Accounting is the methods and procedures for identifying, analyzing, recording, classifying, and summarizing the financial activities to provide management and other interested parties with information. Accounting is the science of tracking money an organization. Accounting is sometimes called the language of business. An accounting system is a way of tracking how a business is doing, in terms of the flows of money in and out of a business. Accountants suggest strategies for improving the financial position of organizations. Accountants may also provide tax advice and prepare tax returns. Accountants prepare financial reports called financial statements.

Accounting Standards

Uniform financial reporting standards are critical in a society that needs to communicate financial activity. A common vocabulary, accounting methods and full disclosure on accounting reports are the mandates of the accounting profession. The standards that govern the accounting profession are the Generally Accepted Accounting Principles (GAAP). You can assume that a business has used GAAP unless it is otherwise stated in the financial reports. As a general rule, the income tax accounting rules for determining the annual taxable income of a business are in agreement with GAAP.

Transactions

Transactions are something that your business does that generates recordable financial impact. These events are classified into groups when they are recorded. These groups are called accounts. For example, if you go to the store to buy note paper for the back office of your business and pay cash for it, your Cash account is decreased and your Office Supplies account is increased by the same amount. The account Office Supplies can be used in this way for many types of purchases of stationery including note paper, pens, pencils, erasers, rulers, file folders and so on. It is possible to create a separate account for note paper, pens, and pencils, for example, but that level of detail is seldom needed. If it’s not needed by managers to analyze at a later date, then these details aren’t worth tracking. Accounts are classified into six main categories: assets, liabilities, owner’s equity, sales, cost of goods sold and expenses. Where are these transactions recorded? They are recorded in a journal.

Bookkeeping

Bookkeeping is the process of recording financial transactions in a journal. Bookkeeping is only a small part of accounting.

Journal

A journal is a place where transactions are recorded, one after the other. The transaction’s data will include the names of the accounts, the monetary amounts, the date of the transaction and a brief description of the transaction’s purpose and any codes or numbers that will help you to trace back to any source documents. When the dollar amounts are recorded, they are recorded as either a debit or a credit. A journal is a temporary holding place for transactions until they can be classified by transaction type in a ledger.

The Accounting Equation

The accounting equation is fundamental to accounting. The equation is Assets = Liabilities + Owner’s Equity. To understand this equation, it helps to have a look at the Balance Sheet. Cash is often the first item. While the balance sheet doesn’t say which items are debits and which are credits, a positive cash balance is always a debit. When an increase in cash is recorded in the journal, it is recorded as a debit. If there was a transaction that caused a decrease in cash, the amount would be a credit to the Cash account. Since total debits must always equal total credits, every single transaction recorded in the journal must have an equal amount of total debits and total credits. For example, if you purchased office supplies with cash, the Cash account would be credited in the journal (decrease in cash) and Office Expenses would be debited (an increase in expenses). The account names in your own accounting system may have different names other than Cash and Office Expenses. That is fine, as long as it is descriptive and is properly classified by type.

Types of Accounts

There are six major categories of accounts: assets, liabilities, owner’s equity, revenues, cost of goods sold and expenses. An individual account, such as “Bank Loan” or “Cash”, is an individual piece of information that belongs to one of those categories and is used as a source of information in preparing financial statements. For financial statement purposes, having a single account called “Cash” is acceptable. However, in your accounting software package, you might have set up several different accounts that represent “Cash”. For example, you might have one account for each bank account you have, and a petty cash account. Small businesses can easily have more than one hundred different accounts in their accounting system.

Ledger

A ledger is a holding place for financial transactions of a particular account type. A ledger is an account. Types of accounts include Cash, Payroll, Sales, and many others. The list of all accounts is called the chart of accounts. Charts of accounts differ depending on the type of organization you are keeping track of. On a regular basis, journal entries in the journal are moved over to their ledgers. The term general ledger refers to the complete set of accounts of a business and often to the balances in those accounts.

Assets

An asset is anything that has some sort of financial value and can therefore be converted to cash, if necessary. Assets are further grouped into current assets and fixed (or long-term) assets. A current asset is an asset that is converted into cash within one year. Assets that can be converted into cash quickly are called liquid assets. The speed by which you can convert assets into cash is called liquidity. Fixed assets are assets that take more than a year to be converted into cash, under normal business operations. Real estate that the business owns is an example of fixed assets. Assets have sources. They have to come from somewhere. These sources are actually “claims” on the assets of a business.

Liabilities

Liabilities are money owed to others outside of the organization. They are debts. If you have borrowed any money from the bank as a bank loan, that is a liability. All liabilities are classified into either Current Liabilities and Long-term Liabilities. A current liability is to be completely repaid within one year. Long-term liabilities are to be repaid in a period longer than one year.

Owner’s Equity

Owner’s equity is the money that remains in the business after you take all of your assets and subtract all of your liabilities. Owner’s equity represents the owner’s investment in the business. Net worth is another way of expressing owner’s equity.

Double-Entry Accounting System

The accounting equation, Assets = Liabilities + Owner’s Equity, is similar to any other type of equation in that a change to one side causes a change to the other side. The equation must always balance. This is a method of recording transactions that is standard throughout the world. For each transaction, a debit is made to at least one account and a credit is made to at least one account. The total of all debits must always equal the total of all credits. Double-entry accounting means two-sided accounting. Both the assets and the claims on these assets are accounted for.

Debits and Credits

The terms debit and credit are used in accounting to indicate which side of the equation we are referring to. You can think of a debit is the left side and credit is the right side. For each transaction recorded in the journal, the amount of the debits must always equal the amount of the credits so that the accounting equation is valid. If all debits equal all credits, other errors are still possible. Wrong accounts could have been used in the recording of a transaction in the journal. A journal entry could have been missed. Wrong amounts could have been entered.

Recording Transactions

Let’s take an example of a series of transactions. Suppose that you purchase something for $50 and agree to pay the vendor for it at a later date. Suppose this item is for resale to customers, and is therefore now part of your inventory. Inventory is an asset. In the accounting equation, the Inventory account would increase by $50 and your liabilities would also increase by $50. The accounting equation still balances. The journal entry is a debit to Inventory (increases) and a credit to Accounts Payable (increases). How do you know that it is a debit to Inventory and not a credit to Inventory? Inventory is an asset. Since assets are on the left hand side of the accounting equation, the balances in those accounts are debits. To increase the Inventory account we need to debit the account to increase it. Liabilities (debts) are on the right hand side of the equation and therefore are credits. To increase an account that is on the right hand side of the accounting equation, the amount is a credit to, in this case, the Accounts Payable account. If a transaction decreases an asset account, the amount in the journal entry would be a credit. If a transaction decreases a liability account, the amount in the journal entry would be a debit.

Revenues and Expenses

Revenues and expenses also follow the debit and credit rules. A revenue ultimately increases owner’s equity. Owner’s equity carries a credit balance. Making a profit increases assets. This increase in assets is not the result of borrowing money or having a capital infusion from owners. It’s the result of having more revenues than expenses. This difference is recorded in a Retained Earnings account that is part of the Owner’s Equity section of the Balance Sheet.

Accrual Based Accounting

In accrual-based accounting, when profit is measured, revenue is recorded at the time when sales are made, rather than when cash is received from customers. The recording of expenses are matched to the sales revenue in the period benefited, rather than when expenses are actually paid. The purpose of using accrual-based accounting is to capture the economic reality of a business’s activities, in contrast to the cash flow basis of accounting. With the cash flow basis accounting, only cash inflows and outflows trigger a financial transaction to be entered in the books. This simulator uses accrual-based accounting.

Financial Accounting

Financial accounting includes the preparation of financial statements that present information on the company as a whole rather than on individual departments or segments. It is designed for use by external users such as consumer groups, unions, shareholders, investors and government agencies.

Managerial Accounting

Managerial accounting is used to provide information to managers within the organization to assist them in decision making. Managerial accounting is also called management accounting. Managerial accounting serves internal users. It provides information to alert managers and supervisors to potential problems and aids them in planning and decision making.

Internal Control

Accounting internal control is a system of checks and balances designed to discourage and detect both honest and dishonest mistakes. Internal theft and fraud are costly to businesses. Accountants can help with this. One of the things that they suggest includes the inspection and counting of all items purchased and received by the company before paying for them. Another example is the requirement of having two signatures on each cheque. Another example would be the "closing out" of the cash register at the end of the day.