Business 101: Accounting Summarized

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Business 100: Why Business Matters

Business is everywhere, and accounting helps you navigate it

  • Whenever money changes hands, you’re doing business
  • Accounting is the language of business
  • Accounting isn’t math, it’s the art of keeping records and then expressing the information in those records

Accounting operates on Generally Accepted Accounting Principles (GAAP) with four basic assumptions, four basic principles, and four basic constraints

  • ASSUMPTIONS
    1. Accounting Entity
      • The business is separate from its owners or other businesses
      • Revenue and expense should be kept separate from personal expenses
    2. Going Concern/Continuity
      • The business will be in operation indefinitely and will continue to exist in the unforeseeable future
      • This validates the methods of:
        • Asset capitalization
        • Depreciation
        • Amortization
      • This assumption is not applicable only when liquidation is certain
    3. Monetary Unit Principle
      • Use a stable currency as the unit of record
      • The FASB accepts the nominal value of the US Dollar unadjusted for inflation as the monetary unit of record
    4. Time-Period Principle
      • The economic activities of an enterprise can be divided into artificial equal time periods
  • PRINCIPLES
    1. Historical Cost Principle
      • Companies are required to account and report based on acquisition costs rather than fair market value for most assets and liabilities
      • This principle provides reliable information that removes the opportunity for subjective and potentially biased market values, but isn’t very relevant
      • There is, therefore, a trend to use fair values
      • However, most debts and securities are now reported at market values
    2. Revenue Recognition Principle
      • Companies are required to record when revenue is
        1. Realized or realizable
        2. Earned, not when cash is received
      • This accounting method is called accrual basis accounting
        • Contrastingly, a cash basis is only when revenue is actually received, but most organizations aren’t allowed to use it
    3. Matching Principle
      • Expenses have to be matched with revenues as long as it is reasonable to do so
      • Expenses are not recognized when the work/product is performed/produced, but when the work or the product actually makes its contribution to revenue
      • Cost may be charged as expenses to the current period only if no direct connection with revenue can be established
      • This principle allows greater evaluation of actual profitability and performance
      • Depreciation and Cost of Goods Sold are both applications of this principle
    4. Full Disclosure Principle
      • The more information gathered, the greater the cost to prepare and use the information
      • Therefore, the types and amounts of information disclosed should be decided based on trade-off analysis
      • Information disclosed should be enough to make a judgment while keeping costs reasonable
      • Information is presented in the main body of financial statements, in the notes or as supplementary information
  • CONSTRAINTS
    1. Objectivity Principle
      • The company financial statements provided by the accountants should be based on objective evidence
    2. Materiality Principle
      • The significance of an item should be considered when it is reported
      • An item is considered significant when it would affect the decision of a reasonable individual
    3. Consistency Principle
      • A company uses the same accounting principles and methods from period to period
    4. Conservatism Principle
      • When choosing between two viable solutions, the one that will be least likely to overstate assets and income should be picked

There are 4 major reports almost always used to convey financial information

  1. Income Statement
    • Shows the financial performance across a period of time
    • Revenue – Expenses = Profit/Loss (i.e. Income)
    • Considered the most important financial statement, since it ties to performance
    • Usually broken into two categories:
      • Operating Revenue & Expenses – directly associated with business operations
      • Non-Operating Revenue & Expenses – everything else
  2. Balance Sheet
    • Shows the financial position as of a specific date
    • Broken down into:
      • Assets
      • Liabilities
      • Equity (where income, expenses and revenue reside)
  3. Statement of Cash Flows
    • Shows the cash that flows into and out of various activities, categorized into:
      • Operating activities – keeping the organization going
      • Investing activities – managing assets to keep operating activities going
      • Financing activities – expanding and growing the organization
    • Can be a tedious report to generate
  4. Statement of Changes in Equity
    • Documents all changes in equity (organization’s value) during a period of time
    • Not very useful internally, so it’s not typically bundled with other internal reports

Financial statements are a bit like a tree (per Geni Whitehouse, CPA)

  • Imagine a business as a fruit-bearing tree
    • Like a tree, a business produces an annual yield that gets reset every year
  • The INCOME STATEMENT starts at zero at the beginning of each year and represents the fruit of the business’ efforts for that year
    • PROFIT = REVENUE – EXPENSES
    • At the end of each year, NET EARNINGS (or NET INCOME) is added to RETAINED EARNINGS on the BALANCE SHEET
  • The BALANCE SHEET is a frozen snapshot in time and measures the cumulative result 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) section of the BALANCE SHEET is the difference between the 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
      • There will be lean years of little or no NET INCOME and strong years with lots of NET INCOME
      • The EQUITY SECTION (or ACCUMULATED RETAINED EARNINGS) of the BALANCE SHEET is a lot like a tree trunk
  • Without water no tree can survive for long, and no business can survive for long without cash
    • The CASH FLOW STATEMENT shows where the cash went in a business
      • It shows how much the INCOME STATEMENT used in producing and how much the BALANCE SHEET used in growing the company
      • OPERATING CASH FLOW keeps the business running
      • INVESTING goes to making the business expand
      • FINANCING is related to getting more cash through loans, others’ investments or donations

The Accounting Cycle

  1. Transactions
    • Transactions can include
      • The sale or return of a product
      • The purchase of supplies for business activities
      • Any other financial activity that involves:
        • The exchange of the company’s assets
        • The establishment or payoff of a debt
        • The deposit from or payout of money to the company’s owners.
  2. Journal Entries
    • Transaction is listed in the appropriate journal in chronological order of transactions
    • Journal is also known as the “book of original entry” and is the first place transaction is listed
  3. Posting
    • Transactions are posted to the account that it impacts
    • These accounts are part of the General Ledger, which has a summary of all the business’s accounts
  4. Trial Balance
    • At the end of the accounting period (which may be a month, quarter, or year depending on a business’s practices) a trial balance is calculated
  5. Worksheet
    • Many times your first calculation of the trial balance shows that the books aren’t in balance
      • If that’s the case, look for errors and make corrections called adjustments, which are tracked on a worksheet
    • Adjustments are also made to account for:
      • Depreciation of assets
        • Assets will eventually wear out if you have them for a while, and depreciation is meant to track that
      • One-time payments (such as insurance) that should be allocated on a monthly basis to more accurately match expenses with revenues
    • After you make and record adjustments, take another trial balance to be sure the accounts are in balance
  6. Adjusting Journal Entries
    • Post any corrections needed to the affected accounts once the trial balance shows the accounts will be balanced once the adjustments are made
    • Adjusting entries aren’t made until the trial balance process is completed and all needed corrections and adjustments have been identified
  7. Financial Statements
    • Prepare the balance sheet and income statement using the corrected account balances
  8. Close The Books
    • Close the books for the revenue and expense accounts by moving it all into equity and beginning the entire cycle again with zero balances in those accounts

One of the biggest reason accounting is vital is because accounting reports pertain to taxes

  • Property taxes – ad valorem (according to value)
    • Real estate
    • Personalty – non-realty such as jewelry, cars, businesses, intellectual properties
  • Transaction taxes – taxes from one party giving something to another
    • Federal/state/local excise taxes – taxes on specific items
    • General sales sax
      • Sales tax is called use tax if it’s from a different state
    • Taxes on transfers at death
      • Estate tax
      • Inheritance tax
    • Gift tax
  • Income taxes – taxes from income
    • Federal income tax – operates on a specific formula
      • Income, minus exclusions from income gives you:
      • Gross Income, minus certain deductions gives you:
      • Adjusted Gross Income (AGI),  minus standard or itemized deductions, minus personal & dependency exemptions gives you:
      • Taxable Income, which has tax calculated on it from the tax tables, minus tax credits and previous pre-payments and withholding gives you:
      • Tax Due/Refund
      • The tax tables are based on 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%
        • This means that someone who made $56,000 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
    • State/local income tax (calculated similarly)
  • 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 product being sold
  • Tax audits are more likely when certain situations arise
    • There are large amounts of gross income
    • Self-employed individuals have substantial business income and deductions
    • Taxpayers have prior tax deficiencies
    • Businesses receive large proportion of cash receipts

For tax purposes, expenses can be deducted from income

  • By doing this, less income is taxable
  • There are a lot of possible deductible business expenses, and it’s worth going over the details with a certified accountant
    • 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