Understanding Accounting
Business Transactions

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:

  1. All transactions must be listed in the order they occur. This chronological listing provides a record of all business transactions from the first day of the accounting period to the last.6
2. All transactions must be grouped according to the type of transaction. All transactions involving the cost of electricity, for example, must appear in a separate listing. This separate listing would allow you to see at a glance the cost of electricity to date. These separate listings of similar transactions form the accounts of the business.
3. All transactions must be summarized to show the complete financial condition of the business. The "to date" totals from the accounts of the business provide information for creation of financial statements showing the relationship of all similar business transactions.
The Books of Accounting
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.
  Journal
The chronological listing of each individual transaction is recorded in a journal. A checkbook register is a simple form of a journal.

Journal Example

      In this age of computers you rarely see journal pages like the above, but it serves to illustrate the information needed when recording individual transactions. The "DATE" column is for the date of the actual transaction (not the date you are recording it). The "ACCOUNT TITLE" is the name of the account where this transaction amount will be transferred. For example, "Electricity" is a typical account title. The "DOC. NO." notation indicates the originating document. This might be a check number or sales receipt number. The "POST REF." notation is filled in with the number of the account to which this amount was transferred after the amount has been transferred (or POSTed) to the ledger (shown next). For example, the "Electricity" account may be account number 650. Filling in this column as you transfer each amount is a critical way of keeping track of your steps. The remaining columns record the amount of the transaction.

Ledger
Transaction amounts are transferred from the journal to the individual accounts in the ledger. A page in the ledger might be for electricity expense. If you went through your checkbook and totaled all the amounts paid out for electricity during the year, you would accomplish the same thing as an account for "electricity expense" in the ledger.

Ledger Example

       Again, you will rarely see ledger pages like this, but they serve to illustrate the information for each account. Each page is titled with the name and number of the account. Continuing with our examples, the account name or title would be "Electricity" and the number would be "650." The "DATE" and "ITEM" columns here are not important, because you already have that information in the journal, but you might find it convenient to see that information here as well. The "POST REF." for each entry on a ledger page indicates the page of the journal from which the transaction was copied. This is a critical piece of information. The amount of the transaction is recorded in either the debit or credit column. Then a current balance is calculated and recorded in the balance section. This balance can then be used to create summary statements of the financial condition of the business.

     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:

  Cash Receipts Journal to record cash sales.
Cash Disbursements Journal to record cash disbursements.
Purchases Journal to record credit purchases (amounts due to others).
Sales Journal to record credit sales (amounts due from others).
General Journal to record transactions which do not to apply to other journals.
Accounts Receivable Ledger to track the accounts of entities who owe the business money.
Accounts Payable Ledger to track the accounts of entities to whom the business owes money.
General Ledger the general ledger will always contain all the financial statement accounts of the business.

     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.

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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. return
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. return
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. return

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Copyright © 1997-2007 Kathleen A. O'Connell, ALL RIGHTS RESERVED. Last updated Dec. 27, 2007
Kat