ACCOUNTING

1. Accounting Fundamentals

Accounting is the process of documenting, classifying, and summarizing

financial transactions in order to produce data that may be used to
make business decisions. Accounting has its own vocabulary and is
based on a set of distinct rules and concepts.

Vocabulary

Anyone can grasp it, not just those who have studied accounting for a
long period. All of one's day-to-day actions are included in financial
management. Yes, accountants employ a lot of jargon that may appear
frightening at first. When you look at your own personal finances,
however, you can often find a similar example — and a simpler term.

You can see how managing a business's financial operations is similar to

managing your own financial activities on this page. Corporations and
personal accounts use terms like income, expenditures, profit, and loss.
Personal finance and corporate accounting are both responsible for
tracking and managing money, which is a resemblance. Individuals
must check if payments were made, prepare overviews and budgets,
and track income in both personal finance and accounting. While the
two sectors have numerous distinctions, the overarching goal is to
guarantee that money is managed in an efficient and effective manner
and that everything is properly documented.

Accounting Principles

The Generally Accepted Accounting Concepts (GAAP) are a set of

essential accounting principles that form the foundation of the industry
(GAAP). Varying countries have different standards, which are normally
monitored by a mix of commercial accounting firms and government
regulators. The following are the eight most significant principles:
 1. Revenue Principle

Revenue should be recognized when it is earned, realized, or realizable,

according to the revenue principle. This accounting principle ensures
that income is reported in the period in which it is generated (when
legal ownership of the items changes from seller to buyer), rather than
when it is received (when cash is collected). This notion is also helpful in
preventing enterprises from overstating their revenue.

2. Expense Principle

According to the expense principle, all expenses incurred during a

period should be recorded in the financial accounts for that period. This
comprises all costs associated with generating income as well as all
costs associated with maintaining operations. Regardless of when they
were paid, all expenses must be reported in the period in which they
were incurred.

3. Matching Principle

The matching principle states that expenses should be disclosed in the

same period as the revenue they helped produce. The matching
principle aims to provide a more realistic picture of a business's
financial health.

4. Cost Principle

According to the cost principle, assets should be reported at their

historical cost. This idea is crucial because it ensures that financial
statements are comparable and consistent.

5. Objectivity Principle
One of the most essential accounting rules is the objectivity principle. It
stipulates that financial data must be objective and unbiased. This idea
is critical for guaranteeing financial statement accuracy and reliability.

6. Continuity Assumption

The continuity concept is an accounting idea that asserts that firms

should operate indefinitely. In accounting, this approach is used to
identify the optimum way to value specific assets and liabilities.

7. Unit-of-Measure Assumption

The assumption that all economic activity can be described in terms of

a single unit is known as the unit-of-measure assumption. Money, units
of production, or some other measure can be used as this universal
unit. This assumption is critical in accounting because it allows for
consistent and comparable economic activity measurement.

8. Separate Entity Assumption

The separate entity assumption assumes that a company exists

independently of its owners. This indicates that the company has its
own funds and assets. This assumption is crucial in accounting because
it allows firms to keep their finances distinct from the finances of their
owners. This assumption is especially significant in tax law since it
allows firms to file and pay their own tax returns.
Accruals vs. Cash Accounting

Cash accounting and accrual accounting are the two types of

accounting. When revenues and expenses are documented, there is a
distinction between the two methods of accounting:

 Revenues are recorded when cash is actually received, and

expenses are recorded when they are actually paid, regardless of
when they were originally billed, in cash accounting.

 Revenues and expenses are recorded when they are earned in

accrual accounting, regardless of when the money is actually
collected or paid.
Cash Accounting Has Its Advantages

Because it is directly linked to the physical transaction of money, cash

accounting is basic and straightforward. Cash accounting's biggest
disadvantage is that it does not provide a clear picture of a company's
financial status at any given time. For instance, if a corporation has
incurred $10,000 in expenses but has yet to pay them, the cash balance
will not represent this responsibility.

Accrual Accounting Has Its Advantages

While the cash method of accounting can provide a snapshot of a

company's cash flow at a given point in time, accrual-based accounting
provides a more accurate picture of the company's long-term financial
state because revenue and expenses are recorded immediately,
allowing the company to better analyze trends and manage its finances.
This is a more popular method than the cash method. However,
because accrual accounting does not immediately relate to the practical
transaction of money, it might be more difficult to understand.

3. Accounting Equation

All accounting principles are built on the foundation of the basic

accounting equation. It depicts the link between a company's assets
(what it owns), liabilities (what it owes others), and equity (what it
owns) (the difference between assets and liabilities). Assets = Liabilities
+ Owners' Equity is the formula.

Assets
An asset is something that can be used to create value in accounting.
This encompasses both tangible and intangible assets, including as
buildings and machinery, as well as intellectual property and goodwill.

The goal of asset classification is to make it easier for organizations to

manage and track their assets. Assets can be classified in a variety of
ways. Liquidity, which relates to how rapidly an asset may be changed
into cash, is the most prevalent approach. Businesses can prioritize
their usage of cash by categorizing assets according to their liquidity.
For instance, if a company needs cash immediately, it would prioritize
using its liquid assets:

 Assets that can be converted into cash within a year are known as
current assets. Cash, accounts receivable, and inventory are just a
few examples.

 Non-current assets are those that will take more than a year to
convert to cash. Buildings, machines, and patents are all
examples.

The classification of assets can have a big impact on a company's

financial results. Current assets, for example, are often reported as part
of working capital on the balance sheet. On the other hand, non-
current assets are frequently reported separately from current assets.

Cash and cash equivalents, investments, property, plant and

equipment, intangibles, and receivables are the most common asset
kinds. The next sections go over each type of asset in further depth.

Cash and cash equivalents: These assets are the most liquid of all, and
include bank accounts, money market funds, and short-term
government bonds.
Investments: These are long-term investments that are difficult to
convert to cash. Shares, bonds, and real estate are examples.

Property, plant, and equipment: Physical assets such as land, buildings,

machinery, and vehicles fall under this category. These assets are
utilised in a company's activities and have a finite lifespan.

Intangibles: These are non-physical assets that offer a business with

economic benefits but have no physical form. Goodwill, copyrights, and
trademarks are examples.

Receivables: Customers owe money to a business in the form of

receivables. Accounts receivable and notes receivable are two
examples.

Liabilities

A liability is defined in accounting as everything owing by a corporation

to another party. Money due for goods or services, money borrowed
from financial institutions, or any other sort of debt can fall into this
category. Liabilities should be tracked because they can have a
significant impact on a company's financial health.

Liabilities are divided into two categories: current liabilities and long-
term liabilities.

Debts that must be paid within a year are called current liabilities,
whereas debts that must be paid after a year are called long-term
obligations.
In order to maintain a company's finances healthy, it's critical to
manage both types of obligations.

Accounts payable, short-term loans, and accrued expenses are all

instances of current liabilities.

The sum owing to suppliers for products or services received but not
yet paid for is referred to as accounts payable. This is a relatively
common liability for firms because it occurs in the normal course of
business. If a corporation orders $5,000 in office supplies on credit, the
$5,000 is recorded as an accounts payable liability.

Another prominent sort of current liabilities is short-term loans.

Typically, these are used to fund corporate operations or to meet
unexpected expenses. For example, if a business has to buy
merchandise but lacks the funds to do so, it may take out a short-term
loan to cover the expense. In most cases, short-term loans are repaid
within a year.

Costs that have been incurred but not yet paid for are referred to as
accrued expenses. If a corporation pays its employees every two weeks
but pays payroll taxes once a month, the monthly payroll tax bill is
recorded as an accumulated expense until it is paid.

Long-term liabilities, as defined above, are obligations that are not due
for at least a year. Mortgages, bonds, and long-term loans are the most
common instances of long-term liabilities.

Mortgages are a sort of long-term loan used to fund the acquisition of

real estate. Mortgages are typically 15 or 30 years in length and are
paid in monthly installments. For example, if a corporation takes out a
$1 million mortgage to finance the acquisition of a new office building,
the $1 million is represented on the balance sheet as a long-term debt.
Another prominent sort of long-term liability is bonds. Bonds are simply
IOUs that are issued by businesses or governments to raise funds. For
instance, if a corporation needs $500,000 to fund a new project, it may
issue bonds. The $500,000 would subsequently be reflected on the
balance sheet as a long-term obligation.

Another prominent sort of long-term liabilities is long-term loans.

Typically, these are used to fund large projects or expansions. If a
corporation needs to develop a new plant, for example, it may take out
a long-term loan to finance the project. Long-term loans are usually for
five years or more and are paid back in monthly installments.

The main distinction between current and long-term obligations is their

timing; however, there are a few other distinguishing aspects. To begin
with, current liabilities are usually incurred throughout the course of
corporate activities, whereas long-term obligations are usually tied to
finance. Second, current liabilities are usually unsecured, whereas long-
term liabilities are usually secured by assets like as property or
equipment.

Owners’ Equity

The owner's equity refers to their investment in the company or their

claim on its assets. It's also known as the worth of a company's assets
after all liabilities have been paid. If the company were to be liquidated,
this value represents the amount of money that would be returned to
shareholders.

Common stock and retained earnings are the two types of owner's
equity.
Paid-in capital is money invested in a firm by individuals (such as the
business owner or investors).

The gains that a firm has reinvested back into itself are known as
retained earnings.

By a corporation takes on too much debt – for example, when acquiring

another company – owners' equity might turn negative.

The equation

The accounting equation expresses the relationship between assets,

liabilities, and owners' equity and is the foundation of double-entry
bookkeeping. In most cases, the equation is expressed as: Liabilities +
Owners' Equity = Assets
The Accounting Equation's Rules:

 Assets must always match the total of liabilities and equity in

order for the accounting equation to be balanced.

 Every business transaction necessitates the switching of two

accounts. This indicates that for every benefit acquired, another
benefit must be sacrificed.

 The accounting equation is crucial since it ensures that a

business's accounts are in order. This is due to the fact that each
transaction must include a debit and credit entry; that is, each
transaction must influence at least two separate elements of the
equation.

 For example, if a corporation buys $100 of inventory on credit,

its assets will increase by $100 while its liabilities will increase
by $100. The equation is correct.

 If a business owner invests $100 on new merchandise, the

company's assets will increase by $100, while the owners'
equity would increase by $100. The equation is now balanced
once more.

 If a firm spends $500 on debt repayment, its assets (cash) are

reduced by $500, while its liabilities are reduced by $500. And,
once again, the equation is in the right place.
The double-entry bookkeeping system is based on the accounting
equation. Every transaction in double-entry accounting is recorded in at
least two separate accounts (we will cover this in the next chapter).

4. Bookkeeping

The process of recording, preserving, and retrieving financial

transactions for a firm is known as bookkeeping. It is an important
aspect of every firm because it keeps track of all income and expenses.
It would be difficult to track a company's financial health without good
recordkeeping.

All financial transactions and activities that occur over a period are
recorded using journal entries. Manual or electronic journal entries are
also acceptable. If they're done by hand, they're usually written down
in a journal, which is a volume of original entries. They are usually
recorded in an accounting software application if they are made
electronically.

Regardless of how journal entries are created, they must always include
a date, a description, and a reference number, as well as a list of the
accounts that were affected. The date shows when the transaction took
place. More details about the transaction may be found in the
description. If necessary, the reference number is utilized to locate the
original source document.

The entries in your journal must always be balanced. This indicates that
the total debits and credits must be equal. If the journal entry is out of
balance, it must be adjusted before being placed into the ledger.
What kind of information can we glean from these three diary entries?
The first record indicates that we have purchased stock and accessories
(inventory) for $1500,000 and we have paid by check or in a different
way through our bank account. The second entry states that we have
spent $800,000 in order to buy office furniture and we have paid by
check again or in a different way through our bank account. The third
one depicts the purchase of plant and equipment for $845 and also a
computer expense of $350 that have been paid through our bank
account.

After all of the journal entries for a certain time have been completed,
they are posted to the proper ledger accounts. During a given period,
ledger accounts reflect all of the activity for a certain account. Financial
statements are ultimately derived from the ledger. In the following
chapters, we'll look at how to create financial statements.

5. Financial Statements

Financial statements are a set of reports that detail a company's

financial performance, financial status, and cash flows. The purpose of
financial statements is to inform readers and the entity about the
entity's financial situation, performance, and changes.

Why Statements?

Financial statements are a valuable source of information for all

business stakeholders. They can be used to make judgments about
lending, investments, and other commercial partnerships since they
provide information about the company's financial health.

Internal and external users of financial statements can be divided into

two categories. Internal users are individuals who are involved in the
business's day-to-day operations and have access to its financial
records. External users are people who aren't directly involved in the
company but are interested in its finances.

Managers, owners, and staff are among the internal users. Financial
statements are used to make decisions about how to run the company
and how to distribute its resources. Managers might utilize financial
statements, for example, to determine if the company is progressing
toward its objectives or to find areas where cost reductions could be
made. Financial statements can be used by investors to track the
performance of their investments and choose whether to sell. Financial
statements can be used by employees to track their progress toward
fulfilling performance goals or to examine how their remuneration
compares to that of other employees in comparable roles.

Creditors, suppliers, customers, and regulatory authorities are

examples of external users. Financial statements are used by creditors
to assess a company's creditworthiness and determine whether or not
to give credit to it. Financial statements are used by suppliers to
determine whether a firm is likely to pay its obligations on schedule.
Financial statements are used by customers to analyze a company's
financial health before engaging into a contract with it. Financial
statements are used by regulatory entities such as banks and
government agencies to monitor compliance with laws and regulations.
The income statement is a financial statement that illustrates a
company's earnings and expenses over a specific time period, usually a
year. The profit and loss statement, or P&L, is another name for it. The
income statement is a financial statement that may be used to evaluate
a company's financial performance and compare it to other companies
in its industry.

A balance sheet depicts a company's assets, liabilities, and equity at a

specific point in time. Remember that assets include anything of value
that a company has, including cash, inventory, equipment, and
buildings. Liabilities are the debts due to creditors by the company,
such as loans and accounts payable. The difference between assets and
liabilities is called equity, and it symbolizes the owner's investment in
the company.

The statement of cash flows illustrates how much money a company

has made or spent during a specific time period, usually a year.
Operating activities, investing activities, and financing activities are the
three sections. The cash flow statement is crucial because it shows if a
firm has enough cash on hand to pay its payments and invest.

Managers and business owners must comprehend these financial

figures and how they connect to one another. They can make informed
decisions about how to manage their resources by tracking their
income and expenses. This can assist them in expanding their company
and achieving financial success.

Income Statement

One of the most significant financial statements is the income

statement. It's a report that details a company's revenue and expenses
over a specific time period, commonly quarterly or annually. The
income statement is a financial statement that can be used to assess a
company's financial performance and make resource allocation
decisions.

Revenue, costs, and net income are the three key elements of the
income statement.

 The money that comes into the company from the selling of
products or services is referred to as revenue.

 Expenses are the costs associated with generating revenue.

  The difference between revenue and expenses is net income,
which indicates the company's profit (or loss) for that time.

The total revenue for the period is the first step in preparing an income
statement. This can be accomplished by adding all of the company's
sales, both product and service-related. The overall expenses for the
time period are then computed. Cost of goods sold (COGS), operational
expenses, and interest expenses are all included. Finally, total expenses
are subtracted from total revenue to arrive at net income.

The single-step statement and the multi-step statement are the two
most common types of income statements.

Single-Step Income Statement

A single-step revenue statement is simple and straightforward. Small

firms and companies with only one type of revenue or expense
frequently employ it.

Revenues appear first on a single-step income statement, followed by

expenses. After that, deduct total expenses from total revenues to
arrive at net income (or loss). This figure is significant because it
indicates whether a business made or lost money over the time period
covered by the income statement.

Using a single-step revenue statement has various advantages. First and

foremost, it is simple to prepare and comprehend. If you're new to
accounting or just need a brief summary of a company's financial
status, this can be useful. Second, it compiles all of the information you
require in one convenient location. When studying a company's
financial accounts, this can save time.
The use of a single-step income statement has certain drawbacks as
well. One disadvantage is that it lacks the level of detail found in other
types of income statements. It does not, for example, demonstrate how
revenue and expenses are divided into separate categories. It can be
difficult to see where a company is profitable or losing money as a
result of this.

The income statement's headline conveys crucial information. The term

"Income Statement" appears first, followed by the company's name.
The third line informs the reader of the profit and loss statement's time
interval. Because income statements can be created for any time
period, you must tell the reader what time period is being covered (for
example: Year Ended May 31 or Month Ended May 31.)
A more detailed Income Statement:
Multiple-Step Income Statement

The multiple-step income statement is an alternative to the single-step

income statement. To get at net income, the statement starts with total
revenue and subtracts all operational and non-operational expenses.
The bottom line can then be broken down into various areas, including
gross profit, operating income, and net income before taxes. Businesses
may gain a clear view of their overall financial health and detect trends
that may require further inquiry by analyzing these statistics over time.

While multiple-step income statements can provide useful information

about a company's financial health, they can have some drawbacks.
One disadvantage is that they can be complicated and difficult to
comprehend for individuals without prior accounting training.
Using the above multiple-step income statement as an example, we see
that there are three steps needed to arrive at the bottom line net
income:

Cost of goods sold is subtracted from net sales to arrive at the gross
profit:
$490,000 – $150,000 = $340,000
Operating expenses are subtracted from gross profit to arrive at
operating income / net income before taxes:
$340,000 – $47,000 - $2000 = $291,000

The net amount of non-operating revenues, gains, non-operating

expenses, and losses is combined with the operating income to arrive
at the net income (or net loss): (Net Income before Taxes – Income Tax
Expense = Net Income)
$291,000 - $15,000 = $276,000

Balance Sheet

A balance sheet is a financial record that shows the assets, liabilities,

and shareholders' equity of a corporation at a specific point in time. It's
the report version of the accounting equation, in which assets always
equal liabilities + shareholder's equity.
The balance sheet does not reflect how much money a business has
made or spent over time (like the income statement does). On any
given day, it indicates what a company owns and owes, as well as who
owns it.

The balance sheet depicts what the company has (assets) and how it is
financed (through liabilities or equity).

The majority of accountants construct balance sheets that divide

accounts into various categories (such as current assets, fixed assets,
etc.). It's now easy to see which areas need to be improved. The
balance sheet, like all financial statements, has a heading that includes
the company name, the statement's title, and the report's time period.

One thing to keep in mind is that total assets equal total liabilities and
equity, just like in the accounting calculation. This is the situation all of
the time. Total assets are $650,000, and total liabilities plus
shareholders' equity are also $650,000 in this example:
The balance sheet gives us an idea of a firm’s financial position. For
example, the balance sheet above shows us that:

The company has total assets of $472,100 – such as $100,000 in cash,

$15,000 in inventory and $319,325 in property.
The company has liabilities of $247,000 ($47,000 current liabilities plus
$200,000 long-term debt). The company has equity of $225,100.
The firm’s total assets equal the firm’s total liabilities and equity. This is
not only true for this company but for all balance sheets.

Cash Flow Statement

A statement of cash flows is a financial statement that illustrates how

much money a company has made and spent over time. The statement
normally covers a year, however it might be shorter or longer
depending on the needs of the organization.

The goal of the cash flow statement is to show investors and creditors
how successfully a company manages its cash. It's also used to see if a
business has enough cash on hand to meet its immediate obligations.

Operating operations, investment activities, and financing activities are

the three primary elements of the cash flow statement. Each part is
divided into sub-sections that describe the various methods in which
money was made or spent throughout the time period.
  The operations that are relevant to a company's principal business
are known as operating activities. Selling items or services,
creating goods, and delivering services are all examples of this.

 Investing operations include the purchase and sale of long-term

assets such as real estate, machinery, and equipment.

 Borrowing money or issuing fresh equity are both examples of

financing activity.

The reconciliation of the beginning and ending cash and equivalents

balances completes the statement of cash flows. This reconciliation is
crucial because it determines if a company has enough cash on hand to
meet its immediate obligations.

Example:

On August 1st, John invests $3,000 of his personal money into his
company. On August 15th, his company buys inventory for $2,000. The
company has no other transactions during August.

John prepares the Cash Flow Statement for his new business as of
August 31. Like all financial statements, the statement of cash flows has
a heading that displays the company name, the title of the statement
and the time period of the report. It also lists the operating, investing
and financing activities:
The cash flow statement reports that the company’s operating activities
resulted in a decrease in cash of $2,000. The decrease in cash occurred
because the company increased its inventory by $2,000 during August.
The financing activities section shows an increase in cash of $3,000
which corresponds to John’s investment in the business. The net
change in the cash account from the owner’s investment and the cash
outflow for inventory is a positive $1,000.

This net change of $1,000 is verified at the bottom of the cash flow
statement. There was $0 cash on August 1st, but on August 31st, the
cash balance is $1,000.