Introduction
Accounting is a function in which business transactions are recorded and presented in the form of financial statements. The three main financial statements are the balance sheet, the profit and loss statement, and the cash flow statement.
Accounting transactions must be recorded in accordance with a set of rules. In the United States, the two main rule-setting bodies are the Internal Revenue Service (IRS), which sets the rules for calculating taxable income, and the Financial Accounting Standards Board (FASB), which sets the rules for the financial reporting of public companies.
The main purpose of accounting is to convey information to various stakeholders of the firm regarding the firm’s operations and financial position. There are two types of stakeholders who use accounting information: internal and external stakeholders. Internal stakeholders are people within the business who are tasked with making operating and investment decisions. External stakeholders of the business include capital providers (equity and debt) and regulators.
Recording Business Transactions
Suppose you are planning to start a business and want to create an accounting system before commencing operations. The first thing you would do is to create a list of accounts, which are the headings under which all transactions are recorded.
All accounts are of the following types: assets, liabilities, equity, sales, and expenses. Every transaction will affect two or more of these accounts, which is why accounting is often called double-entry bookkeeping.
Transactions are initially recorded in a journal. The journal is a form for recording transactions chronologically. In the journal, every transaction is recorded as a debit or a credit. The terms debit and credit simply mean left side and right side, respectively.
The basic layout of a journal is as follows (from left to right): date of transaction, account, description of transaction, reference number for the journal entry, column for debits, and column for credits.
The debit column is used to increase an asset or expense account and decrease a liability, equity, or sales account. The credit column is used to increase a liability, equity, or sales account and decrease an asset or expense account. A rule of double-entry bookkeeping is that the total of the debit column must equal the total of the credit column.
Another way of viewing accounting transactions is with the accounting equation. The accounting equation states that the total recognized value of a firm’s assets is equal to the sum of the firm’s liabilities and shareholder’s equity:
Assets = Liabilities + Owner’s Equity
One way to think about the accounting equation is to recognize that the left side of the equation represents what the company owns, while the right side of the equation represents how those assets are financed.
A major consideration in accounting is when to record transactions. This largely depends on whether the firm uses cash accounting or accrual accounting.
For firms generating less than $25 million in sales, the IRS allows those firms to file their taxes on a cash basis. With cash basis accounting, the firm records sales and expenses when cash changes hands. Thus, profit represents the flow of cash involved in operating transactions.
In contrast, accrual accounting involves recording transactions as they occur, regardless of when payments are received or made. When a sale is made and payment is to be received in the future, the firm records the sale and simultaneously recognizes an asset for the future cash inflow. When the firm incurs a liability for which payment is made in the future, the firm records the expense and simultaneously recognizes an expense for the future cash outflow.
The Accounting Cycle
Firms must take information from the journal and use that information to prepare financial statements. This process, which begins with the journal entries and ends with the financial statements, is known as the accounting cycle.
The next step after the journal is to group transactions by account. This group of accounts is known as the ledger. The ledger shows the account balances at a point in time.
The bookkeeper will then examine the ledger for errors. This examination begins by preparing a trial balance. The trial balance is a worksheet which lists the accounts with their corresponding debit or credit balances (some accounts have normal credit balances while others have normal debit balances).
In the trial balance worksheet, the sum of debits must equal the sum of credits. Although the trial balance does not detect all accounting errors, it helps accountants quickly determine many of the most common errors.
After analyzing the trial balance, the accountant will look through each account searching for anomalies. If any anomalies are found, the accountant will make the necessary adjustment in the journal and ledger, respectively.
For firms using accrual accounting, certain journal entries must be made at the end of an accounting period. Once these period-end entries are made, the accountants will prepare an adjusted trial balance for review. If the adjusted trial balance is free of errors, the accountants will use the ledger balances to prepare the financial statements.
The Financial Statements
Financial statements are the key tools for conveying information about the position and operations of the business. The three main financial statements are the balance sheet, the profit and loss statement, and the cash flow statement.
The balance sheet, also known as the statement of financial position, provides a breakdown of a firm’s financial resources at a point in time.
The balance sheet begins with a listing of a firm’s assets. An asset is a resource which is expected to provide a future economic benefit. Assets are further broken down into current assets and long-term assets. Current assets are those resources that are expected to provide an economic benefit within one year of the balance sheet date. Long-term assets are assets that are expected to provide benefits beyond one year.
The next section of the balance sheet presents the firm’s liabilities. Liabilities are financial and operational obligations of the firm. Like assets, liabilities are classified as current or long-term. Current liabilities are obligations that must be satisfied within one year of the balance sheet date. Long-term liabilities are obligations of the firm that must be satisfied in a period beyond one year of the balance sheet date.
The final section of the balance sheet presents the owner’s equity. The rules of double-entry bookkeeping state that an increase in an asset account must have a corresponding increase in a liability or equity account. Thus, equity represents the difference between assets and liabilities, as total assets must equal the sum of total liabilities and owner’s equity.
It is important to note that the accounting value of owner’s equity does not represent the market value of owner’s equity. In other words, the appraised value of a private business or the trading price of public shares can vary significantly from the equity value on a firm’s balance sheet.
The next statement is the profit and loss statement (P&L), also known as the income statement. This statement shows the firm’s sales and corresponding expenses. The difference between sales and expenses is the firm’s profit (or loss) for the period.
Unlike the balance sheet, which is a snapshot of account values at a single point in time, the profit-and-loss statement shows the sum of activities over a period. For example, a June balance will show balance sheet values as of June 30th, whereas a June P&L shows sales and corresponding expenses which occurred from June 1st through June 30th.
For firms that are taxed at the corporate level, the “bottom line” (net income) will be presented on an after-tax basis. Firms that are taxed as pass-through entities will show no tax provision on the P&L.
A firm’s statement of cash flows (or cash flow statement) presents the cash inflows and outflows that occurred over a period. The cash flow statement separates cash flows into three categories: operating cash flows, investing cash flows, and financing cash flows.
Operating cash flows are those cash receipts and disbursements which arise from the firm’s normal business operations. The operating section of the cash flow statement can be presented under the direct method or indirect method. The direct method of calculating operating cash flow begins with payments from customers and subtracts the corresponding cash outflows, such as for inventory purchases, operating expenses, and interest on borrowings. The indirect method starts with net income, adds non-cash expenses, and then adds or subtracts changes in current asset and liability accounts as needed.
The next section of the cash flow statement shows the cash flows associated with sales or purchases of property, plant, and equipment and other long-term assets.
The final section of the cash flow statement shows the cash flows associated with financing activities. In this section, cash inflows are associated with the issuance of debt or equity. Cash outflows are associated with dividends, debt reduction, and share repurchases.
The sum of the net cash flows from the cash flow statement should equal the change in the firm’s cash account over the same period.
Certain transactions may not have direct cash flow consequences. For such transactions, the cash flow statement may contain a supplementary section presenting such noncash transactions.
Conclusion
Accounting is the “language of business” – it is essential for every business operator and investor to understand basic business accounting. As we study more advanced business concepts, such as strategy, financial management, and valuation, we will rely heavily on accounting information.
