Basic Functions of an Accounting System
1. Interpret and record business transactions.
The records that are kept for the individual asset, liability, equity, revenue, expense, and dividend components are known as accounts. All accounts, collectively, are said to comprise a firm's general ledger. the general ledger is, in essence, another notebook that contains a page for each and every account in use by a company.
Debits and credits (abbreviated “dr” and “cr”) are unique accounting tools to describe the change in a particular account that it is said necessitated by a transaction.
Businesses record their performance in standard formats called financial statements. The most common of these are:
The bookkeeping process keeps track of these changes in various ledgers and journals. The financial statements are then prepared using this information.
Accounting is based on the fundamental accounting equation:
The records that are kept for the individual asset, liability, equity, revenue, expense, and dividend components are known as accounts. All accounts, collectively, are said to comprise a firm's general ledger. the general ledger is, in essence, another notebook that contains a page for each and every account in use by a company.
Debits and credits (abbreviated “dr” and “cr”) are unique accounting tools to describe the change in a particular account that it is said necessitated by a transaction.
It is now apparent that transactions and events can be expressed in
"debit/credit" terminology. In essence, accountants have their own
unique shorthand to portray the financial statement consequence for
every recordable event. This means that as transactions occur, it is
necessary to perform an analysis to determine (a) what accounts are
impacted and (b) how they are impacted (increased or decreased). Then,
debits and credits are applied to the accounts.
Businesses record their performance in standard formats called financial statements. The most common of these are:
- Balance Sheet (also known as a Statement of Financial Position, or a Statement of Financial Condition).
- Income Statement (Statement of Profit and Loss, Statement of Earnings, Statement of Operations).
- Cash Flow Statement.
The bookkeeping process keeps track of these changes in various ledgers and journals. The financial statements are then prepared using this information.
Accounting is based on the fundamental accounting equation:
Total Assets = Total Liabilities + Equity
2. Classify similar transactions into useful reports.
As
shown at left, asset, expense and dividend accounts each follow the
same set of debit/credit rules. Debits increase these accounts and
credits decrease these accounts. These accounts normally carry a debit
balance. To aid recall, rely on this mnemonic: D-E-A-D = debits increase expenses, assets, and dividends.
Liability,
revenue, and equity accounts each follow rules that are the opposite of
those just described. Credits increase liabilities, revenues, and
equity, while debits result in decreases. These accounts normally carry a
credit balance.
The Balance Sheet has three sections:
The Income Statement communicates the inflow of revenue, and the outflow of expenses, over a given period of time.
The Cash Flow Statement records inflows and outflows of cash during a period of time, and is divided into cash flow from operations, financing, and investing activities.
As
shown at left, asset, expense and dividend accounts each follow the
same set of debit/credit rules. Debits increase these accounts and
credits decrease these accounts. These accounts normally carry a debit
balance. To aid recall, rely on this mnemonic: D-E-A-D = debits increase expenses, assets, and dividends.Liability,
revenue, and equity accounts each follow rules that are the opposite of
those just described. Credits increase liabilities, revenues, and
equity, while debits result in decreases. These accounts normally carry a
credit balance.The Balance Sheet has three sections:
- Assets – the things of value that the company owns.
- Liabilities – obligations to pay or provide goods or services at some later date.
- Equity – the amount of net assets (assets - liabilities) owing to the owners of the business.
The Income Statement communicates the inflow of revenue, and the outflow of expenses, over a given period of time.
The Cash Flow Statement records inflows and outflows of cash during a period of time, and is divided into cash flow from operations, financing, and investing activities.
3. Summarize and communicate information to decision maker.
The debt ratio (total debt/total assets) analyzes how much debt you have in relation to total assets. This ratio checks your company's long-term ability to pay debts. A healthy company should have a debt ratio that is less than 1. If the ratio is greater than 1 that means the company could potentially default on debt obligations and become bankrupt if they are not able to turn things around. This ratios is extremely important for bankers and other creditors and if your company is thinking about obtaining financing you will want to focus on keeping this ratio as low as possible.
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What an Income Statement says:
- The Income Statement reports the main and any secondary sources of income. For example, Fees Earned would be the primary revenue in a dental office. If they had bonds, a secondary source of revenue would be Interest Earned from Bond Investment.
- The terms used to describe the revenue will provide a clue about the nature of the organization. For example, Fees Earned implies a service company; Commissions Earned implies a brokerage; while Sales Revenue implies a retail or wholesale firm.
- The items listed as expenses are expired, meaning they have no useful value left.
- The result of matching the revenues and expenses yields the Net Income or Net Earnings if the statement is called the Earnings Statement. The term 'net' implies that the revenues and expenses have been matched, and therefore there is not an over or under statement of the income (loss).
What an Income Statement does not say:
- An Income Statement does not predict the future net income for any accounting period. Since the future is full of uncertainty, a reader of a historical Income Statement can't rely on the reported results of any single period for an indication of future results.
- An Income Statement, no matter how well prepared, does not provide an exact measurement of net income for the accounting period. No matter how hard you try, it is impossible to get an exact match. Consider, for example, an advertising expense. If management spent $1,000 in December on advertising, and achieved $5,000 sales revenue for December, that does not mean that the advertising brought in exactly $5,000 revenue. There may also be revenue generated in January that can be attributed to the December advertising. When it is difficult to measure, the expense is accounted for in the period it was incurred.
- An Income Statement does not report True Profit, which is the difference between total funds invested over the life of the company and funds realized from the sale of the company. To calculate this, you would have to calculate the difference between assets invested during the lifetime of the business, and the amount finally received from remaining assets after winding up the business. You would also have to deduct any personal withdrawals because these were actually paid out of the 'profits.'
- Net Income does not mean cash! Always keep in mind that net income is the excess revenue over related expenses for a specific accounting period. Cash has very little to do with determining net income. True, revenue refers to an inflow of cash and expense to an outflow, but often the inflow of cash is used for further investment. Additionally, revenues and expenses are recorded at the time of occurrence, not when cash changes hands. What about the case of depreciation expense which does not represent an outflow of cash at all?
What a Balance Sheet says:
- A Balance Sheet gives readers a detailed summary of the assets and claims against those assets, as at a particular date.
- A Balance Sheet provides the reader with information about the financial position of the firm with regard to its ability to pay current debts. By comparing the current assets to the current liabilities, the reader can assess whether the company is in a position to meet to meet its short-term financial obligations.
- A Balance Sheet gives the reader a view of the firm's financial position to carry on its business operations. The fixed-asset section indicates how many resources the company has working for it to assist in revenue generation.
- Finally, a Balance Sheet reveals the strength of the owner's claim against the assets. Remember, however, that this claim is residual, or the remaining claim after the creditors'.
What a Balance Sheet does not say:
- A Balance Sheet does not report the details of how the profits were made. That information comes from the Income Statement.
- A Balance Sheet does not show the claims of the creditors and the owner(s) against a specific asset. The claims are against the assets in general.
- The word 'Capital' under owner's equity must not be interpreted as cash. The investment can come in many forms – cash being just one of them. The owner's original cash investment may have gone primarily to purchase fixed assets in order to assist revenue generation. Capital means investment not cash.
- A Balance Sheet does not report the market value, current value, or worth of a business. Many readers believe the total assets represent a bundle of future cash reserves. This is not true because fixed assets are reported at historical cost, and their purpose is to assist revenue generation. They are not intended for sale to enhance cash flow.
The debt ratio (total debt/total assets) analyzes how much debt you have in relation to total assets. This ratio checks your company's long-term ability to pay debts. A healthy company should have a debt ratio that is less than 1. If the ratio is greater than 1 that means the company could potentially default on debt obligations and become bankrupt if they are not able to turn things around. This ratios is extremely important for bankers and other creditors and if your company is thinking about obtaining financing you will want to focus on keeping this ratio as low as possible.
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