Accounting is an essential aspect of any business or organization’s financial management. It encompasses the process of documenting, classifying, and clarifying financial transactions to provide accurate and timely information to internal and external stakeholders.
The fundamentals of accounting are critical principles for financial decision-making by individuals and companies alike. To help you learn more about these foundational aspects of accounting, we will delve into the details of the accounting process, including the accounting equation, types of accounts, recording transactions, financial statements, the accounting cycle, adjusting entries, and closing entries.
The Accounting Equation
The accounting equation is the most foundational of accounting principles. It represents the relationship between a company’s assets, liabilities, and equity. The equation states that the total assets of a company are equal to the total liabilities and equity.
The equation can be written as Assets = Liabilities + Equity. For example, if a company’s total assets are $100,000, and its total liabilities are $50,000, then its equity is $50,000. This equation is used to keep track of a company’s financial position and ensures that financial statements are accurate.
Types of Accounts
There are several types of accounts in accounting, including:
- Assets: anything of value that a company owns, such as property, equipment, or inventory.
- Liabilities: obligations that a company owes to others, such as loans or unpaid bills.
- Equity: Equity: residual interest in assets of a business after deducting liabilities.
- Revenue: the income that a company earns from its operations, and expenses are the costs incurred in generating that revenue.
- Profit: revenue gained from sales or investments that exceeds expenses and/or costs.
Assets are classified into current and non-current assets. Current assets are assets that you can have converted to cash within one year, while non-current assets are assets that will last longer than a year, such as property or machinery.
Liabilities are classified as current or non-current. Current liabilities are obligations that need to be paid within one year, while non-current liabilities are obligations that will last longer than a year, such as long-term loans.
Equity is classified as contributed capital and retained earnings. Contributed capital is the amount of money that shareholders have invested in the company, while retained earnings are the accumulated profits or losses of the company since its inception.
Recording Transactions
The double-entry accounting system is used to record transactions. Every transaction affects at least two accounts at minimum: one account being debited and another being credited. The debit and credit amounts are equal, which means that the accounting equation always remains in balance.
The double-entry system helps to ensure that all transactions are accurately recorded and that the financial statements are correct. For example, if a company sells merchandise for $1,000, it will record a debit of $1,000 to cash or accounts receivable and a credit of $1,000 to revenue. If a company purchases inventory for $500 on credit, it will record a debit of $500 to inventory and a credit of $500 to accounts payable.
Financial Statements
There are four financial statements that companies prepare:
- Income statement
- balance sheet
- statement of cash flows
- statement of retained earning
The Income Statement
The income statement reports a company’s revenue, expenses, and net income or loss over a specified period. It shows how much money a company made or lost during a specific period. The statement is divided into two parts, operating and non-operating.
The operating section of the income statement includes revenue and expenses related to the company’s primary business operations. The non-operating section includes revenue and expenses that are not directly related to the company’s primary business operations, such as interest income or gains/losses on investments.
The Balance Sheet
The balance sheet provides a high-level overview of a company’s financial position during a specific point in time. It displays the company’s assets, liabilities, and equity.
Assets are listed in order of liquidity, meaning they are listed in order of how quickly they can be converted into cash. Liabilities are listed in order of maturity, meaning they are listed in order of when they are due. Lastly, equity is shown at the bottom of the balance sheet and represents the residual interest in the assets of the entity.
The Statement of Cash Flows
The statement of cash flows reports the inflow and outflow of cash during a specific period. It shows how much cash a company generated from its operations, investing activities, and financing activities.
Operating activities include cash received from customers and cash paid to suppliers. Investing activities include cash paid for investments, such as property or equipment. Financing activities include cash received from issuing stock or taking out loans, as well as cash paid for dividends or loan payments.
The Statement of Retained Earnings
The statement of retained earnings details the manner in which a company’s earnings have been distributed over time. It shows the beginning balance of retained earnings, net income or loss, dividends paid, and the ending balance of retained earnings. Retained earnings are a part of equity and represent the profits that have been retained by the company rather than paid out as dividends.
The Accounting Cycle
The accounting cycle is the process of recording, classifying, and summarizing financial transactions. The cycle begins with identifying and analyzing transactions and ends with the preparation of financial statements. The steps of the accounting cycle include:
1: Analyzing Transactions – Identifying the financial events that have occurred and determining their effect on the financial statements. Transactions can be classified as revenue, expenses, assets, liabilities, or equity.
2: Recording Transactions in a Journal – A journal is a chronological record of all transactions that have occurred during a specific period. Each transaction is recorded in the journal as a journal entry. Journal entries include the date, accounts affected, and the amount of the transaction.
3: Posting Transactions to the General Ledger – After transactions have been recorded in the journal, they are posted to the general ledger. The general ledger is a book or electronic record that contains all the accounts used by a company. Posting involves transferring the information from the journal entries to the proper accounts in the general ledger.
4: Preparing an Unadjusted Trial Balance – An unadjusted trial balance is a record of all accounts and their balances at a specific point in time. The purpose of an unadjusted trial balance is to verify that the total debits equal the total credits.
5: Making Adjusting Entries – Record events that have occurred but are not yet recorded in the accounts. These entries are necessary to confirm the accuracy of the financial statements and the true financial position of the company. Adjusting entries include accruals, deferrals, and estimates.
6: Preparing an Adjusted Trial Balance – After adjusting entries have been made, an adjusted trial balance is prepared. An adjusted trial balance is similar to an unadjusted trial balance but includes the effects of adjusting entries. The purpose of an adjusted trial balance is to ensure that the total debits equal the total credits after adjusting entries have been made.
7: Preparing Financial Statements – Financial statements include the income statement, balance sheet, statement of cash flows, and statement of retained earnings. These statements provide information about the financial position, performance, and cash flows of the company.
8: Making Closing Entries – Closing entries are journal entries made at the end of an accounting period to close out temporary accounts and transfer the balances to the retained earnings account. Temporary accounts include revenue, expenses, and dividends. Closing entries ensure that the company’s financial records are accurate and ready for the next accounting period.
9: Preparing a Post-Closing Trial Balance – A post-closing trial balance is similar to an unadjusted trial balance but includes only permanent accounts. The purpose of a post-closing trial balance is to ensure that the total debits equal the total credits after closing entries have been made.
Get Expert Accounting Services for Your Construction or Trade Business
Understanding the fundamentals of the accounting process is crucial for anyone who wants to manage their finances efficiently. These core principles must be understood to maintain accurate financial records and ensure the health of your business. By following the information above, companies can make informed financial decisions and ensure their long-term success.
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