What is accounting?
Accounting is the process of assessing, recording and communicating financial transactions. Organisations and individuals do accounting to develop detailed understanding of their financial situation. An accountant is a finance professional who facilitates this, for companies and clients, by tracking their profits, losses, expenses and incomes.
Accountants are responsible for ensuring that their clients are made aware of their financial performance and legal obligations. They help companies make financial plans for the future and prepare budgets. The managerial staff of a company will often require an accountant's expertise to make decisions regarding transactions and investments.
What are the three fundamental concepts of accounting?
To be able to do accounting, you should understand some of its central concepts. The 3 fundamental concepts of accounting are:
Accruals concept
The accruals concept states that revenues can be recognised only when they are earned, and expenses, when assets are used. This means that businesses do not have to go by cash value when they recognise profits, losses and revenue. For example, if your company sells a product, the value of that product will have to factor in additional costs like customer support and logistics, and not just the cost of production. It is general practice among auditors to verify that a company's financial statements are prepared following the accruals concept.
Going concern concept
In accounting, it is always assumed that a business remains in operation in future time periods. Expenses and revenue may be pushed to future periods, depending on the situation. For example, companies can defer debt amounts (or portions of it) to their next financial quarters, under the assumption that they will be operational in the future. Without the going concern concept, all potential future expenses will have to be accounted for in the current period and this can make it difficult for businesses to function, especially if they rely on credit/loans to function.
Economic entity concept
The economic entity concept maintains that business transactions be kept separate from the business owner's personal transactions. Auditors have to verify that there is no mixing of business and personal transactions in a company's financial records. If any person, including the owner, uses company funds for their own personal transactions, it is considered embezzlement of funds, which has legal and professional ramifications.
What are the five basic principles of accounting?
These are five basic principles of accounting that are important:
Revenue principle
The revenue principle, also called the ‘revenue recognition principle', determines when accountants may record transactions as revenue in their books. It states that businesses earn revenue when customers gain legal possession of a service or product, and not at the point of cash transaction between the company and the customer.
Expense principle
The expense principle is similar to the revenue principle, but it deals with expenditure. The principle determines when an accountant can record a transaction as an expense in their books. It states that expenses occur when businesses accept the services or goods of another entity, regardless of when they may be billed for it.
Matching principle
The matching principle states that a company should match all its revenue items with a corresponding expense item. For example, if your company makes garments, you should account for the cost of production, like fabric, dyes, threads, equipment and labour, and match it with the revenue the company earn when a customer purchases that product at a given price. Businesses who follow the revenue, expense and matching principle are said to operate under accrual accounting methods.
Cost principle
The cost principle requires businesses to record historical costs for items, instead of their resale values. For example, if your business operates from a building purchased 10 years back, your property cost will be the value at which the building was purchased, and not its current market value.
Objectivity principle
According to the objectivity principle, businesses are expected to utilise only verifiable data and objective facts for their accounting processes. There may be instances where subjective information seems more practical than objective data. However, accountants are bound to use the verifiable data.
Basic Accounting Terms
These 15 terms will create the foundation on which you’ll build your knowledge of business accounting. While some of these terms might not apply to your business right now, it’s important to develop a holistic understanding of the subject in case you expand or move into another type of business.
1. Debits & Credits
Not to be confused with your personal debit and credit cards, debits and credits are foundational accounting terms to know.A debit is a record of all money expected to come into an account. A credit is a record of all money expected to come out of an account. Essentially, debits and credits track where the money in your business is coming from, and where it’s going.
Many businesses operate out of a cash account – or a business bank account that holds liquid assets for the business. When a company pays for an expense out of pocket, the cash account is credited, because money is moving from the account to cover the expense. This means the expense is debited because the funds credited from the cash account are covering the cost of that expense.
Here’s a simple visual to help you understand the difference between debits and credits:
Assets:-
Increases - Debit (Dr.)
Decreases - Credit (Cr.)
Liability:-
Increases - Credit (Cr.)
Decreases - Debit (Dr.)
Capital/Equity:-
Increases - Credit (Cr.)
Decreases - Debit (Dr.)
Expenses/Losses:-
Increases - Debit (Dr.)
Decreases - Credit (Cr.)
Incomes/Gains:-
Increases - Credit (Cr.)
Decreases - Debit (Dr.)
2. Accounts Receivable & Accounts Payable
Accounts receivable is money that people owe you for goods and services. It’s considered an asset on your balance sheet.
Accounts payable is money that you owe other people and is considered a liability on your balance sheet.
3. Accruals
Accruals are credits and debts that you’ve recorded but not yet fulfilled. These could be sales you’ve completed but not yet collected payment on or expenses you’ve made but not yet paid for.
4. Assets
Assets are everything that your company owns — tangible and intangible. Your assets could include cash, tools, property, copyrights, patents, and trademarks.
5. Burn Rate
Your burn rate is how quickly your business spends money. It’s a critical component when calculating and managing your cash flow.
6. Capital
Capital refers to the money you have to invest or spend on growing your business. Commonly referred to as “working capital,” capital refers to funds that can be accessed (i.e. cash in the bank) and don’t include assets or liabilities.
7. Cost of Goods Sold
The cost of goods sold (COGS) or cost of sales (COS) is the cost of producing your product or delivering your service.
COGS or COS is the first expense you’ll see on your profit and loss (P&L) statement and is a critical component when calculating your business’s gross margin. Reducing your COGS can help you increase profit without increasing sales.
8. Depreciation
Depreciation refers to the decrease in your assets’ values over time. It’s is important for tax purposes, as larger assets that impact your business’s ability to make money can be written off based on their depreciation.
9. Equity
Equity refers to the amount of money invested in a business by its owners. It’s also known as “owner’s equity” and can include things of non-monetary value such as time, energy, and other resources. (Ever heard of “sweat equity”?)
Equity can also be defined as the difference between your business’s assets (what you own) and liabilities (what you owe).
A business with healthy (positive) equity is attractive to potential investors, lenders, and buyers. Investors and analysts also look at your business’s EBITDA , which stands for earnings before interest, taxes, depreciation, and amortization.
10. Expenses
Expenses include any purchases you make or money you spend in an effort to generate revenue. Expenses are also referred to as "the cost of doing business".
There are four main types of expenses, although some expenses fall into more than one category.
Fixed expenses are consistent expenses, like rent or salaries. These expenses aren’t typically affected by company sales or market trends.
Variable expenses fluctuate with company performance and production, like utilities and raw materials.
Accrued expenses are single expenses that have been recorded or reported but not yet paid.
Operating expenses are necessary for a company to do business and generate revenue, like rent, utilities, payroll, and utilities.
11. Fiscal Year
A fiscal year is the time period a company uses for accounting. The start and end dates of your fiscal year are determined by your company; some coincide with the calendar year, while others vary based on when accountants can prepare financial statements.
12. Liabilities
Liabilities are everything that your company owes in the long or short term. Your liabilities could include a credit card balance, payroll, taxes, or a loan.
13. Profit
In accounting terms, profit — or the “bottom line” — is the difference between your income, COGS, and expenses (including operating, interest, and depreciation expenses).
14. Revenue
Your revenue is the total amount of money you collect in exchange for your goods or services before any expenses are taken out.
15. Gross Margin
Your gross margin (or gross income), which is your total sales minus your COGS — this number indicates your business’s sustainability.