Entri Adminwritten by Sibusiso Mqwati
The thought of preparing and interpreting financial statements can be somewhat daunting to a small business owner with limited accounting experience. However, that should not be the case as accounting is a mere system that communicates a message about the financial results or effects of past business activities and decisions. Given that a business owner knows and understands the economics behind transactions and decisions that have been made, the accounting should follow quite naturally. The purpose of this article is to introduce the concept of accounting and the flow of information that ultimately results in financial statements.
Recording vs reporting
An important distinction to keep in mind is that the accounting cycle comprises two processes, namely recording and reporting. Recording refers to maintenance of a day-to-day record of all the transactions of the business, typically by a bookkeeper, in the books of the business. This process differs between businesses in terms of detail and format as it is essentially a means of keeping information. Some businesses automate part or all of the recording process using accounting software that may be linked to other systems. Reporting, however, is more specific and involves preparing and showing the financial information, such as financial position, performance and cash flows; in a format that is useful to external users in making economic decisions. The output of the reporting process would , therefore, be management reports and financial statements.
The primary financial statements are the statement of profit and loss and other comprehensive income (SPLOCI), the statement of financial position (SFP), the statement of changes in equity (SOCE), the statement of cash flows (SCF) and the notes to the financial statements. Each of these statements view the business through different lenses and as such, should be read together in order to get a broad and detailed understanding of the business.
Statements
The SPLOCI shows us how the business has performed over a period of time. It comprises two sections namely profit and loss as well as other comprehensive income. Profit and loss (sometimes referred to as an income statement) is a common measure of financial performance. The elements that are directly related to the measurement of profit and loss are incomes and expenses. Other comprehensive income includes items that represent unrealised gains and losses and would not be considered in profitability analysis. The statement of financial position lists the assets that business controls and shows how these assets have been funded i.e. using equity or liabilities. It is prepared as at a particular point in time (usually the end of the financial year) as users are interested in what the balance of accounts are at year-end. The balances of assets can be presented at market value or book value. The statement of changes in equity shows the changes in a business’ equity over a period and distinguishes between transactions that are with the owner in their capacity as such and those which are not (which would be reflected in the SPLOCI). The cash flow statement shows how the business used or generated cash over a period. It reflects all cash inflows and outflows and distinguishes between the types of decisions for which the cash was utilised. The notes to the financial statements are equivalent to footnotes which detail additional information that has not been presented in the abovementioned financial statements.
The Accounting Cycle
But how do financial statements actually come about? The diagram below summarizes the accounting cycle.
The accounting cycle is initiated by a business transaction or event. Routine transactions would normally result in a source document such as a sales invoice and these would be recorded in the books of the business. The nature of the transaction would then be analysed in order to determine the journal in which it would be recorded. A journal is a book in which transactions are recorded. This is done using a double-entry bookkeeping system whereby at least two accounts are affected by each transaction i.e. one debited and one credited. For convenience, specific journals are normally maintained for routine transactions of a similar nature where these are recorded chronologically. Common examples of such journals include the cash receipts journal, the cash payments journal and the petty cash journal. All transactions that would not fall within the scope of a special journal would then be recorded in a general journal. Typically at the end of each month, the journals are aggregated and the totals are posted to a ledger which is a summary of all amounts that have been processed in the journals. The ledger is made up of a number of accounts that show the changes to each account for the period. The totals of the ledger would then be extracted and summarized into a pre-adjustment trial balance. The purpose of a trial balance is to determine whether the double-entry system has been correctly applied by testing whether the total debits and credits are equal. Where there are discrepancies, correcting journal entries would then be processed to make the necessary corrections from the amounts (balances or transactions) that have been recorded in the ledger to the amounts that should be reported in the financial statements. At the end of the accounting period, adjusting journal entries are processed as an application of the accrual basis of accounting. Under the accrual basis of accounting, incomes and expenses are reported when earned and incurred respectively and not necessarily when cash changes hands. This results in an income statement that better measures the profitability of a company over a specific period of time. After adjusting journal entries have been processed, a post-adjustment trial balance would be generated. It is only at this point that the financial statements can be prepared based on the totals of the post-adjustment trial balance.
Closing journal entries are also processed at year-end but only in respect of temporary or nominal accounts (i.e. incomes and expenses and withdrawal accounts) in preparation for the next accounting period. This ensures that each income and expense account begins the next accounting year with a zero balance. These accounts are closed off to a profit and loss account which is a summary account that is further closed off to an equity reserve such as retained earnings. A post-closing trial balance is then prepared to testing the equality of debits and credits excluding the nominal accounts that have been closed off.
Hopefully this article has clarified the process of preparing financial statements. In the next few articles, we will explore the accounting cycle further using an example as well as understand how to use them in analysing the financial performance, position and cash flows of the business.