Understanding the basics of accounting

The complete set of IFRS financial statements includes:

1. Balance Sheet (Statement of Financial Position)
2. Statement of Comprehensive Income (Includes the Profit or Loss and so called Other
Comprehensive Income). In some countries, the Statement of Comprehensive Income does not
exist and there exists only Profit or Loss (sometimes called the Income Statement).
3. Statement of Cash Flows
4. Statement of Changes in Equity
5. Notes to Financial Statements

Balance Sheet
Basic structure of the Balance Sheet
Assets Equity and Liabilities
Non-current (fixed, long-term assets) Equity
Tangible fixed assets (land, buildings, factory
and office equipment, cars, etc)
Share capital (Investments in the business from
the owners)
Intangible assets (patents, brands and similar
assets without physical substance)
Other parts of equity (share premium, reserves,
etc.)
Financial assets (long-term receivables,
investments in other entities, long-term deposits)
Retained earnings (profits or losses from
previous years together with those from current
accounting period)
Current assets (short-term assets) Non-current (long-term) liabilities
Inventories Long-term borrowings
Trade and other receivables Provisions
Cash and cash equivalents Other long-term payables
Current (short-term) liabilities
Short-term borrowings
Trade and other payables
Provisions
Current tax liabilities
Total Assets = Total Equity + Liabilities


There are many possible forms of the Balance Sheet. Normally, the form of the Balance Sheet could
be this:
Assets
Non-current (fixed, long-term assets)
Tangible fixed assets (land, buildings, factory and office equipment, cars, etc)
Intangible assets (patents, brands and similar assets without physical substance)
Financial assets (long-term receivables, investments in other entities, long-term deposits)

Current assets (short-term assets)
Inventories
Trade and other receivables
Cash and cash equivalents
Total Assets

Equity and Liabilities
Equity
Share capital (Investments in the business from the owners)
Other parts of equity (share premium, reserves, etc.)
Retained earnings (profits or losses from previous years together with those from current
accounting period)

Non-current (long-term) liabilities
Long-term borrowings
Provisions
Other long-term payables

Current (short-term) liabilities
Short-term borrowings
Trade and other payables
Provisions
Current tax liabilities
Total Equity and Liabilities


Changes in Balance Sheet
Each accounting transaction influences the Balance Sheet in two different line items.
Example
You have decided to start a new business being an accounting adviser. At the start of your business
you put in your business 10,000 in cash. This money comes from your savings that you have had in
the bank and now you have decided to use it in your new business.
The items that have changed in the Balance Sheet are highlighted.
(1) Your first accounting transaction will be as follows:
Balance Sheet at the start of your business
Current assets Equity
Cash 10,000 Capital 10,000
Total assets 10,000 Total equity and liabilities 10,000

(2) You have decided to buy a new computer for 1,000. You have paid for the computer in cash.
Balance Sheet after the transaction (2)
Non-current assets Equity
Computer 1,000 Capital 10,000
Current assets
Cash 9,000
Total assets 10,000 Total equity and liabilities 10,000
The Balance Sheet has changed. You have spent 1,000 in cash, this suggests now you have 9,000, but
you have a new computer. We can say that in this transaction the structure of assets has changed.
After every transaction we must check whether the Balance Sheet balances.
(3) You have decided to buy a printer. This time you have bought the asset (printer) on credit. You
have to pay your supplier in one month. The cost of the printer is 500.
Balance Sheet after the transaction (3)
Non-current assets Equity
Computer + Printer 1,500 Capital 10,000
Current assets Current liabilities
Cash 9,000 Trade payables 500
Total assets 10,500 Total equity and liabilities 10,500
The Balance Sheet has changed again. You have a new printer, but you have not paid for it yet.
Instead, you have a liability that you have to pay in a month. The Balance Sheet balances.
(4) You have rent an office room. The month rentals are 600. You have paid the rents in cash.
Balance Sheet after the transaction (4)
Non-current assets Equity
Computer + Printer 1,500 Capital 10,000
Profit or loss (600)
Current assets Current liabilities
Cash 8,400 Trade payables 500
Total assets 9,900 Total equity and liabilities 9,900
The rents are your expense (i.e. not an asset). If you account for an expense, you deduct your profit for
the period. Profit for the period can be calculated as:
Profit = Income (revenues) less expenses
Up to now, we have had no income but we have had an expense of 600. This means we have
recognised a loss of 600.
(5) You have given an advice to your customer and he has paid you for this service 2,000 in cash.
Balance Sheet after the transaction (5)
Non-current assets Equity
Computer + Printer 1,500 Capital 10,000
Profit or loss 1,400
Current assets Current liabilities
Cash 10,400 Trade payables 500
Total assets 11,900 Total equity and liabilities 11,900
You have earned in your business the amount of 2,000. The customer has paid immediately in cash.
This suggests that you have increased your cash by 2,000 and you have increased your profit by 2,000.
Now you do not recognise the loss (as in transaction 4) but instead you are in profit of 1,400.
(6) You have given an accounting advice to customer 2. You have agreed that the customer will pay
you in a month. The amount was 1,000.
Balance Sheet after the transaction (6)
Non-current assets Equity
Computer + Printer 1,500 Capital 10,000
Profit or loss 2,400
Current assets Current liabilities
Cash 10,400 Trade payables 500
Trade receivables 1,000
Total assets 12,900 Total equity and liabilities 12,900
In this transaction, a new trade receivable is recognised in the Balance Sheet. Also the profit has
increased by 1,000. In this transaction, you have seen the main rule of so called ACCRUAL
accounting:
In Accrual accounting, the revenue (income) is recognised when earned and expenses are
recognised when incurred. Revenues and expenses are recorded even though cash has not been
received or paid.

(7) You have received the bill for telephone calls you have made in the past month (but in current
accounting period). You have to pay the bill in 14 days. The amount is 100.

Balance Sheet after the transaction (7)
Non-current assets Equity
Computer + Printer 1,500 Capital 10,000
Profit or loss 2,300
Current assets Current liabilities
Cash 10,400 Trade payables 600
Trade receivables 1,000
Total assets 12,900 Total equity and liabilities 12,900
Changes in the Balance Sheet the summary
We have had seven accounting transactions. In every transaction, the Balance Sheet has changed. You
could observe that in every transaction the Balance Sheet has changed in two items (highlighted). This
is a basis of so called double-entry accounting.
1 transaction = 2 accounting entries
You have also seen that the changes were not always the same. Some changes in the Balance Sheet
have increased the Assets and at the same time have increased the Equity or Liabilities. We can
describe such changes like this:
Assets Equity and Liabilities
+ +
The examples of such a change are transactions number (1), (3), (5) and (6).
Some changes in the Balance Sheet we can describe like this:
Assets Equity and Liabilities

The example of this change is transaction number (4).
Some changes in the Balance Sheet we can describe like this:
Assets Equity and Liabilities
+

The example of such a change was transaction number (2).
The last possibility is this change:
Assets Equity and Liabilities
+

The example of this change was transaction number (7).
The purpose of the Income Statement (Profit or Loss)
Note
According to IFRS, you have to produce the Statement of Comprehensive Income, which is something like enlarged form
of the Income Statement. Statement of Comprehensive Income includes the Income Statement plus some other line items that
will be explained later during the semester. Now we will focus just on the Income Statement.

In some countries, the profit of an entity for the current period is recognised in the Balance Sheet
together with its profits (or losses) from the past accounting periods (in the line item called Retained
Earnings). In this situation, you can just read in the Balance Sheet what the total profits were since the
entity has been established but you cannot identify what the profit for the current period was.
In some countries, Retained Earnings are split into profits (or losses) from the past accounting periods
and profit (or loss) for the current period. In this situation you are able to see the profit (or loss)
separately in the Balance Sheet. But even if you see in the Balance Sheet the profit for the current
period separately, you (or the users of financial statements) normally need more information about the
structure of profit (or loss). The purpose of the Income Statement is to show:
1. The total profit or loss for the current accounting period, and
2. The structure of the profit or loss
The basic structure of the Income Statement is:
Revenue X
Expenses (X)
Profit or loss X

The Income Statement of real entity is more detailed than the basic format mentioned above. In some
countries, the Income Statement has three parts (in some countries just two parts):
1. Operating Operating revenues include product sales and fees earned from
services rendered; operating expenses include cost of sales and
other expenses that differ based on the nature of particular
business. The examples are: wages, insurance, rentals, utilities,
equipment maintenance, depreciation of tangible fixed assets or
amortisation of intangibles, etc.
2. Other (non-operating) Interest expenses and revenue, gains or losses from the sale of
fixed assets, etc.
3. Extraordinary This exists only in some countries. Examples are earthquake,
floods, hurricanes, terrorist attacks or nationalisation of some
formerly private property.

Example
During the explanation of the purpose of the Balance Sheet we have had seven accounting
transactions.
1. The contribution of the owner in the business 10,000.
2. Purchase of a computer 1,000 in cash.
3. Purchase of a printer 500 on credit.
4. Payment of the rent of 600 in cash.
5. Revenue from the service rendered 2,000 in cash.
6. Revenue from the service rendered 1,000 sold on credit.
7. The telephone bill for calls that have already incurred 100 (but the expense belongs to the
current accounting period).

After the transaction number (7) the Balance Sheet looked like as follows:
Balance Sheet after the transaction (7)
Non-current assets Equity
Computer + Printer 1,500 Capital 10,000
Profit or loss 2,300
Current assets Current liabilities
Cash 10,400 Trade payables 600
Trade receivables 1,000
Total assets 12,900 Total equity and liabilities 12,900

Because all seven transactions have occurred in one accounting period, retained earnings are equal to
profit for the period. In the list of transactions, the transactions with the impact in the Income
Statement are highlighted. We can read in the Balance Sheet that our profit is 2,300.
If we now produce the Income Statement, we will also see the structure of our profit.

The Income Statement for the period....
Operating revenues
Rendering of services 3,000

Operating expenses
Rents (600)
Telephone (100)
Profit 2,300

Using T-Accounts
The Balance Sheet is normally not produced (or printed from the records in your computer) after every
single transaction as we did in our transactions. So called Accounting cycle means that you prepare the
complete set of financial statements at the end of accounting period (typically 1 year). The closing
Balance Sheet at the end of previous accounting period is simultaneously the opening Balance Sheet
of the new accounting period. The accounting cycle means:
Balance Sheet at the beginning of the period (Opening Balance Sheet) Opening the Accounts
Recording the transactions on particular accounts Closing the accounts at the end of accounting
period Preparing the Closing Balance Sheet (and the rest of Financial Statements) Publishing the
complete set of Financial Statements (including Notes).

The knowledge of Balance Sheet means the understanding accounting. The accountant must
distinguish: what is an asset, what is a liability, what belongs to the equity. The accountant must also
identify when the expense has incurred or revenue was earned. The reason is that when we need to
open the accounts, it really matters what kind of account we are speaking about. When you want to
produce accounts from the Balance Sheet, the name of the Balance Sheet item is usually
simultaneously the name of the T-account (sometimes you open accounts in higher detail and when
you prepare the Balance Sheet you put them together into one Balance Sheet item) and the amount is
typically called the Opening Balance. The left side of account is called DEBIT (Dr); the right side is
called CREDIT (Cr).

Dr Cash Cr
Opening
balance (OB)




The basic rule when opening the accounts is:
The Opening balance of accounts that are produced from the Balance Sheet is ALWAYS on the same
side of the T-account as the item underlying is placed in the Balance Sheet.

Example
We open the T-accounts from our Balance Sheet after the Transaction number (1):
Balance Sheet after transaction (1)
Current assets Equity
Cash 10,000 Capital 10,000
Total assets 10,000 Total equity and liabilities 10,000


Cash Capital
OB 10,000 OB 10,000



How to recognise which side of T-account should be used?
It depends on what kind of account we speak about. The behaviour of all ASSETS and EXPENSES
accounts is:

Dr Assets + Expenses Cr
OB
Additions Reductions


The behaviour of all EQUITY, LIABILITIES and REVENUES accounts is:

Dr Equity, Liabilities, Revenues Cr
OB
Reductions Additions


Example
Now we can use T-accounts and record all seven transactions that we have had in previous text.
1. The contribution of the owner in the business 10,000.
2. Purchase of a computer 1,000 in cash.
3. Purchase of a printer 500 on credit.
4. Payment of the rent of 600 in cash.
5. Revenue from the service rendered 2,000 in cash.
6. Revenue from the service rendered 1,000 sold on credit.
7. The telephone bill for calls that have already incurred 100 (but belong to the current
accounting period).

Cash Capital
Tangible fixed assets
(computer + printer)
(1) 10,000 (2) 1,000 (1) 10,000 (2) 1,000
(5) 2,000 (4) 600 (3) 500


Trade payables Expenses (rent + telephone) Revenues
(3) 500 (4) 600 (5) 2,000
(7) 100 (7) 100 (6) 1,000


Trade receivables
(6) 1,000



At the end of accounting period, the closing balances are calculated. The closing balance is calculated
as follows:

Opening balance + Additions Reductions = Closing balance

After calculation of closing balances we can prepare the Balance Sheet and the rest of financial
statements. We focus on two financial statements the Balance Sheet and the Income Statement. In
the Balance Sheet, the items of expenses and revenues are not explained line-by-line (as we already
know). That means the profit (or loss) are included in the Balance Sheet in one line item (in some
countries called Retained Earnings; in some countries Retained Earnings are split into Retained
Earnings of previous accounting periods and Profit or Loss of the current period).

Balance Sheet after the transaction (7)
Non-current assets Equity
Computer + Printer 1,500 Capital 10,000
Profit or loss 2,300
Current assets Current liabilities
Cash 10,400 Trade payables 600
Trade receivables 1,000
Total assets 12,900 Total equity and liabilities 12,900

The Income Statement for the period....
Operating revenues
Rendering of services 3,000

Operating expenses
Rents (600)
Telephone (100)
Profit 2,300