Accounting

Definition of Accounting: It is a systematic process of identifying, recording, measuring, classifying, verifying,

summarizing, interpreting and communicating financial information. It reveals profit or loss for a given period, and
the value and nature of a firm's assets, liabilities and owners' equity.
Accounting, is the production of financial records about an organization. Accountancy generally produces financial
statements that show in money terms the economic resources under the control of management; selecting
information that is relevant and representing it faithfully. The principles of accountancy are applied to accounting,
bookkeeping, and auditing.
Definition of Income Statement
The income statement is also known as the statement of operations, profit and loss statement, and statement of
earnings. It is one of a company's main financial statements. The purpose of the income statement is to report a
summary of a company's revenues, expenses, gains, losses, and the resulting net income that occurred during a year,
quarter, or other period of time.
Examples of Items Appearing in the Income Statement
The main items reported in the income statement are:
Revenues, which are the amounts earned through the sale of goods and/or the providing of services
Expenses, which include the cost of goods sold, SG&A expenses, and interest expense
Gains and losses, such as the sale of a noncurrent asset for an amount that is different from its book value
Net income, which is the result of subtracting the company's expenses and losses from the company's revenues and
gains. Corporations with shares of common stock that are publicly traded often refer to net income as earnings and
their income statements must include the earnings per share of common stock
How the Income Statement Amounts are Calculated
The income statement amounts are best calculated for a specific period of time by using the accrual basis of
accounting. Under the accrual basis the revenues are the amounts that were earned (not the amount of cash
received), and the expenses are the amounts that best match the revenues or were used up during the period (not the
cash that was paid out).
Components of an Income Statement
The income statement may have minor variations between different companies, as expenses and income will be
dependent on the type of operations or business conducted. However, there are several generic line items that are
commonly seen in any income statement.
The most common income statement items include:
Revenue/Sales
Sales Revenue is the company’s revenue from sales or services, displayed at the very top of the statement. This
value will be the gross of the costs associated with creating the goods sold or in providing services. Some companies
have multiple revenue streams that add to a total revenue line.
Cost of Goods Sold (COGS)
Cost of Goods Sold (COGS) is a line-item that aggregates the direct costs associated with selling products to
generate revenue. This line item can also be called Cost of Sales if the company is a service business. Direct costs
can include labor, parts, materials, and an allocation of other expenses such as depreciation (see an explanation of
depreciation below).
Gross Profit
Gross Profit Gross profit is calculated by subtracting Cost of Goods Sold (or Cost of Sales) from Sales Revenue.
Marketing, Advertising, and Promotion Expenses
Most businesses have some expenses related to selling goods and/or services. Marketing, advertising, and promotion
expenses are often grouped together as they are similar expenses, all related to selling.
General and Administrative (G&A) Expenses
SG&A Expenses include the selling, general, and the administrative section that contains all other indirect costs
associated with running the business. This includes salaries and wages, rent and office expenses, insurance, travel
expenses, and sometimes depreciation and amortization, along with other operational expenses. Entities may,
however, elect to separate out depreciation and amortization in its own section.
EBITDA
EBITDA, while not present in all income statements, stands for Earnings before Interest, Tax, Depreciation, and
Amortization. It is calculated by subtracting SG&A expenses (excluding amortization and depreciation) from gross
profit.
Depreciation & Amortization Expense
Depreciation and amortization are non-cash expenses that are created by accountants to spread out the cost of capital
assets such as Property, Plant, and Equipment (PP&E).
Operating Income (or EBIT)
Operating Income represents what’s earned from regular business operations. In other words, it’s the profit before
any non-operating income, non-operating expenses, interest, or taxes are subtracted from revenues. EBIT is a term
commonly used in finance and stands for Earnings Before Interest and Taxes.
Interest
Interest Expense. It is common for companies to split out interest expense and interest income as a separate line item
in the income statement. This is done in order to reconcile the difference between EBIT and EBT. Interest expense is
determined by the debt schedule.
Other Expenses
Businesses often have other expenses that are unique to their industry. Other expenses may include things such as
fulfillment, technology, research and development (R&D), stock-based compensation (SBC), impairment charges,
gains/losses on the sale of investments, foreign exchange impacts, and many other expenses that are industry or
company-specific.
EBT (Pre-Tax Income)
EBT stands for Earnings Before Tax, also known as pre-tax income, and is found by subtracting interest expense
from Operating Income. This is the final subtotal before arriving at net income.
Income Taxes
Income Taxes refer to the relevant taxes charged on pre-tax income. The total tax expense can consist of both
current taxes and future taxes.
Net Income
Net Income is calculated by deducting income taxes from pre-tax income. This is the amount that flows into retained
earnings on the balance sheet, after deductions for any dividends.

Accounting Equation
The basic accounting equation, also called the balance sheet equation, represents the relationship between the assets,
liabilities, and owner's equity of a business. It is the foundation for the double-entry bookkeeping system. For each
transaction, the total debits equal the total credits. It can be expressed as:
Assets = Liabilities + Owner’s equity [Capital]
Assets
Assets are tangible and intangible items of value which the business owns. Examples of assets are:
*Cash. *Cars. *Buildings. *Machinery. *Furniture
*Debtors (money owed from customers). *Stock / Inventory
Liabilities
Liabilities are those items which are owed by the business to bodies outside of the business. Examples of liabilities
are:
*Loans to banks. *Creditors (money owed to suppliers). *Bank overdrafts
Owner’s Equity
The simplest way to understand the accounting equation is to understand what makes up ‘owner’s equity’. By
rearranging the accounting equation you can see that Owner’s Equity is made up of Assets and Liabilities.
Owner’s Equity = Total Assets less Total Liabilities
Owner’s Equity can also be expressed as:
Owner’s Equity = Capital invested by owner + Profits (Losses) to date (also known as ‘Retained Earnings ’)
Rearranging the equation again, therefore:
Total Assets - Total Liabilities = Capital + Retained Earnings

Definition of Double-Entry System

The double-entry system of accounting or bookkeeping means that for every business transaction, amounts must
be recorded in a minimum of two accounts. The double-entry system also requires that for all transactions, the
amounts entered as debits must be equal to the amounts entered as credits.
The Balance Sheet
The balance sheet shows a snapshot of the business’s net worth at a given point in time. Below is a basic balance
sheet. Have a look at how it displays the elements of the accounting equation:
The accounting equation establishes the basis of Double Entry Bookkeeping.
The balance sheet is a report that summarizes all of an entity's assets, liabilities, and equity as of a given point in
time. It is typically used by lenders, investors, and creditors to estimate the liquidity of a business. The balance sheet
is one of the documents included in an entity's financial statements. Of the financial statements, the balance sheet is
stated as of the end of the reporting period, while the income statement and statement of cash flows cover the entire
reporting period.
Typical line items included in the balance sheet (by general category) are:
Assets: Cash, marketable securities, prepaid expenses, accounts receivable, inventory, and fixed assets
Liabilities: Accounts payable, accrued liabilities, customer prepayments, taxes payable, short-term debt, and long-
term debt
Shareholders' equity: Stock, additional paid-in capital, retained earnings, and treasury stock
The exact set of line items included in a balance sheet will depend upon the types of business transactions with
which an organization is involved. Usually, the line items used for the balance sheets of companies located in the
same industry will be similar, since they all deal with the same types of transactions. The line items are presented in
their order of liquidity, which means that the assets most easily convertible into cash are listed first, and those
liabilities due for settlement soonest are listed first.
The total amount of assets listed on the balance sheet should always equal the total of all liabilities and equity
accounts listed on the balance sheet (also known as the accounting equation), for which the equation is:
Assets = Liabilities + Equity
If this is not the case, a balance sheet is considered to be unbalanced, and should not be issued until the underlying
accounting recordation error causing the imbalance has been located and corrected.
KEY TAKEAWAYS
A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity.
The balance sheet is one of the three (income statement and statement of cash flows being the other two) core
financial statements used to evaluate a business.
The balance sheet is a snapshot, representing the state of a company's finances (what it owns and owes) as of the
date of publication.
Fundamental analysts use balance sheets, in conjunction with other financial statements, to calculate financial ratios.
Assets
Within the assets segment, accounts are listed from top to bottom in order of their liquidity – that is, the ease with
which they can be converted into cash. They are divided into current assets, which can be converted to cash in one
year or less; and non-current or long-term assets, which cannot.
Here is the general order of accounts within current assets:
Cash and cash equivalents are the most liquid assets and can include Treasury bills and short-term certificates of
deposit, as well as hard currency.
Marketable securities are equity and debt securities for which there is a liquid market.
Accounts receivable refers to money that customers owe the company, perhaps including an allowance for doubtful
accounts since a certain proportion of customers can be expected not to pay.
Inventory is goods available for sale, valued at the lower of the cost or market price.
Prepaid expenses represent the value that has already been paid for, such as insurance, advertising contracts or rent.
Long-term assets include the following:
Long-term investments are securities that will not or cannot be liquidated in the next year.
Fixed assets include land, machinery, equipment, buildings and other durable, generally capital-intensive assets.
Intangible assets include non-physical (but still valuable) assets such as intellectual property and goodwill. In
general, intangible assets are only listed on the balance sheet if they are acquired, rather than developed in-house.
Their value may thus be wildly understated – by not including a globally recognized logo, for example – or just as
wildly overstated.
Liabilities
Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest on
bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within one year
and are listed in order of their due date. Long-term liabilities are due at any point after one year.
Current liabilities accounts might include:
*current portion of long-term debt. *bank indebtedness. *interest payable
*rent, tax, utilities. *wages payable. *customer prepayments
*dividends payable and others. *earned and unearned premiums
Long-term liabilities can include:
*Long-term debt: interest and principal on bonds issued
*Pension fund liability: the money a company is required to pay into its employees' retirement accounts
*Deferred tax liability: taxes that have been accrued but will not be paid for another year (Besides timing, this figure
reconciles differences between requirements for financial reporting and the way tax is assessed, such as depreciation
calculations.)
Some liabilities are considered off the balance sheet, meaning that they will not appear on the balance sheet.
Shareholders' Equity
Shareholders' equity is the money attributable to a business' owners, meaning its shareholders. It is also known as
"net assets," since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to
non-shareholders.
Retained earnings are the net earnings a company either reinvests in the business or use to pay off debt; the rest is
distributed to shareholders in the form of dividends.
Treasury stock is the stock a company has either repurchased or never issued in the first place. It can be sold at a
later date to raise cash or reserved to repel a hostile takeover.
Some companies issue preferred stock, which will be listed separately from common stock under shareholders'
equity. Preferred stock is assigned an arbitrary par value – as is common stock, in some cases – that has no bearing
on the market value of the shares (often, par value is just $0.01). The "common stock" and "preferred stock"
accounts are calculated by multiplying the par value by the number of shares issued.
Additional paid-in capital or capital surplus represents the amount shareholders have invested in excess of the
"common stock" or "preferred stock" accounts, which are based on par value rather than market price. Shareholders'
equity is not directly related to a company's market capitalization: the latter is based on the current price of a stock,
while paid-in capital is the sum of the equity that has been purchased at any price.
The balance sheet is an invaluable piece of information for investors and analysts; however, it does have some
drawbacks. Since it is just a snapshot in time, it can only use the difference between this point in time and another
single point in time in the past. Because it is static, many financial ratios draw on data included in both the balance
sheet and the more dynamic income statement and statement of cash flows to paint a fuller picture of what's going
on with a company's business.
Different accounting systems and ways of dealing with depreciation and inventories will also change the figures
posted to a balance sheet. Because of this, managers have some ability to game the numbers to look more favorable.
Pay attention to the balance sheet's footnotes in order to determine which systems are being used in their accounting
and to look out for red flags.

Double Entry Bookkeeping

All accounting transactions are made up of 2 entries in the accounts: a debit and a credit.
For example, if you purchased a book, your value of books would increase, but your value of cash would decrease
by the same value, at the same time. This is double entry bookkeeping.
Ledger Accounts
A ledger account is an item in either the Profit & Loss account (which we’ll discuss shortly) or the balance sheet. A
Ledger account is either a:
*Asset. *Liability. *Equity. *Income. *Expense
The example of purchasing a book, mentioned above, can be shown in the form of ledger “T” accounts as follows:
If all transactions are entered into the books in this way, then the sum of all of the debits would equal the sum of all
of the credits.
Trial Balance
A trial balance is a list of all of the ledger accounts of a business and the balance of each. Debits are shown as
positive numbers and credits as negative numbers. The trial balance should therefore always equal zero.
Following on from the previous example, if we were to sell a CD for $25 cash then the ledger accounts and trial
balance would look like this:
Profit and Loss account
Whereas the balance sheet shows a snapshot at a point in time of the net worth of the business, the profit and loss
account shows the current financial year’s net operating profits, broken down into various sales, cost of sales and
expenses ledger accounts.
Sales
Sales accounts show all sales made in the period, regardless of whether or not money has been received yet, and are
shown as a credit in the Profit and Loss accounts. Where money has not yet been received, the debit is not to cash
(as per the CD example above), but to a Debtors account (money owed from customer account).
Cost of Sales
Cost of Sales are expenses that can be directly attributed to sales items, such as purchases of stocks.
Expenses
These are all other expenses (other than purchases of assets) which cannot be attributed directly to sales items, such
as rent, electricity or advertising.