fundamentals of accounting

fundamentals of accounting

Introduction

For any functioning business, financial statements are required to know how the business has been functioning. The essential characteristics of any business are its assets, liabilities, and capital. As the business continues to operate daily, there are expenses involved, such as renting office space, telephone bills, fuel expenses, and advertising the business. Also, the main reason to start a business to make money or have returns. To know and measure the health of the business, financial statements such as the balance sheet are required, and knowing assets, equity, revenue, expenses, liabilities is essential in business. The following research work explains and defines the fundamentals of accounting.

Assets

Assets are valuable properties that a business has. characteristics of assets are (ref1–):

1. Ownership: the business is the sole owner of the properties
2. Measurable cost: the business obtained the asset at a quantifiable cost.
3. Value: the property is valuable

There are different types of assets, classified either as current or non-current assets (ref1—). Current assets are held by a business for trading, sales and expected to be realized within one year after the end of the reporting period (ref2—). Current assets are also likely to be used in business operations within the next operating cycle. For example, cash collected from sales is used to pay for goods that the business purchases and other operating expenditures. For any cash that is set aside for long-term plans is excluded from current assets (ref2—). Current assets are classified according to their liquidity, the period it takes to convert a non-cash asset into cash (ref2—163). For instance, marketable securities are readily convertible into cash than inventory or prepayment.

Non-current assets are divided into three main categories (ref2—-):

1. Fixed Assets: these are assets held and used by the business and are not expected to be sold (ref2—). Fixed assets are used in the typical day to day activities of the business to sell goods, produce goods, or provide services. They are also tangible, and examples include land, plant, and machinery.
2. Investments: these are debentures, shares, retirement benefits, and cash for long-term use (ref2—).
3. Intangible assets: these are non-physical assets that will provide long-term or future benefits to the business (ref2—). Intangible assets have a value from the holder’s right of possession. Examples include patents, brand names, and copyrights.

   Don't use plagiarised sources.Get your custom essay just from $11/page

   GET CUSTOM PAPER

Liabilities

Liabilities are debts. They represent the amount a business owes creditors for goods or services bought on credit, borrowed money from an external source, or any obligation of a business to pay money (ref3—–). Liabilities have the following three characteristics (ref4—):

1. There is a past transaction that was conducted
2. There is a present obligation
3. There is a future payment of goods or services.

Liabilities are either current or long-term liabilities. Current liabilities are due within the company’s operating cycle or within one year, whichever is longer (ref4—). Current liabilities are paid using current assets or another current liability. Examples include paying monthly wages and salaries to employees, taxes paid to the government, and warranties.

Long-term liabilities are not payable within the business lifecycle or one year (ref4—). In a balance sheet, long-term liabilities can be reported as a single total of all long-term liabilities or in multiple categories (ref4—). Examples include bonds payable and leases.

Equity

This is the claim of the owner of a business to the business after deducting all the liabilities (ref2—). The fundamental  accounting equation is stated as (ref3—):

Assets = Liabilities + Owners Equity

Thus:                                       Assets –Liabilities = Equity

Net Assets= Equity

In business, the creditor’s claim has a priority over the owner’s claim, with the owner being the final risk-taker. Thus, if the business or its assets are sold, the creditors’ are paid first before the owner of the business has any claim.

For ordinary business, company, or private organization, equity is the capital of the entity. For government organizations, the owner of the organization is the public; thus, equity is the accumulated surplus (ref2—). Not-for-profit organization refers to equity as accumulated funds.

In a balance sheet, the equity section differs based on the type of business (ref5—). For a sole proprietorship, equity is the capital. In a partnership, equity is the partners’ equity, a total of each partner’s capital (ref5—).

A company legally is owned by its shareholders, and thus it is a separate legal entity. A company’s equity is called shareholder’s equity and is divided into two (ref5—):

1. Contributed capital: shows the invested assets by the shareholders. In a balance sheet, contributed the par value of stock issued represents capital, and the excess in par value per share of the amount contributed (ref5—194).
2. Retained earnings are the assets earned from the company’s operations that are reinvested in the company (ref5—). Retained earnings are the earnings of a company less than the dividend paid out to the shareholders in the company’s lifetime.

Revenues

Revenue is the income a business earns out of its core activities, such as providing services or selling goods. Revenues are measured by the genuine value of received assets (ref2—). Types or revenues include legal service revenue, commission revenue, sales revenue, or consulting revenue, depending on their nature.

In a balance sheet, there are accrued revenues, defined as revenues earned, but neither recorded nor received in cash or otherwise (ref4—). For instance, when offering consultancy to be paid after job completion, if only a quarter of the job is complete after some time, then the consultant enters the expected payment in the said duration. However, the work is not yet paid.

There are also deferred revenues, which is the amount received in advance for providing services or goods (ref4—-). Deferred revenues are liabilities, but as the products or services are provided, they become earned revenue.

Expenses

Expenses are the cost of consumed and lost revenue and any liabilities incurred by a business during a specified period (ref2—). Expenses are recorded by crediting the asset account and debiting the expense account. Some examples of expenses are fuel, advertising, rent, or telephone expenses.

There are also prepaid expenses, such as payment of rent for business premises for months or years in advance. Prepaid expenses are assets, and when used, they, in turn, become expenses (ref4—).  Depreciation or loss of value is also a prepaid expense. Another type of expenses found while adjusting statements is accrued expenses, which are costs incurred by the business but are neither recorded nor paid out (ref4—).

Both expenses and revenues affect the owner’s equity. Expenses incurred decrease owner’s equity while earned revenue increases the owner’s equity.

Double Entry Accounting System

Double entry means that for every debit, there is a corresponding credit (ref1—). Each transaction done affects at least two accounts, hence double entry.

Example: On January 10^th, Jane invested $50,000 to form Jane Designs, a design and advertising sole proprietorship.

Using the T-account, Jane’s investment increased asset account while decreasing or crediting the owner’s equity.

This is represented as:

The same week, on January 15^th, after starting the company, Jane went searching for office space and found one, paying $5,000 for three months. This is an example of prepaid expenses, and therefore it is an asset. Since she paid with business money, there is a credit for $5 000 and a debit for the prepaid expense of the same amount.

From the two transactions, for any debit, there is a corresponding credit. In a balance sheet, assets are debit in nature, while liabilities and owner’s equity are credit. For any balance sheet, the total debit is equal to the total credit.

Conclusion

A clear definition of accounting terms is required for the proper functioning of any business entity. Knowing the difference between what to debit and what to credit and why starts with knowing what assets, liabilities, equity, expenses, and revenue are. With such knowledge, any person can be able to determine on a fundamental level how a business is functioning and know what measures to take when things do not add up.

References