KR editions 137 to 139
KR-137 : Accrual?
Hi everyone,
We came across GAAP in the previous edition; there's one more term we need to be familiar with: accrual accounting.
There are basically two types of accounting practices:
Accrual accounting
Cash basis accounting
What is accounting? Accounting is the process of recording every transaction that occurs (a company should have an account of everything happening in the company).
The problem is in determining what is a "transaction".
Let's take our whizkid's company. This company provides services to their customers- like designing websites. They might have struck a deal with a customer saying: "We'll develop a website for you for $1000 in one month. The entire amount should be paid within 2 weeks of deploying the website".
Note: Typically the time given to customers to pay for goods/services will be one month (but it again depends on different factors like relationship between the provider and customer).
The accounting department has a problem: When do they record this transaction as having occured? Should it be recorded only after cash has been paid or can they record it at the time of deploying the website itself?
The answer to this question determines the type of accounting used.
CASH-Based accounting: Recording a transaction only when cash has exchanged hands.
Accrual based accounting: Recording a transaction when an event has occured (even though cash may not be involved at that moment).
In GAAP, they use accrual based accounting and larger companies prefer it. Accrual doesn't apply only to sales/income (it can be extended to many other financial transactions as well).
KR-138 : Double-entry accounting
Having touched upon accounting, before continuing with our balance sheets there is one more interesting thing to note in accounting. It's called double-entry accounting!
DOUBLE-ENTRY system
In accounting we generally use double-entry accounting.
According to this every transaction will have two sides and money flows from one side to the other – or we can say there will be 2 accounts to denote the two sides involved in the transaction.
One account is debited and one is credited but in double-entry system the terminology would be confusing!
For example: If Jerry bought a computer, then Jerry pays for the computer in cash. Or cash flows from Jerry to the computer – the two accounts in this scenario are the cash account and the computer account (remember in accounting we look at everything in terms of accounts). It would appear as if cash is losing money (and normally we would say that the cash account has been debited). But in accounting they look at it from a different perspective.
Consider it this way: Jerry gives out cash and in return he would get a receipt for the purchase of the computer (or a credit note) while the computer account has received the cash. Thus the computer account, is in debit with respect to cash (if B borrows money from A then B is in debt to A and similar is the case here).
So the computer account is marked as the debit part of the transaction and the cash account is marked as credit. So the FROM side of the transaction is the credit side while the TO side is the debit: money flows from credit to debit! (In our example money went from cash to computer and so cash is on the credit end and computer is on the debit side).
How do we decide what are the accounts involved? It depends on what we want to track. If we want to just track our expenses, we would have a CASH account and an EXPENSE account.
It's not really necessary to worry over the credit and debit flow but always remember that every transaction has 2 accounts and one will be on the debit while one is on the credit.
Did you know that in accounting they always report the debit first and then credit (i.e. debit will be on the left side and credit will be on the right side)?
KR-139 : Credit=Debit?
Continuing with finance.....
We saw about double entry accounting in the previous edition. How does this fit in with our balance sheet?
The balance sheet is basically a snapshot in time regarding the various accounts of a company. The accounts in a balance sheet are sort of high-level accounts: like cash, assets, accounts payable, accounts receivable etc.
To find out the actual amounts in these accounts a company has to record each and every transaction that occurs in the company (selling a product, buy raw materials, paying out commissions, taxes, investing in bonds etc.). And as we saw in the last edition each of these transaction will have 2 sides: a debit and a credit side.
Every transaction is recorded as a journal entry in a book called the ledger (nowadays they use software databases instead of physical books).
At regular intervals these entries are classified (grouped together) based on accounts.
These accounts are at a very low level - for example we might have accounts like computer expenses, miscellaneous expenses, land assets, computer assets etc.
The outside world is more keen to know the high-level picture rather than a very detailed level breakup of all accounts. So the account department will club these accounts under larger categories (like putting all the separate asset accounts under a single account called Asset).
In a journal entry we have 2 sides (one on debit and one on credit) and the interesting thing is that the amounts on both sides will be equal!
If A pays B $100, then A stands to gain $100 (credit) while B has to one day pay back $100 (debit). Thus in our case credit=debit=$100!
Similarly on the balance sheet, ASSETS = LIABILITIES + EQUITY and the total values will be equal.
Note: For those interested in seeing financial reports; there are many websites where one can find a collection of financial statements issued by companies (usually the websites contain details for the last 5 years).
Go back to the main contents page
Copyright © 2020 Sethu Subramanian All rights reserved. Reach me via email at ssbell @ gmail.com