Lesson 3: Key Accounting Terms

Lesson 3: Key Accounting Terms

Introduction to Essential Terminologies: Assets, Liabilities, Equity, Revenue, and Expenses

Objective:

Understand and define the essential accounting terminologies used in financial recordkeeping and reporting. Learn how these terms relate to one another and how they are applied in real-world accounting.

Lesson Content

1. Assets

Definition:
Assets are resources owned by a business that have economic value and are expected to provide future benefits. They are classified into two main categories:

• Current Assets: Resources expected to be used or converted into cash within one year (e.g., cash, accounts receivable, inventory).
• Non-Current Assets (Fixed Assets): Long-term resources used for business operations (e.g., buildings, machinery, patents).

Examples:

1. Cash in the company’s bank account (Current Asset).
2. A company van used for deliveries (Non-Current Asset).

Real-Life Application:
A bakery owns an oven (non-current asset) to bake goods and maintains a stock of flour (current asset) for daily operations.

2. Liabilities

Definition:
Liabilities are obligations or debts that a business owes to external parties. These are amounts the business is required to pay in the future. Liabilities are classified into:

• Current Liabilities: Debts payable within one year (e.g., accounts payable, short-term loans).
• Non-Current Liabilities: Long-term obligations (e.g., mortgages, bonds payable).

Examples:

1. An outstanding utility bill of AED 1,000 (Current Liability).
2. A loan taken from a bank for 5 years (Non-Current Liability).

Real-Life Application:
A retail shop owes AED 50,000 to a supplier for inventory purchased on credit (accounts payable).

3. Equity

Definition:
Equity represents the owner’s residual interest in the business after deducting liabilities from assets. It is also known as “net worth” or “capital.”
Formula:
Equity = Assets – Liabilities

Components of Equity:

1. Owner’s Capital: Initial investment made by the owner(s).
2. Retained Earnings: Profits reinvested in the business instead of being distributed to owners or shareholders.

Examples:

1. A business owner invests AED 100,000 to start a bakery (Owner’s Capital).
2. A portion of profits, AED 20,000, is retained to purchase new equipment (Retained Earnings).

Real-Life Application:
If a business owns AED 500,000 worth of assets and owes AED 200,000 in liabilities, the equity of the business is AED 300,000.

4. Revenue

Definition:
Revenue is the income earned by a business from its core operations, such as sales of goods or services. It is often referred to as “top-line income” because it appears at the top of the income statement.

Examples:

1. AED 10,000 earned from selling baked goods (Sales Revenue).
2. AED 5,000 received from providing consulting services (Service Revenue).

Real-Life Application:
A consulting firm earns revenue by charging clients for services provided, while a retail store earns revenue from selling products.

5. Expenses

Definition:
Expenses are the costs incurred by a business to generate revenue. These include operational costs, salaries, rent, and utilities. Expenses are categorized into:

• Operating Expenses: Regular expenses related to daily operations (e.g., salaries, rent).
• Non-Operating Expenses: Costs not directly tied to operations (e.g., interest on loans).

Examples:

1. AED 3,000 spent on raw materials for baking (Operating Expense).
2. AED 500 paid as interest on a bank loan (Non-Operating Expense).

Real-Life Application:
A café incurs expenses for coffee beans, employee wages, and electricity to operate daily. These expenses reduce the overall profit.

How These Terms Interconnect

1. Assets, Liabilities, and Equity (The Balance Sheet Equation):
   The relationship between these terms is captured in the fundamental accounting equation:
   Assets = Liabilities + Equity

Example:
If a business owns AED 50,000 in assets and owes AED 20,000 to creditors, the owner’s equity is AED 30,000.

2. Revenue and Expenses (The Income Statement):
   Revenue and expenses determine the profitability of a business.
   Net Profit = Revenue – Expenses

Example:
A restaurant earns AED 50,000 in revenue for a month and incurs AED 30,000 in expenses. The net profit is AED 20,000.

Summary of Key Terms

This lesson introduces you to the foundational terminologies that form the basis of accounting. These terms will be applied throughout the course to help you understand financial statements and analyze business performance.