How Accounting Works in the Real Business World [Basic]

Recalling my other post about: Basic Accounting: Debit and Credit – Double Entry [a really basic accounting knowledge]. After reading the post you should know how T-accounts work. The next question is: How accounting works in the real business world?

On this post, I aim to answer the question, and hopefully will be able to give you yet another accounting basic knowledge. You are right, still about “debit” and “credit”, recording transactions in accounting manner (what to debit and what to credit.) Not only makes you become familiar with it, but it  also show you how a typical series of business transactions, in an operating cycle, affects a company’s asset and liability accounts. And, it comes with case example.

The principal equation of accounting boils down to this:

 Assets = Liabilities + Shareholder’s Equity

[Info_Box]Anything that affects one side of this equation affects the other side.[/Info_Box]

For instance, let’s say your company generates $100 in revenues.

Revenue represents an increase in assets from operations. But because assets are rising, so, too, must shareholder equity to balance this equation. Similarly, an expense represents a decrease in assets through operations or an increase in liabilities. If assets are decreasing while liabilities are increasing, then shareholder equity must go down as expenses are incurred to balance the equation.

Let’s walk through…..

 

Step#1. A Company Buys Raw Materials

Let’s assume you work for Lie Dharma Toys. Like all manufacturers, the company needs raw materials to make its products. So it buys $100 worth of wood and plastic from its supplier. Lie Dharma pays for this on credit. It takes delivery of the supplies and promises to pay the supplier back at a later date. When a company does this, you’ll recall, it establishes an account payable, which is a liability account.

Because Lie Dharma is increasing a liability account, it must credit accounts payable by $100. At the same time, the company takes possession of $100 worth of raw materials, which goes into its inventories. Inventory is an asset, so the accountants must debit this account by $100. In a manual expression, it can be expressed as:

[Debit]. Inventory – Raw Materials = $100

[Credit]. Accounts Payable = $100

 

Step#2. The Company Makes Its Products

Lie Dharma converts the raw materials into toys, which are then warehoused in its facilities. The conversion process costs the company $100.

This adds to the value of inventory, which went from raw materials to finished goods. So we debit inventory $100. On the other side of the ledger, Lie Dharma owes its employees for the labor it took to make the toys.

Since it won’t issue paychecks for another week or two, it establishes a liability account called wages payable. Since it is adding to this liability, it credits this account.

Therefore, you want to make the following entry:

[Debit]. Inventory – Finished Goods = $100

[Credit]. Wages Payable = $100

 

Step#3. The Company Sells Products

A department store has agreed to buy the company’s total inventory of toys for $300. Lie Dharma ships the toys and books the sale.

Since the store hasn’t paid for the toys yet, Lie Dharma sets up an account receivable worth $300. An account receivable is an asset and Lie Dharma is adding to this asset, so it debits the account $300.

[Debit]. Accounts  Receivable = $300

[Credit]. Sales = $300

At the same time, Lie Dharma must account for the loss of inventory. A reduction in an asset account must be credited, so Lie Dharma credits its inventory ledger $200.

[Debit]. Cost of Goods Sold = $200

[Credit]. Inventory – Finished Goods = $200

Notice that the company credits the account $200 the amount of money it cost to produce the toys, not the actual selling price.

 

Step#4. The Company Pays Bills

The toy company still owes its supplier $100 for the raw materials from Step 1. So it takes $100 in cash out of its checking account and uses it to pay off its account payablea liability. That means it credits cash and debits accounts payable.

[Debit]. Accounts Payable = $100

[Credit]. Cash = $100

 

Step#5. The Company Collects Bills

The company receives payment from the department store for the toys it shipped. This means Lie Dharma adds $300 to its account called cash (which it debits) and subtracts $300 from its asset account called accounts receivable (which it credits).

[Debit]. Cash = $300

[Credit]. Accounts Receivable = $300

 

Step#6. The Company Pays Its Workers

Finally, Lie Dharma takes $100 out of its cash account to pay its workers the money they are owed. This reduces its cash account and reduces its liability account. This means it credits cash $100 and debits wages payable $100.

[Debit]. Wages Payable = $100

[Credit]. Cash = $100

 

Step#7. The Company Tallies the Accounts

The company can now calculate its accounts. After seven steps, Lie Dharma Toys discovers that it has zeroed out both its accounts payable and accounts receivable. In fact, it has zeroed out every account except for cash, which shows a $100 debit. This represents the company’s recorded profit.

 

Summing Up The Debit and Credit Rules (One More)

The rules of posting a transaction to a T-account are just that straightforward:

When a transaction adds value to an asset account, the company then debits that amount. All that means is that the amount of the additional value is written down on the left side of the T. When a transaction reduces the value of an asset account, the amount is credited, or written down on the right side of the T.

Conversely, if a transaction adds to a liability or net worth account, it is credited. Once again, that means that amount of the transaction is written down on the right-hand side of the T. And if a transaction reduces the value of a liability or net worth account, that amount is debited. Note: You may be wondering how a net worth account can change.

Expenses and the issuance of dividends, for instance, reduce net worth and are therefore debited. Revenues add to net worth, and therefore are credited. Once you memorize these rules and get over any confusion you have with debits and credits posting transactions to a T is quite simple.

 

There Is Certain Degree of Flexibility in the Accounting World

The rules of accounting demand consistency, BUT (probably) not uniformity up to certain degree. There is certain degree of flexibility in the accounting.

Wouldn’t a uniform accounting system allow you to compare and assess companies that much more accurately? You may ask.

Well, the problem is that an absolutely uniform system of accounting would not reflect the unique nature of different types of businesses. And in that sense, uniformity may be not only inaccurate but unfair.

  • Is it fair, for instance, for a steel manufacturer which is constantly investing in heavy machinery to account for those purchases the same way a service-oriented company like a restaurant accounts for pots and pans? Of course not. The heavy machinery could last 20 years, while the pots and pans may only survive two years.
  • Would it be fair for a computer company to value its assets the same way a jeweler does? Of course not. The computer maker’s inventory of PCs tends to lose value every day as technology becomes obsolete, while the jeweler’s inventory of diamonds and precious metals tends to appreciate in value over time.

To be fair, then, the rules of accounting sometimes allow companies to record transactions and assets in different ways provided that those accounting methods remain consistent within the company and over time. In general, there is a degree of flexibility in determining: (a) when transactions are recorded; (b) how inventory is valued; (c) how other assets are value; and (d) how the devaluation or depreciation of assets is recorded.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

One thought on “How Accounting Works in the Real Business World [Basic]”

  1. Putting up a business is somehow complicated but the most effective way to save some amount. You need to study cases so before implementing it to the market.

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