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
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accounting cycle which we just went through or you can hit that join button below
and if you'd like to learn more about accounting then I recommend
starting right here Thanks for watching and
I'll see you in the next one!