Fundamentals of Accounting
The Perfect Accounting Recipe
The main objective of this blog, “Fundamentals of Accounting”, is to educate readers understand fundamental accounting concepts and principles, as well as to develop the capability to perform the basic accounting functions.
The basic accounting functions include the recognition, valuation, measurement and recording of the most common business transactions and the preparation of accounting statements.
Building Blocks of Accounting
Like any other tangible structure accounting too has basic building blocks which form integral part of accounting environment, procedures and practices.
The following are the basic terms that one should be familiar with: –
- Income
- Expense
- Assets
- Liabilities
- Owner’s equity
- Debit and;
- Credit
Income
An income is the transaction that give you money, this can be one time from one source and also on repetitive basis e.g. Salary of an employee.
The following are the examples of income accounts: –
Revenue from sales of product $1000
Revenue from services $ 800
Revenue from rental services $ 500
Expense
An expense is the transaction against which you make payment or consider paying at some future date. The expenses can be paid for one transaction or more than one transactions e.g. Paying Utility Bill for the month.
The following are the examples of expense: –
Payment of Utility Bills $750
Payment of employee wages $600
Payment for office equipment $450
Assets and Liabilities
Asset – Anything that you own and that thing does have some value. The value of asset is that it can be exchanged for money when needed or you can generate money from an asset by simply putting it to some task and sometimes it also prevents from losing money.
Example: Your car is an asset and so is your Laptop, as both of these can be sold for money. Like machinery in a paper manufacturing company is an asset as it produces paper which can be sold for money.
Your patent is an asset as it prevents your competitors from copying your ideas and related loss.
We can say an asset is anything that contributes to income.
The following are the examples of assets: –
Office Building $ 25,000
Plant and Machinery $100,600
Office Equipment $ 18,000
Liabilities – A liability is opposite of an asset. Something that you owe and it takes money from you. For example your telephone bill is a liability because at the time of paying the bill you will lose money.
The following are the examples of liabilities: –
Payable to vendors $125,000
Payable to employees $ 19,600
Bank loan $ 80,000
Owner’s Equity
When you total the assets belongs to the owner of the company its called owner’s equity. To calculate the owner’s equity the difference between a person’s assets and liabilities is taken.
Owner’s Equity = Assets – Liabilities
However, when that value of assets is greater than the liabilities, then you have positive owner’s equity and if your assets are lesser than your liabilities, then you have negative owner’s equity.
Debit and Credit
For every transaction there is an equal and opposite Debit/Credit entry. You cannot say if the debit or credit is positive or negative value.
Assets and expenses accounts increase in value when they’re debited and decrease when credited. Liability, equity and revenue accounts decrease debited and increase when credited.
The following table can help you a lot in understanding this very concept: –
| Increase | Decrease | |
| Assets | Debit | Credit |
| Liabilities | Credit | Debit |
| Income | Credit | Debit |
| Expenses | Debit | Credit |
Whenever there is an increase in an asset, the value is placed under debit and vice versa when the asset decreases it will be recorded in credit side.
Debit and Credit – Examples
A company received rental income of $12,000 in cash.
Cash Debit $12,000
Rental Income Credit $12,000
Utility Bill paid for the month at $400
Utility expenses Debit $400
Cash Credit $400
Purchase of new Machinery
Machinery Debit $10,000
Cash Credit $10,000
Accrual and Cash based Accounting
Under the cash based accounting, revenues are recorded in the period in which the cash is received from clients/ customers and Expenses are receded when the cash is paid.
Under the accrual basis of accounting, the revenues are reported and recorded in the income statement when they are incurred/ earned against which cash will be received in future. and
Expenses are reported and recorded in the income statement when they are incurred and against which cash will be received in future.
The accrual basis of accounting provides a true picture of a company’s affairs during an accounting period.
Accrual basis of accounting will report all the revenues actually earned during the period and of the expenses incurred to earn revenues.
The cash basis of accounting gives liquid position of the affairs of the company and its main focus is on cash collection.
Cash basis of accounting is less accurate and close to facts method of recording accounting transactions.
Revenue Recognition & Matching Principle
Revenue Recognition Principle
Revenue recognition principle enlightens that the revenue to be recognized when the benefits associated with the items sold or services provided is transferred and the amount can be estimated reliably and its recovery in future.
Example:
A monthly magazine receives 500 subscriptions of $240 to be at the beginning of the year. $10,000 will be recorded as revenue monthly.
Prudence Concept
Sometimes accounting transactions and associated financial results are not certain but in order to be accurate and relevant we have to report them in time. In order to make judgment, prudence is prerequisite and key to accounting principle which makes sure nothing is overstated or understated.
Example:
Some liabilities are contingent and are dependent to any future possible event of its occurrence or non-occurrence, for instance a law suit etc. based upon probability, if it is more than 50%, we record liability and expense at a certain amount. In this case we prevented liability and expense from being understated.
Matching Principle & Concept
Under matching principle the expenses incurred by an organization are charged to income statement in the accounting period in which the revenue, related to those expenses, is earned.
Example:
A manufacturing incurs cost on manufacturing or purchase of inventory charges the same to income statement in the relevant accounting period in which the inventory is sold. Therefore, any inventory remaining unsold at the end of an accounting period is excluded from the computation of cost of goods sold.
Accounting Cycle
Accounting is not just working with numbers, its about following guidelines and fundamentals of accounting.
There are specific steps that complete accounting process, the accounting cycle starts from a point and revolves through a circle. Each accounting cycle has a length which is variable on the basis of financial reporting of the company.
Steps in Accounting Cycle
These are basic steps to the accounting cycle: –
- Source documents
- Transactions analysis
- Journal transactions
- Transaction posting
- Unadjusted trial balance
- Adjusting entries
- Final trial balance
- Preparation of Financial statements
Source Documents/ occurrence
The source documents are the receipts, bills, cheques, bank statements, sales invoice, purchase orders which are basically the evidence of transactions at the time of occurrence.
Source documents are the main source to determine the nature of transactions.
Like an expense receipt is the source document for recording expenses.
Transaction analysis
In the next step you will analyze the transaction to make sure of the effect of such transaction on the company’s financial affairs.
Journal transactions
After the transactions are analyzed its time to post them into respective journals through journal entry. When a journal entry is used to record a transaction the double entry rule is in place which means with every transaction two accounts are affected at the same time.
Journal entries are recorded in chronological order for future tracking purposes.
- Transaction posting
- Unadjusted trial balance
- Adjusting entries
- Final trial balance
- Preparation of Financial statements
Transaction posting
The next step is to post the transactions into the general ledger. A ledger keep the records of all accounts in a company.
Ledgers are classified and numbered. When the information/ data is transferred to ledger account it is transferred to each account affected by the transaction using the double entry system.
- Unadjusted trial balance
- Adjusting entries
- Final trial balance
- Preparation of Financial statements
Unadjusted trial balance
The unadjusted trial balance is the contains list of the accounts and their balances affected by double entries for the specific accounting period.
The debits and credits of unadjusted trial balance are tallied as a result of double entry and the reason its called unadjusted trial balance is that its drafted before entering adjusting entries.
- Adjusting entries
- Final trial balance
- Preparation of Financial statements
Adjusting entries
Adjusting entries are entries which are discovered after preparation of unadjusted trial balances and later on are posted into the ledger.
It is not necessary that every organization has adjusting entries.
Adjusting entries are recorded at the end of accounting period. Adjusted entries are not recorded at the end of accounting cycle.
- Final Trial Balance
- Preparation of Financial statements
Final Trial Balance
A final trial balance is the trial balances containing account balances of all the ledgers after posting the adjusting entries in ledgers.
At the level the accountant makes sure that the debits and credits are equal after adjusting entries.
Financial statements are from the final trial balance.
- Preparation of Financial statements
Preparation of Financial statements
Financial statements are prepared with the help of final trial balance as it is believed to be the complete and error-free trial balance.
Each company’s financial statements vary on the basis of nature of business activities of such company. Financial statements mainly consist upon the following:
- Balance Sheet
- Profit and loss account/income statement
- Cash flow statement
- Notes to the accounts
Maintain Cash and Bank account
Managing cash and bank accounts is different from cash flow management and accounts receivables management. It purely concerns the day to day cash in hand and bank account management.
Managing Cash in hand
Petty cash management can sometimes be excruciating and can cost a lot of time in reconciling the difference due to timely non-tracking of receipts and payments.
Working Capital Management
- Working Capital
- Assets/liabilities required to operate business on day-to-day basis
- Cash
- Accounts Receivable
- Inventory
- Accounts Payable
- Accruals
- Short-term in nature—turn over regularly
- Assets/liabilities required to operate business on day-to-day basis
- Gross working capital = Current assets
- Gross Working Capital (GWC) represents investment in current assets
- (Net) working capital =
Current assets – Current liabilities
Working Capital Trade-offs
| Accounts Receivable | |
| High Levels (favourable credit terms) | Low Levels (unfavourable terms) |
| Benefit:
• Happy customers • High sales Cost: • Expensive • High collection costs • Increases financing costs |
Cost:
• Dissatisfied customers • Lower Sales Benefit: • Less expensive |
| Accounts Payable and Accruals | |
| High Levels | Low Levels |
| Benefit:
• Reduces need for external finance–using a spontaneous financing source Cost: • Unhappy suppliers |
Benefit:
• Happy suppliers/employees Cost: • Not using a spontaneous financing source |
Operations—The Cash Conversion Cycle
- Firm begins with cash which then “becomes” inventory and labour
- Which then becomes product for sale
- Eventually this will turn into cash again
- Firm’s operating cycle is time from acquisition of inventory until cash is collected from product sales
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