Accounting 101 | Standard Practices

Welcome to Accounting 101

Accounting, often referred to as the "language of business," is a systematic process of recording, summarizing, analyzing, and interpreting financial transactions and data of an organization. At its core, it provides a quantitative snapshot of a company's performance, financial position, and cash flows over a specific period. By documenting financial activities and following accounting standards, accounting ensures transparency and accuracy in the financial world. Businesses rely on accounting to make informed decisions, assess their financial health, and strategize for growth. Investors and creditors utilize financial statements, products of the accounting process, to gauge the viability and creditworthiness of enterprises. Governments and regulatory bodies use accounting to ensure legal compliance and proper taxation. Employees and the general public benefit from accounting as it facilitates job security and corporate accountability. Accounting underpins trust in financial markets, promotes economic growth, and ensures ethical business practices. Without accounting, the complex web of global commerce would lack clarity and reliability. Below our team have but together an easy to understand document to help you understand the fundamentals of accounting. We will use real-world non-business examples to help you grasp the concepts.

Let's Start at the End

At its core, accounting is a system of recording, classifying, and summarizing financial transactions. It tracks the flow of money within a business, organization, or other entity. Once this information is compiled, accounting presents it in the form of financial statements. These statements provide a snapshot of an entity's financial position and performance, and they're vital for end users like businesses, investors, creditors, and governments to make informed decisions.

End Users and their Interest in Financial Statements:

Businesses: Use financial statements to assess their own performance, compare against industry benchmarks, and plan for the future.
Investors: Rely on financial statements to make decisions about buying, holding, or selling securities. They assess the financial health, profitability, and future prospects of businesses.
Creditors: Use financial statements to evaluate the creditworthiness of businesses seeking loans. They want to ensure the business can repay its debts.
Governments: Require financial statements to ensure compliance with tax laws, to calculate taxable income, and sometimes for regulatory purposes.

Core Financial Statements - 4 to Know:

Balance Sheet (Statement of Financial Position):
- Definition: The balance sheet is a statement that details an entity's financial position at a specific point in time. It's structured around the fundamental accounting equation: Assets = Liabilities + Equity.
- Assets: Resources controlled by the entity as a result of past events from which future economic benefits are expected to flow. They can be current (expected to be realized within one year) or non-current.
- Liabilities: Present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits. Like assets, liabilities can be current or non-current.
- Equity: Represents the residual interest in the assets of the entity after deducting liabilities. It consists of items such as issued capital, reserves, and retained earnings.
- Example (Non-Business):
  - Assets: Sally's car ($10,000), savings in her bank account ($5,000), and a laptop ($1,000).
  - Liabilities: Student loan Sally is still paying off ($7,000) and credit card debt ($1,500).
  - Equity (Net Worth): Total assets minus total liabilities = ($10,000 + $5,000 + $1,000) - ($7,000 + $1,500) = $7,500.
Income Statement (Profit and Loss Statement):
- Definition: The income statement provides a summary of an entity's financial performance over a particular period, detailing how much was earned (revenues) and how much was spent (expenses). The bottom line of this statement indicates either a net profit or a net loss.
  - Revenues: Inflows of economic benefits (usually cash or receivables) during the period arising from the main operating activities of an entity.
  - Expenses: Outflows or depletions of assets or incurrences of liabilities during the period, resulting from delivering goods, rendering services, or other ordinary activities.
- Example (Non-Business):
  - Income: John's monthly salary from his job ($3,500) and a freelance gig he did ($500).
  - Expenses: John's rent ($1,200), groceries ($400), utilities ($150), and entertainment ($250).
  - Net Income: Total income minus total expenses = ($3,500 + $500) - ($1,200 + $400 + $150 + $250) = $2,000.
Cash Flow Statement:
- Definition: This statement offers a detailed account of the cash inflows and outflows an entity experienced over a specific period, segmented into three key activities:
  - Operating Activities: Cash flows from the principal revenue-producing activities of the entity.
  - Investing Activities: Cash flows from the acquisition and disposal of long-term assets and investments.
  - Financing Activities: Cash flows from transactions with the entity's owners and creditors, including borrowing, repaying debt, issuing stock, and paying dividends.
- Example (Non-Business):
  - Operating Activities: Peter receives his monthly salary ($2,800) and pays for groceries ($300), gas ($100), and a gym membership ($50).
  - Investing Activities: Peter buys a new camera ($600).
  - Financing Activities: Peter borrows $1,000 from a friend and pays back $200 of a previous loan.
  - Net Cash Flow: Cash inflow minus cash outflow = ($2,800) - ($300 + $100 + $50 + $600 + $200) = $1,550.
Statement of Changes in Equity:
- Definition: This statement illustrates the changes in an entity's equity over a given period. It details movements in shareholders' equity sections, such as issued capital, reserves, and retained earnings.
  - Components: The main components include beginning equity, total comprehensive income (which includes net profit or loss from the income statement), dividends paid, issuance or repurchase of shares, and other adjustments.
- Example (Non-Business):
  - Beginning Equity: Mary's net worth at the start of the year is $12,000.
  - Income for the Year: Mary earns a total of $30,000 from her job.
  - Expenses for the Year: Rent, food, transport, and other expenses amount to $20,000.
  - Other Adjustments: Mary receives a gift of $5,000 from her parents.
  - Ending Equity: Starting net worth plus income and gifts, minus expenses = $12,000 + $30,000 + $5,000 - $20,000 = $27,000.

By interpreting these financial statements, end users can get a comprehensive view of an entity's financial position and performance. This information is critical for making a wide range of financial decisions.

Know that you know WHY, Let's learn some Accounting Principles...

Accounting principles serve as the foundation for all accounting practices and procedures. They ensure consistency, reliability, and relevance in the preparation of financial statements. Basically when preparing the financial statements, accountants have to ensure that we abide by these principles. Here's a breakdown of the major accounting principles:

Accrual Principle:
- Definition: Income and expenses are recorded when they are earned or incurred, not necessarily when cash changes hands.
- Non-Business Example: Imagine you mow your neighbor's lawn in June, but they agree to pay you in July. Even though you haven't received the money yet, you consider it as earnings for June.
- Business Example: A company provides consultancy services in December but receives payment in January. The revenue is recorded in December when the service was provided.
Economic Entity Principle:
- Definition: The transactions of an entity should be kept separate from those of its owner and other entities.
- Non-Business Example: Think of keeping your personal savings account separate from a joint account with a friend, even if you use both for a shared goal like a vacation.
- Business Example: A business owner buys a personal car but doesn't record the transaction in the company's books.
Monetary Unit Principle:
- Definition: Transactions are recorded in a stable currency.
- Non-Business Example: In your "piggy bank", you only count coins and notes and not other items like buttons or toy money..
- Business Example: A company operating in multiple countries converts and records all transactions in its home country's currency.
Time Period Principle:
- Definition: Financial statements are produced for specific periods of time.
- Non-Business Example: You check your savings every month to see how much you've added. Each check is for that specific month..
- Business Example: A corporation releases quarterly financial reports to its shareholders.
Cost Principle:
- Definition: Assets and liabilities are initially recorded at their cost.
- Non-Business Example: If you bought a toy for $10 a year ago, you remember its cost as $10, even if similar toys are now $12.
- Business Example: A company buys a machine for $50,000 and records it at this price in its assets.
Full Disclosure Principle:
- Definition: Relevant information should be disclosed to stakeholders.
- Non-Business Example: When selling a used car, you'd inform the buyer about any accidents it's been in or repairs it might need..
- Business Example: A company discloses potential lawsuits in its annual report.
Going Concern Principle:
- Definition: Assumes that an entity will remain in business indefinitely.
- Non-Business Example: You buy a calendar for the year assuming you'll use it throughout the entire year..
- Business Example: A company assumes it will continue operations while preparing its financial statements.
Matching Principle:
- Definition: Expenses are matched with the revenues associated with them.
- Non-Business Example: If you purchased clothes in June that you plan on selling in July. Your June expenses would be inflated and your July sales will inflated. The goal is to ensure your expenses are recognized in the same month of the sale.
- Business Example: Recognizing sales commission as an expense in the same period the related sale is recognized.
Revenue Recognition Principle:
- Definition: Revenue is recognized when it's earned.
- Non-Business Example: You babysit in December but get paid in January. You still consider December as the time you earned the money.
- Business Example: A software company recognizes revenue when it delivers the software to a customer, not when it's paid.
Materiality Principle:
- Definition: Significant transactions should be reported.
- Non-Business Example: You won't rewrite your shopping list just because you forgot to add a candy bar, but you would if you forgot the main ingredients for dinner
- Business Example: A company doesn't adjust its financial statements for a minor typo but would for a large misstatement.
Reliability Principle:
- Definition: Financial information should be verifiable and free from bias.
- Non-Business Example: Trusting a recipe from a well-known chef over one scribbled on a random note because the chef's is more verifiable and factual.
- Business Example: A company's financial statements are audited by an external party to ensure accuracy.
Consistency Principle:
- Definition: Entities should consistently apply the same accounting methods.
- Non-Business Example: Always using the same measuring cup when baking, so the results are consistent each time.
- Business Example: A company uses the FIFO method for inventory valuation consistently over the years.
Conservatism Principle:
- Definition: Choose the method least likely to overstate assets or income.
- Non-Business Example: If you're unsure if your plant needs water, you decide to wait another day to avoid overwatering.
- Business Example: A company records potential liabilities even if the outcome is uncertain.
Comparability:
- Definition: Financial statements should be easily compared with other entities.
- Non-Business Example: When you and your friend both run a race and want to compare times, you ensure you both ran the same distance.
- Business Example: A company follows industry accounting standards to ensure its financial statements are comparable to its competitors.

Recording transactions - Let's learn the tools we can use

Recording transactions refers to the process of documenting every financial event or change that affects the financial position of a business. These events typically arise from business operations such as sales, purchases, borrowing, repayment of loans, paying employees, receiving payments from customers, paying bills, investments etc. The recorded details often include the date, amount, parties involved, and nature of the transaction.

Transactions are recorded using a double-entry system, which means every transaction affects at least two accounts. For example, when a business makes a sale, it not only increases its revenue but also adds to its cash or accounts receivable.

Double-Entry System: This system ensures that the accounting equation (Assets = Liabilities + Equity) always balances. By recording both the debit and credit aspects of a transaction, we ensure a complete view of the transaction's impact on financial position.

Debits (Dr):

Represents the left side of an account ledger or a T-account.
In asset accounts, a debit increases the balance and a credit decreases the balance.
In liability and equity accounts, a debit decreases the balance, while a credit increases the balance.

Credits (Cr):

Represents the right side of an account ledger or a T-account.
In asset accounts, a credit decreases the balance and a debit increases the balance.
In liability and equity accounts, a credit increases the balance, while a debit decreases the balance.

*Accounting Equation*: A fundamental principle in double-entry bookkeeping and accounting that states that at any given point in time, a company's assets will always equal the sum of its liabilities and equity. The equation is represented as: Assets = Liabilities + Equity

1. Assets: These are resources owned by a company which have future economic value. Think of assets as everything a company owns that can help it make money in the future. This includes cash, buildings, equipment, and even things like patents.

2. Liabilities: These are obligations the company owes to others. Imagine liabilities as all the debts or bills the company has yet to pay. This could be loans from a bank, wages owed to workers, or unpaid bills to suppliers.

3. Equity: This represents the ownership interest in the company. In simple terms, equity is what's left over when you subtract liabilities from assets. If a company were to pay off all its debts (liabilities), the remaining value (assets) would belong to the owners. This "leftover" value is what we call equity.

Non-Business Example: Imagine you bought a house (an asset) worth $500,000 with a bank loan (liability) of $400,000. The remaining $100,000 represents your own money or your equity in the house. The house's total value ($500,000) is made up of the bank's loan ($400,000) and your equity ($100,000). In this scenario:

House (Asset) $500,000 = Bank Loan (Liability) $400,000 + Your Money (Equity) $100,000

This concept is foundational in accounting because it always has to balance. If it doesn't, there's likely an error in the financial records. It ensures that every financial transaction impacts at least two accounts, maintaining the equation's balance.

Chart of Accounts (COA):

Imagine the Chart of Accounts as the backbone or the table of contents for a company's financial story. It provides structure, ensuring that every financial activity and transaction has a designated place. When a business wants to record any financial change, whether it's purchasing equipment or taking out a loan, it refers to this chart to determine where and how to document it.

Just as the Accounting Equation gives a high-level view of a company’s financial health, the COA gives a detailed view, breaking down every financial nuance and category:

Assets: Every resource the company owns. Remember the house in our previous example? That's an asset. In a business setting, assets can range from the cash in the bank to a patent on a groundbreaking invention.
Liabilities: All the obligations, the "IOUs". In our house example, the bank loan was a liability. In a business, it can be everything from money owed to suppliers to long-term loans.
Equity: The value that belongs to the owners. Just like the equity in the house was what's left after accounting for the loan, in business, equity represents the residual value after all debts are settled.
- Revenue & Expenses: While not part of the basic Accounting Equation, they're critical for businesses to track their performance. Revenue is the total income from selling goods or services, and expenses are the costs incurred to earn that revenue. Revenue and Expenses can be thought as sub-types of Equity Accounts.

The COA doesn’t just stop at these broad categories. It further breaks down into specific accounts, such as "Office Supplies Expense" under expenses or "Vehicle Assets" under assets. This detailed classification ensures that businesses can capture and review their financial data with precision.

In conclusion, while the Accounting Equation gives a snapshot, the Chart of Accounts provides the full movie script. It's an organized, structured, and methodical way to keep track of every penny that comes into or goes out of a business.

Finally some transaction examples

Journal entries are the fundamental building blocks of the accounting system. They record financial transactions of a business in the simplest form: as debits and credits. Each journal entry impacts at least two accounts, ensuring the accounting equation remains balanced.

When do you record transactions:

Accrual Basis Accounting:

Records transactions when they are earned or incurred, regardless of when the cash is actually received or paid.
Example: If you provide a service in December but don't get paid until January, under accrual accounting, you'd record the revenue in December when you performed the service.

Cash Basis Accounting:

Records transactions only when cash changes hands.
Example: Using the same scenario, under cash accounting, you'd record the revenue in January when you received the cash.

Key Difference:

Timing. Accrual basis takes into account both cash and credit transactions, recording them when they happen, while cash basis only considers transactions when cash is received or paid.
In the business world, accrual accounting gives a more comprehensive picture of financial health, as it includes all financial commitments (like debts owed or pending income). Cash basis is simpler but may not capture all financial activities if there's a delay between services rendered and cash received/paid.

This example shows a $1,000 cash investment by the owner. The Cash account is debited (increased) by $1,000, while the Owner's Capital account is credited (also increased) by $1,000.

Below are some transaction examples