2

Recording Business Transactions

2.1 The Accounting Cycle

2.2 Timing

2.3 Analyzing Transactions

2.4 Recording in Journals

2.5 Posting to the General Ledger

2.6 Generating Financial Statements

2.1 The Accounting Cycle

In this subchapter, we explain the accounting cycle, or how transactions are recorded, summarized, and translated into useful financial information. Understanding the accounting cycle is essential to knowing how financial transactions are converted into hard data about a company.

Unlike the operating cycle, which may vary by company or industry, the accounting cycle is the same for all entities. It can be broken down into the following steps:

SEE ALSO Chapter 11, “Year-End Reporting”

2.2 Timing

When setting up for business, a company needs to make at least two important timing-related decisions: choosing an accounting period or fiscal year, and deciding whether to record transactions as they occur (accrual basis) or when cash is received or paid out (cash basis). This subchapter covers the factors to consider in making these choices.

Accounting Periods

An accounting period is the length of time for which transactions are recorded, summarized, and reported—typically a year. For tax purposes, this is also the period upon which taxes are computed. Many large public firms publish monthly and quarterly reports and statements as well, but their primary accounting period as far as the IRS is concerned is the fiscal year. Companies often choose to have their accounting period coincide with the calendar year for simplicity and convenience, but this is not required. Retailers, for example, typically use January 31 as the end of their fiscal year because this encompasses their peak season (Christmas), as well as the costs related to it.

Sole proprietors are the owners of their businesses, and their profit and loss must be reported on their personal tax return on Schedule C at the end of the calendar year. For this reason, their accounting fiscal year needs to end on December 31. Otherwise, there are no hard-and-fast requirements for deciding when to begin and end an accounting period, but it should reflect the business cycle. If you want to change accounting periods, you need to get permission from the IRS.

Cash vs. Accrual

A company also must determine at the outset whether to use a cash basis or accrual basis for recording transactions and filing taxes. From a financial statement standpoint, the accrual basis is more informative, because it clearly matches revenue and expenses. When you receive and are billed for an item you purchase, it makes sense that you should be required to record a liability for the amount you owe. The IRS requires most established businesses with revenues over a certain amount to use the accrual method, and that is the focus of this book.

However, for small and start-up businesses, it’s worth knowing that there are advantages to the cash basis, including …

Many small businesses maintain their records on a cash basis throughout the year to take advantage of cash basis tax filing while preparing the financial statements on the accrual basis for more meaningful reporting. You can do this, but you need to make a few adjusting entries at year-end to convert cash basis records to the accrual basis.

Note: If you use an accounting software program, you’ll be asked to select your preferred method—cash or accrual—for recording transactions. However, you still have the option of producing individual reports in the other method. Some business owners find this useful when starting out to see the differences in their financial reporting.

SEE ALSO 15.2, “Evaluating Computerized Systems”

2.3 Analyzing Transactions

Before any activity can be properly recorded, transactions must be analyzed to determine what accounts they affect. In this subchapter, you learn about debits and credits and the importance of recording transactions in the proper period.

Understanding Debits and Credits

In accounting, every transaction affects at least two accounts—increasing one and decreasing the other. This is the basis for the double entry bookkeeping and the first step in analyzing any transaction.

SEE ALSO 1.1, “Accounting Basics”

SEE ALSO 1.4, “Establishing the Chart of Accounts”

For example, if you paid $1,500 to buy two new laptops for your company on January 5, your cash account would decrease by $1,500. At the same time, you’ve acquired two computers, so your office equipment account would increase by $1,500.

Remember, the general ledger shows two sides for each account so additions and subtractions are recorded separately. The left side of an account is the debit side; the right side is the credit side.

SEE ALSO 1.5, “Opening the General Ledger”

Recording Assets

Assets typically have debit balances. Increases in assets are shown on the left, or debit, side. Decreases in assets are shown on the right, or credit, side. Liabilities are the opposite, with increases coming on the credit side and decreases being debits. This may seem counterintuitive to how it is in everyday life, where your bank account is credited with deposits and debited with withdrawals, but it actually isn’t. From your bank’s point of view, when you deposit money, this increases their liability to you (credit) and when you withdraw money it reduces their liability (debit).

So after our laptop purchase, the transaction would be reflected in the accounts as follows:

The cash in bank account now has a balance of $2,740 ($4,240 – $1,500). Meanwhile, the $1,500 debit to the office equipment account has increased the account to $3,500 ($2,000 + $1,500).

Recording Liabilities

Liability accounts typically have credit balances. Record an increase in a liability on the right side, or as a credit to the account. A decrease in a liability is debited to the account.

Continuing our laptop example: if instead of paying cash, you bought the computers on account with one of your suppliers, you would record an increase in accounts payable (a liability) as opposed to a decrease in cash.

SEE ALSO 6.1, “Accounts Payable”

This would be reflected in your general ledger accounts as follows:

The balance in office equipment increased $1,500 to $3,500, while accounts payable also increased $1,500 to $3,100.

Recording Owner’s Equity

Owner’s equity, like liabilities, is a claim on assets. Consequently, increases in owner’s equity are recorded on the right or credit side, while a decrease is considered a debit. For example, if the owner invested more of his own cash into the business, this would ultimately affect the equity and cash accounts as follows:

The cash account would now have $4,740, while the equity account, called proprietor’s capital here because this is a sole proprietorship, would have a balance of $7,000. Note that balances don’t ordinarily need to be calculated after each entry, but we are doing it here for purposes of illustration. In a computerized system, the accounts would automatically be updated as the entries are recorded and saved.

SEE ALSO 15.1, “Benefits of Computerized Accounting”

Recording Revenue

Revenue (income) accounts usually have credit balances. Increases in revenues are credited to the right side, while decreases are debited on the left. If our company had credit sales of $3,275 for the week, this would be recorded in the accounts as follows.

The balance in accounts receivable is now $5,875, while our month-to-date sales are $7,775.

Recording Expenses

Expenses generally have debit balances. An increase in an expense goes on the left or debit side. A decrease in an expense is credited to the right side of the account. So if we are billed for advertising expenses of $1,400 on January 20, this would be reflected as follows:

So advertising expense is charged $1,400 for the month, and accounts payable increases to $4,500. Note that advertising expense did not have an opening balance. This is because revenue and expense accounts are closed into the equity at the end of the period.

SEE ALSO 11.3, “Preparing a Trial Balance”

Is It a Debit or Credit?

The second part of analyzing a transaction is determining whether the accounts involved are debited or credited. Sometimes accounts won’t have the usual balance, but this is a temporary state. The following table provides a quick reference:

Documentation

Every accounting transaction is going to be initiated by some sort of documentation. This is usually your first clue as to how to classify it. A sales receipt, for example, obviously represents a sale. It also tells you whether the sale was made for cash or on credit. At the end of the day, a cash register tape lists total sales and also breaks down sales between cash and credit. This makes it easy to decide what accounts will be affected.

If the tape for 4/15 shows sales of $2,654, and $1,200 of that was cash and the rest was store credit, you know that the following accounts will have changes:

Sales:	+ $2,654
Cash:	+ 1,200
Accounts Receivable:	+ $1,454

In accounting, there’s a specific way of writing down this transaction that mirrors the effects on the left and right (debit and credit) sides of the account:

This is called a journal entry because the journal is the book where it is recorded. The journal is the first place a transaction is recorded. It is the only place in accounting where both sides of the transaction are shown together, so it is an important link in the process. Remember, postings to the general ledger only show the debit or credit in the particular account. In our preceding example, accounts receivable would only reflect a debit for $1,454. The other parts of the transaction would be recorded in the cash and sales accounts.

A number of different journals exist, and sometimes postings are summaries of days’ or months’ worth of transactions. We cover journals in the next subchapter.

2.4 Recording in Journals

In accounting, the journal is the book of first entry, where all transactions are recorded and explained. But there’s more than one journal:

In this subchapter, we describe each of these different types of journals and teach you how to know where to record what.

The General Journal

A small business that has few transactions might use the general journal as the only journal, but this is extremely rare in our experience. Let’s take a look at a sample general journal page. Note that one column refers to the general ledger account number. This enables you to trace each entry to its ultimate reflection in the general ledger.

SEE ALSO 1.5, “Opening the General Ledger”

BRIGHT IDEA MANUFACTURING COMPANY
GENERAL JOURNAL

Notice that many of the transactions recorded here are noncash transactions. Any activity affecting cash would be recorded in the cash receipts or cash disbursements journal.

The Sales Journal

In most large businesses, the sales journal is used to record credit sales only. However, in some small businesses, the sales journal and cash receipts journal are combined so all sales of any type are recorded in one place. For the purposes of this example, assume that Bright Idea Manufacturing Company is a large-enough concern to warrant a separate sales journal.

BRIGHT IDEA MANUFACTURING COMPANY
SALES JOURNAL

Each entry in the journal reflects a transaction with one customer and, as such, should be debited to that customer’s account in the accounts receivable subsidiary ledger. The X in the Reference column denotes this has been done. In addition, you would want to put the open invoice in the customer’s paper file.

SEE ALSO 4.3, “Accounts Receivable”

SEE ALSO 1.3, “Creating a Filing System”

The postings to sales in the general ledger would not be made individually, unless the company had very few, high-dollar sales. Instead, all sales for the month would be totaled, and the totals would be posted to the general ledger at the end of the month. The effect of this summary posting is represented in the following entry.

The Cash Receipts Journal

The cash receipts journal is where you record any receipt of cash, whether from a sale, payment on account, or any other reason.

BRIGHT IDEA MANUFACTURING COMPANY
CASH RECEIPTS JOURNAL

You can easily customize the cash receipts journal for your business by taking out credit accounts and substituting your own. Small businesses with a limited accounting staff often use a combined cash/sales journal that includes both cash and credit sales and all cash receipt transactions. This saves time, and if one accountant handles both, there’s no need for separate journals.

Regardless of which format you choose, the mechanics are the same. At the end of the month, you post totals from the cash receipts journal to the general ledger. The following journal entry summarizes the net effect.

WILSON AND COMPANY
CASH AND SALES JOURNAL

The Purchases Journal

The purchases journal is similar to the sales journal, in that all credit purchases of merchandise are recorded here. Anything purchased for cash, on the other hand, goes in the cash disbursements journal.

BRIGHT IDEA MANUFACTURING COMPANY
PURCHASES JOURNAL

At the end of the month, the total amount of purchases on credit would be recorded to account 401, purchases, as referenced at the bottom of the Amount column. The individual vendor accounts would be updated at the time of each sale by crediting the appropriate account in the individual accounts payable subsidiary ledger. The unpaid invoice would be put in the file for the appropriate date due. The net effect to the accounts is represented by the following journal entry.

The Cash Disbursements Journal

Cash payments of any type are recorded in the cash disbursements journal.

BRIGHT IDEA MANUFACTURING COMPANY
CASH DISBURSEMENTS JOURNAL

As with the cash receipts journal, you can easily customize the cash disbursements journal for your business. The number of columns you include is up to you and depends on your chart of accounts and the activities of your particular business.

Small businesses with a limited accounting staff often use a combined cash disbursements/purchases journal that includes both cash and credit payments and all cash disbursement transactions, including payroll and the related taxes. This saves time, and if one accountant handles both, there’s no need for separate journals unless the volume of transactions recorded becomes cumbersome.

Regardless of which format you choose, the mechanics are the same. At the end of the month, the activity in the journal would be totaled by individual accounts and posted to the general ledger. The net effect could be summarized as follows:

SEE ALSO 6.4, “Cash Disbursements”

BRIGHT IDEA MANUFACTURING COMPANY
PURCHASES AND CASH DISBURSEMENTS JOURNAL

2.5 Posting to the General Ledger

After transactions are entered in the journal, the next stop is the general ledger. In this subchapter, we show you how to summarize and make postings to the general ledger.

Note in the following examples we list the journal with its abbreviation to avoid confusion when we start out. In practice, the abbreviation is sufficient. Here’s what we’re using:

General Journal	GJ
Sales Journal	SJ
Cash Receipts Journal	CR
Purchase Journal	PJ
Cash Disbursements Journal	CD

BRIGHT IDEA MANUFACTURING COMPANY
GENERAL LEDGER

SEE ALSO 10.5, “Adjusting Entries”

Liabilities

Equity

As you can see from this example, posting to the general ledger from your journals is a fairly straightforward process. Some smaller companies might choose to post individual entries as they occur during the month; however, most organizations post summary totals for items like sales or cash disbursements at the end of the month. However you decide to proceed, what’s important is having a consistent system so you can go back to your journals to check or verify transactions.

2.6 Generating Financial Statements

At the end of the period (a month, a year, etc.), the general ledger is used as the basis for generating financial statements. Here we offer a quick preview of how general ledger balance totals become part of the balance sheet and income statement.

Notice that we’ve taken some liberties. In the actual closing process, we would make sure the numbers in the ledgers balance first. We would then make any adjustments, which would include taking the beginning inventory + purchases – the cost of goods sold to arrive at ending inventory. The net result would then be added or subtracted to inventory, with the offset going to cost of goods sold. We’d also close an income of $3,200 into the profit and loss account 299 (not shown here) and add it to proprietor’s equity to arrive at total owner’s equity.

SEE ALSO 1.4, “Establishing the Chart of Accounts”

SEE ALSO 10.4, “Developing a Trial Balance”

SEE ALSO 10.5, “Adjusting Entries”

SEE ALSO 10.6, “The Adjusted Trial Balance”

Following is an income statement for Bright Idea Manufacturing Company. If you’ve posted properly to your general ledger and accurately tallied totals for each account, you should be able to simply put these balances into your preliminary financial statements (known as a trial balance). We don’t show that step here, because no additional adjustments were required, but we do further explain trial balances in a later subchapter.

SEE ALSO 10.4, “Developing a Trial Balance”

In this chapter, we’ve taken you through the accounting cycle. After an accounting transaction has been executed, it must be analyzed and recorded in the appropriate journal. Journal entries are then summarized and posted to the general ledger. At the end of the month, general ledger balances are reconciled to any subledgers and tallied on a trial balance before the figures are transferred to the income statement and balance sheet. Following this process should provide you with financial statements that accurately reflect your company’s business transactions and financial results for the period.

Note: If you use a computerized system, the biggest difference will be that sales, payments, and other transactions need only be recorded a single time. Once you input the data, any posting to or reconciling with subledgers, summary to trial balance, and update to financial statements will be done automatically. This is obviously a huge time-saving benefit provided all transactions have been entered properly.

SEE ALSO Chapter 15, “Computerized Accounting”