financial accounting pro tips for beginners
The. Balance sheet the income statement, and the statement of cash flows don't just drop out of the sky they, don't come down from a mountaintop and they aren't delivered by a stork, these. Financial, statements are the result of a systematic. Method of analyzing, transactions. Inputting. The results, of the analysis, into an accounting, system and then, summarizing. The resulting information into reports, for decision-makers the, process. Of analyzing business, events, collecting. And processing information. Related. To those events and, summarizing. That information, in report form is called the, accounting, cycle for. Large multinational. Companies the accounting, system is tailor-made, to process, thousands. Of daily transactions. Conducted. In multiple. Currencies, in, multiple. Locations, around, the, world for. A small, sole, proprietorship. The, accounting, system may be required, to process only, a few, transactions. Each day. Now. A common, question that is asked at this point is haven't. Computers, made having a knowledge of the accounting, cycle obsolete. This. Provocative. Question, requires two, answers, first. Even. With computers. Transactions. Need to be analyzed, and their effects recorded. So that summary, financial information can be prepared, now. It is true that most transactions. Are routine, and computers. Can handle these without, human intervention but. Analysis, of complex, or unusual. Transactions. Or in other words everything, that's really interesting, still. Requires, the exercise, of accounting, judgment in that, sense computers, have not changed the steps in the accounting cycle at all second. Computers. Have enhanced our ability to process large, amounts of information so that now we can not only identify, the accounts, involved, in a transaction, but. We can also easily, identify. The salesperson. The, exact, item being sold the, address, of the customer the customers. Bank account number and a whole bunch of other things, Computers. Allow us to collect and process much, more information, than is required by a traditional accounting system but again. Knowing, what data to accumulate, and how to summarize it are still, matters of accounting, judgment, so. Accountants, have developed, a system whereby large, amounts, of information, can be collected. Analyzed. And summarized. Into, three primary financial. Statements, now, these financial, statements have stood the test of time it's. Hard to believe that the operations, of Microsoft.
For Example can. Be summarized, in three financial, statements each, only one, page, long, but. Microsoft has been providing, these three financial statements, to the public since they went public in 1986. The. Balance sheet a listing, of a company's resources, and claims against those resources, the, income, statement a measure of a company's economic, performance for a period of time and the, statement, of cash flow is a summary, of cash inflows. And outflows for, a period of time these. Combine, to provide a financial, picture of a company that can allow conclusions. To be drawn and decisions. To be made about, a company's, past and, about, its future. You. As we, begin our study of accounting, we should start at the start with the fundamental, financial statement the balance sheet the balance. Sheet simply, lists our stuff the technical, term is asset, and how, we've been able to pay for that stuff, assets. Are economic, resources, owned or, controlled by, a company that will provide future benefit, to the company. Examples. Include cash, that certainly, provides a future benefit, inventory. Items, help to resell in the future and buildings. And equipment the hope is that these items will provide benefit to the business in the future now. There are two general methods used, to finance our assets, liabilities. And owner's. Equity. Liabilities. Are obligations, that are satisfied, either through payments or, by providing services, to someone else we. Borrow money to buy assets, and we have to pay that money back someone. Pays us money and we have to provide them a service, with. Liabilities. We owe in the future either money or services. Those. Liabilities go, away when we pay the money or we provide the service, now. Owner's equity comes, about as owners invest in the company with, no obligation, for the company to repay that investment. Or, the owners, leave the profits, generated by, the company in the company those, retained, profits can, then be used to purchase additional assets. So, the balance sheet can be stated as follows assets. Equal, liabilities plus, owner's equity this. Equality is termed the accounting, equation in fact. The, name balance, sheet comes from the fact that a proper, balance sheet must always balance total. Assets, must, equal, the total of liabilities, and owner's equity the. Accounting equation is, not some miraculous, coincidence. It is true by, definition, the. Two sides of the accounting, equation must, always be equal because there are two views of the same company, the left-hand side shows the economic, resources controlled, by a business, and the. Right-hand, side shows, the claims against, those resources. Another. Way to view this equality is that the firm's assets must. Have sources and the. Right-hand, side of the equation, shows the origin of those resources this. Equal, sign is, one of the most important, aspects, of accounting, this, mathematical. Fact helps, us to determine if we've identified all, the effects of a transaction. It, forces, discipline. On our, analysis, we, are required to think through all aspects. Of a transaction, because at the end of the day the, accounting, equation has. To balance we. Receive cash assets. Go up but why what did that cash come from that. Equals sign requires, us to answer these questions cash. Coming in because of loans is different, than cash coming in from profitable, operations, because. The accounting, equation must, always balance, those. Preparing, the financial statements for our use must carefully, determine. Why assets, changed, why liabilities. Changed, and why, owner's, equity might, have changed, the, Equality, embedded. In the accounting, equation forces. Those. Preparing, financial statements, to answer, the question, that those of us using, financial statements, often want answered, why. You. So. You've been introduced, to the, fundamental. Financial statement, the balance sheet but. You've probably heard of others the, other two, primary, financial statements, are the income, statement, and the statement of, cash flows these, are the big three financial statements, all publicly. Traded companies, provide these financial, statements to users and most. Private companies, of any size are also preparing. These financial, statements as well for use within their company so. From where do these financial, statements derive, well let's. Go back to the accounting equation assets. Equal.
Liabilities Plus. Owner's equity the. Left side of the equation the asset, side is made, up of a bunch of asset accounts, inventory. Supplies, equipment, land, and cash. The. Statement, of cash flows is simply, a detailed. Analysis, of the flows of cash going in and, out of the cash account over a specific time period, those. Inflows, and outflows are, categorized, as being related, to either operating. Activities, things that happen everyday in a business. Investing. Activities, transactions. That affect the productive, capacity of, a business like buying a building and. Financing. Activities borrowing. And paying back money selling, and buying your own stock. Now. For a period of time like a quarter, or a year. Sort. The inflows and outflows of cash, buy activity, and the, result the. Statement, of cash flows now, of course that sorting, is easier said than done but. That's the gist of it by drilling down on the asset, side we, separate, the cash account from, the other asset, accounts, and then, just do a detailed, analysis, of just, that account so. If we know where to look we, can see in the accounting, equation exactly. Where. To find the statement of cash flows. You. Now, the income, statement, comes from a detailed, look at an account on the other side, of the accounting equation owner's. Equity just. As assets, is comprised, of a bunch of individual, asset, accounts, owner's. Equity is comprised, of individual, accounts, as well the. Two most common, are paid in capital and retained, earnings, now paid in capital is, exactly, that it is the amount of money directly, invested, by the owners of the business it is the amount of capital that they the owners have paid in hence the name the, other account, retained, earnings is exactly. That it's the earnings, that have been retained, in the business, since the founding of the business, earnings. That have not been retained, in the business are called dividends, this is cash that has been returned, to the owners so. A company's, earnings or, income, are disclosed, or added, in owner's equity in, the retained earnings account from. That account the earnings that are not retained, dividends. Are subtracted. And at. This point we must bring revenues, and expenses, into the picture obviously, they are part of every ongoing, business. Revenues. Provide resource, inflows, they, are increases. In resources, from the sale of goods or services. Expenses. Represent, resource, outflows. They, are costs, incurred in generating, revenues. Now. Note that revenues, are not synonymous with cash or other assets, but. They are a way of describing, where, the assets, came, from, for. Example, cash, received, from the sale of a product is recorded, as the asset, cash but, the source of that asset, would be considered, revenue, in. Contrast. Cash. Received, by borrowing from the bank would not be revenue, but, would be an increase, in a liability, by. The same token. Expenses. Are a way of describing how an asset has been used, thus, cash paid for interest on a loan is, an expense, but. Cash paid to buy a building represents the exchange, of one asset for another, so. How do revenues, and expenses fit into the accounting equation well. Revenues. Minus expenses, equals. Net income and net. Income is a major source, of chain owner's, equity from, one accounting period to the next, in this. Expanded. Equation, we see the balance sheet the, income statement, and the statement of cash flows if we. Know where to look we, can see each of the, primary financial statements, embedded, in the accounting, equation. You. So, let's start drilling down into the balance sheet let's start with assets what exactly, is an asset. Assets. Are the firm's economic, resources, formally. Defined as probable. Future, economic, benefits obtained. Or controlled, by a particular, entity, as a result of past transactions. Or events this. Carefully. Worded definition. Includes. Several, important, phrases that merits some discussion, first the word probable. Contrary. To popular belief, accounting. Is not an exact, science, business. Is full of uncertainty, as acknowledged, by inclusion of the word probable. In the definition, of an asset for. Example, will, all people, who owe a business, money pay, probably. Not as. A result, accounts. Receivable, the asset, representing, the amounts owed by customers, is reported. And an amount lower, than the gross or face, amount of all receivables, is reported. At the amount that will probably. Be paid. Second. Term future.
Economic. Benefits. Although. The balance sheet summarizes the, results of past transactions. And events its. Primary, purpose is, to help forecast, the, future, hence. The only items, included, as assets, are those with implications, for, the future. Let's. Suppose your business, owns a now obsolete patent. That patent, was purchased, ten years ago at a cost of $50,000. It. May have been an asset 10 years ago but. Because it now has no future, economic. Benefit, it's. Not an asset now. Finally. The. Term obtained, or controlled. Accountants. Have a phrase substance, over form meaning. That financial, statements, should reflect the underlying, economic. Substance and not the superficial, legal, form if. A, company controls, the future economic benefits associated. With an item that. Item qualifies. As an asset, whether it's legally, owned or not for. Example a, company, will sometimes, report a building, as an asset, on the balance sheet, when, in fact the company has not actually purchased, the asset, but, only leased it, a long-term. Non-cancellable. Lease if. The lease gives the company control, of the building for most of the building's economic, life then. The leased building is reported, as an asset. Remember. The underlying, concept, here is that the balance, sheet should report economic, substance, not. Legal, form. Now. Assets, generally, are listed on the balance sheet in the order of their liquidity which. Is the ease with which the item can be turned into cash. As a, result, cash, and items that can be turned into cash are listed first these. Items are most commonly cashed short-term, investments, account receivable, inventory and, prepaid expenses. Assets. Such as buildings and, equipment used in the operation of the business are listed next. Intangible. Assets, are usually, listed last now. At what amounts, are assets, reported, that, is a great question and the answer may, surprise you, it, depends. Some. Assets are reported, at the current market value like cash what it's worth today some. Assets, are reported, at their net realizable value, the. Amount that the asset is expected, to yield the, accounts receivable example. Mentioned previously is an example, of an asset that is listed, at the, amount that is expected to be realized, or received, some. Assets, are reported at their historical, cost like buildings, and equipment and land it, is tough in most cases to get at these assets, current, market value so. We go with a measure that everyone, can agree on what, was the original cost hey, hold it you, mean that the amounts, listed on a balance, sheet are not all comparable, some. Are historical, some. Are a current market value and some are an estimate, of future value, that's, exactly, what I mean amounts. On the balance sheet are like fruit in a fruit basket there are apples, and there are oranges, but. Knowing that fact, there are different valuation, measures puts, you ahead of many users of financial information many. Think the balance sheet is just a basket, of apples now you, know.
Something Many people don't when, it comes to amounts, on the financial, statements, there are a variety of. Valuation. Measures. You. Now. Let's turn our attention to the other side, of the accounting equation, liabilities. Liabilities. Are the economic, obligations, of a company and comprised, primarily, the money or services, that the company owes to, its creditors. Liabilities. Are formally, defined, as probable. Future sacrifices. Of economic. Benefits, arising. From present, obligations, of a particular entity, to transfer, assets or, provide, services to other entities, in the future as a, result of past transactions. Or events, Wow. The. Following, phrases in the liability, definition, are important, to consider first, obligation. This. Term includes, legal commitments. As well as moral, social. And implied, obligations. Again the phrase substance. Over form applies. Liabilities. Are recognized, in financial, statements, if they can be reasonably, estimated. And represent, obligations. To others. So. Second, transfer. Assets or provide, services. Most. Liabilities. Involve, an obligation, to transfer, assets in, the future an, obligation. To provide a service however is also a liability for example, having. Your tuition, check at the beginning of the semester your, college, or university now. Has a liability, to you to provide a top-notch, education during. The semester and. Finally. Past transactions. Or events assets. And liabilities, arise, from transactions. Or events that have already happened, consider. A company that expects, to pay eighty thousand, dollars next, year for, the electricity, that it will use throughout the next year if the, world ends, on December, 31st of this year does. The company have to pay the eighty thousand dollars no. Because. The transaction. The actual, use of the electricity. Will not occur until next year thus. Says of December, 31st, this, year the company would not report, the eighty thousand dollars as a liability, there, would be a liability however. If electricity. Had already been used but not yet paid for. Liabilities. Are sources, of the funds a company has used to acquire its assets, for, example. Businesses, frequently, by goods on credit rather than paying cash thus, creating, a liability called, accounts, payable in, addition. Businesses. Often borrow. Money from banks and other lenders for, various purposes, such as purchasing, land new machinery or equipment or, additional, merchandise. Now. Loans may be short-term, less, than a year or. Long-term, and unlike, accounts, payable, they, usually require, the payment of interest to the lender, other. Liabilities result. From incurring expenses that, are yet to be paid in cash such, as wages payable and interest payable, now. Liabilities. Generally, are grouped on the balance sheet according to their due dates with, short term liabilities listed. First, for, example, accounts. Payable that's the amount due to suppliers or probably due to be paid within 30 to 60 days in. Contrast. Some of the long-term notes, and debentures, don't have to be paid for 30 years. Now. Quantifying. The amount of a liability can require extensive, judgment, as one. Example consider, the difficulties. Faced by a company, in quantifying, its obligation. To clean up a toxic waste site in, many. Cases, the cleanup will take years, to complete the. Exact, extent, of the environmental damage at the site is still unknown and, legal. Responsibility. For the toxic, mess is still, in dispute. Properly. Valuing, a company's, liabilities. Is one of the biggest if not the biggest, challenge. That an accountant, can face. You. The, remaining claim against, the assets of a business, after, the liabilities. Have been deducted is owner's, equity, thus, owner's. Equity is a residual, amount it represents. The net assets, total assets, minus total liabilities, available. After all obligations. Have been satisfied. Obviously. If there are no liabilities. An unlikely, situation except.
At The start of a business then. The total assets, are exactly. Equal to the owners claims against those assets the owner's, equity in. Order. To get a business started investors. Transfer, resources, usually cash, to the business, in return, for part ownership, ownership. Of a company can be restricted, to one person, a sole, proprietorship, to. A small group a partnership. Or to. A diverse, group of owners who often, don't even know one another a corporation. When. Owners initially. Invest money in a corporation, they, receive, evidence of their ownership in the form of shares of stock represented, by stock certificates. These. Shares, of stock may then be privately, traded, among existing owners of the corporation. Privately. Sold to new owners or, traded. Publicly on an organized stock exchange like, the New York Stock Exchange or, coca-cola shares, are traded or the Nasdaq exchange. Where, Apple shares are traded in a. Corporation, the difference, between assets. And liabilities, is referred, to as stockholders, or shareholders. Equity or owner's, equity in. Presenting. The owners equity on the balance sheet a distinction. Is made between the, equity, originating, from the stockholders, investments. Referred. To as contributed, capital or paid in capital and the, equity, originating. From earnings, referred, to as retained, earnings. Owner's. Equity increases. When owners make additional, investments in a business that is when they pay in more, capital, or, when the business generates, profits, that are retained in the business. Owners. Equity decreases, when. The owners take back part of their investment, if the. Business is a corporation. Distributions. To the owners the stockholders. Are called dividends. Owner's. Equity also, decreases. If operations. Generate, a loss instead. Of a profit, in the, extreme, very. Poor performance can, result in the loss of all the assets originally, invested, by the owners, now. For corporation. The amount of accumulated, earnings of the business that have not been distributed. To owners is called retained, earnings, the. Portion, of owner's equity contributed. By owners in exchange, for shares of stock is called paid, in capital, the. Amount of retained earnings plus the amount of capital stock, equals, the corporation's, total, owner's equity as an, example consider ExxonMobil. As of. December, 31st 2017. They, reported, paid in capital of fourteen, point seven billion dollars and retained. Earnings of just over four hundred and, fourteen. Billion dollars they. Have been retaining, those earnings since 1870. When john d rockefeller. Formed, Standard Oil Company, contrast.
That With Microsoft. Which has been retaining, earnings only since 1976. Their. Retained earnings balance as of September 20th 2017. Was just over ninety, eight million dollars so, now we are back to the accounting, equation assets. Equal. Liabilities plus. Owner's equity the. Resources, of a company and the sources, of those resources. Some. Of those resources come, through investment, by owners paid in capital some. Of those resources come, through profitable, operations, retained, earnings, and some. Of those resources, result, from obligations. To repay money to creditors, or to provide services, those are liabilities as. We. Proceed further down this accounting, road it is important, to hold on to the fact that the accounting, equation must balance, always. Always. That, equality is going to make things so, much easier as we, go further down the road. You.