Accounting Basics: The Basics
AAA
  1. Accounting Basics: Introduction
  2. Accounting Basics: History Of Accounting
  3. Accounting Basics: Branches Of Accounting
  4. Accounting Basics: The Basics
  5. Accounting Basics: The Accounting Process
  6. Accounting Basics: Financial Statements
  7. Accounting Basics: Financial Reporting
Accounting Basics: The Basics

Accounting Basics: The Basics

By Bob Schneider

The Difference Between Accounting and Bookkeeping
Bookkeeping is an unglamorous but essential part of accounting. It is the recording of all the economic activity of an organization - sales made, bills paid, capital received - as individual transactions and summarizing them periodically (annually, quarterly, even daily). Except in the smallest organizations, these transactions are now recorded electronically; but before computers they were recorded in actual books, thus bookkeeping.

The accountants design the accounting systems the bookkeepers use. They establish the internal controls to protect resources, apply the principles of standards-setting organizations to the accounting records and prepare the financial statements, management reports and tax returns based on that data. The auditors that verify the accounting records and express an opinion on financial statements are also accountants, as are management, tax and forensic accounting specialists. (To learn more see, Accounting Not Just For Nerds Anymore.)

Double-Entry Bookkeeping
The economic events of a business are recorded as transactions and applied to the accounts (hence accounting). For example, the cash account tracks the amount of cash on hand; the sales account records sales made. The chart of accounts of even small companies has hundreds of accounts; large companies have thousands.

The transactions are posted in journals, which were (and for some small organizations, still are) actual books; nowadays, of course, the journals are typically part of the accounting software. Each transaction includes the date, the amount and a description.

For example, suppose you have a stationery store. On April 19, a saleswoman for an antiques company visits you, and you buy a lamp for your office for $250. A journal entry to record the transaction as a debit to the Office Furniture account and a $250 credit to Accounts Payable could be written as follows (Dr. is the abbreviation for debit, while Cr. is for credit):


Date

Account

Dr.

Cr.

April 19

Office Furniture

250



Accounts Payable


250

(Bought antique lamp; voucher #0016)

Each accounting transaction affects a minimum of two accounts, and there must be at least one debit and one credit.

Keeping Good Accounting Records
Even a seemingly simple transaction like this one raises a host of accounting issues.

Date:Suppose you had already agreed by phone to buy the lamp on April 15, but the paperwork wasn't done until April 19. And the lamp wasn't delivered on the 19th, but the 23rd. Or even as you bought it, you were thinking that you didn't like it that much, and there's a strong chance you'll return it by the 30th, when the sale becomes final. On which date - 15th, 19th, 23rd, or 30th - did an economic event occur for which a transaction should be recorded?

Amount:The sales price is $250, but you get a 10% discount (to $225) if you pay in 30 days; business is bad, though, so you may need the full 90 days to pay. Similarly, however, you know the antique business is also lousy; even though you agreed to pay $250, you can probably chisel another $50 off the price if you threaten to return it. On the other hand, being in the stationery business, you know one of your customers has been looking for a lamp like that for a long time; he told you in February he'd pay $300 for one.

So what amounts should you record on April 19 (if indeed you record a transaction on that date)? $250 or $225 or $200 or $300?

Accounts:You've debited the Office Furniture account. But actually you buy and sell antiques frequently to your customers, and you're always ready to sell the lamp if you get a good offer. Instead of an Office Furniture account used for fixed assets, should the lamp be recorded in a Purchases account you use for inventory? And if this was a big company, there might be dozens of office furniture sub-accounts to choose from.

Accountants rely on various resources to answer such questions. There are basic, time-honored accounting conventions: standards set forth by various rules-making bodies, long-standing industry practices and, most important, their own judgment honed through years of experience.

But the important point is that even the most basic accounting questions - when did an economic event take place? What is the value of the transaction? Which accounts are affected by the transaction? - can get very complex and the right answers prove very elusive. There's no excuse for out-and-out misrepresentation of company results and sloppy auditing that certainly occurs. But the seeming precision of financial statements, no matter how conscientiously prepared, is belied by the uncertainty and ambiguity of the business activities they seek to represent.

Debits and Credits
We're accustomed to thinking of a "credit" as something "good" - our account is credited when we get a refund; you get "extra credit" for being polite. Meanwhile, a "debit" is something negative - a debit reduces our bank balance; it's used to mean shortcoming or disadvantage.

In accounting, debit means one thing: left-hand side. Credit means one thing: right-hand side. When you receive cash - a "good" thing - you increase the Cash account by debiting it. When you use cash - a "bad" thing - you decrease Cash by crediting it. On the other hand, when you make a sale, which is nice, you credit the Sales account; when someone returns what you sold, which is not nice, you debit sales.

"Good" and "bad" have nothing to do with debit and credit.

Debit = Left; Credit = Right. That's it. Period.

Accrual vs. Cash Basis Accounting
As we've seen, deciding when an economic event occurs and an accounting transaction should be recorded is a matter of judgment. Accrual accounting looks to the economic reality of the business, rather than the actual inflows and outflows of cash. (For more on this see, The Essentials of Cash Flow.)

Although cash basis statements are simpler and make good sense for many individual taxpayers and small businesses, it results in misleading financial statements. Consider a Halloween costume maker: it conceives, produces and sells costumes throughout the year, but gets paid for its costumes mostly in October. If sales were recognized only when cash was received, October would show an enormous profit while all other months would show losses. Accrual accounting seeks to match the revenues earned during a period with the expenses incurred to generate them, regardless of when cash comes in or goes out. (For details see, When should a company recognize revenues?)

Accounting Basics: The Accounting Process

  1. Accounting Basics: Introduction
  2. Accounting Basics: History Of Accounting
  3. Accounting Basics: Branches Of Accounting
  4. Accounting Basics: The Basics
  5. Accounting Basics: The Accounting Process
  6. Accounting Basics: Financial Statements
  7. Accounting Basics: Financial Reporting
Accounting Basics: The Basics
RELATED TERMS
  1. Capital Loss Coverage Ratio

    The difference between an asset’s book value and the amount received ...
  2. Inherent Risk

    The risk posed by an error or omission in a financial statement ...
  3. Policyholder Surplus

    The assets of a mutual insurance company minus its liabilities. ...
  4. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  5. Net Premium

    The expected present value of a policy’s benefits less the expected ...
  6. Quick Liquidity Ratio

    The total amount of a company’s quick assets divided by the sum ...
  1. How do small firms record installment sales?

    Read up on what an installment sale is, how to account for it and the benefits a small business may receive by using the ...
  2. Does gross profit include tax?

    Find out what gross profits are, how they are calculated, how they are interpreted by investors and whether taxes are taken ...
  3. Does gross profit include depreciation or amortization?

    Understand the distinction between depreciation and amortization, and learn under which circumstances either type of expense ...
  4. What are the differences for barter transactions recognition between IFRS and USGAAP?

    Understand the key differences between how the IFRS and the U.S. GAAP accounting systems recognize and record barter transactions ...
comments powered by Disqus
Related Tutorials
  1. Ethical Investing Tutorial
    Fundamental Analysis

    Ethical Investing Tutorial

  2. Investing For Safety and Income Tutorial
    Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Macroeconomics
    Economics

    Macroeconomics

  4. Capital Budgeting
    Investing Basics

    Capital Budgeting

  5. Complete Guide To Corporate Finance
    Professionals

    Complete Guide To Corporate Finance

Trading Center