Explanation of Basic Accounting Concepts
Accounting tracks not only individual transactions but also the effect these transactions have on a company's overall financial strength. Companies requiring more than the very simplest picture usually use double-entry bookkeeping, which lists each transaction twice to represent what a company has gained and lost in the transaction.
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Purpose
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Many people asked to explain the purpose of accounting would say it is to keep track of the money that moves into and out of a company's accounts. In principle this is true, but the ultimate aim is to be able to assess a company's overall financial health in terms of the money it has, the money it is owed and the money it owes. A set of accounts does not merely show the transactions but also the overall effect that the transactions have had on a company's financial health.
Concept
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The key to accounts is a simple equation: Assets = Liabilities + Owner's Equity. Assets are everything a company owns that has value, which can include cash, money tied up in investments, physical assets such as machinery, land and buildings, and money owed by customers. Liabilities are all the financial obligations a company has, such as outstanding loans, unpaid tax bills and money owed to suppliers. Owner's equity is effectively the value the company has to the owner. In theory it is the money that would be left over if the company ceased trading, settled its liabilities and liquidated its assets (turned them into cash, for example, by selling them.)
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Systems
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The simplest version of accounting is known as single-entry bookkeeping. This consists of nothing more than the details of all the money that a company receives or spends. While this is easy to carry out, it does not give an easy record of assets and liabilities. This makes it unsuitable for a company, where it is important to know the owner's equity, for example, in a partnership or a publicly owned company.
The more complicated system is double-entry bookkeeping. This works by recognizing that every transaction is an exchange. For example, buying a machine means money goes out of the company but an asset comes into the company. Selling a product means merchandise goes out of the company but cash comes into the company. The system works by listing every transaction twice in the accounts, once to represent the company's "gain" and once to represent its "loss." These two listings are known as a debit and a credit, though these are purely accounting terms, with no positive or negative connotations; indeed, the terms are usually applied to transactions in a way that seems counter-intuitive to non-accountants.
Benefits
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Double-entry bookkeeping makes keeping track of the figures easier in two ways. First, it records every transaction's effects on both the assets and liabilities totals. Second, it gives an easy way to check for errors: At any stage of the accounts, the figures in the debit and credit listings should add up to the same totals. If they do not, it is clear that either a listing or arithmetical error has been made.
Technology
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Most companies use automated computer accounting systems that avoid the need for mental arithmetic. Such systems usually allow the accountant to carry out double-entry bookkeeping but only input one entry per transaction: The system lists both the debit and credit entries in the appropriate section of the accounts.
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