What counts as a transaction¶
Most of what happens inside a business in a day never shows up in its financial statements. Someone has to draw a line between what gets recorded and what doesn't, then measure everything on the recorded side the same way, every time. That line, and the six-step process built on it, is what this chapter is about.
One restaurant, thousands of transactions¶
Chipotle Mexican Grill runs roughly 3,500 restaurants. A single location can ring up a few thousand sales in one day: burrito bowls, chips and guac, an order picked up from the counter. Every one of those sales changes what Chipotle owns or owes, and every one has to be captured the same way. That's the only way 3,500 separate restaurants can add up, at month's end, to one set of financial statements for the whole company. The rest of this chapter is the machine that makes that addition work.
The first thing that machine needs is a rule for what counts. During the period, accountants record external transactions: exchanges between the business and someone outside it, at a price both sides treat as real. A customer paying for a burrito bowl is one. So is the company paying a supplier for produce, or borrowing cash from a bank.
Plenty of things happen inside a business that are not external transactions, no matter how important they feel. A store manager deciding to schedule two more cooks for the dinner rush changes nothing yet: no cash has moved and no work has been exchanged for pay. That's an internal event. Internal events aren't recorded as they happen during the period; events such as supplies being used up or rent expiring are recorded at period end through adjusting entries (Chapter 3). Once that cook works a shift and earns pay for it, an external transaction has happened, and it gets recorded right away.
Signing a contract works the same way. A signature is a promise, not an exchange, so it isn't recorded by itself. Once a business starts performing under the contract, using the space it leased or delivering the service it promised, the exchange begins and the accounting starts.
Same day, two different events
Marlow Landscaping's owner decides on June 1 to expand into snow removal next winter. That's a plan, not a transaction, so nothing is recorded. Also on June 1, a customer pays Marlow Landscaping $150 for a completed lawn job. That's an exchange with an outside party at a known price, so it is a transaction, and it gets recorded.
Accounts and the chart of accounts¶
Every external transaction has to land somewhere specific. An account is a running record of one thing: how much cash a company has, how much it owes a supplier, how much stock it has issued. A company's full list of accounts, organized by category, is its chart of accounts. A small service business might use a chart of accounts like this one:
| Type | Example accounts |
|---|---|
| Asset | Cash, Accounts Receivable, Supplies, Prepaid Insurance, Equipment |
| Liability | Accounts Payable, Notes Payable, Deferred Revenue |
| Stockholders' equity | Common Stock, Retained Earnings |
| Dividend | Dividends |
| Revenue | Service Revenue |
| Expense | Salaries Expense, Rent Expense |
Chapter 1 introduced these categories: assets, liabilities, stockholders' equity, revenue, and expense. This chart adds a sixth line, Dividends, which is tracked separately because it reduces equity directly. Every account belongs to exactly one category, and that never changes.
Source documents¶
Recording a transaction starts with proof it happened. A source document is the paper or digital trail an external transaction leaves behind: a cash register receipt, a supplier's invoice, a signed loan agreement, a bank statement. Source documents are where the amount and the date of a transaction come from; nothing gets recorded on a guess.
The six-step roadmap¶
Once a transaction clears the external-transaction test, this chapter measures and records it the same way every time:
- Identify the transaction, using a source document as proof.
- Analyze its effect on the accounting equation: which accounts change, in which direction, by how much.
- Decide the debits and credits that will represent those changes.
- Record the journal entry.
- Post the entry to the ledger, updating each account's balance.
- Prepare a trial balance once all the period's transactions are posted.
Each of the next five sections zooms in on one of these steps, in order. Every worked example for the rest of this chapter is just these six steps, run once per transaction.
Before you go on¶
- An external transaction is an exchange with an outside party at a measurable price, recorded as it happens during the period. A decision, a plan, or a signed-but-unperformed contract is an internal event and isn't recorded until it becomes an exchange or, for events like supplies being used up, until Chapter 3's adjusting entries at period end.
- An account tracks one specific balance; a chart of accounts is a company's full, categorized list of accounts, built on the categories from Chapter 1 plus dividends.
- A source document is the evidence a transaction happened and how much it was for.
- Every transaction gets measured the same six-step way. Identify it, analyze its effect on the accounting equation, decide the debits and credits, record the journal entry, post it to the ledger, and prepare a trial balance.
Next, the second step gets its own close look: exactly how a transaction moves the accounting equation, and why it always moves at least two parts of it at once.