Basic of Accounting

 
 

Basic Accounting Concepts

As we saw in the previous chapter, accounting is based on 5 basic account types: Assets, Liabilities, Equity, Income and Expenses. We will now expand on our understanding of these account types, and show how they are represented in GnuCash. But first, let’s divide them into 2 groups, the balance sheet accounts and the income and expense accounts.
Let’s have a quick look at the Accounting Equation (Assets - Liabilities = Equity + (Income - Expenses)) again as a reminder, before we go deeper into each account type.

A graphical view of the relationship between the 5 basic accounts. Net worth (equity) increases through income and decreases through expenses. The arrows represent the movement of value.

3.1.1. Balance Sheet Accounts

The three so-called Balance Sheet Accounts are Assets, Liabilities, and Equity. Balance Sheet Accounts are used to track the changes in value of things you own or owe.
Assets is the group of things that you own. Your assets could include a car, cash, a house, stocks, or anything else that has convertible value. Convertible value means that theoretically you could sell the item for cash.
Liabilities is the group of things on which you owe money. Your liabilities could include a car loan, a student loan, a mortgage, your investment margin account, or anything else which you must pay back at some time.
Equity is the same as "net worth." It represents what is left over after you subtract your liabilities from your assets. It can be thought of as the portion of your assets that you own outright, without any debt.

3.1.2. Income and Expense Accounts

The two Income and Expense Accounts are used to increase or decrease the value of your accounts. Thus, while the balance sheet accounts simply track the value of the things you own or owe, income and expense accounts allow you to change the value of these accounts.
Income is the payment you receive for your time, services you provide, or the use of your money. When you receive a paycheck, for example, that check is a payment for labor you provided to an employer. Other examples of income include commissions, tips, dividend income from stocks, and interest income from bank accounts. Income will always increase the value of your Assets and thus your Equity.
Expenses refer to money you spend to purchase goods or services provided by someone else. Examples of expenses are a meal at a restaurant, rent, groceries, gas for your car, or tickets to see a play. Expenses will always decrease your Equity. If you pay for the expense immediately, you will decrease your Assets, whereas if you pay for the expense on credit you increase your Liabilities.

Accrual

Accrual (accumulation) of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in accounting, where it can refer to accounts on a balance sheet that represent liabilities and non-cash-based assets used in accrual-based accounting. These types of accounts include, among others, accounts payable, accounts receivable, goodwill, deferred tax liability and future interest expense.^[1]
For example, a company delivers a product to a customer who will pay for it 30 days later in the next fiscal year, which starts a week after the delivery. The company recognizes the proceeds as a revenue in its current income statement still for the fiscal year of the delivery, even though it will get paid in cash during the following accounting period.^[2] The proceeds are also an accrued income (asset) on the balance sheet for the delivery fiscal year, but not for the next fiscal year when cash is received.
Similarly, a salesperson, who sold the product, earned a commission at the moment of sale (or delivery). The company will recognize the commission as an expense in its current income statement, even though the salesperson will actually get paid at the end of the following week in the next accounting period. The commission is also an accrued expense (liability) on the balance sheet for the delivery period, but not for the next period when the commission (cash) is paid out to the salesperson.

OR

Accruals are adjustments for 1)  revenues that have been earned but are not yet recorded in the accounts, and 2) expenses that have been incurred but are not yet recorded in the accounts. The accruals need to be added via adjusting entries so that the financial statements report these amounts.

An example of an accrual for revenue involves your electric utility company. The utility used coal and many employees in December to generate electricity that customers received in December. However, the utility doesn't bill the electric customers for the December electricity until the meters are read in January. To have the proper amounts on the utility's financial statements, there needs to be an adjusting entry to increase revenues that were earned in December and the receivables that the utility has a right to as of December 31.

An example of an accrual involving an expense is an employee's bonus that was earned in 2012, but will not be paid until 2013. The 2012 financial statements need to reflect the bonus expense and the bonus liability. Therefore, prior to issuing the 2012 financial statements an adjusting entry is prepared to record this accrual.