Basic Accounting

# Introduction to Accounting

Accounting is the language of business. Accountants are responsible for organizing all financial information into meaningful sets of data that can be used to conduct analysis of a business. Whether this analysis is done by Managers (Internal), Owners (Stockholders), or Investors (External) some of the most important business decisions comes from this information. Financial Statements (as they are called) can be prepared Yearly, Quarterly, Monthly, or on demand of management or owners. The most useful analysis comes from documents that are prepared on a yearly basis because they contain the most information and give a better idea of how a business is performing over time.

You can see examples of all three documents at Google Finance and Yahoo Finance.

A cautionary note for those with some accounting background: We are making a simplification for the purposes of this class and breaking the linkage between the income statement and balance sheet. The intent is to simplify things just a little and make it easier to get to the income and cash flow statements later in the class. Sorry for any confusion this may cause.

# The Three Basic Accounting Documents

## Balance Sheet

The Balance sheet is the first of the three main accounting documents. This document provides a single day snapshot for the business in three main headings. It is basically a statement of what is owned by the business (Assets), who owns it (Equity), and how much debt the business has (Liabilities). The Assets $A$ must be equal to the combined value of both the Liabilities $L$ and the Owner Equity $O_E$. The basic equation is a statement of stock variables (rather than flow variables) and can be thought of as being analogous to a statics problem.

(1)
$$A-L-O_E=0$$

Wikipedia has a nice article if you want more details and for an example.

What does and does not go on the balance sheet and all the documents is evolving. There has been a recent change in how leases are treated, described in this Economist article. Leases are now both an asset and a liability. Essentially they treat the asset as something purchased on an installment plan. There are national and international bodies that make these kinds of declarations and the rules are known as Generally accepted accounting principles (GAAP).

### Assets

Assets are things which can be owned such as anything that can be considered property. This includes both physical and non-physical objects that range from cars and printing presses to intellectual property such as patents and copyrights. One thing that won’t be found here are things that cannot be owned, such as the employees and their associated skill sets. Assets are broken down into three main categories, current assets, fixed assets, and other assets. You will see other taxonomies in the real world, often finer subdivisions, but this is what we will use in class.

• Current Assets
• Current assets consist of cash and other things that turn into cash during the normal course of business.
• Examples include Cash, Inventory, and Accounts Receivable.
• Fixed Assets
• Fixed assets consist of items that require an act of volition to convert into cash.
• Examples include Vehicles, Real Estate, Buildings, Tools, Computers and Furniture. While they are all worth something, they are not converted to cash on a day to day basis.
• Other Assets
• This is the catchall for the rest of the assets.
• Examples include Patents, Copyrights, and Goodwill (Goodwill is not items given away for donation, it is the leftover amount paid for another business beyond the amount of its actual assets).

### Liabilities

That which is owed, liabilities are effectively the bills and loans that the company currently owes. They are divided into two sections, Current and Other. Again, you will see other taxonomies in the world but this one works for the purposes of this class.

• Current Liabilities
• Current Liabilities consist of things that require cash now or in the near future. If you borrow money from a friend for coffee this morning, and plan to repay it tomorrow morning, it’s a current liability.
• Examples include Accounts Payable (bills received, ex: water bill), Notes Payable (short term agreements where the total balance is due in the near future), Advance Payments (Retainers and other prepaid orders), and other accrued expenses.
• Other Liabilities
• Other Liabilities is the residual category, if it is owed, and not currently due, it’s here. If you borrow money from your parents for college, and they expect it paid back someday, it goes here.
• Examples include Vehicle Loans, Mortgages, credit cards, Student Loans, and Medical Bills.

### Owner Equity

Owner Equity is the category for listing what stake the owner or owners of the company have invested in the company. Owner equity is a bit more confusing than the previous categories due to the split between owner types. There are effectively two different options here; the first is for sole proprietorships and partnerships, the other (significantly more complicated) for corporations.

• Partnership and Sole Proprietorship Equity
• For these two business models, the Owner Equity section effectively consists of an account for each partner, and reflects the total amount invested in the business by that owner.
• Single line for sole proprietor, separate line for each partner.
• Corporate Equity
• For the corporation, Owner Equity is where we find the amount of money invested in the company by its various shareholders.
• Examples include Preferred Stock (first chance at dividends and non-voting), Common Stock (Gets second chance at dividends), Excess Contributions (aka, Paid in Capital, Capital Surplus), and Retained Earnings (Accumulated earnings not released as dividends). Wikipedia has a nice description of Preferred Stock here and Common stock here.
• Retained earnings are how you expand, and are owned by common shareholders
• For a specific example, assume that at initial IPO, a company sells $100,000 of stock. The money earned on the sale of the stock is found under two headings, part under Common Stock, and part under Excess Contributions. • The first is listed under common stock and is the value for the number of shares sold at Par value (10,000 shares, par =$1 per share, total $10,000). • The second part is listed under excess contributions and includes the rest of the amount of money spent for the stocks (10,000 shares, sold at$10 per share minus the par value of $1 per share, leaving a total here of$90,000).

## Income Statement

The income statement is a financial statement for companies that indicates how Revenue (money received from the sale of products and services before expenses are taken out) is transformed into net income (the result after all revenues and expenses have been accounted for) during a time period (usually quarterly or annually). The income statement represents a flow measure (measures of the rate of change). The basic equation is the net income $ΔI$ (profit or loss) is equal to the sum of the revenues (inflows) $ΣΔR_{in}$ minus the sum of the expenses (outflows) $ΣΔE_{out}$. It is analogous to a mass-balance equation.

(2)
$$ΔI=ΣΔR_{in}-ΣΔE_{out}$$

Wikipedia also has a nice description and an example.

### Revenue (also known as the "top line")

Cash inflows (gross profit or sales) or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major operations. Include sales, revenue, and operating revenue

### Expenses

Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major operations. Any of these line items can be included:

• Research and Development
• Cost of Goods Sold

### Special Expenses

A few expenses are singled out because they are different in one way or another:

• Depreciation expense — Because, while this is an expense, does not represent a payment made to another party
• Interest expense — While this is an expense, it is representative of the capital structure of the firm and could be different depending on the industry of the firm.
• Income tax expense — Also an expense, but can be very different depending on where the firm operates.

### Special Subtotals

There are also some subtotals of interest on the income statement that allow you to compare firms holding a few factors constant:

• Earnings before interest and taxes — allows for comparisons of firms with different capital structures in different locations.
• Income before taxes — allows for comparisons of firms in different tax jurisdictions.

### Net Income

The net income (AKA the "bottom line") is calculated after subtracting the expenses from revenue and is generally the bottom line of the income statement. It is important to investors as it represents the profit for the year.

The income statement reflects funding sources compared against program expenses, administrative costs, and other operating commitments. With the information that is on the income statement you can calculate the time interest earned ratio, inventory turnover, and total assets turnover.

## Cash Flow Statement

The cash flow statement is a financial statement that shows a company's incoming and outgoing money (sources and uses of cash) during a time period (usually quarterly or annually). The cash flow statement reflects a firm's liquidity or solvency and is measure of flow.

Again, Wikipedia has a more detailed description and an example

### Operations

This section contains information about the production, sales and delivery of the company's product as well as collecting payment from its customers. This could also include purchasing raw materials, building inventory, advertising and shipping the product. Any of these line items can be included:

• Depreciation (loss of tangible asset value over time)
• Changes to accounts receivables
• Changes in liabilities
• Changes in inventories
• Changes in other operating activities

This section is concluded with the Total Cash Flow from Operating Activities. Please note that to simplify the rules for this brief introduction, we treat all asset purchases as a change in cash from investments. This simplification is made to make it easier to treat a lot of accounting topics in a short period of time without the complications of the full GAAP rules. Beware!

### Investments

This section contains information about the purchase of the long-term assets a company needs in order to make and sell its products, and the selling of any long-term assets. Any of these line items can be included:

• Capital expenditures
• Investments
• Other cash flows from investing activities.

### Finance (borrowing and lending)

This section contains activities that include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and owner's equity of the company are also listed in the financing activities section of the cash flow statement. Any of these line items can be included:

• Dividends paid
• Sale purchase of stock
• Net borrowings
• Other cash flows from financial activities

The last line of the cash flow sheet is a Total Change in Cash and Cash Equivalent, which includes the totals from each section and the effect of exchange rate. There is also noncash investing and financing activities which are disclosed in footnotes to the financial statements (required by IAS 7). Under US GAAP, non-cash activities may be disclosed in a footnote or within the cash flow statement itself. Noncash financing activities may include:

• Leasing to purchase an asset
• Converting debt to equity
• Exchanging noncash assets or liabilities for other noncash assets or liabilities
• Issuing shares in exchange for assets

# What You Can Learn

## The income statement is intended to:

• Show managers and investors whether the company made or lost money during the period being reported
• Help investors and creditors determine the past performance of the enterprise, predict future performance, and assess the capability of generating future cash flows

## The cash flow statement is intended to:

• Provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances
• Provide additional information for evaluating changes in assets, liabilities and equity
• Improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods
• Indicate the amount, timing and probability of future cash flows

The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments.