Accounting System Essentials: Key Concepts and Principles

Posted on Feb 12, 2025 in Accounting and Finance

Accounting System Activities

The three main activities of an accounting system are identifying, recording, and communicating financial information.

Bookkeeping vs. Accounting

Bookkeeping usually involves only the recording of economic events. Accounting, however, encompasses the entire process of identifying, recording, and communicating these events.

Users of Accounting Information

Accounting information is used both internally and externally:

  • Internal Users: Marketing, finance, HR, and management
  • External Users: IRS, investors, labor unions, creditors, SEC, and customers

Key Accounting Principles and Bodies

  • GAAP (Generally Accepted Accounting Principles): These principles dictate how to report economic events in a generally accepted and universally practiced manner.
  • Account: A record of increases and decreases in a specific asset, liability, equity, revenue, or expense item.
  • FASB (Financial Accounting Standards Board): The primary accounting standard-setting body in the United States.
  • SEC (Securities and Exchange Commission): The U.S. government agency that oversees U.S. financial markets and accounting standard-setting bodies.
  • IASB (International Accounting Standards Board): The body whose accounting standards are adopted by countries outside the U.S.

The Accounting Equation

Assets = Liabilities + Equity – Drawings + Revenue – Expenses

Core Accounting Elements

  • Assets: Resources a business owns.
  • Liabilities: Claims against assets.
  • Transaction: A business’s economic events recorded by accountants.

Financial Statements

  • Balance Sheet: Reports the assets, liabilities, and stockholders’ equity of a company at a specific date.
  • Statement of Cash Flows: Summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.

Common Accounts

Examples of common accounts include cash, accounts receivable, accounts payable, service revenue, salaries and wages, and expenses.

Double-Entry Accounting

A system that records the dual effect of each transaction in appropriate accounts.

Accounting Records

  • Journal: The book of original entry for each transaction.
  • General Ledger: Contains all asset, liability, and stockholders’ equity accounts.
  • Chart of Accounts: Lists the accounts and their numbers, identifying their location in the ledger.
  • Trial Balance: A list of accounts and their balances at a given time.

Depreciation and Contra Accounts

  • Depreciation: The process of allocating the cost of an asset to expense over its useful life.
  • Contra Accounts: An account offset against an asset account on the balance sheet.

Adjusting Entries and Balances

  • Adjusted Trial Balance: A list of accounts and their balances after all adjustments have been made.
  • Adjusting Entries: Entries made at the end of an accounting period to ensure that companies follow revenue and expense recognition principles.

Accrual vs. Cash Basis Accounting

  • Accrual Accounting: Transactions are recorded when they change a company’s financial statements, regardless of when cash changes hands.
  • Accrual Expenses: Expenses incurred but not yet paid in cash or recorded.
  • Accrual Revenues: Revenues for services performed but not yet received in cash or recorded.
  • Deferrals: Adjusting entries for prepaid expenses or unearned revenue.
  • Cash Basis Accounting: Revenue is recorded when cash is received, and expenses are recorded when cash is paid.

Closing and Reversing Entries

  • Closing Entries: Entries made at the end of an accounting period to transfer temporary account balances to permanent stockholders’ equity accounts (retained earnings).
  • Reversing Entry: An optional bookkeeping procedure, not a required step in the accounting cycle.
  • Income Summary: Closes revenue and expense accounts; debit and credit indicate net loss and net income, respectively.

Forms of Business Ownership

Common forms include proprietorship, partnership, corporation, and LLC.

  • Proprietorship: Owned by one person who receives all profits and losses and has unlimited liability for all debts.
  • Partnership: Two or more individuals with unlimited liability.
  • Corporation: Divided into shares of stock with limited liability.

Net Income vs. Net Loss

  • Net Income: Occurs when revenue exceeds expenses.
  • Net Loss: Occurs when expenses exceed revenue.

The Accounting Cycle (9 Steps)

  1. Analyze transactions
  2. Journalize transactions
  3. Post to ledger accounts
  4. Prepare a trial balance
  5. Journalize and post adjusting entries
  6. Prepare an adjusted trial balance
  7. Prepare financial statements
  8. Journalize and post closing entries
  9. Prepare a post-closing trial balance

Debits and Credits

  • Debit: Indicates the left side of an account. Asset accounts typically show debit balances. DEAD – Debits Expenses Assets Dividends
  • Credit: Indicates the right side of an account. Liability accounts typically show credit balances. CLER – Credits Liabilities Equity Revenue
  • Common stock and retained earnings increase with credits and decrease with debits.

Revenue Recognition Principle

Recognize revenue in the accounting period when it is earned.

Classified Balance Sheet

Assets are classified as current assets, long-term investments, property, plant, and equipment, and intangible assets.

Time Period Assumption

Divides the economic life of a business into artificial time periods.

Types of Adjusting Entries

Deferrals (prepaid expenses, unearned revenues) and accruals.