Small Business Doctor

There are six steps in the accounting process.

1. A journal entry is made in a journal.
2. Transactions are summarized by account in the general ledger.
3. The unadjusted trial balance lists all of the general ledger account balances.
4. Adjusting entries are made to reflect events like depreciation not yet recorded.
5. The adjusted trial balance lists all account balances after the adjusting entries.
6. The financial statements are prepared.

Journals

In the double-entry accounting system, every transaction must record an equal and opposite effect in at least two separate accounts. One account is debited, and the other account is credited. Debits should therefore always equal credits.

Think about balancing the books like you would balancing a shelf on a wall so that it’s level. The supports on the left side should equal the supports on the right side. Debit is the left side. Credit is the right side. When debits equal credits, the books are in balance.

A good way to remember whether any account is a left-hand side debit account or a right-hand side credit account is to consider the organization of the Balance Sheet and Income Statement. The balance sheet has three sections: Assets, Liabilities and Equity. The income statement is organized around Income and Gains as well as Expenses and Losses.

This table shows each of these account types with their natural balance type, which is whether you should expect to see a debit or a credit balance there, and how that natural balance type is increased and decreased.

This journal entry shows inventory purchased for $250 cash on August 3, 2015. Inventory and Cash are both asset accounts. To record the increase to inventory, the Inventory account is debited. To record the decrease to cash, the Cash account is credited.

This journal entry shows a loan received from a bank on that same day. Cash is an asset account. To record the increase to cash, the Cash account is debited. Loan Payable is a liability account. To record the increase in loans we have to pay back, the Loan Payable account is credited.

This journal entry shows a cash payment for rent at the beginning of August. Rent is an expense account. To record this increase in expenses, the Rent Expense account is debited. Cash is an asset account. To record this decrease in cash, the Cash account is credited.

Ledgers

Ledgers are the central repository for all financial transactions. Ledgers perform the following four functions in the accounting process:

1. Classify transactions
2. Summarize account activity
3. Facilitate tracking and control of all transactions
4. Provide the data for the financial statements

Posting to the journals is a systematic and essential part of bookkeeping. Posting to the ledger transforms those chronological journal entries into a summarized and well classified format.

Each account has its own separate ledger. There are two sides to each ledger, debit on the left and credit on the right. The difference between debits and credits is that account’s net value balance at the end of the period.

The account balances for asset, liability and equity accounts are carried forward to the next period as opening balances. The process for doing so if it is an asset account looks like this journal entry.

The process for doing so if it is a liability or equity account looks like this journal entry.

Account balances for Revenues, Expenses, Gains and Losses are transferred to the Income Statement. They are not carried forward, but are instead zeroed out when closing the books for a period.

Ledgers look like these examples for assets, liabilities, income and expenses.

Unadjusted Trial Balance

The trial balance is a statement that lists all of the ledger accounts for the business at a specified point in time. The total of all debit balances should equal the total of all credit balances.

Preparing the unadjusted trial balance helps the accountant to verify ledger balances, detect errors, summarize data for the preparation of financial statements, and helps identify accounts that may need adjusting journal entries for things like accruals, deferrals, or depreciation.

The Trial Balance should look like this.

Adjusting Journal Entries

At the end of a period as part of the closing process, adjusting journal entries are made to update these account balances prior to preparing the financial statements. These adjusting journal entries align the books with the accrual basis of accounting so that revenues are recognized when earned and expenses are recognized when incurred.

There are six types of adjusting journal entries.

1. Accrued Revenues (Outstanding Revenues) are revenues earned but not yet recorded or received.
2. Accrued (Outstanding Expenses) are expenses incurred but not yet recorded or paid.
3. Deferred (Unearned Revenues) are revenues received in advance but not yet earned.
4. Deferred Expenses (Prepaid Expenses) are expenses paid in advance but not yet incurred.
5. Depreciation is the allocation of the cost of a fixed asset over its useful life.
6. Estimates for often estimated events like warranty expenses.

This adjusting journal entry shows the application of depreciation on a small business’s delivery van. The asset account Van is reduced by the depreciation amount. So, the Van account is credited.

Adjusted Trial Balance

The Adjusted Trial Balance is taken after the adjusting journal entries have been made. It looks just like the Unadjusted Trial Balance except that all of the amounts have now been finally adjusted.

Financial Statements

Balance Sheet

The balance sheet presents the economic resources (assets), economic obligations (liabilities), and the owners’ residual interest in those assets (equity). The balance sheet is a snapshot.

Income Statement and Statement of Comprehensive Income

The income statement presents the results of a company’s operations over a period of time. We compare a small business’s revenues from sales to the expenses incurred in providing those sales. The difference between revenue and expenses is operating income or loss for that period.

The Statement of Comprehensive Income includes items of income or losses that are not yet ready for the Income Statement. Other Comprehensive Income appears as a line item below the Income Statement.

Cash Flow Statement

The cash flow statement tells us the amount of cash provided or used by operating, investing, and financing activities by the company over a period of time.

Statement of Changes in Stockholders’ Equity

The Statement of Changes in Stockholders’ Equity shows information related to changes and reconciliations of equity like common stock, additional paid-in capital and retained earnings.