Financial accounting relies on several underlying concepts that have a significant impact on the practice of accounting. Assumptions The following are basic financial accounting assumptions: Separate entity assumption – the business is an entity that is separate and distinct from its owners, so that the finances of the firm are not co-mingled with the finances of the owners. Going concern assumption – the business is going to be operating for the foreseeable future. Stable monetary unit assumption – e.g. the U.S. dollar Fixed time period assumption – info prepared and reported periodically (quarterly, annually, etc.) Principles The basic assumptions of accounting result in the following accounting principles: Historical cost principle – assets are reported and presented at their original cost and no adjustment is made for changes in market value. One never writes up the cost of an asset. Accountants are very conservative in this sense. Sometimes costs are written down, for example, for some short-term investments and marketable securities, but costs never are written up. Matching principle – matching of revenues and expenses in the period earned and incurred. Revenue recognition principle – revenue is realized (reported on the books as earned) when everything that is necessary to earn…

 business transaction involves an exchange between two accounts. For example, for every asset there exists a claim on that asset, either by those who own the business or those who loan money to the business. Similarly, the sale of a product affects both the amount of cash (or cash receivable) held by the business and the inventory held. Recognizing this fundamental dual nature of transactions, merchants in medieval Venice began using a double-entry bookkeeping system that records each transaction in the two accounts affected by the exchange. In the late 1400’s, Franciscan monk and mathematician Luca Pacioli documented the procedure for double-entry bookkeeping as part of his famous Summa work, which described a significant portion of the accounting cycle. Double-entry bookkeeping spread throughout Europe and became the foundation of modern accounting. Two notable characteristics of double-entry systems are that 1) each transaction is recorded in two accounts, and 2) each account has two columns. In a double-entry system, two entries are made for each transaction – one entry as a debit in one account and the other entry as a credit in another account. The two entries keep the accounting equation in balance so that: Assets    =    Liabilities   +   Owners’…

The resources controlled by a business are referred to as its assets. For a new business, those assets originate from two possible sources: Investors who buy ownership in the business Creditors who extend loans to the business Those who contribute assets to a business have legal claims on those assets. Since the total assets of the business are equal to the sum of the assets contributed by investors and the assets contributed by creditors, the following relationship holds and is referred to as the accounting equation :   Assets    =      Liabilities   +   Owners’ Equity Resources   Claims on the Resources Initially, owner equity is affected by capital contributions such as the issuance of stock. Once business operations commence, there will be income (revenues minus expenses, and gains minus losses) and perhaps additional capital contributions and withdrawals such as dividends. At the end of a reporting period, these items will impact the owners’ equity as follows:   Assets    =      Liabilities   +   Owners’ Equity         +   Revenues         –   Expenses         +   Gains         –   Losses         +   Contributions         –   Withdrawals These additional items under owners’ equity are tracked…

When a business transaction occurs, a document known as the source document captures the key data of the transaction. The source document describes the basic facts of the transaction such as its date, purpose, and amount. Some examples of source documents: cash receipt cancelled check invoice sent or received credit memo for a customer refund employee time sheet The source document is the initial input to the accounting process and serves as objective evidence of the transaction, serving as part of the audit trail should the firm need to prove that a transaction occurred. To facilitate referencing, each source document should have a unique identifier, usually a number or alphanumeric code. Prenumbering of commonly-used forms helps to enforce numbering, to classify transactions, and to identify and locate missing source documents. A well-designed source document form can minimize errors and improve the efficiency of transaction recording. The source document may be created in either paper or electronic format. For example, automated accounting systems may generate the source document electronically or allow paper source documents to be scanned and converted into electronic images. Accounting software often provides on-screen entry forms for different types of transactions to capture the data and generate the…

After a transaction occurs and a source document is generated, the transaction is analyzed and entries are made in the general journal. A journal is a chronological listing of the firm’s transactions, including the amounts, accounts that are affected, and in which direction the accounts are affected. A journal entry takes the following format:   Format of a General Journal Entry Date Accounts Debit Credit mm/dd account to be debited xxxx.xx          account to be credited   xxxx.xx In addition to this information, a journal entry may include a short notation that describes the transaction. There also may be a column for a reference number so that the transaction can be tracked through the accounting system. The above format shows the journal entry for a single transaction. Additional transactions would be recorded in the same format directly below the first one, resulting in a time-ordered record. The journal format provides the benefit that all of the transactions are listed in chronological order, and all parts (debits and credits) of each transaction are listed together. Because the journal is where the information from the source document first enters the accounting system, it is known as the book of original entry….

 While the journal lists transactions in chronological order, its format does not faciliate the tracking of individual account balances. The general ledger is used for this purpose. The general ledger is a collection of T-accounts to which debits and credits are transferred. The action of recording a debit or credit in the general ledger is referred to as posting. The posting of a journal entry to the general ledger accounts is a purely mechanical process using information already in the journal entry and requiring no additional analysis. To understand the posting process, consider a journal entry in the following format: General Journal Entry Date Accounts Debit Credit mm/dd Account 1 xxxx.xx          Account 2        xxxx.xx There are two ledger accounts affected by the above journal entry (Account 1 and Account 2). Each of these accounts is represented by a T-account in the general ledger. To post the entry to the ledger, simply transfer the information to the T-accounts: Ledger Accounts Account 1 mm/dd xxxx.xx                                                           Bal. xxxx.xx                                     Account 2                            mm/dd xxxx.xx                                          Bal. xxxx.xx Note that the debit portion of the journal entry…

  A basic rule of double-entry accounting is that for every credit there must be an equal debit amount. From this concept, one can say that the sum of all debits must equal the sum of all credits in the accounting system. If debits do not equal credits, then an error has been made. The trial balance is a tool for detecting such errors. The trial balance is calculated by summing the balances of all the ledger accounts. The account balances are used because the balance summarizes the net effect of all of the debits and credits in an account. To calculate the trial balance, construct a table in the following format: Trial Balance Calculation     Account         Debits         Credits     Account 1 xxxx.xx   Account 2 xxxx.xx   Account 3 xxxx.xx   . . .     Account 4   xxxx.xx Account 5   xxxx.xx Account 6   xxxx.xx     . . .   ________ ________ Totals:  xxxx.xx  xxxx.xx In the above trial balance, the balances of Accounts 1, 2, and 3 are net debits, and the balances of Accounts 4, 5, and 6 are net credits. The totals of the debits and credits should be equal; if they are not,…

In the accounting process, there may be economic events that do not immediately trigger the recording of the transaction. These are addressed via adjusting entries, which serve to match expenses to revenues in the accounting period in which they occur. There are two general classes of adjustments: Accruals – revenues or expenses that have accrued but have not yet been recorded. An example of an accrual is interest revenue that has been earned in one period even though the actual cash payment will not be received until early in the next period. An adjusting entry is made to recognize the revenue in the period in which it was earned. Deferrals – revenues or expenses that have been recorded but need to be deferred to a later date. An example of a deferral is an insurance premium that was paid at the end of one accounting period for insurance coverage in the next period. A deferred entry is made to show the insurance expense in the period in which the insurance coverage is in effect.   How to Make Adjusting Entries Like regular transactions, adjusting entries are recorded as journal entries. The following illustrates adjustments for accrued and deferred items.  …

Revenue, expense, and capital withdrawal (dividend) accounts are temporary accounts that are reset at the end of the accounting period so that they will have zero balances at the start of the next period. Closing entries are the journal entries used to transfer the balances of these temporary accounts to permanent accounts. After the closing entries have been made, the temporary account balances will be reflected in the Retained Earnings (a capital account). However, an intermediate account called Income Summary usually is created. Revenues and expenses are transferred to the Income Summary account, the balance of which clearly shows the firm’s income for the period. Then, Income Summary is closed to Retained Earnings. The sequence of the closing process is as follows:   Close the revenue accounts to Income Summary. Close the expense accounts to Income Summary. Close Income Summary to Retained Earnings. Close Dividends to Retained Earnings.   The closing journal entries associated with these steps are demonstrated below. The closing entries may be in the form of a compound journal entry if there are several accounts to close. For example, there may be dozens or more of expense accounts to close to Income Summary.   1.  Close Revenue…

Businesses report information in the form of financial statements issued on a periodic basis. GAAP requires the following four financial statements:  Balance Sheet – statement of financial position at a given point in time.   Income Statement – revenues minus expenses for a given time period ending at a specified date. Statement of Owner’s Equity – also known as Statement of Retained Earnings or Equity Statement.   Statement of Cash Flows – summarizes sources and uses of cash; indicates whether enough cash is available to carry on routine operations.   Balance Sheet  The balance sheet is based on the following fundamental accounting model:  Assets  =  Liabilities  +  Equity  Assets can be classed as either current assets or fixed assets. Current assets are assets that quickly and easily can be converted into cash, sometimes at a discount to the purchase price. Current assets include cash, accounts receivable, marketable securities, notes receivable, inventory, and prepaid assets such as prepaid insurance. Fixed assets include land, buildings, and equipment. Such assets are recorded at historical cost, which often is much lower than the market value.  Liabilities represent the portion of a firm’s assets that are owed to creditors. Liabilities can be classed as short-term liabilities (current)…

Accounting standards are needed so that financial statements will fairly and consistently describe financial performance. Without standards, users of financial statements would need to learn the accounting rules of each company, and comparisons between companies would be difficult. Accounting standards used today are referred to as Generally Accepted Accounting Principles (GAAP). These principles are “generally accepted” because an authoritative body has set them or the accounting profession widely accepts them as appropriate. Securities and Exchange Commission (SEC) The Securities and Exchange Commission is a U.S. regulatory agency that has the authority to establish accounting standards for publicly traded companies. The Securities Act of 1933 and the Securities Exchange Act of 1934 require certain reports to be filed with the SEC. For example, Forms 10-Q and 10-K must be filed quarterly and annually, respectively. The head of the SEC is appointed by the President of the United States. When the SEC was formed there was no standards-issuing body. However, rather than set standards, the SEC encouraged the private sector to set them. The SEC has stated that FASB standards are considered to have authoritative support. Committee on Accounting Procedure (CAP) In 1939, encouraged by the SEC, the American Institute of Certified…

Traditional financial reporting systems provide an indication of how a firm has performed in the past, but offer little information about how it might perform in the future. For example, a firm might reduce its level of customer service in order to boost current earnings, but then future earnings might be negatively impacted due to reduced customer satisfaction. To deal with this problem, Robert Kaplan and David Norton developed the Balanced Scorecard, a performance measurement system that considers not only financial measures, but also customer, business process, and learning measures. The Balanced Scorecard framework is depicted in the following diagram: Diagram of the Balanced Scorecard        Financial            Customer     Strategy     Business     Processes                  Learning     & Growth   The balanced scorecard translates the organization’s strategy into four perspectives, with a balance between the following: between internal and external measures between objective measures and subjective measures between performance results and the drivers of future results   Beyond the Financial Perspective In the industrial age, most of the assets of a firm were in property, plant, and equipment, and the financial accounting system performed an adequate job of valuing those assets. In the information age, much of the value of the firm is…