ACCOUNTING
Accounting is a system that identi es, records and communicates information that
is relevant, reliable and comparable to help users make better decisions.
It is a system because it has an input, process, output and feedback.
If every company would recall informations in di erent ways, it would be messy.
Accounting provides a common language for all businesses, so that, for example,
a company from Pakistan can understand a company from USA.
There’s a standard way to record everything.
ACCOUNTING ACTIVITIES
1. Identifying business activities: we have to identify relevant business activities
for accounting, for recording nancial information.
2. Recording business activities: So, we have to be able to identify which
activities record. How do we record it, what’s the method and why do we
choose it? This is the object of the class.
3. Communicating business activities
Transaction: exchange of goods and services.
Who are the users of accounting information? Management, investors, society,
government too, because of taxes.
There are two di erent types of users:
they want to
understand if you’ll
be able to give
them their money
back
The accounting that we do for external users is called nancial accounting, while
the accounting that we do for internal users is called managerial accounting.
Internal people are more focused on detail: how the product is made, the price of
each product etc. Instead, external users are focused only on how you make
money, that’s like the “tip of the iceberg”.
In this class, we will focus on nancial accounting.
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BUILDING BLOCKS OF ACCOUNTING
If a company wants to be good at accounting, they have to ensure these three
important things:
1. ASSUMPTIONS: we have to keep in mind the assumptions in accounting and
stay in-between those boundaries. In this case, assumptions explain that we
have a limited playground.
2. ETHICS IN FINANCIAL REPORTING: we’ve had accounting for decades, but
we still see companies involved in huge accounting scandals. That means that,
even having those assumptions, there’s still a possibility to be corrupt and to
hide certain information. In accounting there’s a term called “window
dressing”, that means making something look prettier than it actually is.
Companies could be overstating income or expenses to avoid taxes. That’s
why we say that we need to be good at ethics to be good at accounting.
3. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP): a set of
general accepted rules and practices. They are the guiding tool for accounting.
Who sets this principles? Standard setting bodies: SEC (security and
exchange commission), FASB (Financial accounting standards board), IASB
(international accounting standards board).
There are thousands of these standards. The main ones are:
• Objectivity principle: accounting information is supported by independent,
unbiased evidence. Whenever you record something, that something has to
be objective. When determining the worth of something, that worth has to be
determined objectively.
• Cost principle: accounting information is based on actual cost. Example: I
bought a building for 70000$. Now, that same building values 150000$. I have
to record the price for which I bought it, so 70000$.
• Going-concern principle: re ects assumption that the business will continue
operating instead of being closed or sold.
• Monetary unit principle: express transactions and events in monetary or
money units.
• Revenue recognition principle:
1. Recognize revenue when it is earned.
2. Proceeds need not to be in cash. (Proceeds=earning). Even if I have not
received the cash, I can still record it, by writing that these money will be
received in the future.)
3. Measure revenue by cash received plus cash value of items received (a
revenue is something you earn).
• Business entity principle: a business is accounted separately from other
business entities, including its owner. Example: If I have three businesses, I
have to have three separate accounting information.
BUSINESS ENTITY FORMS:
1. Proprietorship: business started by one person, generally one entrepreneur.
The business owner is liable for all the pro ts and losses.
2. Partnership: two or more people open a business together. The liability is
usually unlimited: that means that if my business goes in loss I have to use my
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own money to pay for those losses. If I have to supply money, I have to pay for
it.
3. Corporation: ownership divided into shares of stock. It is a separate legal
entity organized under state corporation law. The liability is limited: if my
business goes in loss, all I lose is my investment.
THE COFFEE HOUSE
Let’s assume that I want to set up a co ee house.
What kind of resources do I need? A Shop, employees, co ee machines, materials
(co ee, milk…), money, strategy, budget.
In accounting, we record information that can be translated into monetary terms.
So, strategy is not relevant for accounting (even though it’s really important).
In accounting, the resources of the company are called ASSETS (plant, property,
equipment, cash etc.). They are all the things that you bought for the business and
have a life of one year. Life of one year doesn’t have to be precisely 365 days.
There are two categories of assets:
- Current assets: also called liquid assets or short-term assets. These are assets
that are either cash or that can be easily converted into cash. For example,
cash, inventory, raw material, accounts receivable, notes receivable, supplies.
They are resources but we don’t really consume them. In this case, they are
expenses (the salaries of the employees, the rent, the utilities of gas and water,
they are all things that you pay every month).
- Non-current assets: also called long-term assets, they are not easily converted
into cash, it takes time for them to be converted. They are there for longer
periods of time (machinery, plant, equipment).
When you have to judge the nancial position of the company, you look at their
current assets (does the company have enough money?).
RESOURCES
COST OF THE RESOURCES
Property
250000$
Machine
50000$
Inventory (raw materials)
20000$
Furniture
100000$
Supplies
5000$
Cash/Bank
25000$
TOTAL
450000$
We don’t have to record only the resources, but we also have to explain the
sources (where did that come from).
I could have investors, I could partner with somebody, I could put my own money
or I can borrow money.
If you borrow money from somebody, it is called a LIABILITY (something that I
have to pay back): I can borrow some liabilities. If you borrow from small business,
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you have to pay back with interests. Liabilities are debts that represent negative
future cash ows for the enterprise because I have to pay them back.
So, returning to the co ee house:
The sources that are not yours are called LIABILITIES (something that you have to
pay back, with interest or without).
SOURCES
Creditors (friends and family)
100000$
Creditor (bank)
200000$
Owners capital
150000$
TOTAL:
450000$
The owners’ equity or capital are sources that can be owners investments,
partner investments etc. If the corporation issues more shares and people buy
them, the owners’ investments will increase. It will increase also when the business
earns money and reinvest them into the business. Paying to the owner and
business losses will decrease owners’ equity.
An expense, instead, is a cost that is related to generating revenue and is for a
short period of time.
In the balance sheet we have to make sure that
ASSETS= LIABILITIES+OWNERS’ EQUITY
This is an accounting equation.
After every transaction, we have to make sure that assets and liabilities+owners
equity are in balance. This whole process is called a BALANCE SHEET because in
order for it to work, it always has to be on balance.
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TYPES OF BUSINESS ACTIVITIES
- Financing activities: transactions involving external sources of funding (owners
and creditors)
- Investing activities: you invest in long-term resources (PPE) and resources not
involved in normal operations (something that we buy for long term, such as
inventory)
- Operating activities: transactions related to primary operations (example,
paying salaries, paying for the bills etc.)
- Returning activities: transactions related to the remuneration of the invested
capital (if a partner retires his investment, you have to return them their money)
FORMS OF TRANSACTIONS:
A transaction is an exchange between the business and the other part. It can
happen:
- On cash: In this case, we record it as cash or banks.
- On credit:
• Debtors: the amount of money that customers owe to the business: you’re
giving them services, but they haven’t given you money yet. These are
accounts receivables.
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• Creditors: people the business owes money to. These are accounts
payables.
REMEMBER: every transaction has a cash/credit source and whenever there’s a
transaction, there will always be at least two accounts involved. This is called the
DOUBLE ENTRY ACCOUNT SYSTEM: there will always be at least a source and
a resource.
FINANCIAL STATEMENTS
- Balance sheet:it describes where the enterprise stands at a speci c date.
Balance sheet is normally prepared either at the beginning of the year or at the
end of the year. Assets, liabilities and owner’s equity will explain the nancial
position of the company.
- Income statement: it depicts the revenue and expenses for a designated
period of time. When you prepare a balance sheet, you consider the assets from
when the business started until today. For the income statement, instead, you
only consider a particular period of time (a month, a year…). In the income
statement we have the revenue: revenues are the amount of money that you
either have received, are receiving now or will receive after you have provided
services if it’s a service business. If it’s a commodity business, then it’s simply
your sales and sales is not pro t. Pro t is the di erence between the sales and
the expenses.
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- Statements of cash ows: it depicts the ways cash has changed during a
designated period of time. It is important to report cash because it is where the
fraud happens. It clearly explains the position of cash: where it came from and
where it went during that period of time. To run a successful business, NEVER
EVER RUN OUT OF CASH.
- Statement of stockholders’ equity (or investors’ equity if you are a
corporation): it explains how much pro t we are sharing with the investors
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THE LEDGER
In accounting records, ledgers are the most important thing.
A ledger is kind of a folder, it is the entire group of accounts
(accounts are individual records showing increases and
decreases). For example, if you want to know all the
transactions related to cash for a particular account, you go
to cash ledger.
So ledgers, also called T-Accounts, provide you with the
summary of a particular account in a given time.
Normally, the ledger looks like a T.
On the T we have three spaces:
1. The top, where we nd the title of account.
2. The left side, called the “Debit side”.
3. The right side, called the “Credit side”.
Increases are recorded on one side and decreases on the other side.
The position of increases and decreases depends on the account, you have to
memorize it. However, remember to always record the debit side rst, then the
credit.
Debit and credit side have to be equal.
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Before we get to the ledgers, we record all the exchanges in the journal.
Journals work the same way as ledgers: you write the date and there’s a debit and
a credit side.
Once you write in the journal, you post in the ledger.
REVENUE AND EXPENSES
Net income is not an asset, but it does increase or decrease the owners’ equity.
Whenever you earn a net income, there will be an increase in the asset (you either
will receive in cash) or your accounts receivable increase. When you have a net
income, you may want to pay your liabilities.
Expense: cost of good and services used up in the process of earning revenue.
They decrease owner’s equity.
Revenue: income earned from selling products or services to customers.
When it comes to revenues, we have to follow the revenue realization principle,
that says that revenue should be recognized at the time goods are sold and
services are rendered.
With expenses, instead, we have to follow the matching principle: expenses
should be recorded in the period in which they are used up.
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ADJUSTING ENTRIES
Adjusting entries are needed whenever revenue or expenses a ect more
than one accounting period.
Every adjusting entry involves a change in either a revenue or expense and
an asset or liability.
1. CONVERTING ASSETS TO EXPENSES
CONCEPT OF DEPRECIATION
Once we buy an asset, we record it like this:
To calculate the depreciation expense (per period), we use the STRAIGHT-LINE
METHOD:
Example: JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50
months for $2,500 cash. Using the straight-line method, we can calculate the
monthly depreciation expense:
$2,500/50= $50
2. CONVERTING LIABILITIES TO REVENUE
When a company is payed in advance for services they haven’t provided yet, this
service can’t be recorded as a revenue, it’s a liability.
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This liability will be recorded as an UNEARNED REVENUE.
The moment I start delivering those services, that liability becomes a revenue.
Example: I paid 10000$ for 10 sessions during the semester and on September I
only conducted only 2 sessions worth 2000. At the end of September, I can say
that I earned the revenue for 2 sessions.
I can record those 2 sessions as a revenue and the liability would reduce.
3. ACCRUING UNPAID EXPENSES
Expenses that incurred but you have not realized them nor recorded them. All you
have to do is simply record them in the period they occurred (matching principle).
Examples include interest, wages and entries.
Example: On May 31, a company owes wages of $3,000. Pay day is Friday, June
2. Should I record these expenses in June or May? I must record them in May,
because they happen in May.
We record them as wages expenses and wages payable.
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On June 2:
4. ACCRUING UNCOLLECTED REVENUE
Revenue that is due but not yet received or recorded.
Example: Interest you earned on the amount that you kept in the bank. This
amount is source of revenue.
RECORDING DIVIDENDS
Dividends are ..
When recording dividends, there are only two scenarios:
1. Issued (declared) and paid dividend:
In this case, it is recorded as:
Dividend
DR
Cash
CR
Issued (declared) and paid dividend:
In this case, it is recorded as:
Dividend
Accounts payable
DR
CR
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