Accountancy/Introduction to Accountancy
Accounting is the process by which financial information about a business is recorded, classified, summarized, interpreted, and communicated. Accounting is the language of business.
What are the Rules of Accounting?[edit | edit source]
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 Principles (G.A.A.P), 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 G.A.A.P, 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 easier, we can follow the golden rules of accounting. Accounts are one of three basic types:
|Personal||Accounts related to individuals, firms, organizations, or companies||Individuals; partnership firms; corporate entities;Capital;Drawings; non-profit organizations; any local or statutory bodies including governments at the country, state or local levels|
|Real||Accounts related to assets of a tangible or intangible nature||
|Nominal||Temporary income and expenditure accounts for recognition of the implications of financial transactions during each fiscal term till finalization of accounts at term end||rent, salary,discount,utilities, dividends|
Example: The Sales account is opened for recording the sales of goods or services. At the end of the financial period, the total sales are transferred to the revenue statement account (Profit and Loss Account or Income and Expenditure Account).
Similarly, expenses during the financial period are recorded using the respective Expense accounts, which are also transferred to the revenue statement account. The net positive or negative balance (profit or loss) of the revenue statement account is transferred to reserves or capital account as the case may be.
THE GOLDEN RULES OF ACCOUNTING:
|Personal||The receiver||The giver|
|Real||What comes in||What goes out|
|Nominal||All expenses and losses||All income and gains (profits)|
The Nature of Accounts: Definitions[edit | edit source]
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.
Overview of the accounting cycle[edit | edit source]
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:
Finally, all the revenue and expense accounts are closed.
Debits and Credits[edit | edit source]
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.
How are debit and credit rules applied to different types of accounts?
DEBIT......NATURE OF A/Cs.......CREDIT
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.
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 (Fundamental Accounting Equation)
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 Assets 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".
- On the right or balancing side or Owner's Equity + Liabilities:
- 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
- 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.
- Liabilities incurred by the business entity (which are tracked by the books) are credits
- Liabilities reduced or paid off are debits.
Separate Entity Concept[edit | edit source]
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.Famous case laws are "salomon vs salomon & co.ltd",Lee vs Lee's air farming ltd." etc
Journal Entries[edit | edit source]
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.
|To record cash sales.|
|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.
T-Accounts[edit | edit source]
Form: Example: Account Name Cash ------------- ------------- Debit |Credit $750.00 | 100.00 | 65.00 | 80.00 _______|_______ ________|_______ Subtotal | Subtotal 815.00 | 180.00 _______|_______ ________|_______ 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.
Ledger Accounts[edit | edit source]
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.
Types of Accounts[edit | edit source]
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:
Summary of types of account[edit | edit source]
The main axiom to remember is that :
- Assets = liabilities + equity
- Debits and credits are opposite, for any one type of account.
- At the first level of the equation, on the left, debits increase, on the right, credits increase.
- Common assets accounts, that are short-term, liquid, or current, are cash in bank, accounts receivable, inventory. They are on the left.
- common non-current asset accounts include property , plant and equipment. They are on the left, however changes to their value is accumulated in contra-asset accounts, called accumulated depreciation, and hence they are contra to debit being positive, credits increase accumulated depreciation. They can be thought of as negative asset accounts on the left, paired with a non-current asset account which shows cost value, or revaluation value, in which case they are also paired with a revaluation reserve account to show the amount of revaluation ( in order for the above equation to stay in balance after revaluation).
- Common current liability accounts are accounts payable, bills payable, salaries payable. They are on the right , so credit increases the liability and debit decreases.
- common non-current liability accounts include bank loans , debentures and mortgage payable, which all incur interest expense and are either repaid in full or incrementally over time with cash in bank. These are on the right too, so an initial credit establishes the long term liability, and debits coupled with cash in bank credits (decrease) account for repayment.
- Common equity accounts are divided according to the entity type: for a sole trader, it is owner capital ; for partnerships, there is a owner capital account for each partner; for companies, there is shareholder's equity, and a retained earnings account to hold accumulated profits. Equity is on the right, so credit increases equity.
- Other accounts arise from temporary , periodic operations, and are temporary accounts. They mainly deal with recording accumulated changes to equity, and are usually divided into Incomes and Expenses. Income accounts move equity positively, so Credit increases Income accounts. Expenses move equity negatively, so increase in these accounts decreases equity, ie in the same direction as Debit, so Debits increase expense accounts.
- Common income accounts are (operating) revenue, dividends, interest, gains.
- Common expense accounts are (operating) expenses such as Cost of Goods sold, salary expense, utilities expense (telephone, electricity), rent expense, insurance expense.
- When equity decreases, assets decrease by the same amount, or liability increases, in order to meet the equation.
- As expense accounts decrease equity, they usual decrease assets , usually as a decrease in cash in bank.
- A special type of expense is depreciation, which decreases non-cash / non-current assets, and for depreciable assets, usually there is a contra-asset account set up, called accumulated depreciation for each type of asset, to record the accumulated depreciation expense. When the accumulated depreciation equals the current assessed value of the non-cash asset, the asset can be disposed of, and written-down , so both the asset and accumulated depreciation are removed from the statement of accounts.
- Another special type of expense is bad debts expense, as they also do not decrease cash asset directly, but decrease accounts receivable asset. There is a contra-asset account which records bad debt expense accrued estimation,allowance for bad debts, which is eventually balanced in the equation with a decrease in accounts receivable asset when bad debts are determined to have occurred, and are written down, and accounts receivable asset as well as the allowance have the amount determined to be bad debt written off. Allowance for impairment of accounts receivables is another name for the allowance account, and it is deducted from the accounts receivables account on the balance sheet , in order to show that the accounting equation balances in the period when the estimated bad debts expense is incurred.
Basic Accounting Principles[edit | edit source]
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.
Financial Statements[edit | edit source]
The Income statement is a list of all inflows and outflows of economic benefits(revenues and expenses).
-Cost of goods sold
= Gross Profit
=Income from Continuing operations before taxes and special items
+ other revenues
- other expenses
=Income from continuing operations
+/- extraordinary items (net of tax)
The balance sheet is a list of all a company's assets, liabilities, and owners' equity.
+ Fixed (or non-current) Assets
+Long-Term (or non-current) Liabilities
=TOTAL OWNERS EQUITY
=TOTAL LIABILITES AND O/E
The statement of cash flows is a listing of the inflows and outflows of cash.
It follows the general subdivision of business activity into trying to make money by operating activities, investing activities, and financing activities. Operating activities include the main business that is concentrated on, and paying taxes on this business, as well as interest for liabilities from owning non-current assets such as machinery to run the business. Investing activities include cash used for investment in plant and equipment or recovered from sale of plant or equipment, and money made outside of the main business activity using resources available from the business : this include investing cash available in other investments , receiving cash interest or dividends from continuing other investment. Financial activities are cash activities undertaken when other entities invest in the operations of the main business. So finance activities include cash from issuing shares in the company, cash given as dividends to shareholders, cash from borrowing and cash out due to borrowing repayment .
Hence this derives a list of activities to account for cash flow:
- operating activities - cash from operations : customer receipts, and supplier payments ; cash paid for taxes; cash paid as interest for borrowings to operate plant and equipment.
- investing activities - cash out for purchase plant and equipment, and cash in from sale of these ; cash put in other investments; cash received from dividends received and from interest earned related to running other investments.
- finance activities - cash in from issuing shares, cash out from payment of dividends ; cash in from borrowing money, cash out for repayment of borrowing
A few items are reported as netted if they are sufficiently short term or liquid ( such as other investments, equity shareholding changes) : e.g. "quick turnover, short maturity and large - AASB 7";, but many items are required to be reported as gross i.e. cash out and cash in for the same type of item are required to be reported separately e.g. property sale and purchase, interest paid and interest earned , borrowings and repayment of borrowings.
cash receipts from customers....................................................xx
cash payments to suppliers......................................................(xx)
cash payment of taxes..............................................................(xx)
cash payment of interest on property,plant&equipment.........(xx)
Cash provided by Operating activities...........................xx
cash invested in/(divesting from) other investments..........................................(xx)
cash used for plant and equipment...................................(xx)
cash recovered from sale of plant and equipment.....................xx
cash from dividend income from other investments..................xx
cash from interest from other investments..........................................xx
Cash Provided by investing activities.............................xx
cash from issuing (buy back of) share capital...................................................xx
cash from long-term borrowings..................................................xx
cash used as repayment of long-term borrowings.....................(xx)
cash paid as dividend to shareholders.......................................(xx)
Cash Provided by financing activities............................xx
Net cash increase (decrease) in cash held......................xx
cash held at beginning of period....................................xx
cash held at end of period.............................................xx
Basic Accounting Classes Course Notes[edit | edit source]
- 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
- a summary :
assets ( current asset (cash in bank + accounts receivables - allowance for bad debts) + ( non-current asset - accumulated depreciation) ) = liability ( current liability + non-current liability ) + equity ( capital + ( issued share equity + retained earnings ) + change in equity ( income (revenue + gains ) - expenses ( operating + depreciation + bad debt ) - drawings ).