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Accounting is the process of recording, classifying, analyzing, and communicating financial information of a company, organization, or individual. This process provides essential data to evaluate the economic and financial situation of an entity and make informed decisions.
The main objectives of accounting are:
To fully understand the world of accounting, we need to grasp the basic concepts. Let’s get started.
The accounting equation Assets = Liabilities + Owner's Equity is the cornerstone of accounting. It reflects the idea that what a company owns (assets) must always equal what it owes (liabilities) plus the ownership interest (owner’s equity).
Example: If a company has $100,000 in assets and $70,000 in liabilities, its owner's equity will be $30,000. Every transaction the company makes must maintain this balance.
Double-entry accounting: To ensure the equation remains balanced, accounting uses a double-entry system: each transaction affects at least two accounts, with one being debited and one being credited.
An asset is a resource with economic value that an individual, company, or country owns or controls, with the expectation it will provide future benefits. Assets can generate cash flows, reduce costs, or improve sales.
There are different types of assets, typically classified into Current Assets, Fixed Assets, Financial Assets, and Intangible Assets for accounting purposes.
Current assets are short-term economic resources expected to be converted to cash or consumed within a year, such as cash, accounts receivable, inventory, and prepaid expenses.
Fixed assets have a useful life of more than one year and include resources like buildings, machinery, and equipment. These assets are depreciated over time to allocate their cost.
Financial assets include stocks, bonds, and other types of securities, typically more liquid and valued at their current market price.
Intangible assets are non-physical economic resources, such as patents, trademarks, copyrights, and goodwill. They can be amortized over their useful life for accounting and tax purposes.
A liability is something a person or company owes, usually a sum of money. Liabilities are settled over time through the transfer of economic benefits, such as money, goods, or services.
Liabilities are classified as current or non-current depending on their time horizon.
Current liabilities are obligations due within one year, such as wages payable, interest payable, and short-term loans.
Non-current liabilities are long-term obligations due beyond 12 months, such as bonds payable, deferred tax liabilities, and pension obligations.
Double-entry accounting is a method that ensures that every financial transaction impacts at least two accounts, keeping the accounting equation balanced. Transactions are recorded as both debits and credits.
Debit increases an asset or decreases a liability, while Credit decreases an asset or increases a liability.
- You purchase $10 worth of inventory on credit.
- Debit $10 to "Inventory" (asset account).
- Credit $10 to "Accounts Payable" (liability account).
- You sell inventory for $15 cash, which cost you $12.
- Debit $15 to "Cash" (asset account).
- Credit $12 to "Inventory" (asset account).
- Record the $3 profit as a credit in the "Owner's Equity" account.
Debits and credits are the two sides of every transaction that help maintain the financial balance of a company. Every accounting transaction involves a double-entry: one part recorded as a debit and the other as a credit.
Assets: A debit increases an asset, while a credit decreases it.
Liabilities: A debit decreases a liability, while a credit increases it.
Owner’s Equity: A debit decreases equity (e.g., losses), while a credit increases equity (e.g., profits).
An accounting method refers to the rules that a company follows when reporting revenue and expenses. The two main accounting methods are **accrual accounting** (generally used by businesses) and **cash accounting** (generally used by individuals). Cash accounting records revenue and expenses when they are actually received and paid through cash flows; accrual accounting records them when they are earned or incurred through sales and credit purchases, using accounts receivable and accounts payable.
We will specifically focus on accrual accounting.
**Accrual accounting** is the standard accounting method used for tax and public reporting purposes. The primary objective is to match revenues and costs to the period in which they are generated, regardless of actual cash flow. This is different from **cash accounting**, where revenues and costs are recorded only when money enters or leaves the company.
- **Practical example**: If you sell a product on credit today for €12, but receive the payment in 30 days, with accrual accounting you recognize the profit immediately (€2, if the production cost was €10), even though the cash will be received later. This method provides an accurate representation of a company's financial performance over time.
- **Tax implication**: Since the profit is recognized immediately, you may need to pay taxes on "virtual" profit, meaning income you haven't yet collected in cash, which could potentially create liquidity issues (needing to borrow money to pay taxes).
Accrual accounting provides a more accurate picture of a company's current condition, but its relative complexity makes it more expensive to implement.
This method originated due to the increasing complexity of business transactions and the need for more accurate financial information. Credit sales and long-term revenue-generating projects impact a company's financial condition at the time of the transaction. Therefore, it makes sense that such events should be reflected in the financial statements within the same period in which the transactions occur.
With Accrual Accounting, businesses receive immediate feedback on expected incoming and outgoing cash flows, making it easier for companies to manage current resources and plan for the future.
A **financial statement** is a document that summarizes a company’s economic and financial situation over a specific period. Financial statements provide essential information about profitability, liquidity, and the financial position of a company, allowing managers, investors, creditors, and other stakeholders to make informed decisions.
There are three main types of **financial statements**:
These documents provide an overall view of the economic and financial conditions of the company, useful for evaluating performance and making future projections.
The cash flow statement tracks the inflow and outflow of money, providing information on a company’s financial health and operational efficiency.
The cash flow statement provides a picture of how a company’s operations work, where the money comes from, and how it is spent. Also known as the statement of cash flows, the CFS helps creditors determine how much cash (liquidity) is available to fund operational expenses and repay the company's debts. The CFS is equally important for investors, as it shows whether a company is financially stable. This allows them to use the statement to make more informed investment decisions.
Creditors, investors, etc., analyze the cash flow to determine the company’s:
It is essential to evaluate the quality of working capital – i.e., inventory and receivables – to ensure they are sellable and collectible, respectively.
Rapid sales growth, slow-moving inventory, price discounting, inferior-quality inventory, or tightening of credit can all impair a company’s ability to generate cash. But why does rapid sales growth impair a company’s ability to generate cash (isn’t rapid sales growth a good thing)?
It is best for companies to finance short-term assets with short-term debt and long-term assets with long-term debt or stock.
The main components of the cash flow statement are:
Operating activities in the CFS include all sources and uses of money derived from a company's core business activities. In other words, they reflect how much cash is generated by a company’s products or services.
These operating activities could include:
In the case of a trading portfolio or investment company, receipts from the sale of loans, debt, or equity instruments are also included, as they are part of the company's business activities.
Investing activities include all sources and uses of cash derived from a company’s investments. Purchases or sales of assets, loans made to suppliers or received from customers, or any payments related to mergers and acquisitions (M&A) fall into this category. In short, changes in equipment, assets, or investments involve cash flow from investing activities.
Changes in cash flow from investing activities are generally considered outflows, as money is used to purchase new equipment, buildings, or short-term assets like marketable securities. However, when a company divests an asset, the transaction is considered a cash inflow in the calculation of cash flow from investing activities.
Cash flow from financing activities includes cash sources from investors and banks, as well as how money is paid to shareholders. This includes any dividends, payments for share buybacks, and repayment of the principal (loans) made by the company.
Changes in cash flow from financing activities are cash inflows when capital is raised and cash outflows when dividends are paid. Thus, if a company issues a bond to the public, it receives financing in cash. However, when interest is paid to bondholders, the company reduces its cash balance. And remember, although interest is a cash outflow, it is reported as an operating activity and not a financing activity.
The balance sheet of a company consists of assets, liabilities, and equity. Assets represent valuable items a company owns or will receive that can be objectively measured. Liabilities are obligations the company owes to others. Equity represents retained earnings and funds contributed by shareholders.
The relationship between these elements is expressed in the fundamental balance sheet equation:
Assets = Liabilities + Equity
Working capital ratios evaluate the efficiency of managing a company's short-term assets. Below are key ratios:
Formula:
Days Receivables = (365 / (Credit Sales / Average Accounts Receivable))
This measures the average number of days it takes for a company to collect receivables after a credit sale. A high value may indicate liquidity issues.
Formula:
Days Inventory = (365 / (Cost of Goods Sold / Average Inventory))
This measures the average number of days needed to sell inventory. High values indicate slow-moving inventory.
Formula:
Inventory Turns = Cost of Goods Sold / Average Inventory
This measures how many times inventory is sold and replaced over a specific period. High turnover is a positive sign.
The income statement, also known as the profit and loss statement (P&L), tracks a company’s revenues, expenses, gains, and losses. It provides insights into a company’s operations and management efficiency.
Revenues generated from the primary activities of the company, such as the sale of goods or services.
Revenues from secondary activities such as interest or rental income.
Expenses incurred to generate operating revenues, including production and management costs.
Net Income = (Revenues + Gains) - (Expenses + Losses)
Companies often use two sets of accounting records:
If you buy an asset for $1,000 with a useful life of 5 years:
If the tax expense in the financial books is higher than the taxes paid (due to accelerated depreciation), the difference is recorded as a liability.