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Basic accounting is one of the business responsibilities that organizations must efficiently accomplish; therefore, whether you intend to perform your own accounting/bookkeeping or employ professionals, you must become familiar with basic accounting.
What are the accounting fundamentals?
The process of recording a company’s financial transactions is referred to as basic accounting. It includes assessing, summarizing, and reporting these transactions to regulators, oversight agencies, and tax collection organizations. The financial statements used in basic accounting provide a concise summary of a company’s cash flows, operations, and financial status for a certain accounting period.
Accounting is one of the primary functions in virtually all sorts of businesses. In a small business, it is often conducted by an accountant or bookkeeper, or by big financial departments with dozens of staff. The reports generated by the various streams of accounting, such as managerial accounting and cost accounting, are essential for assisting management in making educated business choices.
Without accounting, it would be hard to know which products were successful, which business actions were successful, and whether the company is producing money or creating a profit. Additionally, it would be hard to estimate the amount of taxes to pay, whether to purchase or lease a property, or whether to join with another company. In other words, accounting is more than just the recording of financial transactions; it gauges a company’s effectiveness in reaching its objectives and helps shareholders understand how efficiently their money is being utilized. For this reason, accounting expertise is required for organizations to make sound judgments.
What comprises basic accounting?
Included in fundamental accounting are:
Arrangement of records
Before beginning the accounting process, businesses must have a logical record-keeping strategy. They are required to create accounts to store information. The following categories apply to accounts:
- Assets: are resources or items owned by a business. The future economic value of an asset is measurable and quantifiable in monetary terms. Investments, cash, inventory, accounts receivable, land, supplies, equipment, structures, and cars are examples of a business’s assets.
- Liabilities: These are the legal financial commitments or debts that a company incurs while conducting business. There are both limited and unlimited liability options. They are settled gradually by the distribution of economic benefits such as money, products, or services. Liabilities are reflected on the right side of a company’s balance sheet and include accounts payable, loans, mortgages, earned premiums, delayed revenues, and accumulated expenses.
- Equity: Equity, often known as shareholder’s equity, is the amount of money that a firm must return to its shareholders after liquidating all of its assets and paying off all of its debts. Equity is determined by subtracting the total assets from the total liabilities.
- Expenses: Expenses are the costs of operations incurred by enterprises in order to earn income. Employee salaries, payments to suppliers, equipment depreciation, and factory leases are typical business expenses.
- Revenue: Revenue refers to the income generated by a business’s usual operations. It contains deductions and discounts for returned merchandise. Costs are removed from revenue to determine net income.
Transactions
A number of business transactions are generated by the accountant, while others are forwarded from other firm departments. These transactions are recorded in the accounts specified in the first point. Examples of essential business interactions include:
- Sales: Transactions in which products or services are transferred from buyers to sellers in exchange for cash or credit. In the seller’s accounting journal (a record containing a summary of the transaction), sales transactions are documented as credits to the sales account and debits to cash or accounts receivable. Typically, sales require the development of an invoice to be given to customers, which details the amount owed.
- Purchases: These are the transactions essential for firms to acquire the materials and services required to achieve their objectives. Cash purchases are debited from the inventory account and credited to the cash account. If the purchase is made with a credit account, the credit entry is entered in the accounts payable account and the debit entry is recorded in the inventory account. Purchases frequently necessitate the issuance of purchase orders and the payment of supplier bills.
- Receipts: These are the transactions that indicate a corporation has been compensated for the services or products it has provided to clients. The seller’s journal entry for the receipt entry is a credit to accounts receivable and a debit to cash.
- Employee’s compensation: This needs the number of hours employees spend performing paid labor, which is then used to create tax deductions, gross wage information, and other deductions, resulting in net pay for employees.
Reporting
Once all transactions linked to an accounting period have been completed, the accountant consolidates the information recorded in the accounts and sorts it into three financial statements. These consist of the following:
Income statement
This document details the company’s revenues and deducts all expenses to determine the net profit or loss for the reporting period. It evaluates a company’s capacity to expand its consumer base and function effectively.
Balance sheet
This document details a company’s assets, liabilities, and equity at the end of the reporting period. It depicts an organization’s financial standing at a specific point in time and is carefully examined to determine its ability to pay its payments.
Statement of cash flows
This report describes the sources and uses of cash throughout the reporting period. It is especially important when the net income reported on the income statement differs from the net cash flow change throughout the reporting period.
Generally Accepted Accounting Principles (GAAP)
All accountants must adhere to the Generally Accepted Accounting Principles (GAAP). The GAAP establishes a standard that accountants must follow when documenting and reporting financial information. In addition, when all accountants adhere to the GAAP, investors and analysts are able to simply comprehend their filings and financial results.
Illustration of basic accounting
To illustrate double-entry accounting, assume that your business would record $10,000 in sales revenue; you would need to make two entries. These include a $10,000 debit entry to boost the “Cash” account on the balance sheet and a $10,000 credit entry to increase the “Revenue” account on the income statement.
Another example would be the $250 purchase of a new desk for the office. In this example, you would input a $250 debit to increase the “office furniture” expense account on the income statement and a $250 credit to decrease the “Cash” account on the balance sheet.
Likewise, if you borrow money from a bank, your company’s assets will expand, but so will its obligations. In double-entry accounting, the sum of the accounts with debit balances must equal the sum of the accounts with credit balances, ensuring that both sides of the transaction have been recorded.
The accounting cycle
The accounting cycle is the process of recording and classifying an organization’s financial transactions. It ensures that the financial statements of a firm are created appropriately and accurately reflect the company’s financial status. The workflow is cyclical, moving from one accounting period to the next, and is thus considered a cycle. The complete accounting cycle consists of nine processes, which were performed manually and recorded in journals in the past. Today, the majority of accountants utilize accounting software to perform a number of these tasks concurrently.
Consider the following accounting cycle steps:
Transactions
Transactions initiate the accounting cycle. This means that the accounting cycle begins each time a sale is made, an asset is acquired, a product is returned, or a debt is paid. All exchanges of a company’s assets are considered transactions.
Journal entries
A journal is a physical or digital record preserved as a data file, spreadsheet, or book in the accounting software of a business. A bookkeeper documents each financial transaction as a journal entry. If the income or spend affects one or more business accounts, this will be reflected in the journal entry. Journaling is an essential aspect of record-keeping since it permits a quick examination and transfer of records later in the accounting procedure. In addition to the general ledger, the journals are thoroughly examined as part of the auditing process.
Journal to general ledger posting
The general ledger is updated with all information recorded in the diary. The general ledger comprises the account information necessary to generate the financial statements for the company. The transactional data recorded in the general ledger is separated by account type into accounts for expenses, revenues, shareholder equity, liabilities, and assets.
Trial balance
When business transactions are summarized or closed to the general ledger, the accountant prepares a trial balance, which is a summary of the balance of each ledger account. Periodically, often at the end of each reporting month, a business generates a trial balance. The trial balance enables a business to verify the mathematical accuracy of its accounting system entries. The trial balance is thoroughly examined for inaccuracies, and any necessary adjustments are made by adding additional entries.
Adjusting entries
When adjusting entries, accountants take into consideration deferrals and accruals that have influenced the general ledger’s account balances. Before financial statements are created, these adjustments are taken to ensure that the reported results are in line with the company’s financial status.
Reconciliation of the trial balance
After the adjustments to the journal entries have been made and finalized, the accountant generates the trial balance after adjustments. Similar to the trial balance, the modified trial balance verifies that the debits and credits balance after modifications are made to the entries. The trial balance after adjustments is the most accurate account of a business’s financial transactions.
Financial statements
The accountant generates a cash statement, an income statement, and a balance sheet using the corrected trial balance. These will be utilized to illustrate the financial situation, results, and cash flow of the organization.
Closing entries
During this phase, the accountant transfers data from temporary to permanent accounts on the balance sheet. Included in temporary accounts are expenditures, revenues, and dividends. At the end of the accounting period, these accounts must be closed (reduced to zero) in preparation for the next accounting period. For example, $500 in income this year does not count as $500 in revenue the following year, even if the funds are held for use in the following year.
Trial balance after the close
Trial balance after closing is the final phase in the accounting process. After closing entries have been made, the accountant now verifies that all debits and credits match. Additionally, they ensure that the trial balance contains only permanent accounts, as temporary accounts have already been lowered to zero.
