What is Accounting and why is it so important?
Accounting is a system for recording various transactions in an organization, and segregating and analyzing them to provide a summary of the company’s financial standing in the form of statements. Wow, that’s a mouthful. Let’s break it down further and understand it step by step.
Accounting plays a critical role in an organization – irrespective of its size – which helps us to understand the following:
a) What is the current financial position of the company?
b) How has the company been performing?
c) What changes must the company make in the future?
Having a sound financial reporting system becomes all the more important since any publicly listed organization (listed on the stock market) is required by law to publish certain financial statements (which we will get to a little later). It also plays a major role when the company goes to a bank to borrow, as one of the basic requirements of the bank would be to see the financial state of the company.
Let’s say you start a company named Goodwill Inc and hire me as your Accountant. I will walk you through the entire Accounting process and hopefully help you gain some financial prudence in the process. You will see that how Accountants play a major role in every organization; they really work their assets off!
Step 1 – Getting Started
The very first thing that you should do is to create a separate bank account for your organization because now you (an individual) and your organization will be treated as separate entities.
There will be various transactions that your company will undertake such as receiving cash from customers, paying suppliers, borrowing money from a bank, etc. Select a medium where you will be recording these financial transactions. By that I mean – you can do it in a notebook (or ledger), Excel or Accounting software. The purpose of this medium would be to record all transactions at one place which can be combined in the future to get a holistic view of the financial performance of the organization.
In the tool of choice where you will be recording transactions – let’s stick to Excel for now – create headers for Accounts of various entities involved. More on that in the next step.
Step 2 – Bucketizing Financial Transactions
There are three fundamental components of Finance – Assets, Liabilities, and Shareholder’s Equity (or just Equity). Let’s understand them one by one.
a) Assets – It is anything that is expected to provide future economic benefits for your organization. For e.g., say you invest in a piece of equipment which will last 5 years for your company; as an asset it is expected to provide you economic benefits for the next 5 years. Or to take an example from everyday life, when you invest in a stock, you expect it to provide you an incentive or benefit (hopefully a profit) in the future. Thus, that stock is an asset for you. Some examples of commonly used terms under assets are – Cash, Land, Accounts Receivables (what your buyers owe you by virtue of sales done on credit), Prepaid Assets (advance payments such as annual rent paid upfront), etc.
b) Liabilities – Liability represents an obligation for you to pay someone back in the form of cash, goods, or services. For e.g., when you borrow money from the bank, it becomes an obligation for you to pay them back. Hence, a liability on your books (books is just a fancy way of saying where you record transactions). Some common examples of liabilities are – Debt Payable, Interest Payable (yearly interest payable on the loan taken), Accounts Payable (anything that is owed to your suppliers), or Wages Payable ( wages owed to your employees,), etc.
c) Shareholder’s Equity – It is the claim on assets by the owners of the company (after all liabilities are paid off). More on that in the next step.
Step 3 – Show me the money
Let’s now take this journey forward. To actually kick start your venture, you would need capital (that is, cash). Let’s say you pitch your idea to a friend of yours and he comes on board and decides to invest in your venture. He’s a Godsend because you really needed that money. Thus, let’s call him an Angel Investor.
Both of you raise Rs. 5 lakhs for your venture and this will sow the seed of growth for your organization. Let’s call this initial investment Seed Capital. This capital becomes the share value or share capital of Goodwill Inc., and since both of you invested a certain amount of money in the organization, you will be assigned a certain number of Shares of Goodwill Inc. How many shares, you ask? Let’s say you decide that one share should be worth Rs. 100 and thus there would be a total of 5000 shares (Rs. 5 lakh investment divided by Rs. 100 per share) that would be allocated.
And henceforth, any investment in Goodwill Inc. in the form of say Series A, Series B funding would require you to assign more shares, and this will change the Shareholder’s Equity and thus the net value or the Valuation of Goodwill Inc.
Just one more thing – any profit generated by the company gets added to the Shareholder’s Equity.
Step 4 – Choosing the Accounting Method
There are different types of Accounting methods such as Cash basis, Accrual basis, or Tax basis. Cash basis is the simplest form of accounting which tracks all income and expenses associated with the organization as and when cash is received or paid.
Accrual basis completely annihilates Cash basis and goes on a whim and registers an income when it is “earned” or when an expense is “incurred”. To explain it further – in Accrual basis, a transaction is registered when there is an exchange of goods/services in a past transaction and the value of the transaction can be confidently determined. For e.g., when you sell your product to your customer on credit of 30 days (i.e., the customer will pay you in 30 days for goods/services rendered today), no cash transfer has taken place today but since the customer promises to pay you in 30 days (Accounts Receivable) for the goods/services offered by your organization, this transaction will be recorded in the books today as per the Accrual basis.
On the contrary, when you sign a contract for supplying your product to that person in the future, no actual exchange of goods or services has taken place and hence it won’t be registered in the books as per both accrual and cash basis.
I know, it’s accrual world out there.
Most companies use the Accrual basis of accounting even though it is messy and creates a mismatch between what is “earned” and the actual cash flow. That necessitates the next and final step of your accounting journey.
Step 5 – Creating Financial Statements
Remember me telling you earlier about how publicly listed companies are required to disclose certain financial statements; the following are the main financial statements that you would be required to create.
a) Balance Sheet – The balance sheet tells you about the financial position of your organization on a specific date. For e.g., it will list down all the assets (cash, inventory, accounts receivable, etc.), liabilities (long term debt, interest payable, accounts payable, etc.) and the shareholder’s equity of Goodwill Inc. at a specific time – say the end of Financial year, 31st Mar 2020. Why is it called a “Balance” Sheet? Because one of the key features of a Balance Sheet is that the Assets should always be equal to the Liabilities and Shareholder’s Equity (Assets = Liabilities + Shareholder’s Equity). Why should it balance? Well, because the claims to all the assets lie with two entities – Debt holders (Liabilities) and the Investors (Shareholder’s Equity).
b) Income Statement – Income statement tells us about how much profit or loss your company made due to operations over a period of time. It basically shows what was the net income that Goodwill Inc. made between say, 1st April 2019 to 31st March 2020. It is calculated by taking all the revenue generated minus all the expenses incurred by the organization.
c) Cash Flow Statement – This is what helps us rectify the mess created by Accrual accounting that I mentioned earlier. Just to recap, in accrual accounting, we record a transaction not when cash is received or paid but when the actual exchange takes place, even if that means that you will get paid by customers or will pay your suppliers at a later date.
Thus, the net income stated in your Income Statement does not equal your change in cash. Therefore it necessitates the need for a Cash Flow Statement which reports actual cash transactions over a period of time. It further simplifies it by segregating the net cash flows (net cash in minus cash out) into three buckets –
• Cash flow from Operations (CFO) – transactions related to providing goods and services and general business activities
• Cash flow from Investing (CFI) – transactions related to acquiring (or disposal) of long-term assets (which will provide you economic benefits in the future)
• Cash flow from Financing (CFF) – transactions related to debt or change in the shareholding pattern – e.g. taking debt, debt repayment, issuing new shares, etc.
Final thoughts
There you have it. A simplified view of the accounting process in an organization. Obviously, there are various nuances and intricacies involved in the whole Accounting ecosystem but this will be a good starting point for you to deep dive into it further. With that I welcome you to the accounting community, where everybody counts!
Great read!
Thank you for getting me started on accounting basics.