In any business or organization, the discipline which assists management with monitoring revenues and expenditures is called accounting. Accounting is the process of recording, summarizing, reporting, and interpreting financial information.
In practice, accounting is a series of transactions consisting of debits and credits equal to each other. The transactions are journalized by entering them into books of original entry called "Journals". The data is later transferred or "posted" to the General Ledger, a summary file that serves as the source document for the preparation of financial statements. These financial reports reflect the current asset versus liability positions of the company and a serve as a summary of its operations over a given period of time.
Accounting is an old profession and is based on certain generally accepted concepts. Accounting records are kept and interpreted according to Generally Accepted Accounting Principals (GAAP) and general statements accepted by members of the accounting profession. The current principles are issued by the Financial Accounting Standard Board.
The "Business Entity Concept" assumes that a business enterprise is separate and distinct from the person or persons who supply the assets. Each business is it's own entity. As a separate entity the accounting records must relate only to the business and should be kept separate from the owners personal records at all times. This concept applies to all businesses.
The "Unit of Measurement" concept accepts that the effects of business transactions should be expressed in monetary terms. Money is both the common factor of all business transactions and the only feasible unit of measurement that can be used to achieve uniform and comparative financial data.The concept of double entry accounting relates to the "Fundamental Accounting Equation". The equation states that what is owned, that is the assets, must equal the claims against those assets, which is known as liabilities and owner's equity. The accounting equation is expressed as follows:
Assets = Liabilities + Owner's Equity
This equation always remains in balance because it is based on the fundamental accounting equation Debits = Credits. We will return to this equation later and discuss the types of accounts that make up its various elements.
Double entry accounting, simply stated, means that a transaction must affect at least two accounts in the accounting equation. It must be stated in dollar amounts, and that the equation must maintain its equality (debits must equal credits). It is possible to have a transaction that would affect only one side of the equation i.e. one asset amount is increased while reducing another asset amount. In this case there is no net change to the accounting equation, the accounting equation maintains its equality.
The "Matching Principle" requires that the revenues earned in one accounting period be matched against the expenses incurred in earning that revenue over the same accounting period. The expenses must be compared against the related revenues to accurately state the fair amount of net income (or net loss) earned by the business during the accounting period. Accounting periods are generally thought of as a period of one year - a 12-month passage of time. It need not be a regular calendar year ending on December 31. If other than a calendar year is adopted it is referred to as a fiscal year. The accounting period may also be broken down into 52 weeks, 13-week quarters, or 12 months.
We must recognize that for effective management of the business, as well as for proper disclosure of the operations to the absentee owners or shareholders, financial reports are needed more frequently. Such reports are known as interim statements, and the time spanned by interim reports covers less than a year.
All changes in an organizations financial position begins with a transaction. A transaction is a financial event that causes the fundamental equation to change. For example, if the owner started his business with a cash investment of $10,000, the equation and accounts would be affected as follows:
Assets = Liabilities + Owner's Equity OR Cash = Liabilities + Capital
$10,000 = $0 + $10,000
Assume the owner also purchases office equipment on credit for $5,000. The equation is now expanded to:
Assets = Liabilities + Owner's Equity OR
Cash + Furniture = Accounts Payable + Capital
$10,000 + $5,000 = $5,000 + $10,000
Notice the double entry concept and how the equation remains in balance after both transactions have been recorded.
The concept of "debit" and "credit" as used in accounting is easily illustrated with the use of the "T". A "T" divides the account into two sides, the left side is the "debit" side, and the right side is the "credit" side.
Left Side Right Side L-------------------------R | Debits | Credits |
By convention debit amounts are placed on the left side of the account. Credit amounts are placed on the right side of the account. Assets are on the debit side of the ledger and liabilities and owners equity are placed on the credit side. The abbreviations Dr and Cr are used to indicate debit or credit respectively.