Accounting is a vast area of study and seems to get more complicated every day. While most people will never require an in-depth understanding of accounting methodologies and practices, understanding basic accounting concepts gives the average person an advantage when making decisions concerning investments.
There are three common methods of accounting: cash, accrual and modified. Cash accounting means you record income when you receive payment and expenses when you pay for them. Accrual accounting means you record income when you earn it and expenses when you incur the expense. Modified accounting is any combination of cash and accrual.
The Accounting Year
Accounting is reported on a calendar year or fiscal year basis. A calendar year is Jan. 1 through Dec. 31 of any year. A fiscal year begins with whatever date the company elects. For certain types of business a calendar year does not accurately reflect a complete 12-month cycle of income and expense so a fiscal year provides a better picture of annual performance. For example, a professional football team might elect a fiscal year that starts in August and ends in July in order to report on the revenue and cost of a single football season.
The Balance Sheet
A balance sheet is a financial statement that lists all assets, liabilities and owner’s equity for a company. The balance sheet reflects the universal accounting equation of “Assets equals Liabilities plus Owner’s Equity.” (see reference 1) Assets include items such as checking accounts, inventory, office furniture and accounts receivable. Liabilities include items such as operating accounts payable, mortgage notes payable and payroll taxes payable. Owner’s equity includes any money the owner invests in the business and the net income or loss of the business to date.
The Income Statement
An income statement lists a detail of all forms of income and expense for a specific time period. Expenses are usually further broken down into subsections such as office expense, payroll expense and marketing expense. The difference between income and expense is net income or net loss.
The General Ledger
The general ledger is a report that lists every item in a company’s chart of accounts and the transactions that post to that account. The chart of accounts includes every item found on the balance sheet and income statement, making a general ledger a comprehensive, detailed backup for every number on the financial statements.