3 Recording Transactions and the Accounting Cycle

The accounting cycle

The accounting cycle starts by identifying and analyzing business transactions. The transaction data is then recorded in a journal, posted to ledger accounts, and used to prepare an unadjusted trial balance. These steps organize the information and check whether total debits equal total credits.

Analyze transactions and account effects

A transaction is an economic event that can be measured in money and affects the business. Use evidence such as a receipt, invoice, deposit record, or contract to determine what happened, then identify the accounts affected and whether each account increases or decreases.

The accounting equation must remain balanced:

Revenue increases equity; expenses and owner withdrawals decrease equity. For example, when a business buys supplies on credit, supplies, an asset, increase, and accounts payable, a liability, increases by the same amount.

How debits and credits affect accounts

A debit is an entry on the left side of an account, and a credit is an entry on the right. Neither term inherently means “increase” or “decrease”; the effect depends on the account type.

• Assets: increases are debits; decreases are credits; the normal balance is a debit.

• Expenses: increases are debits; decreases are credits; the normal balance is a debit.

• Liabilities: increases are credits; decreases are debits; the normal balance is a credit.

• Owner’s equity: increases are credits; decreases are debits; the normal balance is a credit.

• Revenue: increases are credits; decreases are debits; the normal balance is a credit.

Every journal entry must have equal total debits and credits. Contra accounts and certain special cases can have balances opposite to the usual normal balance.

Journalize transactions

A journal records transactions in date order. A general journal entry identifies the date, accounts, debit and credit amounts, and often a brief explanation. List debit accounts first, then indent credit accounts; the total debits must equal the total credits for each entry.

Suppose a new service business has these transactions:

1. The owner invests cash of $\$10{,}000$.

2. The business buys equipment for $\$3{,}000$ cash.

3. The business buys $\$800$ of supplies on credit.

4. The business earns $\$2{,}400$ in service revenue and receives cash.

5. The business pays $\$600$ rent in cash.

6. The business pays the supplier $\$500$ toward the amount owed.

The corresponding general journal entries are:

1. Debit Cash $\$10{,}000$; credit Owner’s Capital $\$10{,}000$.

2. Debit Equipment $\$3{,}000$; credit Cash $\$3{,}000$.

3. Debit Supplies $\$800$; credit Accounts Payable $\$800$.

4. Debit Cash $\$2{,}400$; credit Service Revenue $\$2{,}400$.

5. Debit Rent Expense $\$600$; credit Cash $\$600$.

6. Debit Accounts Payable $\$500$; credit Cash $\$500$.

In the supplies purchase, the asset increases with a debit and the liability increases with a credit. In the supplier payment, cash and accounts payable both decrease: accounts payable is debited and cash is credited, according to their normal balances.

Post entries to the ledger

A ledger groups entries by account. Posting transfers each journal amount to the corresponding ledger account, where debits and credits accumulate into a balance. The journal preserves transaction order; the ledger shows activity and the balance for each account.

For the six transactions above, posting to Cash produces debit entries of $\$10{,}000$ and $\$2{,}400$, and credit entries of $\$3{,}000$, $\$600$, and $\$500$. The ending Cash balance is a debit balance of $\$8{,}300$.

The ending ledger balances are:

• Cash: $\$8{,}300$ debit.

• Equipment: $\$3{,}000$ debit.

• Supplies: $\$800$ debit.

• Accounts Payable: $\$300$ credit.

• Owner’s Capital: $\$10{,}000$ credit.

• Service Revenue: $\$2{,}400$ credit.

• Rent Expense: $\$600$ debit.

Prepare and interpret the unadjusted trial balance

After posting and before adjusting entries, prepare a trial balance listing each ledger account and its balance in either a debit or credit column. Its purpose is to test whether the total debit balances equal the total credit balances.

For the example business, the unadjusted trial balance is:

• Cash: debit $\$8{,}300$.

• Equipment: debit $\$3{,}000$.

• Supplies: debit $\$800$.

• Accounts Payable: credit $\$300$.

• Owner’s Capital: credit $\$10{,}000$.

• Service Revenue: credit $\$2{,}400$.

• Rent Expense: debit $\$600$.

• Total debits: $\$12{,}700$; total credits: $\$12{,}700$.

Equal totals show that the recorded debits and credits are mathematically balanced. They do not prove that every transaction was recorded, classified, or measured correctly. For example, a transaction omitted entirely or entered in the wrong accounts for equal amounts may leave the columns equal.