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The purpose of accounting is to provide the information that is needed for sound economic decision making. The main purpose of financial accounting is to prepare financial reports that provide information about a firm's performance to external parties such as investors, creditors, and tax authorities. Managerial accounting contrasts with financial accounting in that managerial accounting is for internal decision making and does not have to follow any rules issued by standard-setting bodies. Financial accounting, on the other hand, is performed according to Generally Accepted Accounting Principles (GAAP) guidelines.

Accounting Standards

In order that financial statements report financial performance fairly and consistently, they are prepared according to widely accepted accounting standards. These standards are referred to as Generally Accepted Accounting Principles, or simply GAAP. Generally Accepted Accounting Principles are those that have "substantial authoritative support".

Accrual vs. Cash Method

Many small businesses utilize an accounting system that recognizes revenue and expenses on a cash basis, meaning that neither revenue nor expenses are recognized until the cash associated with them actually is received. Most larger businesses, however, use the accrual method.

Under the accrual method, revenues and expenses are recorded according to when they are earned and incurred, not necessarily when the cash is received or paid. For example, under the accrual method revenue is recognized when customers are invoiced, regardless of when payment is received. Similarly, an expense is recognized when the bill is received, not when payment is made.

Under accrual accounting, even though employees may be paid in the next accounting period for work performed near the end of the present accounting period, the expense still is recorded in the current period since the current period is when the expense was incurred.

Underlying Assumptions, Principles, and Conventions

Financial accounting relies on the following underlying concepts:

  • Assumptions: Separate entity assumption, going-concern assumption, stable monetary unit assumption, fixed time period assumption.

  • Principles: Historical cost principle, matching principle, revenue recognition principle, full disclosure principle.

  • Modifying conventions: Materiality, cost-benefit, conservatism convention, industry practices convention.

Financial Statements

Businesses have two primary objectives:

  • Earn a profit
  • Remain solvent

Solvency represents the ability of the business to pay its bills and service its debt.

The Four Financial Statements are reports that allow interested parties to evaluate the profitability and solvency of a business. These reports include the following financial statements:

  • Balance Sheet
  • Income Statement
  • Statement of Owner's Equity
  • Statement of Cash Flows

These four financial statements are the final product of the accountant's analysis of the transactions of a business. A large amount of effort goes into the preparation of the financial statements. The process begins with bookkeeping, which is just one step in the accounting process. Bookkeeping is the actual recording of the company's transactions, without any analysis of the information. Accountants evaluate and analyse the information, making sense out of the numbers.

For the reports to be useful, they must be:

  • Understandable
  • Timely
  • Relevant
  • Fair and Objective (free from bias)

Fundamental Accounting Model

The balance sheet is based on the following fundamental accounting equation:

Assets  =  Liabilities  +  Equity

This model has been used since the 18th century. It essentially states that a business owes all of its assets to either creditors or owners, where the assets of a business are its resources, and the creditors and owners are the sources of those resources.

Transactions

To record transactions, one must:

  1. Identify an event that affects the entity financially.
  2. Measure the event in monetary terms.
  3. Determine which accounts the transaction affects.
  4. Determine whether the transaction increases or decreases the balances in those accounts.
  5. Record the transaction in the ledgers.

Most larger business accounting systems utilize the double entry method. Under double entry, instead of recording a transaction in only a single account, the transaction is recorded in two accounts.

To illustrate this concept, take the following example. Mike Peddler decides to open a bicycle repair shop. To get started he rents a shop, purchases an initial inventory of bike parts, and opens for business. Here are the transactions for the first month:

Date       Transaction
Sep 1 Owner contributes 7500 in cash to capitalize the business.
Sep 8 Purchased 2500 in bike parts on account, payable in 30 days.
Sep 15 Paid first month's shop rent of 1000.
Sep 17 Repaired bikes for 1100; collected 400 cash; billed customers for the 700 balance.
Sep 18 275 in bike parts were used.
Sep 25 Collected 425 from customer accounts.
Sep 28 Paid 500 to suppliers for parts purchased earlier in the month.

These transactions affect the accounting equation as shown below.

 

 

Assets

=

Liabilities  +  Owner's Equity

 

Cash

+

Bike
Parts

+

Accounts
Receivable

=

Accounts
Payable

+

Peddler,
Capital

+

Revenue
(Expenses)

Sep 1

7500

 

 

 

 

=

 

 

7500

 

 

Sep 8

 

 

2500

 

 

=

2500

 

 

 

 

Sep 15

(1000)

 

 

 

 

=

 

 

 

 

(1000)

Sep 17

400

 

 

 

700

=

 

 

 

 

1100

Sep 18

 

 

(275)

 

 

=

 

 

 

 

(275)

Sep 25

425

 

 

 

(425)

=

 

 

 

 

 

Sep 28

(500)

 

 

 

 

=

(500)

 

 

 

 

Totals:

6825

+

2225

+

275

=

2000

+

7500

+

(175)

 

9325

=

9325

At the end of the month of September, the balance sheet for the business would appear as follows:

Peddler's Bikes
Statement of Financial Position
September 30, 2000
Assets       Liabilities  &  
Owner's Equity
Cash 6825   Accounts Payable 2000
Accounts Receivable 275   Peddler, Capital 7325
Bike Parts 2225      
Total Assets 9325   Total Liabilities 9325

The bike parts are considered to be inventory, which appears as an asset on the balance sheet. The owner's equity is modified according to the difference between revenues and expenses. In this case, the difference is a loss of 175, so the owner's equity has decreased from 7500 at the beginning of the month to 7325 at the end of the month.


Journal Entries

Transactions enter the accounting system in the form of journal entries. Journal entries serve as a chronological record of business transactions and include the date, the names of the affected accounts, an optional short description of the transaction, and the debits and credits for the transaction. Debits are the entries on the left side of a T-account; credits are the entries on the right side.

Finance
Revision Sheets

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