How Accounting Systems Work (Bookkeeping)
Check out my explanation of accounting systems!
VIDEO SUMMARY
We are going to talk about accounting systems, or what is generally called “bookkeeping.” Bookkeeping is the process of recording transactions in an accounting system. Now this is really important, because pretty much all accounting systems are based on the same process. So if you understand the concepts in this video, it will really help you in business.
Let’s start by talking about the problem. Imagine you are running a business and you don’t have an accountant or an accounting system. The only financial information you would have to determine what’s happening in your business is the account balance in your bank account, and your bank statements showing a list of your transactions. The problem is when your business has hundreds of transactions, a list of data doesn’t tell you anything. It doesn’t tell you if you are making money, or how much debt you have. So accounting systems turn economic transactions into useful information.
Journal Entries
So in order to keep track of your business we use an accounting system or bookkeeping. In the old days we used to do this manually and write out each step on paper. Today, accounting systems are all electronic and all the information is kept in your computer system. The way this works is you always start out with an economic transaction. This could be making a purchase, making a sale, transferring money, acquiring debt. What you do is record that economic transaction with a journal entry. The journal entry indicates the account affected and the amount. Each journal entry has a debit and a credit that balances.
Debit Cash 500
Credit Revenue 500
Ledgers
Throughout the year, data from journal entries are captured in Ledgers. Each account has a separate ledger, and information is recorded in T-accounts. At any point in time, you can add up the ledger to know the total in that account.
Cash Revenue
T account T account
Trial Balance
A trial balance is a combination of all ledgers. Each account is listed with the associated total. Accounts are listed in order:
Assets
Liabilities
Owner’s Equity
Revenue
Expenses
Financial Statements
The trial balance turns into financial statements. The income statement is created from Revenue and Expenses to calculate Net Income. The balance sheet is based on the equation Assets = Liabilities + Owner’s Equity. So the balance sheet always balances. The balance sheet represents a snapshot in time, while the Income statement represents activity over a period of time.
The goal
So you end up with reports that show useful information, like how much money you are making, or how much debt you have compared to assets. That is useful information, as opposed to just lists of transactions. And because we went through such thorough and organized steps, to create these financial statements, we can be sure that they accurately represent the underlying economic transactions. Additionally, there is an audit trail of all these steps that can be traced back and checked to confirm the accuracy of these financial statements.
The reason this is so important. Accounting gives us a way to make sense of the chaos of life. I made a previous video on this. (what is accounting) You have all these people walking around engaging in activities and operating businesses. Accounting gives us a way to quantify the productivity of each person. So you can talk about how much money people make, or how much debt someone has. So in a society, banks can look at all these people and their financial statements and decide which people are the best to give loans to. Investors can look at companies and decide who to invest it. Financial statements take the chaos of random activities and communicate them in a formalized and easy to understand report. This is quite amazing, that we have figured out how to do this as a society.
Leave a comment down below letting me know what you think! If you find these videos helpful, please subscribe to my YouTube channel.
Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.