What is Accounting?

Accounting is a system that allows businesses to identify, record, and communicate financial information. Basically, a transaction happens, and the accounting system needs to identify what that transaction is, record it in the accounting records (journal and ledger), and communicate that information through the financial statements. 

Example (Practical Application)

For example, let's say that we own a coffee shop. Our business is to sell coffee. A customer walks in an buy a cup of coffee for $4. Our accounting system must identify this transaction. We know that we sold coffee and received cash ($4) for it. Once we identify that transaction, we need to record it. If we want others to invest in our coffee shop, we must show them how well we are doing. Therefore, we need to communicate these transactions through our financial statements (later about these).

Accounting Principles and Assumptions

Accounting Principles

1. Cost Principle (this principle tells us that we record everything at cost. If you buy a building for $100,000, you record it at $100,000. Simple as that.)
2. Revenue Recognition Principle (this principle tells us that we only record revenues, when we earn them. We earn revenues when we provide a service or sell a product. If we sell a product for $100, we just earned revenue of $100.)
3. Matching Principle (this principle tells us that expenses associated with specific revenues, should matched in the same period. For example, If I provide a service in 2017 that is a revenue to the company. But if they pay me salaries in 2018, that is an expense to the company, directly connected to the revenue earned in 2017. Therefore, we must match the expense to the revenue in 2017.)
4. Full-Disclosure Principle (this principle tells us that we must inform the users of our financial records about everything.)

Accounting Assumptions

1. Business Entity Assumption (this assumption tells us that we assume that we as owners are separate from the business entity. If you own a coffee shop, you are you own entity, and the coffee shop is a separate entity.)
2. Going-Concern Assumption (this assumption tells us that we assume the business will continue running and will not go out of business.)
3. Periodicity Assumption (this assumption tells us that we use artificial periods of time for reporting purposes, such as monthly, quarterly, or yearly.)
4. Unit of Measurement Assumption (this assumption tells us that we use dollars for measurement.

The Accounting Equation

ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

This is the accounting equation. All of accounting comes to this. Stockholders’ Equity represents what the owners own from the company’s assets. Liabilities represents what the creditors own in the company’s assets.

Assets are something of value that the company has. Liabilities are what the company owes to creditors. Stockholders’ Equity is what the owners own.

• Asset Accounts: Cash, Supplies, Equipment, Building, Land, Accounts Receivable, etc.
• Liabilities Accounts: Accounts Payable, Notes Payable, Utilities Payable, Salaries Payable.
• Stockholders’ Equity Accounts: Common Stock, Dividends, Revenues (Service Revenue, Sales Revenues, Interest Revenues), and Expenses (Rent Expense, Insurance Expense, Utilities Expense, Salaries Expense).

Effects on the Accounting Equation

Let's see how various transactions affect the accounting equation.

Financial Statements

Income Statement

The income statement contains revenues and expenses. Revenues minus expenses are either Net Income or Net Loss. If revenues are larger then expenses, then we will have net income. If expenses are larger than revenues, it will result in a net loss. In practice, large amount of people refer to the income statement as a profit and loss statement. Take a look below at our sample Income Statement issued by Best Coffee Shop Company.

This sample shows what we earned and what we expensed for the past year. Revenues shows us how much we earned, and expenses shows us how much in expenses we incurred.

In this income statement we can see that at the end of the year we have a Net Income of $25,500.

The Income Statement always shows the results of a company for the entire period (for example, past year).

Statement of Retained Earnings

The statement of Retained Earnings is consisted of the beginning balance, plus Net Income/-Net Loss, minus dividends. This statement shows us the ending balance of retained earnings, which shows up on the Balance Sheet. Take a look at the Statement of Retained Earnings sample below:

The statement of retained earnings shows us the earnings the company retained. We add the previous balance to net income and we subtract the earnings that were distributed to the owners through dividends.

The Statement of Retained Earnings always shows the results of a company for the entire period.

Balance Sheet

The balance sheet is practically the same as the accounting equation. We are listing all assets, liabilities, and stockholders’ equity accounts.

As you can notice, the Balance Sheet is the same as the Accounting Equation. Assets must equal Liabilities plus Stockholders' Equity. Unlike other financial statements, the Balance Sheet reports the standing of the company at a specific point in time (for example, on December 31, 2021). 

Statement of Cash Flows

The statement of cash flows is consisted of three sections: Cash flows from Operating Activities, Cash flows from Investing activities, and Cash flows from Financing activities. We will learn about this section by the end of the course.

As you can see in the sample, the Statement of Cash flows explains what happens to the cash in our company. It explains where it comes from and where it goes. The balance at the end of the statement is the same amount as the on on the Balance Sheet.

The Statement of Cash Flows always shows the results of a company for the entire period.

Video Explanation

See the following video for better understanding and preparation of these financial statements. We will not prepare the Statement of Cash Flows until the end of this book.

Time to Exercise - Problem Solving

In the following video we will see how some transactions affect the accounting equation.

In the next videos we will see some additional examples on how transactions affect the accounting equation.