This is a series of posts about Accounting. They are simply a rearranged version of my notes and summaries while reading the textbook Financial Accounting: IFRS, 3rd edition by Jerry Weydgandt, Paul Kimmel and Donald Kieso. Taking the auto-education route myself, I know how important notes are to make sure I understand the material within a book ( or several of them). I know too, that sometimes you may need extraordinary level of commitment and motivation to keep going, especially when you get stuck as you will often do throughout your journey towards learning or mastering something.
And so, these posts are for my fellow autodidacts out there, who believe in themselves and who know from within that they don’t need anyone to ‘teach them’; they can learn it themselves. Keep Learning!
You have to know accounting. It’s the language of practical business life. It was a very useful thing to deliver to civilization. I’ve heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double entry bookkeeping was a hell of an invention.Charlie Munger
Although Accounting is one popular major across colleges, many businesses spend money to make their employees more ‘financially literate’. That often means, understanding ‘the numbers’. Which in turn, mean getting familiar with Accounting and its lingo.
Accounting Simply Defined
Here is the formal definition pulled out straight from the Financial Accounting Textbook 3rd edition (IFRS Edition):
Accounting basically is the process of identifying, recording and communicating the economic events (usually monetary transactions, more on that later on within the monetary unit assumption ) of an organization (often, a business, but also can be a non-profit or a government agency/subsidiary) to ‘interested users’.
Who Uses Accounting?
- External users: Debtors, Creditors, Investors/Shareholders, Government Agencies, etc..
- Internal Users: Managers, Decision Makers, etc..
When they prepare financial statements, accountants follow a well defined set of terms and guidelines. And depending on which country or jurisdiction the business is based in, these guidelines can differ.
We call these guidelines Accounting Standards, and they are set by either one of two organizations(also called accounting standard-setting bodies) The IASB(International Accounting Standards Board, its headquarters is in London) or The FASB(Financial Accounting Standards Board).
IFRS is one of these accounting standards. It is set and updated by the IASB and used by businesses in 130 countries. Businesses in the US however use GAAP(generally accepted accounting standards) which is another type of accounting standards set and updated by the FASB.
While in this post, I use IFRS, all the principles are applicable to GAAP as well.
The Measurement Principle
In IFRS, we either use the historical cost principle or the fair value principle when recording assets.
When using the historical cost principle, we must record asset at their original cost. For instance, if the company bought a 10 acre piece of land ten years ago at $2,500 per acre, then according to the historical cost principal, we must record the asset value as $25,000, even though the current market value of the land may have risen over time(to say $3,150 per acre).
On the other hand, if we choose to follow the fair value principle, we must report assets and liabilities at fair value. Fair value means the current market price to sell an asset or settle a debt.
There is a trade-off when choosing between using either the historical cost principle or the fair value principle: a trade-off between relevance and faithful presentation.
Generally, and because IFRS allows the usage of both principle, companies choose to use the fair value principle only when it is perceived as necessary—assets that are often traded on a daily basis or real time or whose prices can be easily determined e.g. investment securities, bonds, etc…
The Monetary Unit Assumption
According to the Monetary Unit Assumption, companies should only record business transactions that can be measured using monetary unit. Hence, business events that cannot be measured in monetary units—and though they can be important to managers and decision makers or to the operation of the business as a whole—such as the attitude of employees (think labor unions and strikes) or the deteriorating health of the CEO should not be included in financial records of a company.
The Economic Entity Assumption
As business owners, we should keep our personal living costs, our personal economic records separate from that of our business. By doing that, we abide by the Economic Entity Principle.
==> The best way to do that? Register a Proprietorship, a Partnership, a Limited Liability Company, or better yet a Corporation!
The Accounting Equation
Assets = Liabilities + Equity
As a business, our assets are everything we have as a resource. That includes the cash in our business accounts, the equipment in our factories, the furniture in our headquarters, the patents we registered as ours, the technology we’ve invented such as source code properties (assets such as patents, and technologies are often called intangible assets).
==> So, our Assets are all our Resources.
Now, Liabilities are our Debtors claims against our assets. So, if we have a total assets value of $150,000 and our debtors’ claims on those assets are $50,000, then we owe those $50,000 to our debtors (creditors/suppliers, etc..) and that is our Liabilities.
Liabilities can include: Notes Payable to a Bank, Accounts Payable to Suppliers, or Salaries Payable to employees, Sales/Real Estate Taxes payable to the government.
Now, subtract the Liabilities from the Assets, and you get the Equity: our Shareholders’ claims on Assets. And by the way, in the case of bankruptcy, debtors are paid first, and the rest, if any remains, goes to the shareholders—often referred to as residual equity.
Equity itself generally consists of:
- Share Capital—Ordinary: The Sum of the face value of all issued Shares—a piece of the company sold to public investors (usually for cash)
- Retained Earnings= Revenues – Expenses – Dividends
==> Expenses decrease equity, while Revenues and new Shares sold to outside investors increase equity
==> Dividends: these are distributed to shareholders, as a result of a net income and an agreement within the board of directors that this is the best use of the increase in assets (they can choose not to distribute dividends instead and reinvest the net income into the business). Dividends, when they are distributed, decrease equity.
The effects of business transactions on the accounting equation:
Let’s define transactions! Transactions are the business events that are worth recording by accountants. They can be classified into:
- External Transaction: these involve business transaction between our company and an external entity or enterprise
- Internal Transaction: these are the economic events that happen within our company
All in all, the company records the transaction only if the event affects the accounting equation.
The 5 Financial Statements
There are 5 financial statements that one must learn to read and interpret:
The Income Statement
The Retained Earnings Statement
The Balance Sheet (AKA The Statement of Financial Position)
The Statement of Cash Flows
The Comprehensive Income Statement