What are the Basics of Accounting?

Accounting is the practice of recording and reporting on business transactions. The basics of accounting can be summarized within the following points:

The system of record keeping. First, there must be a rational approach to record keeping. This means setting up accounts in which information is stored. Accounts fall into the following classifications:

  • Assets. These are items purchased or acquired, but not immediately consumed. Examples are accounts receivable and inventory.
  • 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.
  • Revenue. This is the amount billed to customers in exchange for the delivery of goods or provision of services.
  • Expenses. This is the number of assets consumed during the measurement period. Examples are rent expense and wages expense.

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 in the accounts that we noted in the first point. Key transactions are:

  • Purchase materials and services. Requires the issuance of purchase orders and the payment of supplier invoices.
  • 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.

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:

  • Income statement. This document 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.
  • Balance sheet. This document 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. This document 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.

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, such as:

  • Cost accounting. Involves the review of product costs, examining operating variances, engaging in profitability studies, bottleneck analysis, and many other operational topics.
  • 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.
  • Tax accounting. Involves planning to reduce or defer tax payments, as well as filing many types of tax returns.