A transaction is the exchange of value between the business and another entity. When a transaction occurs, an original or source document is created. A copy of this document is retained by both parties involved. For example, when the business makes a sale, a sales receipt is prepared. One copy is retained by the business and a second copy is given to the customer. When the business makes a purchase, it receives a copy of an invoice. When an exchange of value is made (i.e., a business trades a service for a product), the transaction and its value are recorded on a document.
The original documents provide objective evidence of the transaction.4 The transaction is recorded at actual cash or cash-equivalent value.5 Source documents should clearly indicate the date of the transaction, the amount of the transaction, the type of transaction (i.e., a description of the product purchased or service rendered), and proof that the document is valid. Proof might be letterhead of the business or signatures of the parties involved.
The source documents are then used to record the transactions of the business in the books of accounting. Business transactions must be available for analysis in three forms:
The books of accounting are designed to properly record transactions using a double-entry system that keeps the books in balance. Accounting systems are designed to leave a trail so all amounts can be traced from summary totals back to their source documents.
A large business may utilize subsidiary books of accounting to further categorize transactions and divide recording responsibilities among departments. When subsidiary books are used, the Journal and Ledger become General Journal and General Ledger. For example, a business may use the following journals and ledgers:
The journals necessary to efficient and accurate recording of transactions will depend on the needs of the business. No matter how many journals are used, each transaction is entered just once. The same transaction may not be recorded in more than one journal or duplicate entries may result in the general ledger.
Subsidiary ledgers are only necessary when a group of accounts are contained within a single financial statement account. For example, in the case of Accounts Payable, each vendor who sells you merchandise on credit must have a vendor account in which to track the amount you owe. In this case, you keep a Purchases Journal in which to record individual receipts of your purchases. You then transfer those amounts to the appropriate vendor accounts in the Accounts Payable Ledger. But you still need to record an amount in the Accounts Payable account in the General Ledger. Rather than duplicating each entry you made in the Accounts Payable Ledger, you create a subtotal of the amounts you transferred in the Purchases Journal. You then record that subtotal in the Accounts Payable Ledger. The total of all the customer accounts in the Accounts Payable Ledger and the balance in the Accounts Receivable account in the General Ledger should always match.
4. Objectivity or Objective Evidence Principle
All transactions must be recorded from a source document indicating a transaction was accurate and true. Transactions are recorded at the cost or expense indicated on the source document without any opinion on the actual worth of the item transferred.
5. Cost Principle
All goods and services are recorded at cost which is measured on a cash or cash-equivalent basis. Although the business may purchase a piece of equipment with a market value of $15,000 at a cost of $10,000, the market value has no effect on the recording of the transaction. The actual cash outlay of $10,000 is recorded as the cost of the piece of equipment. Fair market values are only a consideration when an exchange of goods, services, or property is made. When no actual cash is exchanged, the fair market value must be used.
6. Accounting Period Cycle or Time-period Concept
Government units and business owners must have periodic reports on the financial progress of the business. The length of time between financial reports is an accounting period. The accounting period cycle is normally annual and begins January 1 of each year and ends December 31 of the same year. Accounting periods may also be one month, three months, or six months. An accounting period of 12 consecutive months is a fiscal year. Fiscal years may end on the last day of any month. For example, a business may choose to have a fiscal year from May 1 to April 30.