A BRIEF EXPLANATION OF ACCOUNTING

 

The Accounting Cycle:

The accounting cycle consists of a series of general tasks which are completed to generate a financial statement.  These tasks begin when the business transaction occurs. Below is an overview of the accounting cycle:

 

         P  Business Transaction Occurs

         P  Source Document Used to Journalize

         P  Journals Posted to General Ledger

         P  Trial Balance Prepared

         P  Financial Statements Prepared

 

Accounting for Transactions:

For most companies, financial statements summarize the hundreds of transactions in which a company has engaged during a set period of time.  Double entry bookkeeping techniques are used to record and  summarize these transactions.  The resulting figures that are transferred to the financial statements.

 

Double Entry:

In accounting, every event has an equal and opposite event.  Double entry uses this theory as a basis for recording business transactions.  Since all business events are an exchange of one thing for another, every event results in at least two entries in an accounting system.  These entries are classified as either debits or credits.  The total amount of the debits and credits involved in a transaction is always equal. Therefore, double entry ensures that the books will always be in balance.

 

The basic accounting equation:  (Assets  =  Liabilities  +  Owners' Equity)

 

This equation must always remain true.  If it is not true, then the accounting records (books) are not in balance.  Consequently, the financial statements generated from these books will be inaccurate and misleading.

 

Debit and Credits:

As mentioned earlier, the terms debits and credits are used to record an event.  These terms refer to the increase or decrease in an account created by a transaction. It is important to know when to debit and when to credit.  Determining whether to debit or credit an entry depends upon two factors.  1.)  What is the nature of the account?  2.)  Will the event which is to be recorded lead to an increase or decrease in that account?

1

The following schedule shows the different types of accounts and the effect a debit or credit has upon the account:

 

Account Type

Normal Balance

To Increase account enter a:

To decrease account enter a:

Asset

Debit

Debit

Credit

Liability

Credit

Credit

Debit

Capital

Credit

Credit

Debit

Income

Credit

Credit

Debit

Expense

Debit

Debit

Credit

 

Following are several examples to clarify the concepts reflected in the above schedule:

 

Example 1:

Customer purchases product from store for $100 paid in cash.  Cash is increased by $100, Sales are increased by $100.

Debit Cash - $100

Credit Sales - $100

 

Example 2:

You pay telephone bill to telephone company for $50.00.

Expenses increased by $50.00, Cash decreased by $50.00.

Debit Expense - $50.00.

Credit Cash - $50.00.

 

Example 3:

At the end of your first month in business, you paid the utilities company $350.00 in cash.  Of this amount, $50.00 is an installation charge, $100.00 is payment for your first month's service, and $200.00 is a deposit which will be kept by the utilities company for three months before being returned to you.

Expenses increased by $150.00, Assets increased by $200.00, Cash decreased by $350.00.

Debit Expense - $150

Debit Asset - $200

Credit Cash- $350.00.

 

Notice that for each transaction, there are both debits and credits.  Also note, each transaction resulted in a double entry.  In each double entry, the amount of the debits equaled the amount of the credits.  The above concepts always hold true.

 

Transaction Accounts:

The transaction accounts are one, or two-word descriptions of the various types of transactions which will occur.  It is important to pre-identify the types of transactions which will possibly occur and list them in a logical, numbered sequence.  This list is called the Chart of Accounts. 

 

The purpose of the chart of accounts is to simplify your workload.  It groups and numbers accounts according to their classification:  assets, liabilities, capital, income, or expenses.  You should create and use your own chart of accounts.  Some charts of accounts may be long, while others may be short.  It is best to keep your Chart of Accounts as simple as possible.

 

The chart of accounts should always be listed in the following sequential order:  assets first, followed by liabilities, capital, income, and expenses.  Maintain gaps in your numeric sequence to allow for later additions.  Within the asset category, current assets are listed first, followed by fixed assets and then other assets.  For liabilities, the sequential order is current liabilities first, followed by the long-term liabilities.  Within the capital category, paid-in capital is listed, followed by owner's draw, then the company's retained earnings.  In summary, the double entry accounting system reflects each transaction as a debit or credit.  The actual accounting entry will occur using the transaction accounts.