This short course in basic accounting is designed for a small business owner who is looking for training to walk him through the process behind the maintenance of books of accounts
The Need for Accounting
Every business, no matter big or small, has the inherent need of recording their business transactions. This recording helps the business keep an eye on revenues, expenses, people who owe them money and vice versa, profit and losses. Accounting helps businesses record and track these transactions. It sets out uniform guidelines and procedures about how to record these transactions. This uniformity in recording helps all the stakeholders of the business to analyze how well their business is doing at a given point in time compared to a previous internal benchmark as well as other businesses in the industry.
Just to clear this point, let us consider a simple example. A Inc. and B Inc. are two identical companies that are doing business in the same industry. Suppose both companies, using their own methods of recording transactions, report a profit of $20000 in a financial year. In the absence of a uniform accounting system we cannot conclude anything about the performance of any of these companies. It might well be the case that A Inc. reports sales in its records only when it receives cash while B Inc. might be reporting sales as soon as it is made, irrespective of the fact whether they receive money for it or not in which case A Inc. might be having a better liquidity position than B Inc. There are numerous other procedures like this that accounting gives uniformity to so that different business performance, profitability and results are easily comparable.
Users of accounting information
Having identified the need for accounting we would now consider the users of these accounting procedures and the information generated by them. Users of accounting information are interested in knowing:
- How well is the business doing?
- Whether it is making profit or loss?
- If it is making profit then how much profit? Ideally broken down by product and business lines?
- If it is making a loss then what are the reasons behind it?
The first users are owners and shareholders. In large organization where shareholders delegate management to the management team, management and shareholders both become users of this accounting information as it helps them analyze performance and take corrective actions in case of missed goals and targets. Another user is the government since the tax department uses accounting statements to determine the tax liability of a profitable business. In addition governments routinely use accounting information to design policies for a specific industry. If a business requires funding and external financing to expand, investors use financial statements to determine eligibility and repayment capacity.
The Accounting equation
To understand we start with a simple accounting equation.
Consider how a business is setup in a very simplified way. The owner brings together his resources and puts them to work in his business. These resources are then used to buy, or are transformed, into the resources of the business. Having understood this, we can safely conclude that the resources brought by the owner should always be equal to the resources that are in the business at any given point in time for any business. We can simply say:
Resources brought by the owner = Resources in the business
Obviously, the above equation is a simplified version of a very complex concept. We all know that businesses do take loans and other sources of funding as well. If a business borrows money and uses it to buy resources then our equation would not hold true as the resources in the business would be greater than the resources supplied by the owner. In order to rectify this, we need to modify our equation a little.
We need to subtract the resources that are supplied by anyone other than the owner from the resources in the business. So our new equation will be:
Resources brought by the owner = Resources in the business – Resources brought by ‘non-owners’
If we are comfortable with the above equation it is time to introduce some basic terminology
Assets: All the resources in the business are called assets. Assets are used by the business to generate profits. Assets can be further classified in to Current Assets and Fixed Assets. Current assets are those assets that are expected to get consumed within one year e.g. Cash, Inventories and Account Receivables etc. Fixed assets are those assets that have a life more than one year. They are long-term assets e.g. Plant, Machinery and Building etc.
Capital: Any resources brought in to the business by the owners and shareholders are put under the category of Capital.
Liabilities: All the resources supplied to business by anyone other than the owners and shareholders are termed as liabilities. The business is liable to return those resources at some point.
Revenue: The proceeds that a business generates as a result of selling goods and services to its customers.
Expenses: The outflow of resources that takes place while producing goods and services for selling.
Armed with the above terminology, we are now in a position to rewrite our accounting equation. Our equation will now be:
Capital = Assets – Liabilities
Assets = Capital + Liabilities
You may be wondering where do Revenues and Expenses go in this equation. Revenues increase capital while expenses decrease capital. They don’t increase or decrease capital directly but rather through the income statement which generates profits and losses. We will come back to this topic in detail later.