Basics of accounting
/Introduction to Accounting Basics
Accounting is the practice of recording and reporting on business transactions. The resulting information is an essential feedback loop for management, so that they can see how well a business is performing against expectations. The following discussion of accounting basics is needed to give you a firm grounding from which to understand how an accounting system works and how it is used to generate financial reports.
System of Record Keeping
First, there must be a rational approach to record keeping. This means setting up accounts in which financial information is stored. Accounts fall into the following classifications:
Assets. These are items purchased or acquired, but not immediately consumed. Examples are accounts receivable, inventory, and fixed assets.
Liabilities. These are obligations of the business, to be paid at a later date. Examples are accounts payable and loans payable.
Equity. This is assets minus liabilities, and represents the ownership interest of the owners of the business. Examples are common stock and preferred stock.
Revenue. This is the amount billed to customers in exchange for the delivery of goods or provision of services.
Expenses. This is the amount of assets consumed during the measurement period. Examples are rent expense and wages expense.
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Transactions
The accountant is responsible for producing a number of business transactions, while others are forwarded to the accountant from other parts of the company. As part of these transactions, they are recorded within the accounts that we noted in the first point. Key transactions are as follows:
Purchase materials and services. Requires the issuance of purchase orders and the payment of supplier invoices. Alternatively, goods and services may be purchased using company credit cards.
Sell goods and services to customers. Requires the creation of an invoice to be sent to each customer, documenting the amount owed by the customer.
Receive payments from customers. Requires matching received cash to open invoices.
Pay employees. Requires the collection of time worked information from employees, which is then used to produce gross wage information, tax deductions, and other deductions, resulting in net pay to employees.
Financial Reporting
Once all of the transactions related to an accounting period have been completed, the accountant aggregates the information stored in the accounts and reformats it into three documents that are collectively called the financial statements. These statements are noted below.
Income Statement
The income statement presents revenues and subtracts all expenses incurred to arrive at a net profit or loss for the reporting period. It measures the ability of a business to attract customers and operate in an efficient manner. This is the most heavily reviewed of the financial statements.
Balance Sheet
The balance sheet presents the assets, liabilities, and equity of a business as of the end of the reporting period. It presents the financial position of an entity as of a point in time, and is closely reviewed to determine the ability of an organization to pay its bills.
Statement of Cash Flows
The statement of cash flows presents the sources and uses of cash during the reporting period. It is especially useful when the amount of net income appearing on the income statement varies from the net change in cash during the reporting period.
Additional Accounting Topics
The presented basics of accounting only note the barest outline of the functions performed by the accountant. There are numerous more advanced topics that fall under the umbrella of accounting, as noted below.
Cost Accounting
Cost accounting involves the review of product costs, examining operating variances, engaging in profitability studies, bottleneck analysis, and many other operational topics. This is the core activity in management accounting, and contributes to the more profitable operation of a business.
Internal Auditing
Internal auditing involves examining internal records to see if transactions were processed correctly, and whether the established system of controls has been adhered to by the staff. A company’s external auditors may rely on the work of the internal auditors in their conduct of the annual financial statement audit.
Tax Accounting
Tax accounting involves planning to reduce or defer tax payments, as well as filing many types of tax returns. This can be a complex area, especially if a business operates across may tax jurisdictions.