Introduction to accounting, Shahid Mehmood

1. Introduction to Accounting
Accounting is the system of recording financial transactions with both numbers and text in the
form of financial statements. It provides an essential tool for billing customers, keeping track of
assets and liabilities (debts), determining profitability, and tracking the flow of cash. The system
is largely self-regulated and designed for the users of financial information, who are referred to
as stakeholders: business owners, lenders, employees, managers, customers, and others.
Stakeholders utilize financial statements to help make business, lending, and investment
decisions.
Accounting has several specialized fields and roles. Private (internal) accounting generally refers
to accountants who work within a single business entity. Small business accountants may assume
general roles which require preparing the records (bookkeeping) and performing bank
reconciliations. Accounting professionals are generally divided into three fields: tax, audit, and
advisory. The tax field focuses on federal, state, and local tax filings. Audit roles test the validity
of financial statements and internal controls. Advisory services perform general financial
consulting. Public accounting firms have several different clients, whereas private accounting
refers to working for one specific business entity.
What is Accounting?
Accounting is known as the "language of business". Accounting is a means through which
information about a business entity is communicated. Through the financial statements, the
end-product reports in accounting, it delivers information to different users.
ACCOUNTING DEFINITION
Technical definitions of accounting have been published by different accounting bodies. The
American Institute of Certified Public Accountants (AICPA) defines accounting as:
"the art of recording, classifying, and summarizing in a significant manner and in terms of
money, transactions and events which are, in part at least of financial character, and
interpreting the results thereof."
Though I am not a fan of technical definitions, studying the statement above will give us a
better understanding of accounting.
1. Accounting is considered an art
Accounting is considered an art because it requires the use of skills and creative judgment.
One has to be trained in this discipline to be able to perform accounting functions well.
Accounting is also considered a science because it is a body of knowledge. However,
accounting is not an exact science since the rules and principles are constantly changing
(improved).
2. Accounting involves interconnected "phases"
Recording pertains to writing down or keeping records of business
transactions. Classifying involves grouping similar items that have been recorded. Once

2. they are classified, information is summarized into reports which we call financial
statements.
3. Concerned with transactions and events having financial character
For example, hiring an additional employee is qualitative information with no financial
character. Hence, it is not recorded. However, the payment of salaries, acquisition of an
office building, sale of goods, etc. are recorded because they involve financial value.
4. Business transactions are expressed in terms of money
They are assigned amounts when processed in an accounting system. Using one of the
examples above, it is not enough to record that the company paid salaries for April. It must
include monetary figures – say for example, $20,000 salaries expense.
5. Interpreting the results
Interpreting results is part of the phases of accounting. Information is useless if they cannot
be interpreted and understood. The amounts, figures, and other data in the financial reports
have meanings that are useful to the users.
By studying the definition alone, we learned some important concepts in accounting. It also
gave us an idea of what accountants do.
The simple things you do and encounter everyday can actually be related to some level of
accounting. You make budgets, count change and check the receipts from the supermarket.
You may also have listed things you spent your money with at one point in your life.
We are surrounded by business – from managing our own money to seeing profit
statements of big corporations. And where there is business, there sure is accounting.
Definition of Accounting
Accounting is the process of recording, classifying, summarizing and interpreting the financial
data of organizations.
Accounts
There are five different types of accounts: asset, liability, equity, revenue, and expense. Each
account type includes sub-accounts to record transaction details. For example, cash assets may
include several different cash and savings accounts.
 Asset accounts: Cash and cash equivalents, accounts receivable, inventory, allowance
for doubtful accounts (contra account), prepaid expense, investment, property, plant, and
equipment, accumulated depreciation (contra account), intangible assets, accumulated
amortization (contra account) and others
 Liability accounts: Accounts payable, notes payable, accrued expenses, deferred
revenue, long-term bonds payable and others

3.  Equity accounts: Common stock, additional paid-in capital, retained earnings, treasury
stock (contra account) and others
 Revenue accounts: Sales revenue and others
 Expense accounts: Selling, general, and administrative, interest, repairs, depreciation
(non-cash), amortization (non-cash) and others
 Financial Statements
Financial statements are the end results of the completed accounting record. They include the
balance sheet, income statement, statement of shareholders’ equity, statement of cash flows, and
notes to the financial statements. The information provides predictive value, feedback, and
timely data to stakeholders.
 The balance sheet reports business assets, liabilities, and equity up to a specific time
period
 The income statement reports the profit and loss activity for a specified period of time
 The statement of shareholders’ equity reports detail of investment received and prior
earnings
 The statement of cash flows reports the ins and outs of cash in three categories:
Operating, investing, and financing
 The notes to the financial statements disclose information that cannot be understood with
the financial statements alone
 Debits and Credits
Debits and credits is the system used for recording accounting transactions. A debit or credit
transaction can increase or decrease balances, depending on the account type (asset, liability,
equity, revenue, and expense). This forms the basis for double entry bookkeeping which requires
equal debits and credits. The underlying transactions are recorded in detail on the general ledger
and are later combined to form financial statements.
 The sum of debits always equals the sum of credits
 The sum of debits and credits are represented on opposite sides of the balance sheet

4.  Accounting Standards
Accounting standards set guidelines and rules for financial statement preparation. These are set
via a combination of private industry organizations in cooperation with government committees.
Generally Accepted Accounting Practices in the United States (US GAAP) largely governs the
rules for recording transactions and disclosing critical business information to stakeholders.
International Financial Reporting Standards (IFRS) governs international standards. Both
systems require the use of double entry accounting. While both sets of standards are similar,
there are significant differences such as allowed inventory methodologies and reporting asset
valuation.
 Business Types and Entities
Accounting serves diverse entities such as: individuals, companies, trusts, governments, and
charities. These may be legally organized in a variety of ways: corporation, limited liability
company, partnerships, and others. With the exception of governmental accounting, most
accounting systems follow similar double entry, accrual accounting. Financial statements may
have slightly different names, depending on the entity type. An income statement may also be
called a profit and loss or earnings statement. A balance sheet may be referred to as the statement
of financial condition.
 Managerial Accounting and Analysis
Managerial accounting is designed around the needs of managers and not necessarily regulated.
It is for internal purposes and may employ any useful accounting system. Once the financial
statements are compiled, the data may be analyzed using ratios and financial analysis.
Accounting can provide powerful information to all stakeholders when properly maintained and
interpreted.
1. Accounts Payable (AP)
Accounts Payable include all of the expenses that a business has incurred but has not yet paid.
This account is recorded as a liability on the Balance Sheet as it is a debt owed by the company.
2. Accounts Receivable (AR)
Accounts Receivable include all of the revenue (sales) that a company has provided but has not
yet collected payment on. This account is on the Balance Sheet, recorded as an asset that will
likely convert to cash in the short-term.
3. Accrued Expense
An expense that been incurred but hasn’t been paid is described by the term Accrued Expense.

5. 4. Asset (A)
Anything the company owns that has monetary value. These are listed in order of liquidity, from
cash (the most liquid) to land (least liquid).
5. Balance Sheet (BS)
A financial statement that reports on all of a company’s assets, liabilities, and equity. As
suggested by its name, a balance sheet abides by the equation <Assets = Liabilities + Equity>.
6. Book Value (BV)
As an asset is depreciated, it loses value. The Book Value shows the original value of an Asset,
less any accumulated Depreciation.
7. Equity (E)
Equity denotes the value left over after liabilities have been removed. Recall the equation Assets
= Liabilities + Equity. If you take your Assets and subtract your Liabilities, you are left with
Equity, which is the portion of the company that is owned by the investors and owners.
8. Inventory
Inventory is the term used to classify the assets that a company has purchased to sell to its
customers that remain unsold. As these items are sold to customers, the inventory account will
lower.
9. Liability (L)
All debts that a company has yet to pay are referred to as Liabilities. Common liabilities include
Accounts Payable, Payroll, and Loans.
10. Cost of Goods Sold (COGS)
Cost of Goods Sold are the expenses that directly relate to the creation of a product or service.
Not included in this category are those costs that are needed to run the business. An example of
COGS would be the cost of Materials, or the Direct Labor to provide a service.
11. Depreciation (Dep)
Depreciation is the term that accounts for the loss of value in an asset over time. Generally, an
asset has to have substantial value in order to warrant depreciating it. Common assets to be
depreciated are automobiles and equipment. Depreciation appears on the Income Statement as an
expense and is often categorized as a “Non-Cash Expense” since it doesn’t have a direct impact
on a company’s cash position.
12. Expense (Cost)
An Expense is any cost incurred by the business.

6. Learn more about personal vs. business expenses here.
13. Gross Margin (GM)
Gross Margin is a percentage calculated by taking Gross Profit and dividing by Revenue for the
same period. It represents the profitability of a company after deducting the Cost of Goods Sold.
>>Supporting Post: How to Calculate Gross Profit Margin
14. Gross Profit (GP)
Gross Profit indicates the profitability of a company in dollars, without taking overhead expenses
into account. It is calculated by subtracting the Cost of Goods Sold from Revenue for the same
period.
15. Income Statement (Profit and Loss) (IS or P&L)
The Income Statement (often referred to as a Profit and Loss, or P&L) is the financial statement
that shows the revenues, expenses, and profits over a given time period. Revenue earned is
shown at the top of the report and various costs (expenses) are subtracted from it until all costs
are accounted for; the result being Net Income.
16. Net Income (NI)
Net Income is the dollar amount that is earned in profits. It is calculated by taking Revenue and
subtracting all of the Expenses in a given period, including COGS, Overhead, Depreciation, and
Taxes.
17. Net Margin
Net Margin is the percent amount that illustrates the profit of a company in relation to its
Revenue. It is calculated by taking Net Income and dividing it by Revenue for a given period.
18. Revenue (Sales) (Rev)
Revenue is any money earned by the business.
19. Accounting Period
An Accounting Period is designated in all Financial Statements (Income Statement, Balance
Sheet, and Statement of Cash Flows). The period communicates the span of time that is reported
in the statements.
20. Allocation
The term Allocation describes the procedure of assigning funds to various accounts or periods.
For example, a cost can be Allocated over multiple months (like in the case of insurance) or
Allocated over multiple departments (as is often done with administrative costs for companies
with multiple divisions).
21. Business (or Legal) Entity

7. This is the legal structure, or type, of a business. Common company formations include Sole
Proprietor, Partnership, Limited Liability Corp (LLC), S-Corp and C-Corp. Each entity has a
unique set of requirements, laws, and tax implications.
22. Cash Flow (CF)
Cash Flow is the term that describes the inflow and outflow of cash in a business. The Net Cash
Flow for a period of time is found by taking the Beginning Cash Balance and subtracting the
Ending Cash Balance. A positive number indicates that more cash flowed into the business than
out, where a negative number indicates the opposite.
23. Certified Public Accountant (CPA)
CPA is a professional designation that an accountant can earn by passing the CPA exam and
fulfilling the requirements for both education and work experience, which vary by state.
24. Credit
A credit is an increase in a liability or equity account, or a decrease in an asset or expense
account.
25. Debit
A debit is an increase in an asset or expense account, or a decrease in a liability or equity
account.
26. Diversification
Diversification is a method of reducing risk. The goal is to allocate capital across a multitude of
assets so that the performance of any one asset doesn’t dictate the performance of the total.
27. Enrolled Agent (EA)
An Enrolled Agent is a professional accounting designation assigned to professionals who have
successfully passed tests showcasing expertise in business and personal taxes. Enrolled Agents
are generally sought out to complete business tax filings to ensure compliance with the IRS.
28. Fixed Cost (FC)
A Fixed Cost is one that does not change with the volume of sales. For example, rent and salaries
won’t change if a company sells more. The opposite of a Fixed Cost is a Variable Cost.
29. General Ledger (GL)
A General Ledger is the complete record of a company’s financial transactions. The GL is used
in order to prepare all of the Financial Statements.
30. Generally Accepted Accounting Principles (GAAP)

8. These are the rules that all accountants abide by when performing the act of accounting. These
general rules were established so that it is easier to compare ‘apples to apples’ when looking at a
business’s financial reports.
31. Interest
Interest is the amount paid on a loan or line of credit that exceeds the repayment of the principal
balance.
32. Journal Entry (JE)
Journal Entries are how updates and changes are made to a company’s books. Every Journal
Entry must consist of a unique identifier (to record the entry), a date, a debit/credit, an amount,
and an account code (that determines which account is altered).
33. Liquidity
A term referencing how quickly something can be converted into cash. For example, stocks are
more liquid than a house since you can sell stocks (turning it into cash) more quickly than real
estate.
34. Material
Material is the term that refers whether information influences decisions. For example, if a
company has revenue in the millions of dollars, an amount of $0.50 is hardly material. GAAP
requires that all Material considerations must be disclosed.
35. On Credit/On Account
A purchase that happens On Credit or On Account is a purchase that will be paid at a future time,
but the buyer gets to enjoy the benefit of that purchase immediately. “Bartender, put it on my
tab…”
36. Overhead
Overhead are those Expenses that relate to running the business. They do not include Expenses
that make the product or deliver the service. For example, Overhead often includes Rent, and
Executive Salaries.
37. Payroll
Payroll is the account that shows payments to employee salaries, wages, bonuses, and
deductions. Often this will appear on the Balance Sheet as a Liability that the company owes if
there is accrued vacation pay or any unpaid wages.
38. Present Value (PV)

9. Present Value is a term that refers to the value of an Asset today, as opposed to a different point
in time. It is based on the theory that cash today is more valuable than cash tomorrow, due to the
concept of inflation.
39. Receipts
A Receipt is a document that proves payment was made. A business produces receipts when it
provides its product or service and it receives receipts when it pays for goods and services from
other businesses. Received Receipts should be saved and catalogued so that a company can
prove that its incurred expenses are accurate.
40. Return on Investment (ROI)
Originally, this term referred to the profit that a company was making (Return), divided by the
Investment required. Today, the term is used more loosely to include returns on various projects
and objectives. For example, if a company spent $1,000 on marketing, which produced $2,000 in
profit, the company could state that it’s ROI on marketing spend is 50%.
41. Trial Balance (TB)
Trial Balance is a listing of all accounts in the General Ledger with their balance amount (either
debit or credit). The total debits must equal the total credits, hence the balance.
42. Variable Cost (VC)
These are costs that change with the volume of sales and are the opposite of Fixed Costs.
Variable costs increase with more sales because they are an expense that is incurred in order to
deliver the sale. For example, if a company produces a product and sells more of that product,
they will require more raw materials in order to meet the increase in demand.