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ACCOUNTING FUNDAMENTALS

Accounting has been practised since ancient times to keep track of


inventories.

Clay tokens were used in Mesopotamia 7,000 years ago to keep track of
inventories of crops or livestock. This allowed them to make some simple
comparisons of their farm produce on yearly basis thereby enabling them to
take some decisions to increase the produce.

Accounting is quantitative (numbers) and financial (money) in nature i.e. it


tells us about the numbers of money. It is meant to be useful for making
decisions by using the past to change the future.

There are 4 flavours of accounting:


1. BOOKKEEPING- routine gathering of information systematically making
sure that everything gets recorded.
2. FINANCIAL ACCOUTNING - reporting to people outside your organization
who may be willing to loan you some money or invest in you; summary
reports without the details; gives information such as what economic
resources you have, money made or lost the previous year.
3. MANAGERIAL ACCOUNTING - detailed secret data that individuals use
inside the organizations to make detailed decisions such as changes in
marketing strategy, pricing etc.; not revealed to outsiders.
4. INCOME TAXES - accounting that makes sure that you are in compliance
with the law.

BOOKKEEPING:
All accounting starts with bookkeeping because information needs to
be gathered systematically initially for any decision making to take
place.
If bookkeeping were to cease to exist, then societal gridlock is bound to
happen.
Bookkeeping is about collecting information because once we have the
information, we can then organize it and make some decisions based
on it.
Bookkeeping is the system for collecting information systematically
and in an organized manner.

FINANCIAL ACCOUNTING:
Summary information of a business or organization provided to
outsiders.
The key external users of financial accounting data are lenders and
investors i.e. people who provide capital for your business.
Lenders want to know:
Will the loan be repaid by assessing:
Current income
Existing obligations
Existing assets
Investors want to know:
Is the business profitable now?
What is the potential for the future?
Other external users of financial accounting data are suppliers (to
know whether the company will be able to repay them), customers
(to know whether the company will exist long enough to meet their
needs), employees (to know whether the company is making profits
or running in losses), competitors (to know the strengths and
weaknesses of the company), government agencies (to know
whether the company is in compliance with the law), politicians (to
make a point about the trend in the companys progress) and the
press (to provide background information about the company).
When you apply for a loan, they ask you to verify how much your
income was in the last year or the last several years as well to verify
your assets (house, investments, etc.) and obligations (any other
loans, credit card loans, etc.). Basically you are being asked for
personal financial statements so that they can decide whether you will
be able to repay the loan. They are more able to forecast repayment
capability and probability. Providing personal financial statements
reduces the lender uncertainty. It provides the borrower an opportunity
to reveal their creditworthiness.

Investors need access to reliable financial statements. These 3


primary financial statements would be:
1. BALANCE SHEET - list of resources (assets) {cash, land, machinery,
etc.} and obligations (liabilities) {bank loans, how much do you owe in
taxes, how much do you owe in unpaid salaries to employees, etc.}
2. INCOME STATEMENT - informs how much money the business is
making (year-on-year, quarter-on-quarter, or over a period of time)
3. STATEMENT OF CASH FLOWS report of the cash that came into
the company and the cash that went out of the company.
BALANCE SHEET
The Accounting Equation:
ASSETS = LIABILITIES (if money was borrowed) + EQUITY (if
money was invested)
Liabilities and equity are the sources of financing i.e. where did you
get the money to buy the assets.
The Accounting Equation may seem simple but it actually provides
us with the fundamental question about the sources of financing for
the assets.
Assets are the resources, either owned or controlled by a company
that will likely provide future benefit. They could be in the form of
cash, accounts (loans) receivable, inventory, buildings, vehicles etc.
Liabilities are the obligations that may require sacrifice of future
economic benefit in the form of transferring assets or providing
services. They could be in the form of accounts (loans) payable,
wages payable, taxes payable, long-term debt, unearned revenue
etc.
Owners Equity is the amount the owners originally invested in
the business so as to buy assets + how much profit they have left in
the business. It can be subdivided into 2 components:
Paid-In Capital is the amount that owners take out of their
personal savings and invest in the business. It is also known
as Capital Stock or Capital Contributions. The income
generated by the business is for the owners to keep i.e. they
can choose to do what they want to do with the profits.
Sometimes they can take out the profits for their personal
uses which are called dividends.
Retained Earnings is the amount owners invest in the
business and a majority of the profits earned is invested back
into the business for expansion.
Short-term borrowings are loans which a company has to repay
within a year.
Long-term borrowings are loans for which the repayment takes
over a year.
Accounts payable represents the amount that a company owes to
its suppliers for inventories that the company has already received
but hasnt paid for yet.

Limitations of Balance Sheet:


1. Most of the values that you see on a balance sheet are the
original costs and not the current market values.
2. Some very valuable economic assets arent reported at all
such as intangible assets such as the company name, logo,
loyal customers etc.
Book value of a company is often not equal to its market value.
Comparison between Balance Sheet and Income Statement:
Balance Sheet

As of right now:
What do you have?
How much do you owe?

At a point in time

Income Statement
How much did you make:
This week?
This month?
This year?
For a period of time

INCOME STATEMENT
The income statement contains 2 items revenues and
expenses.
The Income Equation:
REVENUES EXPENSES = NET INCOME
Revenues are the amount of assets created from the sale of goods
or services.
Expenses are the amount of assets consumed in generating
revenues.
Net Income is the overall measure of a companys economic
performance during a period.
Earnings per Share (EPS) is defined as the net income divided by
the total number of shares of stock of a company.

STATEMENT OF CASH FLOWS

OPERATING
ACTIVITIES

INVESTING
ACTIVITIES

CASH
INFLOW
(RECEIPTS
)

Selling goods
Providing
services

Selling
buildings
Selling land

Borrowing money
Receiving
investments

CASH
OUTFLOW
(PAYMENT
S)

Purchasing
buildings
Purchasing
land

Repaying loans
Distributions
(dividends) to
owners

Paying
Paying
Paying
Paying

wages
utilities
taxes
interest

FINANCING
ACTIVITIES

Operating Activities are the things that you do every single day
i.e. your operations. They are the routine events done daily.
Investing Activities are the activities done to invest in the
productive capacity of the business. These activities are carried out
occasionally and not on a daily basis.
Financing Activities are the activities done to get the cash to do
what the business requires to be done. These are also carried out
occasionally.

MANAGERIAL ACCOUNTING:
Detailed accounting data used internally for making daily decisions.
Good managerial accounting is a competitive tool.
We can analyse the managerial accounting data by:
1. Store, by country, by region
2. Department
3. Specific item
4. Physical location in the store
5. Season/climate
6. Day of the week
7. Time of the day
8. National/local ad campaigns
9. Payment method
10.Demographics of buyer


1.
2.
3.
4.
5.
6.
7.

Managerial accounting is used for making decisions related to:


PRODUCT COSTS
BREAK-EVEN ANALYSIS
BUDGETING
PERFORMANCE EVALUATION
INVESTING IN LONG-TERM PROJECTS
OUTSOURCING PRODUCTION
ADDING A PRODUCT LINE

INCOME TAXES
Accounting done to satisfy our legal obligations.

1.
2.
3.

Generally large companies maintain 3 sets of books:


FINANCIAL REPORTS (FOR OUTSIDERS)
MANAGERIAL REPORTS (FOR INSIDERS)
TAX REPORTING (TO GOVERNMENTS)

Economic Income is very subjective as it deals with value changes like


how much is my land worth, how much are my investments worth, etc.
Cash flow on the other hand is very objective as it deals with how
much money i made and how much money i spent. These are the 2
extremes of measuring the performance of a company during a year.
Accounting income (accrual income) is attempt to get us as close to
economic income as possible given the practical constraints.