ACCT100 Principles of Accounting
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To enter in the field of accounting one should
be well versed with the principles of accounting. Principles of accounting are
as follows:
Understanding of
accounting terminology
Basis
accounting terms are as follows:
Debit and Credit
These
are the backbone of any accounting system. Understand how debits and credits
work and you'll understand the whole system. Every accounting entry in the general
ledger contains both a debit and a credit. Further, all debits must equal all
credits. If they don't, the entry is out of balance and the trial balance will
not tally. It is a major principle of accounting.
Debits and Credits vs. Account Types
Account
Type Debit
Credit
Assets Increases Decreases
Liabilities Decreases Increases
Income Decreases Increases
Expenses Increases Decreases
Assets Increases Decreases
Liabilities Decreases Increases
Income Decreases Increases
Expenses Increases Decreases
Assets and Liabilities
Balance
sheet accounts are the assets and liabilities. When we set up your chart of
accounts, there will be separate sections and numbering schemes for the assets
and liabilities that make up the balance sheet.
A
quick reminder: Increase assets with a debit and decrease them with a credit.
Increase liabilities with a credit and decrease them with a debit.
Income and Expenses
Further
down in the chart of accounts (usually after the owners' equity section) come
the income and expense accounts. Most companies want to keep track of just
where they get income and where it goes, and these accounts tell you.
For
income accounts, use credits to increase them and debits to decrease them. For
expense accounts, use debits to increase them and credits to decrease them.
Income accounts
If
you have several lines of business, you'll probably want to establish an income
account for each. In that way, you can identify exactly where your income is
coming from. Adding them together yields total revenue.
Typical
income accounts would be
ü Sales revenue from product
A
ü Sales revenue from product
B (and so on for each product you want to track)
ü Interest income
ü Income from sale of asset
ü Consulting income
Most
companies have only a few income accounts. That's really the way you want it.
Too many accounts are a burden for the accounting department and probably don't
tell management what it wants to know. Nevertheless, if there's a source of
income you want to track, create an account for it in the chart of accounts and
use it.
Expense accounts
Most
companies have a separate account for each type of expense they incur. Your
company probably incurs pretty much the same expenses month after month, so
once they are established, the expense accounts won't vary much from month to
month. Typical expense accounts include
ü Salaries and wages
ü Telephone
ü Electric utilities
ü Repairs
ü
Maintenance
ü Depreciation
ü Amortization
ü Interest
ü Rent
·
Generally
Accepted Accounting Principles
·
There are general rules and concepts that govern the field of
accounting. These general rules–referred to as basic accounting principles
form the groundwork on which more detailed, complicated, and legalistic
accounting rules are based.
If a company distributes its financial statements to the public,
it is required to follow generally accepted accounting principles in the
preparation of those statements. Further, if a company's stock is publicly
traded, federal law requires the company's financial statements be audited by
independent public accountants. Both the company's management and the
independent accountants must certify that the financial statements and the
related notes to the financial statements have been prepared in accordance with
GAAP.
The following is a list of the main accounting principles and
guidelines :
1.
Economic Entity Assumption
The accountant keeps all of the business transactions of
a sole proprietorship separate from the business owner's personal transactions.
For legal purposes, a sole proprietorship and its owner are
considered to be one entity, but for accounting purposes they are considered to
be two separate entities.
2.
Monetary Unit Assumption
Economic activity is
measured in currency, and only transactions that can be expressed currency are
recorded.
3.
Time Period Assumption
Accounting is done for a
particular period such as from april to march. It is called financial year.
4.
Cost Principle
From an accountant's point of view, the term "cost"
refers to the amount spent (cash or the cash equivalent) when an item
was originally obtained, whether that purchase happened last year or
thirty years ago. For this reason, the amounts shown on financial statements
are referred to as historical cost amounts.
Because of this accounting principle asset amounts
are not adjusted upward for inflation. In fact, as a general rule,
asset amounts are not adjusted to reflect any type of increase in
value. Hence, an asset amount does not reflect the amount of money a company
would receive if it were to sell the asset at today's market value. (An
exception is certain investments in stocks and bonds that are actively traded
on a stock exchange.) If you want to know the current value of a company's
long-term assets, you will not get this information from a company's financial
statements–you need to look elsewhere, perhaps to a third-party appraiser.
Further we will discuss ACCT 207 Financial accounting A in the following chapters.
5.
Full Disclosure Principle
If certain information is
important to an investor or lender using the financial statements, that
information should be disclosed within the statement or in the notes to the
statement. It is because of this basic accounting principle that numerous pages
of "footnotes" are often attached to financial statements.
As an example, let's say a
company is named in a lawsuit that demands a significant amount of money. When
the financial statements are prepared it is not clear whether the company will
be able to defend itself or whether it might lose the lawsuit. As a result of
these conditions and because of the full disclosure principle the lawsuit will
be described in the notes to the financial statements.
A company usually lists
its significant accounting policies as the first note to its financial
statements.
6.
Going Concern Principle
This accounting principle assumes that a company will continue to
exist long enough to carry out its objectives and commitments and will not
liquidate in the foreseeable future. If the company's financial situation is
such that the accountant believes the company will not be able to
continue on, the accountant is required to disclose this assessment.
The going concern
principle allows the company to defer some of its prepaid expenses or some
provisions until future accounting periods.
7.
Matching Principle
This accounting principle requires companies to use
the accrual basis of accounting (mercantile basis of accounting). The
matching principle requires that expenses be matched with revenues. For
example, sales commissions expense should be reported in the period when the
sales were made (and not reported in the period when the commissions were
paid). Wages to employees are reported as an expense in the week when the
employees worked and not in the week when the employees are paid. If a company
agrees to give its employees 1% of its 2013 revenues as a bonus on January 15,
2014, the company should report the bonus as an expense in 2013 and the amount
unpaid at December 31, 2013 as a liability. (The expense is occurring as the
sales are occurring.)
Because we cannot measure
the future economic benefit of things such as advertisements (and thereby we
cannot match the ad expense with related future revenues), the accountant
charges the ad amount to expense in the period that the ad is run.
8.
Revenue Recognition Principle
Under the accrual basis of accounting (as opposed to the cash
basis of accounting), revenues are recognized as soon as a product
has been sold or a service has been performed, regardless of when the money is
actually received.
9.
Materiality
Because of this basic
accounting principle or guideline, an accountant might be allowed to violate
another accounting principle if an amount is insignificant. Professional
judgement is needed to decide whether an amount is insignificant or immaterial.
An example of an obviously immaterial item is the purchase of a
$150 printer by a highly profitable multi-million dollar company. Because the
printer will be used for five years, thematching principle directs the
accountant to expense the cost over the five-year period. The materiality guideline
allows this company to violate the matching principle and to expense the entire
cost of $150 in the year it is purchased. The justification is that no one
would consider it misleading if $150 is expensed in the first year instead of
$30 being expensed in each of the five years that it is used.
Because of materiality,
financial statements usually show amounts rounded to the nearest dollar, to the
nearest thousand, or to the nearest million dollars depending on the size of
the company.
10.
Conservatism
If a situation arises
where there are two acceptable alternatives for reporting an item, conservatism
directs the accountant to choose the alternative that will result in less net
income and/or less asset amount. Conservatism helps the accountant to
"break a tie." It does not direct accountants to be conservative.
Accountants are expected to be unbiased and objective.
The basic accounting
principle of conservatism leads accountants to anticipate or disclose losses,
but it does not allow a similar action for gains. For
example, potential losses from lawsuits will be reported on the
financial statements or in the notes, but potential gains will not be
reported. Also, an accountant may write inventory down to an amount
that is lower than the original cost, but will not write
inventory up to an amount higher than the original cost.
Accounting equation
The basic accounting equation, also called the balance sheet
equation, represents the relationship between
the assets, liabilities, and owner's equity of a business.
It is the foundation for the double-entry bookkeeping system. For each
transaction, the total debits equal the total credits. It can be expressed as
The accounting equation is fundamental to the double-entry
bookkeeping practice. Its applications
in accountancy and economics are thus diverse.
Financial Statements
A company’s quarterly and annual reports are basically derived
directly from the accounting equations used in bookkeeping practices. These
equations, entered in a business’s general ledger, will provide the
material that eventually makes up the foundation of a business’s financial
statements. This includes expense reports, cash flow, interest and loanpayments,
salaries, and company investments.
Double Entry Bookkeeping System
The accounting equation plays a significant role as the foundation
of the double entry bookkeeping system. This accounting system ensures that a
company’s accounts are always balanced and that all financial transactions are
documented in detail. The primary aim of the double entry system is to keep
track of debits and credits, and ensure that the sum of these always
matches up to the company assets, a calculation carried out by the accounting
equation.
Income and Retained Earnings
Use of the accounting equation is also an essential component in
computing, understanding, and analyzing a firm’s income statement. This
statement reflects profits and lossesthat are themselves
determined by the calculations that make up the basic accounting equation. In
other words, this equation allows businesses to determine revenue as
well as prepare a statement of retained earnings. This then allows them to
predict future profit trends and adjust business practices accordingly. Thus,
the accounting equation is an essential step in determining company
profitability.
Company Worth
Since the balance sheet is founded on the principles of the
accounting equation, this equation can also be said to be responsible for
estimating the net worth of an entire company. The fundamental
components of the accounting equation include the calculation of both company
holdings and company debts; thus, it allows owners to gauge the total value of
a firm’s assets.
Investments
Due to its role in determining a firm’s net worth, the accounting
equation is an important tool for investors looking to measure a company’s
holdings and debts at any particular time, and frequent calculations can
indicate how steady or erratic a business’s financial dealings might be. This
provides valuable information to creditors or banks that might be
considering a loan application or investment in the company
ACCOUNTING CYCLE
The accounting cycle is the complete process which
one can follow after having a good knowledge of principles of accounting.The
name given to the collective process of recording and processing the accounting
events of a company. The series of steps begin when a transaction occurs and
end with its inclusion in the financial statements. The nine steps of the
accounting cycle are:
- Collecting and analyzing data from transactions and events.
- Putting transactions into the general journal.
- Posting entries to the general ledger.
- Preparing an unadjusted trial balance.
- Adjusting entries appropriately.
- Preparing an adjusted trial balance.
- Organizing the accounts into the financial statements.
- Closing the books.
- Preparing a post-closing trial balance to check the accounts.
Also known as "bookkeeping cycle".
Preparation
of Financial Statement
One of the final steps in the accounting cycle is
the preparation of the financial statements.(done after understanding the
accounting principles) The information from the accounting journal and the
general ledger is used to develop the income statement, statement
of retained earnings, balance sheet, and statement of cash flows --
in that order. Information from the previous statement is used to develop the
next statement.
The
income statement is the first financial statement you prepare at the
end of the accounting cycle. The information on sales revenue and expenses from
the accounting journals and the general ledger are used to
prepare the income statement. One item of note is depreciation. The income
statement is related to the accounting equation through revenue,
which increases owner's equity, and expenses, which decrease owner's equity.
The Statement
of Retained Earnings is prepared after the income
statement because net profit or loss has to be calculated before
the Statement of Retained Earnings can be prepared. The Statement of
Retained Earnings shows the distribution of profit between retained earnings
and dividends. Retained earnings is the amount of profit retained by the firm
for growth with dividends the amount paid out by the firm to investors.
The
balance sheet is the financial statement that is prepared to
illustrate the firm's financial position at a point in time -- on the last
day of the accounting cycle. The entries on the balance sheet come from
the general ledger and the format mirrors the accounting equation. Assets,
liabilities, and owner's equity on the last day of the accounting
cycle are stated on the balance sheet.
an understanding of the components of cash
Investors have a wealth of financial ratios they can examine to
better understand the health of a company. One of the most important measures
of management efficiency is the cash conversion cycle, which tells the analyst
how much cash the company has tied up in inventory, its ability to collect
money owed from customers, as well as the time it takes to pay certain
creditors.
In this article, we're going to be covering the topic of the
cash conversion cycle (CCC). As part of that discussion, we'll talk about
the usefulness of the measure, each of its components,
A "Cash Flow
Statement" shows the sources and uses of cash and is typically divided
into three components:
Operating Cash Flow. Operating cash flow, often referred to as working capital, is the cash flow generated from internal operations. It comes from sales of the product or service of your business, and because it is generated internally, it is under your control.
Investing Cash Flow. Investing cash flow is generated internally from non-operating activities. This includes investments in plant and equipment or other fixed assets, nonrecurring gains or losses, or other sources and uses of cash outside of normal operations.
Financing Cash Flow. Financing cash flow is the cash to and from external sources, such as lenders, investors and shareholders. A new loan, the repayment of a loan, the issuance of stock, and the payment of dividend are some of the activities that would be included in this section of the cash flow statement.
An understanding of the
components of receivables
This article will outline some of
the basic components for managing accounts receivable, ranging from policies
and measurement to outsourcing options.
The foundation behind account receivables is your policies and procedures for sales. For example, do you have a credit policy? When and how do you evaluate a customer for credit? If you look at past payment histories, you should be able to ascertain who should get credit and who shouldn't. Additionally, you need to establish sales terms. For example, is it beneficial to offer discounts to speed-up cash collections? What is the industry standard for sales terms? There are several questions that have to be answered in building the foundation for managing accounts receivables.
A system must be in place to track accounts receivables. This will include balance forwards, listing of all open invoices, and generation of monthly statements to customers. An aging of receivables will be used to collect overdue accounts. You must act quickly to collect overdue accounts. Start by making phone calls followed by letters to upper-level managers for the Customer. Try to negotiate settlement payments, such as installments or asset donations. If your collection efforts fail, you may want to use a collection agency.
ACC 201 Financial Accounting
Also remember that the collection process is the art of knowing the customer. A psychological understanding of the customer gives you insights into what buttons to push in collecting the account. One of the biggest mistakes made in the collection process is a "sticks only" approach. For some customers, using a carrot can work wonders in collecting the overdue account. For example, in one case the company mailed a set of football tickets to a customer with a friendly note and within weeks, they received full payment of the outstanding account.
Measurement is another component
within account receivable management. Traditional ratios, such as turnover will
measure how many times you were able to convert receivables over into cash.
An understanding of the capital assets
A type of asset
that is not easily sold in the regular course of a business's operations for
cash and is generally owned for its role in contributing to the business's
ability to generate profit. Furthermore, it is expected that the benefits
gained from the asset will extend beyond a time span of one year. On a
business's balance sheet, capital assets are represented by the property, plant
and equipment figure.
The capital asset pricing
model was the work of financial economist William Sharpe, set out in his 1970
book "Portfolio Theory And Capital Markets." His model starts with
the idea that individual investment contains two types of risk:
1.
Systematic Risk - These are market risks that cannot be diversified
away. Interest rates, recessions and wars are examples of systematic risks.
- Unsystematic Risk - Also known as
"specific risk," this risk
is specific to individual stocks and can be diversified away as the
investor increases the number of stocks in his or her portfolio. In more technical terms, it
represents the component of a stock's return that is not correlated with general market moves.
An understanding of Intangibles
A tangible
investment is
something physical that you can touch. It is an investment in atangible, hard
or real asset or personal property. This contrasts with financial investments such
as stocks, bonds,
and other financial instruments.[1]
Some assets are held purely for their ability to appreciate,
such as collectibles, while others are held for the income they generate while
they depreciate,
such as equipment held for lease. Others exhibit a combination of properties,
appreciating in market value while depreciating in book value, such as rental
real estate. Timberland exhibits depletion of
timber combined with appreciation of land. Other assets’ values fluctuate with
supply and demand, such ascommodities, which are liquid investments
unlike most other tangible investments.
These various properties, together with the lack of correlation
to traditional asset class values, make tangible investments a means of
reducing overall investment risk through diversification.
An understanding of
the long-term investments
DEFINITION OF
'LONG-TERM INVESTMENTS
An account on the asset side of a company's balance sheet that
represents the investments that a company intends to hold for more than a year.
They may include stocks, bonds, real estate and cash.
Using investments to meet your financial
goals
Incorporating investment strategies and products
designed to help you meet your goals.
Prioritizing financial goals can feel like pitting one dream
against another: Would you rather purchase a home or pay off student loans?
Would you rather send your kids to college or be able to retire? Would you
rather attend a friend’s destination wedding or buy a car? But with smart
planning, you can increase the odds of achieving most – if not all – of your
aspirations. Here are some common financial
goals , and
investing strategies that may help turn your plans into reality:
The long-term
investments account differs largely from the short-term investments account in
that the short-term investments will most likely be sold, whereas the long-term
investments may never be sold.
A common form of this type of investing occurs when company A invests largely in company B and gains significant influence over company B without having a majority of the voting shares. In this case, the purchase price would be shown as a long-term investment.
An understanding of the long-term liabilities
DEFINITION OF
'LONG-TERM LIABILITIES'
In accounting, a section of the balance sheet that lists
obligations of the company that become due more than one year into the future.
Long-term liabilities include items like debentures, loans, deferred tax
liabilities and pension obligations. The portions of long-term liabilities that
will come due within the next 12 months are listed under current liabilities,
such as the current portion of long-term debt.
A long-term liability is a noncurrent
liability. That is, a long-term liability is an obligation that isnot due
within one year of the date of the balance sheet (or not due within
the company's operating cycle if it is longer than one year).
Some examples of long-term liabilities are the noncurrent portions of the following:
Some examples of long-term liabilities are the noncurrent portions of the following:
bonds payable
long-term loans
capital leases
pension liabilities
postretirement healthcare liabilities
deferred compensation
deferred revenues
deferred income taxes
derivative liabilities
Some long-term debt that is due within one year of the balance sheet date could continue to be reported as a long-term liability if there is:
a long-term investment that is sufficient and
restricted for the payment of the debt, or
a financing arrangement that replaces the debt
with new long-term debt or with capital stock.
An understanding of the shareholders’
equity
Components of Shareholder's Equity
Also known as "equity" and "net worth", the shareholders' equity refers to the shareholders' ownership interest in a company.
Usually included are:
- Preferred
stock - This is the investment by
preferred stockholders, which have priority over common shareholders and
receive a dividend that has priority over any distribution made to common
shareholders. This is usually recorded at par value.
- Additional
paid-up capital (contributed capital) - This is capital received from investors for stock; it is
equal to capital stock plus paid-in capital. It is also called
"contributed capital".
- Common
stock - This is the investment by
stockholders, and it is valued at par or stated value.
- Retained
earnings - This is the total net income
(or loss) less the amount distributed to the shareholders in the form of a
dividend since the company's initiation.
- Other
items - This is an all-inclusive account that may
include valuation allowance and cumulative translation allowance (CTA),
among others. Valuation allowance pertains to noncurrent investments
resulting from selective recognition of market value changes. Cumulative
translation allowance is used to report the effects of translating foreign
currency transactions, and accounts for foreign affiliates.
The ability to calculate
interest amounts and amortization
An amortized loan payment is a level payment that completely
pays off a loan in a set period of time. For long-term loans like mortgages, it
is helpful to understand how the loan amortizes. The amortization is how each
payment is allocated to principal repayment and interest to the lender. An
amortized loan payment schedule is usually determined using an online mortgage
calculator or spreadsheet program with a mortgage template. The payment and
amortization amounts can be calculated using a calculator with the ability to
perform exponential calculations.
1.Calculate
the monthly interest by dividing the annual interest by 12. This amount will be
designated R. The loan amount will be P, and the number of payments will be N.
2.Calculate
the monthly payment using this formula. R is divided by a denominator
calculated by taking (1+R) to the negative exponent of N and subtracting the
result from 1. The fraction of R divided by the calculated denominator is
multiplied by P. The result will be an amortizing monthly payment.
3.Calculate
the interest and principal for the first monthly payment. The interest is P
times R. The principal is the monthly payment minus the calculated interest.
4.Calculate
the loan balance after the first payment. Subtract the principal of the first
payment from P. The result will be the loan balance after the first payment,
labeled B.
5.Calculate
the principal and interest for the second payment. The monthly interest rate,
R, is multiplied by B for the interest on the second payment. Subtract the new
interest amount from B for the principal repayment in the second payment.
6.Repeat
the interest and principal calculation for each new loan balance until all of
the payments have been calculated and the loan balance, B, is zero.
The ability to interpret
financial statements, including the cash flow
Statement
Financial Statement Analysis
Overview of Financial Statement Analysis
Financial statement analysis involves
the identification of the following items for a company'sfinancial statements over
a series of reporting periods:
§ Trends. Create trend lines for
key items in the financial statements over multiple time periods, to see how
the company is performing. Typical trend lines are for revenues, thegross margin, net profits, cash, accounts receivable, and debt.
§ Proportion analysis.
An array of ratios are available for discerning the relationship between the
size of various accounts in the financial statements. For
example, you can calculate a company's quick
ratio to estimate its ability to
pay its immediate liabilities, or
its debt to equity ratio to see if it has taken on too much
debt. These analyses are frequently between the revenues and expenses listed on the income statement and the assets, liabilities, and equity accounts listed on the balance sheet.
Financial statement analysis is an exceptionally powerful tool
for a variety of users of financial statements, each having different
objectives in learning about the financial circumstances of the entity.
Three Sections of the Cash Flow Statement
Companies produce and consume cash in different ways, so the cash flow statement is divided into three sections: cash flows from operations, financingand investing. Basically, the sections on operations and financing show how the company gets its cash, while the investing section shows how the company spends its cash. (To continue learning about cash flow, see The Essentials Of Cash Flow, Operating Cash Flow: Better Than Net Income? and What Is A Cash Flow Statement?)
Cash Flows from Operating Activities
This section shows how much cash comes from sales of the company's goods and services, less the amount of cash needed to make and sell those goods and services. Investors tend to prefer companies that produce a net positive cash flow from operating activities. High growth companies, such as technology firms, tend to show negative cash flow from operations in their formative years. At the same time, changes in cash flow from operations typically offer a preview of changes in net future income. Normally it's a good sign when it goes up. Watch out for a widening gap between a company's reported earnings and its cash flow from operating activities. If net income is much higher than cash flow, the company may be speeding or slowing its booking of income or costs.
Cash Flows from Investing Activities
This section largely reflects the amount of cash the company has spent oncapital expenditures, such as new equipment or anything else that needed to keep the business going. It also includes acquisitions of other businesses and monetary investments such as money market funds.
You want to see a company re-invest capital in its business by at least the rate ofdepreciation expenses each year. If it doesn't re-invest, it might show artificially high cash inflows in the current year which may not be sustainable.
Cash Flow From Financing Activities
This section describes the goings-on of cash associated with outside financing activities. Typical sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings. Likewise, paying back a bank loan would show up as a use of cash flow, as would dividend payments and common stock repurchases.
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