Accounting is the recording, analysis and reporting of events that are materially significant to a company. Accounts contain records of changes to assets, liabilities, shareholders” equity, revenues and expenses. The usual sequence of steps in the recording process includes analysis, preparation of journal entries and posting these entries to the general ledger. Subsequent accounting processes include preparing a trial balance and compiling financial statements.
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Debits and credits are the basic accounting tools for changing accounts. Debits increase the asset and expense accounts, and they decrease the liability, equity and revenue accounts. Credits increase the liability, equity and revenue accounts, and they decrease the asset and expense accounts. Debits and credits are on the left and right sides, respectively, of a T-account, which is the most basic form of representing an account.
The first step in the recording process is to analyze the transaction, determine the accounting entries and record them in the appropriate accounts. The analysis includes an examination of the paper or electronic record of the transaction, such as an invoice, a sales receipt or an electronic transfer. Common transactions include sales of products, delivery of services, buying supplies, paying salaries, buying advertising and recording interest payments. In accrual accounting, companies must record transactions in the same period they occur, whether or not cash changes hands. Revenue and expense transactions affect the corresponding income statement accounts, as well as balance sheet accounts. Some transactions may affect only the balance sheet accounts.
Journal entries are the second step in the recording process. A journal is a chronological record of transactions. An entry consists of the transaction date, the debit and credit amounts for the appropriate accounts and a brief memo explaining the transaction. For example, the journal entries for a cash sales transaction are to credit (increase) sales and debit (increase) cash. Journal entries disclose all the effects of a transaction in one place. They are also useful in detecting and correcting errors because the debit and credit amounts must balance at the end of a period.
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The third and final step in the recording process is to post the journal entries to the general ledger, which contains summary records of all accounts. Each record has fields for transaction date, comments, debits, credits and outstanding balance. In the earlier sales transaction example, the posting process involves entering a credit amount for the sales account, a debit amount for the cash account and updating the respective balances. The general ledger may be in the form of a binder, index cards or a software application.