The Accounting Cycle: How to Analyze Business Transactions #MMBA5

One of the fundamental skills of accounting is to understand how to record and report the financial activities of a business. This process is called the accounting cycle, and it consists of eight standard steps that start when a transaction occurs and end with its inclusion in the financial statements and the closing of the books.

In this blog post, I will explain the first step of the accounting cycle, which is to analyze the business transaction. This step is very crucial, as it determines the accuracy and completeness of the subsequent steps. If the analysis of the transaction is wrong, it will affect every other step until the very end.

What is a business transaction? A business transaction is an exchange of value between two or more parties that affects the financial position of the business. For example, buying inventory from a supplier, selling goods to a customer, paying salaries to employees, borrowing money from a bank, etc. are all business transactions.

How to analyze a business transaction? When a business transaction happens, the first step is to identify which elements of the financial statements will be affected by the transaction. The financial statements are the summary reports of the financial performance and position of the business. They include the income statement, the balance sheet, the statement of cash flows, and the statement of changes in equity. The main elements of the financial statements are revenues, expenses, assets, liabilities, and equity.

The next step is to determine the impact of the transaction on the values of the elements identified in the first step. The impact can be an increase, a decrease, or both. For example, buying inventory will increase the value of assets, paying salaries will decrease the value of assets and equity, etc.

The final step is to specify the line items affected under each element. A line item is a specific account that records the changes in the value of an element. For example, under assets, there are line items such as cash, inventory, accounts receivable, etc. Under liabilities, there are line items such as accounts payable, loans, taxes payable, etc.

Here is an example of how to analyze a business transaction:

ABC Co. bought inventory worth 1m from their supplier and paid only 400,000 while the rest was on account.

Step 1: Identify which elements of the financial statement are affected. 

Asset is affected because inventory is classified as a current asset, cash is classified as a current asset. However, liability is also affected as the inventory supplied was not paid for in full. So ABC Co. owes its supplier 600,000 as a result of this transaction.

Step 2: Determine the impact on the elements identified 

Asset value will increase in aggregate value as a result of this transaction (inventory goes up by 1m while cash goes down by 400k) Liability value will increase as well, considering the outstanding of 600k owed by ABC Co. on the transaction.

Step 3: Specify the line items under each element 

Under assets, the line items affected are Inventory – increase in value by 1m Cash – decrease in value by 400,000 Under liability, the line item affected is Accounts Payable – increase in value by 600,000

Once this is done, we can then proceed to determine which will constitute a debit or a credit entry in the line item accounts.

How to record a business transaction? 

To record a business transaction, we use a system called double-entry accounting, which means that every transaction affects at least two accounts and has a balanced effect on the equation: Assets = Liabilities + Equity. To maintain this balance, we use the terms debit and credit, which indicate the direction of the change in the value of an account. Debit means to increase the value of an account, while credit means to decrease the value of an account.

However, not all accounts follow the same rule. Depending on the type of account, debit and credit can have different meanings. To remember which accounts are debited and credited, we can use the acronym DEAL CLIP:

Debit Expenses, Assets, and Losses Credit Liabilities, Income, and Provisions

So, based on this, let’s apply it to our example above:

DR: Inventory – increase in value by 1m 

CR: Cash – decrease in value by 400,000 

CR: Accounts Payable – increase in value by 600,000

In case you wonder why cash, an asset, is credited but DEAL CLIP says assets should be debited, here is the explanation: Assets are debited when they increase in value, but when they decrease in value, they are credited to show the effect. Liabilities are credited when they increase in value, but when they decrease in value, they are debited.

In conclusion, the first step of the accounting cycle is to analyze the business transaction, which involves identifying the elements of the financial statements that are affected, determining the impact on the values of the elements, and specifying the line items under each element. This step is very important, as it sets the foundation for the rest of the steps in the accounting cycle, which are to journalize, post, adjust, and report the transaction. In my future blog posts, I will explain the other steps in the accounting cycle. Stay tuned!