Join Jim Stice for an in-depth discussion in this video How can we collect all this information?, part of Bookkeeping.
- Suppose you were asked how much to the nearest dollar you spent on food last year. To answer this question would require that you gather information like receipts, credit card statements, and cancelled checks for all your expenditures. Analyze that information to determine which outflows relate to food, and Summarize those outflows into one number. The cost of your food expenditures for the year. Once you've answered that question, answer this one, how much did you spend on clothes last year? Again, you would have to go through the same process of collecting data, analyzing the information to identify those expenditures related to clothing, and then summarizing those expenditures into one number.
Without a method for gathering and organizing day-to-day financial data, answers to seemingly routine questions like these can get quite complex. Now you may be thinking, "Doesn't' my detailed electronic "bank statement allow me to easily answer these questions?" Your bank statement would ceratinly help but it is limited in that it tracks only the transactions that go through your bank account. Like checks you write or debit card payments. It does not track the cash in your pocket, savings account, or other investment accounts.
These payments are also not categorized by purpose and the totals are not summarized. Now consider the dilemma for businesses. They typically have far more transactions than you and the kinds of transactions are more varied. Businesses buy and sell goods or services, borrow and invest money, pay wages to employees, purchase land, buildings, equipment, distribute earnings to owners, and pay taxes to the government. These activities are referred to as exchange transactions because the entity is actually trading or exchanging one thing for another.
A book store for example, exchanges books for cash. Business documents, such as a sales Invoice, a Purchase Order, or a Check Stub are often used to confirm that a transaction has occurred to establish the amounts to be recorded and to facilitate the analysis of the business event. To determine how well an entity is managing it's resources, the results of transactions must be analyzed. The Accounting Cycle makes the analysis possible by recording and summarizing an entity's transactions, and preparing reports that present the summary results.
A Transaction kicks off the Accounting Cycle. A Transaction is when a business exchanges something and gets something in return. The value exchanged needs to be quantified and recorded. Once all the Transactions for a period have been recorded, those Transactions must then be summarized. Once the day-to-day Transactions are summarized, then financial reports can be created. Sound complicated? Well it would be without a system to capture that information. But there's no need for us to invent the Accounting wheel.
That wheel was codified over 500 years ago and is still used by virtually all businesses around the world to capture and compile financial information. Large multinational corporations have millions of business transactions each day and the more complex and detailed the Accounting System, the more likely it is to be automated. Even small companies generally use some type of inexpensive Accounting software to reduce the number of routine clerical functions and improve the accuracy and timeliness of the Accounting records.
Regardless of whether an automated or manual system is used, the steps in the process are basically the same. A Transaction occurs. The Transaction is then analyzed, journalized, and Recorded to the Accounts. And then Summarized, and Reported, and used for evaluation purposes. The difference lies in who or what does the work. With a computer based system the software transforms the recorded data, summarizes the data into categories, and prepares the financial statements and other reports.
Nevertheless, human judgement is still essential in analyzing and recording transactions. Especially those of a non-routine nature. Because a manual Accounting System is easier to understand, we will use a manual system for the examples in this course. But before we get into the details of the Accounting System, let's first get an overview of the output of the Accounting System. The Financial Statements.
- Reviewing financial statements
- Analyzing transactions
- Categorizing transactions
- Recording a cash acquisition
- Recording the sale of goods or services
- Posting journal entries to accounts