Step 2 - Record and post transactions

Let's discuss the second step in the accounting cycle—recording and posting transactions. Grasping the process of recording and interpreting transactions is a crucial skill for any bookkeeper. It lays the groundwork for precise and dependable financial records for a business.

By monitoring and interpreting sales, expenses, invoices, and payments, we can provide you with a clear understanding of your business and enable you to make informed decisions. 

Whether we identify rising expenses for the business or discover a highly profitable product, we can guide you to concentrate your efforts and enhance profitability.

DOUBLE ENTRY BOOKKEEPING

Double-entry bookkeeping is a method for recording financial transactions, where each transaction is entered twice: once as a debit and once as a credit. This practice ensures that the accounting records remain accurate and balanced. T-charts provide a straightforward way to visualize double-entry bookkeeping, and they can be used to monitor the financial details of a business or individual. In a T-chart, the debit and credit entries must always be equal.

The accounting equation states that Assets = Liabilities + Equity. This equation forms the foundation of double-entry bookkeeping and ensures that the financial records remain in balance.

BALANCING

In double-entry bookkeeping, you monitor increases and decreases using the debit and credit columns. Every transaction is recorded with at least one debit and one credit entry. 

The key is to ensure that the total debits equal the total credits for each transaction. It's about maintaining balance. If the debits and credits don't align, there's an error, and you need to review the entries. 

By keeping things balanced, you maintain accurate financial records and understand how each transaction affects different accounts. So, remember, it's all about recording increases and decreases in the correct columns and ensuring the debits and credits are in balance.

REPORTING

You will use a t-chart or t-account to report, which neatly and systematically organizes your business's financial data. 

Visualize a vertical line dividing the page into two columns. 

On the left side, we log the debits, indicating increases in assets or expenses. 

On the right side, we log the credits, which signify increases in liabilities, equity, or revenues. 

This format allows for quick identification and analysis of each entry's impact, ensuring financial reporting is precise and organized. So, keep in mind, debits on the left, and credits on the right, when creating our t-charts or t-accounts.

Debit vs. credit

Let's look at the difference between debits and credits.

Here is a chart showing Debits and Credits by Account Type:

Account Type	DEBITS	CREDITS
Assets	Increase	Decrease
Liabilities	Decrease	Increase
Equity	Decrease	Increase
Income	Decrease	Increase
Expenses	Increase	Decrease

DEA/LER

DEA/LER is an acronym designed to help you grasp the concept of debits and credits in accounting. Let's explore what DEA/LER entails. 

Introducing DEA/LER, your guide to comprehending debits and credits in accounting.

Firstly, consider the DEA in DEA/LER. D represents Debit, E stands for Expense accounts, and A signifies Asset accounts. Debiting an account increases its value. For instance, when a client incurs expenses like office supplies or acquires assets such as equipment or inventory, those accounts are debited. This action places them on the left side of our financial equation. For example, debiting an asset account raises its value, and since assets increase value, they are debited, appearing on the left side.

Now, examine the L, E, and R in DEA/LER. L stands for Liability, E represents Equity, and R denotes Revenue accounts. Crediting an account signifies an increase in liabilities, equity, or revenue, or a decrease in assets or expenses.

Thus, when a business has liabilities like loans or accounts payable, equity from owner investments or retained earnings, or generates revenue from sales or services, those accounts are credited.

This places them on the right side of our financial equation. DEA/LER serves as a reminder that debiting an Expense or Asset account increases its value, positioning it on the left side of the equation. Conversely, crediting a Liability, Equity, or Revenue account increases its value, placing it on the right side of the equation.

And there you have it! DEA/LER assists you in determining which side of the accounting equation debits and credits belong to.

RECONCILING TRANSACTIONS

Reconciliation aims to confirm that every transaction is accurately documented in the correct locations and amounts. This process ensures the financial records' accuracy and dependability. In accounting, reconciliation typically involves matching the balance of a ledger account with the balance of a supporting document, like a bank or credit card statement.

Reconciliation involves matching entries in the ledger/journal with available documentation, such as receipts and invoices. This process ensures that all transactions are accurately recorded, in the correct locations, and with the correct amounts.

STEP 1: Gather Documents First, collect all relevant documents, including receipts, invoices, bank statements, and other supporting records. These will serve as your reference for verifying and validating the recorded transactions.

STEP 2: Compare Entries Then, carefully compare the ledger/journal entries with the corresponding documentation. Confirm that the transactions regarding the affected accounts, the amounts, and the transaction dates are accurately recorded. STEP 3: Check for Accuracy Ensure the recorded transactions are accurate by verifying them against the supporting documentation. Look for any discrepancies, such as errors in amounts or missing entries. STEP 4: Identify Discrepancies

If any discrepancies or differences are detected during the comparison, investigate and determine the reasons for the errors or omissions. Common causes may include data entry mistakes, missing documents, or incorrect transaction categorization.

STEP 5: Make Adjustments

Next, make any necessary adjustments to correct the identified discrepancies. This could involve correcting errors, adding missing entries, or reallocating transactions to the appropriate accounts. STEP 6: Reconcile and Document After making all adjustments, ensure the ledger/journal entries accurately match the documentation. Document the reconciliation process and any changes made to provide a clear audit trail and reference for future analysis.

T-accounts are a visual representation used in accounting to illustrate the flow of debits and credits. They consist of two sides: the left side represents debits, and the right side represents credits, providing a clear picture of how transactions affect different accounts. Total debits and total credits for a transaction have to be balanced.

CASH BASIS ACCOUNTING

Cash-basis accounting is a system in which revenues and expenses are acknowledged when cash is actually received or paid, instead of when the work is completed or goods are delivered. This implies that transactions are documented in real-time as they happen. Below are some essential points about cash basis accounting:

• Does not have accounts payable or accounts receivable

• Everything is recorded when it happens

• Cannot be used if you offer credit or have inventory

Because of it's simplicity, cash-basis accounting is a favorite of small businesses. However, because you aren't tracking future transactions, it doesn't always give a full picture of income and expenses; it's more of a snapshot of the business activity.  NOTE: If your bookkeeper is not providing accounts payable, accounts receivable, or full inventory tracking in your current accounting program, it could be be that your current services only include CASH BASIS reporting. You may need to request an upgrade or additional add on services in order to get these insights (learn more about ACCRUAL BASIS accounting below).

ACCRUAL BASIS ACCOUNTING METHOD

Accrual accounting involves recording revenue and expenses at the time they occur, regardless of when cash is exchanged. This contrasts with cash-basis accounting, where transactions are recorded only when cash is received or paid.

Accrual accounting provides a more accurate depiction of a business's financial status because it captures the complete financial activities. For instance, when a business sells products on credit, it records the revenue even if the cash has not yet been collected. This ensures that the income statement accurately reflects the total revenue generated.

Additionally, accrual accounting is mandated by GAAP (Generally Accepted Accounting Principles), making businesses that adopt this method more likely to comply with accounting standards.

Note: In this post, we are educating on the accounting principles generally used by most small businesses, not to the GAAP.

In accounting, three fundamental principles for comprehending how revenues and expenses are reported in financial statements are the accrual method, the revenue recognition principle, and the matching principle.

The accrual method involves recognizing revenues and expenses when they are earned or incurred, irrespective of when the payment is made or received. This approach offers a more precise depiction of a business's financial status compared to the cash basis method. It is typically utilized by larger companies or those with more intricate financial operations. It is crucial for businesses that extend credit terms to customers, maintain inventory, or handle prepaid expenses.

Within accrual accounting, the revenue recognition principle dictates when to record revenue. It specifies that revenue should be documented when a business delivers a product or service to a customer, regardless of when the payment is received. Conversely, when a business receives payment in advance, known as deferred or unearned revenue, the revenue recognition principle states that this revenue cannot be recognized until the service is fulfilled.

Lastly, the matching principle ensures that expenses are recorded in the same period as the related revenue. For instance, if your client incurs an expense related to revenue generated in a different month, they should report the expense in the same month as the associated income to accurately align the timing of expenses with revenue. This allows for an accurate calculation of actual profit.

Suppose they rent a truck in April for a job in May, and their client pays them in June. In this scenario, both the truck expense and the job revenue should be reported in the May report. By adhering to the matching principle, your client can accurately represent their profitability and understand which clients or projects are profitable. It also aids in managing cash flow effectively and ensures precise financial reporting. The accrual method is always recommended for inventory companies, even ecommerce companies that have no accounts receivable, because of the complexity of the inventory item bookkeeping. Inventory items affect 3 accounts while all other items only affect two. By using the accrual method, the business will gain a more comprehensive understanding of the business's financials, enabling better analysis and decision-making based on the matching of revenue and expenses, regardless of the timing of cash receipts.

Overall, the accrual method, revenue recognition principle, and matching principle are vital in accounting because they enable businesses to accurately reflect their financial performance and condition. By understanding and applying these principles in your bookkeeping practice, your clients can make informed decisions and maintain dependable financial records.

MODIFIED CASH BASIS ACCOUNTING METHOD

Modified cash-basis accounting is a hybrid approach that combines elements of both cash-basis and accrual accounting. 

Modified cash-basis accounting is a practical and commonly used method among small businesses. This approach merges the advantages of cash-basis and accrual accounting to help businesses manage their finances effectively.

In traditional cash-basis accounting, businesses record revenue and expenses based on actual cash flow—when money is received or paid. Although simple and straightforward, it doesn't provide a clear picture of the business's outstanding financial obligations. Modified cash-basis accounting addresses this by recognizing revenue when payment is received and expenses when they are incurred. By incorporating elements of accrual accounting, this method offers businesses a more comprehensive view of their financial situation.

In modified cash-basis accounting, two important accounts are introduced: accounts payable and accounts receivable.

Accounts payable allows businesses to track money owed to suppliers, vendors, or creditors, while accounts receivable monitors money owed to the business by customers or clients. By recording revenue and expenses on a cash-basis timeline, businesses can see real-time cash flow. At the same time, accounts payable and accounts receivable provide insights into future revenue and expenses that are owed or due but not yet paid. With these additional accounts, businesses can better manage cash flow and understand their overall financial health.

It's important to note that while modified cash-basis accounting offers more comprehensive tracking than traditional cash-basis, it has limitations. For instance, if a business has prepaid expense accounts, this method may not be ideal. In such cases, the accrual method would be more suitable, as it provides a more accurate representation of a business's financial position. Thus, modified cash-basis accounting is a practical and effective solution for small businesses to track their revenue, expenses, and outstanding obligations.

CASH BASIS ACCRUAL BASIS MODIFIED CASH BASIS

Each method presents unique benefits and considerations suited to various business types, sizes, and objectives. Whether it's the straightforwardness of cash basis accounting, the precision of accrual accounting, or the adaptability of modified cash basis accounting, each method has its role. By thoroughly evaluating the business's nature, transactions, and financial reporting requirements, your bookkeeper can assist in selecting the accounting method that best matches the business goals.