Lesson 2: Basic Accounting Concepts

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1 Lesson 2: Basic Accounting Concepts 2.1 Introduction In every business there will be a multitude of transactions. Whether you are making a purchase, making a sale, or taking out a loan, each individual transaction must be recorded in your records/books via journal entries. At the close of a quarter or year, these journal entries must be summarized into financial statements. Thus, financial statements are essentially an aggregation of journal entries. In order to appropriately account for these transactions, there are common concepts and terms you must be familiar with. This lesson will teach you the basics of journal entries and give you a brief introduction into the two most common financial statements. 2.2 Journal Entries Let s say you want to open up a bakery and you buy an oven. How do you record this purchase on your records? You would record a journal entry into your books. Each journal entry is essentially a transaction and is broken down into two sides: debit and credit. As a rule of thumb, total debits should always equal total credits. This is an important rule that should be emphasized. This is not saying that each debit must be matched to a credit; rather the total amount of debits should equal the total amounts of credits when added together. For example, let s say you bought the oven for $3,000. The journal entry would be recorded as follows: Account Debit Credit Equipment (Oven) $3,000 Cash $3,000 As you physically have an oven in your hands, you must show an increase in your books. You do this by debiting the equipment. However, your cash account is credited as it is decreased because you spent money in order to purchase the oven. The two items are known as assets. Assets can be thought things that have positive value to you. Thus, debits increase assets, and credits decrease them. Let s change the scenario. Say you only have $1,000 cash and you need to borrow $2,000 from the store to purchase the oven. How would this be presented in a journal entry? We know we re going to get an oven in our hands so the $3,000 debit from above will be the same. We re paying out $1,000 cash so we know there will be a credit to cash. What about the $2,000 we borrowed? This will be chartered to an account known as Accounts Payable. This is essentially a liability to you meaning you owe $2,000 to the store. A liability is the opposite of an asset; it can be thought of something that has negative value to you.

2 Account Debit Credit Equipment (Oven) $3,000 Cash $1,000 Accounts Payable $2,000 As you can see, debits will always equal credits regardless of the number of accounts. Furthermore, you can see a debit increases an asset (oven) account, while a credit increases a liability (payable) account. They essentially mirror each other thus once again reinforcing the rule that debit equals credits. All business transactions can be placed in five different types of accounts: Assets, Liabilities, Equity, Revenue, and Expense. For the purposes of learning the relationship between debits/credits and accounts, the chart below shows the effect of a debit/credit on the respective accounts. Account Category Debits Credits Asset Increase (Decrease) Liability (Decrease) Increase Equity (Decrease) Increase Revenue (Decrease) Increase Expense Increase (Decrease) Assets, liabilities and equities are organized in the balance sheet, while revenue and expenses are organized in the income statement. 2.3 Balance Sheet (Statement of Net Assets) A balance sheet summarizes the financial balances of a company. It can be viewed as a snapshot of a company s financial condition. There are three areas of a balance sheet: Assets, Liabilities, and Owner s Equity. A. Assets: An asset is essentially something of economic value. Anything a company owns, tangible and intangible, that produces value can be regarded as an asset. As outlined in the chart above, a debit to an asset increases it, while a credit to an asset decrease it. Assets are split into two categories- current and noncurrent. Current assets are assets that are expected to be used within the next 12 months. Typical current assets include: Cash/Cash Equivalents- this includes physical cash as well as investments that can be quickly liquidated Short-term investments- money invested in bonds or securities that have a maturity date of less than a year Accounts Receivable- amounts that a customer owes a business. In others words, sales that have been made, but not yet paid.

3 Prepaids- amounts that you pay in advance. The most common example is prepaid rent. Inventories- raw materials, works in process, finished goods Noncurrent Assets are assets that aren t expected to be used within the next 12 months. Typical noncurrent assets include: Long Term Investments-bonds/securities with a maturity date of greater than 1 year Property, plant, equipment (PPE)- includes equipment that the companies uses like the oven purchased for the bakery. Intangible Assets- Trademarks, patents, goodwill B. Liabilities: A liability is essentially an obligation or debt. These are financial obligations that a company is responsible for. A debit to a liability decreases the balance, while a credit to a liability increases the balance. Liabilities are also segregated into current and noncurrent. Current liabilities are liabilities that are expected to be paid within the next 12 months. Typical current liabilities include: Short Term Debt- money that a company has borrowed for a term shorter than a year Accounts Payable- bill a company owes for a purchase/service that it hasn t paid for yet. Other payables include salaries, interest, income taxes payable. Noncurrent liabilities represent money that the company owes one year or more in the future. Long Term Debt- debt that doesn t need to be paid back for several years. C. Owner s Equity: equity represents the owner s investment in the business. This amount is increased for any capital the owner puts in as well as any money the business makes. You would record the increase with a credit to the account. On the other hand, this amount is decreased for any withdrawals the owner takes out or any losses the business has. Any decrease is recorded with a debit to the account. As a general rule of thumb: Owner s Equity = Assets- Liabilities Typical equity accounts include: Common Stock- a security that represents ownership in a corporation. This is the amount owners paid for their interest in the company. Retained Earnings- the amount of money a company makes less the amounts paid out to owners. In other words, it is the Net Income of the company less dividends. This is the amount that will be reinvested into the business.

4 A typical balance sheet would appear as follows: Assets Liabilities Balance Sheet Cash 1,000 Inventory 2,000 Total Assets 3,000 Note Payable 1,000 Salaries Payable 500 Total Liabilities 1,500 Owner's Equity 1,500 Total Liabilities & Owner's Equity 3,000 As you can see, it is organized into the three main sections with liabilities & owner s equity equaling total assets. We will delve deeper into the preparation of this financial statement in a later lesson. 2.4 Income Statement (Statement of Changes in Net Assets) As alluded to above, one element of retained earnings is the money a company makes, net income. The income statement tracks the operations of a business and arrives at net income. The main elements include: Sales (Revenue)- The total amount that the company took in Cost of Goods Sold- the amount it cost you to manufacture the goods you sold Gross Profit- The difference between Sales/Cost of Goods Sold Operating Expenses- the amount a company spends to run a company. Typical expenses include salaries, rent, insurance, office supplies, selling expenses, depreciation, etc Income from Operations- Gross Profit minus Operating Expenses Other Income/Expenses- this is reserved for non-operating expenses. These include interest income and expense, foreign exchange loss Income Before Taxes- Income from Operations less Other Income/Expenses Income Tax Expense- Income Before Taxes times Income Tax Rate Net Income- Income Before Taxes less Income Tax Expense A typical income statement would appear as follows:

5 Income Statement Sales Revenue $100,000 Cost of Goods Sold ($20,000) Gross Profit $80,000 Less Operating Expenses Rent ($5,000) Insurance Expense ($1,000) Auto Expense ($2,000) Total Operating Expenses ($8,000) Income From Operations $72,000 Other Income Interest Income $1,000 Income Before Taxes $73,000 Tax Rate 25% Income Tax Expense $18,250 Net Income $54,750 Don t worry if this is a lot of information to take in. We will revisit these topics in future lessons. However, for now, all you need is to be familiar with the major items at play.