Accounting Cycle Explained: From Transactions to Financial Statements

In this lesson, we'll explore the first step in the accounting cycle: Recording and Journalizing Transactions.Before we can record anything, we need to identify what qualifies as a business transaction. A business transaction is an economic event that is measurable in monetary terms and affects the financial position of a company.Examples of business transactions include purchasing inventory, paying salaries, and receiving customer payments. Non-transactional events like hiring an employee or receiving a quote don't get recorded until money changes hands or a financial obligation is created.Accounting uses a double-entry system, meaning each transaction affects at least two accounts, and the total debits must equal the total credits.The rule for assets is: debits increase and credits decrease. For liabilities and equity, the opposite is true: credits increase and debits decrease.Now, let's look at how we record these transactions in a journal. A journal entry has a standard format with date, account names, and separate columns for debits and credits.Let's look at our first example. When a company buys inventory worth $5,000 on credit, we debit Inventory for $5,000 because assets increase with debits. And we credit Accounts Payable for $5,000 because liabilities increase with credits.Notice how this transaction increases both an asset account (Inventory) and a liability account (Accounts Payable). The double-entry system keeps the accounting equation in balance.In our second example, when the company pays $2,000 for rent using cash, we debit Rent Expense because expenses increase with debits. We credit Cash because assets decrease with credits.This transaction increases an expense account and decreases an asset account. Remember that expenses ultimately reduce equity.After journalizing transactions, the next step is posting to the general ledger. The journal records transactions chronologically, while the ledger organizes information by account.In the general ledger, each account has its own page or section. Transactions are transferred or 'posted' from the journal to the appropriate accounts in the ledger. This makes it easy to track the balance of each account over time.The posting process creates an organized record system that forms the foundation for preparing the trial balance, which we'll explore in the next section.After journalizing and posting transactions, accountants prepare a trial balance to verify that debits equal credits.A trial balance lists all accounts with their debit or credit balances. The totals should be equal, providing a mathematical check on the general ledger.If our accounting records are correct, the total debits should equal total credits. In this case, both total twenty-six thousand, eight hundred dollars.However, a balanced trial balance doesn't guarantee error-free books. There are several limitations to be aware of.A trial balance cannot detect transactions recorded with incorrect amounts, those posted to wrong accounts, offsetting errors, or completely missing transactions.This is why the adjusting entries phase is critical. Adjusting entries ensure that financial statements reflect economic reality.After making all necessary adjustments, we create an adjusted trial balance, which again verifies that debits equal credits.The adjusted trial balance includes all the accounts affected by our adjusting entries. Note that we now have new accounts like Accumulated Depreciation and Salaries Payable.Again, our total debits and total credits must be equal. Here they both equal thirty-one thousand, one hundred dollars.This adjusted trial balance now forms the basis for preparing accurate financial statements, which is our next step in the accounting cycle.