Accounting Fundamentals
Double-entry bookkeeping, chart of accounts & how financial statements are prepared
About 15 min
What you'll learn
Understand double-entry bookkeeping and the meaning of debit/credit
Grasp the relationship between 5 major account categories: assets, liabilities, equity, revenue, expenses
Understand the accounting equation and the full closing cycle
Explain the difference between accrual and cash-basis accounting
Understand the book structure pipeline (Journal → GL → TB → Financial Statements)
Know the types of audit opinions and the significance of KAM
Recognize the differences between listed and unlisted company accounting
Table of Contents
Interactive tutorial: see accounting fundamentals on real BS / PL / CF
On Meiji Holdings (E21902), feel the accounting basics — assets = liabilities + equity, accrual profit vs cash, and how PL → BS → CF interlock — using real numbers.
1. What is Accounting?
Accounting is the system of recording, classifying, summarizing, and reporting a company's economic activities. Just as a household budget tracks personal money flows, corporate accounting records business transactions accurately and communicates them to stakeholders.
- Investors — "Is this company safe to invest in?" Financial data provides the evidence. e.g. Company A's ROE is 12% vs. industry average 8% → consider increasing position.
- Banks & creditors — "Will we get our money back?" Accounting reveals repayment ability. e.g. Current ratio 150% + equity ratio 45% → short-term solvency sound → approve loan.
- Management — "Where should we invest next year?" Numbers drive decisions. e.g. Overseas segment operating margin 20% vs. domestic 8% → prioritize overseas capex.
- Tax authorities — Because accounting profit and taxable income use slightly different rules, companies make tax-law adjustments to prove "are taxes being paid correctly?" (see §6 Tax-basis accounting). e.g. Bad-debt provision exceeding tax-law cap must be added back to taxable income.
Accounting is the "universal language of business." Because companies worldwide report using standardized rules (accounting standards), you can compare completely different firms on equal footing.
2. The Accounting Equation — Where It All Starts
There is one fundamental formula that holds true for every single business transaction:
This equation says: "Everything the company owns (assets) is funded either by borrowing (liabilities) or by owners' capital (equity)." No matter how complex a transaction, this equation always balances.
Borrowed ¥1,000,000 from a bank
Cash (Asset) +¥1,000,000
Bank Loan (Liability) +¥1,000,000
✓ Balanced
Founded the company with ¥5,000,000 personal capital (Share Capital = funds put in by shareholders)
Cash (Asset) +¥5,000,000
Share Capital (Equity) +¥5,000,000
✓ Balanced
Purchased equipment for ¥2,000,000 cash
Equipment (Asset) +¥2M, Cash (Asset) −¥2M
No change
✓ Balanced (movement within assets)
| Transaction | Left (Assets) | Right (Liabilities + Equity) | Result |
|---|---|---|---|
| Borrowed ¥1,000,000 from a bank | Cash (Asset) +¥1,000,000 | Bank Loan (Liability) +¥1,000,000 | ✓ Balanced |
| Founded the company with ¥5,000,000 personal capital (Share Capital = funds put in by shareholders) | Cash (Asset) +¥5,000,000 | Share Capital (Equity) +¥5,000,000 | ✓ Balanced |
| Purchased equipment for ¥2,000,000 cash | Equipment (Asset) +¥2M, Cash (Asset) −¥2M | No change | ✓ Balanced (movement within assets) |
The Balance Sheet (BS) is a snapshot of this equation at a specific point in time.
3. Double-Entry Bookkeeping
Double-entry bookkeeping records every transaction with a Debit (left) and a Credit (right). Because both sides must be equal, mistakes are easy to catch.
Debit & Credit Rules
Journal Entry Examples
Purchased ¥500,000 of inventory with cash (periodic method; under perpetual method the debit would be "Inventory (Asset)")
Debit: Purchases (Expense) ¥500,000
Credit: Cash (Asset) ¥500,000
Recorded ¥800,000 of sales on credit
Debit: Accounts Receivable (Asset) ¥800,000
Credit: Sales (Revenue) ¥800,000
Repaid ¥100,000 of a bank loan
Debit: Bank Loan (Liability) ¥100,000
Credit: Cash (Asset) ¥100,000
Don't overthink "debit = left" and "credit = right." These are positional labels with historical origins — just remember left and right. Visualize with a "T-account": debits on the left side of the T, credits on the right; every transaction touches two accounts with equal totals on both sides.
4. Chart of Accounts
Account names are the labels used to classify transactions. They fall into five groups, each mapped to a specific part of the financial statements.
AssetsAssets
BS (Left side)
Economic resources the company owns
Cash, Accounts Receivable, Inventory, Buildings, Patents
LiabilitiesLiabilities
BS (Right, upper)
Obligations to pay in the future
Accounts Payable, Loans, Bonds, Retirement Benefit Obligations
EquityEquity
BS (Right, lower)
Assets minus liabilities — what belongs to shareholders
Share Capital, Retained Earnings, Treasury Stock (deduction)
RevenueRevenue
ExpensesExpenses
Costs incurred to earn revenue (decreases equity)
COGS, Salaries, Depreciation, Interest Expense
| Category | Statement | Description | Examples |
|---|---|---|---|
| AssetsAssets | BS (Left side) | Economic resources the company owns | Cash, Accounts Receivable, Inventory, Buildings, Patents |
| LiabilitiesLiabilities | BS (Right, upper) | Obligations to pay in the future | Accounts Payable, Loans, Bonds, Retirement Benefit Obligations |
| EquityEquity | BS (Right, lower) | Assets minus liabilities — what belongs to shareholders | Share Capital, Retained Earnings, Treasury Stock (deduction) |
| RevenueRevenue | PL | Income earned from business (increases equity) | Sales, Interest Income, Gains on Securities |
| ExpensesExpenses | PL | Costs incurred to earn revenue (decreases equity) | COGS, Salaries, Depreciation, Interest Expense |
The PL equation "Revenue − Expenses = Profit" flows into BS Retained Earnings — that's how the two statements connect.
5. The Accounting Cycle
Companies typically prepare financial statements on an annual basis (fiscal year), following this cycle:
Transaction occurs
Day-to-day activities: selling goods, paying suppliers, etc.
Record in journal
Break each transaction into debits and credits, recorded by date
Post to ledger
Aggregate by account (e.g., total cash balance, A/R balance)
Prepare trial balance
Verify total debits equal total credits
Adjusting entries
Depreciation (spreading fixed-asset cost over its useful life), provisions (booking estimated future outflows as expense now), accrued revenue (recognising revenue earned before cash receipt), and similar period-end adjustments.
For investors, Steps 5 and 6 matter most. Adjusting entries can significantly change reported profit — that's why footnotes deserve your attention.
6. Accrual vs. Cash Basis
There are two approaches to recognizing revenue and expenses. All listed companies prepare their financial statements on an accrual basis.
Cash Basis
When cash changes hands
Sold goods in April, received payment in June → Revenue in June
Personal finance, small businesses
Accrual Basis
When the economic event occurs
Delivered goods in April → Revenue in April (payment later is fine)
All listed companies' financial statements
| Method | Recognition Timing | Example | Use Case |
|---|---|---|---|
| Cash Basis | When cash changes hands | Sold goods in April, received payment in June → Revenue in June | Personal finance, small businesses |
| Accrual Basis | When the economic event occurs | Delivered goods in April → Revenue in April (payment later is fine) | All listed companies' financial statements |
Because of accrual accounting, a company can report strong revenue growth while struggling with cash flow. That's exactly why you need to read the Income Statement and Cash Flow Statement together.
Key Concepts
Accounts Payable
Goods purchased but payment not yet made (expense already on PL)
Spreading cost of long-lived assets over their useful life (cash spent only at purchase)
Provisions
Estimating future expenses and recognizing them early
7. Connection to Financial Statements
Here's how everything you've learned ties into the actual financial statements companies publish.
The three statements aren't independent — they're all generated from the same double-entry journal data. In the next page, "How to Read Financial Statements," you'll learn how to read each one in detail.
8. Book Structure: From Journals to Financial Statements
Every business transaction starts with a journal entry and ultimately becomes part of the published financial statements. Understanding this pipeline — the book structure — helps you appreciate how financial data is created and why it can be trusted.
The Path from Books to Statements
Journal
The original book of record where daily transactions are recorded chronologically with debit and credit entries.
General Ledger (GL)
Transactions are posted from the journal to individual accounts. The GL is the master dataset of the accounting system, showing each account's balance.
Trial Balance (TB)
A summary listing all GL account balances. Total debits must equal total credits, verifying recording accuracy.
Reclassification
TB line items are regrouped into financial statement presentation categories. For example, multiple receivable accounts are consolidated into 'Accounts Receivable' and classified as current or non-current.
The financial data you see in Financial Model is the end product of this entire book structure pipeline.
You can check a company's chart of accounts and classification policies in the 'Significant Accounting Policies' section of annual reports.
For consolidated financial statements, each subsidiary's TB is combined and consolidation adjustments are applied before reclassification.
Understanding the Journal → GL → TB → Reclassification → Financial Statements pipeline shows you how disclosed data is produced, helping you read the numbers with greater depth.
9. Financial Statement Auditing
Listed companies are legally required to have their financial statements audited by independent certified public accountants (audit firms). Auditing is a critical system that assures the reliability of financial information.
Types of Audit Opinions
Unqualified Opinion
Unqualified OpinionThe financial statements are presented fairly in all material respects. The vast majority of listed companies receive this opinion — the most reassuring audit outcome for investors.
Qualified Opinion
Qualified OpinionCertain items have issues, but the overall statements are still fairly presented. Investors should check the scope and impact described in the notes.
Adverse Opinion
Adverse OpinionThe financial statements contain material misstatements. Extremely rare for listed companies, but carries significant implications for investment decisions.
Disclaimer of Opinion
Disclaimer of OpinionScope limitations prevent the auditor from forming an opinion. This may signal serious issues with the company's condition.
Key Audit Matters (KAM)
KAM are matters the auditor considered most significant during the audit, disclosed in the audit report. Japan adopted KAM reporting starting from fiscal years ending March 2021.
KAM represents the 'auditor's perspective' on which financial statement items carry risk.
Common KAM topics include goodwill impairment, revenue recognition judgments, and recoverability of deferred tax assets.
You can find KAM in the 'Independent Auditor's Report' section of annual reports — useful supplementary information for investment analysis.
Real KAM excerpts (paraphrased)
Goodwill impairment assessment
e.g. Manufacturer with overseas acquisitions"The goodwill of ¥XXX bn recognized on acquisition depends on management's projected cash flows of the acquired subsidiary. Key assumptions (revenue growth rate, discount rate) involve significant management judgment and high estimation uncertainty, so we identified this as a key audit matter." → Auditor independently challenged the projection assumptions.
Revenue recognition (long-term contracts / subscriptions)
e.g. Software / construction / consulting firms"For performance obligations satisfied over time, revenue is recognized based on progress, and the reasonableness of estimated total costs has a material effect on the financial statements, so we identified this as a key audit matter." → Tested the cost-estimation logic and progress calculations.
Recoverability of deferred tax assets
e.g. Companies with prior losses / turnaround-phase firms"The amount is material and recognition depends on estimates of future taxable income, so we identified this as a key audit matter." → Evaluated feasibility of the business plan.
Checking the audit opinion is the first step when reading financial statements. Start your analysis assuming an unqualified opinion, and review KAM to understand the risk areas the auditor focused on.
10. Tax-Basis Accounting & Unlisted Companies
While listed companies prepare financial statements under accounting standards (J-GAAP or IFRS) mandated by financial regulations, most unlisted companies use tax-basis accounting. Understanding this difference is key to accurately evaluating corporate disclosures.
Listed vs. Unlisted Company Accounting
Audit
Statutory audit by CPAs required
Audit optional (except large companies under Companies Act)
Disclosure
Depreciation
Based on economic useful life (substance-focused)
Tends to use statutory useful lives prescribed by tax law
Provisions
Broad provisioning under accounting standards
Limited to tax-deductible provisions (e.g., bad debt allowance)
Retirement Benefits
Per retirement benefit accounting standards
Often simplified tax-basis retirement allowance
| Item | Listed Companies | Unlisted Companies |
|---|---|---|
| Standards | J-GAAP or IFRS | Tax law (Corporate Tax Act) primarily |
| Audit | Statutory audit by CPAs required | Audit optional (except large companies under Companies Act) |
| Disclosure | Annual Securities Report (FSA/EDINET) | Financial statements (Companies Act) / Tax returns |
| Depreciation | Based on economic useful life (substance-focused) | Tends to use statutory useful lives prescribed by tax law |
| Provisions | Broad provisioning under accounting standards | Limited to tax-deductible provisions (e.g., bad debt allowance) |
| Retirement Benefits | Per retirement benefit accounting standards | Often simplified tax-basis retirement allowance |
The annual reports on EDINET are based on accounting standards applied by listed companies.
When analyzing unlisted company financials (e.g., for M&A or business partner assessment), factor in tax-basis characteristics.
Tax-basis accounting tends to minimize reported profits (for tax savings), so actual earning power may be higher than the numbers suggest.
Listed and unlisted companies differ significantly in accounting standards and disclosure quality. Be aware that EDINET financial data represents high-quality information prepared under proper accounting standards.
Try with Real Data
See how accounting concepts appear in actual company filings.