I did a post a long time back and had the intentions of trying to do a series on the topic, better late than never, here is the next one. This one we’ll start to have a look at the concepts of business transactions and how we records transactions for accounting purposes. The reason I wanted to do this series is to provide some context on accounting not to create a master class in accounting but to add some context eventually to what an ERP system like Dynamics is really there for.
Let’s start but defining what a transaction is. A transaction could be an exchange between the business and an external party. For example we purchase a new computer. Or we sell a product to a customer. These would be external types of transactions. There could be internal events for example a service technician uses spare parts to maintain equipment. A spare part would be an inventory item. Inventory is an asset that gets recorded on the balance sheet. So if we use a spare part then we need to adjust our inventory.
Whether internal and external transactions to the business each transaction needs to be analyzed for its economic effect at the time it happens. This could be considered as an event. An accounting event thus has context of time. Time is important for business aspects because we need to report to our internal and external stakeholders. The stakeholders want to know at what point they are reading the number. Hence when we report financial statements they are an accumulation of accounting events of a period of time as stated on the document. If we have a statement for a specific period then we know that we might want to compare how we are doing this period vs a prior period or the same period last yet. If we can compare periods than we can look for trends and make business decisions based on the movement of the data.
We also need to look at what took place at the event. For example if I issue a quote to a customer, while that might be a business document that isn’t an accounting event because we are not exchanging economic resources at that point. If the customer accepts the terms of a quote and the quote is converted to an order and we ship the goods then we have an accounting event, and when we invoice the customer we have an accounting event.
How do we know what events to recognize for accounting purposes? Well that is why we have accounting standards like GAAP, IFRS which set out the rules for how to treat accounting events. A good percentage of the events are very common and it’s those rules that are encoded in an accounting software systems. The only reason for having accounting software is to avoid manually recording the accounting entries at the time of the event. If we know an accounting event will be triggered when we ship goods to a customer then we can setup rules in the accounting system for handling that event.
Before we go and look at those rules it’s good to go back to basics and understand how accounting entries are recorded. Let’s go back in time for a moment before computers. If I run a business and do work for a number of people and I expect to be paid. I might want to write down a list of the customers and the amount they own me when I give them a pieces of paper, an invoice, which says please make payment for the work that I just did. I might want to then keep a journal each day of the transactions so I have a record. Hence we have two account terms the source document like the invoices and a journal. The journal is a chronological list of source document transactions.
When I record the information from the source document in the journal I will have a date the event took place, the amount and I need a way to classify the transactions so I can group like transactions together for analysis. This classification becomes an account number, just a way that I can codify the events.
Now if I have a journal and writing individual lines each day a transaction happens it’s hard to see a summary I have to go and flip through the pages in my journal to summaries. So if we have another place that we record a summary to that would be handy because then I could go and look at all the transactions that happened on a specific account. This new summary we’ll call the ledger or general ledger. You can see the history on the Wikipedia links for where the names originated long before computers.
In the next post we’ll explore the journal and the ledger.