Hi it's James. Today I'm going to tell you 32 things you should know to help you understand
accounting. Before we get stuck in I want to do a quick shout out to all of my wonderful channel
members. Thanks for supporting Accounting Stuff. Let's do this! First of all, what is accounting?
Accounting or specifically financial accounting is the process of identifying, recording, summarizing
and analyzing a business's financial transactions and reporting them in financial statements. Let's
break this down. Identifying transactions means spotting events that affect a business financially.
Maybe it sold something. Maybe it bought something. Maybe it moved cash from one account to another. We
identify the transaction, then we record it. There are a couple of ways to do that. The simplest way
is to use the single-entry accounting method. In single-entry accounting we only record one
accounting entry for each transaction usually in a cash account. When cash comes in you record revenue
and when cash goes out you record an expense. It's straightforward but it doesn't give you a complete
picture of your business. A better way to record transactions is to use the double-entry accounting
method. In double-entry accounting there are two sides to every transaction. This means that each
accounting entry has at least one opposite corresponding entry in a different account.
Why? Because in Double-Entry accounting, the stuff that a business owns is equal to the stuff that it
owes. This leads us nicely into the fourth thing that you should know about accounting. Which is
of course the accounting equation. The accounting equation says that a business's assets must equal
its liabilities plus equity. Assets are the stuff that a business owns that have value. You can think
of them as resources that are likely to bring economic benefit to a business in the future. An
example would be a printing press that allows a publisher to print magazines which it sells for
monie. Whereas liabilities and equity represent the stuff that a business owes. Liabilities are
the stuff that a business owes to third parties. These are commitments or obligations that require
a sacrifice of economic benefit in the future. For example, a publisher might owe some money to a
freelance writer or a journalist. Equity is the stuff that a business owes to its owners. Let's
think about this one for a moment. What exactly is equity? If we rearrange the accounting equation
we can see that equity is equal to assets minus liabilities. Another name for this is net assets.
So equity is the owner's claim on the net assets of a business. And while we're here, what's equity
made up of? There are two main components to equity: capital contributions and retained earnings.
Capital contributions are the funds invested into a business by its owners out of their own pockets
and retained earnings are a business's accumulated profits held for future use. Retained earnings are
gradually built up over time and are made up of opening retained earnings and current year
profit less withdrawals. Opening retained earnings are what we start the year off with. These are brought
forward from the end of the previous accounting period. Withdrawals are the owners claiming their
net assets by taking their money out of the business. Withdrawals are also called drawings
or dividends depending on how the business is structured. We can work out current year profit
by taking revenue less expenses. It's the financial gain generated over a period of time when revenues
are bigger than expenses. On the other hand a business incurs a loss if its expenses outweigh
its revenue. Revenue is the income earned by business from its primary activities. That usually
means selling products or services. And expenses are the costs incurred in order to produce revenue
they include the direct cost of sales and the indirect costs of running and operating a business.
What we have here is the expanded accounting equation. This is the 14th thing that you should
know about accounting, and trust me this one is key to understanding how it works. As you'll
soon find out. I know this is a lot to take in but please don't panic. I have videos covering each of
these topics in depth, so if we touch anything here that you'd like to spend a little bit more time
on then head on down to the description. You'll find links to those videos there. I've also put
together cheat sheets and question & answer packs for each topic as well and I'll leave links to
those in the description too. Number 15, debits and credits. Debits and credits are words used
to reflect the double-sided nature of financial transactions. All transactions involve a flow of
economic benefit from a source to a destination. That means that there are two sides to every
transaction. If we debit one account we have to credit another. But how do we know which to debit
and which to credit? We can separate all accounts into two groups: normal credit accounts and normal
debit accounts. Normal credit accounts represent the sources the economic benefit flows from.
These are liabilities, equity and revenue. When we credit these accounts they increase in value
and when we debit them they decrease. Normal debit accounts work the other way around. They represent
the destinations that economic benefit flows to. Dividends, expenses and assets. These increase when
debited and decrease when credited. There's a simple acronym to help you remember all of this: DEALER. I
think we're at 16 now. By the way if you think I've missed anything else in this video please,
please let me know in the comments. On the left we have D E A or dividends, expenses and assets. These
are normal debit accounts and on the right we have L E R or liabilities, equity and revenue. These are
normal credit accounts. Debits and credits always work this way. But there is one situation that can
cause some confusion. If you go to the bank and deposit cash into a checking account the bank
credits your checking account which increases your balance. And when you take your cash out they debit
your account which decreases your balance. But in accounting, cash is a type of asset which makes it
a normal debit account. So credits should decrease your cash balance and debits should increase it.
This is correct. But from the bank's point of view, your checking account is actually a
liability, not an asset. So when you put money into your checking account, the bank debits
their cash account increasing their assets and they credit your checking account increasing
their liability owed to you. So debits and credits are never backward. The next thing you should know
is the difference between the cash method and the accrual method of accounting. The cash method says
that revenue is recognized when cash is received and expenses are recorded when cash is paid out.
It's nice and simple but there is a major flaw with the cash method. It can be extremely difficult to
measure your profit. This is because revenue and related expenses are often recorded in
separate accounting periods. The solution is to use the accrual method of accounting. The accrual
method says that revenue should be recognized as it's earned, and expenses should be recorded
as they are incurred. Not when cash changes hands. The accrual method is a must for all
big businesses. This is because they usually have to follow IFRS or GAAP. Either the international
financial reporting standards or a variation of the generally accepted accounting principles.
Both of these rulebooks require you to use the accrual method of accounting. Why is that?
For one, the accrual method applies the revenue recognition principle. The revenue recognition
principle says that revenue should always be recognized as it's earned, not when cash is
received. This means a business records its revenue when the substance of a transaction takes place. At
the moment they deliver a product or a service. It doesn't matter when they receive the cash.
The accrual method also applies the matching principle. The matching principle says that
revenue, and all expenses incurred in order to generate that revenue need to be recorded in
the same accounting period. It aligns revenue and related expenses so you can measure profit
accurately. Now that we've got all of that out of the way, how do we actually record transactions?
We use journal entries. A journal entry is a record of a financial transaction.
It looks like this. We have the journal number which is unique to the journal, a short description
explaining what the transaction is. We have a posting date, the names of the accounts that we're
posting to and the amounts. Debits go on the left and credits go on the right. Always remember that
total debits must equal total credits. Because every journal entry has to balance. When our
journal's prepped and ready to go, we post it. Each side hits a different account. If we jump back to
our definition of financial accounting, then this is how we summarize a business's transactions. We
group similar transactions together and store them in accounts. When we present an account
this way we call it a t-account because it looks like a "T". The general ledger is the 24th thing that
you should know about accounting. It's a database that stores complete record of all accounts and
journal entries. We have a t-account representing every account and each one contains every journal
entry ever posted to it. If we take all of these accounts and pop them in a list, then we have a
business's chart of accounts. This is a structured summary of every account used by a business.
They tend to be arranged by type so we have assets liabilities, equity, revenue and expenses. Each
account has a description and we often give each one a unique code to help us identify it. If we pop
the numbers back in, then we have a trial balance. This is an accounting report showing the balances
in every business account at a point in time. As always debits go on the left and credits go on
the right. The total of the debit column must match the total of the credit column because the trial
balance must balance. At the end of each accounting period we analyze the balances of every account
in the trial balance and then we post adjusting entries to make sure that all of the transactions
align with the accrual method of accounting. So that revenue is recognized as it's earned
and expenses are recorded as they are incurred. Once the adjusting entries have been posted
we're ready to make financial statements. Financial statements are accounting reports that outline the
financial activities of a business over a period of time. They give us insight into its Financial
Health and help investors, lenders and creditors make informed decisions. There are three main
financial statements. First we have the balance sheet, also known as the statement of financial
position. The balance sheet takes the figures from every account in the trial balance and gives us a
snapshot of a business's assets, liabilities and equity at a single point in time. Does this ring
a bell? If we head back to our expanded accounting equation and we can see that the balance sheet
represents this top line. You could think of it as a snapshot of the accounting equation at a point
in time. Assets equal liabilities plus equity. Another important financial statement is the
income statement or statement of profit and loss. P&L for short. We can build an income statement
using the revenue and expense numbers from the trial balance. The income statement summarizes a
business's revenues and expenses over a period of time. You'll notice that on the bottom line we have
profit for the current year which we can measure accurately using the accrual method of accounting
by recording revenue as it's earned and expenses as they are incurred. Which brings me on to the 31st
thing you should know about accounting. The link between the income statement and the balance sheet.
Current year profit slots in right here on the bottom line of the expanded accounting equation.
This means that the income statement and the balance sheet are inherently linked to one another
through current year profit which rolls up into retained earnings or profits held for future use
which makes up part of equity. The owner's claim on the net assets of the business. But don't go
anywhere yet. There's one more financial statement you should know about. The cash flow statement.
The cash flow statement summarizes a business's cash inflows and outflows over a period of time. When
using the cash method of accounting a separate cash flow statement isn't required, because it's
equivalent to an income statement. But when we're accrual accounting, the cash flow statement and the
income statement are two very different beasts. This is because revenue is recorded when it's earned
not when cash is received and expenses are recorded as they are incurred not when
cash is paid out. So the income statement measures profit and the cash flow statement measures cash
flow. So there you go. 32 things you should know about accounting. Did I miss anything?
If so, please let me know down in the comments and I'll see you next time. Thanks for watching!