Process and Bases of Accounting - simple analysis

Process and Bases of Accounting

Process of Accounting
All About MBA TOPIC: Accounting process begins with the origin and identification of business transaction and is followed by recording, classification and summarization of business transactions culminating in the preparation of trial balance and financial statements, i.e., Profit & Loss Account and Balance Sheet. Following steps are

   followed in the accounting process:

(1) Identification of Transactions

(2) Preparation of Vouchers
(3) Recording in books of original entry
(4) Posting to Ledger

(5) Preparation of Trial Balance and Financial Statements

(6)  Analysis and Interpretation :

(7)  Communicating

These steps are explained as below
(1) Identification of Transactions : Accounting deals with business transactions which are monetary in nature. In other words, the transactions which cannot be measured and expressed in terms of money cannot be recorded in accounting. For recording business transactions, it is necessary that these transactions are evidenced by an appropriate document such as cash memo, purchase invoice, sales invoice, pay-in-slip, cheque book, pass book etc. A document which provides evidence of the transaction is called the Source Document.

(2) Preparation of Vouchers : On the basis of source documents entries are, first of all, recorded on vouchers and then on the basis of vouchers recording is made in the Journal or books of original entry. Vouchers are printed separately by all the firms in their own names. A separate voucher is prepared for each transaction and it specifies the accounts to be debited and credited. Source document is generally attached to the voucher. Sometimes, voucher also serves as source document such as in the case of
petty expenses. Vouchers, which are usually arranged in chronological order and serially numbered, are kept in a separate file.

(3) Recording in Books of Original Entry : The books in which transactions are recorded for the first time from a voucher or a source document are called 'Books of Original Entry . Journal is one of the books of original entry in which transactions are recorded in a chronological (day-to-day) order according to the principles of double entry system. When the size of the business is a small one, it may be possible to record all transactions in the journal but when the size of the business grows and the number of transactions is very large journal is sub-divided into a number of books called sub-journals or special journals. For example, all transactions relating to receipt and payments of cash are recorded in cash book, all transactions relating to credit purchase in purchase book, all transactions relating to credit sales in sales book and so on. Recording of transactions in special journals instead of journal only, is called practical system of book-keeping. These special journals are also called subsidiary books as these facilitate the preparation of ledger.

(4) Posting to Ledger : The next step in the accounting process is to transfer all entries recorded in journal or subsidiary books to respective accounts in ledger. A ledger is the principal book of accounts in which all the transactions ultimately find their place under their respective accounts in a duly classified form. For recording in ledger, all transactions are classified and transactions of similar nature are recorded at one place in an account opened in their name which will provide a complete picture of
all the transactions relating to them at a glance. Thus, in ledger separate accounts are opened in the name of each person, whether customer or supplier. Likewise separate accounts are opened for assets, liabilities, purchases, sales etc. Similarly, all incomes and expenses, which are already recorded in Journal are again classified under separate heads in ledger, such as Salary Account, Rent Account, Discount Account etc.

(5) Preparation of Trial Balance and Financial Statements: Last step in the accounting process is the balancing of ledger accounts and the preparation of Trial Balance with the help of such balances. A Trial Balance is a statement, prepared with the debit and credit balances of ledger accounts to check the arithmetical accuracy posting and balancing of ledger accounts. If a trial balance does not tally, it indicates that some errors in posting or balancing of accounts have occurred and steps are taken to locate and rectify such errors. As the trial balance contains the balances of all ledger accounts, it provides a basis for preparation of financial statements namely Trading and Profit & Loss Account and a Balance Sheet.

(6)  Analysis and Interpretation :

The next step is to analyse the data in financial statements and interpret the results.

(7)  Communicating:

The last step is to communicate the summarised data in the form of Trading and Profit & Loss Account and a Balance Sheet to the users.

Bases of Accounting
One of the main objectives of accounting is to ascertain the profit or loss of a business enterprise at the end of an accounting period. There are two bases of ascertaining profit or loss, namely

(1) Cash Basis, and (2) Accrual Basis
(1) Cash Basis of Accounting: Under this basis, incomes are not recorded unless they are received in cash. Similarly, expenses are recorded only when they are paid in cash. In other words, credit transactions are not recorded at all and are ignored till cash is actually received or paid for them. Thus profit is merely the excess of actual cash receipts in respect of sale of goods and other incomes over actual payments in respect of purchase of goods, expenses on wages, salary, rent etc. Income or profit is
calculated with the help of a Receipts and Payments Account. This basis is useful for professional people like lawyers, doctors, chartered accountants etc.
Advantages:
(i) This basis is simple, realistic and satisfies the conservative instinct of many people.
(ii) It does not require the use of estimates and personal judge ments.
(iii) It is suitable for those enterprises where most of the transactions are on cash basis.
Disadvantages:
(i) It does not give a true and fair view of profit or loss and financial position of the enterprise because it ignores outstanding expenses, prepaid expenses, accrued incomes and incomes received in advance.
(ii) It does not follow matching principle of accounting. For example, acquisition of fixed assets 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.
(iii) There is a great possibility of manipulation of profits in cash basis of accounting because payments may either be delayed or made early and similarly incomes may be postponed or collected early.
(iv) Since capital and revenue items are not distinguished in cash basis, there is no consistency in the profits of different years.
(v) Companies Act, 2013 does not recognize it.

(2) Accrual Basis of Accounting:  Under this basis, incomes arc recorded when they are earned or accrued, irrespective of the fact whether cash is received or not, e.g., sales made on credit will be included in the total sales of the period. Similarly expenses are recorded when they are incurred or become due and not when the cash aid for them, e.g., rent due to the landlord but not paid will be treated as expense for the period when it is due and not in the period when it is paid. Hence, in accrual basis, profit or loss of a particular period is the result of matching of the revenues earned and
expenses incurred during the period. This makes it necessary to consider outstanding expenses, prepaid expenses, accrued incomes, incomes received in advance etc. for preparation of financial statements. Under the Companies Act, 2013, all companies required to maintain their accounts according to accrual basis of accounting.
Advantages
(i) It discloses true profit or loss for a particular period and also depicts true financial position of the business at the end of a particular period because it takes into account all transactions relating to a particular period and takes into account all adjustments like outstanding expenses, prepaid expenses, accrued income and income received in advance.
(ii) It follows the matching principle of accounting.

(iii) There is consistency in the computation of profits of different years in accrual basis because it makes a distinction between capital and revenue expenditure
(iv) It is recognised by Companies Act, 2013
Disadvantages:
(i) It is not as simple as cash basis of accounting.
(ii) It requires the use of estimates and personal judgements

Hybrid or Mixed Basis of Accounting:
This basis of accounting is the mixture of cash basis and accrual basis. Under hybrid basis of accounting, revenues and assets are recorded on cash basis whereas expenses and liabilities are recorded on accrual basis. Usually professional people such as doctors, lawyers etc. adopt this method and prepare Receipts and Expenditure Account to ascertain their net income during a period. They ignore their outstanding income but take into consideration outstanding expenses. The idea is to claim deduction for outstanding expenses while computing taxable income. Hybrid system of accounting is an acceptable and approved system as per judgements of the courts.