Tuesday, June 16, 2015

Basic Accounting and Finance

Accounting is internally and operationally oriented. It mostly deals with transactions that have taken place and data that's been recorded.
It also includes preparing, presenting and interpreting financial statements.

Finance is more strategically oriented. It often involves factors external to the organisation, and its activities are aimed at aiding decision making.
Finance deals with planning related and futuristic information.
Finance areas include short-term and long-term financing, management and control of assets and investments, and determining and managing project risks.

Types of Accounting
1) Cash Based - In this type, business records cash inflow and outflow.
2) Accrual Based - In this type, business records sales revenue as soon as the sales is made, regardless of when the customer pays.

Cash based accounting is inadequate for most businesses, as they sell and buy on credit, carry inventories, invest in long term operating assets or make long term commitments such as employee pensions.

Cash based accounting is okay for personal accounts, businesses usually have accrual based accounting.

Types of record keeping documents
1) Journal - A book that records a businesses transaction in chronological order. Journalization is the daily recording of debits and credits.
Journals - also referred to as the 'books of original entry' - are where all the transactions are entered first. Businesses may maintain separate journals for different types of transactions for e.g. sales journal for recording sales transactions etc.

2) Ledger - The ledger - or General Ledger, as it is sometimes called - is distinct from a journal. The ledger is where the various accounting entries are sorted into their appropriate accounts. This is called 'Posting to the ledger'. The ledger is the 'book of final entry' and all financial statements are prepared from it.

Types of Risk
Default Risk - refers to the likelihood that you will fail to get your money back or receive the return you are due. Assessing this risk means deciding if the company in which investment is made is likely to default.

Inflation Risk - refers to the chances that predictable overall economic rise in prices for goods and services will cause the investments to loose some of its value. Investment in long term ventures presents greater inflation risk than short term ventures.

Maturity Risk - refers to the gamble taken when investors tie up their cash in investments that require a set period. When money in tied up in long term investments, it cannot be used for other, perhaps more profitable purposes.

Liquidity Risk - refers to the possibility that an investment may need to sold to free up cash. An investment's liquidity is how readily it can be converted back to cash prior to maturation, or if that's even possible. The easier it is to sell off asset when needed, the lower the liquidity risk.

Accounting Principles
Business Entity Principle - As per this principle the purpose of accounting is to keep records of the transaction only for the organization, not for the people involved.

Money Management Principle - Considers only the financial aspects of the business (such as gross profit, net profit etc.), allowing simple evaluation and comparison.

Going Concern Principle - Maintains businesses will operate over an extended period, so valuation of assets can be simplified.

Cost Based - Use the price originally paid for an item for accounting purposes, as it's a convenient and objective value.

Realization Principle - Holds that revenue should be recorded at the time goods or services are delivered (i.e Accrual based accounting).

Basic Accounting  Equation
Assets = Liabilities + Owner's Equity

Three Financial Statements - Characteristics

Earnings Statement, P&L Statement
   => Statement for a given period of time.
   => It is is the statement of Profit.
   => Shows net profit (or losses) as the difference between revenues and expenses
   => Shows the profitability and the operations of a company over a specific period of time
Cash Flow Statement
   => Statement for a given period of time.
   => It is the statement of Liquidity.
   => Shows the actual cash inflows and outflows from operating, investing, and financing activities.
   => Shows the change in cash balances for a specific period of time.

Balance Sheet
   => Statement at a point in time.
   => It sums up the financial condition.
   => Shows the financial position of a company at a certain point in time
   => Balances assets owned by a company with its liabilities plus owners' (or shareholders') equity

Relationship between the statements
Net Income from Earnings Statement is used to calculate the Cash Flow Statement. It is the first line in the Cash Flow Statement.
Net Cash at the end of Cash Flow statement is used as a Current Cash in the Balance Sheet statement.
Net Income from Earnings Statement is used as Retained Earnings in Balance sheet (assuming no dividends are paid).

Some other points
Revenue => Something which is recognized when the transaction takes place (i.e. the Customer receives the value). This principle of recognizing revenue when a transaction takes place is called 'Accrual Based Accounting', this is the method that is generally accepted by all major Accounting standards.
The other principle of recognizing revenue when the actual cash is received is called 'Cash Based Accounting', this is not preferred method of accounting.
Mainly because so many business work on credit nowadays.

Receipts => Actual receipt of the cash. May be at a different date than the revenue recognition date, generally later.

Income Statement (Profit & Loss Statement
Gross profit  = Net revenue - cost of goods sold
Operating income =  Gross profit - operating expenses
Net income  = Operating Income - Expenses - Taxes

Balance Sheet
Balance sheet should represent the equation
Assets = Liabilities + Equity
Assets = Current Assets + Fixed Assets
Liabilities = Current Liabilities + Long Term Liabilities
Equity = Shareholder's Equity Investment + Retained Earnings
Retained Earnings = Previous Retained Earnings + Net Income - Dividends Paid.

Cash Flow Statement
Cash flow statement is required because normally the 'Accrual Based' accounting is followed, which doesn't give true picture of the Cash.
If 'Cash Based' accounting is followed then there would be no need to generate a Cash flow statement.

1) Operating Activities - show cash transactions that create revenues and expenses. Often these related to current assets and liabilities.
( Current Asset is one that can be easily converted to cash. Example of current assets are Cash, Bonds, Accounts Receivable
  Current Liability are obligations that need to be settled within within one year or less (or to be settled in same fiscal year).
  Example of current liabilities are Short term bank loans, Account Payable, Wages Payable, Tax Payable, Interest Payable)
Cash flows in from the sale of goods and services, from interest on loans, and from dividends received.
Cash flows out to suppliers for inventory, to employees for wages, to the government for taxes, to lenders for interest on loans, and to others for various expenses.

2) Investing Activities - show cash transactions that affect fixed assets.
(Fixed assets, also referred to as long term assets, are assets used by organization that won't be converted to cash immediately.
 Fixed assets are those that an organization needs to produce goods and services. For example property, plant and equipment are fixed assets).
Cash flows in from the sale of property, plant, and equipment; from the sale of debt or equity securities of other businesses; and from the collection of principal on loans to other businesses.
Cash flows out to purchase property plant, and equipment; to purchase debt or equity securities of other businesses; and to make loans to other companies.

3) Financing Activities - show cash transaction related to long-term liabilities and equity financing.
( Long term liabilities are obligations that won't be fulfilled within the next 1 year (or fiscal year).
  Example of Long term liabilities are mortgages that persist over a number of years, bonds payable, pensions
  Equity financing encompasses cash provided by Owner/Shareholder and Dividends paid)
Cash flows in from the sale of the company's own stock and from issuing bonds and notes.
Cash flows out to stockholders as dividends, to repay long-term debt, and to repurchase the company's own stock.

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