To measure a business transaction, you must determine when the transaction occurred (recognition), what value to place on the transaction (valuation), and how the components of the transaction should be categorized (classification). In general, recognition occurs when title passes, and a transaction is valued at the exchange price—the fair value or cost at the time the transaction is recognized. Classification refers to assigning transactions to the appropriate accounts.
In the double-entry system, each transaction must be recorded with at least one debit and one credit, and the total amount of the debits must equal the total amount of the credits. Each asset, liability, and component of owner’s equity, including revenues and expenses, has a separate account, which is a device for storing transaction data. The chart of accounts is a list of account numbers and titles. It serves as a table of contents for the ledger. The T account is a useful tool for quickly analyzing the effects of transactions. It shows how increases and decreases in assets, liabilities, and owner’s equity are recorded. The accounting cycle is a series of steps whose basic purpose is to produce financial statements for decision makers.
The double-entry system is applied by analyzing transactions to determine which accounts are affected and by using T accounts to show how the transactions affect the accounting equation. The transactions may be recorded in journal form with the date, debit account, and debit amount shown on one line, and the credit account (indented) and credit amount on the next line. The amounts are shown in their respective debit and credit columns.
A trial balance is used to check that the debit and credit balances are equal. It is prepared by listing each account balance in the appropriate Debit or Credit column. The two columns are then added, and the totals are compared. The major limitation of a trial balance is that it does not guarantee that the transactions were analyzed correctly or recorded in the proper accounts.
The general journal is a chronological record of all transactions. It contains the date of each transaction, the titles of the accounts involved, the amounts debited and credited, and an explanation of each entry. After transactions have been entered in the general journal, they are posted to the ledger. Posting transfers the amounts in the Debit and Credit columns of the general journal to the Debit and Credit columns of the corresponding account in the ledger. After each entry is posted, a new balance is entered in the appropriate Balance column.
GAAP provides guidance about the treatment of business transactions in terms of recognition, valuation, and classification. Failure to follow these guidelines is a major reason some companies issue fraudulent financial statements. Usually, a transaction should be recorded when title to merchandise passes from the supplier to the purchaser and creates an obligation to pay.
Some transactions generate immediate cash. For those that do not, there is a holding period in either Accounts Receivable or Accounts Payable before the cash is received or paid. The timing of cash flows is critical to a company’s ability to maintain adequate liquidity so that it can pay its bills on time.