Accountancy/Introduction to Accountancy

From Wikibooks, the open-content textbooks collection

Contents 1 What are the Rules of Accounting? 2 The Nature of Accounts: Definitions 3 Overview of the accounting cycle 3.1 Debits and Credits 4 Separate Entity Concept 4.1 Journal Entries 4.2 T-Accounts 4.3 Ledger Accounts 4.4 Types of Accounts 5 Basic Accounting Principles 6 Financial Statements 7 Basic Accounting Classes Course Notes 8 Resources

[edit] What are the Rules of Accounting?

Accounting is the mechanism used to record activities and transactions that occur within a business. In its simplest terms, Accounting is the "language of business." However, in order to have an understandable record, a standard set of rules for accounting within the U.S. has been established. These rules are called the Generally Accepted Accounting Practices (GAAP), and all U.S. businesses are expected to follow them.

The first general rule of accounting is that every transaction is recorded. It has been said that businesses that do not record transactions, or incorrectly record transactions, are committing fraud, although this is not necessarily the case. Fraud is part of a much broader area called material misstatement which also can include error. An error is not necessarily fraud under the law. While there are exceptions to this rule, the guidance for applying those exceptions is specifically defined by GAAP, and is applicable to all businesses.

The second general rule of accounting is that transactions are recorded using what is called a "double-entry" accounting method. Originally developed in Italy in the 1400s, double-entry means that for a complete record of a transaction, two entries are made. For example, if you have $5 in cash, and want to buy some gasoline for your lawn mower, you take your portable gas can and your money to the gas station and exchange $5 in cash for $5 in gas. This transaction is recorded as an increase in the asset "gas" for $5, and a corresponding reduction in the asset "cash" for $5. In this example, one transaction contained two entries. This takes a little time to get used to, but it is a critical concept in basic accounting. Double entry is tied to the concept of Debits and Credits, which you will learn about in the next section. The act of recording transactions is commonly referred to as making journal entries. In a few more paragraphs, we'll discuss what a journal entry looks like.

The third general rule of accounting is that every recorded transaction is captured in a log called the "General Journal."

In general, "Accounting is the art of recording, classifying, summarizing and interpreting a business transaction."

To make this more easy,we can follow the golden rules of accounting.
Accounts are of three types; they are:

1.PERSONAL ACCOUNT: Accounts related to Individuals, Firms, Organizations, or Companies are classified as Personal A/c.

Eg:JIM A/c,MARY A/c,Microsoft A/c.

2.REAL ACCOUNT: Accounts related to assets of Tangible and In tangible nature are the REAL A/c.

Tangible:Assets that can be touch,felt or seen i.e. they have physical existence.

Eg:Cash,Machinery,Furniture etc..,

In tangible:Assets that cannot be seen, but help in the business activities.

Eg:Goodwill,Copy right,Trademark etc..,

3.NOMINAL ACCOUNT: Accounts that does not have a form or shape,but are present in the business transactions.

Eg:Salary A/c,Dividend A/c.

THE GOLDEN RULES OF ACCOUNTING:-
1.PERSONAL ACCOUNT:DEBIT-The recevier,CREDIT-The giver

2.REAL ACCOUNT:DEBIT-What comes in,CREDIT-What goes out

3.NOMINAL ACCOUNT:DEBIT-All Expenses and losses,CREDIT-All Incomes and Gains (or) profit

[edit] The Nature of Accounts: Definitions

An 'account' is a specific location for recording transactions of a like kind. For example, in the gas-for-cash transaction above, two accounts are used, a "Cash" account and a "Gas" account. Unused by that example, but described is an account for "Equipment" which would include the portable gas can and the lawn mower.

The basic types of accounts are:

'Assets:' items of value that the company owns or has right to. Examples include: cash, real estate, equipment, money or services that others owe you, and even intangible items such as patents and copyrights.

'Liabilities:' obligations that are owed to other parties. Examples include: wages payable, taxes due, and borrowed money (also called debt).

'Equity:' the ownership value of a company. Examples include: common stock and retained earnings (we'll describe retained earning below in "Financial Statements")

'Revenues:' the mechanisms where income enters the company (note that revenue and income are not the same thing--they are used here to describe each other in basic terms only).

'Expenses:' the costs of doing business. Examples include: salary expense, rent, utilities expense, and interest on borrowed money.

'Income:' in U.S. business and financial accounting, the term 'income' is also synonymous with revenue; however, many people use it as shorthand for net income, which is the amount of money that a company earns after covering all of its costs.

[edit] Overview of the accounting cycle

When a transaction occurs, a document is produced. Most of the time, these documents are external to the business, however, they can also be internal documents, such as inter-office sales. These documents are referred to as a source document. Some examples of source documents are:

• The receipt you get when you purchase something at the store.
• Interest you earned on your savings account which is documented in your monthly bank statement.
• The monthly electric utility bill that comes in the mail.

These source documents are then recorded in a Journal. This is also known as a book of first entry. The journal records both sides of the transaction recorded by the source document. These write-ups are known as Journal entries.

These Journal entries are then transferred to a Ledger.The group of accounts is called ledger. A ledger is also known as a book of accounts. The purpose of a Ledger is to bring together all of the transactions for similar activity. For example, if a company has one bank account, then all transactions that include cash would then be maintained in the Cash Ledger. This process of transferring the values is known as posting.

Once the entries have all been posted, the Ledger accounts are added up in a process called Balancing. (This will make much more sense when you learn about Debits and Credits. Balancing implies that the sum of all Debits equals the sum of all Credits.)

A particular working document called an unadjusted trial balance is created. This lists all the balances from all the accounts in the Ledger. Notice that the values are not posted to the trial balance, they are merely copied.

At this point accounting happens. The accountant produces a number of adjustments which make sure that the values comply with accounting principles. These values are then passed through the accounting system resulting in an adjusted trial balance. This process continues until the accountant is satisfied.

Financial statements are drawn from the trial balance which may include:

• the Income statement
• the Balance sheet
• the Cash flow statement

Finally, all the revenue and expense accounts are closed.

[edit] Debits and Credits

For the purposes of accounting, please forget what you know about credits and debits. In accounting, debit (Dr.) and credit (Cr.) have nothing to do with plastic cards that let you buy stuff. In fact, what most beginning accounting students need to know about Dr/Cr can be boiled down to two sentences.

Debit is on the left. Credit is on the right.

How are debit and credit rules applied to different types of accounts?

In case of ASSETS and EXPENSES; increases go to the debit side, while decreases go to credit side. On the other hand, in case of LIABILITIES, REVENUE and EQUITY; increases go to the credit side and decreases go to debit side.

An account will have either a "normal credit balance" or a "normal debit balance", depending on the type of account. The normal balance indicates which side of the account the amount goes to when the account balance increases. For example, the account 'Cash' has a normal debit balance: receiving cash results in a debit entry, spending it results in a credit entry.

Debits and credits may be derived from the fundamental accounting equation. They result from the nature of double entry bookkeeping. Two entries are made in each balanced transaction, a debit and a credit. This allows the accounts to be balanced to check for entry or transaction recording errors.

Example Journal  - Page 1

Date		Description	Post Ref.	Dr	Cr
2005 Feb	1	account1		350
		account2			350

Owner's Equity = Assets - Liabilities is written from the perspective of the owner. In accounting this is generally rewritten from the perspective of the business or commercial entity the books detail:

Assets = Owner's Equity + Liabilities

Entries in the books are in pairs and track the advantage or asset of the company simultaneously with the disadvantage or liability. In this view the Owner's equity is a claim of the investor against the company.

On the left side or asset side of the fundamental accounting equation. Transaction halves which increase the business assets are "debits" on the left side of the equation. Transaction halves which decrease the business assets are "credits".

This is inverted on the balancing side: transaction halves (i.e. the part of the transaction) that increase the owner's equity are credits to the company books as they are claims of what the company owes the owner or investor, while transaction halves that decrease the owner's equity (dividends paid or loss writeoffs) are beneficial to the company's future financial position by reducing claims and are considered debits. Likewise, liabilities incurred by the business entity (which are tracked by the books) are credits, while liabilities reduced or paid off are debits.

[edit] Separate Entity Concept

Even when a business has a single owner we make a distinction between the owner's assets and the assets of the business. For example if the owner gives a van to the business this will count as capital introduced, if the owner takes a salary this will be accounted for as drawings.

[edit] Journal Entries

All accounting transactions are first recorded in a journal. The most common of these is the General Journal, sometimes also known as the Book of Original Entry, because it is the first place a transaction is entered into the books. Journal Entries are made from source documents, which can be anything from receipts to invoices to bank statements.

General Journal  - Page 1

Date		Description	Post Ref.	Dr	Cr
2005 Jan	1	Cash		10,000
		Sales			10,000
		To record cash sales.
6		Equipment		15,000
		Accounts Payable			15,000
		To record purchase or equipment on credit

These two entries show the premise of double-entry accounting. Note that the form of what is written is as important as the actual text:

• Debits are always recorded first, followed by the credits.
• In keeping with the rule of "Debit = Left, Credit = Right", all accounts that are credited have their titles indented ("Sales" and "Accounts Payable" in this example).
• The year and month are only recorded once in the date column. They are recorded again at the top of every new page, and whenever the month or year changes. However, a new page is usually started at the beginning of each month, because end-of-period entries are normally recorded on a separate page.
• A description of each entry is placed on the line below the entry. While this is not required, it is good practice because, at times, account titles may not be enough to describe what actually occurred for a specific transaction.
• A blank line is inserted between entries.

The process of recording entries to a journal is called journalizing.

[edit] T-Accounts

Form:                              Example:
    Account Name                          Cash
    -------------                     -------------
    Debit | Credit                  $700.00 |  50.00
          |                           65.00 |  80.00
   _______|_______                  ________|_______
 Subtotal | Subtotal                 765.00 |  130.00
   _______|_______                  ________|_______
  Balance | Balance                 $635.00 |

One representation of an account is called the T-account, shown above. A T-account contains just the basic elements of the account, so it lacks the necessary detail for use in bookkeeping operations. However, it has its uses as both an illustrative tool and a quick reference.

Each account needs to have a unique Account Name, such as Cash, for ease of reference later on. In modern accounting systems, you will often see an account number alongside the name in order to facilitate report generation and computer entry. Under the bar are the debit (from the Latin debere, to owe) and credit (credere, to believe) columns.

As it shows in the example above, the balance of a T-account can be figured by first totaling each column. Second, subtract the smaller subtotal from the larger, and finally placing the total in the larger number's column.

[edit] Ledger Accounts

While a T-Account is useful for quickly summarising an account's balance, it only contains a fraction of the information that was recorded in the Journal.

[edit] Types of Accounts

Assets = Liabilities + Owner's Equity

A central axiom for accounting is the accounting equation above. Depending on the type of company involved, Owner's Equity may be "Shareholder's" or simply "Equity", but the equation holds. The list of all of the accounts (along with their respective account numbers) is called the Chart of Accounts

Asset accounts indicate what a company owns. This can be actual possession or the right to take possession, such as a loan extended to another company. Some assets are identifiable by the term "Receivable". Assets have a normal debit balance.

Liability accounts indicate what a company owes to others. Examples of liabilities include loans to be repayed and services that have been paid for that the company hasn't performed yet. Many liabilities can be identified by the term "Payable" in their account name. Liabilities have a normal credit balance.

Equity accounts are a group of accounts that represent the amount of owner's equity in the business. There are four main types of Equity accounts:

• Revenue accounts indicate revenue generated by the normal operations of a business. Fees Earned and Sales are both examples of Revenue accounts. Revenue accounts have a normal credit balance.

• Expense accounts indicate the expenses incurred by a business during normal operations. Most account names ending in "Expense" are classified as expenses. Expenses have a normal debit balance.

• The Owner's Equity or Owner's Capital accounts (for a Proprietorship/Partnership) or the Shareholder's Equity accounts (for a Corporation) indicate the owner's equity in the business. As the accounting equation indicates, equity is the difference between the assets of the company, and the company's debts. Equity accounts are directly affected by Revenue and Expenses, and the standard Equity accounts have Credit balances.

• Dividends represents equity removed from the business by the owners. In a proprietorship or partnership, each owner has an Owner's Withdrawals account. In a corporation, equity is removed by way of dividends, and a Withdrawal account is not needed. Since these accounts represent capital removed from the business, they have a Debit balance.

The effects of debits and credits on the types of accounts is shown on the following table:

Assets			Liabilities			Equity
						Capital			Dividends			Revenues			Expenses
Debit Increases Normal Balance	Credit Decreases		Debit Decreases	Credit Increases Normal Balance		Debit Decreases	Credit Increases Normal Balance		Debit Increases Normal Balance	Credit Decreases		Debit Decreases	Credit Increases Normal Balance		Debit Increases Normal Balance	Credit Decreases

[edit] Basic Accounting Principles

Historical Cost Principle: Assets and liabilities should be recorded at the price at which they were acquired. This is to ensure a reliable price; market values can fluctuate and be different between differing opinions, so the price of acquisition is used.

Matching Principle: Expenses should be matched with revenues. The expense is recorded in the time period it is incurred, which means the time period that the expense is used to generate revenue. This means that you can pay for an expense months before it is actually recorded, as the expense is matched to the period the revenue is made.

Revenue Recognition Principle: Revenues should not be recorded until the earnings process is almost complete and there is little uncertainty as to whether or not collection of payment will occur. This means that revenue is recorded when it is earned, which means the job is complete.

[edit] Financial Statements

The Income statement is a list of all inflows and outflows of economic benefits(revenues and expenses).

Company Name Income Statement For The Year Ended December 31, xxxx

---

Gross Revenues
-Cost of goods sold
= Gross Profit
-operating expenses
=Income from Continuing operations before taxes and special items
+ other revenues
- other expenses
-taxes
=Income from continuing operations
+/- extraordinary items (net of tax)
NET INCOME

The balance sheet is a list of all a company's assets, liabilities, and owners' equity.

Company Name Balance sheet December 31, xxxx

---

ASSETS
Current Assets
+ Fixed Assets
=TOTAL ASSETS
LIABILITIES
Current Liabilities
+Long-Term Liabilities
=TOTAL LIABILITIES
OWNER'S EQUITY
Common Stock
+Retained Earnings
=TOTAL OWNERS EQUITY
=TOTAL LIABILITES AND O/E

The statement of cash flows is a listing of the inflows and outflows of cash.

Company Name Statement of Cash Flows For The Year Ended December 31, xxxx

---

Cash provided by Operating activities.........................xx
Cash Provided by financing activities.........................xx
Cash Provided by investing activities.........................xx

[edit] Basic Accounting Classes Course Notes

• ALL accounting transactions are entered as journal entries consisting of the Account name, and either a debit (left side) amount or credit (right side) amount. For each entry the debits and credits must balance, and overall on the trial balance (lists all the debits and credits for all the accounts) must always balance.

• There are 5 main classes of Accounts:

• • Assets: Anything of value that the business owns. This includes tangible assets such as cash, accounts receivable, inventory, buildings, and machinery, as well as intangible assets such as copyrights, trademarks, and goodwill. Asset accounts normally have a Debit (left side) balance. In transaction entries, a debit to an asset account shows an increase in its amount, while a credit (right side) indicates a decrease in the asset value.
    • Example: Buying Equipment for Cash. One asset (Equipment) increases, and therefore it is Debited. Cash, which is also an asset, is decreased with a Credit.

 Equipment (debit)			$40,000
     Cash (credit)			     $40,000

• • Liabilities: Debts and obligations that the business owes. This includes accounts payable, payroll liabilities, and long term debts (such as bonds). Liabilities accounts normally have a Credit (right side) balance. In transaction entries, a credit to a liability account signifies an increase in its amount, while a debit (left side) indicates a decrease in the liability value.
    • Example: Buying Inventory on credit. Merchandise Inventory (an asset) increases with a debit, and Accounts Payable (a liability) also increases with a credit.

 Merchandise Inventory (debit)	$100,000
     Accounts Payable (credit)		     $100,000

• • Equity: This is essentially the value that accrues (accumulates) to the owners (shareholders, sole trader…). This ranges from Partner 1’s capital, Partner 1’s profits, retained earnings, etc. Equity accounts normally have a Credit (right side) balance. In transaction entries in the journals, a credit to an equity account signifies an increase in its amount, while a debit (left side) indicates a decrease in the equity value. Always keep the accounting equation in mind:

                Assets = Liabilities + Equity				

Since Assets normally have a Debit balance and both liabilities & equity normally have a credit balance, therefore applying the equation above, we always check that the trial balance has a NET value of Zero (the total debits and credits should match).

• • Revenue: This is the entire amount of income made through the sale of goods/services, and is sometimes referred to as Income or Sales. Depending on the nature of the goods / services being sold, companies track this account either as one big account (e.g. Sales) or as many separate accounts (e.g. Sales Prod 1, Sales Prod 2, Freight Income etc). Revenue accounts normally have a Credit (right side) balance, and therefore a credit to a revenue account signifies an increase in its amount, while a debit (left side) indicates a decrease in the revenue amount. A decrease of revenue would take place in circumstances such as for example sales returns and discounts (explained further down).
    • Example: Recording cash sales. Cash is debited because it is an increase in an asset account, and Sales is credited because a Revenue account is increased.

     Cash (debit)		       $112,000
     Sales (credit)			     $112,000

• • Expenses: These are the general costs of doing business. This would include operating expenses such as Salaries Expense, Rent Expense, and Advertising Expense, as well as non-operating expenses such as Loss on Sale of Assets. Expense accounts normally have a Debit (left side) balance. In transaction entries, a debit to an expense account signifies an increase in its amount, while a credit indicates a decrease (which rarely occurs, unless an error needs to be corrected).
    • Example: The company rents office space at $15,000 per month. Rent Expense is debited, and Cash is credited.

 Rent Expense (debit)		$15,000
     Cash (credit)			     $15,000

• Some very important aspects to remember in addition to the above:

• • Depreciation, Amortization, and Depletion are used to allocate the cost of an asset over its useful life. Depreciation is the allocation over time of tangible assets, Amortization is the allocation over time of intangible assets and Depletion is the allocation over time of natural resources.Accumulated depreciation is a contra-asset account (with a normal Credit balance) used to keep a running total of the depreciation to date. The book value of any asset at any time is the Original Cost less any accumulated depreciation. Contra-asset accounts are listed in the assets section of the balance sheet along with the corresponding asset account, making it easier to see what the assets original cost was and what it is presently valued at. Allowance for Uncollectible Accounts Receivable is also a contra-asset account with a normal credit balance which is netted against the Accounts Receivable account.

• • Sales Returns and Allowances & Sales Discounts are contra-revenue accounts, and the normal balance of this account is a Debit. These are used to offset the revenue credit balance.

• • Cost of Goods Sold (COGS): This account is used to track how much you paid for goods / material that was held in inventory until it was sold. COGS normally is a debit balance. This account is recorded in entries when a sale is made, and COGS is debited for the cost, while inventory is credited (asset account=>decreased) for the cost.

• • Credit Notes/memo/refunds are used to refund customers if they return products bought from the company. The entry for this transaction is usually :

     Revenue (Debit)		sale price
     Inventory (Debit)                     Cost of product
               COGS (Credit)               Cost of product
               Cash or A/R (Credit)	    sale price

[edit] Resources

• Free Business Textbooks Internet Library