Welcome to our lesson on Accounting Basics! This is where we lay down the foundational bricks of our accounting knowledge. Just like learning any new language, we must start by understanding its basic elements. In the world of accounting, these elements include fundamental concepts such as the accounting equation and the accounting cycle.
The Accounting Equation is a fundamental principle of accounting, and it can be represented as:
Assets = Liabilities + Equity
Assets are resources owned by a company that holds value. This can include cash, inventory, property, and more.
Liabilities are what the company owes to others. This could be in the form of loans, accounts payable, salaries payable, etc.
Equity (also known as Shareholder’s Equity or Owner’s Equity) represents the net assets of the company, i.e., the residual interest in the assets of the entity after deducting liabilities. In simpler terms, it’s what’s left over for the company’s owners after all the liabilities have been paid off.
Let’s take an example to illustrate this equation:
Imagine you start a small business with an investment of $10,000. This is your cash, an asset. But where did this cash come from? You, as the owner, contributed to it, which creates an equal amount of owner’s equity. So, at the start, your assets ($10,000 cash) equal your owner’s equity ($10,000).
Let’s say you take out a business loan for $5,000, increasing your total cash (asset) to $15,000. However, the loan is a liability that you must repay, so your equation is now:
Assets ($15,000) = Liabilities ($5,000) + Equity ($10,000)
Now, suppose you buy inventory (another asset) for $3,000. You pay for this using your cash, so your cash decreases by $3,000, and your inventory increases by $3,000, keeping your total assets at $15,000. The equation remains balanced:
Assets ($15,000) = Liabilities ($5,000) + Equity ($10,000)
This basic example gives you an understanding of the accounting equation. No matter what the business transaction is, the accounting equation must always remain in balance. It’s the foundation of the double-entry accounting system, ensuring every financial transaction is correctly recorded and represented.
By mastering these two essential accounting concepts, we can record and analyze business transactions with greater accuracy and ease.
The Accounting Cycle refers to the complete process of recording and processing the financial transactions of a company during an accounting period, from when the transaction occurs, to its representation on the financial statements, to the closing of the accounts.
An accounting period can be a month, a quarter, or a year, depending on the company’s preference. For example, most companies prepare their financial statements annually, but they also use monthly or quarterly accounting periods for management and reporting purposes.
Here’s a breakdown of the steps involved in the Accounting Cycle:
These steps recur in every accounting period, forming a cycle of recording and reporting that provides useful financial information for decision-making. This process is fundamental to maintaining accurate financial records and complying with accounting standards and regulations.
Summary:
Understanding these basic accounting principles sets the stage for the more complex aspects of accounting we will explore in the upcoming lessons. The accounting equation and accounting cycle are the cornerstone of the accounting field, ensuring the accurate recording and reporting of a company’s financial transactions.
Thank you for joining us in this lesson. Next, we will delve into Simple Accounting Definitions. See you there!
We have a detailed Free Accounting Terms Guide for you to learn more.