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 10 minutes or so and you'll see exactly how financial accounting works. We've got a lot to 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're in rough 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. Rough 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 fulfill in the future.
And equity, when rough 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 revolutionized 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 represent 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 rough 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 but that's okay just give it some time and let it all seep in. After this you can always jump into my Accounting Basics playlist and explore everything I mention in a lot more detail. I'll drop a link to that down below in the description. just below that big red subscribe button. Don't know what 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 are places where you record, sort and store all transactions that affect a related group of items. Broadly speaking, there are six types of accounts.
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 Ts and labeling them. Cash and Subscription Revenue These are called T-Accounts and they help us visualize 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 Rough 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 summarizes 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 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 adjustments. 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 recognize 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 Rough times hasn't been playing by the rules. In March, you ran a promotion for annual subscription starting on April 1st. You collected $40,000 in cash and posted a journal to recognize 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 recognize 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 12 months. This is when you do the work. This is when you release each issue of Rough Times.
So today, as things stand on December 31st, you've recognized 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 three 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 rough times from January to March. Let's post this one to your general ledger and run ourselves a new adjusted trial balance. This time it's 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.
Let's see what happens. Your debit and credit totals still match each other because they were two equal and opposite size 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 summarize your business's activities over a period of time. These are external reports designed to give your investors, lenders, and creditors 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 summarizes 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 flows separately in a cash flow statement.
This report summarizes 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 rough 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 analyze your statements using financial ratios which is something that we haven't covered on this channel yet So if you'd like to 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 rough times your journal would look something like this You'd debit your revenue accounts and you'd credit 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, summarizing, and analyzing your business's financial transactions and reporting them in financial statements.
Shout out to Manesh 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 100,000 subscribers on this channel, which is mental. If you'd like to support this channel, then you're welcome to buy my cheat sheets.
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