INTRODUCTION TO ACCOUNTING BASICS
Gaining an understanding of basic accounting concepts is essential for business and financial management. Accounting provides data and information necessary to make business decisions. You can use it to create insightful dashboards with charts and infographics to monitor essential company results. Accounting provides the metrics for comparing budgets and the financially focused area of balanced scorecard goals with actual results. Accounting information can be used to perform financial analysis using ratios, which is a way to monitor performance and compare your company’s results with industry benchmarks. Accounting enables cash management, alerting you to financing needs and opportunities to improve the timing of future cash receipts from customers and payments to your vendors. Accounting is also essential for inventory planning and control.
Accounting begins with coding and recording business transactions into standard accounts, using a debits and credits balancing double entry method to maintain control. Summarizing transactions into account totals is the next step. Accounting generates financial statements for financial reporting, including the balance sheet, income statement, statement of cash flows, and statement of shareholders’ equity. Financial statements are used internally and by other stakeholders, including investors, lenders, and other creditors.
This article is an explanation of accounting for your small business. It drills down from the conceptual and financial statements level to the detail level of recording business transactions.
Accounting Standards and Concepts
The Financial Standards Accounting Board (FASB) is in charge of creating and publishing generally accepted accounting principles (GAAP), which are the basic accounting principles. The FASB organizes accounting standards using a numbering system in the FASB Accounting Standards Codification.
In December 1985, the FASB issued Statement of Financial Accounting Concepts No. 6 “Elements of Financial Statements”, which defines elements including assets, liabilities, and equity. In the future, the FASB may make changes to these definitions, as was done in a 2018 conceptual framework for international accounting standards (issued by IFRS).
In September 2010, the FASB issued a Conceptual Framework for Financial Reporting (SFAC No. 8) as guidance in creating and applying GAAP and understanding financial statements. The Conceptual Framework includes Qualitative Characteristics of useful financial statements including relevance, materiality, and faithful representation. Materiality is assessed by whether omitted or misstated information would cause a financial statement user to make a different decision. In practice, the percentage of an item to total revenues or assets is also used by accountants and auditors to determine materiality as they consider the effect on decision- makers. Faithful representation means the financial statements are complete, neutral, and free from error to the greatest extent possible within preparation cost constraints. The Enhancing Qualitative Characteristics include comparability, verifiability, timeliness, and understandability.
Accountants prepare financial statements for an accounting period, which may be a month, a quarter (three months), six months (half year), or a year. For recording transactions, the accounting period is one month. The accounting period may either follow a calendar year or a fiscal year end that is determined by the company. Some companies select their fiscal year-end date to reflect a low point in inventory. Comparable financial statements include two or more accounting periods to show trends over time (for horizontal analysis). Sometimes financial statements show each line item as a percentage of total assets on the balance sheet or total revenues on the income statement (for vertical analysis).
Accountants prepare GAAP financial statements on an accrual basis rather than a cash basis: revenues and expenses are recorded in the period to which they relate, not when cash is received. To provide consistent rules to ensure that revenues are recorded in the right accounting period, GAAP includes a Revenue Recognition accounting standard (ASC 606) that is based on accounting principles and replaces most industry guidance. Revenue recognition divides contracts into individual performance elements that are recorded as revenue upon the performance of each sale and service element. The matching principle guides that an expense should be recorded in the same accounting period as the revenue to which it relates.
Internal control prevents fraud. To the extent possible given the size of the organization, critical duties should be performed by different employees. Account reconciliations should be performed at least monthly. Cash should be adequately controlled. Approvals should be required for expenditures with a dollar value above a certain amount defined in the company’s accounting policy manual.
The income statement, statement of cash flows, and statement of shareholders’ equity cover transactions over the entire accounting period. The balance sheet takes a snapshot at the end of the accounting period.
The balance sheet is also known as the statement of financial position. It contains three sections: Assets, Liabilities, and Shareholders’ Equity. A properly prepared balance sheet always balances, with Assets = Liabilities + Shareholders’ Equity.
Assets are defined (by the FASB in section 25 of Statement of Financial Accounting Concepts No. 6 “Elements of Financial Statements”, dated December 1985) as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” In simpler terms, assets are valuable economic resources owned by an entity.
Assets are separated into current assets and noncurrent (long term) assets. Current assets are transformed into cash within one year or the company’s operating cycle if longer. The operating cycle is defined as the time between the outlay of cash for goods or services and the receipt of that cash after the goods or services are sold or performed.
Current assets include:
- Cash and cash equivalents
- Investments - debt and equity securities
- Accounts receivable
- Prepaid assets - current
- Intangible assets - current
- Other current assets
Non-current assets include:
- Property, plant, and equipment (net of accumulated depreciation)
- Prepaid assets - noncurrent
- Intangible assets - noncurrent
- Other assets and deferred costs
Accounts receivable are customer billings that have not yet been paid. The accounts receivable account is offset by a valuation contra-account for an allowance for estimated uncollectible customer account balances to lower the account balance. Prepaid assets include expenditures that have been paid in cash for more than one accounting period. An example is insurance premiums paid for the entire year upon policy renewal. The insurance payment is initially recorded as a prepaid asset, then one-twelfth of the amount is recorded as an expense in the month to which it relates, reducing the prepaid asset balance by the same amount. Intangible assets include goodwill, patents, and trademarks. Fixed assets like property, plant, and equipment are recorded at cost (and not revalued above historical cost). When worthless, they may be revalued to zero and removed from the books. Fixed assets are depreciated over the expected life of the property. Land is not depreciated. Accumulated depreciation is the cumulative depreciation to date for the assets held at the balance sheet date. Accumulated depreciation reduces the property, plant, and equipment balance. Deferred costs either relate to future revenues or future periods when they will be earned.
Liabilities are defined (by the FASB in section 35 of Statement of Financial Accounting Concepts No. 6 “Elements of Financial Statements”, dated December 1985) as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”
Current liabilities are obligations that are due within one year or the company’s operating cycle if longer. Liabilities are classified as current and long term.
Current liabilities include:
- Accounts payable
- Accrued wages and other liabilities
- Unearned revenue or Deferred revenue
- Borrowings under revolving credit line
- Notes payable - current
- Other current liabilities
Long term liabilities include:
- Notes payable - long term
- Other long term liabilities
Unearned revenue or Deferred revenue is recorded as a liability because the company has obligations to later provide a product or service for which upfront cash has been collected for either all or part of the contract. When the revenue is earned, deferred revenue is reduced and the income account for revenues is increased.
Equity is defined (by the FASB in section 35 of Statement of Financial Accounting Concepts No. 6 “Elements of Financial Statements”, dated December 1985) as “the ownership interest” in a business. “It stems from the ownership rights (or the equivalent) and involves a relation between an enterprise and its owners, as owners, rather than as employees, suppliers, customers, lenders, or in some other nonowner role. Since equity ranks after liabilities as a claim to or interest in the assets of the enterprise, it is a residual interest: (a) equity is the same as net assets, the difference between the enterprise’s assets and its liabilities, and (b) equity is enhanced or burdened by increases and decreases in net assets from nonowner sources as well as investments by owners and distributions to owners.”
Shareholders’ equity has several components. These are: capital investments in the company at par value, less treasury stock (reacquired stock that can be reissued), retained earnings (or losses) since the company’s inception (cumulative earnings or losses less dividends issued), and accumulated other comprehensive income (or loss) which is defined by GAAP to include certain unrealized gains and losses on investments and foreign currency transactions.
Shareholders’ Equity includes:
- Paid-in capital ($1 par value)
- Less: Treasury Stock
- Retained Earnings
- Accumulated Other Comprehensive Income (Loss)
The income statement records revenues and expenses including cost of goods sold, to derive net income before and after taxes. Another name for the income statement is profit and loss statement. Revenues include net sales and services income, from which sales returns and allowances have been deducted.
Earlier, the matching principle was defined. If an expense does not relate to revenue, it should be recorded at the time the expenditure is made if it relates to one accounting period. If a cash payment applies to more than one accounting period, it should be recorded as a prepaid asset, then spread over the time to which it relates as an expense, as described in the Balance Sheet section.
Major sections of the income statement are:
(Cost of Goods Sold)
= Gross Margin
General & administrative expenses
Sales & marketing expenses
Research & Development expenses (not including capitalized asset amounts)
= Total Operating Expenses
Other income or expense
Net Income Before Taxes
Other Comprehensive Income (Loss)
Earnings per Share - basic
Earnings per Share - fully diluted
Other comprehensive income (loss) would include unrealized gain on held-for-sale debt instruments, unrealized gains or losses on derivative financial instruments used to hedge, and foreign currency translation adjustments.
Basic earnings per share includes only outstanding common shares. Fully diluted earnings per share, which includes the contingent issuance of additional shares from already issued convertible preferred stock, warrants, etc., is a lower amount because earnings is divided by a larger number of shares.
Although it’s not a GAAP concept, EBITDA (earnings before interest, taxes, depreciation, and amortization) is useful for analyzing and valuing companies. EBITDA is an approximation of pre-tax cash flow because it adds back non-cash expenses including depreciation (or depletion) of fixed assets and amortization of intangible assets.
Cash Flow Statement
The statement of cash flows shows the cash receipts and disbursements (inflows and outflows) for the accounting period by operating, investing, and operating categories, plus the beginning and ending cash, cash equivalents, and restricted cash balances. Cash flow from operating activities is from running the business. Cash flow from investing activities is from the purchase or sale of long term assets, including fixed assets and investments in securities or other companies. Cash flow from financing activities includes cash flow related to bank borrowings and repayment, notes payable, and issuance and repayment of company bonds, issuance of stock shares and repurchase of shares (treasury stock).
The cash flow statement may either be prepared on a direct or indirect basis. The direct basis shows the total of cash receipts and cash payments by category as they would be shown on a bank statement. The indirect basis starts with net income or loss from the income statement and adds back non-cash expenses, then adjusts for changes in working capital (current assets less current liabilities) balances to calculate cash flow from operating activities. The indirect method uses amounts from the income statement and balance sheet.
Financial statements prepared on a GAAP basis show supplemental disclosures on the face of the statement of cash flows for cash paid for interest expense and cash paid for income taxes and also for the non-cash items included in the indirect method cash flow statement that have not already been disclosed. Other cash flow related items are disclosed as notes to GAAP-prepared financial statements. The SEC also requires cash flow disclosures.
Statement of Shareholders’ Equity
The statement of shareholders’ equity reconciles the beginning and ending balances of shareholders’ equity.
Financial Statement Footnotes
GAAP accounting standards and SEC requirements for public companies describe types of information (disclosures) to include in financial statement footnotes and exhibits to ensure that the financial statements are not misleading.
Using Debits and Credits with Double Entry Balancing
Although transactions are generally recorded with an automated accounting software system for efficiency, this section describes the basic process of recording transactions.
Debits are used to record increases in assets and expenses and decreases in liabilities and shareholders’ equity. Credits record increases in revenue and other income, increases in liabilities and shareholders’ equity and decreases in assets. Every accounting entry includes both a debit and a credit side, with both sides balancing to ensure control.
When an accounting system is established, a numbered chart of accounts (list of accounts) is created to include each type of asset, liability, shareholders’ equity account, revenue and expense account.
Business transactions are recorded using accounting software for sales and services billing, purchases, accounts receivable, accounts payable, cash receipts and cash disbursements. Other accounting journal entries are used to record transactions, including revenue recognition, cut-off timing adjustments, expense accruals for recording payroll and other expenses in the proper period, adjusting the allowance for doubtful accounts receivable, allocating prepaid expenses to each month, inventory adjustments, gain or loss on sale of fixed assets, and depreciation and amortization. Accounting software systems provide a detailed perpetual inventory system to reconcile to periodic physical inventory counts by part number or SKU (which may use automated electronic devices or wireless radio frequency-based counting systems for efficiency). Fixed assets are tagged with ID numbers when purchased, periodically counted and reconciled with the fixed assets subsidiary ledger.
Transactions including journal entries are summarized in the general ledger. When preparing financial statements, a trial balance, which is a list of all account balances by debit and credit totals, can be reviewed to ensure that the general ledger’s total of debits and credits is equal.
Closing the books for each month includes reconciling subsidiary ledgers like accounts receivable and accounts payable to the general ledger to ensure that the amounts are the same. At year-end, accounting software allows you to record transactions in the final month of a year while working on a new month for the following year. When the year-end closing process is complete, net income is zeroed out for the year, and the total is transferred to the retained earnings account.
If the business owns and controls other entities, then eliminating entries to remove inter-company profits are made before the financial statements are combined into a consolidated financial statements.
When you gain a better understanding of accounting, you can increase the accuracy of financial statements. Using good accounting practices like separation of duties reduces risk by improving internal control. Accounting allows you to control assets, manage cash and determine required financing levels, resulting in better decision-making by your business and the stakeholders.