subject: The Basics of Accounting and how they relate to our daily lives [print this page] The Basics of Accounting and how they relate to our daily lives
The Basics of Accounting and how they relate to our daily lives
The thought of Accounting for many people make them break out in the cold sweats. There are too many numbers and reports to look at that they do not know where to begin. It is true that if you open a companies' annual report you will see many large numbers followed by equally confusing charts and graphs but this does not have to be the case if you understand a couple easy terms and relate them to your daily lives.
The most important concept in accounting is that Assets = Liabilities + Owners Equity. Everyone works with these terms in their daily lives but we might know them by another word. Assets are the items that you own, such as your checking account or savings account or your house or car or other investments or furniture. Liabilities are items that you have to pay for on a regular basis, your mortgage or rent, credit card or other bills. Owners' equity is the difference between what you own and what you owe to others; it is your net worth. Over time you expect that your net worth will increase. If you have more liabilities or bills than assets or things you own you may have to declare bankruptcy because you cannot pay all of your bills. The same is true in business; firms operate to generate a profit which results in an increase in the owners' equity, if a firm goes out of business it typically is because they have more bills to pay than assets to cover those bills.
The next concept is that Debits = Credits. Again we live our daily lives following this concept. When you buy your groceries you need to pay for them with either cash or a credit card. The transaction, another common accounting term, is the act of buying your groceries. When you buy them you have lowered an asset, cash by crediting your checking account but you have increased another asset your food supplies by the same amount so you have debited your food asset. The food assets have been debited and your cash asset has been credited by the same amount. Companies just do this on a large scale and more frequently.
Once you understand these two concepts you can begin to look at companies' financial reports. The first report to look at is the Balance Sheet. The balance sheet uses the first concept of Assets=Liabilities + Owners Equity. You can look at the bottom of any firms' statement and you will see two columns one titled Assets and the other Titled Liabilities and Owners' Equity, and the totals at the bottom of both columns will be the same. The owners' equity will give you a sense of what the companies' net worth is, although it may be a little misleading because assets are typically listed at their original value and not what they could be sold at today. This is similar to looking at what you think your own net worth is, for example unless you have just sold your home today you do not know the true value, you can list what you purchased the house for but that would not be correct or you could try to adjust but that you will not know if that adjustment is correct. Since firms have so many assets they do not take the time to adjust each asset on the Balance Sheet so they use the original value. By using the original value the balance sheet is taking a conservative approach to identifying a companies' net worth, good accountants generally are conservative.
The next financial report typically shown is an Income Statement. This report shows whether a company has made money during the year. You again look at the bottom of the report to see whether there was a profit or a loss for the time period reported. Typically the time period is a year, the year ending may be different for each company but the time period will span only one year. Many times at the very bottom you will see an earnings per share, this takes the net income (profit) and divides it by the number of outstanding shares in a company. As with the other accounting concepts we all live our daily lives with our own income statement. Each year we want to know, did we make money for the year or have to dip into savings to survive? If we have paid down our mortgage or seen our savings or checking accounts increase during the year while not increasing our credit card or other debt then we should have had a good year or a profitably year.
