Accounting Basics For Beginners Dr. P. Sreelakshmi ACCOUNTING BASICS FOR BEGINNERS Module 1: Nature of Financial Accounting Learning Outcome At the end of the module you would have an understanding of: a. b. c. d. e. Why understanding the financial accounting is important for managers The different financial statements The important users of financial statements Basic assumptions of financial statements Important terms in financial accounting Introduction: Accounting basics will introduce you to some of thefundamentalAccounting principles, concepts, and Terminology.Some of the terms that you will learn would include Revenues, Expenses, Assets, Liabilities, Income Statement, Balance Sheet, Statement of Cash Flows etc.Basically, the main purpose of Financial Accounting is to provide useful Financial information to people or groups both inside and outside of companies often called external users. Who Uses Financial Accounting? The ultimate goal of financial accounting is to compile business transactions and other input documents like invoices and sales receipts in the form of general purpose financial statements that can be understood by external users. The key concept here is that external users must be able to understand and use this financial information when they are making decisions about the company. Shareholders or Investors: These can be individuals or entities which own the enterprise by virtue of holding the shares in the company. The ownership would have been acquired by subscribing to the share capital through an offer by the company / promoters or by buying the shares in the open market, if the shares are traded. They will participate in the profits and losses of the company. Participation in the losses might be limited or unlimited depending upon the type of organisation. Lenders or Creditors: Are the people who fund the company to get over the short or long terms financial needs of the company. They do not possess any ownership rights. However, they would lend money at some interest rate. Customers: People or entities which buy goods and services from the enterprise. Suppliers: Those who supply goods or services to the enterprise. Regulators: Government agencies who regulate the type of businesses. E.g. RBI, TRAI, IRDA etc. 1 Unions: They are interested in safeguarding the interest and welfare of the employees. Brokers and Analysts: They advise the general public, to invest or not in the company. Media: Report about the way the company and the promoters operate Accounting has simple and surprisingly elegant ways to track a business. To be precise, accounting is about tracking a business. The end product of the financial accounting process is a set of reports that are called financial statements.To begin with, lets us understand some basic Accounting Terms. Basic Accounting Terms: In order to understand the subject matter clearly, one must grasp the following common expressionsalways used in business accounting. The aim here is to enable the student to understand with theseoften used concepts before we embark on accounting procedures and rules. Transaction: It means an event or a business activity which involves exchange of money or money’sworth between parties. The event can be measured in terms of money and changes the financialposition of a person e.g. purchase of goods would involve receiving material and making paymentor creating an obligation to pay to the supplier at a future date. Transaction could be a cashtransaction or credit transaction. When the parties settle the transaction immediately by makingpayment in cash or by cheque, it is called a cash transaction. In credit transaction, the paymentis settled at a future date as per agreement between the parties. Profit: The excess of Revenue Income over expense is called profit. It could be calculated for eachtransaction or for business as a whole. Loss: The excess of expense over income is called loss. It could be calculated for each transactionor for business as a whole. Asset: Asset is a resource owned by the business with the purpose of using it for generating futureprofits. Assets can be Tangible and Intangible. Tangible Assets are the Capital assets which havesome physical existence. e.g. Plant and Machinery,Furniture and Fittings, Land and Buildings, Books, Computers, Vehicles, etc. The capital assets whichhave no physical existence and whose value is limited by the rights and anticipated benefits thatpossession confers upon the owner are known as intangible Assets. e.g. Goodwill, Patents, Trade-marks, Copyrights,Brand Equity, Designs, Intellectual Property, etc. Liability: It is an obligation of financial nature to be settled at a future date. It represents amountof money that the business owes to the other parties. E.g. when goods are bought on credit, thefirm will create an obligation to pay to the supplier the price of goods on an agreed future dateor when a loan is taken from bank, an obligation to pay interest and principal amount is created. 2 Capital : It is amount invested in the business by its owners. It may be in the form of cash, goods,or any other asset which the proprietor or partners of business invest in the business activity. Frombusiness point of view, capital of owners is a liability which is to be settled only in the event of closureor transfer of the business. Hence, it is not classified as a normal liability. For corporate bodies, capitalis normally represented as share capital. Debtor : The sum total or aggregate of the amounts which the customer owe to the business forpurchasing goods on credit or services rendered or in respect of other contractual obligations, isknown as Sundry Debtors or Trade Debtors, or Trade Payable, or Book-Debts or Debtors. In otherwords, Debtors are those persons from whom a business has to recover money on account of goodssold or service rendered on credit. Creditor : A creditor is a person to whom the business owes money or money’s worth. e.g. money payable to supplier of goods or provider of service. Creditors are generally classified as Current Liabilities. Capital Expenditure : This represents expenditure incurred for the purpose of acquiring a fixed assetwhich is intended to be used over long term for earning profits there from. e. g. amount paid tobuy a computer for office use is a capital expenditure. At times expenditure may be incurred forenhancing the production capacity of the machine. This also will be a capital expenditure. Capitalexpenditure forms part of the Balance Sheet. Revenue expenditure : This represents expenditure incurred to earn revenue of the current period.The benefits of revenue expenses get exhausted in the year of the incurrence. e.g. repairs, insurance,salary & wages to employees, travel etc. The revenue expenditure results in reduction in profit orsurplus. It forms part of the Income statement. Business usually prepares 3 reports. 1. A statement of financial position referred to as balance sheet 2. Income statement 3. Statement of cash flows. In this module, we can just concentrate on the income statement and Balance sheet. Balance Sheet : It is the statement of financial position of the business entity on a particular date.It lists all assets, liabilities and capital. It is important to note that this statement exhibits the state ofaffairs of the business as on a particular date only. It describes what the business owns and whatthe business owes to outsiders (this denotes liabilities) and to the owners (this denotes capital). It isprepared after incorporating the resulting profit/losses of Income statement. Profit and Loss Account or Income Statement : This account shows the revenue earned by thebusiness and the expenses incurred by the business to earn that revenue. This is prepared usuallyfor a particular accounting period, which could be a month, quarter, a half year or a year. The netresult of the Profit and Loss Account will show profit earned or loss suffered by the business entity. 3 Accounting Measurement Assumptions: Only when the financial statements are prepared based on identical measurement criteria and assumptions, it becomes easy to interpret as it conveys same meaning for all the users. A lot of events affect the business, like receiving cash from customers, making payment to suppliers, tax payments, buying and selling on credit etc. Therefore, to have identical understanding of transactions, Accounting adopts the following four major measurement assumptions: a. Reporting Entity: The primary assumption here is that the Firm is different from its owners and other firms. It has an existence of its own. Owners might come and go. But the organisation exists. Therefore, the financial statement of the firm shall show the financial position of the firm alone and does not include the financial transaction of any other individual or entity. Reporting entity is also defined by the purpose and the context of financial reporting. For e.g. A company might have different subsidiary or group companies; Some businesses might want to reports based on segment of business like based on type of products or Geographical segment etc. b. Going Concern: This assumes that unless there is some substantial evidence the business will continue (hence the term ‘Going Concern’) to exist. This assumption is extremely important to understand, as the businesses go through difficult and successful periods of time. However, they will be able to meet their commitments to the stakeholders in spite of seemingly difficult position. Auditors and the management of the firms have the responsibility to certify / state, whether the firm can continue to operate. Usually cost commitments, the assets that the firm owns and the ability of the organisation to generate revenue in the foreseeable future will determine if it is a going concern or not. c. Periodicity: As we assume that the organisations continue to exist under the going concern assumption, the stake holders of the firm may want to find out the results of the operation every now and then. To satisfy this condition, firms have to report to its stake holders, on their financial performance and financial position based on an artificial time period. This is usually a year. However, the current practices also make it mandatory to report once a quarter. d. Money measurement: Under this assumption, financial transactions are recorded and Financial statements are always expressed in terms of money for the ease of understanding. If a transaction or activity cannot be measured in terms of money, such things cannot find a place in the accounting records. However, the type of unit of money (i.e. currency), can be different. E.g. Rupees in India, US Dollars, UK Sterling etc. The important assumption here is that money is a stable measure in the same way as Kg is a stable measure for weight. End of Module 1 4 Check Your Understanding 1. Employees are residual claimants of the profits of the business, i.e., they have to take what is left after paying all outside claimants such as suppliers, lenders, and government. (a) True (b) False 2. Who among the following would be interested in a company's financial information for the sake of resource allocation, formulation of taxation policies and investigation of corporate crimes? (a) Current employees (b) Past employees (c) Senior managers (d) Government 3. _______ provide the risk capital to a business? (a) Shareholders (b) Lenders (c) Employees (d) Credit Rating Agencies 4. What does the accounting assumption 'reporting entity' mean? (a) The entity is a continuing enterprise (b) Separation of owners' business transactions from their personal transactions (c) Valuation of entity's assets (d) Breaking up the life of the entity into time periods 5. What does the accounting assumption 'historical cost' mean? (a) The entity is a continuing enterprise (b) Separation of owners' business transactions from their personal transactions (c) Valuation of entity's assets at cost of acquisition (d) Breaking up the life of the entity into time periods 6. The __________ assumption is an extension of the going concern assumption. (a) Historical cost (b) Periodicity (c) Money measurement (d) Reporting entity 5 Module 2: Get to know Balance Sheet Learning Outcome At the end of the module you would have an understanding of: a. b. c. d. The concept of double entry system The content of a Balance Sheet The Accounting equation The effect of a transaction on the accounting equation Double Entry System: Double entry is a simple yet powerful concept each and every one of a company's transactions will result in an amount recorded into at least two of the accounts in the accounting system. Every transaction has two fold aspects, i.e., one party giving the benefit and the other receiving the benefit. Because of the double entry system all of a company’s transactions will involve a combination of two or more accounts from the balance sheet and/or the income statement. The whole Financial Accounting depends on Accounting Equation which is also known as Balance Sheet Equation. The basic Accounting Equation is: Assets = Liabilities + Owner’s equity Or A = L + P Where A = Assets, L = Liabilities, P = Capital While trying to do this correlation, please note that incomes or gains will increase owner’s equity and expenses or losses will reduce it. Basics of accounting can be understood through the story of a parcel service business started by John who named it as ‘Quick Parcel’. John will no doubt start his business by putting some of his own personal money into it. In means, he owns shares of ‘Quick Parcel’ equity. Quick parcel will need to buy a sturdy, dependable delivery vehicle. 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 John(as he works for the company,) expenses associated with the delivery vehicle, advertising, etc. 6 With thousands of such transactions in a given year, John should get into the habit of entering all of the day's business transactions. Then at the end of the year, try to track what the business has earned or what the business has lost to be given to its owner John or the investor. Balance Sheet accounts: Asset accounts (Examples: Cash, Accounts Receivable, Supplies, Equipment) Liability accounts (Examples: Notes Payable, Accounts Payable, Wages Payable) Stockholders' Equity accounts (Examples: Common Stock, Retained Earnings) Income Statement accounts: (Income) Revenue accounts (Examples: Service Revenues, Investment Revenues) Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation Expense) Let’s illustrate the business with few sample transactions: 1.On December 1, 2017 John starts his business Quick Parcel, Inc. The first transaction that John will record for his company is his personal investment of Rs.20,000 in exchange for 5,000 shares of Quick Parcel’s equity. 2.On December 2, Quick Parcel purchases a used delivery van for Rs14,000 by writing a check for Rs.14,000. The two accounts involved are Cash and Vehicles (or Delivery Equipment). 3.On December 2 when John contacts an insurance agent regarding insurance coverage for the vehicle quick Parcel just purchased. The agent informs him that Rs.1,200 will provide insurance protection for the next six months. John immediately writes a cheque for Rs.1,200 and mails it in. Prepaid Insurance (an asset account reported on the balance sheet) and Insurance Expense (an expense account reported on the income statement). 4.On December 3,a customer gives Quick Parcel a cheque for Rs.10 to deliver two parcels on that day. 5. On December 3 the company gets its second customer-a local company that needs to have 50 parcels delivered immediately. John's price of Rs.250 is very appealing. 6. The only expense incurred by Direct Delivery so far was a fee to a temporary help agency for a person to help Joe deliver parcels on December 3. The temp agency fee is Rs.80 and is due by December 12. Let’s now get to the basics of getting started with recording his transactions Basic accounting equation, which is really the same concept as the balance sheet, it's just presented in an equation format: 7 Just as assets are on the left side of the accounting equation,to increase an asset account's balance, you put more on the left side of the asset account. In accounting jargon, you debit the asset account. To decrease an asset account balance you credit the account, that is, you enter the amount on the right side. Just as liabilities and stockholders' equity are on the right side (or credit side) of the accounting equation,to increase the balance in a liability or stockholders' equity account, you put more on the right side of the account. In accounting jargon, you credit the liability or the equity account. To decrease a liability or equity, you debit the account, that is, you enter the amount on the left side of the account. 1. On December 1, 2017 John starts his business Quick Parcel, Inc. The first transaction that John will record for his company is his personal investment of Rs.20,000 in exchange for 5,000 shares of Quick Parcel’s equity. Transaction Assets No. / Date Cash 1 20,000 = Liabilities - + Equity 20,000 2. On December 2, Quick Parcel purchases a used delivery van for Rs14,000 by writing a check for Rs.14,000. The two accounts involved are Cash and Vehicles (or Delivery Equipment). Transaction No. / Date 1 2 Assets = Liabilities + Equity Cash Van 20,000 0 20,000 -14,000 14,000 Quick Parcel's accounting system will show an increase in its account Cash from zero to Rs.20,000, and an increase in its stockholders' equity account Common Stock by Rs.20,000. Both of these accounts are balance sheet accounts. There are no revenues because no delivery fees were earned by the company, and there were no expenses. 3. On December 2 John contacts an insurance agent regarding insurance coverage for the vehicle Quick Parcel just purchased. The agent informs him that Rs.1,200 will provide insurance protection for the next six months. John immediately writes a cheque for Rs.1,200 and mails it in. 8 Assets = Liabilities Transaction No. / Date Cash Van Ins prepaid 1 20,000 0 2 -14,000 14,000 Balance 6,000 14,000 0 3 -1,200 1,200 Balance 4,800 14,000 1,200 Equity 20,000 20,000 20,000 4. On December 3, a customer gives Quick Parcel a cheque for Rs.10 to deliver two parcels on that day. Date Cash 1 2 Balance 3 Balance 3 Balance 20,000 -14,000 6,000 -1,200 4,800 10 4,810 Assets Van Ins prepaid = Liabilities 14,000 14,000 14,000 1,200 1,200 14,000 1,200 + Equity 0 20,000 0 20,000 20,000 10 20,010 5. On December 3 the company gets its second customer-a local company that needs to have 50 parcels delivered immediately. John's price of Rs.250 is very appealing. Date Cash 1 2 Balance 3 Balance 3 Balance 3 Balance 20,000 -14,000 6,000 -1,200 4,800 10 4,810 250 5,060 Assets Van Ins prepaid 14,000 14,000 14,000 1,200 1,200 14,000 1,200 14,000 1,200 = Liabilities + Equity 0 20,000 0 20,000 20,000 10 20,010 250 20,260 6. The only expense incurred by Direct Delivery so far was a fee to a temporary help agency for a person to help John deliver parcels on December 3. The temp agency fee is Rs.80 and is due by December 12. 9 Assets Date 1 2 Balance 3 Balance 3 Balance 3 Balance 3 Balance = Cash Van Ins prepaid 20,000 -14,000 14,000 6,000 14,000 -1,200 1,200 4,800 14,000 1,200 10 4,810 14,000 1,200 A/c Rec 4,810 14,000 1,200 250 250 4,810 14,000 1,200 250 Liabilities + Equity A/c Payable 0 20,000 0 20,000 80 80 20,000 10 20,010 250 20,260 -80 20,180 Assets include costs that are not yet expired (not yet used up), while expenses are costs that have expired (have been used up). Since the Rs.1,200 payment is for an expense that will not expire in its entirety within the current month, it would be logical to debit the account Prepaid Insurance. (At the end of each month, when Rs.200 has expired, Rs.200 will be moved from Prepaid Insurance to Insurance Expense.) End of Module 2 10 Check your understanding 1. Identify liability items: (a) Bank Loan (b) Office Supplies (c) Office Equipment (d) Dividends 2. Which among the following do not qualify as assets? (a) office expense (b) Cash (c) Inventories (d) office supplies 3. Financial statements do not include the following: (a) Balance Sheet (b) Profit and loss (c) Projected Budget (d) Cash Flow Statement 4. What are the accounts affected by 'Received payment for goods supplied'? (a) Assets (no effect) = Liabilities (increase) + Equity (decrease) (b) Assets (increase) = Liabilities (no effect) + Equity (increases) (c) Assets (no effect) = Liabilities (no effect) + Equity (no effect) (d) Assets (decrease) = Liabilities (no effect) + Equity (decreases) 5. Asset is the sum of liabilities and _________. (a) revenues - expenses (b) capital - dividends (c) capital - drawings (d) capital + revenues - expenses - dividends - drawings 6. Cash, inventories, buildings, machines, etc., are examples of: (a) capital items (b) asset items (c) revenue items (d) expense items 11 Module 3: Understanding Income Statements Learning Outcome At the end of this module you would have learnt: a. b. c. d. The meaning of Income and Expenses in an Income Statement The difference between profit and cash Preparation of an Income Statement The relationship between Balance sheet and Income Statement Income Statement: Income statement will show how profitable a business has been during the time interval. The reporting of profitability involves two things: the amount that was earned (revenues) and the expenses necessary to earn the revenues. Income Statement accounts: Revenue accounts (Examples: Service Revenues, Investment Revenues) Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation Expense) Revenues: The main revenues for a business are the fees it earns for delivering parcels. The revenues are recorded when they are earned, not when the company receives the money (accrual basis of accounting). Recording revenues when they are earned is the result of one of the basic accounting principles known as the revenue recognition principle. For example, if John delivers 1,000 parcels in December for Rs.4 per delivery, he has technically earned fees totalling Rs.4,000 for that month. He sends invoices to his clients for these fees and his terms require that his clients must pay by January 10. Even though his clients won't be paying Direct Delivery until January 10, the accrual basis of accounting requires that the Rs.4,000 be recorded as December revenues, since that is when the delivery work actually took place. After expenses are matched with these revenues, the income statement for December will show just how profitable the company was in delivering parcels in December. When John receives the Rs.4,000 worth of payment cheques from his customers on January 10, he will make an accounting entry to show the money was received. This Rs.4,000 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 Rs.4,000 of receipts will be recorded in January as a reduction in Accounts Receivable. (In December John had made an entry to Accounts Receivable and to Sales.) 12 B. Expenses Now let’s turn to the second part of the income statement—expenses. The December income statement should show expenses incurred during December regardless of when the company actually paid for the expenses. For example, if John hires someone to help him with December deliveries and John agrees to pay him Rs.500 on January 3, that Rs.500 expense needs to be shown on the December income statement. The actual date that the Rs.500 is paid out doesn't matter. What matters is when the work was done—when the expense was incurred—and in this case, the work was done in December. The Rs.500 expense is counted as a December expense even though the money will not be paid out until January 3. The Rs.500 of wages expense on the December income statement will result in a matching of the cost of the labour used to deliver the December parcels with the revenues from delivering the December parcels. This matching principle is very important in measuring just how profitable a company was during a given time period. Other expenses to be matched with December's revenues would be such things as gas for the delivery van and advertising spots. One simple yet important point: an income statement, does not report the cash coming in— rather, its purpose is to (1) Report the revenues earned by the company's efforts during the period, and (2) Report the expenses incurred by the company during the same period. The purpose of the income statement is to show a company's profitability during a specific period of time. The difference (or "net") between the revenues and expenses for Quick Parcel is often referred to as the bottom line and it is labelled as either Net Income or Net Loss. Quick Delivery Inc Income statement For the 3 days ended Dec 3, 2017 Revenue from services Help Expenses Net Income Rs. 260 80 Rs.180 13 A balance sheet is a document that tracks a company's assets, liabilities and owner's equity at a specific point in time. As you know, if the company's has something, it belongs to someone. After the entries through December 3 have been recorded, the balance sheet will look like this: Assets Cash Accounts receivable Prepaid insurance Vehicles Rs 4,810 250 1,200 14,000 Liabilities Accounts Payable Shholders Equity (P&L)Retained earnings 20,260 Rs 80 20,000 180 20,260 There's More To Learn: There's much more to accounting, but you've got an idea of the basics: If a company has something, someone had better own it A balance sheet lists assets, liabilities and owner's equity at a point in time; everything must add up Changes must be made in pairs: if assets, liabilities or owner's equity changes, something else much change as well Any system can be interesting if you look at the reasons it was created and the problem it's trying to solve. Could you have made a simpler way to report what a company is worth and who is owed what? We shall explore the possibilities as we interact in our class room sessions. End of module 3 14 Check your understanding 1. What is the effect of the transaction - 'Rent paid for commercial space'? (a) Assets (no effect) = Liabilities (increase) + Capital (decrease) (b) Assets (no effect) = Liabilities (no effect) + Capital (no effect) (c) Assets (decrease) = Liabilities (no effect) + Capital (decrease) (d) Assets (no effect) = Liabilities (increase) + Capital (decrease 2. which of the following are not “expenses” (a) Depreciation (b) Rent (c) Machinery (d) Advertising 3. Select the most appropriate account title for this item: Salaries accrued for the past month. (a) Salaries payable (b) Salary expense (c) Prepaid salaries (d) Salaries paid 4. Trade Receivables account records: (a) salaries accrued (b) cash receipts (c) purchases and sales of goods (d) credit sales and collections 5. On April 1, 20XX, Ria set up ChefPro, an online cookery channel as a proprietorship. The business completed the following transactions during the month: (a) Ria invested in the business, Rs 10,000. (b) Took an interest-free loan from a friend, Rs 20,000. (c) Provided services for cash, Rs 39,600. (d) Paid salaries, Rs 33,000 (including Rs 4,000 to herself). (e) Billed customers for services provided, Rs 43,400. The amounts are due to be received next month. (f) Paid the monthly bill for web services, Rs 10,000. (g) Paid insurance premium for the month, Rs 1500. (h) Received interest income, Rs 280. 15 Required: You are required to fill in the blanks in the Statement of Profit and Loss for April 20XX and the Balance Sheet for April 20XX. Statement of Profit and Loss Rs. Rs. Revenue and Other Income Revenue from services Interest Income Total revenues and other income 83,280 Expenses Salaries expense Web service expense Insurance expense Total expenses 40,500 Net Profit Balance Sheet Rs. Rs. Assets Trade Receivables 43,400 Cash Total Assets Liabilities Loan Payable Total Liabilities 20,000 Equity Share Capital 48,780 Total Equity 48,780 Total Liabilities and Equity 68,780 16 Answers to Test your understanding Module 1 1. False (b); 2. Government (d) 3. Shareholders (a) 4. Separation of owners' business transactions from their personal transactions (b) 5. Valuation of entity's assets at cost of acquisition (c) 6. Historical cost (a) Module 2 1. Bank loan (a) 2. Office expense (a) 3. Projected Budget (c) 4. Assets (increase) = Liabilities (no effect) + Equity (increases) (b) 5. Capital + revenues - expenses - dividends – drawings (d) 6. Asset items (b) Module 3 1. Assets (decrease) = Liabilities (no effect) + Capital (decrease) (c) 2. Machinery (c) 3. Salaries payable (a) 4. Credit sales and collections (d) 5. Statement of Profit and Loss and Balance sheet Statement of Profit and Loss Revenue and Other Income Revenue from services Interest Income Total revenues and other income Expenses Salaries expense Web service expense Insurance expense Total expenses Net Profit Rs. Rs. 83,000 280 83,280 29,000 10,000 1,500 40,500 42,780 17 Balance Sheet Assets Trade Receivables Cash Rs. Rs. 43,400 25,380 Total Assets Liabilities Loan Payable Total Liabilities Equity Share Capital Total Equity Total Liabilities and Equity 68,780 20,000 20,000 48,780 48,780 68,780 18