Basics of Accounting Basics of Accounting (The Language of Finance)(The Language of Finance)

Business & AccountingBusiness & Accounting

Accounting is the universal language of Business and Accounting is the universal language of Business and Fiance.Fiance.More CEO’s from fortune 500 companies have come up More CEO’s from fortune 500 companies have come up through the ranks of accounting than from any other area through the ranks of accounting than from any other area in business. Currently: 54%in business. Currently: 54%Small businesses usually fail because of poor accounting Small businesses usually fail because of poor accounting understanding.understanding.Marriages usually fail because of poor financial Marriages usually fail because of poor financial management (80% of divorces are $$$$ related.)management (80% of divorces are $$$$ related.)If you want to get ahead in business & marriage If you want to get ahead in business & marriage determine that you are going to understand accounting determine that you are going to understand accounting basics.basics.

TermsTerms

Assets:Assets: Tangible and Non-tangible Tangible and Non-tangible resources of a business that have future value. resources of a business that have future value. Usually sub-classified as follows:Usually sub-classified as follows: Quick Assets (Liquid Assets)Quick Assets (Liquid Assets)

Cash – Petty Cash – Receivables - SecuritiesCash – Petty Cash – Receivables - Securities Current Assets (Turn into cash/use annually)Current Assets (Turn into cash/use annually)

All the above + Inventories, SuppliesAll the above + Inventories, Supplies Fixed Assets (Depreciated over several yrs.)Fixed Assets (Depreciated over several yrs.)

Buildings, Equipment, Natural ResourcesBuildings, Equipment, Natural Resources Land (Fixed, but never depreciated)Land (Fixed, but never depreciated) Intangible Assets: Patents, Trademarks, CopyrightsIntangible Assets: Patents, Trademarks, Copyrights

What are your Assets?What are your Assets?

Bank Account & Money in your pocketBank Account & Money in your pocketCarCarClothesClothesBooksBooksStocks/Bonds/CD’sStocks/Bonds/CD’sPrepaid rentPrepaid rentComputers & Electronic Equip.Computers & Electronic Equip.Knowledge????Knowledge????Abilities????Abilities????

Accounting Term: LiabilitiesAccounting Term: Liabilities

Other people’s claims against your assets!Other people’s claims against your assets! What you owe!! Debts!What you owe!! Debts! Classified as:Classified as:

Current Liabilities (one year debt)Current Liabilities (one year debt) Credit Card Debt, Accounts PayableCredit Card Debt, Accounts Payable

Long Term LiabilitiesLong Term Liabilities Car, Mortgage, Note PayableCar, Mortgage, Note Payable

Unearned revenuesUnearned revenues

Bonds (usually super long term)Bonds (usually super long term)

What are your liabilities?What are your liabilities?

School LoanSchool Loan

Car LoanCar Loan

Credit Card BalanceCredit Card Balance

J.C. Penny AccountJ.C. Penny Account

BYU-Idaho Amount DueBYU-Idaho Amount Due

Capital or Owners EquityCapital or Owners Equity

The portion of your assets that you can legally claim. The portion of your assets that you can legally claim. (Net Assets) What you really own legally.(Net Assets) What you really own legally.Assets – (minus) Liabilities = CapitalAssets – (minus) Liabilities = CapitalExample (purchased a building for $500,000 with a 10% Example (purchased a building for $500,000 with a 10% down payment ($50,000)down payment ($50,000)

Cost of a building (sales price = Cost of a building (sales price = Asset amountAsset amount) $500,000) $500,000 Less: What you still owe on the building (Less: What you still owe on the building (LiabilityLiability) $450,000) $450,000 Equals: Your equity in the building (Equals: Your equity in the building (CapitalCapital) or your net worth ) or your net worth

in the building. $50,000in the building. $50,000

Formula universally used in all financial and personal Formula universally used in all financial and personal financial institutions:financial institutions:

Assets = Liability + Owners Equity (Balance Sheet Assets = Liability + Owners Equity (Balance Sheet Equation)Equation)

(Resources you have) =(What you owe on them) + (the principle (Resources you have) =(What you owe on them) + (the principle you have paid on them.)you have paid on them.)

Owners Equity Account TitlesOwners Equity Account Titles

Single Proprietorship: Single Proprietorship: CapitalCapital

Corporation: Corporation: Common Stock (what owners paid in)Common Stock (what owners paid in) Preferred Stock (what owners paid in)Preferred Stock (what owners paid in) Retained Earnings (profits that the business Retained Earnings (profits that the business

keeps in the business)keeps in the business)

What is your net worth???What is your net worth???

What you have minus what you owe.What you have minus what you owe.

What format do we use in business and in What format do we use in business and in personal finance to show our net worth?personal finance to show our net worth? A A Balance Sheet Financial StatementBalance Sheet Financial Statement

List of Assets (classified by type in accounts)List of Assets (classified by type in accounts)

Compared or balanced with:Compared or balanced with: List of Liabilities and Owners Equity (classified by type List of Liabilities and Owners Equity (classified by type

and in accounts)and in accounts)

Text Book Example Page 74Text Book Example Page 74

Example (Simplified)Example (Simplified)

John Doe’s Business or Personal Records John Doe’s Business or Personal Records Balance Sheet Balance Sheet

September 10, 2003September 10, 2003Assets:Assets:

Current:Current:Cash at HomeCash at Home $100$100Cash Deposits in BankCash Deposits in Bank 500 500

Fixed:Fixed:Wardrobe Wardrobe 20002000EquipmentEquipment 10001000CarCar 50005000

Total Assets:Total Assets: $8,600Liabilities:Liabilities:

Current:Current:Credit Card PayableCredit Card Payable $500$500

Long Term:Long Term:Note Payable (on Car)Note Payable (on Car) $2000$2000

Total LiabilitiesTotal Liabilities $2,500$2,500Capital, John Doe:Capital, John Doe: 6,100 6,100Total Liabilities & Owners EquityTotal Liabilities & Owners Equity: : $8,600$8,600

Other TermsOther Terms

Temporary Accounts are used in addition to Temporary Accounts are used in addition to balance sheet accounts to record changes in balance sheet accounts to record changes in owners equity each reporting period.owners equity each reporting period. Expenses – Decrease in owners equity during the Expenses – Decrease in owners equity during the

period by using up an asset or a portion of an asset. period by using up an asset or a portion of an asset. (or creating additional liabilities)(or creating additional liabilities)

Revenue – Increase in owners equity during the Revenue – Increase in owners equity during the period by performing a service or selling an asset.period by performing a service or selling an asset.

Drawing or Dividends – Decrease in owners equity Drawing or Dividends – Decrease in owners equity due to personal withdrawals by the owner(s).due to personal withdrawals by the owner(s).

Income Statement ReportIncome Statement Report

Used to determine the net income or net Used to determine the net income or net loss of an individual or business for a loss of an individual or business for a defined period of time.defined period of time. Used for marking progress by comparing Used for marking progress by comparing

months and yearsmonths and years Used by financial institutions for determining Used by financial institutions for determining

the progress and status of a company or the progress and status of a company or individuals financial health.individuals financial health.

Used by the IRS for determining taxesUsed by the IRS for determining taxes

Income Statement – What does it Income Statement – What does it contain?contain?

Matches Expenses with Revenues for a specific Matches Expenses with Revenues for a specific period of time. (Only the temporary type of period of time. (Only the temporary type of accounts are on the income statement.) No accounts are on the income statement.) No Assets/LiabilitiesAssets/Liabilities

Income Statement accounts are closed out at Income Statement accounts are closed out at the end of the reporting period and started over the end of the reporting period and started over again the next period….so comparisons can be again the next period….so comparisons can be made.made.

Personal Income Statement sometimes called a Personal Income Statement sometimes called a Cash Flow Statement example on page 78.Cash Flow Statement example on page 78.

Income Statement – ExampleIncome Statement – Example

Name of Individual or businessName of Individual or businessIncome StatementIncome Statement

For period of time (Month of Sept. 2003)For period of time (Month of Sept. 2003)Revenue:Revenue: Income from JobIncome from Job $500$500 Income from Pell Grant Income from Pell Grant 2000 2000 Total Revenue:Total Revenue: $2500$2500Expenses:Expenses: Clothes ExpenseClothes Expense $300$300 Rent ExpenseRent Expense 200 200 Food Expense 50Food Expense 50 Tuition Expense 1200Tuition Expense 1200

Misc. ExpenseMisc. Expense 250 250 Total Expenses:Total Expenses: $2000$2000Net Income for September: Net Income for September: $ 500$ 500

How do individuals or businesses keep track for all How do individuals or businesses keep track for all their assets, liabilities, capital, expenses, their assets, liabilities, capital, expenses,

revenues. Etc.?revenues. Etc.?

The “Accounting Process” or otherwise The “Accounting Process” or otherwise known as the Accounting Cycle. (also known as the Accounting Cycle. (also called the “Audit Trail” of business.called the “Audit Trail” of business.Based on universally accepted accounting Based on universally accepted accounting principles. (Generally accepted principles. (Generally accepted accounting principles)accounting principles)Double Entry BookkeepingDouble Entry BookkeepingAccrual Accounting vs. Cash AccountingAccrual Accounting vs. Cash AccountingBookkeeping part of accounting.Bookkeeping part of accounting.

Accounting Cycle – Start with Accounting Cycle – Start with financial transactionsfinancial transactions

Verbs & Nouns for each stepVerbs & Nouns for each step

#1 Analyze Source Documents#1 Analyze Source Documents Check, receipts, invoices, deposit slips, etc.Check, receipts, invoices, deposit slips, etc. Decide what accounts they representDecide what accounts they represent

#2 Enter (journalize) data in the journal.#2 Enter (journalize) data in the journal. Chronological record of transactionsChronological record of transactions Book of original entry – checks and balancesBook of original entry – checks and balances Two or more accounts entered at costTwo or more accounts entered at cost

Accounting CycleAccounting Cycle

#3 Post from the journal to the individual ledger #3 Post from the journal to the individual ledger accounts. (to keep a running balance of each accounts. (to keep a running balance of each account)account) Ledger divided up into these different accounts:Ledger divided up into these different accounts:

Assets (100 accounts)Assets (100 accounts)

Liabilities (200 accounts)Liabilities (200 accounts)

Capital/Owners Equity (300 accounts)Capital/Owners Equity (300 accounts)

Revenues (400 accounts)Revenues (400 accounts)

Cost of Goods Sold (Expense) – (500 accounts)Cost of Goods Sold (Expense) – (500 accounts)

General Expenses (600 accounts)General Expenses (600 accounts)

Accounting Cycle #4Accounting Cycle #4

Adjust the necessary accounts to bring Adjust the necessary accounts to bring them up to date.them up to date. Requires internal transactionsRequires internal transactions Requires journal entries & posting as wellRequires journal entries & posting as well Example: Maybe some of your Supplies Example: Maybe some of your Supplies

valued at $500 when you bought them have valued at $500 when you bought them have been used…you need to bring their value up been used…you need to bring their value up to date and expense what has been used.to date and expense what has been used.

Example: Depreciation of EquipmentExample: Depreciation of Equipment

Accounting Cycle #5Accounting Cycle #5

#5 At the end of the period or at any time #5 At the end of the period or at any time (with computers) balance all of the (with computers) balance all of the accounts in a trail balance. (Checks and accounts in a trail balance. (Checks and balance step to see if all of your journal balance step to see if all of your journal entries and posting was correct.)entries and posting was correct.) The trail balance is a list of all of your The trail balance is a list of all of your

accounts with balances.accounts with balances. The total of the debit balances must equal the The total of the debit balances must equal the

total of the credit balances.total of the credit balances.

Accounting Cycle #6 & 7 & 8 Accounting Cycle #6 & 7 & 8

#6 Prepare the Financial Statements#6 Prepare the Financial Statements Income StatementIncome Statement Statement of Changes in Owners EquityStatement of Changes in Owners Equity Balance SheetBalance Sheet

#7 Close out all the temporary accounts #7 Close out all the temporary accounts to zero, so that you can start a new to zero, so that you can start a new period/cycle.period/cycle. Requires journal entries and postingRequires journal entries and posting 8. Prepare a Post-closing trail balance8. Prepare a Post-closing trail balance

The Balance Sheet and Debits and CreditsThe Balance Sheet and Debits and Credits

Balance Sheet EquationBalance Sheet Equation A = L + OEA = L + OE

Use of another checks & balance methodUse of another checks & balance method Debits and Credits are terms used to increase or Debits and Credits are terms used to increase or

decrease various accounts and show balances.decrease various accounts and show balances. All Accounts have either a debit or credit balance.All Accounts have either a debit or credit balance. Assets/Expenses/Withdrawals have debit balancesAssets/Expenses/Withdrawals have debit balances

Increased by debiting and decreased by creditingIncreased by debiting and decreased by crediting Liabilities, Capital, and Revenues have credit Liabilities, Capital, and Revenues have credit

balances.balances.Increased by crediting, and decreased by debitingIncreased by crediting, and decreased by debiting

The best way to learn:The best way to learn:

Complete a simplified practice set that Complete a simplified practice set that covers the entire accounting cycle.covers the entire accounting cycle.Work in partnership with another student Work in partnership with another student and the teacher. Use a pencil!and the teacher. Use a pencil!Final product: Do your own set of Final product: Do your own set of personalized financial statements.personalized financial statements.Problem due on Friday 1/16/04. Quiz over Problem due on Friday 1/16/04. Quiz over the accounting language and Accounting the accounting language and Accounting Cycle on Friday.Cycle on Friday.

Separate Entity Principle Separate Entity Principle (Keep your business records separate (Keep your business records separate

from you personal records)from you personal records)

Lets start a home building business.Lets start a home building business.

First TransactionFirst Transaction Pull $10,000 savings out of your personal Pull $10,000 savings out of your personal

account and put it into your business account.account and put it into your business account. Assets = Liabilities + Owners EquityAssets = Liabilities + Owners Equity

Cash Cash = 0 = 0 CapitalCapital

10,00010,000 10,00010,000

22ndnd Transaction Transaction

Acquire a Loan of $50,000 to buy Acquire a Loan of $50,000 to buy materials to build a spec home for resale.materials to build a spec home for resale.

Assets = Liabilities + OEAssets = Liabilities + OE

Cash Loan Payable CapitalCash Loan Payable Capital

$60,000 $50,000 $10,000$60,000 $50,000 $10,000

($10,000 + $50,000)($10,000 + $50,000)

33rdrd Transaction Transaction

Purchased a lot to build a home. Cost: Purchased a lot to build a home. Cost: $8,000.$8,000.

Assets = Liabilities + OEAssets = Liabilities + OE

Cash Loan Payable + CapitalCash Loan Payable + Capital

$52,000 $50,000 $10,000$52,000 $50,000 $10,000

LandLand

$8,000$8,000

4thTransaction4thTransaction

Paid a concrete subcontractor to put in a Paid a concrete subcontractor to put in a foundation. (Cost $6,000)foundation. (Cost $6,000)

Assets = Liabilities + O.E.Assets = Liabilities + O.E.CashCash Loan Payable CapitalLoan Payable Capital$46,000$46,000 $50,000 $50,000 $10,000 $10,000Home in progressHome in progress$6,000$6,000LandLand$8,000$8,000

55thth Transaction Transaction

Purchased building materials to build your home. Cost Purchased building materials to build your home. Cost $16,000$16,000Assets = Liabilities + Owners EquityAssets = Liabilities + Owners Equity

CashCash Loan Pay. Loan Pay. CapitalCapital$30,000 $30,000 $50,000$50,000 $10,000$10,000Building MaterialsBuilding Materials$16,000$16,000Home in progressHome in progress$6,000$6,000LandLand$8,000$8,000

66thth Transaction – Paid wages for Transaction – Paid wages for helper who helped to put $2000 of helper who helped to put $2000 of

materials into home.materials into home.CashCash L/PL/P CapitalCapital$29,000$29,000 $50,000$50,000

$10,000-------$10,000-------MaterialsMaterials Wages ExpenseWages Expense$14,000$14,000 ($1,000)($1,000)Home in progressHome in progress$8,000$8,000LandLand$8,000$8,000

77thth Transaction – Received $6000 Transaction – Received $6000 earnest money agreement from buyerearnest money agreement from buyer..

Cash Loan/PayCash Loan/Pay OE OE$35,000$35,000 $50,000$50,000 $10,000$10,000MaterialsMaterials Wages ExpWages Exp$14,000$14,000 ($1,000)($1,000)Home in ProgressHome in Progress RevenuesRevenues$8,000$8,000 $6,000$6,000LandLand$8,000$8,000Total Assets Liabilities CapitalTotal Assets Liabilities Capital$65,000 = $50,000 + $15,000$65,000 = $50,000 + $15,000

Owners EquityOwners Equity

Two ways to increase this account:Two ways to increase this account: 1) New investments in the business1) New investments in the business

Cash InvestmentsCash InvestmentsEquipment InvestmentsEquipment Investments

2) Revenues earned in the business2) Revenues earned in the business

Two ways to decrease this account:Two ways to decrease this account: 1) Expenses (Using assets up to generate a 1) Expenses (Using assets up to generate a

profit or incurring new liabilities)profit or incurring new liabilities) 2) Taking money out of the business for 2) Taking money out of the business for

personal use.personal use.

Debits and CreditsDebits and Credits

Terms used to increase or decrease an Terms used to increase or decrease an account and keep everything in balance.account and keep everything in balance.

Assets = Liabilities + O.E.Assets = Liabilities + O.E.

IncreasesIncreases Increases Increases Increases Increases

(Debits) (Credits) (Credits)(Debits) (Credits) (Credits)

DecreasesDecreases Decreases Decreases Decreases Decreases

(Credits) (Debits) (Debits)(Credits) (Debits) (Debits)

Steps in the Accounting CycleSteps in the Accounting Cycle

1. Analyze the transaction source documents 1. Analyze the transaction source documents and decide what accounts are involved. What and decide what accounts are involved. What account needs to be increased and what account needs to be increased and what account needs to be decreased…..what account needs to be decreased…..what account(s) needs to be debited and what account(s) needs to be debited and what account(s) need to be credited.account(s) need to be credited.Examples of Source Documents:Examples of Source Documents: Deposit Slips, Invoices, Sales Slips, Contracts, Deposit Slips, Invoices, Sales Slips, Contracts,

memos, packing slips, electronic memos, etc.memos, packing slips, electronic memos, etc.

Source documents are usually kept on file (three Source documents are usually kept on file (three years) as backup for tax and company audits.years) as backup for tax and company audits.

Step #2 - Enter source document Step #2 - Enter source document data in a chronological journal. data in a chronological journal. (Data Entry on the Computer)(Data Entry on the Computer)

The Journal is called the book of original entry, The Journal is called the book of original entry, and is on the computer in most companies.and is on the computer in most companies. It gives the date of the transaction.It gives the date of the transaction. It gives a record of the accounts debited and credited It gives a record of the accounts debited and credited

in the transaction. (the accounts increased or in the transaction. (the accounts increased or decreased)decreased)

It gives the post reference number of the ledger It gives the post reference number of the ledger accounts involved. (after the transaction has been accounts involved. (after the transaction has been posted to the ledger accounts)posted to the ledger accounts)

Step #3 – Post (transfer) Step #3 – Post (transfer) transaction data from the journal to transaction data from the journal to

the individual ledger accounts.the individual ledger accounts.The “Ledger Accounts” are individual records of The “Ledger Accounts” are individual records of all the assets, liabilities, and owners equity all the assets, liabilities, and owners equity accounts.accounts.Each Ledger Account is updated daily and Each Ledger Account is updated daily and keeps a ongoing record of activity in the account keeps a ongoing record of activity in the account and balance of the account.and balance of the account.All data that goes into the ledger accounts must All data that goes into the ledger accounts must first be put into the journal and then posted from first be put into the journal and then posted from the journal to the ledger account on the day the the journal to the ledger account on the day the information is journalized.information is journalized.

Step #4 – AdjustmentsStep #4 – Adjustments

Adjustments are the internal transactions of a Adjustments are the internal transactions of a company that a good accountant will make to set company that a good accountant will make to set in order each account. They must be journalized in order each account. They must be journalized first and then posted to the ledger.first and then posted to the ledger.

Adjustments are usually made at the end of an Adjustments are usually made at the end of an accounting period.accounting period.

Examples: Depreciation, Use of pre-paid rent Examples: Depreciation, Use of pre-paid rent or insurance, interest earned or expensed, use or insurance, interest earned or expensed, use of supplies and materials, unearned revenues of supplies and materials, unearned revenues earned during the period.earned during the period.

Step #5 – Trial BalanceStep #5 – Trial Balance

Before preparing your statements, make Before preparing your statements, make sure that all of your accounts have the sure that all of your accounts have the correct balance.correct balance.

List of all accounts with debit and credit List of all accounts with debit and credit balances……DEBITS MUST EQUAL balances……DEBITS MUST EQUAL CREDITS.CREDITS.

If not in balance you must go back in your If not in balance you must go back in your audit trail and find your errors.audit trail and find your errors.

#6 Prepare your Financial #6 Prepare your Financial Statement – Income Statement, Statement – Income Statement,

Statement of OE, & Balance SheetStatement of OE, & Balance SheetThis is the main product of the accounting This is the main product of the accounting system that outsiders/investors/creditors system that outsiders/investors/creditors etc. will look at to see the financial health etc. will look at to see the financial health of your business.of your business.

These statements and how to read them These statements and how to read them and create profitability ratios from their and create profitability ratios from their numbers should become second nature to numbers should become second nature to a business owner, or anyone interested in a business owner, or anyone interested in finance. This knowledge is essential.finance. This knowledge is essential.

#7 – Close all the temporary #7 – Close all the temporary accounts and start over.accounts and start over.

Close the temporary accounts:Close the temporary accounts: All Expense AccountsAll Expense Accounts All Revenue AccountsAll Revenue Accounts All Drawing or Dividend accounts.All Drawing or Dividend accounts.

Transfer the net increases or decreases of these Transfer the net increases or decreases of these temporary accounts into the permanent owners temporary accounts into the permanent owners equity account of capital or retained earnings.equity account of capital or retained earnings.

This makes it possible for the company to start a This makes it possible for the company to start a new set of reports to compare with the old etc.new set of reports to compare with the old etc.

#8 Prepare a Post-Closing Trial #8 Prepare a Post-Closing Trial Balance.Balance.

A list of the accounts you start the new A list of the accounts you start the new accounting period with.accounting period with.

A check to see if Debits = Credits with A check to see if Debits = Credits with these continuing accounts.these continuing accounts.

If total DEBITS DO NOT EQUAL total If total DEBITS DO NOT EQUAL total CREDITS a mistake has been made and CREDITS a mistake has been made and needs correction.needs correction.