Accounting and Its Concepts

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Accounting is a systematic tool of recording, reporting and analyzing the financial transactions and performance of any business. It is considered as an art because it involves a particular way of recording and summarizing the performance of business. For example, financial statements are prepared by differentiating transactions into an ‘Income Statement’, ‘Balance Sheet’, ‘Cash-Flow’ statement. Accounting can also be considered as a science when the financial statements are analytical and logically utilized by a business’ management to make informed business decisions in the short-run and the long-run. The following sections in this chapter will aim at introducing conceptual understanding of various terms in the balance sheet and income and expenditure statements. The purpose of revising these terms is to direct and evaluate them beyond their definitions and understand these terms with regards to their application in the real world.

Balance Sheet

The balance sheet is the summary of the financial position of a business at a particular period of time. Financial position what a business owns and owes, as well as the amount invested by their shareholders. Accordingly, there are three main components of a balance sheet – Asset (what the business owns); Liabilities (what the company owes) and; Shareholders’ Equity (the amount invested) which are summarized below:

Assets

Anything that a business or a company owns and has value (in terms of money) is an asset. Assets can be of three kinds – current assets, fixed assets and other assets

  • Current assets are cash or assets that are expected to be converted into cash. For example, Haria is a popcorn seller and has kept aside or stored leftover corn and popcorn after working hours but observed that some customers (or friends) owe him money for popcorn he had sold. He counts the remaining money from the popcorn sales and registers – “stored leftover corn and popcorn” as inventories, “money owed by friends” as account receivables and “money from sale of popcorn” as cash. Within current assets, inventories are the amount of all raw materials considered for producing goods (but not used for production) and finished goods available or ready for sale that are stored in warehouses or storages.  Also, account receivables are money owed by customers to a business in exchange for goods or services that have been delivered or used but not paid and cash is the money from sales proceeds.

Current assets can also include short-term investments, loans and advances. For example, Haria has invested in stock or bond markets (short-term investments) or provided a loan to a friend who sells icecreams (loans) and paid-off the next 6-month loan amount remaining on his vehicle (advances)

  • Fixed assets are assets that are acquired for long-term use and include land, buildings, plant, machinery, equipment, furniture, fixtures, etc. Fixed assets are long-term costs with a cost allocated as depreciation that is deducted from the fixed costs. Depreciation is a measure of wearing out or consumption of a fixed asset leading to loss of value. There are different methods of computing depreciation but the most commonly used methods are the straightline method and the reducing balance method (Please note: Introduction to these methods may happen at the later stage of your under-graduate coursework). For example, Haria’s pop-corn machine, related electric gadgets, popcorn cart and depreciation on all of these are Haria’s fixed assets
  • Other assets include mostly intangible assets like patents, trade investments, good will, etc. For example, Haria’s business name (Puff-pop Popcorn) and a copyright on a mascot promoting his product. Also, if Haria has devised a special popcorn machine which lets butter inside the popcorn and acquired a patent on the same are intangible assets

Interpretation of Assets

The numbers reported as assets are information about a business. However, these numbers can be interpreted with reference to the sales generated by a business. For example, the expected total sales from Haria’s pop-corn business were Rs 250,000 in a year and the value of his business’ total assets was Rs 685,500. The sales to total assets (capital employed) for that year would be 0.36 (Sales/Total Assets). Suppose, the actual sales were to Rs 300,000 then the sales to total assets was 0.44, which was more than what was expected. The sales to capital employed ratio aims at explaining the way a business has utilized its assets or the sales generated based on the amount invested in the assets by a business. In our example, the actual sales has been more than the expected sales leading to another question on the capability of Haria’s business of quickly converting production of goods (popcorn) into cash through sales. The time taken for Haria’s business to convert raw material (corn) into finished goods (popcorn) and make sale of popcorn that gives cash to repurchase raw material is called the operating cycle. Another interpretation of the sales to capital employed ratio is when capital employed is low that can enhance the ratio in addition to higher sales. Low capital employed is related to the liabilities section of a balance sheet and implies that the company has less debt or has been able to pay off debt from the cash generated through sales. In our current example, Haria may have purchased corn on credit and when that translates into popcorn followed by cash from sales, the cash can be directed to pay off the credit on corn as well as repurchase more corn to produce popcorn and so on.

Liabilities

Liabilities are claims of creditors against the assets of a business or debts owed by a business. Liabilities can be of three kinds – current liabilities, long-term liabilities and accrued liabilities. For example, Haria the popcorn seller needs to pay for supplies of butter and salt to his supplier Maria. He has taken a loan for the popcorn cart whose repayment is due after 5 years. He needs to pay a state tax which is due at the end of the year and tax payment is a regular occurrence. In this example, the “payment for supplies” is known as current liabilities or accounts payable, “loan on popcorn cart” is long-term liability and the “state tax” is accrued liability.

  • Current liabilities are short-term liabilities or payments (mostly within a year) due for a business. These are bills that are due to creditors and suppliers within a short period of time. Normally businesses withdraw or cash current assets in order to pay current liabilities
  • Long-term liabilities are debts or part of debts that are not due on payment within a year. Examples of long-term liabilities are debentures, mortgage loans and other bank loans that are not all paid within a year but over a period of time
  • Accrued liabilities are liabilities where an expense has been incurred but the business has not paid. Examples can include pension and provident fund of employees kept aside from the wages until the money is turned over to income tax. Until taxes are paid, the kept aside money is an accrued liability.

Liabilities also include the following aspects:

  • Equity, which is money raised from the market or any other personal sources to run any business. For example, Naria (an investor) invests Rs 1 lakh in Haria’s business for which Haria pays 5% of profit every year. Equity can also include raising money from people at large in the form of IPO, Debentures, etc
  • Capital Stock, which is the sign of a business’ economic health that can be used for enhancing the future efficiency of the company. For example, Haria keeps aside 5% of his profits to upgrade his pop-corn machine and cart

Double Entry Book-keeping

There are 11 broad aspects of accounting that every accounting professional should be aware of and are explained as follows:

  1. Event: a happening of consequence. An event generally is the source or cause of changes in assets, liabilities, and equity. Events may be external or internal.
  2. Transaction: an external event involving a transfer or exchange between two or more entities. Transactions are the economic events of an entity recorded by accountants. Some events (happenings of consequence to an entity) are not measurable in terms of money and do not get recorded in the accounting records. Hiring employees, placing an order for supplies, greeting a customer and quoting prices for products are examples of activities that do not by themselves constitute transactions.
  3. Account: a systematic arrangement that shows the effect of transactions and other events on a specific asset or equity. A separate account is kept for each type of asset, liability, revenue, and expense, and for capital (owners’ equity).
  4. Permanent and Temporary accounts: Permanent (real) accounts are asset, liability, and equity accounts; they appear on the balance sheet. Temporary (nominal) accounts are revenue, expense, and dividend accounts; except for dividends, they appear on the income statement. Temporary accounts are periodically closed; permanent accounts are left open.
  5. Ledger: the book (or computer printouts) containing the accounts. Each account usually has a separate page. A general ledger is a collection of all the asset, liability, owners’ equity, revenue and expense accounts. A subsidiary ledger contains the details related to a given general ledger account.
  6. Journal: the book of original entry where transactions and selected other events are initially recorded.
  7. Posting: the process of transferring the essential facts and figures from the book of original entry to the ledger accounts.
  8. Trial balance: a list of all open accounts in the ledger and their balances. A trial balance may be prepared at any time.
  9. Adjusting entries: entries made at the end of an accounting period to bring all accounts up to date on an accrual accounting basis so that correct financial statements can be prepared.
  10. Financial statements: statements that reflect the accounting data’s collection, tabulation, and final summarization. Financial statements consist of the balance sheet, the income statement, the statement of cash flows and the statement of retained earnings.
  11. Closing entries: the formal process by which all temporary accounts are reduced to zero, and the net income or net loss is determined and transferred to the appropriate owners’ equity account.

An account is an individual accounting record of increases and decreases in a specific asset, liability, or stockholders’ equity item. In its simplest form, an account consists of three parts: (1) the title of the account, (2) a left or debit side, and (3) a right or credit side. Because the alignment of these parts of an account resembles the letter T, it is often referred to as a T-account.

“Credit” does not always mean favourable or unfavourable. In accounting, “debit and “credit” simply mean left and right, respectively. “Debit” is a term that refers to the left side of any account. Thus, the debit side of an account is always the left side. “Credit” is a word that simply refers to the right side of an account. Thus, the credit side of an account is always the right side of the account. The phrase “to debit an account” means to enter an amount on the debit (left) side of an account. Debit can be abbreviated as “Dr.” and credit is abbreviated as “Cr.”

A “+” indicates an increase and a “-” indicates a decrease. Therefore, a transaction, which causes an increase in an asset, is recorded by a debit to the related asset account; a transaction, which causes a decrease in the same asset, is recorded by a credit to the same account.

The left side of an account is the debit side; the right side is the credit side. All asset and expense accounts are increased on the left or debit side and decreased on the right or credit side. Conversely, all liability and revenue accounts are increased on the right or credit side and decreased on the left or debit side. Shareholders’ equity accounts, Common Shares and Retained Earnings, are increased on the credit side, whereas Dividends is increased on the debit side. In the double-entry system of accounting, for every debit there must be a credit(s) of equal amount, and vice versa.

When you encounter a transaction, always analyse it in terms of its effects on the elements of the basic accounting equation (or balance sheet equation). For your analysis to be complete, it must maintain balance in the basic accounting equation. The basic accounting equation is as follows:

ASSETS = LIABILITIES + OWNERS’ EQUITY

or

A = L + OE

Assets are economic resources. Liabilities and owners’ equity are sources of resources; liabilities are creditor sources, and owners’ equity represents owner sources (owner investments and undistributed profits). The basic accounting equation simply states that the total assets (resources) at a point in time equal the total liabilities plus total owners’ equity (sources of resources) at the same point in time.

The basic steps in the accounting cycle are

(1) identification and measurement of transactions and other events, (2) journalization, (3) posting, (4) unadjusted trial balance, (5) adjustments, (6) adjusted trial balance, (7) statement presentation, and (8) closing.

The simplest journal form is a chronological listing of transactions and events expressed in terms of debits and credits to particular accounts. The items entered in a general journal must be transferred (posted) to the general ledger. An unadjusted trial balance should be prepared at the end of a given period after the entries have been recorded in the journal and posted to the ledger.

Adjustments are necessary to achieve a proper matching of revenues and expenses so as to determine net income for the current period and to achieve an accurate statement of end-of-the period balances in assets, liabilities, and owners’ equity accounts.

In the closing process, all of the revenue and expense account balances (income statement items) are transferred to a clearing account called Income Summary, which is used only at the end of the fiscal year. Revenues and expenses are matched in the Income Summary account. The net result of this matching, which represents the net income or net loss for the period, is then transferred to an owners’ equity account (Retained Earnings for a corporation and capital accounts for proprietorships and partnerships.)

Income & Expenditure Account or Profit & Loss Account

A financial statement that summarizes the revenues, costs and expenses incurred during a specific period of time – usually a fiscal quarter or year. These records provide information that shows the ability of a company to generate profit by increasing revenue and reducing costs. The P&L statement is also known as a “statement of profit and loss”, an “income statement” or an “income and expense statement”.

The statement of profit and loss follows a general form as seen in this example. It begins with an entry for revenue and subtracts from revenue the costs of running the business, including cost of goods sold, operating expenses, tax expense and interest expense. The bottom line (literally and figuratively) is net income (profit). Many templates can be found online for free, that can be used in creating your profit and loss, or income statement.

The balance sheet, income statement and statement of cash flows are the most important financial statements produced by a company. While each is important in its own right, they are meant to be analyzed together.