Basic of Accounting Explained

For an investor, it is essential to know the basic of accounting. In this post, we will see simple explanations of accounting.

No matter how big or small is the business, accounting rules must be adhered by one and all.

Idea behind maintaining proper accounts by companies is to keep track of its financial position.

For a publicly traded company maintaining proper accounts is essential.

Every quarterly, a publicly traded company has to report its financial figures for regulators and investors.

By following the basic of accounting, companies can publish its financial figures without difficulty.

It will be impossible for companies to publish reports so frequently without maintaining proper accounting.

In a way, proper accounting keep updating the reports on daily basis.

There is no firefighting done in last moments.

Reports helps investors…

Financial position of a company helps investors understand what is its fair market value.

Generally, company trade at overvalued or undervalued price levels as suggested by its market capitalisation.

If investors cannot evaluate financial position of company, they may risk buying stocks at overvalued price levels.

This is why regulators has made it mandatory for companies to publish its financial reports.

Report publishing must be done on quarterly basis.

This way people can make an informed investment decisions.

Companies follow a standard basic accounting rules called GAAP.

As a result, the report published are standard and reliable.

Good & bad financial position?

Financial position of a company is measured by weight of its asset minus its liabilities.

Total asset minus total liability is equal to shareholders equity.

Shareholders equity is also called net worth or book value.

The higher is the book value the better.

When asset side is stronger than liability side, book value becomes stronger.

Measurement of book value must be done precisely.

A precise book value can be calculated only if the company is maintaining its ‘book of accounting’ well.

It essential for common men (investors) to know the basic of accounting.

This knowledge helps people to analyse the financial position (book value) of any company.

Basic of Accounting Explained with Examples

Companies financial position is linked to the weight of its asset and weight of its liability.

Accountants has developed an Accounting Equation to explain this relationship.

This accounting equation is like a bible for all accountants.

This equation clearly defines how an asset, liability and shareholder’s equity (book value) is related to each other.

Basic of accounting -1

We can also understand ‘accounting equation’ in terms of funds generated and funds used:

Basic of accounting -1.1

Company generates funds from:

  1. Liabilities (loans, deferred payment terms etc).
  2. Equity (Stocks, retained earnings etc).

Liability and equity helps to run its business.

Application of the fund is reflected in the break-up of its asset.

A typical asset break-up of any company is shown below.

This break-up will highlight how company uses it funds to buy the following:

  • Equipment’s,
  • Buildings,
  • Lands,
  • Pay advance payments,
  • Buy investments,
  • Inventory etc.

Company also spends money to make a product ready and effect sales.

Expected payment for sold goods and services is also recorded as ‘ Account Receivables’ in asset column.

Apart from these cash-outs, company also maintains some ‘Cash’ balance that will be sufficient to pay for its liabilities.

Basic of accounting -2

Accounting equation says, money comes in from one account and gets used in other account.

Means, every transaction involves at least one ‘Credit’ & one ‘Debit’.

Double Entry System:

If on liability side loan in credited, simultaneously on asset side equipment purchase (say) must be debited.

This is called as double entry accounting.

Every transaction that happens in a company must be recorded in two accounts.

Suppose a company takes loan of $10,000 from a bank.

How this account will be recorded in companies account?

As loan adds money to companies bank account, it is recorded as ‘Cash’ increase (debited to asst site).

The other entry must be recorded as ‘Loan’ increase.

This is recorded as Credit to Account Payable.

In every transactions, total credits = total debits.

Entry must be recorded in such a way the following equation always stands true:

Basic of accounting -3

There is another important rule which is again a musk-know basic of accounting.

Accrual System

This is called as accrual basis of accounting.

Under this rule revenue is recorded when it becomes due (invoicing to client).

It means, one shall not wait for the money to flow-in the company.

Example:

Consider that a customer buys an Air Conditioner worth $500 from a shop using a credit card.

This transaction will be recorded as Debit of $500 to “Account Receivable” (Asset) in companies account books.

The same transaction will also be recorded as credit of $500 to “Retained Earnings” (Equity).

Lets see how this transaction looks in the Accounting Equation:

Basic of accounting -4

Under accrual account rule expense is recorded when they are incurred (supplier bill received) and not when they are paid.

Suppose bill of vendor is received in January and payment was made in February.

In this case the transaction must be recorded in January itself without waiting for the payment release.

Example:

Suppose company pays interest of $1,000 on its loan on 5th of every month.

The interest accrued for month of January should be paid on 5th of February.

In this case one shall not wait for the cash-out (February).

The transaction must be recorded in January itself.

This transaction will be recorded as Debit of $1,000 to “Interest Expense” (Equity-Retained Earnings).

The same transaction will be recorded as credit of $1,000 to “Account Payable” (Liability).

Let us see how this transaction looks in the Accounting Equation:

Basic of accounting -5

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