This is a summary of the topics covered in Chapter 2: Fundamental Accounting Concepts. You can always check the full lessons out anytime.
A. Basic Accounting Principles
Accounting assumptions and principles provide the bases in preparing, presenting and interpreting general-purpose financial statements.
The basic principles that accountants follow include:
- Accrual – Income is recognized when earned regardless of when collected, and expenses are recognized when incurred regardless of when paid.
- Going Concern – Also known as continuing concern concept or continuity assumption, it means that a business entity will continue to operate indefinitely.
- Accounting Entity Concept – A specific business enterprise is treated as one accounting entity, separate and distinct from its owners.
- Time Period Assumption – The indefinite life of an enterprise is subdivided into time periods or accounting periods which are usually of equal length for the purpose of preparing financial reports.
- Monetary Unit Assumption – Transactions are recorded in terms of money (quantifiability). The currency used has a stable purchasing power (stability).
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B. Elements of Accounting
The elements of accounting pertain to assets, liabilities, and capital. Assets are resources owned by a company; liabilities are obligations to creditors and lenders; and capital refers to the interest of the owners in the business after deducting all liabilities from all assets (or, what is left for the owners after all company obligations are paid).
Assets can be classified as current or non-current. An asset is considered current if it is for sale, if it can be realized within 12 month from the end of the accounting period or within the company's normal operating cycle if it exceeds 12 months. In addition, cash is generally considered current asset.
Current assets include: Cash and Cash Equivalents, Marketable Securities, Accounts Receivable, Inventories, and Prepaid Expenses. Assets that do not meet the criteria to be classified as current are, by default, non-current assets. Examples of non-current assets are: Long-term Investments; Property, Plant and Equipment; and Intangibles.
Liabilities can also be classified as current or non-current. A liability is considered current of they are payable within 12 months from the end of the accounting period, or within the company's normal operating cycle if the cycle exceeds 12 months.
Current liabilities include: Accounts Payable, Short-term Notes Payable, Tax Payable, Accrued Expenses, and other short-term obligations. Non-current liabilities include those that do not meet the above criteria. Examples of non-current liabilities are: Loans Payable and Bonds Payable which are long-term in nature, and Deferred Tax Liabilities.
Capital refers to the interest of the owner/s of the business. The owner's interest is the value of total assets left after all liabilities to creditors and lenders are settled. Capital is increased by contributions by the owner/s and income. It is decreased by withdrawals by owners (dividends in corporations) and expenses.
Income refers to an increase in assets or decrease in liability, and an increase in capital other than that arising from contributions made by owner/s. Examples of income accounts include: Sales, Service Revenue, Professional Fees, Interest Income, Rent Income, and others.
Expenses result in decrease in assets or increase in liabilities, and decrease in capital other than those arising from withdrawals of the owner/s. Some examples are: Cost of Sales, Salaries Expense, Rent Expense, Utilities Expense, Delivery Expense, and others.
C. Accounting Equation
The accounting equation shows the relationships between the accounting elements: assets, liabilities and capital. The basic accounting equation is:
Assets = Liabilities + Capital
It shows that assets owned by a company are coupled with claims by creditors and lenders, and by the owners of the business.
When business transactions take place, the values of the elements in the accounting equation change. Nonetheless, the equation always stays in balance. This is due to the two-fold effect of transactions. The total change on the left side is always equal to the total change on the right. Thus, the resulting balances of both sides are equal.
The accounting equation may be rewritten as:
Liabilities = Assets - Capital, or Capital = Assets - Liabilities.
The capital element may also be spread-out into its components, and thus resulting into the expanded accounting equation:
Assets = Liabilities + Capital - Withdrawals + Income - Expenses
Assets = Liabilities + (Capital, beginning + Additional Contributions - Withdrawals + Income - Expenses)
D. Double Entry Accounting System
The double entry accounting system recognizes a two-fold effect in every transaction. Thus, business transactions are recorded in at least two accounts.
Under the double entry accounting system, transactions are recorded through debits and credits. Debit means left. Credit means right. The effect of recording in debit or credit depends upon the normal balance of the account debited or credited.
The general rules are: to increase an asset, you debit it; to decrease an asset, you credit it. The opposite applies to liabilities and capital: to increase a liability or a capital account, you credit it; to decrease a liability or a capital account, you debit it. Expenses are debited when incurred, and income is credited when earned. See Full Tutorial
E. The Accounting Cycle
The accounting cycle is a sequence of steps in the collection, processing, and presentation of accounting information. It is made up of the following steps:
- Identifying and analyzing business transactions and events
- Recording transactions in the journals
- Posting journal entries to the ledger
- Preparing an unadjusted trial balance
- Recording and posting adjusting entries
- Preparing an adjusted trial balance
- Preparing the financial statements
- Recording and posting closing entries
- Preparing a post-closing trial balance
Reversing entries may be prepared at the beginning of the new accounting period to enable a smoother recording process. In this step, some adjusting entries are simply reversed. Nevertheless, reversing entries are optional. See Full Tutorial