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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.
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Identifying a Transaction |
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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
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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:
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
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:
- 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
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- 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:
| Assets |
= |
Liabilities |
+ |
Owner's Equity |
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:
| Assets |
= |
Liabilities |
+ |
Owner's Equity |
| 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. |
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