What Is Accounting

Basic Accounting What is accounting? Simply speaking accounting is the language of business. Accounting is to record all the detail of any business. It also sometime is called “basis for business decision”, as primary purpose of accounting is to provide information that is useful for the decision making purposes whether the decision is made by owners, management, creditors, government, partners or any other person or group that have an interest in the financial performance of an enterprise. Definition: Accounting is the process of recording financial information of any business, and than to further communicate this information with concerned persons (owner, managers, partners, investors, tax authorities). From this definition we can say accounting is satisfying two purposes, firstly to record the financial information of any business and secondly to communicate this information with internal persons such as, owner, managers etc, and external parties which include, investors, tax authorities. When we talk about recording financial information, it is the information related to rupees, amount, invested into business. And accountant is responsible to maintain the record of this information, from where the cash is been brought in the business, for what this cash is been paid for, in short all the information regarding the cash of any business is to be maintained in an appropriate way defined by accounting. This process starts from transactions Transactions are activities which changes the financial position of the business Transaction is any dealing between two persons or two things. You go out to the book shop you pay cash to buy a book is a dealing between you and the owner of the book shop, so is a transaction between you and him. From your point of view its nothing but to purchase of book but from books shop’s point of view it is a business dealing and they will record this as their sale. There are two types of transactions Cash Transactions Transactions which involve cash are cash transactions. Any purchase made for cash, any sale made for cash, cash paid for office rent, cash paid for the purchase of office table, cash paid for salary of employee, cash paid for any expense, cash received from the sale of asset etc. Credit transactions Transactions which do not involve cash are credit transactions (payable in future or receivable in future). For example If someone purchases office furniture without paying any cash at that time and is to pay cash in future when he will have enough cash to pay, this transaction is credit transaction. Purchased furniture from Amir & sons, sold computer to Rashid & co. etc. there is a simple way to recognize any transaction on credit. When in the transaction there is not mentioned the word “cash” and there is the name of any person, this transaction is credit transaction.

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Basic Accounting Here are some cash transactions which occurs in any business Cash investment to start the business from the owner or outsiders: Cash invested in business rs.10000 by the owner Cash invested in business rs.10000, out of which 8000 from owner and remaining 2000 by outsider (loan) Started business with cash rs.10000 Started business with cash rs.8000 by owner and rs.2000 by outsider (loan) Cash borrowed by a friend Mr. raza rs.50000 Cash, furniture and building investment from owner or outsider: Started business with cash rs.10000 furniture of value rs.5000 and building of value rs.20000 Total invested value is rs.35000 (10000+5000+20000) Purchases of any asset (furniture, office building, goods to sale purpose, motor vehicle for business use etc) Purchased furniture (office table and chair or any other furniture for office) for cash rs.8000 Purchased building (office building, store room building) for cash rs.25000 Purchased goods for cash rs.30000 to resale Purchased a van for office use rs.50000 Expenses paid by any business Cash paid for office rent (rent expense) rs.8000 Cash paid for electricity bill (bill expense) for the month rs.5000 Cash paid for the salary (salary expense) rs.10000 Cash paid for telephone bill rs.3000 Cash paid for depreciation (depreciation expense) of furniture rs.2000 Sales by a business on cash Sold goods for cash rs.20000 Sold 5 computer to Mr. Akbar for cash rs.40000 Here are some credit transactions: Purchased office furniture from raza & company of value rs.9000 Purchased office building on installment for rs.50000 from Mr. Asim Purchased goods from Mr. Raza of value rs.60000 to resale purpose Arshad Malik

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Basic Accounting

Important Accounting Terms Above stated transactions are recorded date wise in the register of general journal. But before starting to record the transactions, before moving onto general journal entries we must understand some important accounting terms.

Assets Liabilities Owner’s Equity Expenses Revenue Depreciation Account

Profit / Net Income Cost of Goods Sold Purchase Sales Accounting Period and Accounting Cycle Accounting Equation

Assets: Assets are the things business own for the purpose to earn profit in future Assets are economic resources business own to use them for the purpose of earning profit Assets are things of value any business own Assets are total worth of business. Lets assume that a business own two buildings, cash, and office furniture and these buildings, cash and furniture are being used by the owner to earn profit by using them is what the concept of assets. How can business earn profit from building or cash or furniture? Well the buildings business own lets owner to use as the office or as the store room or for production, furniture for office lets owner to manage its work by sitting on chair and by using the office table, cash owned by business lets owner to pay bills, expenses, and to buy or purchases things (goods) to sale. As every asset somehow helps owners, managers to generate profit in future by using them There are two types of assets, current assets and long term or fixed assets Current Assets Current assets are the assets which have a life of less than or equal to one year. Or we can say the assets which changes their value within one year, examples are (cash, stock, accounts receivable) Cash Cash amount in hand or owned by any business from which owner or manager can buy something of value for business purpose. Whether owner keeps this cash in hand or deposits it in the bank to later use this for business.

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Basic Accounting Accounts receivable Above I mentioned credit transactions “transactions which do not involve cash”. Accounts receivable is an asset for business which occurs when any business sell goods on credit (amount of which is been collectable in future). Stock Inventories are the goods in hand or stock in hand for the sale purpose. A company is in the business of computers. It purchases computers and sale those computers to other parties (customers). Let’s say a company had purchased 10 computers one month back. During the whole month 7 computers are been sold and 3 computers are still in store room. These remaining 3 computers are inventory or stock in hand, which still is available for sale. Long term/Fixed Assets These are the assets with the life of more than one year. Or we can say the assets which remain in the use of the business for more than one year; examples are (building, land, furniture) Buildings Buildings which business use for office or store room or to keep machinery for the production is also an asset which helps businesses to generate revenue by using them Furniture Office furniture is also the asset for the business. Office table and chairs business own facilitates owners to use for the operation of their running businesses Liabilities Liabilities are the debts of business, or the amounts due on business When business borrow loan or when business is to pay someone any amount of money which business owe Liabilities are the claims of outsiders on the assets of the business Simply speaking we can say liabilities are the amount of money business has to pay in future, even if it has to go through the sale of the assets. Let’s say you are a businessman, and you might get in a position where you have to borrow some loan from someone (bank, financing companies, and any other person) this is what liability really is. The amount you will borrow is the amount of liability for your business. You have borrowed a loan from National Bank of Pakistan for rs.10000; this amount (10000) is your liability which you have to pay back to National Bank. As assets, liabilities also have two types regarding to their life of usage Current liabilities Are the liabilities which have a life of less than one year, or liability business pay within one year are current liabilities.

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Basic Accounting Accounts Payable Accounts payable occurs when you purchase any goods or any other thing for your business on credit. Payment of which is due on you in some future time. Let’s say you purchase a table for your office use from the shop, but you don’t have enough cash to pay right now. It turns into a liability name accounts payable, the accounts you have to pay. Expenses payable You are in a business of computers, and you have hired 2 employees to facilitate your business. Due to some reason you are not been able to pay them the salary of the current month, you have planned to pay them in next month. This salary expense which is yet to be paid or is payable to employees is your liability. Same as any other expense which is been occurred but is not been paid yet is your liability, mean you have to pay the expense in future Long term Liability These are the liabilities which have the life of more than one year, or liabilities which remains in the business for more than one year. If a business borrows a loan from bank with the condition of paying back in equal installments in 5 years, this liability is long term liability because it will be paid out in 5 years Owner’s Equity From the name of this term, an idea might have come in your mind that it is about the owner of the business. Simply speaking owner’s equity is the interest of owner in the business It’s the right of owner on the assets of business It’s the claim of owner on the assets of business Assume you have started a business of computers, and you have invested rs.50000 cash in it. This 50000 from accounts point of view is the owner’s equity. It is your right on the business or on the assets of it. Expenses Expenses are the payments you pay in order to receive or already received benefit. We will take the same example of the employees of any business. Businesses hire managers to get profit by operating the business. For this business pay salary to those managers who are running it. This salary is an expense for business which is been occurred to earn profit. Revenue It is the price of goods sold in case of goods business, and price of services rendered in case of services business. You are the owner of a computer shop, in the end of month you sale 10 computers for 5000 each, total rs.50, 000. This 50,000 is the revenue which is been generated by sales. But this revenue is not your profit or net income. Revenue becomes profit when you subtract all of your expenses from it, which were been occurred or paid to earn this revenue.

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Basic Accounting Depreciation Basically it is an expense but a non cash expense. Depreciation is a technique to allocate the cost of any fixed asset (furniture, building, machinery) over its life. Simply speaking depreciation is the method to decrease the value of the assets like building and furniture time by time. As is a normal practice, when you purchase furniture for your office use and time by time it reduces its value. This is what depreciation is, a charge of the portion of the cost to the asset. We will take an example here. You have purchased an office table for rs.10000 and you know after a year or two this table will reduces its value, mean you cannot sale it for 10,000 but less then its original cost you have paid. So you will spread this whole cost over the useful life (the life or the time period this table will have or will remain good for use) of this office table. Assume the useful life of this table is 10 years, mean for 10 years this table will be usable for you and will expire after that. So you will spread the whole 10,000 cost over 10 years (10000/10) 1000 each year. You will charge 1000 each year as depreciation expense till 10 years. Note I have mentioned depreciation is the non cash expense (does not involve any cash payment). You have already paid the total amount of furniture this is a method to charge a portion of cost every year. Profit or Net Income Above I have described revenue. Revenue becomes profit when it exceeds total expenses of an accounting period. I will use the same example, sale of 10 computers for 5000 each total rs.50000. This 50,000 is the revenue from sales but yet is not the profit. It will become profit when you will subtract any expenses you have paid to generate this revenue. Assume you had purchased these 10 computers for 3000 each total rs.30000, and you have paid salary to your employee rs.5000 and you have also paid telephone bill rs.2000. In above stated example your profit is Sales revenue Less

50000

your cost of computers

30000

Gross Profit

20000

Less

salary expense

5000

Less

telephone bill expense

2000

Profit or Net Income

13000

From this example we can see what profit is. It’s the amount after all the expenses and cost you have paid to earn the revenue or benefit. Gross profit is the profit which comes after subtracting cost of purchases from the sales of the same purchases. Cost of Goods Sold Cost of goods sold is quite same what we just explained up there. Simply speaking it is the statement to calculate the cost of goods which businesses sell. In above example we can say cost of goods sold for the 10 computers was 30,000. It is the total cost you have paid to purchase the goods you have just sold.

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Basic Accounting Purchases Purchases have a special meaning in accounting. It is the acquisition of revenue asset, simply speaking it is the cost you pay for a good to buy for sale purpose to generate revenue from selling it. Sales To sale the purchases we stated above in order to earn revenue. Accounting period It is a time span in which any business measure its position its financial strength its operating results. It can be of 6 months or a year. Most companies measure the performance mentioned above after one year. Accounting Cycle It is the sequence of procedures used to record, classify and summarize accounting information in financial reports (General Journal, General Ledger, Trial Balance, Income Statement, Balance Sheet), on a regular basis.

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Basic Accounting

Accounting Equation It the basic accounting methodology, accounting equation is Assets are equal to liabilities plus owner’s equity

Asset = liabilities + Owner’s Equity I have explained assets liabilities and owner’s equity above. In this section I will define the equality concept of this equation. Every transaction effects business in a two sided manner or an equal manner for example when we say we have purchased an office table for cash rs.5000, two things are happening in this transaction. First new asset (office table) comes in the business and what goes out is cash which we have paid to purchase the table. Let’s briefly describe this concept of equality through the equation. On January 1 2009 Mr. raza started a business with an investment of cash rs.50000 Journal entry to record this transaction is date detail 1/1/2009 cash

debit 50000

credit

capital 50000 cash invested in business by owner We will put the same entry in Accounting Equation

Assets

Liabilities

=

Owner's equity

Cash

Capital

50000

50000

1/1/09

On January 2, 2009 purchases office table for business use for cash rs.10000 Journal entry to record this transaction is date detail 1/2/2009 furniture

debit credit 10000 cash 10000 purchased office table for business use Effect on accounting equation

assets 1/1/09 2/1/09 balance

cash furniture 50000 40000

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10000 10000

=

liabilities

owner's equity capital 50000 50000 Page 8

Basic Accounting Look at the effect of this transaction. It decreases cash balance which we paid to purchase furniture and it increases a new asset named furniture in the business. On January 3, 09 purchased 5computer to sale purpose for cash rs.30000 Journal entry date detail 3/1/2009 purchases (computer) cash purchased computer to sale Effect on accounting equation

1/1/09 2/1/09 balance 3/1/09 balance

assets cash furniture computer 50000 40000

10000 10000

10000

10000

debit credit 30000 30000

liabilities

=

owner's equity capital 50000 50000

30000 30000

50000

As you can see this transaction has changed the cash balance again and have added a new asset in business On January 4, 09 sold 3 computers for cash rs.50000 Journal entry date detail 4/1/2009 cash

debit credit 50000 sales 50000 sold 5 computers on 20,000 profit Effect on accounting equation

assets

=

liabilities

owner's equity capital

1/1/09 cash furniture computer 2/1/09 50000 10000 50000 balance 40000 10000 50000 3/1/09 30000 balance 10000 10000 30000 50000 4/1/09 60000 10000 0 50000 balance 60000 10000 0 70000 Closely look at the effect of the transaction, as the 5 computers which were been purchased for 30000 are sold for rs.50000 with 20000 profit. Profit is always adjusted with capital (profit goes to owner) so 20000 is added in owner’s investment capital 50000 (50000+20000) 70000. Second effect on cash, as cash is increased by 50000. Arshad Malik

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Basic Accounting Account An account may be defined as a record of the increases, decreases, and balances in an individual item of asset, liability, capital, income (revenue), or expense. The simplest form of the account is known as the “T” account because it resembles the letter “T.” The account has three parts: 1. The name of the account and the account number 2. The debit side (left side), and 3. The credit side (right side). The increases are entered on one side, the decreases on the other. The balance (the excess of the total of one side over the total of the other) is inserted near the last figure on the side with the larger amount.

Debit and Credit Simply speaking Debit is the left side of an account and Credit is the right side of account. But this explanation for debit and credit is not enough. Let’s go in detail Every transaction is been recorded in the books of accounts as an entry called, general entry. These entries are recorded in two ways debit and credit. Debit is the benefit receiving side and credit is the benefit giving side or the side through which the benefit is been received. Account Debit

Credit

Benefit receiving side

Benefit giving side Who provided this benefit?

Will further describe it with an example of transaction “cash invested in business rs.5000 by owner’ To record this entry as I have said above I need two parts one is debit and other is credit. So in this transaction benefit receiving side of the business is cash (as cash comes in the business when owner invest it for the business use) so the cash is debit side and benefit giving side or from where this benefit comes is the owner who invested this cash. So credit side is capital (owner). Entry will be:

Debit Cash

5000 Capital

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Credit

5000

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Basic Accounting Another transaction: purchased computer to sale purpose for cash rs.2000 Benefit received from the business is computer which comes in the business and who provided this computer or benefit is the cash you pay. So Entry will be:

Debit Computer

Credit

2000

Cash

2000

We can say, what comes in the business is debit and who provided it is credit or what goes out of the business is credit. Things (cash, purchases, furniture, building) you receive or you will in future, is debit. On the other hand things you pay out or you will pay out in future is credit. Some more transactions to clear debit and credit Transaction: rent exp payable rs.7000 Entry will be:

Debit Rent expense

Credit

7000

Rent payable

7000

I have explained expenses in earlier pages. Expenses are the benefits already been taken to earn profit. Now this entry tells that an amount of rs.7000 is due. This entry is just to record it not to pay it. As it is a liability which will be paid in future, now in this entry debit is rent expense as benefit comes in business is that business has used the facility for rent and rent payable is credit as amount will go out of rs.7000 from business Every transaction is recorded in general journal entry book in the same way of debit and credit. Proper format of general journal entry register is Date Detail/particulars/accounts 1/1/2009 Cash Capital Narration: Cash invested in business

P.R 1

Debit 5000

Credit 5000

This is how every transaction is been recorded. “P.R” stands for post reference number, as entries are recorded on vouchers when in practical businesses so this section is for the voucher number or reference number for the transaction. Narration is a short detail of the transaction for users

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Basic Accounting

General Ledger Ledger is the second step for recording every transaction after journal entry. Ledger gives a complete balance of every account individually after one or more transactions of same account. Here are some transactions to understand ledger 1-7-2004: Started business with an investment of cash rs.50000 1-7-2004: Purchases office table for cash rs.10000 3-7-2004: Purchases 3 computers to sale purpose from MR Amir for rs.3000 each for total 9000 5-7-2004: Sold 3 computers for cash rs.5000 each total rs.15000 5-7-2004: Telephone bill expense paid for the month cash rs.1000 First I will put these transactions in general journal entries and then in general ledger General Journal Entries Date 1-7-2004

1-7-2004

3-7-2004

5-7-2004

5-7-2004

Detail Cash Capital Cash invested in business. Office table Cash Purchased office table for cash Purchases (computers) Accounts payable (Mr. Amir ) Purchased computer from Mr. Amir on credit cash Sales Sold computers for cash Telephone bill expense cash paid cash for telephone bill exp

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P.R

Debit

credit

50000 50000 10000 10000

9000 9000 15000 15000 1000 1000

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Basic Accounting Now I will put these entries in general ledger Simply speaking general ledger is a “T” account Cash Account Debit Cash comes in (capital)

Cash comes in (sales)

Debit Balance

Credit

50000 10000

cash paid for furniture

1000

cash paid for bill exp.

15000

54000

Explanation: As I have said ledger is the balance of every account individually. Above is the cash account which get involved in four transactions, all of these are summarized in one cash account to get the ending balance of cash (54000). In first transaction started business with cash rs.50000 which tells that cash comes in business. Second cash paid for furniture rs.10000 which makes the balance of cash 40000 (50000-10000). Third transaction of sales in which cash comes in business and makes the balance 55000 (40000+15000), fourth entry of telephone bill expense shows that cash goes out of business as is been paid for bill and it makes the balance 54000 (55000-1000). And ending balance of cash account as you can see is 54000 This is what ledger account is, to calculate the ending balance of every single account which comes in general journal. Now I will put all of remaining accounts in ledgers Capital Account Debit

Credit 50000

cash invested by owner

50000 credit balance Explanation Capital account is credited for one time only this is why we will simply write it down in credit side of ledger

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Basic Accounting Office Table Account Debit Office table purchased

Credit

10000

Debit Balance 10000 Office table account is only been debited for once, no other entry is been made for office table, this is why we will simply write it down at debit side of ledger Purchases (Computer) Debit Purchased computers

Credit

9000

Debit Balance

9000

Purchases (computer) account is only been debited for once, no other entry is been made for office table, this is why we will simply write it down at debit side of ledger Accounts Payable (amir) Debit

Credit 9000 9000

purchased computers on credit credit balance

Accounts payable account is credited for one time only this is why we will simply write it down in credit side of ledger Sales Account Debit

Credit 15000

sold computers for cash

15000 credit balance Sales account is credited for one time only this is why we will simply write it down in credit side of ledger

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Basic Accounting Bill Expense Debit Office table purchased

Debit Balance

Credit

1000

1000

This is how all the accounts will be summarized in ledger account separately to get an ending balance of every account. Actually ledger, as defined earlier is the step further from journal entries. At the end of a time period businesses might need to know the ending balances of every running account , ledger gives the right balances of every account in use or been used in general journal entries. Third step in accounting is of “trial balance”

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Basic Accounting

Trial Balance Trial balance is the third step in accounting when you are recording the transactions after ledger and general journal entries.

A trial balance is a list of all the accounts for a period, to test that the Debits agree with the Credits Trial balance is a check statement to see that the ledgers you have posted are accurate or misbalance, this statement is just to check the balances of all the accounts at one place. If the balance is equal than ledgers are accurately posted if balance is not equal than there might be an error in ledgers How to prepare trial balance? Trial balance statement is very simple to continue, all you have to do is to put all the debit balances of ledger accounts in debit side of trial balance and all the credit balances of ledger in credit side of trial balance statement. As in above ledger accounts, balance of cash account is debit balance and will be posted in debit side of trial balance. And capital account in ledger got a credit balance so will be posted in credit side of trial balance Accounts Detail

Debit amount

Accounts Detail

Credit amount

Cash

54000

Accounts Payable

9000

Office table

10000

Capital

50000

Purchases (computers)

9000

Sales

15000

Bills Expense

1000

Balance

74000

Balance

74000

As you can see the balance of every account from ledger in trial balance is equal as I said it’s a check statement for the purpose to check that the ledgers are in balance or not

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Basic Accounting

Income Statement A financial document that shows how much money (revenues) came in and how much money (expenses) was paid out. Subtracting the expenses from the revenue gives the net profit. A report that indicates how much profit or loss a company generates over a period of time—a month, a quarter, or a year Simply speaking income statement is the statement to check or calculate the profit of the business When you are to calculate the profit there you have to put all the costs and expenses you have occurred to earn profit from your business Here you will minus all the operating expenses (bill expenses, and all other expenses you have paid to earn profit) and you will also minus the “cost of goods sold” I have explained cost of goods sold and expenses earlier so I will just make the income statement for above transactions Income statement starts from sales revenue Sales Revenue

15000

Less: Cost of Goods Sold Opening Inventory

0

Add: Purchases (computers)

9000

Less: Ending Inventory

0

Total Cost of Goods Sold Gross Profit

9000 6000

Less: Operating Expenses Bill expense

1000

Net Profit

5000

This is how income statement is been made. As you can see first I started with sales revenue after that cost of goods sold, now in cost of goods sold there comes opening inventory and ending inventory. As I have explained what inventory is.

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Basic Accounting

Balance Sheet A record of the financial situation of an institution on a particular date by listing its assets and the claims against those assets In financial accounting, a balance sheet or statement of financial position is a summary of a person's or organization's balances. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. Statement showing the financial position at a particular point in time (eg, at the end of the financial year), listing all assets and liabilities at that time A balance sheet is part of the financial statements. The balance sheet reports the amounts of assets, liabilities, and owners' equity at a specific date. The total of all assets is always equal to the total of liabilities plus owners' equity. This is a function of the double-entry accounting system A summary of a company's assets and liabilities Financial statement that presents a "snapshot" of what the business owns, what it owes, and what equity is has on a given date See all of these definitions are telling the same thing that balance sheet is a snapshot of your business which include (assets, liabilities and owner’s equity) Here is the format of balance sheet Assets

amount

Liabilities

Credit amount

Cash

54000

Accounts Payable

9000

Office table

10000 Owner’s Equity

Balance

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64000

Capital

50000

Net Income/Profit

5000

Balance

64000

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Basic Accounting This is how balance sheet is been prepared which shows assets liabilities and equity section separately Now from the balance sheet we can see that bill expense and purchases (computer) account is not recorded in here, reason is bill expense and purchases (computer) account is already been recorded in income statement and been subtracted from sales revenue to calculate profit. Means these accounts no more exist in business Another thing that net profit is been add in equity section of amount rs.5000, it is the profit we have calculated from income statement and will be added in owner’s capital investment as profit goes to owner of the business

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