Accounting is the method of systematically capturing a financial transaction so that a business can understand where do they stand financially. It helps them realise how financially sound they are, how much they owe, how much they are owed, how much they have which they can invest in themselves, etc.
Introduction
Accounting (the method used to records day to day business transactions) was in place even before numbers or writing was invented. Luca Pacioli known as “Father of Modern Accounting” set the system of double-entry bookkeeping in 1494. Even though governments and businesses had started recording business information long before but the credits and debits were described by Pacioli which is the basis of the accounting system even today.
Let’s discuss few things about accounting in this post. Please consider this post for people who are learning to invest and have no or little knowledge about reading financials and i have tried to mention concepts to make them as lucid as possible.
Objective of accounting
The main objective of accounting is to provide financial information to various stakeholders. They might be founders, managers, investors, auditors, or anyone else. This information is utilised by the users for making future decisions. The important thing out here is that this information is used to make decisions and hence the information should be accurate, reliable, relevant and understandable.
Double-entry bookkeeping
Double entry bookkeeping is a form of recording transactions. In this method, each financial transaction is recorded with two accounts. One account is credited and other is debited. Two important things to remember for doing double entry bookkeeping are:
- Debit is what comes in. This means if money is coming to company’s account it will be debited.
- Credit is what goes out. This means if money is going from company’s account then it will be credited.
Basic understanding of accounting with the help of example
Let’s learn accounting with the help of an example to make the topic more interesting. Suppose there is a person name Carl who want to start his new business of parcel delivery service. He goes to an accountant for his financial matter. The accountant listens to Carl’s business plan and sees that there likely to be thousands of business transactions everyday.
The accountant tells Carl that the accounting software will help to store, record and retrieve the business transactions and produce financial statements.
Carl gets puzzled with the term transactions. To help Carl understand the meaning of transaction accountant gives few examples of transactions which Carl has to record for his business.
- Carl has to invest money to start his business. In short he has to buy shares.
- Carl has to buy a vehicle for delivering the parcels.
- Carl will earn money from his clients for the service.
Carl also want to know about financial statements from accountant which is an important part of accounting. Accountant tells Carl about three financial statements:
- Income statement
- Balance Sheet
- Statement of cash flows
Income statement
Income statement is something which shows how profitable the company is during that period through two elements, revenues and expenses. A period here can be weekly, monthly, yearly, etc.
Revenues
Revenue is the income from company operations. It is recorded in the income statement when it is earned by the company and not when the actual money is received. For example suppose a client ask Carl to deliver 5 parcels on 10th December for which he will pay on 4th January.
Then income statement will show the revenue for the 5 parcels in the month of December itself even though company will receive money in January. This is based on the concept that revenue is earned when the goods/service is being delivered/rendered and not when the payout for the transaction happens.
Expenses
Expenses are recorded when the company incur them and not when money is paid out by the company. For example suppose Carl hires external agent for delivering some parcels on 14th January and agrees to pay him on 3rd February. Then expenses will show in January even though real payment happened on February.
Balance sheet
Balance sheet is something which shows the financial performance of the company at a particular point and not during a given period. This essentially means that balance is a stock concept, not a flow concept. This shows the financial position of a company till date and not the performance for a specific period. Balance sheet consists of three parts; assets, liabilities and equity.
Assets
Assets are something which the company owns. An asset is something which generates revenue for the company. The equipments, building, inventory, patents etc are all assets for the company. They help the company to make money. Assets are also of other types like prepaid expenses. Example of prepaid expenses is suppose the company pays $600 insurance for 6 months from December to May for the vehicle. Then this is recorded as prepaid insurance. After December $100 will be recorded as insurance expense in income statement and $500 will remain as prepaid insurance.
Liabilities
Liabilities are something which the company owes to others like investors, lenders, etc. so they are basically obligations to pay back entities outside the company. Examples of liabilities are loan the company takes, money to be paid to the suppliers for the items purchased on credit, unearned revenues, etc. One case of unearned revenues is suppose the company receives $600 from a client to deliver 6 parcels. One parcel is to be delivered every month from December to May. Then this $600 will be recorded as unearned revenues and every month $100 will move from unearned revenues to service revenues when company will deliver the parcel.
Stockholder’s equity
Stockholder’s equity is 3rd part of balance sheet. Equity is the difference between Assets and Liabilities. Examples of equities are common stock (the shares of the company), retained earnings (the net income added to the company coffers every year and after dividends are paid out to shareholders), etc.
Assets = Equity + Liabilities
Statement of cash flows
Statement of cash flow helps to show the actual changes in the cash. By this time you must have realised that income statement is not a very apt source of understanding how much money came and went out of the company. Here cash flow statement comes into play. It shows how the cash is recorded and how it gets used in investing activities, financial activities and operating activities. Through cash flow statements we can see how changes in balance sheet and income statement affects cash. Cash flow statements helps in the following:
- Provides information about liquidity and solvency of the firm.
- Gives information about in how much time what amount of cash inflows and outflows will happen in future.
- It helps in comparing different firm performance.
Sample problem to understand accounting
Lets learn how to write transaction through this sample. For example Carl invest $15000 in his company named Griefo Limited and get 5000 shares in return for $15000. Now for double entry we need two accounts. One will be cash account for $15000 which will be debited because money is coming to company’s account. Another account has to be used as credit account to balance this cash account. The credit account which can be used is common stock because shares are going out. Hence double entry will look like this:
| Account Name | Debit | Credit | |
| Cash | $15000 | ||
| Common Stock | $15000 |
Suppose he start his company in December 2015. The balance sheet will look like this:
Griefo limited
Balance Sheet as on 31st December 2015
| ASSETS | LIABILITIES & STOCKHOLDER’S EQUITY | |||
| Cash | $15000 | Liabilities | $0 | |
| Stockholder’s Equity | $15000 | |||
| Common Stock | $0 | |||
| Total Assets = | $15000 | Total liabilities and stockholder’s equity = | $15000 |
Now suppose that he buy a vehicle with $5000 then debit account can be vehicle and credit account cash. Hence double entry will look like this:
| Account Name | Debit | Credit |
| Vehicle | $5000 | |
| Cash | $5000 |
The changed balance sheet will be:
Griefo limited
Balance Sheet as on 31st December 2015
| ASSETS | LIABILITIES & STOCKHOLDER’S EQUITY | |||
| Cash | $10000 | Liabilities | $0 | |
| Vehicle | $5000 | Stockholder’s Equity | $15000 | |
| Common Stock | $0 | |||
| Total Assets = | $15000 | Total liabilities and stockholder’s equity = | $15000 |
I would request you to go through financial reports of few good companies and try calculating their key financial ratios or find them on Moneycontrol.com. It would give you a good sense of how companies report their financial health. I would suggest you to read financial statements of Infosys Limited and try to understand each statement. If you find any difficulty to get anything, ask here in comments section.
Also, if you are interested to learn to invest and become genuinely rich over time, you can go through our other posts on the website.
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