Fundamentals of Accounting

             The first step to understanding accounting is learning the difference between a debit and a credit.  Many times we are told our account has been credited, after a refund or depositing money. This implies that cash is a credit, and that credits are good which can be confusing. However, in an asset account such as cash, a debit increases the balance. An account balance is the difference between the increases and decreases (debits and credits) in an account. Debits are always entered on the left side of the account and debits and credits must always equal.  When the two accounts equal it is called double entry accounting.

            Most of the accounts can be placed into five categories: Assets, Liabilities, Owner’s Equity, Revenues, and Expenses. Assets are resources owned by a company. There are two types of assets: current and fixed. Current assets represent cash or anything that can be converted to cash in a short period of time. Fixed assets such as land and equipment have a longer life span typically over a year. Asset accounts are increased on the left, a debit, and decreased on the right, with a credit entry. They have a left normal balance side. A liability is a creditors’ claim on an asset. Liabilities are accounted for through accounts payables, notes payables, etc. Liabilities and owner’s equity are slightly different from assets. Although they both debit on the left and credit on the right, the normal balance is switched and is now on the right. For example, if a company purchases supplies on account, they would debit their asset account (+) and credit the liability account (+). An owner’s claim on equity consists of capital, dividends and retained earnings.  When a company performs a service or sells a good they incur revenue. Expenses are entered anytime money is spent. Revenues and expenses are placed under owner’s equity on a balance sheet. A balance sheet equation is used to demonstrate how to balance the accounts: Assets=Liabilities + Owner’s Equity.

            A balance sheet shows the financial position of a company at any given time.  There are several steps to complete before the company can begin to prepare its financial statements.  The first step is to prepare the journal entries. A journal is a record that keeps the transactions of a company in chronological order.  The journal entry shows the transaction date, title of the affected account, dollar amount of debit and credit, a brief explanation of the transaction.  The next step is to post the journal entries into a book called “the Ledger”. The ledger records accounting transactions by account.  This allows the company to view the total for each account at any given time. The trial balance lists all the accounts and their balances. If all transactions in the general ledger were posted correctly then the trial balance will have an equal amount of debits and credits. Now the organization must prepare its financial statements. An income statement, statement of retained earnings, balance sheet, and statement of cash flows all reflect the previous transactions that have been recorded.

            An income statement describes a company’s revenues and expenses along with the resulting net income or net loss over the specific period of time.  If a company’s revenues exceed its expenses a net income has occurred. A statement of retained earnings explains the changes in the retained earnings account. It uses the following information: beginning retained earnings, net income obtained from the income statement, and the dividends paid during the accounting period.  The balance sheet reports the assets, liabilities, and owner’s equity of a company. It consists of the balances from the asset, liability, and equity accounts as well as the retained earnings. This verifies that the company’s assets in fact equal the liabilities and equity.  The final statement is the statement of cash flows. Cash flow explains the reasons for changes in the cash balance identifying receipts and payments. The cash flow statement is a cash-basis report which cannot be derived from the ledger.  There are two methods to obtain cash-basis information the first is direct method. For direct method cash flow is determined by subtracting cash disbursements from cash receipts. The indirect method one would add or subtract non-cash items from net income.

            The following information is the backbone of accounting.  In order to succeed in the accounting world the above concepts must be learned. Always remember that debits are on the left and credits are on the right hand side. In an account and on the balance sheet the debits and credits must equal. With use of the balance sheet equation the company can prepare all the required financial statements.  Since this process constantly repeats itself it is known as the “accounting cycle”.

           

           

Hillary Flook