Accounting / Bookkeeping Basics: Applying The Principles

Before financial statements can be completed, all the information needs to be collected and put together in the right way. The accounting cycle can be broken down into 9 steps that make the entire process a lot less intimidating. Now that you are familiar with the principles of accounting, you should be able to apply them to the accounting cycle for preparing statements and analyzing financial data.

Step 1: Identification and Analysis of Business Transactions
Accountants first go through all the business transactions and events that have occurred since the last reporting cycle. It's important that the transactions pertaining to the business entity are separated from those that do not. When good records are kept and the business owners keep their personal finances separate from the finances of the business, it is significantly easier to do this first step.
Once all the appropriate receipts are separated from those not pertaining to the business, the transactions are analyzed. They should be organized according to date, as this will make the next process easier. While analyzing, you must decide which accounts to debit and which accounts to credit. Though you are going to copy these amounts in the journals, you should keep the primary information as source documents. In the case of a discrepancy or an audit, the source documents are considered more reliable than prepared financial statements or journal entries.

Step 2: Journal Entries
Next, you are going to record the source documents in the journals. The double-entry accounting method is used, so every journal entry is going to include the date, a description, and at least two accounts. One account will be a debit and the other will be a credit. Something to note is that it is possible to have more than two accounts for a single journal entry. For example, if a company has paid part of their rent in advance, the entry might look like this:
 

A basic entry that has just two entries might look like:

As journals are the first official recording of business  transactions, they are often called the Books of Original Entry.
Accounts You Will Use When Writing Journal Entries
As you create journal entries, the biggest challenge is going to be deciding which accounts to debit and which accounts to credit. Accounts are classified according to a specified account. For example, assets are usually broken down into four categories; current assets, long- term assets, prepaid and deferred assets, and intangible assets.

These are the accounts most commonly listed on the income statement: Revenue
- Sales
Cost of Goods Sold
- Cost of Goods Sold Operating Expenses
- Salaries and Wages
- Marketing Expense
- Advertising Expense
- Rent Expense
- Insurance Expense
- Expense
- Utilities Expense

Other Income
- Interest Income
- Gain on Sale Other Expenses
- Interest Expense
- Loss on Sale Income Tax
- Taxes

These are the accounts most commonly listed on the balance sheet: Current Assets
- Cash
- Inventory
- Accounts Receivable
- Marketable Securities
- Allowance for Doubtful Accounts
- Prepaid Expenses

Fixed Assets
- Land
- Equipment
- Buildings
- Accumulated Depreciation
- Leasehold Improvements Intangible Assets
- Intellectual Property
- Goodwill Investments
- Investments in Stocks
- Investments in Bonds Current Liability
- Accounts Payable
- Income Tax Payable
- Cash Dividends Payable Shareholders Equity Common Stock
- Capital Stock
- Preferred Stock
- Stock
- Dividends
- Retained Earnings
- Paid-In Capital

Another Note About Journal Entries
Writing journal entries can be compared to Newton’s third law of motion. Every action should have an opposite and equal reaction. This means two things. First, you should expect that every journal entry requires at least two entries. Second, you should expect that your two journal entries equate to the same amount.
In the case of needing more than one journal entry, two of the entries will have the same value in either debits or credits as the other entry has in debits or credits. This creates a balance that is necessary for checking company financials and being sure that all the values align properly.
The reason balance is so important is because it verifies a company’s earnings. It prevents employees and business owners from stealing from the company, a practice which is called embezzlement. There have been many cases of embezzlement, though the numbers eventually failed to add up and the responsible party was held accountable for their actions.
Bernie Madoff was a famous investor who was arrested in 2008 after a complex scheme allowed him to convince investors to give him $65 billion that he stole from the company. He was sentenced to 150 years in prison. He was charged with false  filings, investment advisor fraud securities fraud, and money laundering with 11 total charges brought against him.
Kenneth Lay was the CEO of Enron who is known for his role in the bankruptcy of the natural gas company. After years of accounting fraud and corporate abuse, Lay cost shareholders of Enron close to $11 billion. Though he was charged, Lay died before sentencing.
There are countless other examples of fraud and embezzlement throughout larger companies. Though many forged accounting statements for some time, the truth eventually came to light and the people responsible in these cases were punished severely. In a way, being aware of discrepancies when the books just do not add up can help uncover these schemes, particularly when whoever is stealing from the company does not fully cover their tracks.
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Examples of Journal Entries
Once you are following the rule of equal and opposite reactions, the biggest obstacle is going to be deciding which accounts to debit/credit with transactions. The best way to do this is through practice. Don’t worry if it takes time, you’ll get the hang of it eventually. Something else that is useful is recording what each entry is for. This makes it simpler to track the flow of cash, particularly if you find yourself unbalanced later. As you create the journal entries, note what each entry stands for.

The ideal entry is going to look like this:

As you can see, each entry is going to include the date, which accounts are involved in the transaction, the debits and credits associated with the transaction, and information about the  transaction. Here are a few examples you can look over to get some ideas about how to create a journal entry.

Step 3: Posting Entries to the Ledger
The ledger is used to aggregate the different accounts and provide an overall amount for each of them. This helps accountants reach a total amount that can be debited or credited to the ledger. For example, you would go through each page of the journal and add all the cash debits and cash credits. In the end, the difference of cash credits and debits would be either debited or credited to the accounts on the ledger (depending on if the credits or debits are larger). This is done for all the accounts.
One of the most common ways of preparing the ledger from the journal entries is T accounts. To do this, you’ll need a T account for each account you use when creating journal entries and preparing your balance sheet. The T account is simply an entry that is headed using the proper account that has two columns. It is called a T account because of the shape of the entry.
To create a T account, simply place all the debits on the left-hand side of the ‘T” and all the credits on the right-hand side of the “T”. The position of values on the T account will be determined by whether they are a positive or negative value, or a debit or credit. For assets, the debits will be positive amounts and the credits will be negative amounts. For both liability and equity, the debits will be negative amounts and the credits will be positive amounts. This makes sense, as all the debits (positives) from the debit column of assets will equal the positive value of the credits in liability and equity. Likewise, all the negative credits associated with assets will be the same amount as the negative  credits of equity and liability.

Step 4: Creating the Unadjusted Trial Balance
The purpose of a balance sheet is to have the same number of debits and credits. This is a sign that a company has credited and debited the proper accounts for each transaction. To create a trial balance, add all the credits from the ledger in one column and add all the debits in the other. The two amounts should be the same if the entries are correct.
The purpose of a trial balance is to determine if there are any errors. If there are errors, they’ll need to be reversed or rectified and you’ll move on to the next step.

Here’s an example of what an unadjusted trial balance might look like:

Step 5: Adjusting Entries

Adjusting entries are those that have not yet been recorded between the preparation of the financial statement and the official reporting of the statement. There may also be some income that has been earned without being entered into the ledgers. These adjustments are posted to the accounts before the summary. You may have to adjust some of the amounts in the trial balance to reflect the new numbers. Usually, adjustments are used to report prepayments, allowances, depreciation, deferrals, accrual of income, and accrual of expenses. For example, an asset with a present cash value of $13,000 with a depreciation of $400 per month would be adjusted at this time. The entry might look like this:

This is also the time when a company accounts for those  things changed by adhering to the accrual accounting principle. For example, imagine that a company was prepaid $900 for providing a service. In the initial recording entry, the company would have debited the cash account and credited the unearned revenue account. Once they have completed the work, the adjusting entry would debit the unearned revenue account 900 and credit the sales revenue account.
On the opposite side, when a company sends an invoice for work completed that can be paid the following month, the accounts receivable account is debited and the sales revenue account is credited.

Step 6: Adjusted Trial Balance
An adjusted trial balance takes the adjusting entries into account and debits or credits them to the accounts on the unadjusted trial balance. When you add the debits and credits, they should equal the same number. If you cannot reach a balanced state, you’ll likely need to go over your work and see where you went wrong.
Another example would be the adjustment entry made for employee wages that were accrued in one period and paid in another. The initial entry would debit wages expense and credit wages payable. The adjusting entry would debit wages payable and credit the cash account.

Step 7: Financial Statements
Once the accounts are up-to-date and you have checked the math, you can prepare the financial statements. If you are creating a complete set of statements, you’ll need to include the statement of comprehensive income, statement of changes in equity, balance sheet, statement of cash flows, and notes to financial statements.
There are five base elements to all the financial statements, including assets, liabilities, equity, income, and expense. By analyzing companies in these areas, it gives a broad scope of the finances of the company without going into the finer details that most investors and stockholders are not interested in.
Within the accounting statements, income is meant to describe any economic benefits. This includes inflowing cash or the improvement of an asset, however, it also can be the decrease in liabilities or amounts owed. What is not included in income is any equity derived from shareholders, as this amount does not reflect money earned by the company using its resources to generate revenue.Put simply, revenue is that tracking of a company’s revenue and gains. Revenue is any money that arises from normal business proceedings. For a private tutor, the revenue would be the cost of a session paid as their fee. For a furniture manufacturer, revenue would come from the sale of furniture. Gain, by contrast, represents money that a company has earned outside their normal scope of business. If a furniture manufacturer decided to sell one of their machines after replacing it with a new one, they could realize any amount earned on the old asset as a gain.

Expenses are any decrease in the economic benefits realized by the business. This includes money spent on operating expenses as well as the deterioration of an asset. Expenses could also be increases to a company’s liabilities. The information that is excluded is any outflow or distribution to shareholders, as this is also considered equity. In addition to including expenses, the expenses are included as losses of the business. For example, if the furniture manufacturer sold their machine asset at a lower price than its depreciable cost, it would result in a loss that would be recognized as an expense.
Equity is the money that an entity can use to make changes, invest in activities, and use to generate revenue. However, this equity is not considered part of a company’s normal profits and losses because it is not related to doing business. Equity includes stock that has been issued and contributions from the owners into the company. When a company experiences a gain, they often decide how much to put back into the business and how much they will distribute to stockholders and owners to maintain their line of equity.

Step 8: Closing Entries
Entities close out temporary accounts to get ready for the following accounting period. For example, income and expense accounts for the month will be zeroed out so they can be accurately calculated the next month. Usually, these are closed using a summary account. The goal of closing entries is to remove those temporary accounts that a company uses to help keep track of earnings during the financial period.
These accounts fluctuate depending on the money coming into and going out of the company. The asset, liability, common stock, and retained earnings accounts are not closed. By zeroing out the temporary accounts, a company has a clean slate and can appropriately track its earnings for the next period.

Step 9: Post-Closing Trial Balance
Once closing entries are made, the debits and credits should be balanced again to check accuracy. Only real accounts can be balanced, meaning those accounts that begin with a balance from the previous accounting period. Real accounts are also considered permanent accounts. Some of the real accounts on the balance sheet include assets, liabilities, and stockholders’ equity. All the accounts that were closed out in the last step are not included. Here’s a look of what company DEF’s post- closing trial balance might look like: Company DEF Post-Closing Adjusted Trial Balance For the Period Ending December 31, 2003