The Accounting Equation

• • • The Accounting Equation: This equation forms the bedrock of accounting. It states that Assets (resources owned) = Liabilities (debts owed) + Owner's Equity (owner's investment). Every transaction impacts at least two elements, maintaining a balanced equation. The Chart of Accounts: This is the organized list of all financial accounts used by a company. It categorizes accounts into assets, liabilities, equity, revenue, and expenses. Each account has a unique identifier for tracking purposes. Debits and Credits: These are the fundamental building blocks of journal entries. Debits represent increases in asset and expense accounts and decreases in liability and equity accounts. Credits represent the opposite. The Eight Steps of the Accounting Cycle Now, let's embark on a journey through the eight crucial steps of the accounting cycle: Step 1: Identifying Transactions The first step involves recognizing economic events that impact the company's finances. Examples include purchases, sales, payments received, and payments made. A keen eye for identifying these events is crucial for accurate recordkeeping. Step 2: Journalizing Transactions Once a transaction is identified, it's documented in a chronological record called the general journal. Each transaction is recorded as a journal entry, which includes the date, account titles affected (debited and credited), and the amount involved. Example: A company purchases office supplies for $500 on credit. Journal Entry: • • • • • Date: [Date of Purchase] Account Title | Debit | Credit -------------- | -------- | -------Office Supplies (Asset) | $500 | Accounts Payable (Liability) | | $500 Step 3: Posting to the General Ledger The general ledger is the heart of the accounting system. Each account from the chart of accounts has its own individual ledger account with space to record debits and credits for that specific account. The journal entries from step 2 are now transferred to their respective accounts in the general ledger. Continuing the Example: • • Office Supplies account: Opening balance = $0, Debit = $500, New balance = $500 Accounts Payable account: Opening balance = $0, Credit = $500, New balance = $500 Step 4: Preparing the Trial Balance After all transactions have been posted to the general ledger, a trial balance is prepared. This is a list of all accounts in the chart of accounts with their ending balances (debits - credits). The purpose of the trial balance is to ensure the total debits equal the total credits, verifying the mathematical accuracy of the accounting records. Continuing the Example (assuming additional transactions): Trial Balance: • • • • • • • • • Account Title | Debit | Credit -------------- | -------- | -------Cash | $1,000 | Accounts Receivable | $2,000 | Office Supplies | $500 | Accounts Payable | | $1,500 Sales Revenue | | $3,000 Rent Expense | $800 | Totals | $4,300 | $4,500 Step 5: Making Adjusting Entries The trial balance might not balance perfectly at this stage because some transactions might not be directly reflected in the general ledger yet. Adjusting entries are made to account for these situations. These entries typically involve: • • • • Accrued Revenue: Revenue earned but not yet received in cash. Accrued Expenses: Expenses incurred but not yet paid in cash. Prepaid Expenses: Expenses paid for in advance but not yet used. Depreciation: The allocation of the cost of an asset over its useful life.