Financial calculations can save lives! Well, this statement needs more explanation. Most of us are familiar with the 1994 blockbuster, The Shawshank Redemption, directed by Frank Darabont. The story of a simpleton, an accountant Andy Dufresne, and how his financial knowledge could save him from a brutal and unfortunate prison life captivated audiences across the world. So, the knowledge of accounting and the power of financial calculations can seal the deal for you. But wait! There’s more to it.
Massive calculations, difficult words, confusing concepts, etc., come to our mind when we hear ‘accounting.’ Indeed, the concepts here can be intimidating at times. However, proper explanations can be quite helpful to understand the subject.
So, are you planning to pursue commerce for higher education? Then, you must have basic accounting knowledge for better understanding. Let’s start our discussion as you read along to learn about basic accounting, its concepts, importance, etc.
1. Key Accounting Terminology
There are various basic accounting terminology that is important for you to learn. Let us look at some of the standard terms. Here, you will also learn about basic accounting principles.
1.1. Assets
Assets are resources with economic value. A single individual or company controls these. Check out the definitions and types in detail.
Definition and examples
When resources like real estate, investments, patents, etc., have a financial value, they are called Assets in basic accounting. Usually, they are expected to offer benefits in the future.
Examples: Financial securities, buildings, equipment, machinery, etc.
Current vs. non-current assets
If you can sell or consume the asset through normal operations within a fiscal year, it is called a Current asset. Examples are cash equivalent, stock inventory, etc.
Resources for long-term investments are called non-current assets. These cannot be exhausted or used within just a year. Examples are land, manufacturing units, etc.
1.2. Liabilities
When a company clears debt by transferring economic benefits at the end of a fiscal year, it is called Liability. Check out the concept in detail.
Definition and examples
If the company has loans, mortgages, unpaid bills, etc., by the end of an accounting year, it is called Liabilities.
Examples: Income tax, short-term loans, rental fees, accounts payable, etc.
Current vs. long-term liabilities
A company’s short-term financial obligations are known as current liabilities—for example, Payable taxes and accrued interest.
Long-term or non-current liabilities are those due over more than a year. Example: long-term leases, bonds payable.
1.3. Equity
Equity mainly refers to the capital owned by the company. Read below for more details.
Definition and components
The capital owned or invested by a company’s owner is termed equity. The four major components are outstanding shares, retained earnings, additional paid-in capital, and treasury stock.
Owner’s equity vs. shareholder’s equity
An owner can claim the section of the company’s assets as owner’s equity. Examples: preferred stock, dividend, etc.
After the company has paid all liabilities, the remaining return is called shareholder’s equity. It is calculated by subtracting all debts from the total assets.
1.4. Revenue
The profit generated from normal business operations is called revenue. Check out the details below.
Definition and recognition principles
The funds acquired by the usual business operations are known as revenue. The recognition principle states that the company must recognise revenue when earned rather than when receiving the payment.
Types of revenue
You will come across two types – operating (profit from primary sources) and non-operating (profit from secondary sources)
1.5. Expenses
The amount of funds spent by a company for earning revenue is termed expenses. Learn them in detail below.
Definition and recognition principles
The capital used by a company to ensure substantial return is called expenses. The recognition principle is also called the matching principle. It states that expenses and revenue from those expenses should be considered during accounting time.
Types of expenses
Four kinds of expenses are fixed, discretionary, variable, and intermittent.
2. Fundamental Accounting Concepts
The key to grasping the subject is learning the financial accounting basics. Some of the essential concepts are discussed below.
2.1. Accounting Equation
This is the founding equation of accounting science. It states the company’s assets are equal to the sum of liabilities and equity. It is commonly seen in a company’s balance sheet.
Assets = Liabilities + Equity
According to the equation, the company’s asset valuation depends on the sum of its liabilities and equity. The equity can be either the owner’s or shareholder’s.
Significance and balance
The equation ensures accuracy in bookkeeping. Additionally, it measures the company’s profitability. Moreover, gauges the success of an investment.
The equation ensures that the company’s balance sheet remains balanced. This means the entries on the debit side have an equal entry on the credit side.
2.2. Double-Entry Bookkeeping
A very important basic accounting concept is double-entry bookkeeping. It is a record that depends on two accounts – debit and credit. Read below to explore it in detail.
Debit and credit system
In this system, the recorded credit amount must equal the debit amount. For instance, a bank loan is deposited in the bank.
Rules for recording transactions
The three main rules are,
- Debit all expenses and credit all incomes (real account)
- Debit the receiver and credit the giver (personal account)
- Debit business losses and credit business gains (nominal account)
2.3. Accrual vs. Cash Basis Accounting
These are the most common basic accounting methods. Read below to understand their differences.
Differences and implications
Accrual Basis Accounting considers revenue and expense when generated, not when they are received. When the account has an unpaid yet earned interest, it is known as accrual. It is mainly used in larger companies.
In cash-based accounting, the calculation is done with the cash received in hand. If you have not received an expected fund, this accounting will not consider it. It is usually used in small and self-employed businesses.
Advantages and disadvantages
The advantages of Accrual accounting are,
- It follows the GAAP framework
- It is more explicit and accurate
The disadvantages are as follows,
- It can subject the company to fraud
- The process can be challenging
The advantages of Cash accounting are,
- Better tracking of cash flow
- Simplified and easy to follow
The disadvantages are as follows,
- Does not match revenues and expense
- Results are not always accurate.
2.4. Generally Accepted Accounting Principles (GAAP)
A very significant accounting knowledge you must acquire is the concept of GAAP. Read below for more. Here, we will learn what are the basic principles of accounting
Definition and purpose
A set of rules and guidelines that financial reporting follows is known as GAAP. Its main agenda is to ensure transparent, understandable, and comparable information on the organisation’s financial condition.
Key principles and assumptions
There are five principles. They are as follows,
- Revenue recognition principle
- Cost principle
- Matching principle
- Full disclosure principle
- Objectivity Principle
The assumptions depend on the monetary unit, economic entity, and period.
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3: Financial Statements
This is another crucial aspect of basic accounting for you to learn. It is like the company’s progress report. It portrays its performance over a given period. Read below for the details.
3.1. Balance Sheet
This financial statement comprises the company’s assets and liabilities for an accounting year. This helps in evaluating the company’s performance.
Purpose and Components
The primary agenda is to gauge the company’s financial health. It also helps in comparing the returns of the company over the year. This aids in understanding the areas for rectification. Here, you will come across two components – assets and liabilities.
Preparing and analysing a balance sheet
To prepare a balance sheet in basic accounting, you must have two columns. List the assets and corresponding liabilities and equity on the other.
There are three factors to consider when you analyse a balance sheet – active capital, the performance of assets, and the debt vs. equity amount.
3.2. Income Statement
This is another financial statement of basic accounting that exhibits the revenues and expenses of the company for a given time. Let us study it in detail.
Purpose and Components
The main purpose is to understand how the revenues are converted into profit. It also helps in early detection for improvement. Additionally, aids in drawing data-driven effective decisions.
There are operating and non-operating income and expenses. For instance, revenue, sale cost, expenses, gains and losses, non-recurring items, and EPS.
Preparing and analysing an income statement
Learning how to curate an income statement is paramount. There are two ways – either ‘one-step’ or ‘two-step.’ In the former, revenues and gains are stated together, and expenses and losses are stated together. In the latter, the subtotal from the previously mentioned calculation shows gross margin, operating income, etc.
You can analyse it using either the vertical or horizontal approach. In the former, you analyse each line item with its base value. In the latter approach, you compare the income statement and the balance sheet over time.
3.3. Cash Flow Statement
This refers to the statement that records a company’s cash inflow and outflow over a given timeframe. It is the third financial statement of basic accounting.
Purpose and components
The objective is to provide insight into the company’s financial condition and operational efficiency. This information will help you modify strategies when required. The three major components are – the in and outflow of cash from operations, investing, and finance
Preparing and analysing a cash flow statement
Refer to your balance sheet for all your transactions, from operations to investing and finance. Adjust all non-cash expenditures. You must include net income, working capital, dividends, tax payments, vendor expenses, etc.
Check whether the inflow is higher than the outflow. If it is higher, then you have a profitable financial condition. If it is the opposite, then you are incurring losses.
4. Importance of Accounting
We have mentioned earlier that learning the fundamentals of basic accounting is paramount. But why? Check out the reasons below.
4.1. Decision Making
The most important is making data-driven decisions. Additionally, it enables you to provide accurate information on the company’s financial condition to the stakeholders.
Another important aspect is using the information to understand the success of investments. Moreover, it also helps in making strategic business decisions.
4.2. Compliance and Regulations
Proper knowledge of basic accounting will save you from paying tax penalties. Prior knowledge will help you meet all legal and tax requirements.
Furthermore, it offers accurate data to equity owners that helps ensure transparency and accountability.
4.3. Performance Evaluation
Lastly, this is the most convenient way to measure your financial performance. Additionally, you can compare multiple financial statements for comparative study.
Additionally, it can assist in detecting areas for improvement. Shortly, this will lead to improved financial conditions.
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5: Tips to Develop Accounting Skills
Are you planning to carve a career in this sector but feeling lost? Read the tips to hone your basic accounting skills for an enhanced experience.
5.1. Understand the Accounting Cycle
The first thing is understanding the process from transacting to curating financial statements. Opt for a step-by-step guide to understand transactional operations. Additionally, check out how they are used in creating financial statements.
Studying real-life examples is the best way to understand the accounting cycle. The best option is to opt for case studies for a better understanding.
5.2. Use Accounting Software
It is the age of technology. Hence, you need to be tech-savvy. Learn how to use the various common softwares, Quickbook, Zero, etc., for more convenience.
You must learn how to use different basic accounting software and tools. They will help you achieve more efficiency and accuracy.
5.3. Practice Problem-Solving
Your case-study reference will also help sharpen your problem-solving skills. Analysing these scenarios will familiarise you with real-life issues.
Moreover, the more you apply your theoretical knowledge practically, the more it will assist you in developing your critical thinking skills. This will eventually improve your problem-solving abilities.
5.4. Stay Updated with Industry Developments
Basic accounting is more about recent developments. Hence, you should constantly be updated with the latest accounting standards and regulations.
There is no age or limit to learning, and accounting is the best example. Hence, you must engage in continuous learning. It will help in ensuring gradual professional development.
Conclusion
The subject matter of accounting is complex but quite enjoyable. Hence, it becomes easier to understand once you clear your fundamental concepts. We hope the above information will help you academically and professionally.
FAQs on Basics of Accounting
Q1. What is basic accounting?
A1. This is one of the business operations companies perform to measure their financial health. The significant concepts include understanding financial statements, GAAP principles, etc.
Q2. What is general accounting?
A2. General accounting is recording a company’s financial transactions. The activities included are noting, analysing, summarising, and ensuring compliance.
Q3. What is the required basic knowledge of an accountant?
A3. To become an accountant, you must learn the fundamentals of the subject. For instance, how to create financial statements, ensure compliance with the updated rules, etc. You must also learn the recognition principles and GAAP principles.
Q4. How can you develop your accounting skills?
A4. You can begin by gaining the fundamental knowledge of the accounting cycle. Additionally, study extensively to keep up with the latest trends. Moreover, you can utilise technology to achieve more efficiency.
Q5. What are the three major financial sheets?
A5. The three major financial sheets are the balance sheet, Income statement, and Cash flow statement. They provide insights into the company’s yearly or monthly transactions.
