How accounting works

This article is for beginners of accounting				Account H Operating expenses – Shows
profession who just started their long way and				cumulatively how much Expenses Company
already struggling to understand the basics. The				incurred to run it’s main business for period of
starting point of almost any accounting course is				time.
an explanation of the double-entry bookkeeping				Account I Interest expense – Shows the
system which then stands as a core of any				amount of interest paid to Bank for the period of
further studies. If you did not clearly understand				time.
how it works in the beginning the effect of				Let’s now get back to our transaction when
further education will be zero.				Company sold the goods for 5 dollars on credit. It
I’ll try to illustrate the basics of accounting in				resulted in increasing of Account B and decreasing
the simplest possible way, avoiding in the beginning				of Account F. Let’s see why. Account B
the use of such confusing terms like assets,				showing us an amount receivable from customers
liabilities, debits and credits, etc.				and since we sold goods on credit this amount
Let’s start:				should increase from 9 to 14. On the other hand
Assume we have some Company X, which was				by selling goods we earned a revenue which must
established a year ago and now we are at the				be reflected on Revenue account. Before the
year-end, trying to draft accounts of Company.				transaction Revenue balance was -5, showing us
All we can guess from the ‘accounting’				that we earned 5 dollars so far – negative
word itself, that it is a bunch of accounts. Great!				sign should be ignored, as it’s used only for
That would be a starting point for us. Let’s				the purpose of getting equality. Surely by selling
put down some accounts on a paper (if				more at the amount of 5 dollars, we should
you’re reading this article on your PC, it’s				increase our Revenue to make it 10. However
advised to do the below manipulations in Excel				because of the negative sign in place,
spreadsheet):				mathematically we decrease the -5 and it
Account A				becomes -10.
Account B				Let’s take another example. Company pays 3
Account C				USD rental for the office in cash. Consequently
Account D				we should decrease Account A (Cash) by 5 and
Account E				increase Account H (Operating expenses) by 5.
Account F				Now, when we understand how double entries
Account G				work, let’s see how these accounts form
Account H				financial statements which are usually the ultimate
Account I				purpose of any accounting. For that purpose
What you see above is just a list until we put				we’ll allocate our accounts to certain groups:
some values opposite every account. The only				Assets, Liabilities, Equity, Incomes and
point to bear in mind is that overall total of listed				Expenditures. Accounts A (Cash) and B
values should eventually be equal to 0:				(Receivables) will form Assets of the Company.
Account A 12				Assets are what Company actually possess(e.g.
Account B 9				Cash) or suppose to possess (e.g. Receivables).
Account C -4				Next group is Liabilities. That’s what Company
Account D -8				owes to suppliers, banks, other partners. In our
Account E -13				case Liability group will include: Accounts C
Account F -5				(Payables) and D (Borrowings). Another group is
Account G -7				Equity, which comprises of accounts showing how
Account H 6				much Company owes to its shareholders. Also
Account I 10				this group can be called share capital. All 3 above
Total = 0				– Assets, Liabilities and Equity eventually
Coming back to accounting, each value above is				constitute Balance Sheet of the Company. Balance
called an Account balance. List itself is usually called				sheet accounts are always showing information as
a Trial balance. Let’s assume that these				of particular date. E.g. if Cash account balance
account balances were actual ones for our				equal to 3, it means that as of present moment
Company X at the year-end.				Company has 3 USD of cash in hand.
Now it’s time to understand how the				Other groups are Incomes and Expenditures.
double-entry system actually works. Basically the				Income or revenue accounts reflect all incoming
purpose of the double-entry system is to reflect				money that Company earn from its activities. E.g.
transactions that Company was involved into. Not				for supermarket it would be revenue from goods
going deep into details let’s imagine that				sold, for bank - interest income, etc. Expenditures
Company X made a credit sale on the first day				reflect amounts expended to maintain business.
of current year amounted to 5 dollars. The effect				Main point to remember about Income and
on our accounts will be the following:				Expenditure accounts is that they are always
Before				showing us amounts earned or expended FOR
Entry Aftertransaction				the period of time (usually year to date). E.g. if
				Revenue account balance equals to 500 USD as
transaction				at March 31 it usually means that Company made
Account A				sales totaling to 500 USD since the beginning of
� 12				year up to date.
Account B				Let’s now draft financial statements out of
9				Trial Balance we have above. They will look like
5 14				this:
Account C -4				Balance Sheet
				Assets
-4				A Cash
Account D				12
� -8				B
Account E -13				� 14
				Total
-1				� 26
Account F -5				Liabilities
				C
-5 -10				� -4
Account G -7				D Borrowings
				-8
-7				Total Liabilities -12
Account H				Equity
� 6				E Share capital 13
Account I				Current year’s profit
� 10				-1
Total 0 0				Total
Above sample illustrates the main principle of				Equity
accounting. So, every transaction, whatever the				-14
substance of it, simultaneously increase one				Total Liabilities and Equity -26
account and decrease the another. In our case				Income Statement
Account B that was increased by 5 and Account				F Revenue
F – decreased by 5. That’s why the Total				-10
of accounts equal to 0 remains unchanged.				G Other income
To make the example more practical let’s				-7
define what each account actually indicates and				Total
call these accounts respectively:				income
Account A Cash - The balance of this account				-17
shows how much cash our Company has in hand				H Operating expenses 6
at the moment.				I Interest
Account B Receivables – This account shows				expense 10
how much money our customers owe to us as				Total
at the moment.				expenses
Account C Payables – Shows the total				16
amount that we owe to our suppliers at the				Net Profit
moment.				-1
Account D Borrowings – Shows how much				Now we came to the last point – introduction
we are due on Bank loan at the moment.				of Debits and Credits. In above example we were
Account E Share capital – Shows how much				calling accounting entries like Increase of Account
money the Company owes to its Shareholder, i.e.				B and Decrease of Account F. However to
money invested into business by owners.				making life easier accountants use Debits and
Account F Revenue – This account shows				Credits to formulate accounting entries. There is
how much Company earned from its main				following rule:
activity for the period of time (usually year to				- Assets and Expenses accounts increase by
date).				debit and decrease by credit.
Account G Other income – This account				- Liabilities, Equity and Income accounts increase
shows any other revenues earned out of main				by credit and decrease by debit.
activities for the period of time.

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How accounting works

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