Accounting Fundamentals Primer (Pre-Course)

Anyone who invests in a business — whether by buying shares in a company or putting money into their own business — needs to know how well or badly that business is doing. Investors need to be updated periodically with answers to two equally important questions:

• Is the business making a profit?
• Has it got enough funds to pay its debts?

Accounts are the means by which these questions are answered.

A set of accounts consists of two principal statements, usually supported by detailed notes:

• The statement of financial position — a statement of the financial position of a business at a given date.
• The statement of profit or loss — a summary of the results of a business's transactions for a period ending on the date of the statement of financial position.

The amount of detail in a set of accounts varies according to the type of accounts and the people who will use them, but the same underlying principles always apply.

Bookkeeping is the recording of a business's commercial transactions (purchases and sales of goods, expenses, receipt and payment of cash) as and when they happen. Its purpose is to enable those transactions to be summarised at the end of a period so that accounts can be produced. The word "books" survives from the days of leather-bound ledgers — today most accounting records are computerised, but the same information is provided nonetheless.

There are three types of business considered at this level. Regardless of type, every business produces a statement of profit or loss and a statement of financial position periodically (usually annually).

The statement of financial position (SFP) considers what the business OWNS or CONTROLS — its assets — and what the business OWES — its liabilities.

Assets: Non-Current and Current

Liabilities: Non-Current and Current

The Business Entity Concept

Capital

The SFP shows the position of a business at a given date — what it owns and owes at that point in time. Non-current assets are presented separately from current assets, and non-current liabilities separately from current liabilities.

Notice that Total Assets = Capital + Total Liabilities. This is the accounting equation, explored in detail later in this primer.

The statement of profit or loss (SPL) is a summary of the results of a business's transactions for a period ending on the date of the SFP. It summarises the sales a business has made and the expenses it has incurred over a period, showing whether the business made a profit (more sales than expenses) or a loss (more expenses than sales).

Revenue includes sales made for cash and sales made on credit — the full sales value, whether or not the customer has yet paid.

Cost of sales ("cost of goods sold") is the cost of the goods actually sold during the period. It is calculated as:

Opening inventories + Purchases − Closing inventories = Cost of sales

This takes the cost of goods available for sale during the period (opening inventories plus purchases) and deducts the cost of goods that weren't sold (closing inventories) — leaving the cost of the goods actually sold. The number of units reflected in cost of sales must equal the number of units reflected in revenue, even though the monetary values differ (revenue is at selling price, cost of sales is at cost).

Gross profit (revenue less cost of sales) is often called the core profit — it shows how successful the buying-and-selling operation itself has been, before incidental expenses.

Net profit is what remains after deducting all other expenses (incidental to the buying/selling/manufacturing of goods) from gross profit.

The SFP includes the amount the business owes back to its owner — capital. Capital is calculated as:

Capital at the start of the year + Capital injections + Profit (− Loss) − Drawings

The net profit or loss from the statement of profit or loss therefore feeds directly into the capital section of the SFP. If a business makes a net profit, capital increases; if it makes a net loss, capital decreases. This is the thread that ties the two principal financial statements together.

Two simple numeracy techniques save significant time in exam calculations: quick percentages and rearranging linear equations.

Percentages the Quick Way

Rearranging Linear Equations

      A
   B     C

The accounting equation is:

Assets = Liabilities + Capital

This equation always holds true: the assets of a business always equal its liabilities plus what the business owes back to its owner (capital).

A consequence of the accounting equation is that every transaction has two effects — a dual effect. For example, if a shopkeeper puts £10,000 of their own money into the business: (i) the business's cash goes up by £10,000 (an asset increases), and (ii) the business's capital goes up by £10,000 (capital increases). Both sides of the equation move together, keeping it in balance.

Inventory and the dual effect: when applying the dual effect to buying or selling goods, we do not track movements in inventory transaction-by-transaction. Instead, the acquisition of inventory is recognised as a purchase (an expense in the SPL, which reduces profit), and selling inventory is recognised as sales/revenue (income in the SPL, which increases profit). Closing inventory is recognised separately at the year end through an adjustment. Since profit flows into capital, a purchase (expense) reduces capital and a sale (income) increases capital.

Rather than expressing every transaction as movements in the accounting equation, bookkeepers use the language of debit and credit to record the dual effect. There are six "types" of account:

• Expenses (e.g. purchases, gas bill, phone bill, electricity bill, salaries)
• Assets (e.g. cash, receivables, factory, cars — inventory is not tracked transaction-by-transaction for this purpose)
• Drawings (whenever a sole trader takes something out of the business)
• Liabilities (e.g. payables, loans)
• Income (e.g. sales, interest income)
• Capital (what the business owes back to its owner)

To increase expenses, assets, or drawings, we debit the account. To increase liabilities, income, or capital, we credit the account. The mnemonic DEAD CLIC captures this:

It follows that a decrease in an expense, asset, or drawings is a credit, and a decrease in a liability, income, or capital is a debit. (By convention, Debit is abbreviated Dr and Credit is abbreviated Cr.)

Steps to record a transaction:

1. Identify the two accounts that are affected.
2. Consider whether each is being increased or decreased.
3. Decide whether each account should be debited or credited.
4. Check that a debit entry and a credit entry for equal amounts have been made.

Worked transaction pattern: a business buys goods from a wholesaler for £2,000 on credit (a bill to be paid later). The business has another purchase expense of £2,000 (expenses ↑ → debit) and now has a liability — a payable — of £2,000 (liabilities ↑ → credit).

Dr Purchases (expense) £2,000    Cr Payables (liability) £2,000

This is a first, simplified introduction to double entry. The full mechanics — books of prime entry, ledgers, the trial balance, and correcting errors via a suspense account — are covered in depth in Double-Entry Bookkeeping later in this module.

Once transactions have been recorded and summarised into a list of debit and credit balances, the statement of profit or loss and statement of financial position can be prepared. Two practical tips make this straightforward:

• Draw up a blank pro-forma SPL and SFP first (with no numbers), using the layouts introduced earlier in this primer.
• Always complete the SPL before the SFP — the net profit or loss it produces is needed for the capital section of the SFP.

Classifying balances: debit balances typically represent assets, expenses, and drawings (DEAD CLIC); credit balances typically represent liabilities, income, and capital (DEAD CLIC). Working through a list of balances is simply a case of routing each balance to the correct statement and the correct side of that statement.