- Suppose you were asked how much to the nearest dollar
you spent on food last year.
To answer this question would require
that you gather information like receipts,
credit card statements and canceled checks
for all your expenditures.
Analyze that information to determine
which outflows related to food
and summarize those outflows into one number,
the cost of your food expenditures for the year.
Now, once you've answered that question, answer this one.
How much did you spend on clothes last year?
Again, you would have to go through
the same process of collecting data,
analyzing the information to identify
those expenditures related to clothing
and then summarizing those expenditures into one number.
Without a method for gathering and organizing
day-to-day financial data,
answers to seemingly routine questions like these
can get quite complex.
Now you may be thinking,
doesn't my detailed electronic bank statement
allow me to easily answer these questions?
Well your bank statement would certainly help
but it's limited in that it only tracks
the transactions that go through you bank account,
like checks you write or debit card payments.
It does not track the cash in your pocket,
savings account or other investment accounts.
These payments are also not categorized by purpose
and the totals are not summarized.
Now, consider the dilemma for businesses.
They typically have far more transactions than you
and the kinds of transactions are much more varied.
Businesses buy and sell goods or services,
borrow and invest money, pay wages to employees,
purchase land, buildings and equipment,
distribute earnings to owners
and pay taxes to the government.
These activities are referred to as exchange transactions
because the entity is actually trading
or exchanging one thing for another.
A bookstore for example, exchanges books for cash.
Business documents such as a sales invoice,
a purchase order or a check stub
are often used to confirm
that a transaction has occurred
to establish the amounts to be recorded
and to facilitate the analysis of the business event.
To determine how well an entity is managing its resources,
the results of transactions must be analyzed.
The accounting cycle makes the analysis possible
by recording and summarizing an entities transactions
and preparing reports that present the summary results.
A transaction kicks off the accounting cycle.
A transaction is when a business exchanges something
and gets something in return.
The value exchange needs to be quantified and recorded.
Once all the transactions for a period have been recorded,
those transactions must then be summarized.
Once the day-to-day transactions are summarized,
then financial reports can be created.
Does this sound complicated?
Well it would be without a system
to capture that information.
But there's no need for us to invent the accounting wheel.
That wheel was cotified over 500 years ago
and is still used by virtually
all businesses around the world
to capture and compile financial information.
Large multi-national corporations
have millions of business transactions each day.
And the more detailed and complex the accounting system,
the more likely it is to be automated.
Even small businesses generally use some type
of inexpensive accounting software
to reduce the number of routine clerical functions
and to improve the accuracy and timeliness
of their accounting records.
Now regardless of whether
an automated or manual system is used,
the steps and the process
are basically the same.
A transaction occurs.
The transaction is then analyzed,
journalized and recorded to the accounts
and then summarized and reported
and used for evaluation purposes.
The difference lies in who or what does the work.
With a computer based system,
the software transform the recorded data,
summarizes the data into categories
and prepares the financial statements and other reports.
Nevertheless, human judgment is still essential
in analyzing and recording transactions.
Especially those of a non-routine nature.