In the regular operations of a business, money comes in and goes out. In our review of accounting elements, we introduced investments, revenues, drawings or withdrawals, and normal expenses. In accounting, these occurrences are referred to as transactions. When transactions occur, in our introduction to accounting, we saw that they must be recorded and documented for the livelihood of a business.
Identifying a Transaction
To categorize the types of transactions that can occur in a business, they are recognized as two types: internal and external.
An internal transaction is a transaction that takes place in the company, usually among the employees of the company. An example would be a payroll when an employee of a company gets paid by the accountant of the company.
For a sole proprietorship, an internal transaction can be done by one person only, the owner of the company. An example would be the owner withdrawing money from the business (for any reason)
An external transaction is a transaction that occurs between a business and an external entity. Example are:
- The company sells a product to a customer
- The owner of the company sends an employee to teach a class to a night school somewhere and then the company gets paid by that other school
- The company borrows money from a bank
In our introduction to accounting, we saw that an accounting transaction is one that involves money exchange. This means that events such as hiring an employee, meeting with a customer, or negotiating the value of a job are not transactions, even if money is mentioned. As long as there is no money exchange, it does not count as a transaction in the accounting sense.
Whenever a transaction occurs, the monetary value of the business is affected. For example, when the business sells a product, its cash flow increases. When a business performs a service and gets paid as a result, it earns a revenue. If a business purchases a machine, money gets out. When an employee is paid, there is withdrawal of the company's money.
In our review or elements of accounting, we saw that the primary equation to deal with transactions is: /span>a result, each transaction that occurs has a dual effect on the accounting equation. For example, when the business starts, it may have a budget. In our example of the car repair shop, we mentioned that the owner had set aside a certain amount of money to start the business. As a result:
Assets = Liabilities + Owner's Equity
This equation should (must) always be balanced. In other words, when something (an event) happens (occurs) to one element of the equation, another element, another part, or a new element must take effect (another event must occur) to balance the equation. As
- An asset increases. For example the cash flow of the company increases AND
- The owner's equity increases. In this case, the capital of the company increases
In the same way, suppose that at one time the owner of the company takes his own money and add it to the business. As a result:
- An asset increases. In this case, the cash flow of the company increases AND
- The owner's equity increases. In this case, the capital of the company increases
Now suppose our car repair shop purchases a new tire rotating machine. The immediate effect is that:
- An asset decreases. In this case, the cash flow of the company decreases. The resulting effect is that the company has a new resource. As a result...
- Another asset increases. In this case, the company has a new equipment it can consider as an asset on the positive side
There are many other scenarios you can think of.
To keep track of these transactions, and because they can be as different as the fingers and toes of your body, when recording them, you can create an account for each type of transaction. Examples are:
- Assets: As seen in our review of elements of accounting, an asset is something that a company owns. Examples of accounts that can be created as assets are
- Cash: This is used for physical currency (money in hand, check from a customer or a bank, or money transferred to a bank account) was exchanged
- Accounts Receivable: This name is used for money that the company is supposed to collect later on but can be recorded now. For example, suppose our car repair shop changes the tires of a customer, performs a tune-up, installs new brakes, and changes the whole muffler system (and the customer had agreed to all these repairs). When presented with the invoice of $850, suppose the customer does not have the whole amount. The customer and the business can make an arrangement that the customer would pay part of it, such as $500. The rest would be paid at a later date. This rest ($850 - $500 = $350) is recorded as Accounts Receivable
- Supplies: This account can be used for accessories that a company purchases. This can include garbage can, cell phone, computer paper, toilet paper, table cloth, hard hats, etc
- Equipment: This is for a machine used by the business. This can be a tire rotating machine, a car, a computer, a printer, etc
- Liabilities: We saw that a liability is something that the company owes to an external entity. Examples of accounts are:
- Accounts Payable: This can be used for money that the company got from a person or from another company. For example, suppose at one time our car repair shop needs a tire changer that costs $1250 but the owner does not currently have the full amount. The selling company could ask the business to pay an advance right now and the pay the rest later on. Suppose our car repair shop agrees. The business would then owe a certain amount. Because the business would owe money, this would be considered an account payable
- Notes Payable: This can be used for a loan that the business signed and promised to pay
- Owner's Equity: This is the result of the transactions from the assets minus the liabilities. A typical exemplar account is the Capital of the company
After identifying a transaction, you can record it. To start, you create the references to the accounting equation:
Under each category, you create the accounts. Remember that the accounts you use depend on you (you decide what accounts you create) but you should follow the generally accepted accounting principles (GAAP). Here is an example of a few accounts created in their respective categories:
|Cash||+||Accounts Receivable||+||Supplies||=||Notes Payable||+||Accounts Payable||+||Capital|
Under each account, you can then enter the amount of the transaction. Most of the time, the amount is entered with a sign as + to indicate that it has an increasing effect, or - to indicate that it has a decreasing effect:
- Cash account: You enter a positive amount when/if the money (physically currency, including electronic deposit) was received. For example, whenever a customer buys a product (and pays), or the company provides a service and gets paid, or the company receives a (monetary) loan from a bank or a financial institution, enter the transaction in the Cash account as positive.
Be careful not to confuse the entries here with those of the Capital account. Everything in the Cash account must have effectively occurred: promises or intentions are not entered in this account.
You enter a negative amount if money was physically taken, either a withdrawal or some type of money that was retrieved (was taken out)
- Equipment Account: When an item such as a machine is bought and brought to the business, the amount that was spent to acquire it should be entered in the Equipment account, as a positive value. If the item was fully bought (for example if the company purchased a computer or a vacuum cleaner), record its purchase value in the Equipment Account as a positive value and decrease the same amount in the Cash account. If the item is financed, which means it was acquired but was not bought completely (for example if the company acquired a car that is being financed), only the amount that was spent, such as the money the company had put down as a down payment, must be entered in the Cash account, but the whole monetary value of the item must be entered in the Equipment Account (for this example, see the Accounts Payable account)
- Supplies Account: The values entered in this account follow the same rules as the Equipment account. If the item, such as soap for the restroom, was bought from a store, which means it now belongs to the company, enter the amount that was spent, as positive value, in the Supplies account because the supplies of the company have increased. Because the item(s) was (were) bought and money was spent, enter the amount as negative in the Cash account. If the item(s) was(were) not bought completely, for example if the business owner went to the store next door, took many items, paid 0 or part of it, and promised to pay the bill or the rest in the next few days, only the amount that was effectively spent must be entered in the Cash account. For the rest owed, refer to the below Accounts Payable
- Accounts Receivable: This is another account in the Cash category. As an item of the left side of the equation, it is related to the cash flow of the company.
When money is promised to the company, enter it as a positive value in the Accounts Receivable account. An example is if the company is a convenience store in the neighborhood and it allows people to come and take things that they will pay later on, you enter the amount they owe as a positive value in the Accounts Receivable. As another example, imagine the company is a hair braiding salon, a customer comes to the store, her hair is done and the bill is $200, she cannot pay the whole amount, she and the store owner agree that she would pay $140 today and the rest next week. You enter the amount that was effectively paid in the Cash account ($140 in this case) and the rest in the Accounts Receivable ($60 in this case) (for this example, see the Capital account)
When a debtor (a person or an institution that owed money to the company) pays a bill, you decrease the amount paid. That is, you enter the amount as a negative value in the Accounts Receivable. You then enter the amount as positive in the Cash account because money was received
- Accounts Payable: This the main account that refers to the liabilities of the company. In the Accounts Payable account, enter as positive any money that the company owes but has not paid yet. For example, when a company receives a (phone, electric, utility, etc) bill, the amount must be entered in the Accounts Receivable. The total in this amount allows a company to have a good idea of the bills that need to get paid or the money that external entities are expecting from this company
- Capital: This can be a tricky account, especially if confused with the Cash account. This account is affected in different scenarios. Whenever money is directly entered in the Cash account, for example the budget in the starting of the business or cash money that the business owner puts in the business to boost it. This account also plays as a counterpart to the Cash account when cash money is taken out not intended to purchase something specific. Typical examples are paying a bill or paying a contractor or an employee. In this case, enter the amount that was taken out, as a negative value, in the Cash account, and enter the amount as a negative value, in the Capital account
At the end of each account, you should calculate the result by adding the account's transactions. Then you should calculate the result of all values from each part of the = sign.
Remember that, for the equation to be balanced, the result from one side of the = sign should (must) be equal to the value on the other side of the = sign.