Business owners use accounting to record the financial transactions undertaken over the course of business. Thus, there are are well established rules and principles to record this information and use such information for making decisions.
So, there are a host of basic accounting terms and procedures that a business owner must know in order to record, measure and communicate the accounting information. Following is a complete guide on basic accounting terms to help you understand the basics of accounting as a business owner.
Accrual accounting is an accounting method that measures the performance and position of your company by recognizing economic events. This is regardless of when cash transactions occur in your business. By recognizing, we mean recording of a transaction.
The underlying concept in accrual accounting emphasizes that the revenues of your business are recognized when they are earned. Accordingly, the economic events of your business are recognized by matching the costs incurred with the revenue earned at the time when a transaction occurs. It is regardless of whether cash has been paid or not.
In this way, revenues are matched with expenses. And the net income or net loss of your business is determined. This is unlike the cash based system where transactions are recognized when the cash is paid out or received.
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The principle of duality is expressed in the form of the fundamental accounting equation. This equation is represented as follows: Assets = Liabilities + Capital
This accounting equation shows that assets of a business always equate the claims of owners and outsiders. This means that at any given point of time, the resources of a business are always equal to the claims of the stakeholders who have provided funds for such resources. These stakeholders include business owners and lenders (outsiders) who provide funds to the business.
The claim of owners on a business is called capital or owner’s equity. Whereas, the claim of lenders or outsiders on the business is called liability or outsider’s equity. The dual effect of every business transaction impact in such a way that the asset side equals the liability plus capital side of the equation.
Accrued liabilities also known as accrued expenses are the expenses that a business has incurred or recognized in its income statement but are not contractually due. Although, the cash for such an expense is yet to be paid, the company must recognize such an expense for the benefit received. Such liabilities are the outcome of accrual method of accounting. Under such a method, the expenses are recognized as and when they are incurred. Such a concept relates to the timing and matching principles of accounting.
Accounts payable, also termed as trade payables, are the amounts that a business owes to its suppliers for goods or services purchased on credit. Such amounts arise on account of time difference between receipt of services or acquisition to title of goods and payment for such supplies. The time period for which such a credit is extended to business typically ranges between 30 – 60 days.
Accounts receivable is defined as the amount owed by the customer to the firm on account of sale of goods or services during the ordinary course of business. Such customers are known as the debtors of the company as they owe money for the goods purchased by them on credit.
A business sells goods on credit to its customer when it does not receive the payment for the same immediately. In other words, the business provides trade credit to its customers. This means the customers get reasonable time to pay for the goods and services purchased by them. This credit is what leads to creation of bills receivable or book debts or debtors in your balance sheet.
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Balance sheet is one of the fundamental financial statements prepared by an entity to report its financial position at a specific point in time. It is a “snapshot” of the company’s financial position at the end of a specified date.
Typically, a standard balance sheet can be grouped into three account categories – assets, liabilities and owner’s equity or capital. Thus, a balance sheet informs the stakeholders about what a company owns and what it owes to third parties as on the specified date; usually the end of a year or a quarter. Additionally, it states an entity’s liquidity position and its capitalization.
As per statutory requirements, companies are required to file their balance sheets at least once a year.
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Basic Financial Statements
Financial statements are the basic and formal annual reports. Through these fundamental accounting statements, the corporate management communicates financial information to all of its stakeholders. These stakeholders include owners, management and employees and other external parties such as investors, creditors, tax authorities, government, etc.
Such users of principal accounting statements take financial decisions based on the entity’s 1) financial position, 2) operating performance and 3) financial health.
Accordingly, the Generally Accepted Accounting Principles (GAAP) requires that 3 such reports need to be prepared:
- A balance sheet (or statement of financial position) that summarizes the financial position of an entity at the end of an accounting period.
- An income statement (or profit and loss statement) that summarizes the results of business operations for a given period.
- A statement of cash flows that summarizes an entity’s operating, financing and investing activities over a period of time.
Cash is the most liquid asset of an entity and thus is important for short-term solvency of the company. The cash balance shown under current assets is the balance available with the business that can be promptly used to meet its day-to-day expenses. It typically includes coins, currencies, funds on deposit with banks, cheques and money orders.
Cash Conversion Cycle
Cash Conversion Cycle is the time period it takes for a business to convert cash invested in operating activities into cash generated from sales. It measures the time elapsed from the raw materials bought for producing goods to collecting cash from the sale of finished goods.
Cash equivalents are the result of cash invested by the companies in very short-term, interest earning financial instruments. Such instruments are highly liquid, secure and can be easily converted into cash usually within 90 days. These securities include treasury bills, commercial paper and money market funds. Such securities are readily tradable in the market and the value of such securities can also be readily determined.
Current Assets are defined as – assets of an entity that are expected to be easily converted into cash or sold, consumed or utilized through the normal operating cycle of the business or within one year whichever is greater. Where operating cycle of a business means the time it takes to buy or produce inventory, sell the finished products and collect cash for the same.
Current assets are short term assets that can be converted into cash or consumed within a year or an operating cycle, whichever is greater. Similarly current liabilities are obligations of an entity that are due within one operating cycle or one year, whichever is greater. Such obligations are terminated by using either current assets or creating other current liabilities. Here, operating cycle refers to the time period elapsed between purchase of goods or services to be used in the manufacturing process and the final receipt of cash as a consequence of selling such goods.
Common Size Analysis
Common size analysis, also termed as vertical analysis, is a technique that is used to analyze and interpret financial statements. Such a technique helps in assessing the financial statements by considering each line item as a percentage of the base amount for that period.
In case of the income statement, the base is taken as the net sales. Whereas in case of balance sheet, the amount of total assets is taken as the base. Then, each line item in the income statement is then expressed as a percentage of total sales. While, each item in the balance sheet is appropriated as a percentage of total assets.
Such an analysis helps in knowing the effect of each of the items in the financial statements. Furthermore, common size analysis also helps in knowing the contribution made by each of the line items to the final figure.
The technique of common analysis is used to interpret three financial statements including balance sheet, income statement and cash flow statement. However, in this article, we will cover most commonly used statements for common size analysis. That is, balance sheet and income statement.
Comparative analysis determines the profitability and financial position of a business by comparing financial statements for two or more time periods. Such a technique is also termed as Horizontal Analysis. Typically, income statement and balance sheet are prepared in a comparative form to undertake such an analysis.
Furthermore, there is a provision attached with comparing the financial data showcased by such statements. This relates with making use of the same accounting principles for preparing each of the comparative statements. In case the same accounting principles are not followed to prepare such statements, then the difference must be disclosed in the footnotes below.
A comparative balance sheet showcases:
- Assets and liabilities of a business for the previous year as well as the current yea
- Changes (increase or decrease) in such assets and liabilities over the year both in absolute and relative terms.
Thus, a comparative balance sheet not only gives a picture of the assets and liabilities in different accounting periods. It also reveals the extent to which the assets and liabilities have changed during such periods. Furthermore, such a statement helps managers and business owners to identify trends in the various performance indicators of the underlying business.
Debit and Credit
Business transactions are to be recorded in at least two accounts in double entry system of accounting. This is to say every amount debited in a transaction must be equal to every amount credited in that transaction. Thus, the terms debit and credit are used to record every business transaction in accounting. These basically indicate on which side of a particular account a business transaction needs to be recorded.
Depreciation means decrease in the value of a fixed asset due to its use, obsolescence or passage of time. According to Accounting Standard 6, depreciation is a measure of wearing out, consumption or other loss of value of a depreciable asset. Such a decline in the value of the depreciable asset arises from the use, expiration of time or obsolescence through technology and market changes. Further, such an amount is apportioned so as to charge a fair part of the depreciable amount in each accounting period. This is done over the expected useful life of the asset.
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Double Entry Accounting System
Double Entry System of Accounting means every business transaction involves at least two accounts. In other words, every business transaction has an equal and opposite effect in minimum two different accounts. Further, Double entry system of accounting is based on the Dual Aspect Concept of accounting.
Financial Statement Analysis
First In First Out (FIFO)
Financial Statement Analysis is a financial management tool that helps in evaluating the financial data given in the financial statements. Such an analysis helps business owners and other key stakeholders in understanding the financial position and operating performance of the business. This helps each of the stakeholders in making credit, investment and other business decisions.
Furthermore, this kind of analysis helps in studying the relationship between various components of the financial statements and their interpretation. Such an analysis helps in knowing the profitability and the operational efficiency of the business. This further assists in forecasting the future condition and performance of the company.
The most commonly used tools for analyzing financial statements include:
- Common Size Statement Analysis
- Comparative Statement Analysis
- Ratio Analysis
- Cash Flow Analysis
- Trend Analysis
General Ledger is the principal book of accounting system. Whereas, journal is the original book of entry. General Ledger consists of numerous accounts in which transactions pertaining to these accounts are recorded.
Basically, all the accounts involved in the journal entries form part of ledger. It is one of the most important books of accounting for a business. This is because the aggregate result of all transactions pertaining to a particular account can only be known through ledger.
Gross Profit is an item in Trading and P&L Account of your company that is deduced after subtracting the sum of purchases and direct expenses from sales. That is, it is the difference between net sales revenue and cost of sales. It refers to the profit generated as a result of conducting basic operational activities of your business. Where the basic operational activities involve manufacturing, purchasing and selling of goods.
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Income statement represents the earning activities of a business. It is also called a flow report that describes the outcome of all revenue-generating activities of an entity.
This statement comprises of two segments. One of the segments depicts the inflows resulting from sale of goods and services to consumers. The inflows are nothing but the assets created as a result of generating revenues for an entity. Such assets include cash or accounts receivable.
The other segment states the outflow of resources utilized to generate sales. Such outflows are termed as expenses. The net excess of all the revenues over all the expenses is the net income of an entity during an accounting period.
Thus, income statement is regarded as an important financial statement as it highlights a) the results of an entity’s operations and b) the reasons for it’s profitability or losses thereof.
As per the Indian Accounting Standard 2, Inventories are the assets that are:
- Held for sale in the ordinary course of business
- In the process of production of such sale
- In the form of materials or supplies to be consumed in the production process or in the rendering of the services
Such inventories are recorded at either cost or net realizable value, whichever is lower.
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Journal is the book in which business transactions are recorded for the first time. This is the reason why Journal is also known as the Book of Original Entry.
Now, transactions in journal are recorded in the order in which they occur. The whole exercise of recording transactions in journal is referred to as journalising.
Journalising results in documenting all transactions at one place. Furthermore, they are recorded based on the principle of duality which is the foundation of double entry system of accounting.
As per this system, every transaction has a minimum of two accounts i.e. a debit and a credit. The account to be debited is written in the first line and the account to be credited is written in the second line with a prefix ‘To’ of the journal.
Liquidity Ratio Analysis
Liquidity ratio analysis helps in measuring the short-term solvency of a business, that is, a company’s ability to meet its short-term obligations. Liquidity suggests how quickly assets of a company get converted into cash and ensures uninterrupted flow of cash to meet its current liabilities. Furthermore, liquidity suggests that a company has sufficient funds to meet its day-to-day business operations.
Hence, this suggests that the conversion of current assets into cash should be so quick so as to ensure timely payment to outsiders. That is to say, if the majority of current assets are tied up in inventories and credit sales, then the company will run out of cash to meet its current debt obligations.
Given this scenario, simply calculating liquidity ratios for a given period does not give a fair view of the company’s short-term solvency. It is also extremely important to analyze the quality of current assets to know the true liquidity position of a company.
The common liquidity ratios include:
- Current Ratio
- Quick Ratio
- Cash Ratio
- Defensive Interval Ratio
- Cash Conversion Cycle
Last In First Out (LIFO)
The Last In First Out Method is one of the methods to value inventory. This method assumes that recent goods purchased are consumed first and the goods purchased first are consumed later. Thus, cost of goods sold is calculated using the most recent purchases whereas the ending inventory is costed using the cost of the oldest units available.
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Net Profit is a measure of profitability of a company that is usually referred to as ‘the bottom line’ of the income statement. It refers to the profit that remains after deducting all operating expenses, non-operating expenses, taxes and preferred stock dividends of a business from the gross profit.
Notes payable are nothing but the obligation of a company in the form of promissory notes that it owes to its lenders. These are written promises that a company would pay a specific some of money on a particular future date to its creditors. Such notes payables arise on account of purchases, financing or other transactions undertaken by a firm.
Furthermore, notes payable can be categorized as short or long term depending upon their maturity period. Thus, notes payable with maturity period of greater than one year are reported as non – current liabilities. Whereas, notes payable with a maturity period of less than a year are represented under current liabilities in the balance sheet.
Prepaid expenses refer to the operating costs of a business that have been paid in advance. The time when such expenses are paid at the beginning of the accounting period, cash reduces in the balance sheet. Simultaneously, a current asset of the same amount is created in the balance sheet by the name of prepaid expenses.
However, these prepaid expenses turn into expenses from current asset at the time the business derives benefit from such an asset as per the matching principle of accounting.
The examples of prepaid expenses include prepaid rent, prepaid insurance etc.
Profitability ratios determine the ability of the company to generate profits as against : (i) Sales, (ii) Operating Costs, (iii) Assets and (iv) Shareholder’s Equity. This means such ratios reveal how well a company makes use of its assets to generate profitability and create value for shareholders.
Companies usually seek higher profitability ratios as these imply greater revenues, profits and cash flows for the company. With the help of these ratios, business owners or managers decide whether to distribute the earnings or reinvest the profits in business.
Trial Balance is a technique for checking the accuracy of the debit and credit amounts recorded in the various ledger accounts. It is basically a statement that exhibits the total of the debit and credit balances recorded in various accounts of ledger. Accordingly, Trial Balance is prepared to check the accuracy of the various transactions that are posted into the ledger accounts. It is certainly one of the important accounting tools as it reveals the final position of all accounts. Further, it is used in preparing the final accounting statements of the business.
Now, the whole idea of preparing Trial Balance is to simplify the task of preparing the basic financial statements. Thus, a business owner or the accountant can simply draw balances of all accounts from Trial Balance rather than looking for such balances in each ledger account.
Unearned revenues are also known as unearned income, deferred revenue or deferred income. Such revenues refer to the cash collected by a business in advance of providing goods and services. This means that the business receives money for goods or services it is yet to supply. Such a revenue can be thought of as an advance payment of goods or services that a business is expected to produce or supply to the customer.
Due to such an advance payment, the seller has a liability equal to the amount of revenue generated in advance till the time actual delivery is made. Thus, when payment is received by the supplier, the cash increases on the asset side and the unearned revenue increases by the same amount on the liability side of the balance sheet.
Working capital is defined as the excess of current assets over current liabilities. It forms a part of the aggregate capital of the business. Now, a business needs working capital to fund its short term obligations. Typically, firms with optimum level of working capital indicate efficiency in managing its operations. This further enables the firm to pay for its short-term dues and day-to-day operational expenses.
Therefore, working capital is a measure of business’ liquidity position, operational efficiency and short-term financial soundness.
Hence, working capital can be put into the following equation:
Working Capital = Current Assets – Current Liabilities
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