The Accounting Process and Issues Explanation and Examples

Sat, 01/24/2015 - 08:35 -- Umar Farooq

What is Financial Accounting Process

The financial accounting process tracks business events and transactions by recording their effect on the business financial position. The end product of this process is the financial statements of the business. In this unit you are introduced to accounts.

Accounts is a form of records used to store and summarize information about one item, i.e. cash, furniture, creditors etc. Through the use of double entry accounting, we record changes in business / transactions in the accounts. By teaching how some common transactions are recorded in the accounts, you are introduced to the mechanics of double entry.

The Recording Process (The Double Entry System)

The prime objective of any accounting system is to record, classify and summarize Financial data in the most economical and efficient way and Convert it into information, which is useful for different interested groups. The financial information is conveyed to these groups through financial statements. The preparation of financial statements involves different se­quential steps. However, before the mechanics of the recording procedure is discussed it is important to understand the following basic issues:

File Recognition Issue

The first issue is when a business transaction should be recorded. Take a simple example of purchases of office furniture by GenX Autos. The purchase process involves the following actions:

  1. Placing the order
  2. Receiving the furniture
  3. Making the payment

Which of these actions constitute a recordable event? In this particular case the transaction is recorded when the title of ownership is transferred from the seller to the buyer. However, in certain situations it really becomes difficult to decide the timings of recognition. It is particularly true in long-term contracts or services like developing an advertising campaign or a construction work spread over a period of more than one year. The transfer of title of owner­ship happens at the conclusion of the purchase or sale agreement. The forms of agreement are numerous ranging from an informal to a very formal act.

For example, purchase of land of' building would involve a lot of paperwork and signing of the papers and making payment iii a court, whereas purchase of grocery on credit from the shop in the neighborhood re­quires only a verbal commitment. Accounting tradition is to accord the transaction when the title of ownership is transferred from the seller to the buyer. The transfer depends on agree­ment. The 1Kutire of agreement differs from one business to another. The problem of recognition is also faced in the case of expenses and other transactions. The accuracy and reliability of net profit or kiss depends on how accurately the events are recog­nized.

The problem of recognition is also faced in the case of expenses and other transactions. The accuracy and reliability of net profit or kiss depends on how accurately the events are recog­nized.

The Valuation Issue

As per Generally Accepted Accounting Principles (GAAP), the business transactions are recorded at original cost that is defined as the exchange price associated .with the business transaction at the time of recognition. It is often called historical cost. It is said that the purpose of accounting is not to account for value but to account for the cost. The value may change immediately after the occurrence of the transaction. The cost principle is used because it is objective and verifiable. The determination of value is a subjective phenomenon. Even the determination of cost at time depends on the assumptions being used, e.g., the cost of closing stock.

The Classification Issue

The classification of a transaction is important because it affects both balance sheet and the income of a period. For example, how to treat the purchase of small tools? Should it be treated as an asset or an expense? Each transaction is to be classified properly to represent its effect correctly. If purchase of small tools is treated as an expense. The net profit of the pe­riod would decrease and similarly the assets on the balance sheet would also be understated

The Recording Process of different Entries in Books

The financial data generated by a large business enterprise is enormous. The method of recording, the data should be such that retrieval may be quick and the information provided is timely and reliable for economic decision-making. The steps involved in recording the trans­actions, right from the analysis of transactions to the preparation of financial statements are collectively called the accounting cycle. The process beings and ends with decision makers. Here is an overview of accounting cycle steps as follows:

  1. Analyze the transaction in terms of its effects on the accounting equation. i.e. increase or decrease in assets, liabilities and capital
  2. First the transaction recorded in general journal
  3. Post the entry to ledger
  4. Balance the accounts and extract the trial balance
  5. Pass and post adjusting entries
  6. Extract the adjusted trial balance
  7. Pass and post the closing entries
  8. Extract post-closing trial balance
  9. Prepare financial statements.

Analysis of Transactions

Every transaction affects the' accounting equation in terms of increase or decrease in assets, liabilities or capital. The change could be in one or more components. At this step we analyses the effect of transaction on accounting.