Accounting is like a big tree it's been around for ages
and it has lots of branches There's financial accounting
managerial, tax, audit and bookkeeping
But generally I think when people say accounting they
usually mean financial accounting So what is financial accounting?
It's the process of identifying, recording,
summarizing and analyzing an entity's financial transactions and
reporting them in financial statements Hey I'm James and if this definition
doesn't mean much to you it's all good
stick around me for the next ten minutes or so and you'll see
exactly how financial accounting works We've got lots cover but I do recommend
watching this right through to the end at least once so that you can get
an idea of the big picture Let's do this!
Imagine that you own Ruff Times a tabloid newspaper covering all
the latest gossip on our furry friends During March you run a promotional
offer for annual subscriptions that begin on April 1st
People can't get enough of your stories and you end up with $40,000
in new subscriptions all paid for in cash
The first step in financial accounting is to identify the transaction
Well that's easy I just mentioned one you made
$40,000 in new annual subscriptions these start on April 1st and continue
through to March 31st next year So what next then?
It's time to prepare a journal entry A journal is a record of a
financial transaction and it looks like this You have a unique journal number,
a date, a description, the accounts affected in this case that's cash and
subscription revenue and then you have your debits and credits
which are both $40,000 Ruff Times is a serious business so
you're using double entry accounting which means this transaction affects
at least two accounts and the total debits are equal to the total credits
But why do we do it this way?
What is double entry accounting?
The first thing you need to know is that Financial Accounting
is built on one simple idea The stuff that your business owns is equal
to the stuff that your business owes We call the stuff that your business owns
Assets these are valuable resources that you'll benefit from in the future
things like cash and inventory but on the other side of this formula
we use two different words to describe the stuff that your business owes
Liabilities when you owe stuff to third-party lenders or suppliers
these are your obligations that you'll need to fulfil in the future
and equity when Ruff Times owes stuff to you
the owner this represents your claim on the
business's net assets So assets equal liabilities plus equity
this little formula is called the accounting equation and it
has big implications It was written down a long time ago
by this guy in this book and it revolutionised the way we record transactions
It’s the foundation of double-entry accounting the theory that there are at least
two equal and opposite sides to every transaction because this
accounting equation is always true it must always balance
Debits and credits are the words we use to reflect these two sides
Credits represents the sources that economic benefit flows from
whereas debits represent the destinations that it flows to
Nowadays pretty much every large business in the world uses
double entry accounting and so does Ruff Times
In this case you debit cash by $40,000 to increase your assets and you
credit subscription revenue by $40,000 to record your income
Are you hanging in there?
I know there's a lot to take in and some of these terms might not
make sense right away that's okay just give it some time
and let it all seep in After this you can always jump into
my accounting bases playlist and explore everything
I mention in a lot more detail I drop a link to that down below
in the description just below that big red subscribe button
I don’t know what that voice that was but... anyway...
the next step is to post the journal into your general ledger
The general ledger is a place where you store all of your financial data
It contains a complete record of your accounts and journal entries
Back in the day it used to be this huge book that you’d fill out by hand
but thankfully we've moved on now and businesses like yours
use accounting software which treats the general ledger
as kind of a central database So how do we get this journal
into your general ledger?
You post it to your accounts Accounts of places where you
record, sort and store all transactions that affect a related group of items
Broadly speaking there are six types of account
assets, liabilities and equity which we already know from the accounting equation
and then there's revenue, expenses and withdrawals
also known as dividends These feed into the equity
part of the equation If you'd like to see how and why that works
then you can check out my video on equity I'll pop a link to
that in the description This journal affects two accounts
and we can picture what they look like by drawing out two T’s
and labelling them cash and subscription revenue
These are called T accounts and they help us visualise what your
accounts look like Debits go on the left and
credits go on the right When you post this journal
you debit the left-hand side of your cash account by $40,000 and you
credit the right-hand side of your subscription revenue account
by $40,000 as well When we total these up you now have
$48,000 in cash and you've made $75,000 in subscription revenue
But Ruff Times has other accounts too it has a whole collection of
assets, liabilities, equity, revenue and expense accounts
stored in your general ledger You post this journal during March
when you collect the cash but now let's fast-forward to the
end of your financial year to December 31st
We need to put together your unadjusted trial balance
What's a trial balance?
It's an internal report that summarises the closing numbers in all of your
general ledger accounts It can help us check for errors
but ultimately we use it to make financial statements as you'll soon see
But what does it look like?
Here's your general ledger again and now let's jump ahead to the
end of December Building a trial balance is
actually quite simple you list out all of your accounts
and their closing balances and that's all there is to it
A closing balance is the cumulative total of all transactions
affecting an account As usual debits are on the left
and credits are on the right At the bottom of your trial balance
you have your total debits and total credits these should match each other exactly
because the accounting equation is always true
Trial is another way of saying test which is what the trial balance was
originally used for as a test to check your debits
and credits are in balance and this is an unadjusted trial balance
because we haven't adjusted it yet but we will
now actually because you've ended a financial year so we need to
post some adjusting entries Adjusting entries are journal entries
that bring your books in line with something called the
accrual method of accounting What's that?
To understand you really need to know about the accounting rule books
Yes accountants have to be good and follow the rules
but the rules change a bit depending on where you're based
you might follow the international financial reporting standards
or some variation of the generally accepted accounting principles
IFRS or GAAP These two rule books make sure that
your financial statements reflect a true and fair view of your business
which is important because a lot of people rely on financial statements
particularly those who’ve lent you money or invested in your business
Anyway IFRS and GAAP have one major thing in common
they both want you to follow the accrual method of accounting
which means you need to recognise your revenue as you earn it
and record your expenses as you incur them
This is the most accurate way to calculate your profit
but here's the thing Ruff Times hasn't been
playing by the rules In March you ran a promotion on annual
subscriptions starting on April 1st You collected $40,000 in cash and
posted a journal to recognise that whole amount as revenue on March 31st
This is called cash accounting and it's not the same as accrual accounting
in cash accounting you recognise your revenue as you receive cash
and record your expenses as you pay it out But receiving cash is not the same as
earning revenue let me show you
You received $40,000 of cash during March but you actually earn that revenue
over the next twelve months this is when you do the work
this is when you release each issue of Ruff Times
So today as things stand on December 31st you've recognised 12 months of income
this financial year but you haven't earned three months of it yet
and you won't until the end of March next year
But it's all good that's what adjusting entries are for
These are the journal entries that you post to bring your books in line
with the accrual method We can fix this situation by reversing
3 out of the 12 months of your subscription revenue which is $10,000
and temporarily holding it as a liability in an account called deferred revenue
or unearned revenue This is a liability account because you
still have an obligation at the end of the year to provide your customers
with Ruff Times from January to March Let's post this one to your general ledger
and run ourselves a new adjusted trial balance
This time is adjusted because you’ve posted your adjusting entries
We can see that your subscription revenue has gone down by $10,000 and your
liabilities have gone up by $10,000 Your debit and credit totals still
match each other because there are two equal and opposite sides to the journal
and now you're playing by the rules because you're following the
accrual method of accounting Nice one!
Now we can create your financial statements Financial statements are
accounting reports that summarise your business's activities over a period of time
These are external reports designed to give your
investors, lenders and creditors and an understanding of your
business's financial health The three main financial statements
are called the balance sheet, the income statement and the
cash flow statement We can build all of these
using your adjusted trial balance Your balance sheet looks like this
it gives us a snapshot of your business's assets, liabilities and equity
at a single point in time which can teach the readers about
your financial position they can see what you own and what
you owe at the end of your financial year Now let's check out your income statement
this summarises your business's revenues and expenses over a period of time
Here that's the previous year and it gives the readers a glimpse of your
financial performance and profitability If you were cash accounting
then this income statement would also mirror your cash flows
but you're using the accrual method so profit and cash flow aren't the same thing
You keep track of your cash flow separately in a cash flow statement
This report summarises your cash inflows and outflows over the same period of time
Once you've created these three financial statements you can send
them out to your investors, lenders and creditors
if Ruff Times was listed on a stock exchange then investors
all around the world would compare your performance against their
expectations and decide whether to buy or sell shares in your business
They'd analyse your statements using financial ratios which is
something that we haven't covered on this channel yet
so if you'd like see some videos on that then by all means
please let me know down in the comments But we're not finished yet
Once you're done with your financial statements you need to
post some closing entries to prepare your books for next year
A closing entry is a journal entry that you post to clear out all of your
temporary accounts like revenues, expenses and dividends
For Ruff Times your journal would look something like this
You’d debit your revenue accounts and you’d credits your expense accounts
to clear them down to zero The balance of $26,440 goes to
retained earnings in the equity section of your balance sheet
These are your profits that you're holding on to for the future
So if we look at your trial balance again then we can see your
revenue and expense accounts have been reset to nil and now you're ready to
tackle the new year Together these steps make up the
accounting cycle and this is what Financial Accounting is all about
It’s the process of identifying, recording summarising and analysing your
business's financial transactions and reporting them in financial statements
Shout out to Munesh at home food maniacs for requesting this one
a long time ago so thanks for being so patient with me
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