Accounting transactions are not recorded on a cash basis but on an accrual basis. This means that the transaction occurs when it takes place, not necessarily when cash has been exchanged. Receipt or payment of cash may be a separate transaction from when the goods were sold, purchase made or wages earned by an employee. Each transaction is recorded in a journal, or book, and periodically a business will want to close these books to see how it is performing.
An accounting period is usually a month, quarter or year. Accrual accounting recognizes transactions in the period for which they affect either revenue or expense. For example, materials may be purchased in one month but not paid for until the following month. However, they need to be recognized in the first months as they will be used to create goods to be sold for revenue. When they are paid for, a separate transaction will take place.
What Is a Transaction?
A transaction is any event that takes place in a business and has an impact on money. The purchase of supplies, the sale of goods and an employee working and earning a salary are all examples of business transactions. Each needs to recorded in an appropriate journal with a debit and a credit entry for the same amount. To debit an account is generally to add to it. To credit is to remove the amount from it.
The General Ledger
Once the transactions have been recorded in their appropriate journals, they are then recorded in the general ledger. It is easiest to think of the general ledger as a detailed report of daily transactions. These transactions are recorded in chronological order.
Closing the Books
At the end of an accounting cycle, the books will need to be closed to start a new cycle. Adjusting journal entries will need to be done to record any amounts accrued for the period that are not yet listed and to remove any deferred items. Closing journal entries will need to be done to rid the ledger of revenue and expense accounts, attributing the amounts to income and retained earnings.
Other Reasons to Close the Books
When closing entries are made, the amounts are recorded to income and retained earnings. This helps create financial statements for the business to gauge its general performance. There are three primary types of financial statements: the balance sheet, the income statement and the statement of cash flows. Another reason to close the books is to detect errors. Adding together debits and credits will show any major errors because the totals must always match.