The Accounting System

Before you can set up your accounting records, dive into your day-to-day transactions, and get your books ready for end-of-month or end-of-year reporting, you must gain an understanding of basic accounting concepts.

Accounting is the method in which financial information is gathered, processed, and summarized into financial statements and reports. An accounting system can be represented by the following graphic, which is explained below.

1. Every accounting entry is based on a business transaction, which is usually evidenced by a business document, such as a check or a sales invoice.
2. A journal is a place to record the transactions of a business. The typical journals used to record the chronological, day-to-day transactions are sales and cash receipts journals and a cash disbursements journal. A general journal is used to record special entries at the end of an accounting period.
3. While a journal records transactions as they happen, a ledger groups transactions according to their type, based on the accounts they affect. The general ledger is a collection of all balance sheet, income, and expense accounts used to keep a business's accounting records. At the end of an accounting period, all journal entries are summarized and transferred to the general ledger accounts. This procedure is called "posting."
4. A trial balance is prepared at the end of an accounting period by adding up all the account balances in your general ledger. The sum of the debit balances should equal the sum of the credit balances. If total debits don't equal total credits, you must track down the errors.
5. Finally, financial statements are prepared from the information in your trial balance.

Your accounting records are important because the resulting financial statements and reports help you plan and make decisions. They may be used by some third parties (bankers, investors, or creditors) and are needed to provide information to government agencies, such as the Internal Revenue Service.

For a more in-depth explanation of the accounting system, take a look at the following:

• accounting basics
• definitions of accounting terms
• cash vs. accrual accounting
• who can use the cash method?
• single- or double-entry accounting