What is Accounting?
Accounting is the process of systematically recording financial transactions in a business. It also involves summarizing, analyzing, and reporting the financial information to its stakeholders.
Accounting in simple terms is the language of business. It is very important to maintain proper accounts for any business as it helps provide transparent and reliable data and information to make important business decisions.
Accounting consists of 2 processes: Book-Keeping, Management reporting
Book-Keeping is the process of recording and summarizing financial information. It involves recording day to day transactions (like sales, purchases, expenses etc.) and summarizing this information in the form of financial statements. Book-Keeping is the most important process or the backbone of the accounting process.
Management Reporting involves data analysis and providing reliable and meaningful information to the management for performance assessment, future planning and decision making.
Why is it required?
There are number of interested parties who wants to look at the financial statements of an entity. Few of them are listed here:
What are the types of financial statements?
There are three types of financial statements which Companies must report periodically. They are
- Income Statement
- Balance sheet
- Cash flow statement
Let us discuss each of them one by one.
Income statement or profit and loss statement shows the entities incomes and expenses during a period. It shows how the revenues (top line) of the company has translated into net income (bottom line) during the period.
Corporate's are required to file their income statement with the regulatory authorities on a periodic basis (Annually and quarterly).
John has started a business of selling dress material with $1,000 on 1st January 2020. He purchases 100 meters of the material from his suppliers for $9 each.He sells this material for $20 each. At the end of the month, John has no material left. Apart from the material purchase, he incurred an additional expense of $100 in marketing his material. You as an accountant are required to prepare the Profit and loss account for John.
Profit and Loss account of John for the period 01st Jan 2020 to 31st January 2020
Revenue is the amount received on sale of goods. Revenue is also referred to as Sales, Turnover or Top-line. In our example, John sold 100 meters of dress material @ $20 per meter. Hence, his total revenue is $2,000.
Cost of goods sold(COGS) is the price paid for acquiring goods and services. COGS include all the direct costs (labor, material, overheads) associated with acquisition/manufacturing of goods and services.
In our example, John purchased 100 meters of dress material @ $9 per meter. Hence his total purchase cost or Cost of goods sold is $900.
Gross profit is the profit after deducting the cost of goods sold from total revenues/ sales generated during a period.
Gross profit= Revenues – Cost of goods sold.
Marketing Spend is a spend associated with sales of products and services. This is considered as an indirect spend. Indirect expenses are included in the income statement below the Gross profit. In the above example, John incurred a marketing spend of $100. Hence, it is included as an indirect expense in the income statement.
Net income is the profit generated by a Company after accounting for all expenses. In our example, it is $1000.
For simplicity, we have ignored the interest cost and taxes for calculating the net income
Balance sheet is the statement of Assets, liabilities and equity of a company as at a given date. It is a statement showing what an entity owns (Assets), what it owes to others (Liabilities) and what its owners have invested in the business (Equity).
Assets = Liabilities + Equity
This means that assets invested in the business are financed by liabilities (Operating liabilities and Debt) and Equity.
Continuing with our previous example, lets assume that John had invested $1000/- equity in his business. On the day of investment his balance sheet would look like this.
Balance sheet of John as on 1st Jan 2020.
Let us discuss each of the items one by one.
Current assets are those assets which can be converted into cash within one year. They include: Cash and cash equivalent, Trade receivable, Inventory, prepaid expenses etc.
Non-current Assets include assets such as Property plant and equipment, Long term investments etc. which cannot be converted into cash (during the normal course of operations) within one year.
Total Assets is a sum of current and non-current assets
Current Liabilities are those liabilities which are expected to be paid within one year. These liabilities include: Trade payable/ creditors, Short term outstanding expenses, Short term debt etc.
Non-current liabilities are those liabilities which are expected to be paid after one year. It includes Long term debt, Pension, Post-retirement benefit liabilities etc.
Equity is the amount invested in the business by its owners.
Equity = Total Assets – Total Liabilities
Now coming back to our example, John had invested $1,000 in the business. His balance sheet will look as shown above. Equity will be $1,000 and cash/Assets will be $1,000 cash.
Once he buys the dress material for $900 his balance sheet will look as under.
Balance sheet of John as on 1st Jan 2020.
$1,000 cash gets reduced to $100, as he paid $900 for the dress material.
The dress material purchased becomes his inventory of $900 in the balance sheet.
In the next one month, John sells off all the inventory and earns a net profit of $1000. His balance sheet on 31st January will look like this.
Balance sheet of John as on 31st Jan 2020.
His inventory gets converted to revenues of $2,000. Out of
which he pays $100 for marketing spend. That means his cash balance would
increase by $1,900.
Closing cash balance for John would be $100 + $2,000 - $100 = $2,000
Inventory gets reduced to NIL.
Equity increases by $1,000 which is the net profit earned during the period.
Closing Equity = Opening Equity + Net profit
Closing Equity = $1,000 + $1000 = $2,000
Cash flow statement
Cash flow statement is the third financial statement. It is an important statement to report as it shows how efficiently a company manages its cash. It shows how much cash a company has generated from its operations and how much of it was spent and retained during a period.
Type of Cash flows
Cash flow Statement has 3 parts:
- Cash flows from operating Activities
- Cash flows from Investing Activities
- Cash flows from financing Activities
Cash flows from Operating Activities (CFO) is the most important part of a cash flow statement. It shows how much cash a company has generated from its operations.
Cash flows from Investing Activities (CFI) shows the cash spent by the company for future growth.
Cash flows from Financing Activities (CFF) includes raising and repayment of capital (through equity or by debt).
To learn more, Please refer our blog on CASH FLOW STATEMENT: EXPLANATION AND EXAMPLE
Continuing with our previous example. Let’s look at the cash flow statement of John on 01st Jan 2020 before he purchases the dress material.
There is no cash flow from Operating and Investing
Activities. John has financed his business with $1000 equity. Hence cash flows
from Financing Activities would be positive $1000.
Opening cash is NIL and closing cash is $1,000 funded in the business.
Now, once he purchases the dress material, his cash flow statement would look like this.
$900 used in purchasing dress material is a cash outflow for John from Operating Activity. Closing cash left in the business is $100.
At the end of the month, John’s cash flow statement would look like this.
$1000 earned in the business or net income is a cash inflow from operating activity. The inventory during this period reduced to NIL (see balance sheet above). This decrease is a cash inflow of $900 for the business.
Summing these two up give the cash flow from operations, which is $1,900.
This when added to the opening cash balance gives the closing cash balance for John’s business: i.e. $2000/-. This balance should match with what we have in the balance sheet
To become an expert in financial analysis and modeling techniques, you need to master the skills through Financial Analyst courses.
Good luck, keep learning!!
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