Business 101: Accounting Summarized

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Business 100: Why Business Matters

Accounting is the language of business

Money that changes hands is almost always business

Accounting isn’t math

  • Accounting keeps records of transactions, then expresses the most relevant information in reports

Generally Accepted Accounting Principles (GAAP) has four assumptions, principles, and constraints

Accounting assumptions

1. Accounting entity

  • The business is separate from its owners and other businesses
  • Revenue and expense should stay away from personal expenses

2. Going concern/continuity

  • The business will keep operating indefinitely into the unforeseeable future
    • The only exception to going concern/continuity is from 100% certainty of liquidation
  • Going concern/continuity validates several methods
    • Fixed assets versus current assets
    • Short-term versus long-term liabilities
    • Capital and revenue expenditure
    • Asset capitalization, depreciation, and amortization

3. Monetary unit principle

  • The unit of record is a stable currency
  • The FASB accepts the nominal value of the US Dollar unadjusted for inflation

4. Time-period principle

  • An enterprise’s economic activities divide evenly into artificial time periods
  • Attach revenue and expenses in the same periods as much as possible

Accounting principles

1. Historical cost principle

  • Companies must base the costs of most assets and liabilities on how much they paid instead of fair market value
  • Historical cost principle avoids subjective or biased market values but can conflict with marketing (later section)
  • However, most debts and securities report at market values

2. Revenue recognition principle

  • Companies must record either when revenue is received (cash basis) or earned (accrual basis)
  • Most organizations aren’t allowed to use cash basis

3. Matching principle

  • Expenses must match with revenues as long as it’s reasonable
  • Expenses are recognized when they contribute to revenue, not when the expenses incurred
    • Expenses can charge to the current period, but only if they can’t trace directly to revenue
  • Matching principle allows for more profitability and performance analysis
  • Depreciation and Cost of Goods Sold both apply the matching principle

4. Full disclosure principle

  • More gathered information costs more to prepare and use
    • As a result, trade-off analysis determines which information to disclose
  • Disclosed information should keep costs reasonable but provide enough knowledge for all business decisions
  • Information can be in the main body of financial statements, in the notes or as supplementary information

Accounting constraints

1. Objectivity principle

  • Financial statements accountants have provided to the company must use objective evidence

2. Materiality principle

  • Only report an item if it’s significant
  • Something is significant if it might affect a reasonable individual’s decision

3. Consistency principle

  • From period to period, a company uses the same accounting principles and methods

4. Conservatism principle

  • Accountants should pick the least likely solution to overstate assets and income

Accountants use four significant reports to convey financial information

Income Statement

  • Shows financial performance across time
  • Revenue – Expenses = Profit/Loss (i.e., Income)
  • Income statements are considered the most important financial statement because they tie to performance
  • Expenses have two categories
    • Operating Revenue & Expenses – directly associated with business operations
    • Non-Operating Revenue & Expenses – everything else

Balance Sheet

  • Shows a financial position on a specific date
  • Broken down into
    • Assets
    • Liabilities
    • Equity (Income, Expenses, and Revenue from the Income Statement)

Statement of Cash Flows

  • Shows how money flows into and out of various activities
  • Three major activity groups
    • Operating activities – keeps the organization going
    • Investing activities – manages assets to keep operating activities going
    • Financing activities – expands and grows the organization through loans, others’ investments or donations
  • Statement of Cash Flows is often tedious to generate

Statement of Changes in Equity

  • Shows all changes in equity in a period
    • Equity is the organization’s net worth, not value
  • Statement of Changes in Equity isn’t usually bundled with the other three because it’s not very useful internally

Financial statements are a bit like a tree

Imagine a business as a fruit-bearing tree that produces an annual yield which resets every year

The INCOME STATEMENT starts at zero at the beginning of each year and represents the business’ efforts’ fruit

  • PROFIT = REVENUE – EXPENSES
  • At the end of each year, NET EARNINGS (or NET INCOME) adds to RETAINED EARNINGS on the BALANCE SHEET

The BALANCE SHEET is a frozen snapshot in time and measures cumulative results of business efforts

  • A tree can’t bear fruit without a strong trunk, and a business can’t produce annual NET INCOME without a solid BALANCE SHEET
  • The BALANCE SHEET measures what you own (ASSETS) and what you owe (LIABILITIES)

The EQUITY (sometimes called NET WORTH or ACCUMULATED RETAINED EARNINGS) section of the BALANCE SHEET is the difference between the other two
(ASSETS – LIABILITIES = EQUITY)

  • EQUITY approximates the value of your business
  • If you slice open the trunk of a tree, you can read the story of each year of its life
    • Some years are lean, with little or no NET INCOME, and others are strong, with plenty of NET INCOME

Trees need water, and businesses need cash

  • The CASH FLOW STATEMENT shows where the cash traveled in a business
    • It shows how much the INCOME STATEMENT went to producing its yield (OPERATING/INVESTING ACTIVITIES) and how much the BALANCE SHEET helped grow the company (FINANCING ACTIVITIES)

The accounting cycle starts at the end of a period and processes everything for that period

1. Transactions identified

  • Transactions can include selling or returning a product, purchasing supplies for business, or anything else
    • Exchange of company assets
    • Borrowing or paying off a debt
    • Depositing from or paying out money to the company’s owners
    • Losing from natural disasters and theft or collecting an insurance payment

2. Journal entries

  • Transactions are chronologically recorded in a journal (also known as the “book of original entry”)
  • A journal is the first accounting documentation of a transaction
  • Every journal entry affects at least two accounts where the difference between debits and credits is always zero

3. Posting

  • Transactions post to their corresponding accounts
  • Accounts are part of a summary of all the business’ accounts called a General Ledger

4. Trial Balance

  • A trial balance is calculated a the end of the accounting period
  • Accounting periods may be a week, month, quarter or year depending on a business’s practices

5. Worksheet

  • The first calculation of the trial balance often shows the books aren’t in balance
    • Track errors and make corrections (adjustments) on a worksheet
  • Adjustments also account for one-time payments which affect multiple periods
    • Depreciation tracks assets that eventually wear out to their corresponding periods of use
    • One-time payments like insurance should allocate on a monthly basis to more accurately match expenses with revenues
  • Take another final trial balance to ensure adjustments balance the accounts

6. Adjusting journal entries

  • Post any necessary adjustments to affected accounts
  • Adjusting entries come after identifying all corrections and adjustments and performing a final trial balance

7. Financial statements

  • Prepare the balance sheet and income statement with the corrected account balances

8. Close the books

  • Close the revenue and expense accounts by moving them into equity to begin the entire cycle again with zero balances

Beyond decision-making, accounting also connects to taxes

Property taxes – ad valorem (according to value)

Realty – buildings, land

Personalty – any non-realty like jewelry, cars, businesses, intellectual properties

Transaction taxes – taxation when one party gives something to another

Federal/state/local excise taxes – taxes on specific items

General sales sax

  • Sales tax from a different state is called use tax

Taxes on transfers at death

  • Estate tax
  • Inheritance tax

Gift tax

Income taxes

US Federal income tax uses a formula

  • Income minus exclusions give Gross Income
  • Gross Income minus certain deductions give Adjusted Gross Income (AGI)
  • AGI minus standard/itemized deductions and personal/dependency exemptions give Taxable Income
  • Taxable Income references to tax tables to calculate Tax Owed
  • Tax Owed minus tax credits, previous pre-payments, and withholding give Tax Due/Refund

Tax tables use tax brackets

  • An example:
    • up to $10,000 = 5%
    • $10,001 to $25,000 = 10%
    • $25,001 to $45,000 = 20%
    • over $45,000 = 35%
  • A $56,000 Taxable Income will pay
    • 5% on $10,000 ($500)
    • 10% on the next $15,000 ($1,500)
    • 20% on the next $20,000 ($4,000)
    • 35% on the last $11,000 ($3,850)
    • Total Tax: $9,850

US State and Local income tax are calculated similarly to Federal, with some adaptations

Employment taxes

Social Security

Medicare

Unemployment tax

Other Taxes

Federal customs duties (tariffs)

Franchise tax (corporations)

Occupational fees (trade-related)

Value-added tax

  • For buyers – a tax on the purchase price
  • For sellers – a tax on the increased value of the sold product

Certain situations can increase the likelihood of a tax audit

  • Very high gross income
  • Self-employed individuals with substantial business income and deductions
  • Taxpayers with prior tax deficiencies
  • Businesses have a large proportion of cash receipts

Many, many business expenses can deduct from taxable income

  • Accounting fees
  • Advertising
  • Automobile and transportation expenses
  • Bank charges
  • Commissions and sales expenses
  • Consultation expenses
  • Continuing professional education
  • Contract labor
  • Credit and collection fees
  • Delivery charges
  • Dues and subscriptions
  • Employee benefit programs
  • Equipment rentals
  • Factory expenses
  • Gifts (to an extent)
  • Home office
  • Insurance
  • Interest paid
  • Internet subscriptions, domain names, and hosting
  • Laundry
  • Legal fees
  • Licenses
  • Maintenance and repairs
  • Meals and entertainment
  • Office expenses and supplies
  • Pension and profit-sharing plans
  • Postage
  • Print and copy
  • Professional development and training
  • Professional fees
  • Promotion
  • Rent
  • Salaries, wages, and other compensation
  • Security
  • Small tools and equipment
  • Software
  • Supplies
  • Taxes
  • Telephone
  • Trade discounts
  • Travel
  • Utilities
Next: The Simplest Accounting Dictionary Ever