Accounting Basics for Business How To

Accounting Basics for Business: How To

Annette will help you understand the 10 key principles of accounting and she will cover each one of it. It is important for you to know the essence of these 10 principles, this is the foundation for all accounting work, in your annual accounts, income statements, profit and loss account, balance, etc. Also, she will share 8 steps on how accounting works in reality called the Accounting cycle.

Highlights of this episode:l

  • What is financial accounting?
  • Deeper understanding about the 10 principles of accounting?
  • What is Double Entry Bookkeeping or Bookkeeping?
  • Why is double-entry bookkeeping important?
  • What are Financial Statements?
  • 8 Steps on how accounting really works in reality or Accounting Cycle

Resources:

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Have you ever wondered what all those numbers in your business books mean? In this podcast I will talk about the basics of accounting. Enjoy listening, I am Anneete Ferguson, a chartered accountant and certified Profit First professional and I am CEO of Annette and CO, a UK based accounting firm. 

What is the purpose of Financial Accounting?

So what is the purpose of financial accounting? The main purpose of financial accounting is to report the financial performance of business. It provides information to external parties such as investors, creditors and tax authorities. It can also overlap with management reporting when it is used to make internal business decisions. 

The 10 Key Principles to Accounting

There are 10 key principles to accounting and I will cover each one in turn.

1. Economic Entity Principle.

This principle says that the business is a separate entity to the individual and so the activities of the business must be kept separate from those financial activities of the business owners. 

2. Monetary Unit Principle

States that in the accounts only one unit of currency is used and in the UK, that unit is required to be GBP, Great British Pounds. We also ignore inflation when we are preparing the accounts. 

3. Time Principle

This says that activities must be recorded in distinct short time intervals, be that weeks, months, quarters or calendar or fiscal year. That time interval needs to be identified in the headings to the reports of the balance sheet, the profit and loss account, cash flow statement and shareholders equity statements.

4. Cost Principle

The cost principle mentions the historic cost of an item. This refers to the cash or cash equivalent value that was paid to purchase an item and the historic cost must be reported in the financial statement.

5. Full Disclosure Principle 

This says that all information relating to the business that is important to a lender or investor must be disclosed in the financial statements of the business. This is sometimes why you see for some businesses, lots and lots of notes supporting the accounts to fully disclose, to be compliant with the full disclosure principle.

6. Going Concern Principle

This is an accounting principle that refers to the intent of the business to carry on its operations and commitments for the foreseeable future and not to liquidate the business.

7. Matching Principle. 

The matching principle states that when income is incurred, the expenses that are associated with that income must be reported in the same period that the income is reported, hence matching the income and expenses to the same time period. You can use this using the accrual method of accounting, that is how we get those two things together in the same period.

8. Revenue Recognition Principle

States that revenues must be entered into the ledger entered into the accounts in the period and in which the revenue is incurred.

9. Materiality Principle

This refers to the misstatement in accounting records when the amount is insignificant or deemed to be immaterial. Basically, the materiality principle is the reason why we often see financial statements rounded to the nearest pound, and not showing pounds and pence.

10. Conservatism Principle

That conservatism principle basically says that if you're unsure whether you should include something in the accounts, then you should probably include it.  

These 10 principles are the foundation for all accounting work in your annual accounts, in your income statements, your profit and loss account, your balance sheet, your cash statements, they are all underpinned by these 10 principles. And whilst these 10 principles underpin everything that we do in accounting, what they don't tell us is how you actually do it. So that's what I'm going to explain to you now. 

8 steps that explains how accounting works 

Step 1, identify the transactions.  What is the difference between bookkeeping and accounting?

There are eight steps that we are going to look at together to explain how accounting actually works in reality.  Step one, identify the transactions. So in identifying the transactions, we really need to be clear on where bookkeeping and accounting meet each other, so where one stops and the other begins. Bookkeeping is the activity of keeping records of the financial affairs of the business. So in basic terms, bookkeeping is in, amongst the weeds of the transactions.

Accounting then takes that data and layers up on top of it. That means that accounting starts where bookkeeping leaves off. And that is why both accounting and bookkeeping are absolute fundamentals for the financial recording and reporting in a business. It also means that if bookkeeping is done incorrectly, then it creates a big problem on the accounting side. So making sure that someone in your business that is competent is doing the bookkeeping is just as important as having a competent accountant and tax preparer. 

Step 2, record journal entries and post ledger entry. 

Step two, record journal entries and post ledger entries. So what is a journal entry? A journal entry is the record of a business transaction in the accounting books of the business. A properly documented journal entry consists of the correct date, amounts to be debited and credited. Don't worry, I'll cover what that means shortly. A description of the transaction and a unique reference number.

A journal entry is usually the first thing that an accountant will do that actually impacts the numbers and the finances in your bookkeeping system and from your bookkeeping records. The journal entry has two sides, we use a double entry bookkeeping system. And again, don't worry if that confuses you, we'll be covering a bit more about that. But every financial transaction impacts at least two accounts. So one side will be debited and the other side will be credited. This means that a journal entry always has an equal debit and a credit. 

Step 3, double entry accounting

So what is double entry accounting, or bookkeeping? Double entry bookkeeping is an accounting method where the transaction is equally recorded in two or more accounts, a debit is made to at least one account and a credit is made to at least one other account. The total debits and credits must balance. That means if on one side you have a debit of, say 1000 pounds, the credit side must add up to a total of 1000 pounds as well, they must always equal each other.

Now you may have a situation where you have multiple debits and one credit or multiple credits and one debit or multiples of both. But you need to make sure that they both match each other. In most pieces of software, you will find that the transaction will not be able to be entered into the software unless they equal each other,  it will give you an error when you try and process it.

So as we know at this stage, the bookkeeping has been done by the bookkeeper. And examples of typical journal entries, that accountant might enter in, maybe, for example, depreciation, where they're writing down the value of the assets on an annual basis in the accounts of the business. 

Discussing double entry bookkeeping or double entry accounting also leads us to the accounting equation. The accounting equation, which states that the assets of the business equal the liabilities plus the equity. What that means is that the value of things that the business owns is equal to the value of things that the business owes.

Now, I do have another video on this on my channel. So do make sure you check that out if you want to know more information about that and the accounting equation, and we will also put a link to that in the description of this video. So back to double entry bookkeeping, or double entry accounting. Now, the vast majority of software nowadays uses a double entry system. If you are using the few pieces of software that don't use double entry, then please just stop.

All you're doing is wasting your own time, your accountant will have to go back and redo everything you do anyway, so you may as well not bother. If you're going to use a piece of software to do your bookkeeping, please choose one that has a double entry. Things like Xero and QuickBooks all have double entry systems because they are the absolute core of what needs to happen to keep correct and accurate books and records for business. And like I mentioned, in these pieces of accounting software, it will always make sure that your journals have equal debits and credits.

And there's usually a function in the software for you to enter journal entries or your accountant to enter them as part of this process. So this is where it gets a little bit technical in the weeds of debits and credits. 

What are debits and credits?

So debits are an increase in an asset account, or a decrease in an equity or liability account. A debit is also a decrease in revenue, or an increase in an expense account. And a credit is a decrease in an asset account, or increase in equity or liability accounts, an increase in revenue, a decrease in expense accounts. So, for example, what happens in your software, when you enter a sale into it, is that, there is a credit to the income account of the amount of the sale, let's say it's 500 pounds. So we credit the income account 500 pounds, and the cash goes into the bank. So we debit the asset account of the bank by 500 pounds. That is your debits and credits for that transaction. So you can see the debits and the credits always equal each other. They're always both that exist. 

Why is double entry important?

So why is double entry important? Well, in short, it delivers a complete financial picture of a business. And that is of course, why it's required for Companies' House and HMRC for your legally required financial statements. But small businesses can use double entry bookkeeping as a way to better monitor the financial health of a company and the rate at which the company is growing.

In fact, a double entry system really is essential to any company that has really more than one employee, or maybe has inventory. And to be honest, I actually can't think of any situation that I would ever recommend someone not to keep a double entry bookkeeping system all the time in their business. Other important reasons to have a double entry bookkeeping system are, it helps make better financial decisions.

The double entry bookkeeping financial statements tell a full picture of the business's profitability, of its value, how financially strong the business is, as well. It also helps reduce errors when you generate a balance sheet using double entry bookkeeping.  Your liabilities and equity must equal the assets. It's not possible under double entry for these things to go wrong. The double entry system is also a more generally transparent way to keep your books and records and keep businesses accountable.

So it's preferred by investors, by banks and by purchases, purchasers of your business as well. So hopefully you understand the absolute importance of having a double entry bookkeeping system in your business, so that the starting point for producing your accounts is accurate. And then your accountant can go in and make adjustments. 

Step 4, the unadjusted trial balance stage. (What purpose does the trial balance actually serve?)

And that takes us to step four, which is called the unadjusted trial balance stage. So what is a trial balance? You may have not even seen what a trial balance looks like, but a trial balance lists the closing balances of all, what we call the general ledger accounts in the business. So all the income accounts, all the expenses accounts, assets accounts, liability accounts and equity. It basically puts them in a big list, and then it has the debits and credit balances beside that big list.

It's usually run at the end of an accounting period to detect any, perhaps posting errors or mathematical errors within the business's bookkeeping system. So what purpose does the trial balance actually serve? Well it is often the first step towards interpreting the financial results of a business. If you are doing bookkeeping within a bookkeeping package that does double entry, you should be able to run a report that shows you what the trial balance looks like for your business. 

Step 5, adjusting entries.  (Why do we need generally accepted accounting principles and International Accounting Standards?) 

So next we have step five, adjusting entries. To make the financial statements compliance with accounting frameworks and things like generally accepted accounting principles, International Accounting Standards, there are entries that are required to be made. These entries typically include things like accrued income, accrued expenses, unearned revenue and prepaid expenses.

So why do we need generally accepted accounting principles and International Accounting Standards? This is so that companies are reporting under the same framework under the same rules. And we don't end up with a situation where businesses can hide things and pick and choose what they report publicly to investors to banks, and whatever institution requires their accounts. In your annual accounts, it will state which regulations that have been complied with, when the accounts are prepared. 

Step 6, adjusted trial balance.

And that leads us on to step six, which is the adjusted trial balance. The adjusted trial balance is basically the trial balance plus the adjusting entries. Now, in days gone by when we used to do these things by hand, on paper, or even in Excel before the computer programs were as good as they are now, we used to have listed out the original trial balance, and then all the adjusting entries would be in two more columns, the debits and the credits, and then you would have the adjusted trial balance being shown. Now some software can do this, but others can't. But ultimately, the adjusted trial balance is the trial balance that exists post these adjustments that are made to comply with accounting standards and regulations. 

Step 7, producing the financial statements.  (What are financial statements?)

And Step seven is where we get to producing the financial statements. So what are financial statements? The financial statements of a business are the summary of the company's financial performance over a certain reporting period, and financial statements are important because they contain significant information about the financial health and activities of a business. Financial statements help companies to make informed decisions. They highlight which areas the company has provided the best return on investment for and they are also important for companies to file with Companies House and to submit as part of their tax submissions for HMRC. 

The 3 types of reports that make up the financial statements.

There are three types of reports that make up the financial statements. Firstly, the balance sheet. Secondly, income statement also known as the profit and loss account, and third, the statement of cash flows.

The balance sheet is a snapshot in time of the business's assets, liabilities and equities. It basically shows the value of things that the business owns and the value of things that the business owes. That means it gives a good indication of the company's financial condition. If the balance sheet is negative, if the totals add up to a negative number, that means the business is technically insolvent.

The income statement is also known as the profit and loss or the profit and loss account. This provides information about the income and expenditure of the business over a specified time period. So the financial statements might be drawn out for a quarter or a year, in which case the profit and loss account will cover that time period. That is different to the balance sheet, which like I mentioned, is a snapshot in time.

So the assets and liabilities and equity in the balance sheet are shown as at a specific date, whereas the profit and loss account is a span of time. And finally, the statement of cash flows is the third financial statement. It provides details of how the company has used cash and produced cash over a set period of time.

Financial statements contain significant information about a company's financial health. They can also help companies to decide whether to invest or not. Financial statements help companies make informed economic decisions. They are not just something that is produced nine months after the year end for the taxman. 

Step 8, post closing entries.

Our final step, step eight is to post closing entries. Closing Entries, basically transfer the balances from the profit and loss accounts, into the retained earnings account in the balance sheet. If you're using online bookkeeping software or even desktop bookkeeping software, typically this is done automatically. In certain pieces of software, you have to run what is called a year end close out, but nowadays, most of those online softwares, they will automatically do this process for you. But if you're doing your accounts manually on paper or with spreadsheets, or you have an old school accounting package, then you may need to do this manually yourself and do the transfers manually via journal entry.  

Closing 

The steps I've just discussed with you are called the accounting cycle. They are done whenever accounts are produced, and this can be monthly, quarterly annually, depending on the reporting requirements of a business. At the very least, this is done annually for tax return submissions and annual accounts submissions. If you are struggling with accounting for your business, I would love to help you. Do reach out to me at YT@annetteandco.co.uk and let me know how I can help. 

Thank you so much for tuning in today. I hope you got lots of value from this episode. Now if you're struggling with any accounting things for your business, I'd love to help.  Make sure you reach out to me at podcast at annette and co dot co dot uk, that's podcast@annetteandco.co.uk  and let me know how I can help. Of course, remember to subscribe to this podcast as well. Thanks again.

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About the Author

Owner of Annette & Co. - Chartered Accountants & Certified Profit First Professionals. Helping online service-based entrepreneurs find clarity in their numbers, increase wealth and have more money in their pockets.

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