Accounting is broadly defined as the process of recording financial information. However, business owners must also understand that accounting is a process, and you must implement the process to generate useful financial information. This discussion explains the accounting cycle, which is the process used to create the financial statements.
The Starting Point
The accounting process starts with source documents. A source document is generated when an event happens in your business, such as a customer sale or a purchase of inventory.
Assume, for example, that you operate a coffee shop. When you make a sale, you enter a transaction into your point-of-sale (POS) system, and accept payment in cash, by debit card, or using a credit card. The coffee shop’s copy of the receipt is a source document for the sale.
A timecard, on the other hand, is a source document for payroll costs. Source documents support your decision to record an accounting entry.
What is the Impact?
Each event (transaction) in your business has a financial impact, and the impact must be documented in the accounting records.
When your shop sells a cup of coffee to a customer who pays cash, for example, two events happen at the same time:
- You increase the cash account and record a sale
- You reduce inventory and increase the cost of sales (an expense account)
Think about inventory this way: the customer receives coffee, a cup, and a lid. Each of those items was purchased by the coffee shop as inventory. When you sell the items, the total cost is moved to cost of sales, an expense account. The sale amount less cost of sales is your profit on the coffee sale.
An accountant must consider the financial impact of each transaction.
Using Journal Entries
Once you understand the financial impact of a transaction, you need to record the impact using a journal. A journal is a record of each transaction that occurs, listed in chronological order, and accountants post activity using a journal entry.
Using the coffee sale, assume that the sale was for $2. One part of the transaction requires you to increase sales and increase cash. Here is the journal entry for this part of the transaction:
(To record a sale of coffee)
Note the following:
Accounts: The entry lists an account number and account title for both cash and sales. This information is taken from the chart of accounts that an accountant creates when the business starts operating. You can add, change, or delete accounts as your business grows.
Dollar amounts: Cash and sale accounts are both increased by $2.
Debits and credits: The double-entry accounting concept requires you to post debit and credit entries, and the total dollar amount of debits and credits must balance. In this case, cash is increased with a debit, and you increase sales with a credit.
Explanation: Accountants provide an explanation below each journal entry, and this documentation makes it easier to understand why a particular entry was made.
In some cases, a journal entry may require more than two accounts, but the total dollar amount of debits and credits must balance.
During the month, an accountant may post dozens, or even hundreds of journal entries to record transactions. Many journal entries are routine items that are posted every month. Depreciation expense on fixed assets, for example, is recorded monthly. The same is true of interest earned on a bank balance.
Other journal entries may only be posted occasionally. For example, if you take out a new bank loan, you may not borrow money again for years. The entry to record the cash received and the long-term debt may not be repeated for some time.
Do You Trial Balance?
In order to create the monthly financial statements, you need to check your work, and accountants generate a trial balance to review all of the journal entries for the month. The trial balance lists each account and the account’s balance as of a specific date. Here are some important items you must review:
The totals: The total dollar amount of debits posted must equal total credits in dollars. Fortunately, accounting software will prevent you from posting a journal entry that does not balance. If you use software, balancing debits and credits should not be an issue.
Reasonableness: The dollar amount of each balance should look reasonable to you. If, for example, the trial balance lists a negative balance in your cash account, you should check the journal entries to see if you made an error. On the other hand, if the trial balance presents a $20,000 increase in the furniture asset account- and you didn’t buy any furniture during the month- you most likely have made an error.
More detail: As your business grows and becomes more complex, you may need to add more accounts to your accounting system. If your coffee shop expands and you start offering a lunch menu, you’ll need more accounts to record and analyze the accounting activity.
An accountant may produce a trial balance multiple times each day, because it’s a great tool to review accounting transactions. However, the month-end review is particularly important, so that you can make any needed corrections and produce accurate financial statements.
Finishing the Process
After making corrections, an accountant runs an adjusted trial balance and uses that document to create the financial statements, including the balance sheet and the income statement.
Then, the accounting cycle starts all over again.
You start the first day of the next month by reviewing source documents and posting journal entries. At year-end, you generate your annual financial statements.
So, why bother learning about the accounting process?
Even if you hire a bookkeeper to post accounting entries for you, or your firm grows and you find a full-time accountant, you will benefit from understanding this process.
Your knowledge about accounting will help you identify errors, and you’ll be able to use your financial statements to make more informed business decisions. Invest the time to learn how the accounting process works. Your efforts will pay off.