Why a business exists?
- In accounting, this is called the “going concern”
- The going concern is the assumption that the business will operate, carry our its objectives, and pay all their obligations
- Business do not need to make profit; but the purpose is to make a profit
- Profitability is the capacity for the business to create internal value through its operations by generating more sales than expenses
Why does accounting exists?
- There must be a universal way for every business in the world to have a standard in which the financial transactions are recorded in order to measure Profitability (and other concepts to follow) for businesses.
- Not all businesses are operated by the owners. Many investors (such as the entire stock market) want to understand the businesses they are investing into based on their financial measures, such as profitability and others. Financial Reports must be Reliable, Consistent, and Comparable in order to make informed investment decisions
- Accounting is designed to record (and balance) every transaction with a double-entry system
Accounting Principles
- Economic Entity: the business is a separate/independent entry from the owners
- Monetary Unit: economic activity is measured in a currency, such as USD $
- Time Period: it is assumed that the business can report their financial activities in a standard periodic matter, and this is clearly stated
- Cost Principle: all transactions are evaluated at the price they were paid for, not the current market value or other objective approaches of measurement
- Full disclosure: when financial statements are made public or given to an investor/lender; certain additional notes are required to disclose information “beyond the numbers” such as whether there is an outstanding lawsuit threatening the business capacity to exist in the future
- Going Concern: it is assumed that the business plans to continue to operate and meet its obligations
- Matching Principle: expenses need to match the sales related to those activities. This is the pillar for Accrual-Basis method accounting
- Materiality: because accounting in a lot of ways is making “estimated summaries” of large amounts of financial information. Accountants must always report all Material (or significant) amounts
- Conservatism: in principle, accounts must take a conservative approach to recognizing income.
- Revenue Recognition: Sales/Income is recognized when earned
Double-Entry Accounting System
- The principal subject matter being measured in accounting is Money (although sometimes we measure non-monetary assets, but in their historical monetary cost) and every transaction will affect 2 or more accounts
- Accounts are different category from our Financial Statements in which we organize all transactions into. Accounts will fall into one of these 8 major categories: Assets, Liabilities, Equity, Income, Cost of Goods Sold, Expense, Other Income, or Other Expenses.
- Every transaction will have at least one Debit and one Credit.
- Debits are used increase the value of our assets and increase our expenses. And credit decrease the value of assets and expenses
- Credits increase the value of our sales, liabilities, and equity.
- In QuickBooks, you do not have to worry about Debits/Credits unless you are doing a journal entry
Profit & Loss
- This report ultimately calculates Net Income; which is the “bottom line” of the business.
- Profit & Loss explains the activities during a period of time or a range of dates. These are temporary values, expected to be different in different periods of time
- Profit & Loss tells the story on how the business operates in a day-to-day basis such as what you sold and what expenses you had paid for
- Components:
–Sales: AKA Revenues or Income
–Cost of Goods Sold: AKA Direct Expenses such as the cost of all the product/inventory being sold, direct job materials, subcontractors, all cost associated with making a sale or preparing the product to be sold
–Gross Profit: (Calculated amount of Sales – Cost of Goods Sold)
Gross Margin is the percentage of gross profit as a proportion to Sales
–Expenses: indirect expenses, typically the overhead required to run the business such as Rent, Payroll, Office Supplies, etc.
–Other Income and Other Expenses: extraordinary income and expense items that are not part of the normal operations
–Net Income: this is the bottom line and the number that matters, often referred to as “profit”
Balance Sheet
- This report is always calculating the accumulated value of what the business OWNS and the business OWES. To ultimately arrive to the Net Worth (equity) of the business
- The Balance Sheet explains the financial health of a business at a specific point in time, Balance Sheets always display one day (not a range of dates) and its considered to be a snapshot at a single moment in time.
- The Balance Sheet accounts have permanent value, which means they accumulate (increase or decrease) over time, but measured from inception of the business
- The Balance Sheet is connected to the Profit and Loss by the Net Income. Net Income accumulates into the Equity or Net Worth section of the Balances Sheet
- Components:
–Assets: What the business owns. In cash or other measurable investments that could be converted into cash. Assets are listed in order of liquidity- Current Assets are cash (bank accounts or cash on hand), inventory, accounts receivables (open invoices), and other components of value that can be or will be exchanged for cash within an operating cycle (1 year typically)
- Fixed Assets permanent investments into the business into tangible assets that help the business generate income, such as a building, machinery, vehicle, etc.
- Other Assets is something of value owned by the business which is not expected to be turned into cash (liquidated) within an operating cycle (so typically over 1 year)
–Liabilities: What the business owes. These are claims by 3rd parties against the business’ cash or assets. Liabilities are listed in order of liquidity (how fast they need to be paid)- Current Liabilities are forms of short-term debt such as Credit Cards (that must be paid within 30 days most of the time), Accounts Payable (which is when a vendor lets you purchase on terms), or a Bank’s Line of Credit
- Long Term Liabilities are forms of long-term debt which entire principles does not have to be paid within a operating cycle (typically over 1 year). A mortgage or car loan are good examples
–Equity: This is the difference between Assets and Liabilities. Consequently, Equity is also the sum of Owner’s Capital (what the owners invest into the business minus what they distribute in form of dividends or owner’s draw) and Net Income (profit from the Income Statement) that turns into Retained Earnings if not distributed to owners
Why a business exists (what do we measure)?
- Profitability is the capacity for the business to create internal value through its operations by generating more sales than expenses
- Ultimately, the owners of the business want to enjoy the fruits of their investment by DISTRIBUTING these profits among the owners if the business is liquid
- Liquidity is the capacity for the business to pay all its short term obligations and have some cash left over to continuing to operate.
- Solvency is when the business has more assets than liabilities. An insolvent business is by definition a bankrupt business
Accrual vs Cash Basis Accounting
- Cash Basis means that we will only report sales as we receive payments and expenses as we pay them.
- Many taxpayers are “cash basis” for the purposes for filling tax returns, but they can still manage their business and accounting in accrual basis
- Accrual basis means we recognize sales when they are earned regardless of us receiving a payment or not. Expenses are recognized as they are incurred regardless of us paying them
- Accrual basis wants to measure activities not payments. If an item is sold on terms (but the client will pay you 30 days later) the sale is recorded (Credit Sales) and the Accounts Receivable (Debit Accounts Receivable Asset) is recorded to track that open invoice. At the same time, when an expense is incurred by making a purchase on credit (that our vendor allows us 15 days to pay) the expense is recorded (Debit Expense) and the debt is recorded as well (Credit Accounts Payable Liability)
Journal Entries
- Are used to create adjustments to accounts that QuickBooks calculated to a different amount that the desired amount the Accountant determines based on their knowledge of the business activities and the application of Accounting principles
- Debit/Credits are used to adjust accounts:
–Debits are used increase the value of our assets and increase our expenses. And credit decrease the value of assets and expenses
–Credits increase the value of our sales, liabilities, and equity.
- Debits and credits must balance in order to maintain integrity on the double-entry accounting system. QuickBooks will not let you save a journal entry until its balanced
