ACCOUNTING BASICS: a Guide to (Almost) Everything

Summary

This script introduces financial accounting as a process that involves identifying, recording, summarizing, and analyzing financial transactions to report them in financial statements. It uses the metaphor of a tree with various branches to describe the different types of accounting. The video follows the journey of Ruff Times, a tabloid newspaper, to explain key concepts such as double-entry accounting, the accounting equation, and the importance of adhering to the accrual method. It outlines the steps from journal entries to creating financial statements, including the balance sheet, income statement, and cash flow statement, and concludes with the accounting cycle's role in reflecting a business's financial health.

Takeaways

• 🌳 Accounting is an ancient practice with various branches, including financial, managerial, tax, audit, and bookkeeping.
• 📈 Financial accounting involves identifying, recording, summarizing, and analyzing an entity's financial transactions for reporting purposes.
• 👋 James explains financial accounting in a simplified manner over a 10-minute video, aiming to provide a clear understanding of the topic.
• 📚 The accounting equation (Assets = Liabilities + Equity) is the foundation of double-entry accounting and ensures that transactions always balance.
• 📝 Journal entries are the first step in recording financial transactions, consisting of a journal number, date, description, and debits/credits.
• 💼 Double-entry accounting requires that every transaction affects at least two accounts, with equal total debits and credits.
• 📋 The general ledger is a central database that stores all financial data, including accounts and journal entries, often managed through accounting software.
• 🔄 Adjusting entries are made at the end of a financial year to align financial records with the accrual method of accounting.
• 📊 Financial statements, including the balance sheet, income statement, and cash flow statement, summarize a business's financial activities and health.
• 🔄 The accounting cycle is a series of steps that include identifying transactions, recording them, and preparing financial statements for the next accounting period.

Q & A

What is the primary purpose of financial accounting?

The primary purpose of financial accounting is to identify, record, summarize, and analyze an entity's financial transactions and report them in financial statements.

What are the main branches of accounting mentioned in the script?

The main branches of accounting mentioned are financial accounting, managerial accounting, tax accounting, audit, and bookkeeping.

What is the accounting equation?

The accounting equation is Assets = Liabilities + Equity, which represents the fundamental principle that a business's assets are equal to its liabilities and equity.

How does double-entry accounting work?

Double-entry accounting works on the principle that every transaction affects at least two accounts, with total debits equaling total credits, ensuring the accounting equation always balances.

What is the difference between cash accounting and accrual accounting?

Cash accounting recognizes revenue when cash is received and expenses when they are paid out. Accrual accounting recognizes revenue as it is earned and records expenses as they are incurred, providing a more accurate reflection of a business's financial performance.

What is an adjusting entry in accounting?

An adjusting entry is a journal entry made at the end of a financial period to ensure that revenues and expenses are recorded in the correct period, in accordance with the accrual method of accounting.

What are the three main financial statements?

The three main financial statements are the balance sheet, the income statement, and the cash flow statement.

What is a trial balance in accounting?

A trial balance is an internal report that summarizes the closing balances of all general ledger accounts, used to check for errors and ensure that debits and credits are in balance.

What is the purpose of closing entries in the accounting cycle?

Closing entries are used to clear out temporary accounts like revenues, expenses, and dividends, resetting them to zero and preparing the books for the next financial period.

Why is it important for businesses to follow the accrual method of accounting?

The accrual method of accounting is important because it provides a true and fair view of a business's financial health by recognizing revenues as they are earned and expenses as they are incurred, which is more accurate than cash accounting for financial reporting purposes.

Outlines

00:00

🌳 Introduction to Financial Accounting

This paragraph introduces the concept of financial accounting as a process involving the identification, recording, summarizing, and analysis of an entity's financial transactions, as reported in financial statements. It uses the analogy of a big tree with various branches, such as financial, managerial, tax, audit, and bookkeeping accounting. The focus is on financial accounting, and the video aims to explain its workings through a hypothetical business scenario involving a tabloid newspaper called Ruff Times. The narrative includes the importance of understanding the accounting equation and the principles of double-entry accounting.

05:00

📋 The Accounting Equation and Double-Entry

The paragraph delves into the accounting equation (Assets = Liabilities + Equity) and the concept of double-entry accounting. It explains how financial transactions are recorded in a journal entry, affecting at least two accounts with equal debits and credits. The distinction between assets, liabilities, and equity is clarified, along with the difference between cash accounting and accrual accounting. The example of Ruff Times' promotional subscription revenue is used to illustrate the recording of transactions and the use of T accounts to visualize account balances.

10:01

📊 Adjusting Entries and Financial Statements

This section discusses the importance of adjusting entries to align financial records with the accrual method of accounting. It explains how Ruff Times' cash accounting for subscription revenue needs to be adjusted to reflect revenue recognition over the period it is earned. The paragraph outlines the creation of an unadjusted trial balance, the posting of adjusting entries, and the resulting adjusted trial balance. It then describes the preparation of financial statements, including the balance sheet, income statement, and cash flow statement, which summarize a business's financial activities and health. The paragraph concludes with the necessity of closing entries to reset accounts for the next financial year.

Keywords

💡Accounting

Accounting is the process of systematically recording, summarizing, and analyzing financial transactions of a business. In the video, it is likened to a big tree with various branches such as financial, managerial, tax, audit, and bookkeeping accounting. The main focus is on financial accounting, which involves the creation of financial statements to report a company's financial health.

💡Financial Accounting

Financial accounting specifically refers to the branch of accounting that deals with the preparation of financial statements for external users, such as investors, creditors, and regulators. It is the process of identifying, recording, summarizing, and analyzing an entity's financial transactions. In the context of the video, it is used to explain how Ruff Times, a tabloid newspaper, would account for its annual subscriptions and other financial activities.

💡Double Entry Accounting

Double entry accounting is a method of bookkeeping where every transaction is recorded in at least two accounts, with equal debits and credits, ensuring that the accounting equation (Assets = Liabilities + Equity) remains balanced. This principle is fundamental to the video's explanation of how Ruff Times would record its financial transactions, such as the $40,000 in new subscriptions, by debiting cash and crediting subscription revenue.

💡General Ledger

The general ledger is a comprehensive record of all financial transactions of a business. It contains detailed accounts for assets, liabilities, equity, revenue, and expenses. In the video, it is described as a central database in accounting software where Ruff Times would post its journal entries, such as the cash inflow from subscriptions, to maintain a complete financial record.

💡Trial Balance

A trial balance is a report that lists all the accounts of a business and their balances, used to check for errors and to ensure that the total debits and credits are equal. In the video, it is used to summarize the closing numbers in Ruff Times' general ledger accounts before creating financial statements, and it is adjusted to reflect the accrual method of accounting.

💡Accrual Method

The accrual method of accounting is a system where revenues are recognized when they are earned and expenses are recorded when they are incurred, regardless of when cash is received or paid. This method provides a more accurate picture of a company's financial performance. In the video, Ruff Times initially uses cash accounting but adjusts to the accrual method by creating deferred revenue for the unearned portion of subscription revenue.

💡Deferred Revenue

Deferred revenue, also known as unearned revenue, is a liability account that represents revenue that has been received but not yet earned. It is used in the accrual method to adjust for revenue that will be recognized in future periods. In the video, Ruff Times creates a deferred revenue account to hold the portion of subscription revenue that corresponds to the months of service not yet provided.

💡Financial Statements

Financial statements are formal records of a business's financial activities, including the balance sheet, income statement, and cash flow statement. They provide external users with a summary of the company's financial health and performance. In the video, Ruff Times prepares these statements using the adjusted trial balance to report its financial position, performance, and cash flows to stakeholders.

💡Closing Entries

Closing entries are journal entries made at the end of an accounting period to reset temporary accounts like revenues and expenses to zero for the next accounting cycle. This process clears the accounts and transfers the balances to retained earnings. In the video, Ruff Times uses closing entries to prepare its books for the new financial year, ensuring that the revenue and expense accounts are ready for the next cycle.

💡Retained Earnings

Retained earnings represent the accumulated profits of a company that have not been distributed as dividends but are instead retained for future operations or investment. In the video, the balance of revenues and expenses after closing entries is transferred to retained earnings, reflecting Ruff Times' profits held for future use.

Highlights

Accounting is often associated with financial accounting, which involves identifying, recording, summarizing, and analyzing financial transactions.

Financial accounting is based on the accounting equation: Assets = Liabilities + Equity.

Double-entry accounting is a method where every transaction affects at least two accounts, with total debits equaling total credits.

The accounting equation is the foundation of double-entry accounting, ensuring that every transaction has two equal and opposite sides.

In the example of Ruff Times, a $40,000 cash inflow from new subscriptions is recorded as both an increase in cash (an asset) and subscription revenue (income).

Journal entries are posted to the general ledger, which serves as a central database for all financial data.

T accounts are used to visualize the effects of transactions on specific accounts, with debits on the left and credits on the right.

A trial balance is an internal report summarizing the closing balances of all ledger accounts, used to check for errors and prepare financial statements.

Adjusting entries are made to align the books with the accrual method of accounting, which recognizes revenue as it is earned and expenses as they are incurred.

Deferred revenue or unearned revenue accounts are used to temporarily hold revenue that has been received but not yet earned.

Financial statements, including the balance sheet, income statement, and cash flow statement, are created from the adjusted trial balance.

The balance sheet provides a snapshot of the business's financial position at a specific point in time.

The income statement summarizes the business's revenues and expenses over a period, reflecting financial performance and profitability.

The cash flow statement tracks cash inflows and outflows, separate from profit, which is crucial for liquidity management.

Closing entries are made to clear temporary accounts and prepare the books for the next financial year.

The accounting cycle is the process that encompasses all these steps, ensuring accurate financial reporting for businesses.

Transcripts

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

and thank you for subscribing We've now hit a hundred thousand

subscribers on this channel which is mental

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