Explained Through a Story
In this post, I’ll give you an introduction to accounting by telling you a story.
It’s a story about Claudio, and how he runs his business in Italy.
Before we start, let’s just get clear on what accounting is.
Accounting makes it possible to systematically record, analyze, and report important financial information, and communicate the financial health of a business to all interested parties.
It’s called the language of business, and it’s the backbone of any company because every business needs reliable data to make informed decisions.
But what does that really mean? Let’s just take a moment to make this a bit more transparent and understand the basics of accounting.
Let me tell you about Claudio
Imagine we’re in Italy, a nice beach city, where a man called Claudio is selling souvenirs to tourists.
He only sells one item, a beautiful plate made from colorful glass.
In the morning, he leaves his home with 100 euros, and goes to the manufacturer of the souvenir.
Each plate costs one euro, so Claudio buys 100 pieces with his 100 euros.
He walks to the beach and sells the plates to tourists for five euros a piece, and by noon, he sold out.
He goes home happily and repeats the same process the next day.
After a month, he wants to know how much the business made.
- What if he sold more than one item? Which one was more profitable?
- Would it make sense to expand his business, like rent a fixed stand at the beach?
Without a way of recording the daily activities of his business, he’s not going to be able to answer these questions.
Accounting makes this possible
Not only will each financial transaction be recorded, but Claudio will also get detailed reports, summarizing his financial performance.
We call these reports financial statements.
Let’s start with Claudio’s profitability.
If you want to find out about a business’s profitability, you go to their income statement.
This is one of the main financial statements.
There you can find out how much sales a business had in a certain period, which costs, and what was the resulting profit or loss.
There is another name you may hear for the income statement. “P&L”, for profit and loss.
It’s a fairly simple business model, and the P&L for Claudio’s business would look like this.
He sold 100 plates for five euros each.
That’s what we call sales or revenue, which were 500 euros.
The plates he sold, he didn’t get for free, right? He incurred costs to buy them.
Each plate cost him one euro.
Therefore, in total, his costs were 100 euros.
We call this the cost of goods, which we need to deduct from revenue.
To keep it simple, we don’t consider any other costs for now, like fees and taxes.
If we add this up, we can see that Claudio made a profit, or a net income of 400 euros.
That’s how a simple income statement would look like.
The Balance Sheet
Next, we’re going to take a quick look at the second main financial statement, the balance sheet.
The balance sheet shows which ASSETS the company owns, the LIABILITIES it owes to others, and the EQUITY that belongs to the owners.
Assets are usually things of value, or resources the company owns and uses.
For instance, land and buildings, office equipment, inventory, or cash, just to name a few.
Liabilities are what you owe to others.
For example, a bank loan, or what you owe to your suppliers for goods, or to the IRS in taxes.
The third component is equity.
This is a bit more abstract.
It’s the residual amount that would be left if the company sold all its assets and paid off all its liabilities.
In other words, it’s the difference between total assets and total liabilities.
This leftover money belongs to the owners of the company.
In the balance sheet, the assets are on one side, and equity and liabilities are on the other side.
If you draw a line between the two, and one on top, it looks like a T.
This is what accountants use to visualize accounting transactions.
It’s a very helpful tool, and we’re going to come back to these T accounts all the time.
You can see that the left side of the T is just as big as the right side.
That’s because everything the company owns, its assets, was purchased either from debt, so somebody else’s money, or its own money, meaning equity.
For money to go to one account, it must come out of another.
We call this a flow of economic benefit from a source to a destination.
We already said that assets minus liabilities equals equity.
If we rearrange this, like this, we get assets equal liabilities plus equity.
Both sides are always in balance, hence the name balance sheet.
And that is the foundation for any accounting system; the accounting equation.
The total amount of assets equals total liabilities plus equity.
Both sides are in balance.
Claudio’s Balance Sheet
With that in mind, let’s see how the balance sheet looks like for Claudio.
A balance sheet is always created at a certain point in time, like at the end of the business year, or at the end of a quarter.
In our example, it’s the end of Claudio’s business day.
Claudio started out with 100 euros in cash, which is also the money, or equity, he put into the business.
The cash on the left side equals equity on the right side.
The balance sheet, at this point, is in balance.
Then, he spent the cash in the morning, to buy the colorful plates.
The plates are what we call his inventory.
In the process, his cash got reduced to zero, but in exchange, he received another asset, inventory.
He didn’t get richer or poorer by that, right? The total amount of assets is still 100, but of course, his equities too.
After he sold the plates five euros each, he ended up with 500 euros in his pocket at the end of the day.
His inventory is gone because he sold all the plates to the tourists.
At the end of the day, his inventory value, therefore, is zero.
He doesn’t have any more plates.
If we look at Claudio’s balance sheet at the end of the day, we can see that the total value of assets, the left side, is 500 euros.
That’s the cash he came home with.
On the credit side, we only have 100 euros.
The balance sheet is out of balance.
As we know, this can’t be.
Both sides always need to be in balance.
So, what’s wrong here?
The missing component is the profit he made during the day.
If you go back to the income statement, we see that Claudio’s net income was 400 euros.
This will be added to equity, why? Because due to his successful business, he made the business more valuable.
When he started out the day, it was worth only 100 euros, which was the money he put into the business when he walked out the door.
When he came home, he had sold all his plates with a profit of 400 euros.
So, his business is now worth more, which is reflected in a higher equity.
Net income is the link between the income statement and the balance sheet.
So, when we add the profit of 400 euros he achieved to equity, also the right side gets to a total of 500 euros, and the balance sheet balances like it should.
So, that’s how it would look like for Claudio at the end of his successful day at the beach.
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