Recording Business Transactions

This chapter explains the rules regarding debits and credits. Debits and credit increase and decrease certain accounts. Spend some time learning the rules of debits and credits, since they are the foundation of accounting principles. Posting a debit where a credit should be, or vice versa, will cause you to be out of balance. You will then have to re-trace all of your postings to uncover your error, which would be very frustrating and time-consuming. Since accounting is the "language of business", it is very important that you understand the building blocks of the language.  Even if you hire a CPA to do your books, you need an understanding of what drives your results so that you can manage accordingly, and avoid becoming a victim of fraud.

The accounting cycle

The accounting cycle is a series of steps performed during the accounting period (some throughout the period and some at the end) to analyze, record, classify, summarize, and report useful financial information for the purpose of preparing financial statements. Before you can visualize the eight steps in the accounting cycle, you must be able to recognize a business transaction. Business transactions are measurable events that affect the financial condition of a business. For example, assume that the owner of a business spilled a pot of coffee in her office or broke her leg while skiing. These two events may briefly interrupt the operation of the business. However, they are not measurable in terms that affect the solvency and profitability of the business.

Business transactions can be the exchange of goods for cash between the business and an external party, such as the sale of a book, or they can involve paying salaries to employees. These events have one fundamental criterion: They must have caused a measurable change in the amounts in the accounting equation, Assets = Liabilities + Stockholders' Equity. The evidence that a business event has occurred is a source document such as a sales ticket, check, and so on. Source documents are important because they are the ultimate proof of business transactions.

After you have determined that an event is a measurable business transaction and have adequate proof of this transaction, mentally analyze the transaction's effects on the accounting equation. You learned how to do this in Chapter 1. This chapter and Chapters 3 and 4 describe the other steps in the accounting cycle. The eight steps in the accounting cycle and the chapters that discuss them are: 

  • Analyze transactions by examining source documents
  • Journalize transactions in the journal
  • Post journal entries to the accounts in the ledger
  • Prepare a trial balance of the accounts
  •  and complete the work sheet
  • Prepare financial statements
  • Journalize and post adjusting entries
  • Journalize and post closing entries
  • Prepare a post-closing trial balance

Notice that firms perform the last five steps at the end of the accounting period. Step 5 precedes steps 6 and 7 because management needs the financial statements at the earliest possible date. After the statements have been delivered to management, the adjusting and closing entries can be journalized and posted. In Exhibit 7, we diagram the eight steps in the accounting cycle.

You can perform many of these steps on a computer with an accounting software package. However, you must understand a manual accounting system and all of the steps in the accounting cycle to understand what the computer is doing. This understanding removes the mystery of what the computer is doing when it takes in raw data and produces financial statements