Business Education: Finance - Business Accounting Basics

Assets
An asset is something that has or produces value and is owned. There are different types of assets. A fixed asset is a tangible asset that is generally used to generate profit and will not be turned into cash within the year. These may be known as property, plant, and equipment assets and can include land, computer equipment, furniture, cars, buildings, and equipment used to build products. A variable asset may be transformed to cash sooner and will include the inventory of the actual product. It can also include accounts receivable, the money customers owe for delivered items. An intangible asset is not tangible—it's not physical. It includes recognition of the brand name as well as intellectual property like logos, trademarks, and patents. Though they aren't physical, intangible assets can be of high value.

Liquidity, Equity, Depreciation, and Cash Flow
Liquidity refers to how easily an asset can be bought or sold on the market at the same price. It also refers to being able to make an asset become cash easily and quickly. Equity in a business shows what the owner has contributed in addition to the retained earnings. Basically, it's the ownership minus the debts. Depreciation refers to how things lose value as time goes on. Cash flow refers to the actual cash that is going in and out of a business such as revenues or expenses due to business activities.

Generally Accepted Accounting Principles (GAAP)
Generally accepted accounting principles (GAAP) provide a set of standards for how accounting figures and statements such as income statements, balance sheets, and cash flow statements are prepared. It is a set of rules that directs how these forms are prepared so that investors understand what they are getting when they receive the statements. It covers economic activity measurement, timing disclosures, and details on how financial statements are prepared and presented. It directs what financial information should be reported and makes it easier for investors to understand and compare companies. GAAP is required of many regulated companies by the US Securities and Exchange Commission (SEC) (many small businesses are excluded). The Financial Accounting Standards Board (FASB) issues GAAP through pronouncements.

Cash and Accrual Accounting
The two major types of accounting systems are cash and accrual accounting. In cash accounting, the transactions are counted when the money is actually received or the expenses are paid out, regardless of when an item was ordered or delivered. Alternatively, in the accrual method, the transactions are counted when the orders are made or delivered, even if no cash has actually exchanged hands. For instance, if a furniture company sold and delivered a bed in January, but it was paid for in February, then the accrual method would record it in January and the cash method would show it in February. This affects where it is recorded for tax purposes. Most small businesses and individuals use the cash method but larger businesses may use the accrual method. The cash method is advantageous because it gives the company a better idea of cash on hand but may not show the correct profits, especially if a big sale has been made but not paid for. The accrual method shows the right profitability but may not give a good view of actual cash flow.

Fundamental Accounting Equation
The fundamental accounting equation states that assets = liabilities + owners' equity. It is used in double entry accounting and shown in the balance sheet, in which all assets can be added up as the equivalent of the liabilities and shareholder equality. When there is a purchase or sale, both sides will be affected equally. When a company buys an asset such as $100 in office supplies, then it will delete $100 of assets such as $100 of cash or it will be funded with shareholder equity or liabilities. This might be done by borrowing the money. When everything equals as it should, it is considered 'balanced.'

Accounting Cycle
The accounting cycle describes the steps taken in the accounting process. It is often shown as a circular diagram, thus the term
'cycle.' The first step is to attain all the source documents that are associated with financial transactions, including receipts, checks, and bank statements. Next, these transactions are analyzed to see how the accounts will be affected. The third step is to place entries into the journals for these transactions in a double-entry system. Next, the transactions are posted by moving them from the journals to the ledgers. An unadjusted trial balance is prepared showing the company's accounts. Next, the company will make adjusting entries as necessary. Account balances will go to where they should be. They will next prepare a trial balance with the adjustments in them. The company can then prepare financial statements such as the income statement. Closing entries are made as the balances of accounts that are temporary go to owner's equity.
Finally, there is an after-closing trial balance.

Double-Entry Bookkeeping, Credits, and Debits
With double-entry bookkeeping, two columns are used.
All of the debits are placed on the left while the credits go on the right.
Debts are recorded in the debit column as debits; these make assets and expense accounts go up and income, liability, and equity accounts go down. Likewise, credits make liability, income, and equity accounts go up and asset and expense accounts go down. Essentially, money leaving an account is a debit and money entering the account is a credit.The debits and credits always need to equal each other. When one changes, there should be another change to account for that. For instance, if a $10,000 car is bought with cash, then there should be a $10,000 car shown as an asset and a decrease in cash by $10,000. Therefore everything stays equal. It uses the fundamental accounting equation (assets = liabilities + owners' equity) as a basis.

Ledgers and Journals
Both ledgers and journals are quite important to the accounting cycle. Although they contain much of the same information, they are used differently. When a transaction occurs, it is first put into a journal.
Transactions are put in based on when they occur. Journals can be for something specific, such as sales or purchases, or transactions may go into the general journal for less routine transactions like a bad debt or depreciation. The company will have a record of the transactions to refer to in the future.
Later, the information is transferred to the ledger. The frequency of this varies. The ledger contains different accounts like asset accounts, revenue accounts, expense accounts, liability accounts, and equity accounts. The two types of ledgers include the general ledger and subsidiary (sub) ledgers. The ledgers are very important because documents such as income statements and balance sheets are produced from them. The exact use of journals and ledgers may be different in a computerized system.

Trial Balance
A trial balance is a document showing the ending balances of ledger accounts. It is done on a certain date as the company is preparing to create financial documents. On the top is the title, entity, and accounting period. Then the account titles are listed. Then there is a list of the debits (assets and expenses) on the left and a list of the credits (liabilities, income, and equity) on the right. The sum of the credits and debits are at the bottom. If everything is correct, these numbers should match, although they can still be inaccurate even if they do match. This can happen if incorrect entries were put into both the debit and credit sections at the same time, or if something was omitted altogether. Still, if they do not match, there is definitely a problem, and the company has a chance to investigate and fix it before creating the financial documents. If the company prepared the financial documents and then noticed the error, then the accountants would have to redo the documents, a much more arduous and time-consuming process. Accountants use the trial balance when making the financial documents.

Manual and Computerized Accounting Methods
Businesses can choose between manual and computerized accounting methods, and each has its advantages and disadvantages. In a manual system, people do the calculations on paper by hand; in a computerized system, they input them into a computer system. The actual formulas, calculations, and numbers are the same.
Computerized systems are far quicker. The user simply enters the numbers and can have calculations and reports generated in an instant. It is very convenient. They can change numbers to see potential outcomes. This can minimize accidents one may make when calculating by hand. The business has to pay for the computer system, of course, but the money saved in labor hours might more than make up for this. Data can be easily backed up. Disadvantages are that there could be a computer malfunction that causes a loss of data.
There could also be a security breach in which the information is leaked to the wrong person or hackers get in. If the data is entered incorrectly, even by a single digit, everything can be inaccurate. Most large businesses use a computerized system.

Income Statements
One of the most important financial documents is the income statement, which shows company profitability for a period of time. It contains many elements including revenues, gains, expenses, and losses. It lists revenues from primary activities (also known as operating revenues) such as sales revenues, service revenues, and revenues from secondary activities such as if a business earns interest or money from a source other than selling.
It also lists gains such as long-term asset sales or lawsuits from something other than the primary activity. The income statement also shows expenses in primary activities, such as those used during normal operation, and expenses from secondary activities like interest. Losses from other sources should also be listed. This can occur if the company loses money on the sale of a long-term asset or suffers a lawsuit outside of normal transactions. The income statement will display the net profit or loss for the period of time it covers.

Balance Sheets
A balance sheet is one of the major financial documents, showcasing a moment in time. Essentially, it is a snapshot showing the financial situation of the company. It showcases assets, liabilities, and ownership equity, with the assumption that assets = liabilities + equity. It lists assets, which are things that have value, in the order of their liquidity. These may include things such as cash, accounts receivable, inventory, plant and equipment, investment property, and more. After that, it lists liabilities such as accounts payable, promissory notes, corporate bonds, deferred tax liabilities, and more. Next it shows equity, which is the net worth of the company's capital. It is the difference between assets and liabilities. The two forms of balance sheets are the report form and the account form. The balance sheet is very important for every business.

Statement of Retained Earnings
The statement of retained earnings is a very important financial document, required when income statements and comparative balance sheets are given. It showcases how a business' retained earnings change over a period of time. Retained earnings are defined as a business' accumulated net income minus the dividends that were given to stockholders. The information it contains is sourced from the income statement; subsequently, the information from the statement of retained earnings is used for the balance sheet. At the beginning is the starting balance. Factors like profits and dividend payments are added and subtracted to get the final retained earning balance.

The general equation is starting retained earnings + net income – stockholder dividends = final retained earnings.
Sometimes the statement gets into more detail by showing various types of retained earnings.

Cash Flow Statement
A cash flow statement is a major accounting document that outlines the influx and outflow of cash from a company. It is important because it shows what a company's cash position is, which can be different from its income if there are accounts that have not paid. It can show if the company is managing cash wisely or having difficulty with it.
A cash flow statement covers cash gained and used in operating activities, investing activities, financing activities, and supplemental information. Operating activities convert the business' net income to cash basis with the balance changes in the current liability and current assets accounts. Investing activities include balance changes of long-term assets like buildings and equipment. Financing activities includes balance changes in stockholders' equity and long-term liability accounts like preferred stock. Supplemental information shows interest, income taxes, and major non-cash exchanges. It will list each of these and show the increase or decrease in cash from each. At the end, it will show the net increase in cash from all, the cash at the beginning of the month, and finally the cash at the end of the month.

Financial Ratios
Liquidity ratios measure if a company can meet its obligations in the short term. The more liquid assets it has compared to short-term liabilities, the more liquid it will be. The current ratio is equal to the current assets divided by the current liabilities. The quick ratio formula is
.

This is a tougher test for liquidity. The cash ratio formula is
.

The higher these ratios are, the more liquid the firm is and the more likely it can reach its short-term debts. The debt to equity ratio shows the company's financial leverage. It is equal to total liabilities
shareholders equity. If it is high, a lot of debt has been used to finance growth.

The return on equity (ROE) ratio is a percentage with the equation
.

It shows profitability. Activity ratios show how balance sheet accounts can be transformed into sales or cash. It shows a firm's efficiency. Two popular ones are the inventory turnover ratio and total assets turnover ratio.

Payroll Records
Payroll records must include a variety of components.
It will contain identifying information such as the employee's name, social security number, address, birth date (for employees under 19), gender, and occupation. It may also contain the hiring letter, a pay authorization, the employee's W-4 form, payroll deduction forms, direct deposit forms, time sheets, records of attendance, W-2 forms, and all other forms related to payment. It will have the details of the compensation such as the wage base, pay rate per hour (if applicable), hours worked, dates, and more. It will also show deductions from the wages, such as taxes like income taxes, as well as contributions to retirement accounts or deductions for social security, healthcare expenses, and more. Many items are taken out of the pay before the employee receives them so the employee does not have to do so regularly.

Payroll Accounting Procedures
Companies follow specific payroll accounting procedures to ensure accurate compensation and reporting. First, a company must have a way to compute the amount of time an employee works. Sometimes this is set to a schedule, whereas other times an hourly employee works different hours every day. A time card or an electronic time clock may be used to keep track of this.
Sometimes, employees keep their own records or are salaried and receive the same amount no matter how many hours they work. The pay must then be computed for each person. This may be a set amount based on a salary, or be the number of hours worked multiplied by the hourly rate. It may be more complicated and include other things such as investment account distributions, bonuses, or reimbursements. They must have a system to account for special time such as when the employee is taking paid leave. The company must compute and submit all applicable taxes such as income taxes on behalf of the employee and payroll taxes. They must make other deductions such as healthcare premiums. Once this is worked out, the company will distribute the money. This is often done by check or direct deposit.

Periodic and Perpetual Inventory Systems
Two major types of inventory systems are periodic and perpetual inventory systems. In perpetual inventory systems, the inventory changes and cost of goods sold are updated in real time as the item is sold. Other inventory changes, such as returns, are also recorded immediately. In a periodic system, a purchases account record is changed when the purchase is made, but the cost of goods sold and inventory doesn't change until the accounting period closes.
Perpetual inventory systems are very popular, especially with the increase in technology point-of-sale systems. They allow businesses to always know what inventory they have and restock as necessary. They provide much more useful and updated information. The disadvantage is that it can cost a lot of money initially to put in the technology for a perpetual inventory system.
Some small businesses do not have the money or ability to do this.

Inventory Costing
Inventory costing is the process of assigning a cost to a particular item. There are various methods a company can use. With the first in, first out (FIFO) method, the oldest cost is assigned to the first item sold, then the next oldest cost to the next item sold, and so on. For instance, if five shirts were bought wholesale for $10, and then next five were bought for $12, then the first five sold would have the $10 cost and the next five would have the $12 cost, even if they weren't the ones actually bought for those amounts. This is very common because it is a good approximation of the real world. The last in, first out (LIFO) method is the opposite, and the most recent cost is assigned to the first items sold. In this case it would be $12 for the first five shirts sold and then $10 for next five shirts. This is used less often.
The average cost and specific identification methods are two inventory costing methods. The average cost method keeps a running average of inventory and assigns the item sold the current average. For instance, if a company buys five shirts for $10 and five for $12, then the next shirt sold would be assigned the cost of $11. This is good when a company has non-perishable items that are not sold sequentially. It can be steadier and more reliable as long as there is not a great change in the costs of the items.
The specific identification method assigns the cost of a product with the actual cost paid for that specific product. These are used for low-volume, high-dollar producers. For instance, a company that sells high-end cars might use this system so they know exactly how much they made on a car. It is not good for companies with a lot of very similar items.

Depreciation
Depreciation is the concept that assets such as equipment, machinery, and cars have a useful life and will only be usable for a certain amount of time and therefore depreciate (or lose value) as time goes on. This is used in accounting. There might be a residual value to the asset, or a value at the end. For instance, imagine a company buys a truck for $110,000 and expects it to have a 10-year useful life. At the end of the 10 years, they expect to be able to sell it for $10,000. They may use the straight line method of depreciation in which they simply average the depreciation across the years. For every year, they will show a depreciation expense of $10,000. Businesses can use this as an income tax deduction as long as it meets all the criteria.

Costs
Direct costs are the costs that go directly into making a product. For instance, if a company is manufacturing pens, then the cost of the ink would be a direct cost. An indirect cost is incurred to the company as a whole and is necessary but not directly tied into that one product. For instance, the office supplies used in the marketing department would be an indirect cost. They are not used directly in making the pens, but they are still important to the function of the marketing department that helps to promote the pen. Fixed costs are costs that stay the same. For instance, the cost of a salaried employee would be a fixed cost because it is always the same. No matter how many pens are made, it stays the same. Variable costs can change, however. For instance, if the pen making machine uses more electricity when it makes more pens, then this would be a variable cost.
Companies work to minimize these costs while maximizing efficiency.

Cost Accounting
Cost accounting is useful for managers to help make decisions while planning and controlling. It looks at the costs of different items such as products and projects. To accomplish this, both the input costs of production and the fixed costs are considered. Once input and output are measured, these can be compared to see how the item is performing financially.
This can help managers make a decision on whether to continue with the project or product and ways they can improve it. It analyzes many things such as cost-volume-profit connections, activity-based costing, and cost behavior. It helps managers decide how much to charge for certain processes or services because they will know how much it cost.

Management Accounting
Management accounting refers to the evaluation of information for the purpose of managers. It can include the identification, measurement, evaluation, interpretation, and communication of information. Its main goal is to help managers make decisions about the business. This is different than financial accounting, which is done to give information to outside parties. In management accounting, management accounts are created that have financial information suitable for managers. Managers use these to make short-term decisions. Elements that may be included in these reports include sales reports numbers, cash available, order amount, sales revenue, inventory reports, accounts payable and receivable accounts, trend charts, and more. Managers can get an idea of how projects will progress, understand how business choices will affect the business financially, oversee finances, and more.

Evaluating an Organization's Financial Performance
A cost-volume-profit analysis (CVP) is part of managerial economics and looks at how alterations in the cost (fixed and variable) and sales volume change the profit of a company. A break-even analysis calculates when the expenses of a company are covered and there is a profit.

The general equation for this is
return on investment (ROI) shows an investment .

The answer is a percentage.

A company can use this to compare different projects. Managers might not want to continue a project that has a negative ROI. Likewise, when comparing two projects, they would look for the one with the higher ROI. It is a simple but powerful equation. Companies will often use multiple strategies to evaluate financial performance.