The purpose of accounting is to record each item, which appears in the financial statements separately in order to be able to trace it back if required.
Type of record used for the purpose of recording individual transactions is called an account.
Simplest form of account has three parts:
1. Title, containing name of the account
2. Space of increase in the amount of item in monetary terms
3. Space of decrease in the amount of item in monetary terms.
Simplistic form of the account is T form, therefore they are called T accounts. Left side is called debit side and right side is called credit side.
It is important to remember that every business transaction affects a minimum of two accounts. Process, when accounting for business transaction one account is debited and another account is credited is called double entry accounting. Recalling basic accounting equation and examples of changes as a result of different transactions double entry is logical, as despite any change in parts of accounting equation after recording business transaction must result in balance, i.e. equation between asses and sum of liabilities and equity.
Let’s take as an example transaction, when one shareholder establishes a company, which will provide documents copying services. The shareholder invests 15000$ cash by opening entity’s bank account and transferring cash into bank account.
First step of recording a transaction is journalizing, recording of the transaction into the general journal.
D Cash 15000
C Equity (share capital) 15000
Data from general journal is transferred to the accounts and this process is called as posting.
Referring back to accounting equation, when assets equal to liabilities plus equity and taking into account that left side is debit and right side is credit, final balance in assets accounts must be on debit (left) side and final balance in equity and liabilities accounts must be on credit (right) side.
The above were balance sheet accounts. Analyzing income statement accounts, important to remember that income and expenses are related to equity, i.e. income increases equity and expenses decrease equity. Therefore increase in income is accounted under credit side, increase in expenses is accounted under debit side.
Balances in income and expenses accounts are equal to zero, as these figures are accounted for a period and as it will be in detail presented later are closed at the end of each period and are transferred to retained earning balance sheet account which is a part of equity, i.e. belongs to the shareholders. Usually you can find single all purpose two column journal. Before a transaction is entered into the journal it should be analyzed: 1. determine whether the asset, liability, equity, income or expenses affected; 2. determine whether asset, liability, equity, income or expenses affected in increased or decreased 3. determine whether such increase/decrease to be recorder as debit or credit Going back to the transaction taken as an example, when one shareholder establishes a company which will provide document copying services and the shareholder invests 15000$ cash by opening entity’s bank account and transferring cash into bank account, the general journal entry is a follows:
In column “No” number of transaction is indicated, further date of transaction is written. In the 3rd column “Description” it is indicated which accounts are affected, i.e. debited and credited and short description of transaction is provided. Column “Post acc.” Is required for general ledger posting which is discussed in further stages of accounting cycle, i.e. in this column number of account in general ledger is indicated. Further in column “D” amount of the debit is indicated and in the column “C” amount of credit is indicated.
Important! debit must be equal to credit. Group of accounts for a particular entity is called a general ledger. Separate accounts are set up for separate items of financial statements. The following main parts are included into the financial statements:
Assets – any physical thing (tangible) or right (intangible) that has a monetary value. Divided into current assets (cash and other assets that may reasonably be expected to realized in cash or sold or used within period less or equal to one year. Examples: inventory, cash, accounts receivable, prepaid expenses) and long-term assets (used by the entity for a period longer that one year. Examples: long-term investments, fixed assets, intangible long-term assets).
Liabilities – debts owned to outsiders, i.e. creditors. Divided into current liabilities, which are due within one year (accounts payable, salaries payable, taxes payable, interest payable) and long-term liabilities which are due after one year.
Equity – residual claim against assets of business after total liabilities are deducted. Included share capital (financial means invested by the shareholders, retained earnings – net income retained in the business)
Income – gross increase in equity as a result of receiving income (sales of goods, provision of services)
Expenses – costs consumed in the process of earning income Depending on the type of business different entities require different set of accounts. A listing of accounts in the ledger is called chart of accounts. It is quite convenient that separate accounts or group of accounts correspond to the items in the financial statements.