Fundamentals of Accounting
Have you ever lost track of your financial expenses? I know that I have, every time I get a lot of money, it vanishes in a few days, and I just wondered where I spent it all. Accounting and its fundamental solve this issue and solve many other financial and accounting problems.
Whether you're a small business owner or a big multinational company like Amazon.com, you will need to understand accounting fundamentals. It will not only source you how to manage your financial aspects and assets, but it will lead to managing your whole business activity within the budget you have allocated.
What is Accounting?
The concept of accounting is used to record and analyse financial transactions in every business activity. The basic notes a housekeeper makes of the monthly budget, the diary a student keeps to track his pocket money, or a financial journal book are part of accounting. The process in which every financial transaction is recorded, evaluated, retrieved, and reported for the legal purpose of filing taxes and maintaining the records to develop good financial health is called Accounting.
It can be divided into two aspects of management: accounting internal processes, such as budgeting and ensuring efficiency. The second aspect of financial accounting deals with the financial, income, expenditure, and saving sector.
Objectives of Accounting
Accounting has objectives that can lead to a common goal:
The first objective of accounting is record keeping which is stocking or tracking the records of every financial and non-financial activity, which can be useful at the time of analysis. This objective of accounting is to have easy and accurate records for tally and evaluation. The journal entries or every entry in a book is called record keeping.
The second objective is reporting the records, which report the financial status where they belong. This reporting also creates financial statements, such as balance sheets, ledgers, and petty accounts, by putting together all the records.
The third objective is an analysis of the financial reports. In this analysis objective, every expense or gain is evaluated to determine if the business is in profit or loss. This analysis also determines if there is any mistake in the records or reporting.
Key Steps in Accounting Process
The fundamental of accounting is also its process; this fundamental can also be known as the accounting cycle. There is an 8-step fundamental process that can be identified and used by a business or a company as their accounting model.
Step 1- Identification of transaction
The first step of the accounting process is similar to its first objective: keeping records. However, understanding that every little detail is as essential as the big one. Tracking and keeping records of every purchase, sales, expenditure, income, profit, loss, small expenses, transport, telephone bill, rent, salary wages, creditors, debtors, drawing from business, charity, loan, interest, etc. is important for keeping a clean and sperate record of financial and non-financial changes.
Step 2- Creation of Journal
All the saved records need to be entered in a journal. The journal is a book for keeping financial records; this book is essential if there is a misplacement of the already kept records. They can have all the transactions safely recorded and securely stored for future accounting purposes.
Step 3- Creation of General ledger
The third step requires creating a ledger account, which keeps a separate account of every activity, for example, a separate purchase account, sales account, cash account, bank account, and separate account of every creditor and debtor. Creating a ledger can help monitor a particular account and keep track of each account differently. A general ledger sheet has two columns one is credit, and the other is debt. The records are entered according to the golden rules of accounting, which determines that the debit side is entering the expenses, losses, debtors, and purchases. On the other hand, the credit side determines all income, gain, creditors, and sales.
Step 4- Creation of Trial Balance
This step requires creating a trial balance. Every account balance of every ledger account is transferred to the credit and debit side of every account so that it can be clarified for analyses of the next step.
Step 5- Creation of worksheet
In the next step, the business or the account requires to create a worksheet, which determines that there should be an explanation of both credit and debit sides, and they should match as equal. When the matching is not accurate, it determines that there is an error in the accounting recording or reporting, which needs to be reconciled. The ledger account mistake on both the credit and debit sides needs to be added and analysed on the worksheet.
Step 6- Adjustment of journal entries
This is the stage of reconciliation, where every mistake found in the above step is adjusted in the journal entries. This step ensures that the debit and credit sides become equal and can be moved to the next step with current and authentic records. The adjustment step creates journal entries with the name of the reconciliation account and then credits or debits the amount or entry which was wrong and needed correction.
Step 7- Financial Statement Preparation
A financial statement includes creating a cash flow statement, balance sheet, petty account, profit and loss account, income statement, trading, and P&L statement. This step follows creating these accounts, determining the profit earned or loss that occurred in a financial year. All the entries recorded and reported in a journal and adjusted correctly are later reported in these statements for analysing profit or loss.
Step 8- Closing of the statement and account- the final step is closing the books of a financial year. This step tally and passes all the financial statements to the respected parties who need those records and close the books of that financial year. The whole cycle explained above is repeated until the business is running.
Essential Reports of Accounting
Profit and loss statement- The financial statement includes the profit and loss account, also called a P&L account or income statement. As the name suggests, this statement evaluates all the revenues earned and expenses bared to determine if the business gained profit or suffered a loss. The P&L generates information that can determine if the company has the stability to run or not by calculating profit or loss. It can be created quarterly or annually as per the requirement of identifying the business status.
A cash flow statement is another financial statement that analyses and tracks the cash flow that occurred in a company during a financial year. The cash flow statement has three functional activities based on which it identifies the flow of cash. The first is operation activity, the second is investing activity, and the third is financial activity. This statement evaluates the position of cash in all these activities and areas of the company. It determines how much cash is generated and how much debt the company needs to pay. It evaluates all the in and out of cash flow and, in the end, determines the cash remaining or debt remaining at the end of a financial year.
Balance sheet- The last and most important financial statement is the balance sheet which reports all the recorded transactions and determines the assets, liabilities, profit or loss, and the shareholder's equity present in the company. The balance sheet determines what the company owns and what the company needs to pay after a financial year. A balance sheet also determines the financial ratios useful for a financial analyst. The balance sheet is an essential financial record used and evaluated by the company's stakeholders.
All these fundamental process objectives and financial statements of accounting will make you understand the flow of income, expenditure, and expenses you face while running a business. As we know, running a business is a matter of great responsibility for the sake of stakeholders. Accounting fundamentals will help in managing that responsibility.
Frequently Asked Questions
Q1- What are the golden rules of accounting?
There are three golden accounting rules concerned with the crediting and debiting of accounting aspects.
- 1st rule- Debit the receiver and credit the giver.
- 2nd rule- Debit what comes in and credit what goes out.
- 3rd rule- Debit all expenses and losses, credit all income and gains.
Q2- what are the three types of accounts?
The three types of accounts include-
Q3- Why the basic knowledge of accounting is necessary?
Accounting plays an important role in every person's life; when a person is running a business or running a household, basic knowledge of accounting helps track the income earned and expenditure, ensuring the saving of resources. With the knowledge of Accounting and its procedure and principles, a person can identify financial health and its nature; this knowledge can help an individual avoid critical situations such as bankruptcy, poverty, becoming insolvent, etc.