ABOUT,
Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of management; the art lies in selecting the information that is relevant to the user and is reliable.
Accountancy is a branch of mathematical science that is useful in discovering the causes of success and failure in business.The principles of accountancy are applied to business entities in three divisions of practical art, named accounting, bookkeeping, and auditing.
Accounting is defined by the American Institute of Certified Public Accountants (AICPA) as "the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof."
Accounting is thousands of years old; the earliest accounting records, which date back more than 7,000 years, were found in the Middle East. The people of that time relied on primitive accounting methods to record the growth of crops and herds. Accounting evolved, improving over the years and advancing as business advanced.
Early accounts served mainly to assist the memory of the businessperson and the audience for the account was the proprietor or record keeper alone. Cruder forms of accounting were inadequate for the problems created by a business entity involving multiple investors, so double-entry bookkeeping first emerged in northern Italy in the 14th century, where trading ventures began to require more capital than a single individual was able to invest. The development of joint stock companies created wider audiences for accounts, as investors without firsthand knowledge of their operations relied on accounts to provide the requisite information. This development resulted in a split of accounting systems for internal (i.e. management accounting) and external (i.e.financial accounting) purposes, and subsequently also in accounting and disclosure regulations and a growing need for independent attestation of external accounts by auditors.
Today, accounting is called "the language of business" because it is the vehicle for reporting financial information about a business entity to many different groups of people. Accounting that concentrates on reporting to people inside the business entity is called management accounting and is used to provide information to employees, managers, owner-managers and auditors. Management accounting is concerned primarily with providing a basis for making management or operating decisions. Accounting that provides information to people outside the business entity is called financial accounting and provides information to present and potential shareholders, creditors such as banks or vendors, financial analysts, economists, and government agencies. Because these users have different needs, the presentation of financial accounts is very structured and subject to many more rules than management accounting. The body of rules that governs financial accounting is called Generally Accepted Accounting Principles, or GAAP.
Theory
The basic accounting equation is assets=liabilities+stockholders equity. This is the balance sheet. The foundation for the balance sheet begins with the income statement, which is revenues-expenses=net income or net loss. This is followed by the retained earnings statement, which is beginning retained earnings+net income-dividends=ending retained earnings or beginning retained earnings-net loss-dividends=ending retained earnings.
Etymology
The word "Accountant" is derived from the French word Compter, which took its origin from the Latin word Computare. The word was formerly written in English as "Accomptant", but in process of time the word, which was always pronounced by dropping the "p", became gradually changed both in pronunciation and in orthography to its present form.
History
Proof of Beginning of Accounting in Vedas
Vedas are the oldest books of the world and after deep study of these sanskrit books, you can find that accounting was started at India's vedic period. Vikraya is found in the Atharvaveda and the Nirukta denoting ‘sale’. Sulka in the Rig veda clearly means ‘price’. In the Dharma Sutras it denotes a ‘tax’.
Token accounting in ancient Mesopotamia
The earliest accounting records were found amongst the ruins of ancient Babylon, Assyria and Sumeria, which date back more than 7,000 years. The people of that time relied on primitive accounting methods to record the growth of crops and herds. Because there is a natural season to farming and herding, it is easy to count and determine if a surplus had been gained after the crops had been harvested or the young animals weaned.
The invention of a form of bookkeeping using clay tokens represented a huge cognitive leap for mankind.
Accounting in the Roman Empire
The Res Gestae Divi Augusti (Latin: "The Deeds of the Divine Augustus") is a remarkable account to the Roman people of the Emperor Augustus' stewardship. It listed and quantified his public expenditure, which encompassed distributions to the people, grants of land or money to army veterans, subsidies to the aerarium (treasury), building of temples, religious offerings, and expenditures on theatrical shows and gladiatorial games. It was not an account of state revenue and expenditure, but was designed to demonstrate Augustus' munificence. The significance of the Res Gestae Divi Augusti from an accounting perspective lies in the fact that it illustrates that the executive authority had access to detailed financial information, covering a period of some forty years, which was still retrievable after the event. The scope of the accounting information at the emperor's disposal suggests that its purpose encompassed planning and decision-making.
The Roman historians Suetonius and Cassius Dio record that in 23 BC, Augustus prepared a rationarium (account) which listed public revenues, the amounts of cash in the aerarium (treasury), in the provincial fisci (tax officials), and in the hands of the publicani (public contractors); and that it included the names of the freedmen and slaves from whom a detailed account could be obtained. The closeness of this information to the executive authority of the emperor is attested by Tacitus' statement that it was written out by Augustus himself.
Records of cash, commodities, and transactions were kept scrupulously by military personnel of the Roman army. An account of small cash sums received over a few days at the fort of Vindolanda cira 110 CE shows that the fort could compute revenues in cash on a daily basis, perhaps from sales of surplus supplies or goods manufactured in the camp, items dispensed to slaves such as cervesa (beer) and clavi caligares (nails for boots), as well as commodities bought by individual soldiers. The basic needs of the fort were met by a mixture of direct production, purchase andrequisition; in one letter, a request for money to buy 5,000 modii (measures) of braces (a cereal used in brewing) shows that the fort bought provisions for a considerable number of people.
The Heroninos Archive is name given to a huge collection of papyrus documents, mostly letters, but also including a fair number of accounts, which comes from Roman Egypt in 3rd century CE. The bulk of the documents relate to the running of a large, private estate is named after Heroninos because he was phrontistes (Koine Greek: manager) of the estate which had a complex and standarised system of accounting which was followed by all its local farm managers. Each administrator on each sub-division of the estate drew up his own little accounts, for day to day running of the estate, payment of the workforce, production of crops, the sale produce, the use of animals, and general expetiditure on the staff. This information was then summarized as pieces of papyrus scroll into one big yearly account for each particular sub—division of the estate. Entries were arranged by sector, with cash expenses and gains extrapolated from all the different sectors. Accounts of this kind gave the owner the opportunity to take better economic decisions because the information was purposefully selected and arranged.
Simple accounting is mentioned in the Christian Bible (New Testament) in the Book of Matthew, in the Parable of the Talents.
Islamic accounting and algebra
In the Qur’an, the word "account" (Arabic: hesab) is used in its generic sense, relating to one's obligation to account to God on all matters pertaining to human endeavour. According to the Qur’an, followers are required to keep records of their indebtedness thus Islam thus provides general approval and guidelines for the recording and reporting of transactions.
The Islamic law of inheritance defines exactly how the estate is calculated after death of an individual. The power of testamentary disposition is basically limited to one-third of the net estate (i.e. the assets remaining after the payment of funeral expenses and debts), providing for every member of the family by allotting fixed shares not only to wives and children, but also to father and mothers. The complexity of this law served as an impetus behind the development ofalgebra (Arabic: al-jabr) by the Persian mathematician Muhammad ibn Mūsā al-Khwārizmī and other medieval Islamic mathematicians. Khwārizmī's "The Compendious Book on Calculation by Completion and Balancing" (Arabic: Hisab al-jabr w’al-muqabala, Baghdad, c. 825) devoted a chapter on the solution to the Islamic law of inheritance using linear equations. In the 12th century, Latintranslations of al-Khwārizmī's "Book of Addition and Subtraction According to the Hindu Calculation" (Arabic:Kitāb al-Jamʿ wa-l-tafrīq bi-ḥisāb al-Hind) on the use of Indian numerals, introduced the decimal positional number system to the Western world.
The development of mathematics and accounting was intertwined during the Renaissance. Mathematics was in the midst of a period of significant development in the late 15th century. Hindu-Arabic numerals and algebra were introduced to Europe from Arab mathematics at the end of the 10th century by the Benedictine monk Gerbert of Aurillac, but it was only after Leonardo Pisano (also known as Fibonacci) put commercial arithmetic, Hindu-Arabic numerals, and the rules of algebra together in his Liber Abaci in 1202 that Hindu-Arabic numerals became widely used in Italy.
Luca Pacioli and double-entry bookkeeping
Bartering was the dominant practice for traveling merchants during the Middle Ages. When medieval Europe moved to a monetary economy in the 13th century, sedentary merchants depended on bookkeeping to oversee multiple simultaneous transactions financed by bank loans. One important breakthrough took place around that time: the introduction of double-entry bookkeeping, which is defined as any bookkeeping system in which there was a debit and credit entry for each transaction, or for which the majority of transactions were intended to be of this form. The historical origin of the use of the words ‘debit’ and ‘credit’ in accounting goes back to the days of single-entry bookkeeping in which the chief objective was to keep track of amounts owed by customers (debtors) and amounts owed to creditors. ‘Debit,’ is Latin for ‘he owes’ and ‘credit’ Latin for ‘he trusts’.
The earliest extant evidence of full double-entry bookkeeping is the Farolfi ledger of 1299-1300. Giovanno Farolfi & Company were a firm of Florentine merchants whose head office was in Nîmes who also acted as moneylenders to Archbishop of Arles, their most important customer. The oldest discovered record of a complete double-entry system is the Messari (Italian: Treasurer's) accounts of the city of Genoa in 1340. The Messari accounts contain debits and credits journalised in a bilateral form, and contains balances carried forward from the preceding year, and therefore enjoy general recognition as a double-entry system.
Luca Pacioli's "Summa de Arithmetica, Geometria, Proportioni et Proportionalità" (Italian: "Review of Arithmetic, Geometry, Ratio and Proportion") was first printed and published in Venice in 1494. It included a 27-page treatise on bookkeeping, "Particularis de Computis et Scripturis" (Italian: "Details of Calculation and Recording"). It was written primarily for, and sold mainly to, merchants who used the book as a reference text, as a source of pleasure from the mathematical puzzles it contained, and to aid the education of their sons. It represents the first known printed treatise on bookkeeping; and it is widely believed to be the forerunner of modern bookkeeping practice. In Summa Arithmetica, Pacioli introduced symbols for plus and minus for the first time in a printed book, symbols that became standard notation in Italian Renaissance mathematics. Summa Arithmetica was also the first known book printed in Italy to contain algebra.
Although Luca Pacioli did not invent double-entry bookkeeping, his 27-page treatise on bookkeeping contained the first known published work on that topic, and is said to have laid the foundation for double-entry bookkeeping as it is practiced today. Even though Pacioli's treatise exhibits almost nooriginality, it is generally considered as an important work, mainly because of its wide circulation, it was written in vernacular Italian language, and it was a printed book.
According to Pacioli, accounting is an ad hoc ordering system devised by the merchant. Its regular use provides the merchant with continued information about his business, and allows him to evaluate how things are going and to act accordingly. Pacioli recommends the Venetian method of double-entry bookkeeping above all others. Three major books of account are at the direct basis of this system: the memoriale (Italian: memorandum), the giornale(journal), and the quaderno (ledger). The ledger is considered as the central one and is accompanied by an alphabetical index.
Pacioli's treatise gave instructions in how to record barter transactions and transactions in a variety of currencies – both being far more commonplace than they are today. It also enabled merchants to audit their own books and to ensure that the entries in the accounting records made by their bookkeepers complied with the method he described. Without such a system, all merchants who did not maintain their own records were at greater risk of theft by their employees and agents: it is not by accident that the first and last items described in his treatise concern maintenance of an accurate inventory.
The nature of double-entry can be grasped by recognizing that this system of bookkeeping did not simply record the things merchants traded so that they could keep track of assets or calculate profits and losses; instead as a system of writing, double-entry produced effects that exceeded transcription and calculation. One of its social effects was to proclaim the honesty of merchants as a group; one of its epistemological effects was to make its formal precision based on a rule bound system of arithmetic seem to guarantee the accuracy of the details it recorded. Even though the information recorded in the books of account was not necessarily accurate, the combination of the double entry system's precision and the normalizing effect that precision tended to create the impression that books of account were not only precise, but accurate as well. Instead of gaining prestige from numbers, double entry bookkeeping helped confer cultural authority on numbers.
Double entry accounting means that money is never lost or gained. It is always transferred from one place to another. This is done by recording transactions. Each transaction requires the use of at least two accounts.
Accounting scandals
The year 2001 witnessed a series of financial information frauds involving Enron Corporation, auditing firm Arthur Andersen, the telecommunications company WorldCom, Qwest and Sunbeam, among other well-known corporations. These problems highlighted the need to review the effectiveness of accounting standards, auditing regulations and corporate governance principles. In some cases, management manipulated the figures shown in financial reports to indicate a better economic performance. In others, tax and regulatory incentives encouraged over-leveraging of companies and decisions to bear extraordinary and unjustified risk.
The Enron scandal deeply influenced the development of new regulations to improve the reliability of financial reporting, and increased public awareness about the importance of having accounting standards that show the financial reality of companies and the objectivity and independence of auditing firms.
In addition to being the largest bankruptcy reorganization in American history, the Enron scandal undoubtedly is the biggest audit failure. The scandal caused the dissolution of Arthur Andersen, which at the time was one of the five largest accounting firms in the world. It involved a financial scandal of Enron Corporation and their auditors Arthur Andersen, which was revealed in late 2001. After a series of revelations involving irregular accounting procedures conducted throughout the 1990s, Enron filed for Chapter 11 bankruptcy protection in December 2001.
One consequence of these events was the passage of Sarbanes-Oxley Act in 2002, as a result of the first admissions of fraudulent behavior made by Enron. The act significantly raises criminal penalties for securities fraud, for destroying, altering or fabricating records in federal investigations or any scheme or attempt to defraud shareholders.
What are the Rules of Accounting?
Accounting is the mechanism used to record activities and transactions that occur within a business. In its simplest terms, Accounting is the "language of business." However, in order to have an understandable record, a standard set of rules for accounting within the U.S. has been established. These rules are called the Generally Accepted Accounting Principles (GAAP), and all U.S. businesses are expected to follow them.
The first general rule of accounting is that every transaction is recorded. It has been said that businesses that do not record transactions, or incorrectly record transactions, are committing fraud, although this is not necessarily the case. Fraud is part of a much broader area called material misstatement which also can include error. An error is not necessarily fraud under the law. While there are exceptions to this rule, the guidance for applying those exceptions is specifically defined by GAAP, and is applicable to all businesses.
The second general rule of accounting is that transactions are recorded using what is called a "double-entry" accounting method. Originally developed in Italy in the 1400s, double-entry means that for a complete record of a transaction, two entries are made. For example, if you have $5 in cash, and want to buy some gasoline for your lawn mower, you take your portable gas can and your money to the gas station and exchange $5 in cash for $5 in gas. This transaction is recorded as an increase in the asset "gas" for $5, and a corresponding reduction in the asset "cash" for $5. In this example, one transaction contained two entries. This takes a little time to get used to, but it is a critical concept in basic accounting. Double entry is tied to the concept of Debits and Credits, which you will learn about in the next section. The act of recording transactions is commonly referred to as making journal entries. In a few more paragraphs, we'll discuss what a journal entry looks like.
The third general rule of accounting is that every recorded transaction is captured in a log called the "General Journal."
In general, "Accounting is the art of recording, classifying, summarizing and interpreting a business transaction."
To make this easier, we can follow the golden rules of accounting. Accounts are one of three basic types:
| Type | Represent | Examples |
|---|---|---|
| Personal | Accounts related to individuals, firms, organizations, or companies | Individuals; partnership firms; corporate entities; 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 | Sales, purchases, 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:
| Type | Debit | Credit |
|---|---|---|
| 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
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
When a transaction occurs, a document is produced. Most of the time, these documents are external to the business, however, they can also be internal documents, such as inter-office sales. These documents are referred to as a source document. Some examples of source documents are:
- The receipt you get when you purchase something at the store.
- Interest you earned on your savings account which is documented in your monthly bank statement.
- The monthly electric utility bill that comes in the mail.
These source documents are then recorded in a Journal. This is also known as a book of first entry. The journal records both sides of the transaction recorded by the source document. These write-ups are known as Journal entries.
These Journal entries are then transferred to a Ledger.The group of accounts is called ledger. A ledger is also known as a book of accounts. The purpose of a Ledger is to bring together all of the transactions for similar activity. For example, if a company has one bank account, then all transactions that include cash would then be maintained in the Cash Ledger. This process of transferring the values is known as posting.
Once the entries have all been posted, the Ledger accounts are added up in a process called Balancing. (This will make much more sense when you learn about Debits and Credits. Balancing implies that the sum of all Debits equals the sum of all Credits.)
A particular working document called an unadjusted trial balance is created. This lists all the balances from all the accounts in the Ledger. Notice that the values are not posted to the trial balance, they are merely copied.
At this point accounting happens. The accountant produces a number of adjustments which make sure that the values comply with accounting principles. These values are then passed through the accounting system resulting in an adjusted trial balance. This process continues until the accountant is satisfied.
Financial statements are drawn from the trial balance which may include:
- the Income statement
- the Balance sheet
- the Cash flow statement
Finally, all the revenue and expense accounts are closed.
Debits and Credits
For the purposes of accounting, please forget what you know about credits and debits. In accounting, debit (Dr.) and credit (Cr.) have nothing to do with plastic cards that let you buy stuff. In fact, what most beginning accounting students need to know about Dr/Cr can be boiled down to two sentences.
How are debit and credit rules applied to different types of accounts?
DEBIT......NATURE OF A/Cs.......CREDIT
Increase.........ASSETS........Decrease
Decrease......LIABILITIES......Increase
Decrease.........REVENUE.......Increase
Decrease.........EQUITY........Increase
Increase........EXPENSES.......Decrease
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.
| Date | Description | Post Ref. | Dr | Cr | |
|---|---|---|---|---|---|
| 2005 Feb | 1 | account1 | 350 | ||
| account2 | 350 | ||||
Owner's Equity = Assets - Liabilities is written from the perspective of the owner. In accounting this is generally rewritten from the perspective of the business or commercial entity the books detail:
Assets = Owner's Equity + Liabilities
Entries in the books are in pairs and track the advantage or asset of the company simultaneously with the disadvantage or liability. In this view the Owner's equity is a claim of the investor against the company.
On the left side or asset side of the fundamental accounting equation. Transaction halves which increase the business assets are "debits" on the left side of the equation. Transaction halves which decrease the business assets are "credits".
This is inverted on the balancing side: transaction halves (i.e. the part of the transaction) that increase the owner's equity are credits to the company books as they are claims of what the company owes the owner or investor, while transaction halves that decrease the owner's equity (dividends paid or loss writeoffs) are beneficial to the company's future financial position by reducing claims and are considered debits. Likewise, liabilities incurred by the business entity (which are tracked by the books) are credits, while liabilities reduced or paid off are debits.
Separate Entity Concept
Even when a business has a single owner we make a distinction between the owner's assets and the assets of the business. For example if the owner gives a van to the business this will count as capital introduced, if the owner takes a salary this will be accounted for as drawings.
Journal Entries
All accounting transactions are first recorded in a journal. The most common of these is the General Journal, sometimes also known as the Book of Original Entry, because it is the first place a transaction is entered into the books. Journal Entries are made from source documents, which can be anything from receipts to invoices to bank statements.
| Date | Description | Post Ref. | Dr | Cr | |
|---|---|---|---|---|---|
| 2005 Jan | 1 | Cash | 10,000 | ||
| Sales | 10,000 | ||||
| To record cash sales. | |||||
| 6 | Equipment | 15,000 | |||
| Accounts Payable | 15,000 | ||||
| To record purchase or equipment on credit | |||||
These two entries show the premise of double-entry accounting. Note that the form of what is written is as important as the actual text:
- Debits are always recorded first, followed by the credits.
- In keeping with the rule of "Debit = Left, Credit = Right", all accounts that are credited have their titles indented ("Sales" and "Accounts Payable" in this example).
- The year and month are only recorded once in the date column. They are recorded again at the top of every new page, and whenever the month or year changes. However, a new page is usually started at the beginning of each month, because end-of-period entries are normally recorded on a separate page.
- A description of each entry is placed on the line below the entry. While this is not required, it is good practice because, at times, account titles may not be enough to describe what actually occurred for a specific transaction.
- A blank line is inserted between entries.
The process of recording entries to a journal is called journalizing.
T-Accounts
Form: Example: Account Name Cash ------------- ------------- Debit | Credit $700.00 | 50.00 | 65.00 | 80.00 _______|_______ ________|_______ Subtotal | Subtotal 765.00 | 130.00 _______|_______ ________|_______ Balance | Balance $635.00 |
One representation of an account is called the T-account, shown above. A T-account contains just the basic elements of the account, so it lacks the necessary detail for use in bookkeeping operations. However, it has its uses as both an illustrative tool and a quick reference.
Each account needs to have a unique Account Name, such as Cash, for ease of reference later on. In modern accounting systems, you will often see an account number alongside the name in order to facilitate report generation and computer entry. Under the bar are the debit (from the Latin debere, to owe) and credit (credere, to believe) columns.
As it shows in the example above, the balance of a T-account can be figured by first totaling each column. Second, subtract the smaller subtotal from the larger, and finally placing the total in the larger number's column.
Ledger Accounts
While a T-Account is useful for quickly summarising an account's balance, it only contains a fraction of the information that was recorded in the Journal.
Types of Accounts
A central axiom for accounting is the accounting equation above. Depending on the type of company involved, Owner's Equity may be "Shareholder's" or simply "Equity", but the equation holds. The list of all of the accounts (along with their respective account numbers) is called the Chart of Accounts
Asset accounts indicate what a company owns. This can be actual possession or the right to take possession, such as a loan extended to another company. Some assets are identifiable by the term"Receivable". Assets have a normal debit balance.
Liability accounts indicate what a company owes to others. Examples of liabilities include loans to be repayed and services that have been paid for that the company hasn't performed yet. Many liabilities can be identified by the term "Payable" in their account name. Liabilities have a normal credit balance.
Equity accounts are a group of accounts that represent the amount of owner's equity in the business. There are four main types of Equity accounts:
- Revenue accounts indicate revenue generated by the normal operations of a business. Fees Earned and Sales are both examples of Revenue accounts. Revenue accounts have a normal credit balance.
- Expense accounts indicate the expenses incurred by a business during normal operations. Most account names ending in "Expense" are classified as expenses. Expenses have a normal debit balance.
- The Owner's Equity or Owner's Capital accounts (for a Proprietorship/Partnership) or the Shareholder's Equity accounts (for a Corporation) indicate the owner's equity in the business. As the accounting equation indicates, equity is the difference between the assets of the company, and the company's debts. Equity accounts are directly affected by Revenue and Expenses, and the standard Equity accounts have Credit balances.
- Dividends represents equity removed from the business by the owners. In a proprietorship or partnership, each owner has an Owner's Withdrawals account. In a corporation, equity is removed by way of dividends, and a Withdrawal account is not needed. Since these accounts represent capital removed from the business, they have a Debit balance.
The effects of debits and credits on the types of accounts is shown on the following table:
| Assets | Liabilities | Equity | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Capital | Dividends | Revenues | Expenses | |||||||||||||
 DebitIncreases Normal Balance |  CreditDecreases | DebitDecreases | CreditIncreases Normal Balance | DebitDecreases | CreditIncreases Normal Balance | DebitIncreases Normal Balance | CreditDecreases | DebitDecreases | CreditIncreases Normal Balance | DebitIncreases Normal Balance | CreditDecreases | |||||
Basic Accounting Principles
Historical Cost Principle: Assets and liabilities should be recorded at the price at which they were acquired. This is to ensure a reliable price; market values can fluctuate and be different between differing opinions, so the price of acquisition is used.
Matching Principle: Expenses should be matched with revenues. The expense is recorded in the time period it is incurred, which means the time period that the expense is used to generate revenue. This means that you can pay for an expense months before it is actually recorded, as the expense is matched to the period the revenue is made.
Revenue Recognition Principle: Revenues should not be recorded until the earnings process is almost complete and there is little uncertainty as to whether or not collection of payment will occur. This means that revenue is recorded when it is earned, which means the job is complete.
Financial Statements
The Income statement is a list of all inflows and outflows of economic benefits(revenues and expenses).
Gross Revenues
-Cost of goods sold
= Gross Profit
-operating expenses
=Income from Continuing operations before taxes and special items
+ other revenues
- other expenses
-taxes
=Income from continuing operations
+/- extraordinary items (net of tax)
NET INCOME
The balance sheet is a list of all a company's assets, liabilities, and owners' equity.
ASSETS
Current Assets
+ Fixed Assets
=TOTAL ASSETS
LIABILITIES
Current Liabilities
+Long-Term Liabilities
=TOTAL LIABILITIES
OWNER'S EQUITY
Common Stock
+Retained Earnings
=TOTAL OWNERS EQUITY
=TOTAL LIABILITES AND O/E
The statement of cash flows is a listing of the inflows and outflows of cash.
Cash provided by Operating activities.........................xx
Cash Provided by financing activities.........................xx
Cash Provided by investing activities.........................xx
Basic Accounting Classes Course Notes
- ALL accounting transactions are entered as journal entries consisting of the Account name, and either a debit (left side) amount or credit (right side) amount. For each entry the debits and credits must balance, and overall on the trial balance (lists all the debits and credits for all the accounts) must always balance.
- There are 5 main classes of Accounts:
- Assets: Anything of value that the business owns. This includes tangible assets such as cash, accounts receivable, inventory, buildings, and machinery, as well as intangible assets such as copyrights, trademarks, and goodwill. Asset accounts normally have a Debit (left side) balance. In transaction entries, a debit to an asset account shows an increase in its amount, while a credit (right side) indicates a decrease in the asset value.
- Example: Buying Equipment for Cash. One asset (Equipment) increases, and therefore it is Debited. Cash, which is also an asset, is decreased with a Credit.
- 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.
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.
- 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.
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.
- 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).
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.
- 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).
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 priceAccountancy/Principles of Accounting
Accounting Operations: Credit & Debit
Accounting approaches the world of economic transactions from the viewpoint of Capital Transformation. Accounting books record the source of the Capital and the form it takes after passing through a company's productive & administrative mechanism. Since Accounting wants to capture these two pieces of information (whence the Capital comes - to what it is transformed), it needs two operations - and Accounting has indeed two and two only operations: Credit & Debit. Traditionally we always say "Debit & Credit" and we always put "Debits" to the "left" (of a page) and "Credits" to the "right" (of a page). But causally speaking, the act which the operation "Credit" captures comes first: because Credit shows the source of the Capital, while Debit shows to what the capital has been transformed before. That's why "A Debit must always equal the corresponding Credit".
Suppose now that the company's Board of Directors, after receiving the cash from the shareholders, decides to spend it in order to buy new productive equipment, striking a deal with a supplier to pay him or her after 60 days from purchasing the equipment. In order to reflect this transaction we need to record two different Accounting Entries.
A) The purchasing of the equipment under 60 days credit terms. Here, since we are buying "on credit", the supplier essentially supplies us with Capital (for 60 days). So we will Credit the Suppliers Account in order to show that we initially are buying the equipment using the suppliers capital, and we will Debit a Fixed Assets account (with equal amount) in order to show that we transformed this capital into Equipment.
B) The cash payment for the equipment after 60 days. Here Accounting sees that capital available to us in the form of Cash (the initial shareholders capital increase in cash), is transformed into Capital returned to supplier. So we will Credit our Bank Account (to show whence capital comes), and we will Debit the Suppliers Account to show to what we have transformed this capital (into Capital Returned to the Supplier).
Forms of Capital
As the above example indicated, "capital" in the world of Accounting, can take many forms. We can state the following all-encompassing definition: Any debt of a company, with or without interest, that is not paid in cash or otherwise settled, at the moment it is recorded in the Accounting Books, becomes capital given to the company.
Essentially then, "capital given to a company" is the amount that the company must return to its creditors. And we record as "capital" even temporarily unpaid debt. For example, suppose that from the payroll of a certain month, you have deducted from the employees' salary a payroll tax that you should pay to the State. If this payment, according to the relevant laws, must be executed three months after the month to which it originates, then for these three months, the state has given to you an amount of capital equal to the Payroll tax amount.
So what are we actually seeing in a Balance Sheet?
In a Balance Sheet we have three main headlines: Assets, Liabilities, Owner's Equity (aka Equity). In many countries, Assets are shown in the left of the page, while Owners' Equity to the top right and Liabilities to the lower right.
Now, it is a fundamental Accounting rule that "Assets = Owners' Equity + Liabilities". But why?
...If we use the "Capital Transformation" approach, we can understand why: "Assets" are of course what the word Assets means. But at the same time they show to us to what the company has transformed the capital given to it by... whom?
a) The Shareholders ("Owner's Equity"), and b) Everybody Else (Liabilities). In Equity we see the amount that is to be returned to the Shareholders, after all Assets are liquidated and all Liabilities are paid in full. In that sense, "Owners' Equity" is also a liability for the company: A company does not own anything - it owes all of its Assets to somebody, Third Parties or its Shareholders. A company is a separate entity from its owners.
In Liabilities, we see the amounts that the company owes to third parties - Suppliers, Banks, Internal Revenue Service, etc. At the same time they show to us "whence the capital came".
So the right side of a Balance Sheet shows how much capital and from whom the company has managed to get at the specific moment of the balance sheet (from third parties-"Liabilities" or from its own shareholders-"Equity"). On the left side of the Balance Sheet, we see to what the company has transformed this capital-"Assets". Again, we are talking about the same capital, the same quantity. So the "right side" (Equity + Liabilities) must equal the "left side" (Assets).
The fundamental accounting equation, which is also known as the balance sheet equation looks like this:
Assets = Liabilities + Owner's Equity
On the left-hand-side of the equation are the resources (assets) of the business. Or more correctly, the term assets "represents" the value of the resources of the business. On the other side of the equation are claims of ownership on those assets. Liabilities are the claims of creditors (those "outside" the business). The equity, or owner's equity, is the claim of the owners of the business (those "inside" the business).
This equation is kept in balance after every business transaction. Everything falls under these three elements in a business transaction.
Accountancy/Double Entry
Double Entry is the principle of accounting which requires that every transaction has two effects one of which is a debit and the other of which is a credit of the same amount. What this means is that the total of the Debits must always equal the total of the Credits.
In this example we deposit 10 units of currency into our bank account.
| Date | Description | Post Ref. | Dr | Cr | |
|---|---|---|---|---|---|
| 2005 Feb | 1 | Bank (Asset) | 10 | ||
| Cash (Asset) | 10 | ||||
Since the total of the Debits equals the total of the Credits we say the transaction is Balanced.
[edit]The Accounting Equation
- A = Assets
- L = Liabilities
- F = Owners'Funds
- D = Drawings
- P = Profit
The Value of the business is the value of its assets less the value of its liabilities and this value belongs to the owners of the business:
A − L = F
The Owners fund must also equal the amount the owners have put into the business (Capital) less any amounts they have taken out (Drawings) plus any profit. For the time being we assume the business is profitable.
A − L = C − D + P
We add D + L to both sides to remove the minus signs. A + D = C + P + L
We call items on the left hand side Debits and items on the right hand side Credits. Then:
TotalDebits = TotalCredits
In order that this equation holds we must also ensure that a loss is on the opposite side to a profit and therefore a loss is a debit.
Note that items of income increase profit so they are also credits, while expenses decrease profit and are therefore debits.
[edit]When to Debit, when to Credit?
Another look. Debit (Dr) and Credit (Cr) only refer to which side of the double entry an account/value goes to. Debit on left, and Credit on right. The normal of an account refers to which side it normally increases on, whether it be good or bad for the company.
The D.E.A.D. C.O.I.L. Mnemonic
- Debit side
- Expenses
- Assets
- Drawing (of Equity)
- Credit side
- Owner's Equity
- Income
- Liabilities
Another-nother look.
Debit/Credit-ishness of an account comes from the elements of the accounting equation, Owner's Equity=Assets - Liabilities, and lots of flipping.
Start by looking at the Dr. side.
- If your account is an Equity term, flip it.
- Equity terms are Capital, Drawing, Income, Expenses. These are the financial borders of the business.
- If it's a Liability, flip it.
- Liabilities are negative (well, it's good to have access to resources now, but they still are a hole that demands filling). Remember, if somebody prepaid you for a something you haven't fulfilled, that's a liability too!
- If is an "evil parallel universe" form of an Asset, Liability,or Equity, then flip it (again, if need be).
- Expenses are equity accounts, in a negative way. Drawing is a negative overlay to Capital, and gets flipped here, too. Depreciation (an overlayed contra-asset), flips as well.
- You now know the normal of the account. One last flip if the account needs to be reduced.
Within all of this flipping, Debit/Credit has two meanings, whether a term is negative to the company's finances, and whether it is external to the company. By demanding each entry set to balance, the journal tracks motions of money (or widgets, labor..) in the company. Changes of value are expressed as a motion into yet another account, such as moving part of the "Merchandise" Asset (as Cr) into the "Damaged Goods" Expense (as Dr).
As a mnemonic device for students: Note that only Assets and Expenses show an Increase for Debits and Decrease for Credits. All other accounts are the reverse. First memorize the acronyms AID (Assets Increase Decrease) & EID (Expenses Increase Decrease)and then keep in mind that the table reads Debits on the left and Credits on the right.
| Account | Debit | Credit | Account Debit Credit |
|---|---|---|---|
| Assets | Inc. | Dec. | A I D |
| Expenses | Inc. | Dec. | E I D |
| Liabilities | Dec. | Inc. | |
| Shareholder Equity | Dec. | Inc. | |
| Revenue | Dec. | Inc. |
