The formation of a financial statement is initiated by recording a double entry in the accounting system. When the business carries out some activity, an accounting record must be updated. An activity may be referred to as the occurrence of some business-related event that needs to be recorded as a transaction in the accounting record.
The accounting transactions need to be posted in five different accounts relevant to the nature of the transactions. These accounts include assets, liabilities, equity, revenue, and expenses.
Accounting transactions need to be posted considering the double impact on the accounting system. Hence, one of the accounts is debited, and one of the accounts is credited. Sometimes, both credit and debit may be posted in the same account depending on a financial transaction.
Let’s discuss detailed aspects of these types of accounts.
Assets
An asset is a resource controlled by the entity; it has certain economic value and may be tangible on intangible. An asset may be equipment purchased/developed by the business, some patent purchased/developed by the company, or even brand value/goodwill.
Further, assets are expected to generate cash in-flows, help reduce expenses to be incurred and improve the company’s sales. However, the business must expect to have future cash in-flows with this ownership/control.
An asset may be financial/non-financial, depending on the way the value can be derived from it. For instance, a financial asset derives its value from a contractual claim to receive the cash. On the other hand, the value of a non-financial asset is dependent on the physical net worth.
Similarly, assets can be current assets and non-current assets. Current assets are assets that are liquid enough to be converted into cash/cash equivalents—for instance, marketable securities, term deposits, accounts receivables, inventory, and short-term deposits, etc.
On the other hand, it’s difficult for the non-current assets to be converted into cash/cash equivalents. These assets are also termed long-term assets/fixed assets; examples include equipment, plant, vehicles, furniture, machinery, etc.
Liability
Liability is a financial obligation on the business that needs to be settled in the future. It’s recorded in the books of accounts when it’s established that the business has an obligation to make payment.
This obligation to make payment is settled when economic benefit outflows from the business. Further, liability is considered to be an alternate of equity financing. However, it’s for the short term.
Effective management of the liability is one of the essential requirements for business management because there is a need to balance between the financing needs of the company and the expectation of the suppliers/parties to have timely payment of their funds.
Liability can be current/non-current, depending on the date of maturity. If the liability to be paid is due within a year, is said to be a current liability. On the other hand, if the liability to be paid is due in a time more than a year, it’s said to be a non-current liability. Further, some liabilities may be interest-bearing and need to be paid in preference.
Examples of liability include accounts payable, income taxes payable, interest payable, short-term loans, bank overdrafts, mortgage payable, deferred tax liabilities, bonds payable, and accrued expenses, etc.
Equity
Equity is what is left for the business owners when all of the liabilities have been deducted from the company’s assets. Equity is also referred to as owner’s equity because it’s worth that actually belongs to an owner.
Equity is recorded in the balance sheet and If the figure of equity is positive, it means the business has more assets than liabilities. On the other hand, if an equity figure is negative, liability outweighs the assets, which may not be a good financial indicator.
It’s important to note that the company’s equity can be of two types: book value and market value. Books value is what remains after deduction of the liabilities from assets.
On the other hand, the market value of equity is calculated by multiplying the share price by the total number of shares issued by the company. Alternative for the book value calculation is estimating the value of equity with discounted cash flow method.
Further, there may be different balances in the equity account. These balances include share capital, retained earnings, surplus, dividends, net income/net losses, etc.
Revenue
Revenue is the income generated from the sale of the services/products by the company. It’s recorded on the top line of the income statement and is subject to the risk of an overstatement. Revenue needs to be recognized in the income statement when related risks and rewards are transferred to the customers or buyers of products/services.
It’s important to note that cash receipt is not a prime condition for the revenue to be recognized in the income statement. It’s about the establishment of the right to receive an economic benefit in the future.
However, it’s only the case when business follows the accrual basis of accounting. On the other hand, if the business follows cash-based accounting, a business must receive the cash to record the transaction.
In addition to this, revenue is considered one of the riskiest areas in the financial statements. It’s because revenue directly affects profitability, and management may find revenue a soft target to be misstated.
Further, if we deduct expenses from the revenue, it leads to profit/loss.
Expenses
Expense is the money spent by a business to generate revenue or support the business processes that generate revenue. Under the accrual basis of accounting, the business needs to recognize the expenses in a period of occurrence irrespective of whether cash is paid or not. However, the business must have received the products or services associated with the expense.
It’s important to note that all of the cash the business pays is not an expense. Some payments of the cash may be for the purchase of assets or decrease of the liability.
Some of the expenses may be straightforward and directly recorded in the income statement. For instance, an amount paid under repair and maintenance is directly recorded in the income statement.
On the other hand, some expenses may be tricky to deal with. For instance, depreciation is one of the complex expenses calculated based on figures in the balance sheet, and the amount is obtained after applying judgmental accounting policy and rates.
In addition to this, the business may incur some expenses for production that are classified under the cost of sales. On the contrary, expenses incurred for the support of company operations are classified under administrative expenses.
Examples of administrative expenses include legal and professional expenses, repair and maintenance, insurance expenses, tax expenses, traveling expenses, etc.
Frequently asked questions
What are the variable and fixed expenses?
Variable expenses are the expenses that change with the level of activity. If the level of activity increases, variable expenses increase. On the other hand, fixed assets do no change with changes in the level of activity.
What are the types of expenses?
Types of expenses include the cost of sales, administrative expenses, selling and & admin expenses, etc.
Does a company need to record sales tax expenses?
If your business is registered with the sales tax authority, the sales tax paid on the purchases (input tax) can be claimed from a customer. So, there is no need to record sales tax expenses. On the contrary, if the business is not registered with the tax authority, the tax paid on the purchase has to be recorded as an expense.
What is the matching concept, and how it’s related to expense recognition?
The matching concept means that corresponding revenue and expenses should be recorded in the same accounting period irrespective of whether cash is paid. This recognition of the expense without making payment gives rise to the concept of recording accrual.
Similarly, if the business has paid more than the services received, the remaining portion of the payment is recognized as prepaid.
What evidence is needed for recording expenses?
Evidence needed for recording expenses includes invoices from suppliers, receipt notes, and the approved purchase order.
