How Does Accounting Work?

Estimated reading time: 5 minutes

In this post, we're going to take a brief look at the basic idea behind how accounting works. Our aim is to shed some light on what can often be a confusing and frustrating topic. But with the help of a simple analogy, everyone can understand basic financial principles quickly and easily.

At its heart, accounting consists of balances and transactions. Business events such as customers buying products, a company purchasing new machinery or even just staff performing their daily jobs are all events that will cause accountants to record accounting transactions. This is because these events have a financial value: the money that comes in from sales, the cost of the machinery and the cost of employees.

Of course there are many business events that don't get recorded by accountants because they don't have financial value. Examples would be sales pitches, sending emails to clients or publishing a blog post. These events are obviously important and may lead to future events that do affect the company's finances. But they don't have an immediate financial impact, so they are not recorded as accounting transactions.

Accounting Balances

So how are these accounting transactions recorded? To answer this, we need to consider the other type of accounting building-block which is an accounting balance. An accounting balance is not an event like a transaction, instead it generally corresponds to something that the business either owns or owes. The bank balance for example is the amount of money that the company has at any given time. Another example for a retail business is the inventory balance - this is the estimated value of all the stock the company owns and hasn't yet sold.

3 water tanks connected by various pipes
Accounting can be represented as a system of connected water pipes and tanks.

How are accounting transactions and balances related then? The best way to visualise and really understand accounting balances and transactions is as a simple system of water pipes and tanks. Water is stored in  tanks that are connected together by pipes. In the analogy, the water in the tanks are accounting balances. Accounting transactions are the events that cause water to flow through a pipe from one tank to another. Let's look at a simple example to understand this in action.

Revenue vs Cash Receipts

We're going to use the idea of water pipes and tanks to look at 2 accounting transactions: revenue and cash receipts. When most people hear the word "revenue" they automatically think "money in". This isn't a terrible way to think about it, but it is not quite how accounting works. Let's look at how revenue is linked to the money that actually comes in, which is called the cash receipts.

To keep things simple, let's consider a wholesale business that sells goods to supermarkets and let's explore how its revenue is linked to its cash receipts. Watch the video below to see how the timing difference between revenue and cash receipts gives rise to something called the receivables balance.

The video shows an interactive model that lets you alter the amount of revenue generated and the amount of credit offered to customers. These simulation models form the foundation for our online Basic Accounting course which allows you to visualise how accounting works as a simple, connected system.

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What is Revenue?

So if revenue isn't the amount of money that comes in, then what actually is it? The simple answer is that revenue is the best estimate of the amount of money that a business believes it has generated through the sale of its products or the provision of its services. Often some of the actual cash receipts from this revenue are not received by the business until much later.

At this point you may be wondering why revenue is the "top line" of every profit and loss statement. Wouldn't it be better to use cash receipts because this is the amount of money the business has actually received? The reason for this is to do with the accrual principle, which is the fundamental idea that governs how accounting works. The accrual principle is the starting point for our simple online Basic Accounting course. More on the accrual principle and other accounting principles next time.

Basic Accounting Course

Our free online course assumes no prior knowledge and gradually introduces all the building blocks of accounting using simulation models that build on the one featured in the video. It explores financial statements and working capital and it reveals how profit & loss, cashflow and the balance sheet are all connected. If you'd like to find out more, click the button below.

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