Accounting and bookkeeping can seem like an overwhelming task, especially for those who are self-employed and have received no special training in the subject. However, the steps of this process are not as difficult as they appear, and with a little help the accounting cycle does not need to be a mysterious or intimidating thing.
Single-Entry Bookkeeping
Before there was double-entry bookkeeping, accounting was a simple and rudimentary process. Total cash income was calculated daily, and total cash income and spending would be calculated at the end of every month. This was called single-entry bookkeeping, as it only required a single column of digits to operate. Today, this system is only suitable for the simplest of businesses. The main problem with single-entry bookkeeping is that it is not self-correcting, so clerical and mathematical errors are common.
Double-Entry Bookkeeping
Double-entry bookkeeping or accounting solves many of the common problems associated with single-entry accounting. It consists of two columns, into which transactions are entered as either additions or subtractions. The accounting cycle refers to the process a bookkeeper or accountant follows when entering and eventually filing transactions into a double-entry bookkeeping system. This form of accounting is self-correcting as a result of the debit/credit system, which leads to higher accuracy and reliability in transaction records, and is very useful for larger businesses.
Understanding Credits and Debits
The credit and debit columns are the self-correcting mechanism of double-entry bookkeeping. Essentially, the two columns represent expenses and income; debits are used to record transactions in which money is spent or lost, while credits record income, liability, and equity gains. Each transaction recorded will actually be entered into both columns. In the case of a 250.00 purchase, for example, that sum would be added to the debits column (paid out), and subtracted from the credits column (taken from available funds). Thus the columns would read D + 250.00, C – 250.00 for a balance sum of zero, as the two amounts cancel one another out.
Preparing a Financial Statement
A weekly, monthly, or yearly financial statement is the official, formal record of the company in questions monetary transactions. It is created from the temporary debit/credit records discussed above. Usually this statement consists of four separate reports: a statement of financial position, also referred to as a balance sheet; a statement of comprehensive income, detailing profits and losses over time; a statement of changes in equity, and a statement of cash flows, discussing operating and investing activities.
There are a variety of helpful diagrams available to help with a visual understanding of the accounting cycle, but the formula of equity – losses = profits is the basic principal upon which double-entry bookkeeping operates. As complex as the topic may seem, it is actually simpler and more difficult to make errors using a double-entry system; this is why it has become so popular with major businesses and accounting firms around the world!