Do you keep financial accounts of yourself? Some may say yes and some may say no. If your answer is no, then I suggest you open an excel or grab a notebook as soon as possible because knowing what happens to bills in your wallets is the most efficient way to keep track of your money and the foundation of smart financial decisions.
But accounting doesn’t stop there: it is more than merely a record of income and expense that helps people to remember their financial activities. For an individual this could be the primary function of his or her account book; but for a corporation, recording is among one of the many functions of accounting. Even though there isn’t a clear definition of accounting functions, I conclude after my lessons that accounting can also help classifying monetary activities of a corporation, serve as the resource of analysis and interpretation of these activities and “be used for preparing the future plan and framing of policies for executing such plans”
Because it serves more functions, accounting as a business department is also a lot more complicated than an individual account book. In fact, it is complicated enough to become a college major and I will not be able to cover even a decent portion of it in my infinitesimal blog. So, I will talk about the basic of the basic: the five primary indexes of accounting and the interaction between them. This time, instead of using somebody else’s story, I will illustrate the concepts with my own story, Sole Garage.
The heart of accounting is hidden behind the five primary elements of accounting: assets, liabilities, equity, revenue and expense. Their relationship, also know as the accounting equation, is written as (Assets – Liabilities = Equity + (Income – Expenses)).
Wow, hold up wait a minute, what are those? I don’t understand what you are talking about. I don’t understand them neither a week ago. So please be patient and inquisitive, and I will navigate your path through understanding these seemingly complicated terms and equation.
Let’s start with the easiest index: revenue, otherwise known as income. Revenue is nothing but what the corporation earns though a business activity. For my dearest Sole Garage, revenue is apparently the cash customers pay for sneakers in most cases. But in a few occasions, a sneaker trade takes place. In that situation my revenue is no longer cash, but the sneaker I get from the trade. And it can even be a combination of both: I can trade a pair of my sneakers for another pair from somebody else and some cash because my pair worth more (The trade in the picture is an example for this). So in conclusion, revenue refers to the increase of things a company own through business activity.
On the contrary, expense refers to the good and service spent in a business cycle. For Sole Garage it refers to the shoes when we talk about me as a seller; it is the cash I spend when we talk about me as a buyer of other sneakers. In a sentence, expense is the loss of a company in a business.
While income and expense are relatively common terms, the other three indexes might not be as familiar. Liabilities, by definition, are the “economic obligations or payables of the business”. For corporations, liabilities can be stocks, bank loans, mortgages and so on. One noticeable characteristic of liability is that all of liability is expected to be settled in the future, and the time of which a liability is expected to be settled divides liabilities into two categories: current liabilities and non-current liabilities. The distinction line is one year, which means that if a liability will be paid within the next fiscal year then it is a current liability and vice versa. For Sole Garage, Roger and I don’t have any liability besides the cash borrowed from parents, and that loan is a current one as we are certain that our shoes will be sold and the loan will be returned within a few months.
The opposite term of liability is equity, or capital. My definition of equity is the collection of things owned by owners in a business. It does not include liabilities because liabilities are owned by people outside the company like bankers and stockers. Use Sole Garage as an example: the economic capital includes my cash and sneakers I posses bought using my own money, not money borrowed from my parents. In other words, equity is what is left after all liabilities are settled. An alternative perspective of equity is the net gain of the business since its initiation plus owners’ input in the business. Both definition point to a key characteristic of equity: it is possessed solely by the owners of the business and nobody else.
The last index is asset. Without a business cycle, asset of a corporation is the combination of its liabilities and equity, which includes all properties within the business. Assets contains both positive (equity) and negative (liabilities) valued possessions. It refers to all resources used by the business to create income from different angel of perception. Similar to liabilities, assets are also classified into current assets and non-current ones. The distinction between the two is also whether the the asset will be used to create economic flow into the business within a year from the reporting date; so a vehicle an an office room are normally considered to be non-current assets while all current liabilities fall into the category of current assets.
And finally we are at our last piece: connecting the dots. When Sole Garage was first founded by Roger and me, our income and expense were both zero because no business activity had taken place, and we didn’t have any liability either because we hadn’t borrowed money or anything else from others. All we had was $50 cash, which formed both our equity and assets. Then we borrowed another $50 from our parents; that portion of our cash was our liability. After adding the liability number to our account book we started our business cycle by buying shoes using the $100 we had and that money became our expense, while shoes we purchased became our assets. Finally, we sold our shoes for $150, our revenue. On our account book, the five categories were recorded in the following chart:
|Before Business Cycle||After Business Cycle|
By the end of that business cycle, the $50 profit (Income – Expense) had not yet become our equity because in this cycle it is not possessed by us but it would before the start of the next cycle. And it is noticeable how both before and after the cycle the numbers verify the equation (Assets – Liabilities = Equity + (Income – Expenses)): this equation explains the relationship between the five main accounting indexes.
Now we have gone through the principle of accounting. What I just explained, however, is merely a minor section of accounting and there are so much more about the subject, like subsets of each index, the business cycle and so on, for me to learn. I do wish to pursue my study in this field a little more and if anything I wrote inspired any one of you, accounting might be a considerable college major for you. But above all, I highly advise you starting keeping financial accounts if you haven’t already, because you will be able to spend your money more wisely by simply knowing where your money has gone to and seeing the defects of your monetary arrangements.