Regarded as the language of business, Accounting plays a pivotal role in everyday life. It’s often unfortunately deemed “complicated”, but is in fact one of the most intuitive subjects out there. The accounting process is the subject’s foundation. And knowing it inside out helps gain a solid command of the subject.
What is the Accounting Process?
The accounting process is a 7 step process that applies for every single business. So whether it’s a food and drinks based business like Starbucks, or a hi-tech aerospace firm like SpaceX, this 7 step process holds.
For simplicity, we’re going to work with Starbucks as we walk through the 7 steps.
Phase #1: The Event
The occurrence of an event marks the first phase of the accounting process. For example. this might be when you crave a cup of coffee from Starbucks.
While this step is not formally recorded, it helps to think about it. And so you know that this accounting process isn’t some sort of “magic”.
Phase #2: The Transaction
When you buy your coffee, you end up participating in a transaction. You pay for the coffee with your debit / credit card or cash.
Starbucks then records the transaction, which brings us to the next phase.
Phase #3: Recording the transaction (“Journal Entries”).
Each transaction has 2 sides. When you buy a coffee from Starbucks, you receive the coffee in exchange for paying money.
From Starbucks’ perspective, they receive money in exchange for selling a product (the coffee).
The system of recording both sides of each transaction is called “double entry bookkeeping”. And the most vital part of this system is recording or “posting” Journal Entries.
Journal Entries take the form of ‘debits’, and ‘credits’. That’s Accounting lingo for describing each side of the transaction.
In the most simplistic of intuition, you would ‘debit’ what comes in, and ‘credit’ what goes out.
Starbucks will thus ‘debit’ the money they receive, and ‘credit’ the coffee they sell. Their ‘journal entry’ will look like this:
|Details||Debit (Dr)||Credit (Cr)|
|Dr. Cash and Cash Equivalents||£2.20|
Cash and cash equivalents is just a fancy way of saying money. Strictly speaking, there’s more to it than that – but in essence, it is just cash.
Importantly, journal entries are posted for every single transaction that occurs.
For a company like Starbucks, there will literally be millions – if hundreds of millions – of journal entries posted every single day.
Naturally, doing any sort of analysis with that sort of data is difficult to say the least. Because the data isn’t organised in any particular manner.
You can think of posting journal entries like logging different events. It’s just a log.
To make our lives easier, and to cross-check that journal entries are ‘posted’ correctly, the accounting process includes posting to ‘T-accounts’ or ‘ledgers’.
Phase #4: Posting to ‘Ledgers’ and ‘T-Accounts’.
Ledgers (aka ‘T-Accounts’) essentially group similar types of journal entries, thereby making cross-checking and basic analyses easier.
They’re called T-accounts because they look like ‘T’s.
Recall that we said every single transaction has 2 sides. And that we refer to the two sides as ‘debits’ and ‘credits’.
Notice that each T-account has a debit side and a credit side. But for any given transaction, only one of the two sides will have an ‘entry’. The other side will be recorded in a separate T-account.
If all the transactions are recorded correctly, then the debits balances of all T-accounts must equate to the credit balances of the corresponding T-accounts.
This is verified when we create a ‘Trial Balance’.
Phase #5: Creating the ‘Trial Balance’
The Trial Balance (TB) lists every single ledger / T-account and stacks them one below the other. In the T-account template above, you’ll notice an undated value for “Bal b/f” (i.e., Balance Brought Forward). It’s that balance which goes on to the Trial Balance.
Now, there are instances where the Trial Balance ‘balances’, but is still incorrect.
For example, one might forget to record a transaction, in which case it would be ‘omitted’ from the accounts. The accounts would thus be incorrect, however the Trial Balance would still ‘balance’.
Phase #6: Closing the books & preparing the ‘Extended Trial Balance’
While all transactions should be recorded as and when they occur, some things are left to the end of the year / period.
For instance, the value of inventory (aka stock) tends to be recorded at the end of the period, when the books are closed.
That along with a few other ‘adjusting entries’ are made at the end of the period, after which an ‘Extended Trial Balance’ is prepared.
Once the Extended Trial Balance is prepared, no changes can be made to that set of accounts. The only thing left to do is to communicate the financial performance and position of the business. That’s done via the financial statements.
Phase #7: Preparing Financial Statements
Last but certainly not the least, the accounting process involves preparing financial statements including:
- The Income Statement (aka Profit and Loss Statement),
- The Statement of Financial Position (aka Balance Sheet),
- The Cashflow Statement (aka Statement of Cashflows),
- The Statement of Changes in Equity, and
- Notes to Financial Statements.
The objective of each statement is consistent – communicate information about the business. While one statement focuses on the financial performance (e.g., the Income Statement), another focuses on the financial position (e.g., the Balance Sheet).
Together, the financial statements must tell the same, or at least similar, story.
Financial statements that tell considerably different stories from one another are likely ‘cooked’.