Basic accounting concepts

Basic accounting concepts

Financial accountants produce financial statements based on Generally Accepted Accounting Principles of a respective country. In particular cases financial statements must be prepared according to the International Financial Reporting Standards.
Financial accounting serves following purposes:

• producing general purpose financial statements
• provision of information used by management of a business entity for decision making, planning and performance evaluation
• for meeting regulatory requirements

Graphic definition

The accounting equation (Assets = Liabilities + Owners' Equity) and financial statements are the main topics of financial accounting.
The trial balance which is usually prepared using the Double-entry accounting system forms the basis for preparing the financial statements. All the figures in the trial balance are rearranged to prepare a profit & loss statement and balance sheet. There are certain accounting standards that determine the format for these accounts (SSAP, FRS, IFS). The financial statements will display the income and expenditure for the company and a summary of the assets, liabilities, and shareholders or owners’ equity of the company on the date the accounts were prepared to...
Assets, Expenses, and Withdrawals have normal debit balances (when you debit these types of accounts you add to them), remember the word AWED which represents the first letter of each type of account.
Liabilities, Revenues, and Capital have normal credit balances (when you credit these you add to them).

0 = Dr Assets                            Cr Owners' Equity                 Cr Liabilities  
          .       _____________________________/\____________________________       .
          .      /    Cr Retained Earnings (profit)         Cr Common Stock  \      .
          .    _________________/\_______________________________                      Cr Revenue                           .            .
      \________________________/  \______________________________________________________/
       increased by debits           increased by credits


          Crediting a credit                         
Thus -------------------------> account increases its absolute value (balance)
           Debiting a debit                             


          Debiting a credit                         
Thus -------------------------> account decreases its absolute value (balance)
          Crediting a debit

When you do the same thing to an account as its normal balance it increases; when you do the opposite, it will decrease. Much like signs in math: two positive numbers are added and two negative numbers are also added. It is only when you have one positive and one negative (opposites) that you will subtract.

 

Account types (nature)

Type	Represent	Examples
Real	Physically tangible things in the real world and certain intangible things not having any physical existence	Tangibles - Plant and Machinery, Furniture and Fixtures, Computers and Information Processing Equipment etc. Intangibles - Goodwill, Patents and Copyrights
Personal	Business and Legal Entities	Individuals, Partnership Firms, Corporate entities, Non-Profit Organizations, any local or statutory bodies including governments at country, state or local levels
Nominal	Temporary Income and Expenditure Accounts for recognition of the implications of the financial transactions during each fiscal year till finalisation of accounts at the end	Sales, Purchases, Electricity Charges

Example: A sales account is opened for recording the sales of goods or services and at the end of the financial period the total sales are transferred to the revenue statement account (Profit and Loss Account or Income and Expenditure Account).
Similarly expenses during the financial period are recorded using the respective Expense accounts, which are also transferred to the revenue statement account. The net positive or negative balance (profit or loss) of the revenue statement account is transferred to reserves or capital account as the case may be.

Account types (periodicity of flow)

The classification of accounts into real, personal and nominal is based on their nature i.e. physical asset, liability, juristic entity or financial transaction.
The further classification of accounts is based on the periodicity of their inflows or outflows in the context of the fiscal year.
Income is immediate inflow during the fiscal year.
Expense is the immediate outflow during the fiscal year.
An asset is a long-term inflow with implications extending beyond the financial period and by the traditional view could represent unclaimed income. Alternatively, an asset could be valued at the present value of its future inflows.
Liability is long term outflow with implications extending beyond the financial period and by the traditional view could represent unamortised expense. Alternatively, a liability could be valued at the present value of future outflows.

Type of accounts	Long term inflows	Long term outflows	Short term inflows	Short term outflows
Real accounts	Assets
Personal accounts	Assets	Liability
Nominal accounts			Incomes	Expenses

Items in accounts are classified into five broad groups, also known as the elements of the accounts:^[9] Asset, Liability, Equity, Revenue, Expense.
The classification of Equity as a distinctive element for classification of accounts is disputable on account of the "Entity concept", since for the objective analysis of the financial results of any entity the external liabilities of the entity should not be distinguished from any contribution by the shareholders.

Accounting entries

• The double-entry accounting system records financial transactions in relation to asset, liability, income or expense related to it through accounting entries.
• Any accounting entry in the double-entry accounting system has two effects: one of increasing one account, the other of decreasing another account by an equal amount.
• If the accounting entries are recorded without error, at any point in time the aggregate balance of all accounts having positive balances will be equal to the aggregate balance of all accounts having negative balances.
• The double-entry bookkeeping system ensures that the financial transaction has equal and opposite effects in two different accounts.
• Accounting entries use terms such as debit and credit to avoid confusion regarding the opposite effect of the accounting entry e.g. If an accounting entry debits a particular account, the opposite account will be credited and vice versa.
• The rules for formulating accounting entries are known as "Golden Rules of Accounting".
• The accounting entries are recorded in the "Books of Accounts".

Books of accounts

It does this by ensuring that each individual financial transaction is recorded in at least two different nominal ledger accounts within the financial accounting system. The two entries have equal amounts and opposite signs, so that when all entries in the accounts are summed, the total is exactly the same: the accounts balance. This is a partial check that each and every transaction has been correctly recorded. The transaction is recorded as a "debit record" (Dr.) in one account, and a "credit record" (Cr.) entry in the other account. The debit entry will be recorded on the debit side (left-hand side) of a General ledger and the credit entry will be recorded on the credit side (right-hand side) of a General ledger account. A General ledger has a Debit (left) side and a Credit (right) side. If the total of the entries on the debit side is greater than the total on the credit side of the nominal ledger account, that account is said to have a debit balance..
Double entry is used only in nominal ledgers. It is not used in daybooks, which normally do not form part of the nominal ledger system. The information from the daybooks will be used in the nominal ledger and it is the nominal ledgers that will ensure the integrity of the resulting financial information created from the daybooks (provided that the information recorded in the daybooks is correct).
(The reason for this is to limit the number of entries in the nominal ledger: entries in the daybooks can be totalled before they are entered in the nominal ledger. If there are only a relatively small number of transactions it may be simpler instead to treat the daybooks as an integral part of the nominal ledger and thus of the double-entry system.)
However as can be seen from the examples of daybooks shown below, it is still necessary to check, within each daybook, that the postings from the daybook balance.
The double entry system uses nominal ledger accounts. From these nominal ledger accounts a trial balance can be created. The trial balance lists all the nominal ledger account balances. The list is split into two columns, with debit balances placed in the left hand column and credit balances placed in the right hand column. Another column will contain the name of the nominal ledger account describing what each value is for. The total of the debit column must equal the total of the credit column.

Bookkeeping process

The bookkeeping process refers primarily to recording the financial effects of financial transactions only into accounts. The variation between manual and any electronic accounting system stems from the latency  between the recording of the financial transaction and its posting in the relevant account. This delay, absent in electronic accounting systems due to instantaneous posting into relevant accounts, is not replicated in manual systems, thus giving rise to primary books of accounts such as Sales Book, Cash Book, Bank Book, Purchase Book for recording the immediate effect of the financial transaction.
In the normal course of business, a document is produced each time a transaction occurs. Sales and purchases usually have invoices or receipts. Deposit slips are produced when lodgements (deposits) are made to a bank account. Cheques are written to pay money out of the account. Bookkeeping involves, first of all, recording the details of all of these source documents into multi-column journals (also known as a books of first entry or daybooks). For example, all credit sales are recorded in the Sales Journal, all Cash Payments are recorded in the Cash Payments Journal. Each column in a journal normally corresponds to an account. In the single entry system, each transaction is recorded only once. Most individuals who balance their cheque-book each month are using such a system, and most personal finance software follows this approach.
After a certain period, typically a month, the columns in each journal are each totaled to give a summary for the period. Using the rules of double entry, these journal summaries are then transferred to their respective accounts in the ledger, or book of accounts. For example the entries in the Sales Journal are taken and a debit entry is made in each customer's account (showing that the customer now owes us money) and a credit entry might be made in the account for "Sale of Class 2 Widgets" (showing that this activity has generated revenue for us). This process of transferring summaries or individual transactions to the ledger is called posting. Once the posting process is complete, accounts kept using the "T" format undergo balancing, which is simply a process to arrive at the balance of the account.
As a partial check that the posting process was done correctly, a working document called an unadjusted trial balance is created. In its simplest form, this is a three column list. The first column contains the names of those accounts in the ledger which have a non-zero balance. If an account has a debit balance, the balance amount is copied into column two (the debit column). If an account has a credit balance, the amount is copied into column three (the credit column). The debit column is then totalled and then the credit column is totalled. The two totals must agree - this agreement is not by chance - because under the double-entry rules, whenever there is a posting, the debits of the posting equal the credits of the posting. If the two totals do not agree, an error has been made either in the journals or during the posting process. The error must be located and rectified and the totals of debit column and credit column recalculated to check for agreement before any further processing can take place.
Once the accounts balance, the accountant makes a number of adjustments and changes the balance amounts of some of the accounts. These adjustments must still obey the double-entry rule. For example, the "inventory" account asset account might be changed to bring them into line with the actual numbers counted during a stock take. At the same time, the expense account associated with usage of inventory is adjusted by an equal and opposite amount. Other adjustments such as posting depreciation and prepayments are also done at this time. This results in a listing called the adjusted trial balance. It is the accounts in this list and their corresponding debit or credit balances that are used to prepare the financial statements.
Finally financial statements are drawn from the trial balance, which may include:

• the income statement, also known as the statement of financial results, profit and loss account, or P&L
• the balance sheet, also known as the statement of financial position
• the cash flow statement
• the statement of retained earnings, also known as the statement of total recognised gains and losses or statement of changes in equity

Abbreviations used in bookkeeping

• A/C - Account
• A/R - Accounts Receivable
• A/P - Accounts Payable
• B/S - Balance Sheet
• c/d - Carried down
• b/d - Brought down
• c/f - Carried forward
• b/f - Brought forward
• Dr - Debit record
• Cr - Credit record
• G/L - General Ledger; (or N/L - Nominal Ledger)
• P&L - Profit & Loss; (or I/S - Income Statement)
• PP&E - Property, Plant and Equipment
• TB - Trial Balance
• GST - Goods and Services Tax
• VAT - Value Added Tax
• CST - Central Sale Tax
• TDS - Tax Deducted at Source
• AMT - Alternate Minimum Tax
• EBITDA - Earnings before Interest,Taxes, Depreciation and Amortisation.
• EBDTA - Earnings before Depreciation, Taxes and Amortisation.
• EBT - Earnings before Taxes.
• EAT - Earnings after Tax.
• PAT - Profit after tax
• PBT - Profit before tax
• Depr - Depreciation