You can master accounting fundamentals by taking this Free Accounting Training Course Basic Level in less than 1 hour. I assume that you are visiting this page because you are interested in learning more about accounting. Perhaps you are an engineer, science graduate or from a non-commerce background struggling to grasp this seemingly complicated concept of accounting.
I had my fair share of struggles with accounting; those debits & credits I never understood. However, while working at JPMorgan and many other research firms, I was fortunate to develop an intuitive sense of accounting and financial analysis. This story of accounting is for those who are still struggling with this basic concepts. I bet you will learn the core fundamentals of accounting in just 1 hour and without the usage of debits & credits!
Following are the list of topics covered in this article.
- What is Accounting?
- What is the purpose of Financial Statements?
- Introduction to the Case Study
- Income Statement
- Balance Sheet
- Consolidated Income Statement
- Consolidated Balance Sheet
- Cash Flows
What is Accounting?
Wikipedia defines accounting asAccounting, or accountancy, is the measurement, processing and communication of financial information about economic entities. Accounting, which has been called the “language of business”, measures the results of an organization’s economic activities and conveys this information to a variety of users including investors, creditors, management, and regulators. Practitioners of accounting are known as accountants. The terms accounting and financial reporting are often used as synonyms.
source – wikipedia
Explanation-
- There are three main aspects that are discussed above – measurement, processing and communication.
- Measurement involves making judgement about the value of the economic transactions, assets or liabilities.
- The measurement of this economic information needs to be processed and communicated through various forms of accounting forms.
- We call these accounting forms as “financial statements” namely the Income Statement, Balance Sheet and Cash Flows
What is the purpose of financial statements?
- To report on the financial position of an entity (e.g. a business, an organization);
- To show how the entity has performed (financially) over a particularly period of time (an “accounting period”).
- The most common measurement of “performance” is profit. It is also important to understand that financial statements can be historical or relate to the future.
The Story of Accounting
Accounting can be best internalized through a story of a person starting a new business. Kartik is young dynamic guy, who always wanted to start his own business. Post his graduation in science, he researched the idea of the Transportation and Logistics market. Kartik is not comfortable with matters of accounting because he has a science background and not an accounting one.
Kartik’s call’s his business as FastTrack Movers and Packers. Kartik must invest money in the business to kick-start the same. Let’s assume that Kartik puts some of his personal money into it. This implies Kartik is buying shares of Fast Track Logistics Common Stocks. (becomes a shareholder of the firm)
Let us look at FastTrack Movers and Packers Business Cycle
- Kartik infuses capital (money) in FastTrack Movers and Packers (thereby becoming a shareholder of the firm)
- With this investments, FastTrack Movers and Packers will buy a sturdy, dependable delivery van and inventory.
- The business will begin earning fees and billing clients for delivering their parcels.
- The business will be collecting the fees that were earned.
- The business will incur expenses in operating the business, such as a salary for Kartik, expenses associated with the delivery vehicle, advertising, etc.
For a business like above, there will be thousands and thousands of transactions each year. It will be difficult for Kartik to put all these transactions together in a structured format. In such cases, accounting software are very beneficial as they help generate invoices to performing accounting entries, prepare cheques, update the financial statements without any additional work.
By putting all of these entries into the accounting software on a daily basis will result in quick and easy access of desired information and will be helpful for strategic business decision making process.
Kartik wants to understand the financial statements and wants to keep on top of his new business. His friends recommends Neeraj, an ex Investment Banker and an Independent Financial consultant, who has helped many of the small business customers. Neeraj promises that he will explain the content and purpose of the three main financial statements:
- Income Statement
- Balance Sheet
- Statement of Cash Flows
Income Statement
Income Statements show the profitability of the company during the chosen time frame. Neeraj suggests that the time frame could be a day, a week, a month or a full year. Profitability primarily takes care of two important things
- Revenue Earned
- Expenses to earn the Revenue
Neeraj point’s out that revenue earned is not same as cash received and the term expenses is more than the cash outflows.
Download the Case Study Working files here
Case Study 1 – Revenues/Sales
If Fast Track delivers 200 parcels in December for $5 per delivery. Kartik sends invoices to his clients for these fees and his terms require that his clients must pay by 15th Jan’2008. How should the Revenues/Sales be accounted for December?
Before we look at the solutions, we need to understand some “accounting jargons”
Revenues/Sales
FastTrack Movers and Packers earn money for delivering customer’s parcels. It is important for us to understand here that there are two methods of revenue accounting
- Accrual method – Revenue is recorded only when they are “earned” (not when the company receives money)
- Cash Method – Revenue is recorded only when Cash is received.
It is important to note that accrual method of accounting is generally followed
With the above understand, let us apply the same in our first Accounting Case Study
Applying Accrual Basis of Accounting at FastTrack Movers and Packers
If we are looking to record Revenue/Sales figures of December, there are two important aspects that one should think –
- Revenue earning process i.e. delivery of parcels is completed in the month of December itself.
- Cash is not received in December. It is only received in the month of January.
- Under the accrual method of accounting, revenue is recorded when it is earned. In this case, Revenue is “earned” in the month of December as the deliveries were completed during this month.
- Revenue of $1000 recognized in the month of December as the revenue was earned in this month.
What if Kartik followed cash method of accounting?
Cash method of accounting is no more followed. However, had the above transaction been recorded on cash basis, Revenues would have been $0 for December and $1,000 for January.
Case Study 2 – Accounts Receivables
When Kartik receives 1,000 fees from the client on January, 15th, how should he record the entry when the money was received?
Introduction to Accounts Receivables
Money was not received in the month of December, “receivables will be recorded” as assets for the month of December. However, when Kartik receives the $1,000 worth of payment checks from his customers on January 15, he will make an accounting entry to show the money was received. This $1,000 of receipts will not be considered to be January revenues, since the revenues were already reported as revenues in December, when they were earned. This $1,000 of receipts will be recorded in January as a reduction in Accounts Receivable.
Now that we have covered the Revenue or Sales, let us look at the Income Statement expenses. Like the accrual method of accounting, the expenses incurred during December should be documented regardless of whether the company actually paid for the expenses or not.
Case Study 3 – Expenses
For delivering the parcels, Kartik hires some labors on contract basis and agrees to pay them $300 on January 3rd. Also, Kartik buys some packaging and other supporting material of $100 in December. What is the cost to be accounted for in December?
In the case of revenue, we saw the accrual concept of accounting (revenue is recognized when it is earned). Likewise, for expenses, the actual date of payment doesn’t matter; It is important to note when the work was done. In this case study, the parcels were delivered (work completed) in the month of December .
Thus, Total Expenses = $300 (labor) + $100 (supporting material = $400
This recording of expenses (irrespective of actual payment made or not) and matching it with the related revenue is know as Matching Principle.
Other examples of expenses that needs to be “matched” could be Petrol/Diesel for delivery van, advertisement costs, and others.
Please note that accrual basis of accounting and Matching Principles are the two most important rules of accounting. You should be in a position to intuitively understand these concepts.
To clarify further on these two principles, Neeraj provides another example. This time he uses “Interest Expense” on borrowed loan as an example.
Case Study 4 – Interest Expenses
In addition to Kartik infusing his own capital in the business, he borrows additional $20,000 from a bank to start his business on 1st December. Let’s assume that the bank charges 5% in interest, to be paid annual at the end of each year. What is the interest expense for the month of December?
Please note that interest expense is paid as lump sum amount at the end of the year. Kartik pays the total interest expense of $20,000 x 5% = $1,000. Now think about the Matching Principle concept. If Kartik wants to know his business position in the month of December, should he also record one month of Interest Expense in his income statement? The answer is YES.
Kartik needs to match the interest expense to each month’s revenue.
Interest expense to be recorded for 1 month = $1000/12 = $83
I am now assuming that you are pretty clear on the following concepts –
- Income Statement does not report the cash position of the company.
- Sales/Revenue is recorded when the revenue earning process is completed (not when the cash is received)
- Expenses are “matched” with the related revenues (not when the cash is paid)
The primary purpose of income statement is show the net difference between the Revenues and Expenses which we refer to as PROFIT or Bottom Line or Net Income/Net Loss
With this let us prepare the Income Statement for the four case studies above.
FastTrack Income Statement as per the transaction discussed for the month of December, 2007
You may be wondering that what is Income Tax. An income tax is a government levy (tax) imposed on individuals or entities (taxpayers) that varies with the income or profits (taxable income) of the taxpayer. I have assumed that Kartik pays Income Tax at 33%. What ever comes after deducting the tax is the Net Income or Profit.
Balance Sheet
Now that Kartik understood the Income statement, Neeraj moves to explain the Balance Sheet. Balance Sheet to gives an idea of what the company owns (ASSETS) and owes (LIABLITIES), as we as amount invested by the Shareholders at a specific point in time.
Please note the key word “specific point in time”. This is different from Income statement which is prepared for a period of time (for example Income Statement for the month of December). However, if a balance sheet is dated December 31, the amounts shown on the balance sheet are the balances in the accounts after all transactions pertaining to December 31 have been recorded.
A Typical Balance Sheet
Assets – Assets are firm’s economic resources. They are probable current and future economic benefits obtained or controlled by a entity as a result of past transaction or events. As you can see above, Assets are primarily divided into two types – Current Assets and Long Term Assets. Example of Asset for Kartik’s company could be cash, packaging material and supplies, Vehicle etc. Also, note that Accounts receivables are Assets. Kartik has already delivered the parcels, however, he has not been paid immediately for the delivery. In the near future, amount owed to Kartik’s Fast Track is an asset known as Accounts Receivables.
Liabilities – Liabilities are obligations owned to others as of the balance sheet date. They arise from present obligations of a particular entity to transfer assets or provide services to other entities in future as a result of past transaction or events. For example, Kartik took loan from the Bank. This loan is basically a liability which Kartik needs to pay in future. Also, Kartik’s hired few people to deliver the parcels, however, did not pay them (accounts payable), classified as accounts payable.
Shareholder’s Equity – The third section of a balance sheet is Stockholders’ Equity. (If the company is a sole proprietorship, it is referred to as Owner’s Equity.) The amount of Stockholders’ Equity is exactly the difference between the asset amounts and the liability amounts.
A = L + E
Within the Shareholder’s Equity section, you would primarily find two sections – Common Stock and Retained Earnings.
Common stock represents the initial amount invested in the company by the shareholder. For example, in this case, if Kartik invests a certain amount in his company, this would come broadly under Common Stock section.
The second important part is the Retained Earnings. Retained Earnings will increase when the corporation earns a profit. There will be a decrease when the corporation has a net loss. This means that revenues will automatically cause an increase in Stockholders’ Equity and expenses will automatically cause a decrease in Stockholders’ Equity. This illustrates a link between a company’s balance sheet and income statement.
This is the most important LINK between the Balance Sheet and the Income Statement.
Case Study 5 – Cash & Common Stocks
On December 1, 2007 Kartik starts his business FastTrack Movers and Packers. The first transaction that Kartik will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of FastTrack Movers & Packers common stock. There are no revenues because no delivery fees were earned by the company on 1st December, and there were no expenses. How will this transaction get recorded in the balance sheet?
Cash & Common Stocks
- Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset)
- Retained Earnings will increase when the corporation earns a profit and there will be a decrease when the corporation has a net loss
- Core link between a company’s balance sheet and income statement
Case Study 6 – Purchase of Vehicles
On December 2, FastTrack Movers & Packers purchases a truck for $14,000. The two accounts involved are Cash and Vehicles (or Delivery Truck). How does this transaction get recorded in the Balance Sheet?
Purchase of Vehicle & Depreciation Expenses
Kartik also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by the basic accounting principle known as the matching principle. Depreciation is used for assets whose life is not indefinite—equipment wears out, vehicles become too old and costly to maintain, buildings age, and some assets (like computers) become obsolete. Depreciation is the allocation of the cost of the asset to Depreciation Expense on the income statement over its useful life.
Fast Track’s truck has a useful life of five years and was purchased at a cost of $14,000. The accountant might match $2,800 ($14,000 ÷ 5 years) of Depreciation Expense with each year’s revenues for five years. Each year the carrying amount of the van will be reduced by $2,800. (The carrying amount—or “book value”—is reported on the balance sheet and it is the cost of the van minus the total depreciation since the van was acquired.) This means that after one year the balance sheet will report the carrying amount of the delivery van as $11,200 (14,000 – 2,800), after two years the carrying amount will be $8,400 (14,000 – 2×2800), etc. After five years—the end of the truck’s expected useful life—its carrying amount is zero.
Case Study 6 – Balance Sheet (as of 2nd December)
Case Study 7 – Prepaid Expenses
Neeraj brings up another less obvious asset—the unexpired portion of prepaid expenses. Along with the Truck, Kartik takes the insurance coverage for the Truck purchased. The insurance purchase costs him $1,200 for one year. Kartik immediately gives cash of $1,200 to the insurance agent.
Fast Track pays $1,200 on December 1 for a one year insurance premium on its delivery truck. That divides out to be $100 per month ($1,200 ÷ 12 months). Between December 1 and December 31, $100 worth of insurance premium is “used up” or “expires”. The expired amount will be reported as Insurance Expense on December’s income statement. Kartik asks Neeraj where the remaining $1,100 of unexpired insurance premium would be reported. On the December 31 balance sheet, Neeraj tells him, in an asset account called Prepaid Insurance.
Other examples of things that might be paid for before they are used include supplies and annual dues to a trade association. The portion that expires in the current accounting period is listed as an expense on the income statement; the part that has not yet expired is listed as an asset on the balance sheet.
Case Study 4 – Rising Debt (Revisit)
FastTrack Movers and Packers borrowed an additional $20,000 from a bank on 3rd December to invest further in business and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on December 1st of each year.
As Kartik raises further money through debt, cash (Asset) increases by 20,000. However, Kartik is liable to return the amount after the term and hence, Debt termed as liability. On this debt, Kartik will have to pay Interest Expense (as discussed earlier)
Case Study 8 – Inventory
Kartik keeps an inventory of packing boxes not only to use it for his business but also earn additional revenues by carrying an inventory of packing boxes to sell. Let’s say that FastTrack Movers and Packers purchased 1,000 boxes wholesale for $1.00 each.
Inventory
Kartik learns that each of his company’s assets was recorded at its original cost, and even if the fair market value of an item increases, an accountant will not increase the recorded amount of that asset on the balance sheet. This is the result of another basic accounting principle known as the cost principle.
Although accountants generally do not increase the value of an asset, they might decrease its value as a result of a concept known as conservatism.
Scenario 1: Assume that since the time when Kartik bought them, however, the wholesale price of boxes has been cut by 40% and at today’s price he could purchase them for $0.60 each. Because the replacement cost of his inventory ($600) is less than the original recorded cost ($1000), the principle of conservatism directs the accountant to report the lower amount ($600) as the asset’s value on the balance sheet.
Scenario 2: Assume that since the time when Kartik bought them, however, the wholesale price of boxes increase by 20% and at today’s price he could purchase them for $1.20 each. Because the replacement cost of his inventory ($1,200) is higher than the original recorded cost ($1000), the principle of cost directs the accountant to report the lower amount at cost ($1000) as the asset’s value on the balance sheet.
In short, the cost principle generally prevents assets from being reported at more than cost, while conservatism might require assets to be reported at less than their cost.
Case Study 9 – Unearned Revenues
Another liability is money received in advance of actually earning the money.The client has made an upfront payment of $600 for delivery of 30 parcels/month for the next six months.
FastTrack Movers and Packers has a cash receipt of $600 on December 1, but it does not have revenues of $600 at this point. It will have revenues only when it earns them by delivering the parcels. On December 1, Fast Track will show that its asset Cash increased by $600, but it will also have to show that it has a liability of $600. (It has the liability to deliver $600 of parcels within 6 months, or return the money.)
The liability account involved in the $600 received on December 1 is Unearned Revenue. Each month, as the 30 parcels are delivered, Fast Track will be earning $100, and as a result, each month $100 moves from the account Unearned Revenue to Service Revenues. Each month Fast Track’s liability decreases by $100 as it fulfills the agreement by delivering parcels and each month its revenues on the income statement increase by $100.
Consolidated Income Statement
Consolidated Balance Sheet
Kartik wants to be certain that he understands what Neeraj is telling him regarding the assets on the balance sheet, so he asks Neeraj if the balance sheet is, in effect, showing what the company’s assets are worth. He is surprised to hear Neeraj say that the assets are not reported on the balance sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and furnishings) are reported at their cost minus the amounts already sent to the income statement as Depreciation Expense. The result is that a building’s market value may actually have increased since it was acquired, but the amount on the balance sheet has been consistently reduced as the accountant moved some of its cost to Depreciation Expense on the income statement in order to achieve the matching principle.
Another asset, Office Equipment, may have a fair market value that is much smaller than the carrying amount reported on the balance sheet. (Accountants view depreciation as an allocation process—allocating the cost to expense in order to match the costs with the revenues generated by the asset. Accountants do not consider depreciation to be a valuation process.) The asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost.
Short-term (current) asset amounts are likely to be close to their market values, since they tend to “turn over” in relatively short periods of time.
Neeraj cautions Kartik that the balance sheet reports only the assets acquired and only at the cost reported in the transaction. This means that a company’s reputation—as excellent as it might be—will not be listed as an asset. It also means that Bill Gates will not appear as an asset on Microsoft’s balance sheet; Nike’s logo will not appear as an asset on its balance sheet; etc. Kartik is surprised to hear this, since in his opinion these items are perhaps the most valuable things those companies have. Neeraj tells Kartik that he has just learned an important lesson that he should remember when reading a balance sheet.
Cash Flows
Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information. As a result, savvy business people and investors utilize this important financial statement.
The cash flow statement reports the cash generated and used during the time interval specified in its heading. The period of time that the statement covers is chosen by the company. For example, the heading may state “For one month ended December 31, 2007″ or “The Fiscal Year Ended September 30, 2009″.
The cash flow statement organizes and reports the cash generated and used in the following categories:
- Operating activities: converts the items reported on the income statement from the accrual basis of accounting to cash.
- Investing activities: reports the purchase and sale of long-term investments and property, plant and equipment.
Financing activities: reports the issuance and repurchase of the company’s own bonds and stock and the payment of dividends.
Cash Provided From or Used By Operating Activities
This section of the cash flow statement reports the company’s net income and then converts it from the accrual basis to the cash basis by using the changes in the balances of current asset and current liability accounts, such as:
- Accounts Receivable
- Inventory
- Supplies
- Prepaid Insurance
- Other Current Assets
- Notes Payable (generally due within one year)
- Accounts Payable
- Wages Payable
- Payroll Taxes Payable
- Interest Payable
- Income Taxes Payable
- Unearned Revenues
- Other Current Liabilities
In addition to using the changes in current assets and current liabilities, the operating activities section has adjustments for depreciation expense and for the gains and losses on the sale of long-term assets.
Cash Provided From or Used By Investing Activities
This section of the cash flow statement reports changes in the balances of long-term asset accounts, such as:
- Long-term Investments
- Land
- Buildings
- Equipment
- Furniture & Fixtures
- Vehicles
In short, investing activities involve the purchase and/or sale of long-term investments and property, plant, and equipment.
Cash Provided From or Used By Financing Activities
This section of the cash flow statement reports changes in balances of the long-term liability and stockholders’ equity accounts, such as:
- Notes Payable (generally due after one year)
- Bonds Payable
- Deferred Income Taxes
- Preferred Stock
- Paid-in Capital in Excess of Par-Preferred Stock
- Common Stock
- Paid-in Capital in Excess of Par-Common Stock
- Paid-in Capital from Treasury Stock
- Retained Earnings
- Treasury Stock
In short, financing activities involve the issuance and/or the repurchase of a company’s own bonds or stock. Dividend payments are also reported in this section.
Consolidated Cash Flow Statement
Things to note on Cash Flows
The cash from operating activities is compared to the company’s net income. If the cash from operating activities is consistently greater than the net income, the company’s net income or earnings are said to be of a “high quality”. If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash.
Some investors believe that “cash is king”. The cash flow statement identifies the cash that is flowing in and out of the company. If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value.
What next?
If you learned something new or enjoyed the post, please leave a comment below. Let me know what you think. Many thanks and take care. Happy Learning!
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