The Basics of

Accounting
Definitions, Principles,
and Examples
What is
Accounting ?
Accounting, the systematic
recording, analysis, and
reporting of financial
transactions, serves as the
fundamental language of
business, ensuring
transparency and reliability in
data for informed decision-
making by stakeholders.

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Accounting consists of 2
processes:
Book-Keeping
Management Reporting
 Book-Keeping is the process of
Book-Keeping

recording and summarizing

financial information. It
involves recording day to day
transactions (like sales,
purchases, expenses etc.) and
summarizing this information in
the form of financial
statements. Book-Keeping is
the most important process or
the backbone of the
accounting process.

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Reporting
Management
Management Reporting
involves data analysis
and providing reliable
and meaningful
information to the
management for
performance assessment,
future planning and
decision making.

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 Why is it required?
There are number of interested parties who
wants to look at the financial statements of
an entity

Few of them are listed here:

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What are the types
of financial
statements?

There are three types of financial

statements which Companies
must report periodically. They are

Income Statement
Balance sheet
Cash flow statement

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Let us discuss each of them one by one.

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Income statement
Income statement or profit and loss
statement shows the entities
incomes and expenses during a
period. It shows how the revenues
(top line) of the company has
translated into net income (bottom
line) during the period.

Corporate’s are required to file their

income statement with the
regulatory authorities on a periodic
basis (Annually and quarterly).

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 Prepare a profit and loss
Example
account for John covering
the period from January 1st,
2020, to January 31st, 2020,
considering an initial
investment of $1,000,
purchase of 100 meters of
dress material at $9 each,
selling the material at $20
each, and an additional
marketing expense of $100.

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Revenue is the amount received on
sale of goods. Revenue is also
referred to as Sales, Turnover or
Top-line.

In our example, John sold 100

meters of dress material @ $20 per
meter. Hence, his total revenue is
$2,000.

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Cost of goods sold(COGS) is the
price paid for acquiring goods and
services.

COGS include all the direct costs

(labor, material, overheads)
associated with
acquisition/manufacturing of goods
and services.

In our example, John purchased 100

meters of dress material @ $9 per
meter. Hence his total purchase cost
or Cost of goods sold is $900.

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Gross profit is the profit after
deducting the cost of goods
sold from total revenues/
sales generated during a
period.

Gross profit= Revenues –

Cost of goods sold.

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Marketing Spend is a spend
associated with sales of
products and services. This is
considered as an indirect spend.
Indirect expenses are included in
the income statement below the
Gross profit. In the above
example, John incurred a
marketing spend of $100. Hence,
it is included as an indirect
expense in the income
statement.

Net income is the profit generated

by a Company after accounting for
all expenses. In our example, it is
$1000.

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Balance sheet
Balance sheet is the statement of
Assets, liabilities and equity of a
company as at a given date.

It is a statement showing what an

entity owns (Assets), what it owes
to others (Liabilities) and what its
owners have invested in the
business (Equity).

Assets = Liabilities + Equity

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 This means that assets invested in the
business are financed by liabilities
(Operating liabilities and Debt) and
Equity.

Continuing with our previous

Example

example, lets assume that

John had invested $1000/-
equity in his business. On
the day of investment his
balance sheet would look like
this.

Balance sheet of John as on

1st Jan 2020.

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Let us discuss each of the items
one by one.

Current assets are those assets

which can be converted into cash
within one year. They include:
Cash and cash equivalent, Trade
receivable, Inventory, prepaid
expenses etc.

Non-current Assets include assets

such as Property plant and
equipment, Long term investments
etc. which cannot be converted into
cash (during the normal course of
operations) within one year.

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Total Assets is a sum of current
and non-current assets

Current Liabilities are those

liabilities which are expected to be
paid within one year. These
liabilities include: Trade payable/
creditors, Short term outstanding
expenses, Short term debt etc.

Non-current liabilities are those

liabilities which are expected to be
paid after one year. It includes Long
term debt, Pension, Post-retirement
benefit liabilities etc.

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Equity is the amount invested in
the business by its owners.

Equity = Total Assets –

Total Liabilities
Now coming back to our example,
John had invested $1,000 in the
business. His balance sheet will
look as shown above. Equity will be
$1,000 and cash/Assets will be
$1,000 cash.

Once he buys the dress material

for $900 his balance sheet will look
as under.

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 Balance sheet of John as on 1st Jan
2020.

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$1,000 cash gets reduced to $100, as
he paid $900 for the dress material.

The dress material purchased

becomes his inventory of $900 in the
balance sheet.

In the next one month, John sells off

all the inventory and earns a net
profit of $1000. His balance sheet on
31st January will look like this.

Balance sheet of John as on 31st Jan

2020.

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His inventory gets converted to
revenues of $2,000. Out of which he
pays $100 for marketing spend. That
means his cash balance would
increase by $1,900.

Closing cash balance for John

would be $100 + $2,000 – $100 =
$2,000

Inventory gets reduced to NIL.

Equity increases by $1,000 which

is the net profit earned during the
period.

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Closing Equity = Opening Equity +
Net profit

Closing Equity = $1,000 + $1000 =

$2,000

Inventory gets reduced to NIL.

Equity increases by $1,000 which

is the net profit earned during the
period.

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Cash flow
statement
Cash flow statement is the third
financial statement. It is an
important statement to report
as it shows how efficiently a
company manages its cash. It
shows how much cash a
company has generated from
its operations and how much of
it was spent and retained
during a period.

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Type of Cash flows

Cash flow Statement has 3 parts:

Cash flows from operating

Activities
Cash flows from Investing
Activities
Cash flows from financing
Activities

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Cash flows from Operating
Activities (CFO)

is the most important part of a

cash flow statement. It shows
how much cash a company has
generated from its operations

Cash flows from Investing

Activities (CFI)

shows the cash spent by the

company for future growth.

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 Cash flows from Financing
Activities (CFF)

includes raising and repayment of

capital (through equity or by debt).

Cash flows from Investing

Activities (CFI)

shows the cash spent by the

company for future growth.

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 Continuing with our previous
Example

example. Let’s look at the cash

flow statement of John on 01st
Jan 2020 before he purchases
the dress material.

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There is no cash flow from
Operating and Investing Activities.
John has financed his business
with $1000 equity.

Hence cash flows from Financing

Activities would be positive $1000.

Opening cash is NIL and closing cash

is $1,000 funded in the business.

Now, once he purchases the dress

material, his cash flow statement
would look like this.

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$900 used in purchasing dress
material is a cash outflow for
John from Operating Activity.

Closing cash left in the business

is $100.

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 Ashish Agarwal

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