Introduction – How Accounting Works
Accounting is the language of business, but how does it work? If you are new to accounting, you might feel overwhelmed by the terms, concepts, and rules that govern this field. However, accounting is not as complicated as it seems. In this blog post, we will explain how accounting works simply and easily. You will learn:
The Basic Elements of Accounting
Accounting is based on a few fundamental elements that represent the financial position and performance of a business. These elements are:
- Assets: Assets are the resources that a business owns or controls, such as cash, inventory, equipment, and accounts receivable. Assets are expected to provide future economic benefits to the business.
- Liabilities: Liabilities are the obligations that a business owes to others, such as loans, accounts payable, taxes, and salaries. Liabilities are expected to result in future outflows of economic resources from the business.
- Equity: Equity is the residual interest that the owners of the business have in the assets after deducting the liabilities. Equity represents the owners’ investment and claim on the net assets of the business.
- Revenues: Revenues are the inflows of economic resources that a business earns from providing goods or services to its customers. Revenues increase the equity of the business.
- Expenses: Expenses are the outflows or consumption of economic resources that a business incurs from operating its activities. Expenses decrease the equity of the business.
Please keep in mind that the following equation, which is known as the accounting equation, relates these elements.
Assets=Liabilities+Equity
The accounting equation shows that the total assets of a business must always equal the total liabilities and equity. This means that any change in one element must be matched by a corresponding change in another element, so that the equation remains balanced.
The Main Steps of the Accounting Cycle
The accounting cycle is the process of recording, summarizing, and reporting the financial transactions of a business. The accounting cycle consists of the following main steps:
- Identify and analyze transactions: The first step is to identify the business events that have a financial impact and analyze how they affect the accounting elements. For example, if a business purchases inventory on credit, it increases both its assets and liabilities.
- Record transactions in journals: The second step is to record the transactions in chronological order in journals, which are books of original entry. Each transaction is recorded as a journal entry, which shows the accounts and amounts involved, as well as the date and description of the transaction. For example, the journal entry for the inventory purchase would debit the inventory account and credit the accounts payable account.
- Post transactions to ledgers: The third step is to post the journal entries to ledgers, which are books of final entry. Each ledger contains a separate account for each element of accounting, such as cash, inventory, accounts payable, etc. Each account shows the balance and changes of that element over time. For example, the inventory account would show the increase in inventory due to the purchase, while the accounts payable account would show the increase in liability due to the credit.
- Prepare a trial balance: The fourth step is to prepare a trial balance, which is a list of all the accounts and their balances at the end of an accounting period, such as a month, a quarter, or a year. The trial balance is used to check the accuracy and completeness of the accounting records. The total debits and credits of the trial balance should be equal, otherwise there is an error in the accounting process.
- Adjust the accounts: The fifth step is to adjust the accounts, which is to make certain entries at the end of the accounting period to reflect the accrual basis of accounting. The accrual basis of accounting means that revenues and expenses are recognized when they are earned or incurred, not when they are received or paid. For example, an adjustment is needed to record the depreciation expense of an asset, which is the allocation of its cost over its useful life.
- Prepare an adjusted trial balance: The sixth step is to prepare an adjusted trial balance, which is a list of all the accounts and their balances after the adjusting entries. The adjusted trial balance is used to prepare the financial statements in the next step.
- Prepare the financial statements: The seventh step is to prepare the financial statements, which are the reports that summarize the financial position and performance of a business. The four main financial statements are:
- The income statement, which shows the revenues and expenses, and the net income or loss, of a business for a period of time.
- The balance sheet, which shows the assets, liabilities, and equity of a business at a point in time.
- The statement of cash flows, which shows the sources and uses of cash from operating, investing, and financing activities of a business for a period of time.
- The statement of changes in equity, which shows the changes in the equity of a business due to net income or loss, dividends, and other transactions with owners for a period of time.
- Close the accounts: The eighth and final step is to close the accounts, which is to transfer the balances of the temporary accounts, such as revenues, expenses, and dividends, to the permanent account of retained earnings. This step is done to prepare the accounts for the next accounting period.
The Benefits of Accounting for Businesses and Individuals
Accounting is not only a technical process, but also a useful tool for businesses and individuals. Some of the benefits of accounting are:
- Accounting helps businesses to measure and monitor their financial performance and position, and identify their strengths and weaknesses.
- Accounting helps businesses to plan and budget for their future operations and goals, and allocate their resources efficiently and effectively.
- Accounting helps businesses to comply with the legal and tax requirements, and avoid penalties and fines.
- Accounting helps businesses to communicate and report their financial information to various stakeholders, such as owners, investors, creditors, customers, suppliers, regulators, and the public.
- Accounting helps businesses to improve their internal controls and risk management, and prevent fraud and errors.
- Accounting helps individuals to manage their personal finances, such as income, expenses, savings, investments, and taxes.
- Accounting helps individuals to achieve their financial goals, such as buying a house, starting a business, or retiring comfortably.
- Accounting helps individuals to improve their financial literacy and skills, and make better financial decisions.
Conclusion
Accounting is the language of business that helps to record, summarize, and report the financial transactions of a business. Accounting is based on a few fundamental elements, such as assets, liabilities, equity, revenues, and expenses, and follows a systematic process, known as the accounting cycle, to produce the financial statements. Accounting is important for businesses and individuals, as it provides valuable information and insights for decision making, planning, compliance, communication, and improvement.
