Understanding the Basics of Accounting
Individuals that perform bookkeeping services must have a basic knowledge of accounting. They also must be able to apply that knowledge when recording transactions. In some instances, however, the entry-level accountants and bookkeepers that provide much of the bookkeeping work do not possess that basic knowledge. The following paragraphs discuss basic financial statement terminology commonly used in bookkeeping. Balance Sheets
The balance sheet (or statement of financial position) is a financial statement that reports an entitys assets, liabilities, and equity at a specific point in time. On the balance sheet, the total of the assets presented equals the sum of total liabilities and total equity.
Balance sheets may be classified or unclassified. A classified balance sheet distinguishes current assets and current liabilities from other assets and liabilities. Because classified balance sheets disclose the components of working capital (or current assets less current liabilities), they are presumed to be more useful. Generally, classified balance sheets are presented unless an industry accounting or auditing guide specifically permits an unclassified presentation or an unclassified balance sheet is industry practice. (For example, it is accepted practice for financial institutions to present unclassified balance sheets because the working capital distinction is not relevant.)
Assets
Assets are economic resources that have the following essential characteristics: (a) they represent probable future benefits that can contribute directly or indirectly to future net cash flows, (b) an entity can obtain those benefits and control others access to it, and (c) the event giving rise to the entitys right or control of the benefits has already occurred. Examples of assets include cash, marketable securities, accounts receivable, inventories, and equipment.
Current assets are defined as cash and other assets that are reasonably expected to be realized in cash or sold or consumed within one year (or within an entitys normal operating cycle if it is longer than a year). Current assets normally include cash, marketable securities, receivables, inventories, and prepaid expenses. Liabilities
Liabilities are economic obligations that have the following characteristics: (a) they represent present duties to one or more entities that will be settled by the transfer or use of assets at a specified date, on occurrence of a specified event, or on demand; (b) they obligate an entity, leaving it little or no discretion to avoid the future sacrifice of assets; and (c) the transaction obligating the entity has already occurred. Examples of liabilities include accounts payable, accrued expenses, notes payable, and revenues collected in advance.
Current liabilities are obligations whose liquidation is reasonably expected to require the use of current assets or the creation of other current liabilities. Generally, current liabilities include short-term obligations such as payables for materials and supplies, wages, taxes, amounts collected in advance of delivery of goods or services, the current portion of long-term obligations, and any other obligations expected to be liquidated within a year. Equity
Equity is often referred to as net assets and is the residual interest in an entitys assets after deducting its liabilities. Equity accounts vary depending on the type of legal entity. For example, a corporations equity accounts may include common stock, preferred stock, treasury stock, additional paid-in capital, and retained earnings. A partnerships equity accounts, however, may consist only of partners capital.
Income Statements
An income statement is a financial statement that reports an entitys results of operations for a specific period. That is, it presents an entitys revenues, expenses, gains, and losses for a given period. Revenues are actual or expected cash inflows that have occurred or will eventuate as a result of an entitys major or central operations. Revenues increase assets or decrease liabilities (or both) and, thus, increase equity. Revenue accounts vary depending on the type of business and the type of transaction that generated the revenue. Examples of revenue accounts include sales, royalty income, interest and dividend income, and rent income. Expenses are outflows or other using up of assets or incurrence of liabilities (or a combination of both) from producing or delivering goods, rendering services, or carrying out other activities that constitute the entitys ongoing major or central operations. Expenses decrease assets or increase liabilities (or both) and, thus, decrease equity. Examples of expenses include cost of sales, salaries, taxes, interest expense, and supplies. Gains are increases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners. Losses are decreases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners. Classifying amounts as revenues, gains, expenses, or losses varies among companies and depends on the nature of a company's operations. Events or circumstances that are sources of revenues for one company may be gains for another. The primary differences between revenues and gains and between expenses and losses are that (a) revenues and expenses result from an entitys ongoing major or central operations such as producing or delivering goods or rendering services, while gains and losses result from incidental or peripheral events or circumstances; and (b) revenues and expenses usually are recorded at their gross amounts while gains and losses usually are recorded at net amounts.
Depreciation
Depreciation is the accounting process of allocating the cost of an asset to expense over the useful life of the asset. For example, if manufacturing equipment is expected to have a useful life of five years, a portion of its cost would be allocated each year for five years to the cost of production. It is important to note that depreciation is merely a method of allocating the cost of assets to expenses. It is not a method of valuing assets.
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