Revenues
Expenses
Assets
Liabilities
Income statement
Balance sheet
Statement of cash flows
Debits and credits
How to record transactions
Two basic accounting principles - the revenue recognition principle and the matching principle - to assure that a company's income statement reports a company's profitability.

1.1 Some sample bookkeeping transactions

To get started, some sample transactions #1 to #6:

Start off your business by putting some of your own personal money into it. You are in effect buying shares in the common stock of your new business.
Purchase the basics you need to set up your business - eg computer, software, office desk and chair.
Earn your first fees and bill your first clients for the products or services you offer.
Collect those fees you've earned (perform the service and collect the money – not the same things).
Record expenses incurred operating the business - your first salary cheque, expenses making products, expenses like rent and heating, also regular depreciation of assets that get used up, and prepayments of insurance.

1.2 Start as you mean to carry on

Get into a routine, get software, and use it daily

Get the software to record all these transactions, eg AceMoney or Quickbooks or Sage
Get into the habit of recording transactions as they happen - keeping a daybook, "la main courante", or just entering the transactions daily into the software on the fly.

1.3 Basic financial statements

Let the computer take the strain - the accounting software will print out your financial statements:

Income Statement
Balance Sheet
Statement of Cash Flow.

2 Income statement

The income statement shows how profitable your company has been over the time interval shown in the statement's heading - a week, a month, three months, five weeks, a year ... choose whatever period is most useful.

To report profitability: the amount that was earned (revenues) and the expenses necessary to earn these revenues. Revenues is not the same as receipts, and expenses is not just making a transfer to pay a bill.

2.1 Revenues

The main revenues are the fees you earn for the services you provide.

2.1.1 Revenue Recognition Principle

Accrual basis of accounting - you record these fees in your software when you rpovide the service, not when you get paid - this is the Revenue Recognition Principle. Cf cash accounting.

Then you can match the expenses with the fees and show your profit for the period in question. And you can record when you received the money which can be at a different time. So first, record the fee under the heading (ie in the book or ledger) "Accounts Receivable". Then when you get paid, move it to "Sales".

2.2 Expenses

Expenses are the second part of the income statement. The Income statement in period December, say, will show expenses incurred during December - never mind when the customer actually paid for the service it received. What matters is when your work was done, this is when the expense was incurred. The expense is counted as a December expense even though the money will not be paid out until maybe January.

2.2.1 Matching principle

Recording expenses with the related revenues is another great basic accounting principle known as the "matching principle".

This matching principle is very important in measuring just how profitable your company is during a given time period, eg December - to earn revenues in December, you had to incur some business expenses in December, even though these expenses may not be paid until January. Other expenses to be matched with December's revenues might be your transport, rent, electricity, advertising in a trade rag.

Another expense on December's income statement could be Interest on borrowed money - eg you borrowed 1,000 GBP for office furniture at 1% monthly interest or an annual payment of 120 GBP.

But though you pay once a year, the interest should accrue monthly, if you do a monthly Income Statement, under the matching principle., because the interest expense is considered a cost that is necessary to earn the revenues shown on the income statements. So you should add this to the expenses every month and then when you pay it at the end of the year, take the monthly expense payments out of expenses and put the one annual payment into the interest book.

In sum, an income statement, does not report the cash coming in. No. It reports the revenues earned by your efforts during the period, reports the expenses incurred during the same period. In this way, the income statement shows your profitability during a specific period of time. The difference (or "net") between the revenues and expenses is often referred to as the bottom line and it is labeled as "net income" or "net loss".

3 Balance sheet - assets

The Balance Sheet is a financial statement that reports your (A) assets, (B) liabilities, and (C) stockholders' (or owner's) equity at a specific point in time. It is a snapshot, not a movie as was the Income statement. For example, if a balance sheet is dated 31/12/yyyy, the amounts shown on the balance sheet are the balances in the accounts after all transactions up to 31/12 have been recorded.

3.1 (A) Assets

Assets are things that a company owns. They are the resources of the company. "Make the assets sweat." Eg the office furniture, yes, but the productive capacity like plant and equipment, cash in the bank, all the supplies you might have on hand. Assets are worth something. They are recorded in separate ledgers, eg Banks, Cash, Office Furniture, Supplies.

Accounts Receivable is an asset - you are waiting to be paid.

3.1.1.1 ROCE – return on capital employed

This is an investment term. Return on Capital Employed is profit (ie revenues minus costs) before you pay interest and before you pay tax, over the net value of the assets you are using:

ROCE = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

3.1.2 Prepaids

What about tthe unexpired portion of a prepaid expense? Suppose you pay 1,200 for annual insurance on your office. That's 100 per month. So for December, 1st to 31st, 100 worth of insurance premium is "used up" or "expires". The expired amount will be reported as an insurance expense on December's income statement. And what about the remaining 1,100 of unexpired insurance premium - where to report that? On the balance sheet of 31 December 31, this will show as an asset in an account called Prepaid Insurance.

Other things that might be paid for before they are used include supplies or annual subscriptions to trade associations. The portion that expires in the current accounting period is listed as an expense on the income statement, the part that has not yet expired is listed as an asset on the balance sheet.

There is a significant link between the income statement and balance sheet, but for now let us continue with our explanation of assets.

3.1.3 Cost Principle and Conservatism

Your company's assets are recorded at their original or historic cost, and even if the fair market value of an item increases, you cannot increase the amount of that asset recorded on the balance sheet. This is the because of another basic accounting principle known as the cost principle.

Although accountants generally do not increase the value of an asset, they might decrease its value as a result of a concept known as conservatism. For example, after a few months in business, you may decide that you can help out some customers—as well as earn additional revenues—by carrying an inventory of items to sell. Let's say you purchased 100 items wholesale for 1.00 each, but since then, the the wholesale price has been cut by 40% and at today's price you could purchase them for 0.60 each. If the net realizable value of his inventory is less than the original recorded cost, the principle of conservatism says that the accountant must report the lower amount as the asset's value on the balance sheet.

The cost principle generally stops you reporting assets at more than cost, while being conservative might mean assets being reported at less than they cost.

3.1.4 Depreciation

Assets such as equipment, vehicles, and buildings are routinely depreciated. Depreciation is required by the basic accounting principle known as the matching principle, as we've seen, because assets get used up - equipment wears out, vehicles become too old and costly to maintain, buildings age, and some assets (like computers) become obsolete. But land, no.

Allocate the cost of depreciation of the asset to Depreciation Expense on the income statement. Schedule this over the useful life of the asset.

Does the Balance sheet show what the company's assets are worth? Surprisingly, assets are not reported on the balance sheet at their worth ie fair market value. Long-term assets (such as buildings, equipment, and furnishings) are reported at their cost minus the amounts already sent to the income statement as Depreciation Expense.

The result is that a building's market value may actually have increased since it was acquired, but the amount on the balance sheet has been consistently reduced as the accountant moved some of its cost each month or year to Depreciation Expense on the income statement in line with the matching principle.

Depreciation is a routine process, part of matching expenses to revenues. It is not making a valuation.

Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost.

Short-term (current) asset amounts are likely to be close to their market values, since they tend to "turn over" (get used up) in relatively short periods of time.

Note that the balance sheet reports only the assets acquired and only at the cost reported in the transaction you've booked. So a company's reputation—as excellent as it might be—will not be listed as an asset. Not Nike's logo or Jamie Oliver's reputation.

4 Balance Sheet - Liabilities and Stockholders' Equity

4.1 (B) Liabilities

The balance sheet reports liabilities as of the date in the heading of the sheet. Liabilities are obligations of the company; they are amounts owed to others as of the balance sheet date.

Some examples:

· the loan you received (Notes Payable or Loan Payable)

· the interest on the loan (Interest Payable)

· the amount you owe to the shop for items purchased on credit (Accounts Payable)

· the wages you owe an employee but haven't yet paid (Wages Payable).

Also

money received in advance of actually earning the money – eg an agreement with a customer who prepays to supply at regular ingervals a service or product. You accept the money into the asset Cash, but you have to show a liability of in Unearned Revenue (or Deferred Revenues, Customer Deposits, etc.).

Then as you perform the service, each time you move from the account Unearned Revenue to Service Revenues, as you fulfill the agreement and revenues on the income statement increase.

4.2 (C) Stockholders' Equity

If the company is a corporation, the third section of a corporation's balance sheet is Stockholders' Equity. (If the company is a sole proprietorship, it is referred to as Owner's Equity.)

The amount of Stockholders' Equity is exactly the difference between the asset amounts and the liability amounts. Stockholders' Equity is also the "book value" of the corporation.

Shareholder’s equity can be common stock, retained earnings, and additional paid-in capital.

4.2.1.1 PBV – price to book value

PBV Price to Book Value is an investing term used by Value Investors to compare the value of a company on the stock market to its Assets, as recorded in the books (not necessarily what you may have paid as the assets have been depreciated). A PBV of less than 1 is usually cheap but the quality of the assets (especially Intangibles such as Goodwill, patents, trademarks, IP, brand) must be examined. Many Value investors prefer to use PTBV - Price to Tangible Book Value is the ratio of Market Capitalisation to Tangible Equity Shareholders’ Funds.

PBV = Market capitalisation (ie number of shares * share price) ÷ Shareholders equity (ie Total Assets - Total Liabilities).

4.2.1.2 DCF – discounted cash flow

Note that as assets are shown at cost or lower (and not at their market values), Stockholders' Equity is not the same as the market value of the corporation and Stockholders' Equity is not in some way the corporation's "net worth". If you want to value a company, use for example Discounted Cash Flow – this helps determine the value of an investment based on the sum of all its expected future cash flows. The present value of each future expected periodic future cash flows, is arrived at by using a discount rate. A Value investor would look at that present value per share – the Intrinsic value – and if less than the share price, might be interested….

4.2.1.3 Stockholders' Equity

Within the Stockholders' Equity section you may see accounts such as

· Common Stock

· Paid-in Capital in Excess of Par Value-Common Stock

· Preferred Stock

· Retained Earnings

· Accumulated Other Comprehensive Income

· Treasury Stock

· Current Year's Net Income.

The account Common Stock, which is a liability account, will be increased when the corporation issues shares of stock in exchange for cash (or some other asset).

Another account Retained Earnings will increase when the corporation earns a profit. There will be a decrease when the corporation has a net loss. This means that revenues will automatically cause an increase in Stockholders' Equity and expenses will automatically cause a decrease in Stockholders' Equity. This illustrates a link between a company's balance sheet and income statement.

5 Statement of Cash Flows

This statement shows how the cash amount has changed during the time interval shown in the heading of the statement. You can see at a glance the cash generated and used by your company's

· operating activities – how you fulfil your basic company mission, here you make your profit

· investing activities – what you do with the profits like purchases of physical assets, investment in R&D, investments in securities, or the sale of securities or assets

· financing activities – how you raise and pay for money to fund your company: debt, equity, dividends.

Much of the information on this financial statement comes from the balance sheets and income statements.

5.1 Getting started with recording your transactions

5.1.1 Double Entry System

A 500-year-old accounting procedure. Double entry is a simple yet powerful concept: every o transaction will result in an amount recorded into at least two of the accounts in the accounting system.

The easiest way to show this is using T-bars or T-accounts.

5.1.2 The Chart of Accounts

To begin the process of setting up your accounting system, make a detailed listing of all the names of the accounts you use – bank, cash, different assets, sales, costs and so on. This full and detailed listing is referred to as a chart of accounts. Personal software calls them categories – eg Income:salary or Household:utilities:electricity.

The chart of accounts will help him select the two (or more) accounts that are involved. You can tailor your chart of accounts so that it best sorts and reports your business or personal transactions.

Double entry system means all transactions will involve two or more accounts from the balance sheet and/or the income statement. Sample accounts in a chart of accounts:

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:

· Revenue accounts (Examples: Service Revenues, Investment Revenues)

· Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation Expense)

5.2 Sample Transactions #1 – startup your business

Start off your business by putting some of your own personal money into it. You are in effect buying shares in the common stock of your new business.

Your accounting system will show an increase in its account Cash, and an increase in its stockholders' equity account Common Stock by the same amount. Both of these accounts are balance sheet accounts. There are no revenues because nothing earned yet, and there were no expenses.

The balance sheet is just that-in balance.

Marilyn shows Joe something called the basic accounting equation, which, she explains, is really the same concept as the balance sheet, it is just presented in an equation format:

Assets = Liabilities + Stockholder’s or Owner’s equity.

The accounting equation (and the balance sheet) should always be in balance.

5.3 Debits and Credits

Cash and Common Stock were affected by the transaction – two accounts.

Here is the next basic accounting concept: the double entry system requires that the same amount of the transaction must be entered on both the left side of one account, and on the right side of another account. Instead of the word left, accountants use the word debit; and instead of the word right, accountants use the word credit. (The terms debit and credit are derived from Latin terms used 500 years ago.)

How to know which accounts to debit—meaning enter the numbers on the left side of one account—and which accounts to credit—meaning enter the numbers on the right side of another account. The answer is to memorise the accounting equation:

Assets = Liabilities + equity.

Just as assets are on the left side (or debit side) of the accounting equation, the asset accounts in the general ledger have their balances on the left side.

Ø 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.

Ø 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, the liability and equity accounts in the general ledger have their balances on the right side.

Ø 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.

Ø To decrease a liability or equity, you debit the account, that is, you enter the amount on the left side of the account.

As with all rules, there are exceptions, but this helps at the beginnning.

Since many transactions involve cash, remember how the Cash account is affected when a transaction involves cash: if you receive cash, the Cash account is debited (on ze left); when you pay cash, the Cash account is credited (on ze right).

Ø When a company receives cash, the Cash account is debited.

Ø When the company pays cash, the Cash account is credited.

In keeping with double entry, two (or more) accounts need to be involved. Because the first account (Cash) was debited, the second account needs to be credited.

But which account to credit? In this case (startup capital you put in), the second account is Common Stock. Common stock is part of stockholders' equity, which is on the right side of the accounting equation. As a result, it should have a credit balance, and to increase its balance the account needs to be credited. Common Stock is a liability owed by the company to the shareholders.

5.3.1 T-bar (to show general journal entries)

Accountants indicate accounts and amounts using the following format:

Accountants usually first show the account and amount to be debited. On the next line, the account to be credited is indented and the amount appears further to the right than the debit amount shown in the line above. This entry format is referred to as a general journal entry.

(You can use T-bars to illustrate to colleagues. Normally, you won’t use them as this is what the software does.

6 Sample Transactions #2 - #3

6.1 Sample Transaction #2 – buy equipment

Purchase the basics you need to set up your business - eg computer, software, office desk and chair, or a vehicle for deliver.

Purchase of a delivery vehicle. The two accounts involved are Cash and Vehicles (or Delivery Equipment). When the money is transferred, the accounting software will automatically make the entry into these two accounts.

The company pays, so the Cash account is credited. (Accountants consider the chequing account to be Cash, and when cash is paid out, you credit Cash.)

So we know that the Cash account will be credited and we know the other account will have to be debited. We need only identify the best account to debit. In this case we choose Vehicles and the entry is:

The balance sheet will look like this after the vehicle transaction is recorded:

The balance sheet and the accounting equation remain in balance:

As you can see in the balance sheet, the asset Cash decreased and another asset Vehicles increased by the same amount. Liabilities and stockholders' equity were not involved and did not change.

6.2 Sample Transaction #3 – Buy prepaid expense

Buy prepaid insurance

The third sample transaction is for insurance coverage for the vehicle just purchased. The agent informs him that $1,200 will provide insurance protection for the next six months.

Since a money is transferred is transferred, we know that one of the accounts involved is Cash at Bank. Since cash was paid, the Cash account will be credited. While we have not yet identified the second account, what we do know for certain is that the second account will have to be debited.

At this point we have most of the entry-all we are missing is the name of the account to be debited:

We know the transaction involves insurance, and a quick look through the chart of accounts reveals two possibilities:

Prepaid Insurance (an asset account reported on the balance sheet) and Insurance Expense (an expense account reported on the income statement)

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 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 and then at the end of each month, when a monthly sum has expired, move it from Prepaid Insurance to Insurance Expense.

The entry in the general journal format is:

After the first three transactions have been recorded, the balance sheet will look like this:

Again, the balance sheet and the accounting equation are in balance and all of the changes occurred on the asset/left/debit side of the accounting equation. Liabilities and Stockholders' Equity were not affected by the insurance transaction.

Xxx

7 Sample Transactions #4 - #6

7.1 Sample Transaction #4 – customer payment

Collect payment

The fourth transaction occurs when a customer gives a cheque for a service. Because of double entry, we know there must be a minimum of two accounts involved—one of the accounts must be debited, and one of the accounts must be credited.

Because Direct Delivery received 10, it must debit the account Cash. It must also credit a second account for 10.

The second account will be Service Revenues, an income statement account. The reason Service Revenues is credited is because you must report that your company earned 10 (not because it received 10 – not the same things). Recording revenues when they are earned results from a basic accounting principle known as the revenue recognition principle. The following tip reflects that principle.

Revenues accounts are credited when the company earns a fee (or sells merchandise) regardless of whether cash is received at the time.

Here are the two parts of the transaction as they would look in the general journal format:

7.2 Sample Transaction #5 – record advance payment

Record expenses incurred operating the business - your first salary cheque, expenses making products, expenses like rent and heating, also regular depreciation of assets that get used up, and prepayments of insurance.

Let's assume the company gets its second customer. The customer tells Joe to submit an invoice for the 250, and they will pay it within seven days.

Joe does the job as agreed, meaning has earned 250. Hence the 250 is reported as revenues on December 3, even though the company did not receive any cash on that day. The effort needed to complete the job was done on December 3. (Depositing the cheque in the bank when it arrives seven days later is not considered to take any effort.)

One account will be a revenues account, such as Service Revenues.

In the general journal format, here's what we have identified so far:

We know that the unnamed account cannot be Cash because the company did not receive money at that stage. However, the company has earned the right to receive the money in seven days. The account title for the money that Direct Delivery has a right to receive for having provided the service is Accounts Receivable (an asset account).

Again, reporting revenues when they are earned – not necessarily when customer invoices are paid - results from the basic accounting principle known as the revenue recognition principle.

7.3 Sample Transaction #6 – record expenses

Receive a service or product and pay later.

For simplicity, let's assume that the only expense incurred so far was a fee to a temporary help agency for a person to help do the job for the customer.

If a company does not pay cash immediately, you cannot credit Cash. But because the company owes someone the money for its purchase, we say it has an obligation or liability to pay.

Most accounts involved with obligations have the word "payable" in their name, and one of the most frequently used accounts is Accounts Payable. Also keep in mind that expenses are almost always debited.

The accounts and amounts for the temporary help are:

Revenues and expenses appear on the income statement as shown below:

After the entries have been recorded, the balance sheet will look like this:

Notice that the year-to-date net income (bottom line of the income statement) increased Stockholders' Equity by the same amount, 180. This connection between the income statement and balance sheet is important.

· For one, it keeps the balance sheet and the accounting equation in balance.

· Secondly, it demonstrates that revenues will cause the stockholders' equity to increase and expenses will cause stockholders' equity to decrease.

After the end of the year financial statements are prepared, you will see that the income statement accounts (revenue accounts and expense accounts) will be closed or zeroed out and their balances will be transferred into the Retained Earnings account. This will mean the revenue and expense accounts will start the new year with zero balances—allowing the company "to keep score" for the new year.

To summarise this first chapter

1. When a company pays cash for something, the company will credit Cash and will have to debit a second account. Assuming that a company prepares monthly financial statements—

§ If the amount is used up or will expire in the current month, the account to be debited will be an expense account. (Advertising Expense, Rent Expense, Wages Expense are three examples.)

§ If the amount is not used up or does not expire in the current month, the account to be debited will be an asset account. (Examples are Prepaid Insurance, Supplies, Prepaid Rent, Prepaid Advertising, Prepaid Association Dues, Land, Buildings, and Equipment.)

§ If the amount reduces a company's obligations, the account to be debited will be a liability account. (Examples include Accounts Payable, Notes Payable, Wages Payable, and Interest Payable.)

2. When a company receives cash, the company will debit Cash and will have to credit another account. Assuming that a company will prepare monthly financial statements—

§ If the amount received is from a cash sale, or for a service that has just been performed but has not yet been recorded, the account to be credited is a revenue account such as Service Revenues or Fees Earned.

§ If the amount received is an advance payment for a service that has not yet been performed or earned, the account to be credited is Unearned Revenue.

§ If the amount received is a payment from a customer for a sale or service delivered earlier and has already been recorded as revenue, the account to be credited is Accounts Receivable.

§ If the amount received is the proceeds from the company signing a promissory note, the account to be credited is Notes Payable.

§ If the amount received is an investment of additional money by the owner of the corporation, a stockholders' equity account such as Common Stock is credited.

3. Revenues are recorded as Service Revenues or Sales when the service or sale has been performed, not when the cash is received. This reflects the basic accounting principle known as the revenue recognition principle.

4. Expenses are matched with revenues or with the period of time shown in the heading of the income statement, not in the period when the expenses were paid. This reflects the basic accounting principle known as the matching principle.

5. The financial statements also reflect the basic accounting principle known as the cost principle. This means assets are shown on the balance sheet at their original cost or less and not at their current value. The income statement expenses also reflect the cost principle. For example, the depreciation expense is based on the original cost of the asset being depreciated and not on the current replacement cost.

Friday 5 March 2021

1. Accounting Basics

1 Basic accounting terms

2 Income statement

3.1.1.1 ROCE – return on capital employed

4.2.1.1 PBV – price to book value

4.2.1.2 DCF – discounted cash flow

4.2.1.3 Stockholders' Equity

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