Chapter 2 Fundamentals of Accounting Concepts

8/15/2019 Chapter 2 Fundamentals of Accounting Concepts

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Basic Accounting Principles

Accounting principles serve as bases in preparing, presenting and interpreting

fnancial statements.

They provide a foundation to prevent misunderstandings between and among the preparers and

users.

The Conceptual Framework of Accounting mentions the underlying assumption of going

concern.

In addition, the concepts of accrual, accounting entity, monetary unit, and time period are also

important in preparing and interpreting financial statements.

Going Concern Assumption

The going concern principle, also known as continuing concern concept or continuity

assumption, means that a business entity will continue to operate indefinitely, or at least for

another twelve months.

Financial statements are prepared with the assumption that the entity will continue to exist in the

future, unless otherwise stated.

The going concern assumption is the reason assets are generally presented in the balance sheet at

cost rather that at fair market value. ong!term assets are included in the books until they arefully utili"ed and retired.

Accrual Basis of Accounting

The accrual method of accounting means that #revenue or income is recogni"ed when earned

regardless of when received and expenses are recogni"ed when incurred regardless of when

paid#.

$ence, income is not the same as cash collections and expense is different from cash payments.

%nder accrual basis, revenues and expenses are recogni"ed when they occur regardless of when

the amounts are received or paid.

For example, A&C Company rendered repair services to a client on 'ecember (, )*+). The

client paid after * days - anuary /, )*+.

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0hen should the income be recogni"ed1 - 2n the date it is considered earned 3when the service

has been fully rendered4. $ence, the income should be recogni"ed on 'ecember (, )*+) even if

it has not yet been collected as of that date.

Another example, suppose A&C Company received its electricity bill for 5arch on April 6, )*+

and paid it on April +*.

0hen should the electricity expense be recorded1 Correct! - 5arch. 0hy1 &ecause, the

electricity expense was for the month of 5arch even if the bill has been received and paid in

April. In other words, the #electricity# was used7consumed in 5arch.

Accounting Entity Concept

The accounting entity concept recogni"es a specific business enterprise as one accounting entity,

separate and distinct from the owners, managers, and employees of that business.

In other words, it means that a company has its own personality set apart from its owners or

anyone else. 8ersonal transactions of the owners, managers, and employees must not be mixed

with transactions of the company.

For example, if A&C Company buys a vehicle to be used as delivery e9uipment, then it is

considered a transaction of the business entity.

$owever, if 5r. A, owner of A&C Company, buys a personal car using his own money, that

transaction is not recorded in the company:s accounting system because it is not a transaction of

the company.

Time Period (Periodicity)

The time period assumption, also known as periodicity assumption, means that the indefinite life

of an enterprise is subdivided into time periods 3accounting periods4 which are usually of e9ual

length for the purpose of preparing financial reports on financial position, performance and cash

flows.

An accounting period is usually a +)!month period, either calendar or fiscal .

A calendar year refers to a +)!month period ending 'ecember +. A fiscal year is a +)!month

period ending in any day throughout the year, for example, April + to 5arch + of the following

year.

The need for timely reports has led to the preparation of more fre9uent reports, such as monthly

or 9uarterly statements.



Monetary Unit Assumption

The monetary unit assumption has two characteristics - 9uantifiability and stability of the

currency.

Quantifiability means that records should be stated in terms of money, usually in the currency of

the country where the financial statements are prepared.

Stability of the dollar (or euro, pound, peso, etc.), a.k.a. stable dollar concept means that the

purchasing power of the said currency is stable or constant and that any insignificant effect of

inflation is ignored.

It is to be noted however that financial statements of a company reporting in the currency of a

hyperinflationary economy 3an economy with a very signifcant inflation rate4 must be restated, in

accordance to applicable accounting standards.

Other Principles eri!ed from the A"o!e Concepts

;ome of the other principles followed in accounting include<

• Matching Principle – The matching concept means that expenses arerecognized in the period the related income is earned, and income isrecognized in the period the related expenses are incurred. In essence,income is matched with expenses and vice versa.

Through the accrual basis accounting, better matching o income and

expenses is achieved.

• !evenue !ecognition Principle – In accrual basis accounting, revenue orincome is recognized when earned regardless o when received. It means thatincome is recorded when the service is ull" perormed or when sale occurs,even i the amount is not "et collected.

• #xpense !ecognition Principle – Also under accrual basis accounting,expenses are recognized when incurred regardless o when the" are paid. Inother words, expenses are recorded when used $incurred%, even i the" arenot "et paid.

• &istorical 'ost Principle – Items in the balance sheet are generall" presented

at historical cost. (onetheless, some accounts are measured using otherbases such as air mar)et value, current cost, and discounted amount. *ouwill learn more about them in intermediate accounting studies.

The #lements o Accounting+ Assets, iabilities, and 'apital

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The three ma-or elements o accounting are+ Assets, iabilities, and 'apital. These

terms are used widel" in accounting so it is necessar" that we ta)e a close loo) at

each element.

&ut first, let:s define account .

0hat is an Account1

The term #account# is used often in this tutorial. Thus, we need to understand what it is before

we proceed. In accounting, an account is a descriptive storage unit used to collect and store

information of similar nature.

For example, #Cash#.

Cash is an account that stores all transactions that involve cash receipts and cash payments. All

cash receipts are recorded as increase in #Cash# and all payments are recorded as deductions tothe same account.

Another example, #&uilding#. ;uppose a company ac9uires a building and pays in cash. That

transaction would be recorded in the #&uilding# account for the ac9uisition of the building and a

reduction in the #Cash# account for the payment made.

=ow, let:s take a look at the accounting elements.

Assets

Assets refer to resources owned and controlled by the entity as a result of past transactions andevents, from which future economic benefits are expected to flow to the entity. In simple terms,

assets are properties or rights owned by the business. They may be classified as current or non!

current.

A. Current assets - Assets are considered current if they are held for the purpose of being

traded, expected to be reali"ed or consumed within twelve months after the end of the period or

its normal operating cycle 3whichever is longer4, or if it is cash. >xamples of current asset

accounts are<

. 'ash and 'ash #/uivalents – bills, coins, unds or current purposes, chec)s,cash in ban), etc.

0. !eceivables – Accounts !eceivable $receivable rom customers%, (otes!eceivable $receivables supported b" promissor" notes%, !ent !eceivable,Interest !eceivable, 1ue rom #mplo"ees $or Advances to #mplo"ees%, andother claims



• Allowance for Doubtful Accounts – This is a valuation account which

represents the estimated uncollectible amount o accounts receivable. It is

considered a contra-asset account and is presented as a deduction to the

related asset, accounts receivable. 1oubtul accounts are discussed in detail

in another lesson.

2. Inventories – assets held for sale in the ordinar" course o business

3. Prepaid expenses – expenses paid in advance, such as, Prepaid !ent, PrepaidInsurance, Prepaid Advertising, and 45ce 6upplies

B. Non-current assets - Assets that do not meet the criteria to be classified as current. $ence,

they are long!term in nature - useful for a period longer that +) months or the company:s normal

operating cycle. >xamples of non!current asset accounts include<

. ong7term investments – investments or long7term purposes such as

investment in stoc)s, bonds, and properties8 and unds set up or long7termpurposes

0. and – land area owned or business operations (not for sale)

2. 9uilding – such as o5ce building, actor", warehouse, or store

3. #/uipment – Machiner", :urniture and :ixtures $shelves, tables, chairs, etc.%,45ce #/uipment, 'omputer #/uipment, 1eliver" #/uipment, and others

• Accumulated Depreciation – This is a valuation account which represents

the cumulative depreciation expense. It is considered a contra-asset accountand is presented as a deduction to the related asset. 1epreciation is

discussed in detail in another lesson.

;. Intangibles – long7term assets with no ph"sical substance, such as goodwill,trademar), cop"right, etc.

<. 4ther long7term assets

#ia"ilities

iabilities are economic obligations or payables of the business.

Company assets come from ) ma?or sources - borrowings from lenders or creditors, and

contributions by the owners. The first refers to liabilities, the second to capital.

iabilities represent claims by other parties, aside from the owners, against the assets of a

company.



ike assets, liabilities may be classified as either current or non!current.

A. Current liabilities - A liability is considered current if it is due within +) months after the

end of the balance sheet date. In other words, they are expected to be paid in the next year.

If the company:s normal operating cycle is longer than +) months, a liability is consideredcurrent if it is due within the operating cycle.

Current liabilities include<

. Trade and other pa"ables – such as Accounts Pa"able, (otes Pa"able, InterestPa"able, !ent Pa"able, Accrued #xpenses, etc.

0. 'urrent provisions – estimated short7term liabilities that are probable and canbe measured reliabl"

2. 6hort7term borrowings – fnancing arrangements, credit arrangements orloans that are short7term in nature

3. 'urrent7portion o a long7term liabilit" – the portion o a long7term borrowingthat is currentl" due.

Example: :or long7term loans that are to be paid in annual installments, the

portion to be paid next "ear is considered current liabilit". The rest, non7

current.

;. 'urrent tax liabilities – taxes or the period and are currentl" pa"able

B. Non-current liabilities - iabilities are considered non!current if they are not currently

payable, i.e. they are not due within the next +) months after the end of the accounting period or

the company:s normal operating cycle, whichever is shorter.

In other words, non!current liabilities are those that do not meet the criteria to be considered

current. Hah! ae sense" =on!current liabilities include<

. ong7term notes, bonds, and mortgage pa"ables8

0. 1eerred tax liabilities8 and

2. 4ther long7term obligations

Capital

Also known as net assets or e#uity, capital refers to what is left to the owners after all liabilities

are settled. ;imply stated, capital is e9ual to total assets minus total liabilities. Capital is affected

by the following<



. Initial and additional contributions o owner=s $investments%,

0. >ithdrawals made b" owner=s $dividends or corporations%,

2. Income, and

3. #xpenses.

2wner contributions and income increase capital. 0ithdrawals and expenses decrease it.

The terms used to refer to a company:s capital portion varies according to the form of ownership.

In a sole proprietorship business, the capital is called $wner%s &#uity or $wner%s Capital' in

partnerships, it is called artners% &#uity or artners% Capital' and in corporations, Stocholders%

&#uity.

In addition to the three elements mentioned above, there are two items that are also considered as

key elements in accounting. They are income and epense. =onetheless, these items are

ultimately included as part of capital.

$ncome

Income refers to an increase in economic benefit during the accounting period in the form of an

increase in asset or a decrease in liability that results in increase in e9uity, other than contribution

from owners.

Income encompasses revenues and gains.

*evenues refer to the amounts earned from the company@s ordinary course of business such as

professional fees or service revenue for service companies and sales for merchandising and

manufacturing concerns.

+ains come from other activities, such as gain in selling old e9uipment, gain on sale of short!

term investments, and other gains.

Income is measured every period and is ultimately included in the capital account. >xamples of

income accounts are< ;ervice evenue, 8rofessional Fees, ent Income, Commission Income,

Interest Income, oyalty Income, and ;ales.

E%pense

>xpenses are decreases in economic benefit during the accounting period in the form of a

decrease in asset or an increase in liability that result in decrease in e9uity, other than distribution

to owners.



>xpenses include ordinary epenses such as Cost of ;ales, Advertising >xpense, ent >xpense,

;alaries >xpense, Income Tax, epairs >xpense, etc.B and losses such as oss from Fire,

Typhoon oss, and oss from Theft. ike income, expenses are also measured every period and

then closed as part of capital.

et income refers to all income minus all expenses.

Conclusion

And we:ve come to the end of this lesson. 0e have covered all the elements of accounting. For a

recap< assets are properties owned by the businessB liabilities are obligations to other partiesB

and, capital refers to the portion of the assets available to the owners of the business after all

liabilities are settled.

2n the next page, you will find some exercises to test and solidify your knowledge of the

accounting elements. -e sure to chec it out!

The Accounting #/uation and &ow It 6ta"s in 9alance

The accounting e/uation is the uni"ing concept in accounting that shows the

relationships between and among the accounting elements+ assets, liabilities, and

capital.

In this lesson 3and the next ones4, you will learn about the basic accounting e9uation and how it

stays in balance.

&efore taking this lesson, be sure to be familiar with the accounting elements.

Basic Accounting E&uation

0hen a business starts to operate, its resources 3assets4 come from two sources< contributions by

owners and resources ac9uired from creditors or lenders. In other words, all assets initially come

from liabilities obtained and owners: contributions. This is the idea of the accounting e9uation.

The basic accounting e9uation is<

Assets = Liabilities + Capital

As business transactions take place, the values of the accounting elements change. The

accounting e9uation nonetheless always stays in balance.

>very transaction has a two!fold effect. 5eaning, at least two accounts are affected. et:s

illustrate all of that through these examples.

Assume the following transactions<

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. Mr. Alex invested ?0@,@@@ to start a printing business,

0. The compan" obtained a loan rom a ban), ?2@,@@@,

2. The compan" purchased printers and paid a total o ?,@@@.

$ow will the transactions affect the accounting e9uation1

et us take a look at transaction +<

Transaction Assets ' #ia"ilities Capital

* O+ner,s in!estment 0@,@@@.@@ 7 B 0@,@@@.@@

Again, every transaction has a two!fold effect. In the above transaction, assets increased as a

result of the increase in Cash. At the same time, Capital increased due to the owner:s

contribution. emember that capital is increased by contribution of owners and income, anddecreased by withdrawals and expenses. =o liability is affected hence, stays at "ero.

et:s continue with transaction )<



-* #oan from "an. 2@,@@@.@@ 2@,@@@.@@ B 7

In transaction ), the company received cash. Thus, the value of total assets is increased. At the

same time, it incurred in an obligation to pay the bank. Therefore, liabilities are increased. The

liability in this case is recorded as oans ayable.

=otice also that the accounting e9uation is still e9ual 3balanced4.

et:s add transaction <



-* #oan from "an. 2@,@@@.@@ 2@,@@@.@@ B 7

/* Purchased printers,@@@.@@

$,@@@.@@% 7 B 7

The company ac9uired printers, hence, an increase in assets. $owever, the company used cash to

pay for the printers. Thus, it also results in a decrease in assets. Transaction results in an

increase in one asset 3Service &#uipment 4 and a decrease in another asset 3Cash4.



/or those who are new to accounting format < The parentheses 0()0 around the +,*** amount

above means minus or 0less0 .

iabilities and capital are not affected. ;till, the e9uation in the third transaction is e9ual. 1n this

case, it has "ero effect on both sides.

At this point, the balance of total assets is D6*,***. The combined balance of liabilities and

capital is also at D6*,***.

The accounting e9uation is 3and should always be4 in balance.

Accounting >9uation< 5ore >xamples

The Accounting #/uation+ More #xamples

To help "ou better understand how the accounting e/uation wor)s and sta"s inbalance, here are more sample transactions and their eCects to the accounting

e/uation.

In addition to transactions +, ) and in the previous lesson, assume the following data<

3. !endered services and received the ull amount in cash, ?;@@

;. !endered services on account, ?D;@

<. Purchased o5ce supplies on account, ?0@@

D. &ad some e/uipment repaired or ?3@@, to be paid ater ; da"s

E. Mr. Alex, the owner, withdrew ?;,@@@ cash or personal use

F. Paid one7third o the loan obtained in transaction G0

@.!eceived customer pa"ment rom services in transaction G;

The transactions will result to the following effects<


* O+ner,s in!estment 0@,@@@.@@ B 0@,@@@.@@

-* #oan from "an. 2@,@@@.@@ 2@,@@@.@@ B

/* Purchased printers,@@@.@@

$,@@@.@@% B

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0* 1er!ice re!enue for cash ;@@.@@ B ;@@.@@

2* 1er!ice re!enue on account D;@.@@ B D;@.@@

3* 1upplies on account 0@@.@@ 0@@.@@ B

4* 5epair of e&uipment 3@@.@@ B $3@@.@@%

6* O+ner,s +ithdra+al $;,@@@.@@% B $;,@@@.@@%

7* Payment of loan $@,@@@.@@% $@,@@@.@@% B

8* Collection of accountsD;@.@@

$D;@.@@% B

Balance 2<,3;@.@@ 0@,<@@.@@ B ;,E;@.@@

E%amples E%plained

3. The compan" received cash or services rendered. Cash increased thereb"increasing assets. At the same time, capital is increased as a result o theincome (Service evenue). As weHve mentioned in the Accountin! Elements lesson, income increases capital.

;. The compan" rendered services on account. The services have beenrendered, hence, alread" earned. Thus, the ?D;@ worth o services renderedis considered income even i the amount has not "et been collected. 6ince

the amount is still to be collected, it is recorded as Accounts eceivable, anasset account.

<. 45ce supplies worth ?0@@ were ac/uired. This increases the compan"Hs"#ce Supplies, part o the compan"Hs assets. The purchase results in anobligation to pa" the supplier8 thus a ?0@@ increase in liabilit" (Accounts$a%able).

D. The compan" incurred in ?3@@ epairs Expense. #xpenses decrease capital. The amount has not "et been paid. Thus, it results in an increase in totalliabilities.

E. The owner withdrew ?;,@@@ cash. Cash is decreased thereb" decreasing totalassets. &ithdrawals or drawin!s decrease capital.

F. 4ne7third o the ?2@,@@@ loan was paid. Thereore, Cash is decreased b"?@,@@@ due to the pa"ment. iabilities are also decreased b" the amountpaid.



@.The ?D;@ account in a previous transaction has been collected. Thereore, the Accounts eceivable account is decreased and Cash is increased.

=otice that every transaction results in an e9ual effect to assets and liabilities plus capital. The

beginning balances are e9ual. The changes arising from the transactions are e9ual. Therefore, the

ending balances would still be e9ual.

The balance of the total assets after considering all the above transactions amounts to DE,6*. It

is e9ual to the combined balances of total liabilities at D)*,E** and capital at D+6,/6* (total of

234,567).

8ssets 9 iabilities : Capital is a mathematical e9uation. %sing your skills in algebra, the

formula can be rewritten to get other versions of the e9uation.

• iabilities Assets 7 'apital

• 'apital Assets 7 iabilities

#xpanded Accounting #/uation

i)e the basic accounting e/uation, the expanded accountin! e'uation shows the

relationships among the accounting elements.

In the expanded accounting e9uation, #capital# portion broken down into several components.

0e know that capital is affected by contributions, withdrawals, income, and epenses.

Contributions and income increase capital. 0ithdrawals and expenses decrease it.

The accounting e9uation then can be rewritten as<

Assets = Liabilities + Capital - Withdrawals + Income - !penses

The owners: contributions are recorded directly into Capital. 8dditional contributions are already

included in #Capital#.

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For corporations, #0ithdrawals# are represented as #'ividends#.

%sing the transactions in the earlier illustration, the effects to the expanded e9uation are as

follows.

A ' # C 9 :ith* $nc* 9 E%p*

0@,@@@ B 0@,@@@ 7 B 7

- 2@,@@@ 2@,@@@ B 7 B 7

/,@@@

$,@@@% B 7 B 7

0 ;@@ B 7 B ;@@ 7

2 D;@ B 7 B D;@ 7

3 0@@ 0@@ B 7 B 7

4 3@@ B 7 B 7 3@@

6 $;,@@@% B 7 ;,@@@ B 7

7 $@,@@@% $@,@@@% B 7 B 7

8D;@

$D;@% B 7 B 7

Bal 2<,3;@ 0@,<@@ B 0@,@@@ 7 ;,@@@ B ,0;@ 7 3@@

$ere are the transactions in the illustration above<

. Mr. Alex invested ?0@,@@@ to start a printing business

0. The compan" obtained a loan rom a ban), ?2@,@@@

2. The compan" purchased printers and paid a total o ?,@@@

3. !endered services and received cash, ?;@@

;. !endered services on account, ?D;@

<. Purchased o5ce supplies on account, ?0@@

D. &ad some e/uipment repaired or ?3@@, to be paid ater ; da"s

E. Mr. Alex, the owner, withdrew ?;,@@@ cash or personal use



F. Paid one7third o the loan obtained in transaction G0

@.!eceived customer pa"ment rom services in transaction G;

Study the eamples above and try to determine what specific items were affected under each

element and why they increased or decreased. ;o it one transaction at a time. 1f you find itdifficult, refer to the eplanations in the previous lesson. <ou will appreciate it better if you do

this yourself.

The e9uation is still and is always in balance. If you take the total of the right side of the

e9uation 3i.e. liabilities, capital, income, expense, and withdrawals4 you will get DE,6*, which

is e9ual to the total assets in the left side.

Conclusion

The accounting e9uation, whether in its basic form or its expanded version, shows the

relationship between the left side 3assets4 and the right side 3liabilities plus capital4. It also showsthat resources held by the company are coupled with claims against them.

There is a two!fold effect in every transaction. This results in the movement of at least two

accounts in the accounting e9uation. The amount of change in the left side is always e9ual to the

amount of change in the right side, thus, keeping the accounting e9uation in balance.

The accounting e9uation is very important. It will guide you in understanding related accounting

principles and help you solve many accounting problems.

The 1ouble #ntr" Accounting 6"stem

In this lesson, we are going to learn the double entr" accounting s"stem or double

entr" boo))eeping.

It is one of the basic foundations upon which the steps in the accounting cycle and other

accounting principles are based.

The double entry accounting system emerged as a result of the industrial revolution. 5erchants

in the olden times recorded transactions in simple lists, similar to what we call today as single

entry method.

Through the ages, business became more and more complex, hence, the development of more

effective ways to keep track of business transactions. The first accounts of the double entry

bookkeeping system was documented by uca acioli, a Franciscan monk and hailed as the

/ather of odern 8ccounting .



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%nder the double entry bookkeeping system, business transactions are recorded with the premise

that each transaction has a two!fold effect - value received and value given.

To better understand the double entry method, let us first take a look at the single entry system.

1ingle Entry Boo..eepingThe single entry bookkeeping system does not explicitly record the two!fold effect of

transactions. %nder this method, separate books are maintained for the company:s basic accounts

such as cash, receivables, and payables. Therefore, the accounting records are incomplete.

For example, consider the following transactions<

• 4n 4ctober , 0@2, Mr. 9riggs invested ?2@,@@@ to start a mar)etingconsultanc" business.

•

4n 4ctober ;, the compan" purchased a computer or the o5ce, ?,@@@.

• 4n 4ctober E, the compan" rendered services and received ?;@@.

%nder the single entry, the company may use a cashboo to record its cash receipts and

disbursements. After recording the above transactions, the cashbook will look this<

ate Particulars Amount Balance

8989-8/ 9eginning balance ? @.@@

8989-8/ Investment o owner ? 2@,@@@.@@ 2@,@@@.@@

89829-8/ Purchase o computer $,@@@.@@% 0F,@@@.@@

89869-8/ 'ash rom customer ;@@.@@ 0F,;@@.@@

0e can readily determine the cash balance using this recording method. $owever, it will be

difficult to determine the balances of other accounts such as revenues and expenses unless the

company maintains separate books for them.

An important note to consider here is that a valid set of financial statements can still be prepared

even if the accounting system is incomplete. &ut, it will re9uire additional work to reconstruct

the accounts to conform to the double!entry method.

Again, under the single entry bookkeeping system, the records do not show the dual!effect of

transactions.



ou"le Entry Boo..eeping

%nder the double entry method, every transaction is recorded in at least two accounts. 2nce all

transactions are processed into the accounting system, the balances of all accounts will be readily

available.

All accounts have a debit and credit side. 'ebit means left and credit means right .

&ecause of the two!fold or duality of effect of transactions, the total effect on the left will always

be e9ual to total the effect on the right. $ence, the famous line #debit e9uals credit#.

Now" here is the rule# To increase an asset , you debit itB to decrease an asset , you credit it. The

opposite applies to liabilities and capital.

To increase a liability or a capital account, you credit itB to decrease a liability or capital

account, you debit it. &penses are debited when incurred and income is credited when earned.

$ere:s a table to summari"e that<

Accounting Element To $ncrease To ecrease

* Asset 1ebit 'redit

-* #ia"ility 'redit 1ebit

/* Capital in!estment 'redit 1ebit

0* Capital +ithdra+al 1ebit 'redit

2* $ncome 'redit 1ebit

3* E%pense 1ebit 'redit

=ip> 1f you are having a hard time remembering the table above, you actually only need to

familiari?e yourself with the 0=o 1ncrease0 part. =he action to decrease the accounts is simply

the opposite of the action to increase them.

Transactions are recorded using @ournal entries in the ?ournal. A @ournal entry is a record

showing the date of the transaction, the account7s debited, the account7s credited, their respective

amounts, and an explanation to describe the transaction.

%sing the transactions presented earlier, the ?ournal would look like this<

ate-8/

Particulars e"it Credit

Oct 'ash 2@,@@@.@@



ate-8/

Particulars e"it Credit

Mr. 9riggs, 'apital 2@,@@@.@@

To record initial investment.

2 'omputer #/uipment ,@@@.@@

'ash ,@@@.@@

To record purchase o computer.

6 'ash ;@@.@@

6ervice !evenue ;@@.@@

To record cash or services rendered.

As mentioned earlier, every transaction has a two!fold effect. Thus, each transaction is recorded

in at least two accounts. =otice the two!fold effects in the above examples.

Gou will learn how to prepare ?ournal entries in another lesson. For a head start, let us take a look

at how we came up with the ?ournal entry for the first transaction. In that transaction, 5r. &riggs

invested D*,*** to start a marketing consultation business on 2ctober +, )*+.

. Place the date o the transaction on the letmost side o the -ournal.

0. 1etermine the account to be debited and the amount. In this case, there is anincrease in cash because o the contribution. To increase cash, an assetaccount, we debit it. 6o, we would then record 'ash and place the amount,2@,@@@ on the debit column.

2. (ext, we determine the account credited. >e are recording the ownerHs initialcontribution. It increases the compan"Hs capital8 thereore we would credit the

capital account – Mr. 9riggs, 'apital, and place the amount in the creditcolumn. 'redits are recorded below the debits. (otice the indentions used.

3. :inall", provide a brie explanation at the end o the entr".

;ee if you can figure out the logic behind the other two ?ournal entries.



After recoding the transactions, we now have a running record of all accounts, and hence a

complete accounting system.

In addition to the ?ournals, some companies maintain separate books for some of their important

accounts for better control.

The preparation of ?ournal entries through the double entry bookkeeping method, along with the

other steps in the accounting cycle, results in a more systematic accounting system. Gou will

learn more about ?ournal entries in detail, including how to prepare them, and the rest of the steps

of the process in later lessons.

The Accounting '"cle+ F76tep Accounting Process

The accounting c"cle, also commonl" reerred to as accountin! process, is a series

o procedures in the collection, processing, and communication o fnancial

inormation.

As defined in earlier lessons, accounting involves recording, classifying, summari"ing, and

interpreting financial information.

Financial information is presented in reports called financial statements. &ut before they can be

prepared, accountants need to gather information about business transactions, record and collate

them to come up with the values to be presented in these reports.

The cycle does not end with the presentation of financial statements. ;everal steps are needed to

be done to prepare the accounting system for the next cycle.

Accounting Cycle 1teps

* $dentifying and Analy;ing Business Transactions

The accounting process starts with identifying and analy"ing business transactions and events.

=ot all transactions and events are entered into the accounting system. 2nly those that pertain to

the business entity are included in the process.

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For example, a loan made by the owner in his name that does not have anything to do with the

entity is not accounted for.

The transactions identified are then analy"ed to determine the accounts affected and the amounts

to be recorded.

The first step includes the preparation of business documents, or source documents. A business

document serves as basis for recording a transaction.

-* 5ecording in the <ournals

A ?ournal is a book - paper or electronic - in which transactions are recorded. &usiness

transactions are recorded using the double!entry bookkeeping system. They are recorded in

?ournal entries containing at least two accounts 3one debited and one credited4.

To simplify the recording process, special ?ournals are often used for transactions that recur

fre9uently such as sales, purchases, cash receipts, and cash disbursements. A general ?ournal isused to record those that cannot be entered in the special books.

Transactions are recorded in chronological order and as they occur. $ence, ?ournals are also

known as -oos of $riginal &ntry.

/* Posting to the #edger

Also known as -oos of /inal &ntry, a ledger is a collection of accounts that shows the changes

made to each account as a result of past transactions, and their current balances. This is the core

of the classifying phase.

After the posting process, the balances of each account can now be determined.

For example, all ?ournal entries made to Cash would be transferred into the Cash account in the

ledger. Increases and decreases in cash will be entered into one ledger account. Thus, the ending

balance of Cash can be determined.

0* Unad=usted Trial Balance

A trial balance is prepared to test the e9uality of the debits and credits. All account balances are

extracted from the ledger and arranged in one report. Afterwards, all debit balances are added.

All credit balances are also added. Total debits should be e9ual to total credits.

0hen errors are discovered, correcting entries are made to rectify them or reverse their effect.

Take note however that the purpose of a trial balance is only test the e9uality of total debits and

total credits and not to determine the correctness of accounting records.



;ome errors could exist even if debits are e9ual to credits, such as double posting or failure to

record a transaction.

2* Ad=usting Entries

Ad?usting entries are prepared as an application of the accrual basis of accounting . At the end of

the accounting period, some expenses may have been incurred but not yet recorded in the ?ournals. ;ome income may have been earned but not entered in the books.

Ad?usting entries are prepared to have the accounts updated before they are summari"ed into the

financial statements.

Ad?usting entries are made for accrual of income, accrual of expenses, deferrals (income method

or liability method), prepayments (asset method or epense method), depreciation, and

allowances.

3* Ad=usted Trial BalanceAn ad@usted trial balance may be prepared after ad?usting entries are made and before the

financial statements are prepared. This is to test if the debits are e9ual to credits after ad?usting

entries are made.

4* >inancial 1tatements

0hen the accounts are already up!to!date and e9uality between the debits and credits have been

tested, the financial statements can now be prepared. The financial statements are the end!

products of an accounting system.

A complete set of financial statements is made up of< 3+4 ;tatement of Comprehensive Income(1ncome Statement and $ther Comprehensive 1ncome), 3)4 ;tatement of Changes in >9uity, 34

;tatement of Financial 8osition or -alance Sheet, 34 ;tatement of Cash Flows, and 364 =otes to

Financial ;tatements.

6* Closing Entries

Temporary or nominal accounts, i.e. income statement accounts, are closed to prepare the system

for the next accounting period. Temporary accounts include income, epense, and withdrawal

accounts. These items are measured periodically.

The accounts are closed to a summary account 3often, Income ;ummary4 and then closed further

to the appropriate capital account. Take note that closing entries are made only for temporary

accounts. eal or permanent accounts, i.e. balance sheet accounts, are not closed.



7* Post9Closing Trial Balance

In the accounting cycle, the last step is to prepare a post!closing trial balance. It is prepared to

test the e9uality of debits and credits after closing entries are made. ;ince temporary accounts are

already closed at this point, the post!closing trial balance contains real accounts only.

?5e!ersing Entries@ Optional step at the beginning of the ne+ accountingperiod

eversing entries are optional. They are prepared at the beginning of the new accounting period

to facilitate a smoother and more consistent recording process.

In this step, the ad@usting entries made for accrual of income, accrual of expenses, deferrals

under the income method, and prepayments under the expense method are reversed.

Author$s Notes# ;o there you have the nine steps in the accounting cycle. This is ?ust an

overview of the accounting process. >ach step will be illustrated one by one in later chapters.

6ummar"+ :undamental Accounting 'oncepts

This is a summar" o the topics covered in undamental Accountin! Concepts under

the Accountin! asics tutorial series. *ou can alwa"s chec) the ull lessons out

an"time.

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 o when collected,and expenses are recognized when incurred regardless o when paid.

0. oing 'oncern – Also )nown as continuin! concern concept or continuit%assumption* it means that a business entit" will continue to operateindefnitel".

2. Accounting #ntit" 'oncept – A specifc business enterprise is treated as oneaccounting entit", separate and distinct rom its owners.

3. Time Period Assumption – The indefnite lie o an enterprise is subdividedinto time periods or accounting periods which are usuall" o e/ual length orthe purpose o preparing fnancial reports.

;. Monetar" Jnit Assumption – Transactions are recorded in terms mone"('uanti+abilit%), in a currenc" with a stable purchasing power (stabilit% of the

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http://www.accountingverse.com/accounting-basics/fundamental-accounting-concepts-summary.html



dollar), 1ee >ull Tutorial

B* Elements of Accounting

The elements of accounting pertain to assets, liabilities, and capital. 8ssets are resources owned

by a companyB liabilities are obligations to creditors and lendersB and capital refers to the interestof the owners in the business after deducting all liabilities from all assets 3or, what is left for the

owners after all company obligations are paid4.

Assets

Assets can be classified as current or non!current. An asset is considered current if it is for sale, if

it can be reali"ed within +) month from the end of the accounting period or within the company:s

normal operating cycle if it exceeds +) months. In addition, cash is generally considered current

asset.

Current assets include< Cash and Cash &#uivalents, aretable Securities, 8ccounts *eceivable, 1nventories, and repaid &penses. Assets that do not meet the criteria to be classified as current

are, by default, non!current assets. >xamples of non!current assets are< ongAterm 1nvestments'

roperty, lant and &#uipment' and 1ntangibles.

#ia"ilities

iabilities can also be classified as current or non!current. A liability is considered current of

they are payable within +) months from the end of the accounting period, or within the

company:s normal operating cycle if the cycle exceeds +) months.

Current liabilities include< 8ccounts ayable, ShortAterm otes ayable, =a ayable, 8ccrued &penses, and other shortAterm obligations. =on!current liabilities include those that do not meet

the above criteria. >xamples of non!current liabilities are< oans ayable and -onds ayable

which are longAterm in nature, and ;eferred =a iabilities.

Capital

Capital refers to the interest of the owner7s of the business. The owner:s interest is the value of

total assets left after all obligations to creditors and lenders are settled. Capital is increased by

contributions by the ownerBs and income. It is decreased by withdrawals by owners (dividends in

corporations) and epenses.

$ncome

Income refers to an increase in assets or decrease in liability, and an increase in capital other than

that arising from contribution by owner7s. >xamples of income accounts include< Sales, Service

*evenue, rofessional /ees, 1nterest 1ncome, *ent 1ncome, and others.





E%pense

>xpenses result in decrease in assets or increase in liabilities, and decrease in capital other than

those arising from withdrawals of the owner7s. ;ome examples are< Cost of Sales, Salaries

&pense, *ent &pense, tilities &pense, ;elivery &pense, and others.

%ee &ull 'utorial

C* Accounting E&uation

The accounting e9uation shows the relationships between the accounting elements< assets,

liabilities and capital. The basic accounting e9uation is<

Assets = Liabilities + Capital

It shows that assets owned by a company are coupled with claims either by creditors and lenders,

or by the owners of the business.

0hen business transactions take place, the values of the elements in the accounting e9uation

change. =onetheless, the e9uation always stays in balance. This is due to the two!fold effect of

transactions. The total change on the left side is always e9ual to the total change on the right.

Thus, the resulting balances of both sides are e9ual.

The accounting e9uation may be rewritten as<

iabilities 9 8ssets A Capital, or Capital 9 8ssets A iabilities.

The capital element may also be spread!out into its components, and thus resulting into theexpanded accounting e9uation<

Assets = Liabilities + Capital - Withdrawals + Income - !penses

HFor corporations, withdrawals are represented in the e9uation as #'ividends#.

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* ou"le Entry Accounting 1ystem

The double entry accounting system recogni"es a two!fold effect in every transaction. Thus,

business transactions are recorded in at least two accounts.

%nder the double entry accounting system, transactions are recorded through debits and credits.

'ebit 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 itB to decrease an asset , you credit it. The

opposite applies to liabilities and capital< to increase a liability or a capital account, you credit itB

to decrease a liability or a capital account, you debit it. &penses are debited when incurred, and

income is credited when earned. %ee &ull 'utorial

E* The Accounting CycleThe accounting cycle is a se9uence of steps in the collection, processing, and presentation of

accounting information. It is made up of nine steps, namely<

. Identi"ing and anal"zing business transactions and events

0. !ecording transactions in the -ournals

2. Posting entries to the ledger

3. Jnad-usted trial balance

;. Preparing ad-usting entries

<. Ad-usted trial balance

D. :inancial statements

E. Preparing closing entries

F. Post7closing trial balance

eversing entries may be prepared at the beginning of the new accounting period to enable asmoother recording process. In this step, some ad@usting entries are simply reversed.

=evertheless, reversing entries are optional . %ee &ull 'utorial

$ere are the answers to the short 9ui" on /undamental 8ccounting Concepts.

&e sure to check out the lessons again for review if you are having trouble with this section.

A. Identi(ication ) &ill in the Blan*s

+. %nder the accrual basis of accounting, income is recogni"ed when earned regardless ofwhen collectedB and expenses are recogni"ed when incurred regardless of when paid.

). It refers to the assumption than an entity will exist indefinitely in the absence ofevidences that suggest otherwise. oing concern

. The indefinite life of an entity is subdivided into e9ual periods. Time period







. Calendar year refers to a +)!month period ending in 'ecember +.

6. Fiscal year refers to a +)!month period ending in any month other than 'ecember.

E. It means that a specific business enterprise is considered one accounting entity, separate

and distinct from its owners. Accounting entity concept

J. 0hat are the two characteristics of the monetary unit assumption1a. Kuantifiability - transactions are recorded in terms of money b. ;tability of the currency - purchasing power of the dollar is stable

/. The matching principle7concept states that expenses are recogni"ed in the period therelated revenues are earned.

B. etermine i( the gi,en is a)n Asset" Liabilit" Capital" Income or !pense.

+. 8repaid Insurance - Asset

). ight and 0ater - >xpense

. >mployees: ;alaries - >xpense

. Accounts 8ayable - iability

6. 5r. &runo, Capital - Capital

E. Accounts eceivable - Asset

J. ;ervice evenue - Income

/. ;ervice >9uipment - Asset

(. &onds 8ayable - iability

+*. 2ffice ;upplies - Asset

C. Indicate whether the account is a Current Asset CA/" Non-Current Asset NCA/"

Current Liabilit CL/" or Non-Current Liabilit NCL/.

+. Inventories - CA

). 8repaid Advertising - CA

. Accounts 8ayable - C

. &onds 8ayable, yrs. - =C



6. Accrued ent 8ayable - C

E. Cash in &ank - CA

J. and - =CA

/. &uilding - =CA

(. 'elivery >9uipment - =CA

+*. Accounts eceivable - CA

. Case Problem. The following accounts pertain to the records of ;harkbait Company at theend of the accounting period<

Assets D +,)**,*** evenues D 6**,***

iabilities D 1 >xpenses D **,***

The company started the year with D/**,*** Capital. The owner made D+**,*** cashwithdrawals during the year. $ow much is the total liabilities at the end of the period1

Answer< D**,***. In solving this problem, the accounting e9uation A L M C is used. $owever,we need to compute for the balance of Capital first. 0e know that Capital is increased byadditional contibutions and income, and decreased by expenses and withdrawals. The capitalending balance and liabilities are computed as follows<

Capital, beginning D /**,***

Add< evenues 6**,***ess< >xpenses **,***

0ithdrawals +**,***

Capital, ending D (**,***

sing 8 9 : C>

iabilities D **,***

Capital (from above) (**,***

Assets 3 given4 D +,)**,***

. Accounting Process. >numerate the ( steps of the accounting process.Answer, in proper order<

+. Identifying and analy"ing business transactions and events

). ecording transactions in the ?ournals

. 8osting entries to the ledger

. %nad?usted trial balance



6. 8reparing ad?usting entries

E. Ad?usted trial balance

J. Financial statements

/. 8reparing closing entries

(. 8ost!closing trial balance

Documents

Chapter 2 Fundamentals of Accounting Concepts