Believe it or not, this chapter is the most important chapter in the entire textbook. It is the most important because this chapter will teach you the fundamental theories underlying all financial accounting concepts. The principles introduced in this chapter will be used extensively in future chapters, more advanced courses and ultimately in your own business career. Just like many other subjects, mastery of the basic principles is critical to comprehending more advanced material. For students to be successful in accounting, they must be able to master every concept found in this chapter.
The next three chapters will focus on building the foundation of your accounting knowledge. We begin by learning the basic principles that form the foundation of financial accounting. We then move on to learning about recording transactions in a standardized manner that follows the fundamental principles of accounting. We conclude by learning about the various financial statements and the specific methods to prepare those financial statements. The remaining chapters focus on specific topics in financial accounting.
The following accounting elements are the basic building blocks for accounting information. The accounting elements are equivalent to words that are used to construct sentences in languages. The elements are directly related to measuring business activity and reporting the activity’s impact on the company’s financial condition. In total, there are ten accounting elements.
Within accounting, several basic assumptions must always be present for accounting information to be useful. An assumption is something that is accepted as being always true without significant evidence. If these assumptions are not followed, the accounting information presented will cease to be useful to anyone. The following assumptions must always hold true for all accounting information:
Economic Entity Assumption: This assumption assumes that each economic entity has separate accounting records from the owners and other non-related business entities. For example, the owners of the company will have separate records for their personal finances while the company will have its own set of records. The company will never record transactions performed by the owners in their personal lives and vice versa. If a company owns another company then both entities must have separate accounting records to not violate the economic entity assumption. This is true even if the company is owned 100% by the parent company.
Monetary Unit Assumption: The accounting records must only contain data that can be measured in a stable monetary unit or currency. Companies often use their country’s national monetary unit such as the British pound or the United States dollar. When transactions are measured in a common monetary unit it allows for easier measurement and comparison for users. If the monetary unit being used for accounting information becomes unstable then another monetary unit should be used or different accounting methods should be used (called inflation accounting).
Going Concern Assumption: The going concern assumption is based around the idea that a company will continue to operate into the future without significant threat of the company going out of business. The going concern assumption will be violated if the company will not be able to meet its agreements or pay its commitments (liabilities). As we will learn later, many accounting principles are reliant on the going concern assumption. If the going concern assumption was violated then most of these accounting principles would not make sense to use. When a company is in the process of going out of business (called liquidation) an alternate set of accounting methods must be used, such as, current market value for valuing assets.
Faithful Representation: For accounting information to be relied upon it must represent transactions that actually exist and those transactions must be represented as they occurred in reality. This assumption is extremely important when it comes to valuing assets and using estimates. The accountant must always follow generally accepted accounting principles and only use estimates that don’t artificially distort reality. For accounting information to be faithfully represented it must be complete, neutral and free from material error. If the business employees intentionally violate this assumption then it is considered accounting fraud.
Time Period Assumption: Accounting information should be recorded based on standard time periods. Common standard time periods are monthly, quarterly or annually. A 12 month period is referred to as a calendar year, from January 1st to December 31st. Most companies report on a 12-month calendar year end (ending December 31st), however, not all companies report with their year-end being December 31st. If the business reports on a period other than a calendar year then it is referred to as a fiscal year. For example, a company that reports an annual year ending June 30th is referred to as having a fiscal year ending June 30th. Companies might select a fiscal year due to seasonality of their business operations or during the slow period of their operations. The time period assumption must be utilized to allow accounting information users to be able to compare and analyze financial accounting data. In other words, the accounting information must be presented in an “apples to apples” format.
For accounting information to be useful, it must be prepared based on the following principles:
Revenue Recognition Principle: This principle states that revenue should be recognized in the financial records when it is earned. The term earned is used very specific in this case. The term earned means when a transaction has taken place and the earning process is substantially complete. Take note that one of the requirements is not when the customer has paid. There should be little uncertainty about future costs and collectability of the transaction. If you were operating a merchandising business, the revenue would be earned when you have shipped the product to the customer. Ultimately this means that revenue is not recognized when cash changes hands. The revenue recognition principle is considered a fundamental principle in accrual accounting.
Matching Principle (Expense Recognition Principle): The matching principle is a fundamental theory of accrual accounting. The principle states that revenue should be ‘matched’ to the expenses that created the revenue. The matching principle can be confusing to understand without a detailed explanation. To elaborate and fully explain the matching principle lets imagine a basic business that sells televisions. The business will purchase televisions in bulk and then slowly resell them to generate revenue. Based on the matching principle, the expense of each television should only be recorded when each television is sold. If the cost of each television is $70 and each television sells for $100 then the company would record $70 cost of goods sold and record $100 revenue when each television is sold. At this point, you might be wondering why this principle is so important. To fully understand this concept, we have to think of how accounting information will appear to external users. If the expense was recorded when the company purchased the original product then the business would appear to have lots of expenses during that month and be a poor investment. In other words, the external users would not able to fully understand how the business is operating. By using the matching principle, we can provide more accurate information in terms of how profitable a business enterprise is. The matching principle is much more detailed than this explanation. Just imagine how you would record various transactions based on the matching principle, for example, insurance expense, rent expense or warranty expense? All of these concepts will be explained later.
Materiality: The concept of materiality is based on the principle of the cost benefit constraint. The materiality assumption assumes that recording accounting information has a cost and accounting transactions should only be recorded when the benefit exceeds the cost. In terms of financial accounting, materiality is relevant to the extent all transactions should be recorded if the external user’s judgement will be altered. If the accounting transaction will not affect the external user’s judgement then the transaction is considered immaterial. An accountant or bookkeeper must use professional judgement to determine what is the threshold for materiality. To further explain materiality, lets imagine that you have a business that generates $10 million in revenue with $7 million in expenses and $3 million profits. For this business, small non-recurring transactions, such as usage of $50 per year worth of office pencils, would be considered immaterial while a $500,000 purchase of factory equipment would be considered a material transaction. Materiality is also an entity specific criterion. For large businesses, the materiality threshold will be higher than $50.
Full Disclosure Principle: The full disclosure principle means that the company must report all necessary information with the financial statements to ensure that external users are able to fully understand the company’s business operations. Often times this information is included as supplementary notes, schedules or statements that accompany the financial statements. An example of the full disclosure principle is the management discussion & analysis (MD&A) and the statement on significant accounting policies that are included in a complete set of financial statements. All major financial reporting frameworks requires strict adherence to the full disclosure principle. If the full disclosure principle is not followed then it is highly likely that the financial statements will be misleading to users of the reports.
Cost Benefit Constraint: The cost benefit constraint means that the cost of obtaining accounting information must be justified by the benefit provided by the information. Generally speaking, if the information is costly to obtain compared to the benefit then the information should not be obtained. The cost benefit constraint is found throughout accounting literature and accounting standards.
Consistency Principle: The consistency principle states that once an accounting method or principle is applied then that method should be applied to future periods. The principle also states that a change in accounting principle should only occur when it reflects the financial condition of the entity more accurately.
Objectivity Principle: This principle states that information recorded in the accounting records must be based on objective or unbiased facts. Records which are not based on objective facts are considered unreliable and should not be recorded.
Recognition and Realization: Recognition and realization are two very important terms. Recognition means to record the transaction in the financial statements while realization means the act of converting an asset, liability, product or service into cash. An easy way to remember what realization is to remember the phrase, “realization is what happens in the real world.” The primary distinction between the two concepts is that transactions can be realized but not recognized in the financial statements. The contrary is true as well, a transaction can be recognized before the transaction has been realized. For example, when a customer pays on credit through an account payable and the merchant ships the goods then the merchant can recognize the transaction in the financial statements even though no cash has been paid.
Measuring transactions in accounting is critical for providing comparability. All transactions must be accounted for by using a common form of currency or other unit of measurement. There are several basis of measurement with two basis of measurement being used most often, they are the cost principle and the fair value principle.
At this point, you are probably wondering why certain transactions are reported at historical cost while other transactions are reported at fair value. The theory is based on the availability and reliability of fair value information. Let’s think about why land would use the historical cost principle rather than fair value. For land, each piece of land is very unique and has its own set of characteristics. With that in mind, it is difficult to find a reliable fair value for land. The only way to find a fair value is to list the property for sale and solicit offers from prospective buyers. Even in that situation, a variety of factors could distort what price you get for the land. Perhaps if you sold the land in summer, you would get a higher price compared to if you sold it in winter. A variety of other factors could distort the amount you would get. Due to all these factors, obtaining a reliable fair value for land is simply too burdensome so it has become customary to report land at historical cost. On the other hand, think about why fair value might be more useful for valuing stocks. With a stock, all shares are equal as long as they are the same class of stock. On any given day, the number of shares that change hands could be in the millions and the information on those trades is publicly disclosed. Furthermore, to obtain this information is convenient and easy. As a result, calculating fair value for a stock is easy, cost effective and provides a high level of fair value. Therefore, it is recommended that stock transactions be reported using the fair value principle. When you adjust assets to fair value it is also referred to as mark-to-market.
An important element of accounting is related to when to record transactions. How accounting transactions are recorded based on timing is called the accounting basis. The timing of recording transactions is very important because it influences how information will be interpreted. Most significantly of this is the recording of revenue and expenses. To fully understand this concept, we need to elaborate on the unique characteristics of recording revenue and expenses. Let’s think about recording revenue. When should a business record its revenue? Should it record the revenue when the service is fully complete or when the business receives the cash? For expenses, should the business record expenses when they are paid in cash or when they have used up the resources of the asset (i.e. prepaid insurance)? The answers to these questions will depend on which basis of accounting you are using. The two most commonly used basis are cash basis and accrual basis.
Cash-Basis: Cash-basis records revenue when cash is received and records expenses when cash is used to pay expenses. To fully understand this just imagine you are operating a business that sells candy. Some of your customers will pay for the candy upfront while other customers will require the merchandise first before they pay. For these transactions, the only factor for recording revenue is simply when the cash is received. For expenses, it is a similar pattern. Expenses are recorded only when cash is paid. If you purchase a 12 month insurance contract and pay upfront then you will record the entire 12 month expense at the time of purchase even though insurance will expire on a month-by-month basis. The primary issue with cash-basis accounting is that it violates the matching principle. The matching principle is essential to determining if a business is profitable based on its primary business operations because it matches the costs associated with earning a specific amount of revenue. By violating the matching principle, the cash basis of accounting distorts the determination of how profitable a company is. However, in certain situations, such as taxes, a cash-basis accounting method might provide for better information for the users (government tax collectors in this case) or provide for the needs of specific requirements. Thus, as we can see, the accounting basis used depends on what the end goal of how it will be used. The use of cash-basis accounting is a violation of the requirements of Generally Accepted Accounting Principles (GAAP), which will be discussed in Chapter 4.
Accrual-Basis: Accrual-basis records revenue when it is earned and records expenses when they are incurred. In this case, the terms earned and incurred are critical for understanding accrual accounting. Based on accounting standards, the term earned means when the earning process for goods or services is substantially complete. Think about if you operated a lawn mowing business. You will record revenue after you have finished mowing each lawn. You will not record revenue when cash is received. You will record revenue even when cash has not been received for the service. If you have substantially completed the service then you can recognize revenue from the completed service. For expenses, they are recognized when incurred. Incurred means the good/service has been used up. Just imagine you have a 12 month insurance contract. Each month you would recognize one month’s worth of the expense associated with the expiration of the insurance contract. If you were selling goods then you would record the cost of the good at the time of the sale. The significant benefit of accrual accounting is that it does not violate the matching principle. All revenue sources are matched with their associated expenses and non-operating expenses (insurance) are recognized using a reasonable allocation method. Overall, the accrual basis is a better measure of economic activity. Accrual basis accounting is required to comply with Generally Accepted Accounting Principles.
Modified Accrual-Basis: Modified accrual combines elements of cash basis and accrual basis. This topic will be left for more advanced financial accounting courses.
Source documents are the underlying documents that derive accounting information. Most source documents are legal documents that are not specifically created for accounting purposes. Instead they are usually designed to facilitate a larger business process, such as, shipping a good to a customer, receiving payment for orders, requesting payments from customers and recording other types of transactions or general information. Source documents are important in accounting because they help to substantiate (prove) transactions made in the accounting information system. Most source documents contain a variety of unique information but almost all source documents contain the date of the transaction, the amount of the transaction and a description of the transaction. Source documents can be in paper form or entirely electronic (stored in an electronic database). In modern business enterprises, it is not uncommon to see most source documents being in a digital form. We will review the most commonly used source documents. It is important to note that these are just general formats. The exact format and variety of source documents can vary from company to company.
Invoice: An invoice is a document that is created by the seller and issued to the buyer. The invoice lists the products/services purchased, the date of the transaction and the agreed amount requested. The invoice is then given to the purchaser who either pays the invoice or abides by other payment terms listed on the invoice. The term invoice may also be referred to as a bill. A sample invoice is shown below:
Receipt: A receipt is created by a store to record a transaction that has occurred. Usually receipts are created by retail stores and a copy of the receipt is given to the customer. The significant difference between an invoice and a receipt is that a receipt is provided after a customer has paid for their merchandise. A sample receipt is shown below:
Bill of Lading: A bill of lading records shipping information between the shipper and the freight carrier of the goods. An example bill of lading is shown below:
Purchase Order: A purchase order is created by a buyer and given to a seller. The purchase order lists the items the buyer wishes to purchase from the seller. It lists the agreed prices, quantity and type of goods to be purchased.
These are just a few sample source documents. At this point, it is simply important to know the most commonly used source documents and that source documents are used to substantiate accounting information.
Now that we have a basic understanding of accounting. We can discuss one of the most important equations in accounting: the accounting equation, which is represented below.
Assets = Liabilities + Owner’s Equity
The accounting equation is significant for a few reasons. It shows us that assets must always equal liabilities plus owner’s equity. The assets of a business are either owned by the creditors (liabilities) or owned by the owners of the business (owner’s equity). It is also significant because it represents the basis for double-entry accounting. If assets are to increase then liabilities or owner’s equity must also increase. In other words, the equation must always be in balance. Ultimately, the equality of the accounting equation means the following transactions must occur to keep the equation in balance:
These entries sound relatively confusing when stated in a written form. An illustrative example will be easier to wrap your mind around the above concepts:
Bob wants to start a new bookstore. He will need to record important business transactions in his accounting records. The new company will be called Bob’s bookstore which will sell books and related merchandise.
Explanation: Borrowing money from a bank will increase your liabilities and a machine is an asset which is being increased. Both assets and liabilities increased which keeps the equation in balance.
Explanation: Cash is an asset which was used to decrease a liability. Assets decreased and liabilities decreased. The equation remains in balance.
Note: In accounting, numbers that are surrounded by parenthesis to indicate a negative or subtraction.
Explanation: Equipment and cash are assets. In this case, cash has decreased while the equipment asset account has increased. The equation remains in balance.
Explanation: Common stock is part of owner’s equity. When common stock is issued it increases owner’s equity. Since the common stock was issued to reduce a liability the liability account is decreased.
As we can see with every transaction, the accounting equation remains in balance. We can also use simple algebra to solve for a missing unknown. For example if we are given information that assets are $10,000 and liabilities are $7,000 then we can use algebra to determine that the owner’s equity must be $3,000. The reason for this is because we know that assets must always equal liabilities plus owner’s equity. More complicated transactions will be explained in later chapters.
It is also important to note that the accounting equation can also be rewritten in a variety of ways. For example, the accounting equation can also be rewritten as any of the following:
Assets – Liabilities = Owner’s Equity
Assets – Owner’s Equity = Liabilities
Upon further analysis, we can dive deeper into the accounting equation by showing the expanded accounting equation. The expanded accounting equation replaces owner’s equity with the following: Owner’s capital + Retained Earnings + Revenue – Expenses – Owner’s draws. The expanded accounting equation is as follows:
Assets = Liabilities + Owner’s capital + Retained Earnings + Revenues – Expenses – Owner’s draws.
Do note that the above equation is for a private business. If the business is for a a corporation then the following expanded accounting equation would be used:
Assets = Liabilities + Common Stock + Retained Earnings + Revenues – Expenses – Dividends.
Common stock is an investor’s ownership interest in a company. Dividends are cash payments of earnings made by corporations to reward their shareholders for investing in the company. The dividend is paid on a per share basis.
An interesting characteristic of the accounting equation shows that as the company generates revenue, the assets of the company will increase and so will the owner’s equity. If the company accrues expenses then assets go down and owner’s equity likewise goes down. Transactions with owners are not considered revenue or expenses.
Double-entry bookkeeping is a system where each entry into the accounting records (called a journal entry) must affect at least two accounts. Using this system of bookkeeping allows for accrual accounting as well as helping to detect errors. Using the double-entry system does not guarantee that the entry is error free. At all times, the accounting equation must remain in balance. If an entry is not in balance then the entry is incorrect. In essence the sum of the debits must equal the sum of the credits. The double-entry system allows for recording complex business transactions. Chapter 3 will discuss in detail how to perform double-entry accounting using accrual accounting rules.
The accounting cycle is the process by which transactions are recorded, summarized and communicated in the form of financial statements. The process is repeated continuously to ensure that accurate accounting information is always being created. The accounting cycle would be completed every time a set of financial statements needs to be prepared which could be monthly, quarterly or annually. The accounting cycle encompasses the following steps:
1) Analyze and journalize business transactions: Relevant business transactions are reviewed to determine if they should be recorded in the accounting records. If the transaction is selected to be recorded then the amounts of the transactions are determined and the accounts to debit and credit are selected. Recording the proper amounts and selecting the correct accounts are critical to ensure that accounting data is of the highest quality possible.
2) Post journal entries to general ledger: After recording our journal entries, we will move those journal entries to the general ledger to create a summarized version of our journal entries.
3) Prepare unadjusted trial balance: The unadjusted trial balance is prepared based on the amounts in the general ledger. This is to ensure that debits equal credits which is used as a way to check for possible errors.
4) Journalize and post adjusting entries: Relevant accounts are selected for adjustments. The related adjusting entries are posted.
5) Prepare adjusted trial balance: The adjusted trial balance is prepared to ensure that debits equal credits and as a way to detect possible errors.
6) Prepare financial statements: The financial statements are prepared using the amounts in the adjusted trial balance.
7) Journalize and post-closing entries: The closing entries are prepared and posted. The closing entries are essentially preparing the temporary accounts for the next accounting cycle.
8) Prepare post-closing trial balance: The post-closing trial balance is used to check the equality of debits and credits as well as a way to detect possible errors.
At this point, many of these steps will seem mysterious to you. In the next chapter we will cover all of these steps in detail.