At the heart of financial accounting is the system known as double
entry bookkeeping (or "double entry accounting"). Each financial
transaction that a company makes is recorded by using this system.
The term "double entry" means that every transaction affects at least
two accounts. For example, if a company borrows $50,000 from its bank,
the company's Cash account increases, and the company's Notes Payable account increases. Double entry also means that one of the accounts must have an amount entered as a debit, and one of the accounts must have an amount entered as a credit. For any given transaction, the debit amount must equal the credit amount. (To learn more about debits and credits, see Explanation of Debits & Credits.)
The advantage of double entry accounting is this: at any given time,
the balance of a company's asset accounts will equal the balance of its
liability and stockholders' (or owner's) equity accounts. (To learn more
on how this equality is maintained, see the Explanation of Accounting Equation.)
Financial accounting is required to follow the accrual basis of accounting (as opposed to the "cash basis" of accounting). Under the accrual basis, revenues are reported when they are earned, not when the money is received. Similarly, expenses are reported when they are incurred,
not when they are paid. For example, although a magazine publisher
receives a $24 check from a customer for an annual subscription, the
publisher reports as revenue a monthly amount of $2 (one-twelfth of the
annual subscription amount). In the same way, it reports its property
tax expense each month as one-twelfth of the annual property tax bill.
By following the accrual basis of accounting, a company's
profitability, assets, liabilities and other financial information is
more in line with economic reality. (To learn more on achieving the
accrual basis of accounting, see the Explanation of Adjusting Entries.)