principle at the end of loan
term or borrower might pay equal monthly sum which includes interest and
principle amount over the period of the loan. Repayment of borrowing will
reduce both assets (cash) and liabilities of the business.
TOPIC 3
Transaction
Basic
Analysis
Accounting
Equation
Accounting
Equation after
Transactions 1,
2, 3, 4 & 5
THE ACCOUNTING CYCLE W
53
25th Sept. 2008, Sonic paid off RM5,000 of the bank loan.
The asset (cash) has decreased by RM5,000.
The liability (loan) has decreased by RM5,000.
Assets
=
p Cash 5,000
Liabilities
Assets
Cash + Equipment
54,000
1,000
=
+
Liabilities
Loan
15,000
OwnerÊs Equity
p Loan 5,000
+OwnerÊs Equity
Capital
40,000
The equation remains in balance.
Figure 3.10: Transaction 1 to 5
3.3.6
Transaction 6: Earning Revenues
The main objective of business is to make profit. In order to make profit, business
must earn revenues. Revenues can be in many forms, a service provider provides
services to customers, a merchandiser sells goods to customer and a
manufacturer sells manufactured goods to a wholesaler. A business can earn
sales commission revenues, interest revenues from cash deposits in bank or event
rental revenues for renting out office space to clients.
Most of the time, customer will pay cash for service rendered or goods delivered
to them, but some will pay later (credit term). Regardless whether cash has been
received or not, as long as you have earned the revenue it should be recorded as
such. Revenues will increase assets (cash or receivables) and ownerÊs equity.
54
X TOPIC 3
Transaction
Basic
Analysis
THE ACCOUNTING CYCLE
26th Sept. 2008, Sonic provided professional photography
service for a wedding, RM2,000 cash was received and
another RM1,000 will be received within 14 days.
The asset (cash) has increased by RM2,000.
The asset (account receivable) has increased RM1,000.
The ownerÊs equity (photography fees) has increased by
RM3,000.
Accounting
Equation
Assets
=
Liabilities
n Cash 2,000
Assets
=
Cash + AR
56,000 1,000
+
Equipment
1,000
OwnerÊs Equity
n OE through
n Account Receivable 1,000
Accounting
Equation after
Transactions 1,
2, 3, 4, 5 & 6
+
photography fees 3,000
Liabilities
+
Loan
15,000
=
The equation remains in balance.
Figure 3.11: Transaction 1 to 6
OwnerÊs Equity
Capital
43,000
TOPIC 3
3.3.7
THE ACCOUNTING CYCLE W
55
Transaction 7: Paying for Expenses
In generating sales, business will incur expenses. Examples of such expenses are
paying for shop rentals, wages and salary, utilities, insurance, advertising, office
supplies, motor vehicle maintenance, repairs and many more. You might pay the
expenses with cash as they incurred or you pay it later. Nonetheless, expenses
will reduce your assets (cash) if pay by cash, or increase your liabilities (if no cash
is paid) and reduce ownerÊs equity.
Transaction
Basic
Analysis
Accounting
Equation
28th Sept 2008, Sonic paid RM500 cash for his employeeÊs
salary, RM300 cash for utilities and RM200 cash for shop
rental.
The asset (cash) has decreased by RM1,000.
The owner equity (expense n) has decreased by RM1,000.
Assets
=
Liabilities
+
p Cash 1,000
OwnerÊs Equity
p OE by 1,000
through n in expenses
Accounting
Equation after
Transactions 1,
2, 3, 4, 5, 6 & 7
Assets
=
Liabilities
Cash 55,000
Loan
+
15,000
Equipments 1,000
+
AR 1,000
+ OwnerÊs Equity
Capital
42,000
The equation remains in balance.
Figure 3.12: Transaction 1 to 7
There are many transactions other than the examples given above. All will have
an effect on the accounting equation. However, the accounting equation will
always remain balanced at all time.
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X TOPIC 3
THE ACCOUNTING CYCLE
SELF-CHECK 2.1
Can you give examples of a business transaction that will have the
following effects to accounting equation?
1.
Increase in an Asset and increase in a Liability.
2.
Increase in an Asset and decrease in another Asset.
3.
Decrease in an Asset and increase in a Liability.
4.
Increase in an Asset and increase in OwnerÊs equity.
5.
Decrease in an Asset and decrease in OwnerÊs equity.
Summaries of how each of the above transaction affects the accounting equation
are given in the following table. Go through this again to check your
understanding.
Table 3.2: Transaction Analysis
Date
(Sept.
2008)
ASSETS
Cash
1st
Balance
3rd
Balance
50,000
50,000
(1,000)
49,000
5th
(10,000)
Balance
6th
Balance
25th
Balance
26th
39,000
20,000
59,000
(5,000)
54,000
Balance
56,000
28th
(1,000)
Balance
+
+
+
+
LIABILITIES
+
OwnerÊs
Equity
Equipment
=
Loan
+
Capital
1,000
1,000
=
=
=
=
50,000
50,000
50,000
(10,000)
Drawings
40,000
=
+
1,000
+
1,000
+
1,000
2,000
55,000
Account
Receivables
=
1,000
+
=
=
=
=
=
20,000
20,000
(5,000)
15,000
+
40,000
+
15,000
+
40,000
3,000
Revenues
43,000
(500)
salaries
(300)
utilities
(200)
rentals
42,000
=
1,000
1,000
=
=
+
1,000
+
1,000
=
15,000
+
TOPIC 3
THE ACCOUNTING CYCLE W
57
The accounting cycle begins with the occurrence of the transaction itself,
analysing and recording the transactions in journals, posting them to ledgers
and then preparing a trial balance. At end of the period, adjusting entries are
made, adjusted trial balance and financial statements are prepared and then
closing entries are done to prepare the temporary accounts for the next
periodÊs accounting cycles.
Basic accounting equation is Assets equal Liabilities plus OwnerÊs Equity.
There are four items that can affect the ownersÊ equity, they are:
(i)
Capital investments; they will increase ownerÊs equity.
(ii)
Drawings; they will decrease ownerÊs equity
(iii) Revenues; they will increase the ownerÊs equity.
(iv) Expenses; they will decrease the ownerÊs equity.
The expanded accounting equation can be written as Assets equal Liability
plus OwnerÊs Equity plus Revenues minus Expenses and minus Drawings.
All transactions will have an effect on the accounting equation; however, the
accounting equation will remain in equilibrium at all times.
Transactions are analysed to see the accounts affected and the effects they
have on the accounting equation.
Accounting Equation
Asset
Liability
58
X TOPIC 3
THE ACCOUNTING CYCLE
1.
Calculate the missing figures.
Assets
Liabilities
Owner's Equity
Business A
79,500
45,000
?
Business B
?
23,000
45,600
Business C
163,700
?
104,500
2.
(a)
(b)
Indicate whether the following items are A (Assets), L (Liabilities), R
(Revenues) or E (Expenses)
(i)
Cash
(viii) Accounts Payable
(ii)
Bank Loan
(ix)
Accounts Receivable
(iii) Equipment
(x)
Sales
(iv) Notes Payable
(xi)
Supplies
(v)
(xii) Advertising
Insurance
(vi) Salaries
(xiii) Salaries Payable
(vii) Furniture and Fittings
(xiv) Motor Vehicle
Explain how the following transactions will affect the accounting
equation. Identify the account affected.
(i)
Pay cash for postage.
(ii)
Buy furniture and fittings on credit.
(iii) Bring own motor vehicle to be used for business purposes.
(iv) Pay salaries to workers.
(v)
1.
(a)
Receive rentals from tenants.
Based on the following transaction analysis worksheet of Azwan
Enterprise, describe the nature of each transaction (1 - 9). Azwan
Enterprise provides printing services to its clients.
TOPIC 3
Date
Cash
Opening
Balance
1/1/2003
Trans 1
Trans 2
Trans 3
Trans 4
7,500
Trans 5
2,000
Trans 6
7,000
-1,000
2,000
-4,000
-1,000
Trans 7
Trans 8
Account
Receivables
3,800
THE ACCOUNTING CYCLE W
Supplies
Land
400
38,000
Account
payable
3,700
Bank
Loan
10,000
Capital
36,000
1,000
-2,000
-4,000
-1,000
(Rent)
-2,000
(Wages)
7,000
(Revenue)
1,500
1,500
3,500
Trans 9
Cash
59
Account
Receivables
-1,200
Supplies
Land
Account
payable
Bank
Loan
3,500
(Revenue)
-1,200
Capital
Ending
Balance,
31/1/2003
2.
(b)
Determine the balance of each account in the worksheet.
(c)
Show the accounting equation for Azwan Enterprise.
(d)
Based on information provided in the transaction analysis worksheet
above, calculate Azwan EnterpriseÊs income.
Che Wan opens a beauty salon on 1 February 2008. During the first month
of operation the following transactions occurred:
February 1
2
5
7
Che Wan invested RM150,000 of her own cash in the business
and borrowed RM100,000 from a bank
She paid cash for furniture and fittings for the shop costing
RM25,000.
Purchased on credit beauty supplies worth RM4,000.
Performed makeup service for a wedding and billed the
customer for RM5,000.
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X TOPIC 3
THE ACCOUNTING CYCLE
10 Che Wan withdrew RM20,000 and invested it in a restaurant
business.
12 Che Wan renovated her apartment, paying RM10,000 from
her own funds.
15 Provided beauty consultation for a client and received
RM3,000 cash for her service.
16 Purchase a second hand car for business use. She paid
RM5,000 cash and borrowed another RM15,000 from a bank.
17 Received RM3,000 cash as partial payment for service
rendered on 7th February.
25 Paid the full amount owed for beauty products purchased on
5th February.
27 Purchased beauty supplies worth RM5,000 for cash.
28 Paid the following expenses for cash:
Electricity RM100
Rental RM1,500
Workers Salaries RM2,000
You are required to:
(a)
Analyse the effects (increase , decrease ) the above transactions have
on accounting equations and identify the specific accounts affected;
and
(b)
Analyse the effects of the above transactions to the accounting
equations, by using the format similar to Table 3.1.