Basic Accounting Concepts and Principles

8/3/2019 Basic Accounting Concepts and Principles

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Basic Accounting Concepts and Principles

Accounting refers to the systematic recording of business transactions and preparation of statements relatingto assets, liabilities and functioning results of a business. Accounting has to follow certain fundamental rulesthat form the basic accounting concepts and principles. Here is a list of the basic accounting concepts andprinciples.Business Entity: This principle treats the company as a separate entity from its owners. Personal accounts of

owners/partners should be kept separate from profits and expenses of the company.

Cost: This principle states that the company has to consider the original cost of f ixed assets like building and

machinery, rather than market value. But today most of the companies report only the market value.

Sincerity: According to this principle, the auditors should prepare the financial reports in order to project the

real financial position of the company rather than fabricating facts.

Monetary Unit: This principle assumes that transactions should be recorded in a single currency and

exchange rate. This will help the company compare its accounts to the previous years, in spite of a change in

the rate of inflation.

Consistency: According to this principle, the accountants should use the same methods and functions fordifferent periods of time. For example, the same rate of percentage should be applied for all depreciation. This

principle is also known as the principle of regularity.

Prudence: The main objective of this principle is to show the real financial position of the company. The

accountants should show the correct revenue accounts and provide a provision for expenses which may occur

in the future.

Matching: According to this principle, all the revenues and concerned expenses incurred should be shown in

the same financial period. The main objective is to avoid any overstatements of income at any particular time.

Accrual: This principle requires the company to record the revenue or income when it is actually earned.

Continuity or Going Concern: This principle presumes that the functioning of the company will be smooth

and the business entity will continue to operate for a fairly long period.

Time Period: This principle specifies a particular interval of time for which the financial reports are prepared. It

can be either year, fiscal year or short period like a quarter or a month.

Full Disclosure/Materiality: This principle states that the full disclosure of information and events should be

ensured. The financial reports should not mislead the investors and should provide clear details of the financial

position of the business.

Dual Aspect: According to this principle, all f inancial transitions have two effects. This is the basis of the

accounting equation:

Assets = Liabilities + Equity

Assets are owned by a business, and liabilities are the debts of a business, that the company owns to its

creditors. Equity is what the company owes to its owners. So all transactions must comply to this equation.

Due to these guidelines of GAAP, consistency in the methods of preparations of financial accounts of the


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companies has been maintained. These principles are directly proportional to the complexity of the accounts of

a business and may hence seem complex. The continuing complexity of business transactions have made it

necessary for the accounts sector to have some standardization. GAAPs have not only set the benchmark for

standardization, but have also ensured that the general public has a clearer view of the financial stability of a

company.Debits and CreditsThese are the backbone of any accounting system. Understand how debits and credits work and you'l l understand thewhole system. Every accounting entry in the general ledger contains both a debit and a credit. Further, all debits must

equal all credits. If they don't, the entry is out of balance. That's not good. Out-of-balance entries throw your balance sheeout of balance.Therefore, the accounting system must have a mechanism to ensure that all entries balance. Indeed, most automatedaccounting systems won't let you enter an out-of-balance entry-they'll just beep at you until you fix your error.Depending on what type of account you are dealing with, a debit or credit will either increase or decrease the accountbalance. (Here comes the hardest part of accounting for most beginners, so pay attention.) Figure 1 illustrates the entriesthat increase or decrease each type of account.Figure 1Debits and Credits vs. Account TypesAccount Type Debit Credit

Assets Increases DecreasesLiabilities Decreases IncreasesIncome Decreases IncreasesExpenses Increases DecreasesNotice that for every increase in one account, there is an opposite (and equal) decrease in another. That's what keeps theentry in balance. Also notice that debits always go on the left and credits on the right.Let's take a look at two sample entries and try out these debits and credits:In the first stage of the example we'll record a credit sale:

Accounts Receivable $1,000Sales Income $1,000

If you looked at the general ledger right now, you would see that receivables had a balance of $1,000 and income alsohad a balance of $1,000.Now we'll record the collection of the receivable:

Cash $1,000 Accounts Receivable $1,000

Notice how both parts of each entry balance? See how in the end, the receivables balance is back to zero? That's as itshould be once the balance is paid. The net result is the same as if we conducted the whole transaction in cash:

Cash $1,000Sales Income $1,000

Of course, there would probably be a period of time between the recording of the receivable and its collection.That's it. Accounting doesn't really get much harder. Everything else is just a variation on the same theme. Make sure youunderstand debits and credits and how they increase and decrease each type of account.

Assets and LiabilitiesBalance sheet accounts are the assets and liabilities. When we set up your chart of accounts, there will be separatesections and numbering schemes for the assets and liabilities that make up the balance sheet.

A quick reminder: Increase assets with a debit and decrease them with a credit. Increase liabilities with a credit anddecrease them with a debit.

Identifying assetsSimply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So isthe company car you drive. Assets are the objects, rights and claims owned by and having value for the firm.Since your company has a right to the future collection of money, accounts receivable are an asset-probably a majorasset, at that. The machinery on your production floor is also an asset. If your firm owns real estate or other tangibleproperty, those are considered assets as well. If you were a bank, the loans you make would be considered assets sincethey represent a right of future collection.There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, andgoodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy.Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of apatent, the value is often linked to its development costs. Goodwill is often the difference between the purchase price of acompany and the value of the assets acquired (net of accumulated depreciation).


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Identifying liabilitiesThink of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable areliabilities, since they represent your company's future duty to pay a vendor. So is the loan you took from your bank. If youwere a bank, your customer's deposits would be a liability, since they represent future claims against the bank.We segregate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more thanseparating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) fromthose not to be paid until later. We often separate debt like this. It gives readers a clearer picture of how much thecompany owes and when.Owners' equity

After the liability section in both the chart of accounts and the balance sheet comes owners' equity. This is the differencebetween assets and liabilities. Hopefully, it's positive-assets exceed liabilities and we have a positive owners' equity. Inthis section we'll put in things like

Partners' capital accounts Stock Retained earnings

Another quick reminder: Owners' equity is increased and decreased just like a liability: Debits decrease Credits increase

Most automated accounting systems require identification of the retained earnings account. Many of them will beep at youif you don't do so.By the way, retained earnings are the accumulated profits from prior years. At the end of one accounting year, all theincome and expense accounts are netted against one another, and a single number (profit or loss for the year) is movedinto the retained earnings account. This is what belongs to the company's owners-that's why it's in the owners' equity

section. The income and expense accounts go to zero. That's how we're able to begin the new year with a clean slateagainst which to track income and expense.The balance sheet, on the other hand, does not get zeroed out at year-end. The balance in each asset, liability, andowners' equity account rolls into the next year. So the ending balance of one year becomes the beginning balance of thenext.Think of the balance sheet as today's snapshot of the assets and liabilities the company has acquired since the first day obusiness. The income statement, in contrast, is a summation of the income and expenses from the first day of thisaccounting period (probably from the beginning of this fiscal year).Income and ExpensesFurther down in the chart of accounts (usually after the owners' equity section) come the income and expense accounts.Most companies want to keep track of just where they get income and where it goes, and these accounts tell you.

A final reminder: For income accounts, use credits to increase them and debits to decrease them. For expense accounts,use debits to increase them and credits to decrease them.

Income accountsIf you have several lines of business, you'll probably want to establish an income account for each. In that way, you canidentify exactly where your income is coming from. Adding them together yields total revenue.Typical income accounts would be

Sales revenue from product A Sales revenue from product B (and so on for each product you want to track) Interest income Income from sale of assets Consulting income

Most companies have only a few income accounts. That's really the way you want it. Too many accounts are a burden forthe accounting department and probably don't tell management what it wants to know. Nevertheless, if there's a source ofincome you want to track, create an account for it in the chart of accounts and use it.Expense accounts

Most companies have a separate account for each type of expense they incur. Your company probably incurs pretty muchthe same expenses month after month, so once they are established, the expense accounts won't vary much from monthto month. Typical expense accounts include

Salaries and wages Telephone Electric utilities Repairs Maintenance Depreciation Amortization Interest Rent


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Definition of 'Balance Sheet'

A financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point

in time. These three balance sheet segments give investors an idea as to what the company owns and owes, aswell as the amount invested by the shareholders.

The balance sheet must follow the following formula:

Assets = Liabilities + Shareholders' Equity

Equity Capital

y Equity capital represents the shareholders' ownership stake in a company. Equity buyers, also called stockholdersor shareholders, hold voting rights and appoint corporate leadership. They make profits when share pricesincrease on securities exchanges, such as the New York Stock Exchange. Stockholders also receive periodicdividend payments, an extra incentive that lures investors to financially healthy companies.

Financial Reporting

y The fundamental accounting equation relates to the balance sheet, also known as a statement of financialposition or statement of financial condition. Other accounting reports include a statement of profit and loss, a cashflow statement and a retained earnings report. A profit and loss statement, or P&L, is also known as an incomestatement or statement of income.

Definition of 'Common Size Financial Statement'

A company financial statement that displays all items as percentages of a common base figure. This type of financial

statement allows for easy analysis between companies or between time periods of a company.

Financial Statement

A written report of the financial condition of a firm. Financial statements include the balance sheet, income statement,statement of changes in net worth and statement of cash flow.

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Basic Accounting Concepts and Principles