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Financial literacy - Part 3 - Accounting Concepts

Regardless of your profession or if you are currently a student or if you are an employee or self-employed entrepreneur, it is good to learn the basic accounting concepts.  You do not need to be an A or B graded math student to find accounting concepts easy.  If you are in high school or post-secondary, please pick up financial accounting I & II in your electives.   After you complete your former schooling, it would be harder to learn accounting due to time.   

For the sick of easy understanding, I will do away with how I was taught accounting at school.  Concept explain will be somewhat according Generally Accepted Accounting Principals.  Those who understand accounting, please do not jump at me. 

Two rules:

Rule 1 - Revenue and Expense.  

Revenue as we know it is money coming into our pocket, either from employment or earned income from our clients.  For simplicity, gifts, grants, insurance payments are all considered revenue.   Borrowed money is not revenue.  Revenue and borrowed money increase our bank account and increase our asset.  However, borrowed money increase liability. 

Expenses are money coming out of our pocket.  They are what we spent in-order to buy the things like food, rent, motor vehicle expenses, travel.  Expenses are also interest we pay on borrowed money like loans and credit cards.  For simplicity, it is non-refundable.   Expenses decrease your bank account and decrease your asset.  The leftovers increases your asset and equity.  

If you put revenue and expenses together, we have what we called Income Statement or Statement of operation.   

Rule 2 - Asset & Liability & Equity.

Assets can be break-down into short-term and long-term.  The short-term asset is commonly known as current asset.  Current asset as the name suggest are purpose to be used over the next year.   They are bank account, GIC, mutual funds, accounts receivable (customers owe you) and inventory.  Unlike inventory, you cannot feel and touch them in a tangible way.   However, you can use them to generate revenue.  You hear the saying "it takes money to make money".   It should also be noted that current asset overtime acts as a spring board to acquire long-term asset.  There is a saying "small axe fall big tree".  This is why forced savings is so important in the life of individuals and business. 

Long-term asset is commonly known as fixed asset like real estate, motor vehicle (car lease is not asset), machinery.  The ownership uses them to generate revenue.  Fixed asset is not expected to be converted in cash within one year. 

How you finance your company is either from your own pocket or others money.  Financing by your own pocket is called equity and financing from others money is called liability.  

Liability are debts owes to others.  This includes loans, accounts payable (owe to suppliers), mortgages.  Liabilities is not necessarily a bad thing.  If liabilities are used in the right places, it will either generate capital gain through asset acquisition or generate more revenue through business operation.  However, if debts are use with none of the above, soon you will have sinking ship.   

Equity are funds invested to the company by the owner(s).  Retained earnings equity too.  Retained earnings are net income or loss accumulated over time.   

To sum-up, Rule 2 are commonly called Balance Sheet or Statement of position.    There are many different purpose of Balance Sheet, the common purpose is to know your financial strength.   Within the framework of financial strength is your overall net worth.  Net worth is calculated by Asset less liabilities.  The less liabilities, the more net worth.   This is one big reason investors and creditors want to see your Balance Sheet to have faith in your company. 

Now that I have explained Rule 1 & 2, how do we use accounting concept to our advantage?   Please stay tune for Part 4. 

 

 

Financial literacy - Part 4 - Paying yourself firs...
Financial literacy Part 2 - Interest & Tax
 

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