Introduction & Accounting Cycle

— Accounting · Video 1 & Video 10 —

★ Exam Tip: Learn the order of the accounting cycle and the source document for each transaction (matching-type questions). Know the 4 qualitative characteristics with a one-line definition each.

1. The Accounting Cycle

The accounting cycle is the process of accounting in any business. It starts with a transaction, ends with the financial statements, and then the process starts again.

Source document = also called documentary record
Books of original entry = also called books of prime entry
Ledgers = books containing T-accounts
Financial statements = income statement and balance sheet

follow the green arrows: Transaction → Source Docs → Books of Original Entry → Ledgers → Trial Balance → Financial Statements → (new transactions)

Order of the cycleTransaction → Source Documents → Books of Original Entry → Ledgers (T Accounts) → Trial Balance → Financial Statements

2. What is a Transaction?

Definition: In a business context, any commercial event is known as a transaction. It means we are exchanging something for another.

Examples:

Buying or selling goods or services (to customers, from suppliers)
Customer paying us / us paying a supplier — cash or cheque
Return of goods — to our supplier, or from our customers

Any activity of a commercial nature = transaction.

Remember: a transaction is where the cycle starts (and where it restarts).

3. Documentary Records (Source Documents)

Definition: A source document is a proof or evidence of a transaction that is carried out in business.

e.g. Sales invoice, receipt, credit note etc.

Why we need it:

If I say I sold goods worth $10,000, you ask "what is the proof?" — the document I make as evidence is the source document.

Type of transaction → Source document

#	Type of Transaction	Source Document
1	Sale of goods / services on credit	Sales Invoice
2	Purchase of goods / services on credit	Purchase Invoice
3	Sale / purchase of goods on cash	Receipt
4	Returned goods by customer	Credit Note (issued to customers)
5	Returned goods to supplier	Credit Note (received from supplier)
6	Payment of wages or salaries	Pay Slip / Wage Sheet
7	Payment to supplier or any other expense by cheque	Cheque Counterfoil
8	Sent summary of transactions to customer	Statement of Account
9	Summary of transactions received from bank	Bank Statement
10	Sale / purchase of non-current assets (NCA) on credit	Invoice

Quick link: Credit Note = returns. Invoice = credit deal · Receipt = cash deal.

Details of each document (from the lesson)

Invoice (1, 2): the same invoice — the seller calls it a sales invoice, the buyer calls it a purchase invoice. Used only for credit transactions, never cash.

Receipt (3): for cash buying or selling. In the syllabus the examiner uses just the word "receipt" (not "sales receipt"/"purchase receipt"). e.g. the small slip from a burger place or supermarket.

Tricky & important — Credit Note vs Debit Note: When a customer returns goods, the customer sends a debit note, but it has no value until we issue a credit note. Likewise when we return goods to a supplier we issue a debit note, but it has no value until the supplier gives us a credit note. So the transaction always ends on a credit note ⇒ in the exam write credit note. Write debit note only if the question asks for the document issued by the customer.

④ sales return: we ISSUE credit note

⑤ purchase return: we RECEIVE credit note

Pay slip vs Wage sheet (6): Wages = weekly/daily pay to factory workers; salary = monthly pay to admin staff.

Pay slip — one for every employee: gross pay, deductions (tax, social security), final take-home pay
Wage sheet — one combined sheet for all employees (or a department)

Cheque counterfoil (7): the part of the cheque that stays in the cheque book when we tear the cheque off. It is our record/evidence that we paid a supplier (or rent, insurance etc.) by cheque.

Statement of Account (8): sent by us (supplier) to our customers at month end as a reminder of how much they owe us (like the milk/water/newspaper vendor's monthly slip).

Bank Statement (9): the bank sends it to us (we are the bank's customer): opening balance, withdrawals, deposits, closing balance.

Invoice for NCA (10): buying/selling a non-current asset on credit (computer, furniture, motor vehicle, old office equipment) → just "invoice".

Why not "sales invoice" for NCA? A sales invoice is only for selling inventory (goods meant for resale — shoes for a shoe shop, clothes for a boutique, cars for a showroom). Assets bought for our own use get a plain invoice.

4. Qualitative Characteristics of Financial Statements

These are also called the objectives of financial statements: qualities required in the final accounts. There are four.

Financial statements consist of: income statement · statement of changes in equity · statement of financial position (O level) · + statement of cash flows (A level) · notes to the accounts.

Users of accounts: shareholders/owners (investors) · lenders (banks, creditors) · employees · government / tax authorities · regulatory bodies.

① Understandability

Information must be readily understandable to users of the financial statements.

It must be clearly presented, with additional information in the supporting footnotes as needed to assist in clarification.

Reader should be fairly knowledgeable — basic education/finance knowledge, not an expert or chartered accountant
Presentation format is set by IAS 1 (A level); details not on the face of the statements go in the notes

② Relevance

Information must be relevant to the needs of the users, i.e. when it influences the economic decisions of users.

May involve reporting particularly relevant information, or information whose omission or misstatement could influence users' economic decisions.

Don't overload users with information they don't need — e.g. number/qualifications of employees (non-financial) is not relevant to a shareholder's decision
Investor decision = buy shares / sell shares
Analogy: for a job offer abroad you want the salary package, benefits and the law-and-order situation — only relevant facts

③ Reliability

Information must be free of material error and bias, and not misleading.

Faithfully represent transactions and other events
Reflect the underlying substance of events
Prudently represent estimates and uncertainties through proper disclosure

Material error: small (immaterial) errors are OK. Materiality is relative — $100,000 may be immaterial for a big company, $1,000 material for a small one
Bias = showing only one side (the positive side), hiding the other → not reliable; show a balanced "helicopter view"
Faithful = true and fair; substance = economic reality

④ Comparability

Information must be comparable to the financial information presented for other accounting periods.

So users can identify trends in the performance and financial position of the reporting entity.

Needs consistency (an accounting concept): e.g. if you use straight-line depreciation one year, don't switch to reducing balance next year without an important reason
Trend = long-term movement of a variable (a batsman's long-term stats, a share price over time)

Characteristic	Key idea	Keyword
Understandability	Clear presentation + footnotes	clarity
Relevance	Influences economic decisions	decisions
Reliability	No material error / bias; faithful; substance	faithful
Comparability	Comparable with other periods → trends	trends

Memory tip: U-R-R-C → Understandability, Relevance, Reliability, Comparability.

Clash between Relevance and Reliability

Key point: The two can pull against each other. Info about a current event is very relevant on the day, but early reports are often not reliable (figures may be wrong). Years later the facts are very reliable but no longer relevant (historical). Raising one means compromising the other ⇒ management must strike a balance.

over time: relevance falls, reliability rises

✓ Quick Recap — Chapter

Cycle: Transaction → Source Docs → Books of Original Entry → Ledgers → Trial Balance → Fin. Statements
Transaction = commercial event (exchange of something for another)
Source document = proof / evidence of a transaction
Credit sale → Sales Invoice · credit purchase → Purchase Invoice · cash → Receipt
Returns → Credit Note · wages → Pay Slip · cheque payment → Counterfoil
Statement of Account → sent to customer · Bank Statement → from bank
Credit note always (debit note only if asked for customer-issued doc) · Invoice = credit only · NCA → invoice
Qualities: Understandability, Relevance, Reliability, Comparability · Relevance ⇄ Reliability clash → balance