Brief Summary
This video explains the financial accounting process, starting with identifying transactions and ending with creating financial statements. It covers key steps such as preparing journal entries, posting to the general ledger, creating trial balances, and posting adjusting and closing entries. The video also touches on the accounting equation, double-entry accounting, the accrual method, and the differences between IFRS and GAAP.
- Financial accounting involves identifying, recording, summarizing, and analyzing financial transactions.
- Double-entry accounting ensures that every transaction affects at least two accounts, maintaining the balance of the accounting equation (Assets = Liabilities + Equity).
- Adjusting entries are crucial for aligning books with the accrual method, which recognizes revenue when earned and expenses when incurred.
- Financial statements, including the balance sheet, income statement, and cash flow statement, provide insights into a company's financial health.
Intro
The video introduces financial accounting as a core branch of accounting, distinguishing it from managerial, tax, audit, and bookkeeping. It promises to explain the financial accounting process, which involves identifying, recording, summarizing, and reporting financial transactions in financial statements. The video aims to demystify these concepts and provide a clear understanding of how financial accounting works.
What is Financial Accounting?
Financial accounting is defined as the process of identifying, recording, summarizing, and analyzing an entity's financial transactions and reporting them in financial statements. This definition serves as the foundation for understanding the detailed steps involved in the accounting cycle, which the video will further explain.
STEP 1: IDENTIFY TRANSACTIONS
The first step in financial accounting is identifying transactions. Using the example of Ruff Times newspaper, the video illustrates this with a $40,000 cash inflow from new annual subscriptions. This step involves recognizing and documenting the financial event that has occurred.
STEP 2: PREPARE JOURNAL ENTRIES
The second step is preparing journal entries, which are records of financial transactions. A journal entry includes a unique number, date, description, affected accounts (e.g., cash and subscription revenue), and debits and credits. In the example, cash is debited, and subscription revenue is credited for $40,000.
What is a Journal Entry?
A journal entry is a detailed record of a financial transaction, including a unique journal number, date, description, the accounts affected, and the corresponding debit and credit amounts. It serves as the initial formal record of a transaction before it is posted to the general ledger.
What does a Journal Entry look like?
A journal entry includes a unique journal number, date, a description of the transaction, the accounts affected (e.g., cash and subscription revenue), and the debit and credit amounts. For example, a journal entry for $40,000 in new subscriptions would debit cash and credit subscription revenue by $40,000 each.
What is Double Entry Accounting?
Double-entry accounting is based on the principle that every transaction affects at least two accounts, ensuring that the accounting equation (Assets = Liabilities + Equity) remains balanced. Debits represent the destinations of economic benefit, while credits represent the sources. This system is widely used by businesses globally.
What is the Accounting Equation?
The accounting equation (Assets = Liabilities + Equity) is a fundamental principle in accounting. Assets are what a business owns, liabilities are what it owes to third parties, and equity represents the owner's claim on the business's net assets. This equation must always balance, forming the basis of double-entry accounting.
STEP 3: POST TO GENERAL LEDGER
The next step involves posting the journal entries to the general ledger, which is a comprehensive record of all financial data. Modern accounting software treats the general ledger as a central database, replacing the traditional manual ledger books.
What is the General Ledger?
The general ledger is a central repository for all financial data, containing a complete record of accounts and journal entries. It serves as the backbone of the accounting system, providing a detailed history of all financial transactions.
Posting to Accounts
Posting to accounts involves transferring journal entries into specific accounts within the general ledger. These accounts categorize and store transactions affecting related items, such as cash, subscription revenue, and other assets, liabilities, and equity components.
What is an Account?
An account is a specific record used to sort, store, and track all transactions affecting a related group of items. Accounts are categorized into six main types: assets, liabilities, equity, revenue, expenses, and dividends (or withdrawals).
The 6 Types of Account - Assets, Liabilities, Equity, Revenue, Expenses & Dividends
The six types of accounts are assets, liabilities, equity, revenue, expenses, and dividends. Assets are resources owned by the business, liabilities are obligations to external parties, and equity is the owner's stake in the business. Revenue and expenses impact equity, while dividends represent distributions to owners.
What are T-Accounts?
T-accounts are visual representations of individual accounts, shaped like a "T," with debits on the left and credits on the right. They help visualize how transactions affect account balances. For example, posting a $40,000 cash receipt involves debiting the cash T-account and crediting the subscription revenue T-account.
What does the General Ledger look like?
The general ledger contains a collection of asset, liability, equity, revenue, and expense accounts. It stores all financial transactions, providing a comprehensive view of a company's financial activities.
STEP 4: UNADJUSTED TRIAL BALANCE
The next step is to prepare an unadjusted trial balance, which summarizes the closing balances of all general ledger accounts. This report helps check for errors and serves as the basis for creating financial statements.
What is a Trial Balance?
A trial balance is an internal report summarizing the closing balances of all general ledger accounts. It is used to verify that total debits equal total credits, ensuring the accounting equation remains balanced.
How to build a Trial Balance
Building a trial balance involves listing all accounts and their closing balances, with debits on the left and credits on the right. The total debits and credits should match, reflecting the balanced accounting equation.
Why is it called Trial Balance?
The term "trial" in trial balance refers to its original purpose as a test to ensure that debits and credits are in balance. It is a preliminary step to verify the accuracy of the recorded transactions before preparing financial statements.
STEP 5: POST ADJUSTING ENTRIES
The next step involves posting adjusting entries, which are journal entries made to align the books with the accrual method of accounting. These entries ensure that revenues are recognized when earned and expenses are recorded when incurred.
What are Adjusting Entries?
Adjusting entries are journal entries that bring the financial records in line with the accrual method of accounting. They correct discrepancies and ensure that revenues and expenses are recognized in the appropriate period.
IFRS vs GAAP
The video briefly touches on the accounting rule books, IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles). These standards ensure that financial statements provide a true and fair view of a business, which is crucial for investors, lenders, and creditors.
What is the Accrual Method of Accounting?
The accrual method of accounting requires recognizing revenue when it is earned and expenses when they are incurred, regardless of when cash is received or paid. This method provides a more accurate picture of a company's profitability compared to cash accounting.
Adjusting Entries Example
Using the Ruff Times example, the video illustrates how to correct an initial entry that recognized all subscription revenue upfront. An adjusting entry is made to reverse the unearned portion of the revenue, recognizing it as deferred revenue (a liability) until it is earned in future periods.
STEP 6: ADJUSTED TRIAL BALANCE
After posting adjusting entries, an adjusted trial balance is prepared. This trial balance reflects the changes made by the adjusting entries, ensuring that the financial data is accurate and in line with the accrual method of accounting.
STEP 7: CREATE FINANCIAL STATEMENTS
The next step is to create financial statements, which are accounting reports summarizing a business's activities over a period. These statements provide insights into a company's financial health for investors, lenders, and creditors.
What are Financial Statements?
Financial statements are accounting reports that summarize a business's activities over a period of time. They are designed to provide investors, lenders, and creditors with an understanding of the business's financial health.
What are the three types of Financial Statements?
The three main financial statements are the balance sheet, the income statement, and the cash flow statement. Each statement provides a different perspective on a company's financial performance and position.
What is the Balance Sheet?
The balance sheet provides a snapshot of a business's assets, liabilities, and equity at a single point in time. It reflects what the company owns and owes at the end of the financial year, offering insights into its financial position.
What is the Income Statement?
The income statement summarizes a business's revenues and expenses over a period of time, typically a year. It provides a view of the company's financial performance and profitability during that period.
Profit vs Cash Flow
The video highlights that profit and cash flow are not the same, especially when using the accrual method of accounting. Profit reflects revenues and expenses, while cash flow tracks the actual movement of cash in and out of the business.
What is the Cash Flow Statement?
The cash flow statement summarizes the cash inflows and outflows of a business over a period of time. It provides a detailed view of how the company generates and uses cash, which is crucial for assessing its liquidity and solvency.
Who would use Financial Statements?
Financial statements are used by investors, lenders, and creditors to assess a company's financial health and performance. Investors use them to decide whether to buy or sell shares, while lenders and creditors use them to evaluate the risk of lending money.
STEP 8: POST CLOSING ENTRIES
The final step involves posting closing entries, which clear out temporary accounts like revenues, expenses, and dividends to prepare the books for the next year. The balances from these accounts are transferred to retained earnings in the equity section of the balance sheet.
What are Closing Entries?
Closing entries are journal entries posted to clear out temporary accounts (revenues, expenses, and dividends) at the end of an accounting period. This process resets these accounts to zero and transfers their balances to retained earnings.
Closing Entries Example
The video illustrates closing entries by debiting revenue accounts and crediting expense accounts to clear them to zero. The net balance is then transferred to retained earnings, which is part of the equity section on the balance sheet.
Post Closing Trial Balance
After posting closing entries, a post-closing trial balance is prepared to ensure that only permanent accounts (assets, liabilities, and equity) have balances. This confirms that the temporary accounts have been properly closed and the accounting equation remains in balance.
THE ACCOUNTING CYCLE
The video concludes by summarizing the accounting cycle, which includes identifying, recording, summarizing, and analyzing financial transactions and reporting them in financial statements. This cycle provides a structured approach to financial accounting, ensuring accuracy and transparency in financial reporting.
