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If you’re a small business owner it’s important to know Financial Accounting Basics for accurate financial reporting. Without it, you have no way of knowing the financial health of your company, not to mention where to allocate funds and how much debt you owe to your creditors. Plus, if you get audited by the Internal Revenue Service (IRS), you’ll need to prove that your books are in order so you don’t have to close your business.

Whether you’re looking to brush up on some bookkeeping terms or you’re trying to find a better way to manage your finances, a fundamental understanding of Financial Accounting Basics will help you organize your books for success.

Financial Accounting Basics Defined

So what do we mean exactly by financial accounting? According to the New York State Society of Certified Public Accountants (NYSSCPA), accounting is the “recording and reporting of financial transactions, including the origination of the transaction, its recognition, processing, and summarization in the financial statements.” In short, basic accounting allows you to keep track of all your business transactions so you have a place (called the general ledger) to see a snapshot of your finances.

The accounting process is often explained as a “cycle” and includes eight steps.

The Accounting Cycle

Step 1: Transactions

A transaction occurs when a business engages in some sort of financial event. This includes any activity that uses a company’s financial resources, such as:

  • The sale of a product or service
  • Purchasing raw materials from a supplier
  • Paying wages to employees or taxes to the government
  • Incurring debt from a creditor

Step 2: Journal entries

After a transaction has occurred, you must record the event in a journal, which is a complete list of all transactions. To do this, many business owners use a method called double-entry accounting whereby two accounts are affected with each transaction. For example, let’s say you own a small lemonade stand and a customer buys a drink for $3.50 using cash. Using double-entry accounting, this transaction involves a debit to the cash account and a credit to the sales account for $3.50.

Step 3: Posting

Posting simply means transferring all of the debits and credits from the journal to the ledger. By definition, a ledger is a list of all the accounts used by your company. Examples include:

  • Cash
  • Accounts receivable
  • Inventory
  • Accounts payable
  • Long-term liabilities
  • Leasehold improvements
  • Revenue
  • Common stock
  • Cost of goods sold
  • Rent expense
  • Supplies
  • Utilities expense
  • Wages expense
  • Interest expense

Step 4: Trial balance

Using the account balances from the ledger, the next step in the accounting cycle is to calculate the trial balance by totaling all debits and credits. This is also done at the end of the accounting period and the purpose is to verify that the basic accounting equation (Assets = Liabilities + Stockholder’s Equity) is in balance. In other words, the trial balance validates that debits equal credits.

Steps 5 & 6: Prepare a worksheet and make adjusting journal entries

After calculating the trial balance, it’s not uncommon to find that your books are not in balance. If so it means there’s an error and you need to make “adjustments” to correct it, which are tracked in a worksheet. Errors can occur for a number of different reasons, but here some of the most common:

  • Adding the total debits and credits incorrectly in the trial balance
  • Inaccurately transferring the ledger account balances to the trial balance
  • Improperly calculating the ledger account balance
  • Making an error when posting a journal entry to the ledger
  • Omitting or miscalculating a journal entry

To correct an error, you first record an adjusting entry in the general journal and then post it to the ledger. This involves balancing the appropriate asset or liability account and updating the corresponding revenue or expense account.

Once you’ve recorded the adjustments, the next step is to prepare another trial balance called the “adjusted trial balance.” If your debits equal credits it generally means you have no errors, but this isn’t always true. For example, your books may have errors but still balance if you:

  • Accidentally exclude a transaction from the journal
  • Record a transaction in the wrong account
  • Log a transaction as a debit instead of a credit, or vice versa
  • Forget to post a journal entry to the ledger

Step 7: Financial statements

With the corrected account balances, you can now prepare your financial statements. These include the following:

  • Income statement
  • Statement of retained earnings
  • Balance sheet statement
  • Statement of cash flows

Step 8: Closing the books

In the last stage of the accounting cycle, you’re now ready to prepare the closing entries so you can start the next accounting period. This may include a post-trial balance to double check that your debits equal credits.

Using the eight steps in the accounting process, it’s easy to see how Financial Accounting Basics can help you make better business decisions. For more information about financial accounting, you can enroll in our Financial Accounting Fundamentals Program today and learn other ways to improve your books.

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