Whether you're planning to pursue a career in accounting, management, finance, economics, or any other related field, learning the fundamentals of accounting can provide the framework you need to be successful. Here are five basic concepts covered in most introductory courses that can help you understand some key accounting principles.
1. Accounting equation
There's a basic accounting equation that serves as the foundation for double-entry bookkeeping and accounting: assets = liabilities + shareholders' equity. This equation can also be written in either of these two ways:
liabilities = assets - shareholders' equity
shareholders' equity = assets - liabilities
The three components of this formula are:
- Assets, including cash, accounts receivable, and inventory
- Liabilities, including accounts payable and outstanding loans
- Shareholders' equity, including funds received from investors and earnings that have not yet been distributed to investors
This equation teaches us that a company's assets will always equal the sum of its liabilities plus shareholders' equity in the case of a public company, and owner's equity in the case of a non-public company.
2. Debits vs. credits
The double-entry accounting system is recognized as the most accurate for businesses of all sizes. This system is based on the idea that every financial transaction that occurs has an equal and opposite effect in at least two of a business's different accounts. As such, transactions are recorded as either debits or credits, and the two will always offset one another.
A debit is an entry that either increases an asset or expense account or decreases a liability or equity account. A credit is an entry that either increases a liability or equity account or decreases an asset or expense account. Debits are recorded on the left side of an accounting ledger, while credits are recorded on the right.
Generally accepted accounting principles (GAAP) are a common set of accounting principles that companies use to put together their financial statements. The idea behind GAAP is to have a set of uniform, recognized standards that all companies adhere to, regardless of industry or size. Imposing GAAP on companies allows investors to benefit from a certain level of consistency when reviewing financial reports and comparing investment opportunities.
4. Financial statements
Financial statements are a collection of reports about a company's financial activities. They highlight a company's ability to generate cash flow and its capacity to repay its debts. Businesses are expected to prepare financial statements in accordance with generally accepted accounting principles.
Financial statements consist of three key reports:
- The balance sheet, which shows a company's assets, liabilities, and shareholders' equity over a specified period
- The income statement, which reviews a company's revenues, expenses, gains, and losses over a specified period
- The statement of cash flows, which highlights changes in a company's cash flows and activity over the course of a specified period
5. Cash vs. accrual
Companies can track their income and expenses on either a cash basis or an accrual basis. Under the cash method, revenue is recorded when it is actually received from customers, and expenses are recorded when cash is actually paid out. Under the accrual method, revenue is recorded when it is earned and expenses are recorded when they are incurred, regardless of when the cash is actually received or paid out. Public companies use the accrual method of accounting when compiling their financial statements, as this is what generally accepted accounting principles dictate.
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