Basics Of Accounting - Terminology, Principles And Concepts
Updated 30 September 2022
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Basic accounting is one of the business functions that companies require to perform efficiently for ensuring sustained success. Whether a business intends to do their own accounting or hire professionals for it, they can benefit a lot by familiarising themselves with basic accounting. In this article, we discuss the basics of accounting, including the components, key terminology, fundamental concepts and principles.
What Is Accounting?
Accounting is the process of assessing, recording and communicating financial transactions. Organisations and individuals do accounting to develop detailed understanding of their financial situation. An accountant is a finance professional who facilitates this, for companies and clients, by tracking their profits, losses, expenses and incomes.
Accountants are responsible for ensuring that their clients are made aware of their financial performance and legal obligations. They help companies make financial plans for the future and prepare budgets. The managerial staff of a company would often require an accountant's expertise to make decisions regarding transactions and investments.
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What Are The Three Fundamental Concepts Of Accounting?
To be able to do accounting, you are required to understand some of its central concepts. The 3 fundamental concepts of accounting are:
The accruals concept states that revenues can be recognised only when they are earned, and expenses, when assets are used. This means that businesses do not require to go by cash value when they recognise profits, losses and revenue. For example, if your company sells a product, the value of that product would require to factor in additional costs like customer support and logistics, and not just the cost of production. It is general practice among auditors to verify that a company's financial statements are prepared following the accruals concept.
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Going concern concept
In accounting, it is always assumed that a business remains in operation in future time periods. Expenses and revenue may be pushed to future periods, depending on the situation. For example, companies can defer debt amounts (or portions of it) to their next financial quarters, under the assumption that they would be operational in the future. Without the going concern concept, all potential future expenses would require to be accounted for in the current period and this can make it difficult for businesses to function, especially if they rely on credit/loans to function.
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Economic entity concept
The economic entity concept maintains that business transactions be kept separate from the business owner's personal transactions. Auditors require to verify that there is no mixing of business and personal transactions in a company's financial records. If any person, including the owner, uses company funds for their own personal transactions, it is considered embezzlement of funds, which has legal and professional ramifications.
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What Are The Basics Of Accounting?
To understand the basics of accounting, it is important to look at its three main components and the terminology related to these components. The basic components of accounting are:
Companies require to identify a clear approach to record-keeping, before they begin the accounting process. They require to set up some basic accounts in which to store information. Accounts fall into the following classifications:
Assets: These refer to resources or items that the company owns. Assets have future economic value that can be measured and can be expressed in monetary terms. Examples of a company's assets include investments, cash, inventory, accounts receivable, land, supplies, equipment, buildings and vehicles.
Liabilities: These refer to the legal financial obligations or debts that companies incur during business operations. Liabilities can be limited or unlimited. They are settled over time through the transfer of economic benefits such as money, services or goods. Recorded on the right side of a company's balance sheet, liabilities include any payable amounts, loans, mortgages, earned premiums, deferred revenues and accrued expenses.
Equity: Equity, also known as shareholder's equity, refers to the amount of money that a company is required to return to its shareholders after all of its assets are liquidated and all of its debt is paid off. Equity is calculated by subtracting a company's total assets to its total liabilities.
Expenses: Expenses refer to the costs of operations that businesses incur to generate revenue. Common expenses include employee wages, payments to suppliers, equipment depreciation and factory leases.
Revenue: Revenue refers to the income that a company generates from its normal business operations. It includes deductions and discounts for returned products. Revenue is the gross income figure from which costs are subtracted to determine net income.
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The accountant is responsible for generating a number of business transactions, while others are forwarded to the accountant from other departments of a company. As part of these transactions, they are recorded within the accounts mentioned in the first point. Some crucial business transactions include:
Sales: These are transactions in which products/services are transferred from buyers to sellers for cash or credit. Sales transactions are recorded in the seller's accounting journal (a document that contains a summary of the transaction) as a credit to the sales account and a debit to cash or accounts receivable. Sales typically involve the creation of an invoice to be sent to the customers, detailing the amount that the customer owes.
Purchases: These are transactions that businesses require to obtain materials and services necessary to accomplish their goals. Purchases made in cash are recorded as a debit to the inventory account and a credit to cash. If the purchase is made with a credit account, the credit entry would be recorded in the accounts payable account and the debit entry would be recorded in the inventory account. Purchases often involve the issuance of purchase orders and disbursement of supplier invoices.
Receipts: These are the transactions that refer to a company getting paid for providing services or goods to customers. The receipt transaction is recorded in the journal for the seller as a credit to accounts receivable and a debit to cash.
Employees' compensation: This requires information about the number of hours that employees spent at paid labour, which is then used to generate tax deductions, gross wage information and other deductions, which result in net pay to employees.
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Once all the company's transactions related to an accounting period have been completed, the accountant consolidates the information stored in the accounts and sort it into three documents that are collectively called financial statements. These statements include:
Income statement: This document contains information about the company's revenues and deducts all expenses incurred to determine the net profit or loss for the reporting period. It measures the ability of a company to expand its customer base and operate efficiently.
Balance sheet: This document contains information about a company's assets, liabilities and equity as of the end of the reporting period. It shows the financial position of an organisation as of a point in time and is carefully reviewed to determine an organisation's ability to pay its bills.
Statement of cash flows: This document contains information about the uses and sources of cash during the reporting period. It is especially useful when the amount of net income that appears on the income statement is different from the net change in cash during the reporting period.
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What Are The Five Basic Principles Of Accounting?
These are five basic principles of accounting that are important:
The revenue principle, also called the ‘revenue recognition principle', determines when accountants may record transactions as revenue in their books. It states that businesses earn revenue when customers gain legal possession of a service or product, and not at the point of cash transaction between the company and the customer.
The expense principle is similar to the revenue principle, but it deals with expenditure. The principle determines when an accountant can record a transaction as an expense in their books. It states that expenses occur when businesses accept the services or goods of another entity, regardless of when they may be billed for it.
The matching principle states that a company is required to match all its revenue items with a corresponding expense item. For example, if your company makes garments, you are required to account for the cost of production, like fabric, dyes, threads, equipment and labour, and match it with the revenue the company earn when a customer purchases that product at a given price. Businesses who follow the revenue, expense and matching principle are said to operate under accrual accounting methods.
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The cost principle requires businesses to record historical costs for items, instead of their resale values. For example, if your business operates from a building purchased 10 years back, your property cost would be the value at which the building was purchased, and not its current market value.
According to the objectivity principle, businesses are expected to utilise only verifiable data and objective facts for their accounting processes. There may be instances where subjective information seems more practical than objective data. But, accountants are bound to use the verifiable data.
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