Managing finances is one of the most important aspects of running a small business. Maintaining accurate and up-to-date financial records is crucial for making informed business decisions, preparing tax returns, and obtaining financing. An effective accounting system can help you manage your business finances and ensure compliance with regulatory requirements. In this small business guide on accounting systems, we will cover the essential steps involved in the accounting process, including analyzing financial transactions, preparing journal entries, creating ledgers, adjusting entries, and preparing financial statements.
1. Analyzing Financial Transactions: The process of accounting starts with analyzing financial transactions and entering the ones pertaining to the business entity into the accounting system. For example, loans taken for personal reasons are not included in the business documents. The first step of the accounting process involves the preparation of source documents. A source document or business document serves as the foundation for recording a transaction.
2. Journal Entries: Business transactions are recorded in a journal (also known as Books of Original Entry) in achronological order using the double-entry bookkeeping system. The journal entries include two accounts – debit and credit. To make this process easier, accountants use a special journal to record recurring transactions such as purchases, sales, cash receipts etc. the transactions that cannot be included in the special journals are recorded in the general journal.
3. Ledger: The general ledger is a collection of accounts that display the changes made to each account based on past transactions, along with the current balances in each account. It is also known as the Books of Final Entry.
4. Unadjusted Trial Balance: A trial balance is prepared to test if the total debits equal the total credits. The accounts are extracted from the ledger and arranged in a report. The balances of the debit and credit columns should be equal. If not, the trial balance contains errors which need to be located and rectified with correcting entries. It’s important to note that some errors may exist despite the debits equaling credits, such as errors caused by the double posting or due to the omission of entries.
5. Adjusting Entries: At the end of the accounting period, the accountant must prepare the adjusting entries to update the accounts that are summarized in the financial statements. For example, income earned but not recorded in the books. Adjusting entries are made for accrual of income and expenses, depreciation, allowances, deferrals, and prepayments.
6. Adjusted Trial Balance: Once the adjusting entries are made, an adjusted trial balance must be prepared. This is done to test if the debits match the credits after the adjusting entries are made. This is the final step before the preparation of the business’ financial statements.
7. Financial Statements: The financial statements which include the income statement, statement of changes in equity, balance sheet, statement of cash flow and notes are the end products of the accounting system.
8. Closing Entries: To prepare the system for the next accounting, temporary accounts that are measured periodically, including the income, expense, and withdrawal accounts, are closed. The balance sheet accounts also called the permanent accounts, remain open for the next accounting cycle. The last step of the accounting cycle is to prepare a post-closing trial balance to test the equality of the debits and credit amounts after the closing entries are made. This trial balance contains real accounts only as the temporary accounts are closed during this accounting cycle.