Basics Of Accounting & Golden Rules

Accounting is the process of recording, assessing, and communicating financial transactions — helps individuals and organizations understand their financial health. Understanding Accounting terminology helps us understand better financial record and keep track of one's business financial information. Fundamentally, accounting comes down to a simple equation. Assets = Liabilities + Equity.

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1. Assets - Assets are resources with economic value which companies expect to provide future benefits. These can reduce expenses, generate cash flow, or improve sales for businesses. Companies report assets on their balance sheets.

Asset types include fixed, current, liquid, and prepaid expenses. Assets may include long-term resources like buildings and equipment. Current assets include all assets a company expects to use or sell within one year. Liquid assets can easily convert to cash in a short timeframe. Prepaid expenses include advance payments for goods or services a company will use in the future.

2. Liabilities - A liability is when someone owes someone else money. Someone can fulfill the obligation of settling a liability through the transfer of money, services, or goods. Types of liabilities can include loans, mortgages, accounts payable, and accrued expenses. Short-term liabilities conclude in less than a year, while businesses may expect long-term liabilities to take longer than a year to resolve.

3. Equity - Equity, often called stockholders’ equity or owners’ equity, is the amount of money left over and returned to shareholders after a business sells all assets and pays off all debt, represented by the equation “Equity = Assets – Liabilities.”

An indicator of a company’s financial health, equity can consist of both tangible (buildings, cash, land) and intangible (copyrights, patents, brand recognition) assets. It exists as a record on a company’s balance sheet. Sole proprietorships only use the term owners’ equity, because there are no shareholders.

4. Accounts Payable - Accounts payable refers to the money a business owes to its suppliers, vendors, or creditors for goods or services bought on credit. A short-term debt that must be paid back quickly to avoid default, accounts payable shows up as a liability on an organization’s balance sheet. An example of accounts payable includes when a restaurant receives a beverage order on credit from an outside supplier.

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5. Accounts Receivable - It is the opposite of accounts payable, accounts receivable refers to the money owed to a business, typically by its customers, for goods or services delivered. An example of accounts receivable includes when a beverage supplier delivers a beverage order on credit to a restaurant. While the restaurant records that transaction to accounts payable, the beverage supplier records it to accounts receivable and a current asset in its balance sheet.

6. Accounting Period - An accounting period is the time frame for which a business prepares its financial statements and reports its financial performance and position to external stakeholders. This could be after three, six or twelve months. It usually coincides with the business’ fiscal year.

7. Accruals - A type of record-keeping adjustment, accruals recognize businesses’ expenses and revenues before exchanges of money take place. Accruals include expenses and revenues not yet recorded in companies’ accounts. Accruals affect businesses’ net income and must be documented before financial statements are issued.

8. Deferral - A deferral often refers to an amount that was paid or received, but the amount cannot be reported on the current income statement since it will be an expense or revenue of a future accounting period. In other words, the future amount is deferred to a balance sheet account until a later accounting period when it will be moved to the income statement.

9. Balance Sheet - A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders. Accountants use the accounting equation, also known as the balance sheet equation, to create balance sheets: “Assets = Liabilities + Equity.”

10. Capital - Capital refers to a person’s or organization’s financial assets. Capital may include funds in deposit accounts or money from financing sources. Working capital refers to a business’s liquid capital, which the owner can use to pay for day-to-day or ongoing expenses. A company’s working capital indicates its overall health and ability to meet financial obligations due within a year.

11. Cash Flow - Cash flow is the total amount of money that comes into and goes out of a business. Net cash flow refers to the sum of all money a business makes. Cash flow statements are financial statements, and they include all cash a business receives from its operations, investments, and financing.

12. Cost Of Goods Sold - The total cost of producing the goods sold by a business is called cost of goods sold (COGS). COGS includes the direct costs of creating goods, including materials and labor, and it excludes indirect costs, such as distribution expenses.

13. Depreciation - Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset's value has been used up. Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profits.

14. Dividends - Dividends consist of company earnings, or profit, which a business pays to its shareholders as a reward for their investment in its equity. Companies may distribute dividends as cash or additional shares of stock. Shareholders may receive regularly scheduled or special one-time dividends. Exchange-traded funds and mutual funds also pay dividends.

15. General Ledger - A general ledger is the master set of accounts that summarize all transactions occurring within an entity. There may be a subsidiary set of ledgers that summarize into the general ledger. The general ledger, in turn, is used to aggregate information into the financial statements of a business. The general ledger is comprised of all the individual accounts needed to record the assets, liabilities, equity, revenue, expense, gain, and loss transactions of a business.

16. Gross Profit - Gross profit, also called gross income or sales profit, is the profit businesses make after subtracting the costs related to supplying their services or making and selling their products. Accountants calculate gross profit by subtracting the cost of goods sold from revenue. Gross profit considers variable costs, not fixed costs. Analysts can look at gross profit as indicative of a company’s efficiency at delivering services or producing goods.

17. Income Statement - An income statement is one of the three important financial statements used for reporting a company's financial performance over a specific accounting period, with the other two key statements being the balance sheet and the statement of cash flows. Also known as the profit and loss statement or the statement of revenue and expense, the income statement primarily focuses on the company’s revenues and expenses during a particular period.

18. Net Income - It is the amount an individual or business earns after subtracting deductions and taxes from gross income. To calculate the net income of a business, subtract all expenses and costs from revenue. Sometimes called the bottom line in business, net income appears as the last item in an income statement. Investors and shareholders look at net income to assess companies’ financial health and determine businesses’ loan eligibility.

19. Profit and Loss Statement - A profit and loss statement, also called an income statement, shows the expenses, costs and revenues for a company during a specific time period. This financial statement, along with the cash flow statement and the balance sheet, provides information about a business’s financial health and ability to generate profit.

20. Receipts - A receipt is a written acknowledgment that something of value has been transferred from one party to another. In addition to the receipts consumers typically receive from vendors and service providers, receipts are also issued in business-to-business dealings as well as stock market transactions. For example, the holder of a futures contract is generally given a delivery instrument, which acts as a receipt in that it can be exchanged for the underlying asset when the futures contract expires.

21. Retained Earnings - Retained earnings, also called an earnings surplus, refers to the amount of net income left for a business to use after paying dividends to its shareholders. A company’s management typically decides whether to keep the earnings or give them to shareholders.

22. Revenue - Revenue, also called sales, is the gross income a business makes through normal business operations. To calculate sales revenue, multiply sales price by number of units sold. Accrual accounting and cash accounting methods calculate revenue differently. When using the accrual accounting method to calculate revenue, accountants include sales made on credit. Those who use the cash accounting method only count sales as revenue once the business receives payment.

Rules Of Accounting

Every economic entity must present its financial information to all its stakeholders. The information provided in the financials must be accurate and present a true picture of entity. For this to be done, it must account for all its transactions. Also there has to be uniformity in accounting. To bring about uniformity and to account for the transactions correctly there are three Golden Rules Of Accounting. These form the very basics of passing journal entries which in turn form the basis of accounting and bookkeeping.

Golden Rules Of Accounting represent the basic rules that govern the recording of day to day financial transactions of a business. Also known as traditional accounting rules, golden rules of bookkeeping , or the rules of credit and debit, these accounting rules play an essential role in the accounting realm. To understand how these work , we need to know the types of accounts first, because these rules apply to transactions based on particular account type.

Types of Accounts

1. Personal Account- These accounts belong to individuals. These individuals can be human beings or artificial persons, and are of three types.

  • Persons: Represent natural persons like Ramesh's account , Suresh's account.

  • Artificial Persons: They represent partnership firms , associations, and companies like XYZ Charitable Trusts, XYZ Industries Ltd etc.

  • Representative Persons: They represent person or group of persons like Salary payable A/c, Prepaid Expenses A/c , Outstanding Salary A/c etc.

2. Real Accounts- These are the ledger accounts that represent all assets belonging to a business enterprise. Real accounts are further divided into two types- tangible and non- tangible.

  • Tangible real accounts include assets that have a physical existence, such as property A/c, inventory A/c, furniture A/c etc.

  • Intangible real accounts include all accounts for non-physical assets such as Trademark A/c, copyrights A/c, Patent A/c etc.

3. Nominal Accounts- These accounts are associated with losses, expenses, income or gains. The Nominal accounts may include wages A/c, Rent A/c, Electricity Expenses A/c, salary A/c, travelling expenses A/c, and commission received A/c etc.

The 3 Golden Rules-

  • Debit The Receiver, Credit The Giver -

This principle is used in the case of personal accounts. A personal account is an account to be used by an individual for his or her own needs. If a person/legal body/group of person receives something from the business, then he is a receiver, and in books of business, his account is represented as debited. Alternatively, if a person/legal body/group of the person grants something to the business, then he is a giver. His account in the books of business is represented as credited.

  • Debit What Comes In, Credit What Goes Out-

This principle is applied in case of real accounts. Real accounts involve machinery, land and building etc. They have a debit balance by default. Thus when you debit what comes in, you are adding to the existing account balance. This is exactly what needs to be done. Similarly when you credit what goes out, you are reducing the account balance when a tangible asset goes out of the organization.

  • Debit All Expenses And Losses, Credit All Incomes And Gains-

This rule is applied when the account in question is a nominal account. As per nominal account rule, if a business incurs any expense or loss, then in books of business, its accounting entry shall be represented as debited. On the other hand, if business gains income or profit by rendering services on any transaction, then its accounting entry is represented as credited.

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