14.3 Basic Accounting Procedures

Accounting Fundamentals

Accounting gives businesses a structured way to track where their money comes from, where it goes, and what's left. Without it, there's no reliable way to measure profit, manage debt, or plan for the future.

This section covers the accounting cycle (the step-by-step process for handling financial data), the difference between bookkeeping and accounting, and the accounting equation that ties everything together.

The Accounting Cycle

The accounting cycle is the repeating process a business follows to record, organize, and report its financial transactions over a set period (a month, a quarter, or a year). Every time the period ends, the cycle starts over.

There are six main steps:

1. Journalizing — Analyze each transaction and record it in a journal. This is the first written record of what happened (e.g., "Paid $500 for office supplies").
2. Posting to the ledger — Transfer journal entries into the ledger, which groups transactions by account (cash, rent, revenue, etc.). Think of the journal as a chronological diary and the ledger as a filing cabinet sorted by category.
3. Preparing an unadjusted trial balance — List every account and its balance to check that total debits equal total credits. If they don't match, something was recorded incorrectly.
4. Making adjusting entries — At the end of the period, record adjustments for things like expenses you've incurred but haven't paid yet (accruals) or payments you've received for services you haven't delivered yet (deferrals).
5. Preparing an adjusted trial balance — Redo the trial balance with the adjusting entries included. Debits and credits should still be equal.
6. Preparing financial statements — Use the adjusted balances to create the three main reports: the income statement (profit or loss), the balance sheet (what the company owns and owes), and the cash flow statement (how cash moved in and out).

Accounting vs. Bookkeeping

These two terms get used interchangeably, but they're not the same thing. Bookkeeping is one piece of accounting, not the whole picture.

Bookkeeping focuses on recording financial transactions accurately. A bookkeeper's day-to-day work includes logging sales and expenses, posting entries to ledgers, and preparing trial balances. The goal is to maintain clean, organized records.

Accounting includes everything bookkeeping does, plus analysis and interpretation. Accountants take those organized records and use them to prepare financial statements, spot trends, assess the company's financial health, and advise on decisions like whether the business can afford to expand or needs to cut costs. Accounting requires a deeper understanding of financial principles and standards (like GAAP), which is why it typically demands more training and expertise.

A simple way to remember it: bookkeepers record the numbers, accountants explain what the numbers mean.

The Accounting Equation

The accounting equation is the foundation of double-entry accounting. Every transaction a business makes can be expressed through this formula:

$Assets = Liabilities + Owners' Equity$

This equation must always balance. If one side changes, the other side has to change by the same amount.

Here's what each piece means:

• Assets are resources the company owns that have economic value. Examples: cash, inventory, equipment, accounts receivable (money customers owe you).
• Liabilities are what the company owes to others. Examples: accounts payable (bills you haven't paid yet), bank loans, taxes owed.
• Owners' equity is what's left over for the owners after you subtract liabilities from assets. It has two main parts:
  • Contributed capital — money the owners have invested into the business
  • Retained earnings — profits the business has accumulated over time instead of distributing to owners

To see how this works in practice: say a business takes out a $10,000 bank loan. Cash (an asset) goes up by $10,000, and the loan (a liability) also goes up by $10,000. Both sides of the equation increase equally, so it stays balanced. Or if the owner invests $5,000 of personal money into the business, cash (asset) rises by $5,000 and owners' equity rises by $5,000. The equation still holds.

Every single transaction follows this logic, which is why accountants can use the equation to check their work and catch errors.