Step 1 - Transactions and/or Events
Identification and measurement of external transactions and internal events. At this stage, the
documents used by the business are analyzed whether it has financial impact or effect. Recall
the rule
that only financial transactions are recorded and that the amount can be measured. These two
conditions must exist in order that a particular transaction is recognized or recorded. As
defined,financial transactions are those activities that change the value of an asset, liability or
an equity.
Examples of financial transactions:
• Receipt of cash from a client as advance payment to repair a computer. In this case (asset) will
increase. At the same time, the advances from clients (liability) will also increase. The advances
from clients are a liability because the business has the obligation to render future service to the
client.
• Payment of electric bills is a financial transaction. This will decrease the cash (asset) and
reduce the
income of the business at the same time.
Examples of non-financial transactions:
• hiring and termination of employees
• recognition from the government as most outstanding business
• death of owner
The information needed when recording transactions are taken from forms used to document
these transactions. In a typical service business, the following are the business documents
used:
1. Official Receipt or Cash Receipt
This document is used when a business receives money or a check. An Official Receipt or
Cash Receipt is a document that acknowledges that money or a check have been
received.
2. Charge Invoice or Sales Invoice
A charge invoice is a document used when a service has been rendered, but the client
will be billed only after a certain number of days from the date of service. Often, a
company will issue a statement of account to a customer, with the charge or sales invoice
attached. For example: in a laundry business, a customer may avail of the services of the
business. However, that customer and the owner of the business had a prior agreement
that all services availed by the customer will be paid only after 30 days. In this case, a charge
invoice is issued on the day the client avails of the services.
3. Check or Cash Voucher
The check voucher is a document used when a check is issued to pay a certain supplier or
vendor. For example, in a laundry business, for the payment of monthly electricity bills,
the business may pay either in cash or check. But the company must prepare a cash or
check voucher to support this payment. This document will serve as a record of payment
and, at the same time, as proof that payment has been made by the company.
Step 2 - Preparation of Journal Entries (journalization)
Through the use of specialized journals (such as those for sales, purchases, cash receipts, and
cash disbursements) and the general journal, transactions and events are entered into the
accounting records. These are called the books of the original entry. Debits and Credits are an
integral part of the journalization process. In accounting, debits or credits are abbreviated as DR
and CR respectively. When to Debit and when to Credit: An increase in an asset account is
called a debit and an increase in a liability or equity account is called a credit. Likewise, if we
decrease an asset account we credit that account. On the other side of the equation, if we
decrease a liability or equity account we debit those accounts.
Rules on Debits and Credits
• The name of the account to be debited is always listed first. The debited account is listed on
the first line with the amount in the left side of the register.
• The credited account is listed on the second line and is usually indented. The credited amount
is recorded on the right side of the register.
• The total amount of debit should always equal the total amount of credit.
Step 3 – Posting
The summary (in specialized journals) or individual transactions (in the general journal) are then
posted from the journals to the general ledger (and subsidiary ledgers). Nothing should ever get
posted to the ledgers without first being entered in a journal. Recall the lesson on the general
ledger. We will now post the previous transactions of Pedro to the general ledger. For purposes
of discussion, we will be using the three-column ledger.
Step 4 - Unadjusted Trial Balance
At the end of an accounting period (for example, one month or one year) the working trial
balance is prepared. This involves copying each account name and account balance to a
worksheet (working trial balance). The resulting first two columns of the worksheet are called the
unadjusted trial balance. In the preparation of the unadjusted trial balance, the balances in all
the general ledgers at the end of the reporting date are forwarded to the appropriate column.
Step 5 - Worksheet
This step is simply about plotting the items in the unadjusted trial balance on the worksheet.
In a manual accounting system, a worksheet is a large columnar sheet of paper specifically
designed to conveniently arrange all the accounting information required at the end of a period.
The worksheet is used to check whether ledger accounts are balanced and adjusted. The
satisfactory completion of a worksheet provides assurance that all the details of the
end-of-period accounting procedures were properly brought together. The worksheet serves as
the source in the preparation of financial statements and other closing and adjusting entries.
Step 6 – Adjusting Entries
At the end of the accounting period, some accounts in the general ledger would require
updating. The journal entries that bring the accounts up to date are called adjusting entries. One
purpose of adjusting entries is for income and expenses to be reported in the correct period.
Adjusting entries ensure that both the revenue recognition and matching principles are followed.
Revenue Recognition – accounting standards require that revenue is recognized when it is
earned and the amount can be measured reliably.
Step 7 - Preparation of the Financial Statements.
The income statement is prepared first so that net income can then be recorded in the
statement of changes in equity. The statement of changes in equity is then prepared to
determine the ending balance of equity or capital account. Once the ending balance is
determined, the statement of financial position is prepared. The cash flow statement is prepared
last.
Step 8 - Journalize the Closing Journal Entries
The income, expense, withdrawal (equity) accounts are called temporary accounts or nominal
accounts. They are called temporary because they accumulate the transactions of only one
accounting period. At the end of this accounting period, the changes in owner’s equity
accumulated in these temporary accounts are transferred into the owner’s capital account. This
process serves two purposes: (1) to update the balance of the owner’s capital; and (2) it returns
the balance of the temporary accounts to zero, so that they are ready to measure the income,
expenses and drawings of the next accounting period again. The owner’s capital account and
other statements of financial position accounts are referred to as permanent or real accounts
because their balances continue to exist beyond the current accounting period. Closing the
books is the process of transferring the balances of the temporary accounts to the owner’s
permanent capital account.
