Learn how information is captured into transactions for the purposes of financial reporting.
Learn the basic concepts of how accountants think about transactions. The mastery of these skills, whilst seemingly simple, are the foundations of the interpretation of all financial information for business owners and professionals aspiring to be more financially literate.
The basis of all accounting transactions in every business around the world is based on this one formula that was developed in 1494. It is what makes the world go around and how all organsiations account for their transactions, no matter what industry.
Would you be surprised to know that if you were to summarise the most common types of accounting transactions across all organisations there are only approximately 20+ types of accounting transactions?
The nature of running accrual accounting means that 'adjusting entries' must be made at the end of each accounting period to 'adjust' for revenues earned and expenses incurred. Learn the most common types of adjusting entries.
The way a business generates its wealth accumulates over time and any remaining profits remain in its 'retained earnings' account. Learn how to account for the closing of the books and what this means for the balance sheet.
Learn about the most commonly used financial statements used within a business for the purposes of financial reporting.
Learn about how to interpret a business and assess its health. There are no two businesses alike, even within the same industry and size of organisation. Learn the tools you can employ to make up your own mind about the health of the business.
BASIC FINANCIAL ACCOUNTING CONCEPTS
ACCOUNTING PERIOD CONCEPT
An accounting period is an established range of time during which accounting functions are performed, aggregated, and analyzed including a calendar year or fiscal year.
The date the event occurred is important but may not necessarily be the date it is accounted for. This will be expanded more once you learn more about accrual accounting concepts.
This is not only used for the purposes of reporting figures on balance sheets and profit & loss statements, but also fundamentally how each transaction is accounted for.
ACCOUNTING ENTITY CONCEPT
All transactions need to be considered from the business's perspective, NOT the owners or shareholders. The whole concept assumes that the accounting records are accounted for seperately to the owner of the business.
If you can apply this thinking to accounting transactions, it'll ensure you account for only items that are business related or paid by the organisation.
The relevance principle is an accounting principle that states in order for financial information to be useful to external users, it must be relevant. Relevant information is useful, understandable, timely, and needed for decision making.
Depending on the audience you are presenting the information to, will determine if the information is relevant or not. Many international accounting standards have been developed in order to standardise the types of information disclosure relevant to the stakeholder interested in that information.
The reliability principle is the concept of only recording those transactions in the accounting system that you can verify with objective evidence.
Not all accounting transactions require a system generated invoice, however, may require a calculation or estimate. The basis of how this information gets into a Finance System needs to be measured reliably. If it itsn't reliable then it should not be accounted for.
The comparability concept of accounting states that the users of financial reports of a business must be able to compare these reports. There are many ways the figures can be compared whether this is across time periods, categories or versions.
The basis of comparability are that accounting transactions need to be comparing 'apples with apples' and not 'apples with oranges'. When understanding accounting transactions, you will learn how to achieve this principle so that the information has integrity.
CASH VS ACCRUAL BASIS OF ACCOUNTING
It is vital for anyone wanting to understand finance to get their head around a cash vs accrual basis of accounting.
The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts. Cash accounting recognises revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it's earned, and expenses when they're incurred (but not paid).
Think of cash basis as running a market stall where transactions are only accounted for when cash actually passes between the parties. Whereas the whole concept of accrual accounting is to account for transactions when they have been earned or incurred regardless of payment.
This is fundamentally one of the most important accounting concepts you will learn.
THE ACCOUNTING EQUATION
The Accounting Equation is the basis of how all accounting transactions are recorded. The methodology is also known as double entry book keeping. The formula was invented in 1494 and is a universal concept used no matter what country, industry or business type to record transactions.
ASSETS = LIABILITIES + OWNER'S EQUITY
HISTORY OF THE ACCOUNTING EQUATION
The Italian mathematician Luca Pacioli formulated a basic accounting equation formula in 1494 in his work “A Treatise on Accounts and Records.” Accounting systems of all countries are based on the use of this basic accounting equation.
The accounting equation plays a significant role as the foundation of the double-entry bookkeeping system. The primary aim of the double-entry system is to keep track of debits and credits and ensure that the sum of these always matches up to the company assets, a calculation carried out by the accounting equation. It is based on the idea that each transaction has an equal effect.
It is used to transfer totals from books of prime entry into the nominal ledger. Every transaction is recorded twice so that the debit is balanced by a credit.
An asset is anything of value or a resource of value that can be converted into cash. Individuals, companies, and governments own assets.
Also known as something with 'future economic benefit' to the organisation.
Typical examples include:
Cash at bank
Property, Plant & Equipment
Intangible Assets (including Goodwill)
A contra account is used in a general ledger to reduce the value of a related account when the two are netted together. A contra account's natural balance is the opposite of the associated asset account.
They offset or reduce the written down book value of a particular asset. So if, for example, you had a balance of $1000 in your accounts receivable and a provision for doubtful debts of $200, your book value would be $800. This book value assumes that only $800 out of your $1000 gross balance is recoverable.
Typical examples include:
Allowance for doubtful debts
Provision for stock obsolescence
Accumulated Depreciation / Amortisation
A liability is something a person or company owes, usually a sum of money. Liabilities are settled over time through the transfer of economic benefits including money, goods, or services.
Also known as having a 'future economic sacrifice' to the organisation.
Typical examples include:
Cost Accruals ie Accrued Wages, Interest Payable, Dividend payable
Equity, typically referred to as shareholders' equity (or owners' equity for privately held companies), represents the amount of money that would be returned to a company’s shareholders.
This could include the original shareholdings contributed to the organisation. In addition any revaluation of assets as well as left over profits if all assets and liabilities were settled.
Typical examples include:
Reserves (Asset Revaluation, Foreign Currency)
Retained Earnings includes:
Opening balance of prior year Profits / (Losses) not distributed to shareholders
Plus: Current Year Profits / (Losses)
Less: Dividends Paid
Current Year Profits includes all:
This is why all revenues increase profit (CR) and expense decrease profit (DR) when looking at the accounting equation.
A T-account is an informal term for a set of financial records that uses double-entry bookkeeping. The term describes the appearance of the bookkeeping entries.
Every account can be turned into a T-Account and forms the basis of a trial balance. All T-Accounts can have a closing balance, however, only balance sheet accounts have an opening balance.
They are used to accumulate all of the relevant transactions for the period, for that particular account.
Different account types can have a natural debit or credit closing balance depending on the type of account:
Assets - DEBIT
Contra-Assets - CREDIT
Liabilities - CREDIT
Owners Equity - CREDIT
Share Capital - CREDIT
Reserves - CREDIT
Retained Earnings - CREDIT
Dividends Paid - DEBIT
Revenues - CREDIT
Expenses - DEBIT
The general journal is a way of writing or narrating the individual transaction of a single transaction into a double entry accounting entry.
These are typically the accounting entries that get posted into a general ledger to form part of the trial balance. This doesn't have anything to do with sub-ledgers, however, modern accounting systems typically post entries based on the activity within the sub-ledger system such as accounts receivable, for example, into a control account.
There are some key features of the general journal:
Date - when the transaction took place.
Ref - various accounts that will be debited and credited from the chart of accounts.
Account name - description of various accounts.
Debit - amount to be debited to a particular account.
Credit - amount to be credited to a particular account.
Narration - a description of the transaction.
Any accounting system whether it is Xero, MYOB or a more complex ERP will be built based on the same principles.
TYPICAL ASSET TRANSACTIONS
All asset transactions follow a very similar structure and here are the most common types of asset transactions in any business, industry or organisation.
In my view, if you learn these types of transaction they will account for 80% of the types of transactions in the asset category:
Using the prepayment
Purchase Equipment or Vehicle
Purchase Intangible Asset
Making an Investment