Basics of Accounting (The Language of Finance)

Business & AccountingAccounting is the universal language of Business

and Finance.More CEO’s from fortune 500 companies have

come up through the ranks of accounting than from any other area in business. Currently: 54%

Small businesses usually fail because of poor accounting & finance understanding.

Marriages usually fail because of poor financial management (80% of divorces are money related.)

If you want to get ahead in business & marriage determine that you are going to understand accounting basics.

What do Accountants Account For?Everything of value!

TermsAssets: Tangible and Non-tangible

resources of a business that have future value. Usually sub-classified as follows:Current Assets (Turn into cash/use annually)Fixed Assets (Depreciated over several yrs.)

Buildings, Equipment, Natural ResourcesLand (Fixed, but never depreciated)Intangible Assets: Patents, Trademarks,

Copyrights

What are your Assets?Bank Account & Money in your pocketCarClothesBooksStocks/Bonds/CD’sPrepaid rentComputers & Electronic Equip.Knowledge?Abilities?

Accounting Term:LiabilitiesOther people’s claims against your assets!

What you owe!! Debts!Classified as:

Current Liabilities (one year debt)Credit Card Debt, Accounts Payable

Long Term LiabilitiesCar, Mortgage, Note Payable

Unearned revenuesBonds (usually super long term)

What are your liabilities?School LoanCar LoanCredit Card BalanceHouse loan

Capital or Owners Equity The portion of your assets that you can legally claim. (Net

Assets) What you really own legally. Assets – (minus) Liabilities = Owners Equity (or Capital) Example (purchased a building for Rs.500,000 with a 10%

down payment (Rs.50,000)Cost of a building (sales price = Asset amount)

Rs.500,000Less: What you still owe on the building (Liability)

Rs.450,000Equals: Your equity in the building (Capital) or your net

worth in the building. Rs.50,000 Formula universally used in all financial and personal

financial institutions:Assets = Liability + Owners Equity (Balance Sheet

Equation)(Resources you have) =(What you owe on them) + (the

principle you have paid on them.)

If assets equal Rs. 195000 and liabilities equal Rs.40000, then owner’s capital/ equity equals_____.

If assets equal Rs. 65000 and owner’s equity equals_____.

If current assets equal Rs. 25000, liabilities equal Rs.40000 and owner’s equity equals Rs.55000, then fixed assets equal ____.

If assets equal Rs.225000 and owner’s claim equals Rs.105000 then liabilities equal __________.

Entity concept There are three basic structures that a company can

have :1. Sole proprietorship2. Partnership3. Corporation

A sole proprietorship is not a legal entity separate from its owner

A partnership is not a legal entity separate from its owners These are both sub-components of their

owners/partners for legal purposes A corporation is a separate legal entity

Owners Equity Account Titles

Single Proprietorship: Capital

Corporation: Common Stock (what owners paid in)Preferred Stock (what owners paid in)Retained Earnings (profits that the business

keeps in the business)

What is your net worth?What you have minus what you owe.What format do we use in business and in

personal finance to show our net worth?A Balance Sheet Financial Statement

List of Assets (classified by type in accounts)

Compared or balanced with:List of Liabilities and Owners Equity

(classified by type and in accounts)

Example (Simplified) An Example of Business or Personal Records

Balance Sheet September 10, 2010 Assets:

Current:Cash at Home Rs.100Cash Deposits in Bank 500

Fixed:Wardrobe 2000Equipment 1000Car 5000

Total Assets: Rs.8,600 Liabilities:

Current:Credit Card Payable Rs.500

Long Term:Note Payable (on Car) Rs.2000

Total Liabilities Rs.2,500 Capital, J D 6,100 Total Liabilities & Owners Equity: Rs.8,600

Other TermsTemporary Accounts are used in addition to

balance sheet accounts to record changes in owners equity each reporting period.Expenses – Decrease in owners equity during

the period by using up an asset or a portion of an asset. (or creating additional liabilities)

Revenue – Increase in owners equity during the period by performing a service or selling an asset.

Drawing or Dividends – Decrease in owners equity due to personal withdrawals by the owner(s).

Income Statement ReportUsed to determine the net income or net loss

of an individual or business for a defined period of time.Used for marking progress by comparing

months and yearsUsed by financial institutions for determining

the progress and status of a company or individuals financial health.

Used by the IT Dept. for determining taxes

Income Statement – What does it contain?Matches Expenses with Revenues for a specific

period of time. (Only the temporary type of accounts are on the income statement.) No Assets/Liabilities

Income Statement accounts are closed out at the end of the reporting period and started over again the next period….so comparisons can be made.

Income Statement – Example

Name of Individual or business Income Statement

For period of time (Month of Sept. 2010)Revenue: Income from Job Rs.500 Income from XGrant 2000 Total Revenue: Rs.2500Expenses: Clothes Expense Rs.300 Rent Expense 200 Food Expense 50 Tuition Expense

1200Misc. Expense 250

Total Expenses: Rs.2000Net Income for September: Rs.500

Quiz Which financial report is a “snapshot” of the

financial status of a business or a family…..and is given a specific date?

Which financial report is a “moving picture” of the business/enterprise for a period of time?

What does a balance sheet balance?What are the two kinds of accounts found on an

Income Statement?On what financial report(s) is the “cash” account

found?What are the three subtitles of a income

statement. (name them in the order they are given on the report)

If the bank wanted to know your “Net Worth” what report would they ask for?

Capital in a corporation is entitled ?Two ways to increase the capital account are?Two ways to decrease the capital account are?If the bank wanted to know your “Net Worth”

what report would they ask for?

How do individuals or businesses keep track for all their assets, liabilities, capital, expenses, revenues. Etc.?The “Accounting Process” or otherwise known

as the Accounting Cycle. (also called the “Audit Trail” of business.

Based on universally accepted accounting principles. (Generally accepted accounting principles)

Double Entry BookkeepingAccrual Accounting vs. Cash AccountingBookkeeping part of accounting.

A few more termsGoodsGoodwillDepreciationGoodsCapital expenditure v/s revenue expenseInsolventTransaction A supplier of goods is also called _ _ _ _ _ _ .A buyer or purchaser of goods or services is

also called _ _ _ _ _ _ .

PurchasesSundry creditorsSalesSundry debtorsRevenueIncomeGainLossDrawings

Definition of accounting “The art of recording, classifying, and

summarizing monetary transactions and events which are, in part at least, of financial character, and interpreting the results thereof."

Who uses accounting information?OwnersManagersInvestors (including potential)

Analysts on their behalfCreditors (including potential)Government (tax assessment)RegulatorsCustomers

Branches of accountingFinancial accountingCost accountingManagement accountingTax accountingSocial accountingHuman resource accounting

Accounting conceptsAccounting concept refers to the basic

assumptions and rules and principles which work as the basis of recording of business transactions and preparing accounts.

Accounting conceptsBusiness Entity conceptGoing concernUnit of measure (Money measurement)Accounting period Cost Dual aspect conceptRevenue recognitionMatchingConsistencyVerifiabilityConservatismFull disclosureMateriality

Business Entity conceptThe Accounting Entity convention states

that the business is an entity (perceived to have its own existence) separate from its owner. Therefore business records should be separated and kept distinct from the personal records of the business owner(s).

Going concernAccountants assume, unless there is

evidence to the contrary, that a company is not going broke and will continue its operation for an indefinite period of time or at least into the foreseeable future.

This concept also allows businesses to spread (amortize) the cost of fixed asset over its expected useful life. 

Unit of measure ( money measurement)Accountants do not account for items unless

they can be quantified in monetary terms.Which implies that either money was

exchanged to acquire it or a market exists that would be prepared to exchange money for it.

A business may have other valuable resources like workforce skill, morale, market leadership, brand recognition, quality of management, but these do not get recorded in the financial statements because they cannot be quantified in monetary terms. 

Accounting periodThis convention allows for the performance

evaluation of a 'going concern' business  to be broken-up into specific period of time such as a month, a quarter or a year.

This is also known as the accounting period convention.

This short time period of assessment allows internal and external users to make adjustments to their strategy in relation to the business.

Also using this time period concept, the accountant and other users can compare financial results over a similar period of time.

The accounting period generally covers a span of 12 months.

Historical Cost conceptThis convention requires that the assets of a

business be recorded in the ledger accounts at the actual price paid to acquire them.

Under this concept no account is taken of the changing values of these assets in the market place.

Satisfies the criteria of objectivity and verifiability.

Dual aspect conceptAccording to duality each transaction will affect

at least two items The dual impact of each transaction would be

such that Assets = Liabilities + Owners Equity.

All transactions recorded in the accounts must keep this equation in balance.

Revenue recognitionRevenue is deemed to be earned at the point of

sale or at the transfer of legal ownership. This may be different from the point when cash

actually changes hands. E.g. precollected revenues, accounts

receivables, accrued revenue,Two classes of gains possible: a) holding gains;

b) trading or operating gains. As per this convention only operating gains will be recorded.

Special cases:a)Contract jobsb)Hire purchase agreement

Matching conceptExpenses should be "matched" against revenues

that they enabled and should be recorded in the same period in which the revenue is earned.

This approach is supported by the accrual accounting method.

Accountants need to prepare accruals at the end of each reporting period to take account of expenses incurred but for which there is no source document.

ConsistencyAccording to this convention, transaction

classification and valuation methods should remain unchanged from one period to the next. 

This allows for a more meaningful comparisons of financial performance between periods by the stakeholders.

VerifiabilityTransactions must be recorded on the basis

of objective evidence. Accounting records will initiate from a

source document to ensure that the information recorded is based on fact and not just on personal opinion. 

ConservatismThe rule is to recognize revenue only when

it is reasonably certain of happening and recognize expenses as soon as they are incurred (whether paid or not).  

Accounting in this manner ensures that financial statements do not overstate the company’s financial position.  

Full disclosureThis concept requires that financial

statements provide sufficient information to help users of the information make knowledgeable and informed decisions about the business. 

To meet this requirement, the enterprise must add notes to the financial statements.

Does not require to reveal business secrets.

MaterialityAccountants only record events that are

significant enough to justify the usefulness of the information. 

Only items that are deemed significant for a given size of operation should be recorded. Accountants are guided to ignore insignificant details otherwise the accounts will be burdened down with minute details.