What are transactions?
All the business activities of a company done in the form of transactions, which can either be external or internal:
- External– transactions made between a company and another company or individual
- Internal– transactions made within a company
How are transactions recorded?
Accounting utilizes accounts– record of all transactions related to a particular item over a period of time, usually one year (Jan 1 to Dec 31, this is the “accounting period”). There are three classifications of accounts:
- Asset accounts, the most common of which are cash, supplies and equipment
- Liability account, the most common of which are accounts payable, salaries payable, utilities payable and taxes payable
- Stockholders’ equity accounts, the most common of which are common stock and retained earnings (revenue, expense, dividend)
Each transaction will have a dual affect such that the accounting equation is maintained: If total assets increase, then liabilities or stockholders’ equity must increase, and vice versa.
While the terms "increase" and "decrease" are commonly understood, accounts prefer "debit" and "credit". Debit refers to increasing left (and decreasing right), and credit refers to increasing right (and decreasing left). In the accounting equation (assets = liabilities + stockholders' equity), the assets are on the left, while liabilities and stockholders' equity is on the right. In summary:
- Assets: debit to increase, credit to decrease
- Liability: credit to increase, debit to decrease
- Stockholders' equity: credit to increase, debit to decrease
- Revenue: credit to increase, debit to decrease
- Expense: debit to increase, credit to decrease (since increasing expenses means taking away from stockholders' equity)
- Dividend: debit to increase, credit to decrease (since increasing expenses means taking away from stockholders' equity)
How are transactions displayed?
Transactions are formally displayed in a general journal– provides a chronological record of all entries representing transactions affecting a firm. Each entry includes date, relevant account names, debit amounts, credit amounts and a description. In an entry, there can be more than one debit or credit amount, but total debits must equal total credits. For example:
General Journal Example |
1 | Issue common stock: company sells shares of common stock worth $200k | Dec 1 Debit Credit Cash (+A).............................................................................200k Common stock (+SE)........................................................................200k Financing activity |
2 | Borrow cash from bank: company borrows $100k from bank as a loan | Dec 1 Debit Credit Cash (+A).............................................................................100k Notes payable (+L).............................................................................200k Financing activity |
3 | Purchase equipment: company buys equipment for $120k | Dec 1 Debit Credit Equipment (+A)......................................................................120k Cash (-A)............................................................................................120k Investing activity |
4 | Pay for rent in advance: company signs agreement to rent facilities and pays one year of rent in advance for $60k | Dec 1 Debit Credit Prepaid rent (+A)...................................................................60k Cash (-A)............................................................................................60k Operating activity |
5 | Purchase supplies on account: company purchase $23k of supplies on account | Dec 1 Debit Credit Supplies (+A).........................................................................23k Accounts payable (+L).......................................................................23k Operating activity |
6 | Provide services for cash: company provides soccer training to customers who pay cash at time of the service for $43k | Dec 1 Debit Credit Cash (+A)..............................................................................43k Service revenue (+SE)........................................................................43k Operating activity |
7 | Provide services on account: company offers soccer training but customers will pay $20k later | Dec 1 Debit Credit Accounts receivable (+A).......................................................20k Service revenue (+SE).......................................................................20k Operating activity |
8 | Receive cash in advance from customers: company receives $6k from customers for soccer training to be provided later | Dec 1 Debit Credit Cash (+A)...............................................................................6k Deferred revenue (+L)........................................................................6k Operating activity |
9 | Pay salaries to employees: company pays salaries for employees costing $28k in this month | Dec 1 Debit Credit Cash (-A).............................................................................................28k Salaries expense (-SE)..........................................................28k Operating activity |
10 | Pay cash dividends: company pays $4k worth of cash dividend to stockholders | Dec 1 Debit Credit Cash (-A)..............................................................................................4k Dividends (-SE).......................................................................4k Financing activity |
Now, a journal is not the most convenient way of displaying transactions if there are hundreds or thousands of transactions occurring per day. To make calculation of account balances more efficient, accountants collect all transactions of one account in one location, called a general ledger– provides each account with its individual transactions and resulting account balance. The process of transferring the debit and credit information form the journal to individual accounts in the general ledger is called posting. For the above 10 transactions, a general ledger would look like:The general ledger can be simplified into a trial balance, which shows the final balances of all accounts separated by debits and credits.
