Accounting can be a tricky subject. Accounting may feel very strange for someone who does not understand it. For those who have never studied accounting or are just starting, the subject might seem daunting at first. This first article is aimed at such people, who want to get started on the subject.
Accounting is generally hyped up to be a complex subject. why do we add one transaction twice? what classifies something as expense? and treated as liability and why prepaid expense is and asset? All of these and other questions would definitely bother a non finance person at one point in life or another. But before we go ahead with trying to answer the difficult questions we have to start from ground zero.
Lets start with the basic fundamental concepts. if you don't understand the very basic concept that no matter how hard you study and try you will still fail.
The very first question that should come in your mind if you take up the subject should be "What is accounting?"
Well if you google that question you would come up with many resources. Each of those will explain the subject or try to explain it in different terms. It is not necessary that you learn each of those answers but you should still read some of the definitions. I will summarize the answer to this question in a simple manner.
Simply put: "Accounting is a method of recording business transactions"
No matter how big or small a business, accounting is used in all of them.
Another important simple point to remember is this: "An accountant's job is to keep track of assets and equity of the business."
Now lets define what these items are, what do we mean when we say keep track of assets and equity, what about that thing we read called liability ?
An Asset is something that is owned by the business (has legal title of it) and either is needed to run the business, or provides (will provide) any benefit to it. Some examples of assets are cash, office equipment, inventories, and office buildings (though most business rent premises but since they have legal title to use the building thus it is considered an asset).
There are many often confusing and complex definition of Equity (also known as Shareholder's Equity-SE or Owner's Equity - OE). In simpler terms, Equity represents ownership in assets. What is the shareholder's share in the assets the company holds?
If there is only a single owner of the business, then the Equity is Owner's Equity. However if multiple shareholders exist, the Equity is Shareholder's Equity.
In case of the rent or mortgage of the office building, someone paid the down payment and is now the title holder, he now has an equity interest in the building.
Assume that the rest of the money was financed through a lender. That lender also has a claim on this building. This interest / claim of the lender on the asset of the company is called a liability. A liability is the debt that the business owes to 3rd parties, parties not owners or shareholders of the business.
A liability has to be settled with someone in future.
Accounting Fundamental Equation:
In Short, to start a business, some assets need to be added to the business. There are two possible ways to do so.
1- Assets can be contributed into the business by its owners.
2- Assets can be contributed into the business by a creditor or lender.
For example, the owner wanted to start a business (let us not go in what business at this point). For this purpose he takes $50,000 form his account and puts it into the business. This $50,000 will be used to pay the down payment of 30% on the office building mortgage. Remaining money will come from a bank loan. All of these are transactions and they need to be recorded.
This building will be held by the company as an asset and the records will keep a track of who owns how much interest in the asset. In this case the 100% building is claimed 30% by the owner and 70% by the bank.
Thus our equation will some out to be something like this:
Building = Bank 70% + Owner 30%
This is the basic accounting equation , Assets must equal to the claim of owners or lenders on those assets, in other words
Assets = Liability + Equity
The above equation is the heart of accounting, at any given time, ownership of the assets held by a business must be traceable. In Other words , the assets must equal to the sum of liabilities and equity.
Before we move forward to other concepts, these basic items have to be understood and learned by heart.
I will be posting further lessons soon. Let me know in the comments below if there are any particular items you need me to focus on.