FUNDAMENTALS OF ACCOUNTING
ACCOUNTING DEFINITION
According to the Accounting Standards Council (ASC) accounting is a service activity. Its function is to provide quantitative
information, primarily financial in nature, about economic entities, that is intended to be useful in making economic decisions.
The American Institute of Certified Public Accountants (AICPA) defines accounting 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.
According to American Accounting Association (AAA), "Accounting refers to the process of identifying, measuring and
communicating economic information to permit informed judgements and decisions by users of the information."
Qualitative Characteristics of Accounting Information
Primary Qualitative
Characteristics Usefulness
Relevance Reliability
Predictive value Representational faithfulness
Ingredients
Feedback value Verifiability
Timeliness Neutrality
Secondary Qualitative
Characteristics Consistency
& Comparability
THE ELEMENTS OF ACCOUNTING ASSETS
ASSETS- Assets are items with money value that are owned by a business. Some examples are: cash, accounts receivable (selling
goods or services on credit), equipment (office, store, delivery, etc.), and supplies (office, store, delivery, etc.).
LIABILITIES- Liabilities are debts owed by the business. Paying cash is often not possible or convenient, so businesses purchase
goods and services on credit. The name of the account used is Accounts Payable. Another type of liability is Notes Payable. This is
a formal written promise to pay a specific amount of money at a definite future date.
OWNERS EQUITY-The difference between Assets and Liabilities is Owners Equity. The can also be called capital, proprietorship,
or net worth.
Elements of Financial Statements
Assets - Liabilities = Equity
Equity = Contributions - Distributions to owners Comprehensive Income
by owners
Comprehensive Income = Revenues - Expenses + Gains Losses
Comprehensive Income = Net income Adjustments to stockholders equity
FINANCIAL STATEMENTS
Summaries of financial activities are called financial statements which are prepared on a
regular basis at the end of an accounting period. The accounting period typically is one year;
however, it can be any length of time for which records are maintained. Usually the minimum is
one month and the maximum length of time is one year for financial statements. There are
several financial statements. You are going to prepare the Income Statement, Statement of
Owners Equity, and Statement of Financial Position. These must be completed in that
order.
Income Statement. This is a summary of a businesss revenue and expenses for a specific
period of time. It ONLY shows revenue and expenses. These should be listed in order from
largest to smallest. Net Income is realized when revenue exceeds expenses. Net loss is
realized when expenses exceed revenue. Statement of Owners Equity. This is a summary of
the changes that have occurred in the owners equity during a specific period of time. This
statement will show either an increase or decrease in the capital account.
Statement of Financial Position. This statement is a listing of the firms assets, liabilities, and
owners equity at a specific point in time. Total Assets must equal the addition of Liabilities and
Owners Equity.
The Normal Balance of Accounts
ASSET = DEBIT LIABILITY = CREDIT OWNERS EQUITY = CREDIT
Drawing Debit Expenses Debit Revenue Credit
THE ACCOUNTING CYCLE
1. Analyze transactions
2. Record in a journal
3. Post from the journal to the ledger
4. Prepare a trial balance of the ledger
5. Determine the adjustments needed
6. Prepare a worksheet
7. Prepare financial statements
8. Journalize and post adjusting entries.
9. Closing entries
10. Post closing Trial Balance
11. Reversing Entries, optional
ANALYZE Decide debits and credits and in which accounts they will be entered
RECORD in journal (diary of information of day-to-day transactions)
Double entryin chronological order by date
Book of original entry(first formally recorded place)
A COMPOUND ENTRY 3 or more accounts are affected by the transaction (be sure to line up
correctly)
ADVANTAGES OF USING A JOURNAL
Provides a chronological record of transactions
A place is provided for an explanation
Lessens the chance of errordebits and credits are recorded together
Easier to locate errors
POST FROM THE JOURNAL TO THE LEDGER
Must transfer to individual accounts to be able to summarize activity and obtain balance
Can post at the end of the day, week, month, or whenever
CHART OF ACCOUNTS directory (The order for the names is taken from the financial
statementsBalance Sheet, then the Income Statement.)
ASSETS, LIABILITIES, OWNERS EQUITY, REVENUE, EXPENSES
The number identifies the account and its location in the ledger. 4-column account form or
balance form of account.
ADJUSTING ENTRIES
Adjustments are a planned part of the accounting cycle. For some accounts like office supplies,
it would be impractical to make entries on a daily or frequent basis. An entry is made at the end
of the accounting period to show usage. Changes in accounts happen because of passage of
time, use of items, etc. Adjustments are internal, never involve cash. Adjusting entries affect
both the balance sheet and the income statement
CLOSING ENTRIES
There is a certain order that must be used to close accounts: REID
1. The balance of the total Revenue to Income Summary
2. The balance of the total Expenses to Income Summary
3. The balance of the Income Summary account to the Capital account. This will be the Net
Income or Net Loss amount.
4. The balance of the owners Drawing account is closed directly to the Capital account. This is
not used in the determination of net loss or gain. You can check the accuracy of the closing
entries by comparing the balance of the Owners Equity capital account, after posting, with the
ending balance of capital as reported on the Statement of Owners Equityamounts MUST be
the same.
ACCOUNTING FOR A MERCHANDISING BUSINESS
PURCHASES AND CASH PAYMENTS
MERCHANDISING ACTIVITY
Retail businesses sell directly to consumers.
Wholesalerspurchase goods in bulk from manufacturers and sell them to retailers, other
wholesalers, schools and other nonprofit institutions, and sometimes directly to consumers.
Purchasing Proceduresa large company would use a purchasing agent who heads the
purchasing department. Small companies would use the owner/manager, etc.
Purchase requisition (written request for goods to be ordered) is sent to purchasing
department
Purchasing department chooses a vendor and prepares a purchase order.
Seller receives the order and sends an invoice (document that shows the name of the
buyer and seller, date, terms of sale, description, price, delivery, and total owed) sales
and purchase invoice and the merchandise
When merchandise is received, it is checked against the purchase order.
DISCOUNTSlist price is usually printed, given, etc.
Trade discountspercentage reduction from the list price of the merchandise. These are not
recorded in the accounting records of the buyer or the seller. The buyer always records goods at
their actual cost. The seller records items sold at their actual selling price.
Cash discountsoffered to encourage prompt and early payment by a buyer. Cash discounts
are recorded in the accounting records of both the seller and the buyer. Sales or purchases
discounts. A common discount is 2/10,n/30. (2 percent discount if paid in 10 days; total due in
30 days)
RECORDING PURCHASES
The source document for recording a purchase of merchandise is the purchase invoice. o An
example of a transaction of purchasing merchandise on account:
Debit to PURCHASES
Credit to ACCOUNTS PAYABLE- NAMED COMPANY
Purchased merchandise on account
An example of a transaction of purchasing merchandise for cash:
Debit to PURCHASES
Credit to CASH
Purchased merchandise for cash
THE PURCHASES ACCOUNT keeps a record of the cost of merchandise purchased for
resale during an accounting period. Assets are recorded as assetsnot purchases.
PURCHASES JOURNAL (SPECIAL JOURNAL) Used to record only credit purchases of
merchandisemay be only one column that is posted to two accounts. The two accounts would
be PURCHASES debit and ACCOUNTS PAYABLE credit. An invoice column is listed also.
MERCHANDISE RETURNS AND ALLOWANCES
Return is when a customer returns to the seller pat or all of the items purchased. An Allowance
occurs when the seller grants a customer a price reduction on items due to some damage or
defective goods. Purchases Returns and Allowances is the name of the account that provides
better control of returns and allowances of merchandise. These transactions are recorded in a
contra account and they have a normal balance of credit.
A debit memorandum is the buyers written request to the seller for credit. The individual
account is debited to reduce the amount that they need to pay. The Accounts Payable account
will also be reduced since it is the controlling account.
RECORDING CASH PAYMENTS
CASH PAYMENTS JOURNALA special journal used to record any payment of cash. There
will be a check number given to be recorded in the journal as well. The source document is the
check stub. Individual accounts will be posted daily. The totals will be posted at the end of the
month.
Purchases Discounts account is used to record discounts given for prompt payment. credit
balance (contra account)
To prove the ACCOUNTS PAYABLE LEDGER, you will look at the balance of the Accounts
Payable account and the balance of the Schedule of Accounts Payable. This schedule lists the
balances of the individual accounts that have amounts due. These two figures must balance.
Schedule of Accounts Payable Lists the balances of the accounts payable ledger, and the
Accounts Payable controlling account shows the total amount owed to ALL creditors. These
amounts must agree.
FREIGHT CHARGES ON INCOMING MERCHANDISE
FOBfree on board shipping point
FOB destinationpay at the destination point The account where this is recorded is named
Freight In or Transportation In. The account is ONLY used to record freight on incoming
merchandise.
SALES AND CASH RECEIPTS SALES ACTIVITY
Just as merchandizing businesses follow certain procedures to process and record purchases,
they follow certain procedures to process and record sales.
Terms of Payment
Revolving charge plans are set up so that you can pay a percentage plus a finance charge on a
monthly basis.
Credit terms allow the purchaser a certain amount of time to pay
SALES ORDER
A Sales Invoice is prepared when the sale is made.
CASH SALESsales slip or cash register tape will be record of sale.
RECORDING SALES OF MERCHANDISE
SALES ACCOUNT is a temporary account with a normal credit balance. It is ONLY used to
record the sale of merchandise on account.
In a General Journal Sales is credited; Cash is debited.
CREDIT SALESAccounts Receivable, the controlling account, and the individual account is
debited
SALES JOURNAL
- Used only to record credit sales of merchandise.
ACOUNTS RECEIVABLE LEDGER Businesses have many customers and the individual
businesses are not assigned an account number they are just in alphabetical order.
Accounts Receivable is the controlling account.
Debit is normal balance.
Posting Accounts Receivable ledger totals and individual accounts.
SALES JOURNAL only records the sale of merchandise on account. Post totals monthly and
individual accounts on a daily basis.
SALES RETURNS AND ALLOWANCES
Allowance results when a buyer decides to keep damaged or defective goods, but at a
reduction from the original price.
Return results when a buyer returns part, or all of the order Recording Sales Returns and
Allowances.
A Credit Memorandum is the original document.
SALES DISCOUNTS
Sales discount is recorded as a reduction in sales revenue.
Recorded as a debit. Contra Revenue Account
CASH RECEIPTS JOURNAL
Source documents: cash register tapes, sales tickets, checks received.
POSTING THE CASH RECEIPTS JOURNAL
Individually to each account and totals to controlling accounts monthly
SCHEDULE OF ACCOUNTS RECEIVABLE Accounts Receivable and individual accounts
must match. The only accounts that will be listed are those accounts with a balance.
ACCOUNTING FOR PARTNERSHIP AND CORPORATION
Partnership
Admitting a Partner
Calculating the Contribution No Goodwill or Bonus
Partnership equity (before new partners contribution)
100% new partners percentage
= Total capital after contribution
New partners percentage
= Amount to be contributed
Journal entry:
Cash xxx
New partners equity xxx
Excess Contribution by New Partner Bonus Method
Partnership equity (before new partners contribution)
+ New partners contribution
= Total capital after contribution
New partners percentage New partners contribution
= New partners capital New partners capital
= Bonus to existing partners
Journal entry:
Cash (new partners contribution) xxx
Capital, new partner (amount calculated) xxx
Capital, existing partners (bonus amount) xxx
Bonus is allocated to existing partners using their P & L percentages
Contribution Below New Partners Capital Bonus Method
Partnership equity (before new partners contribution)
+ New partners contribution
= Total capital after contribution
New partners percentage
= New partners capital
New partners contribution
= Bonus to new partner
Journal entry:
Cash (new partners contribution) xxx
Capital, existing partners (bonus amount) xxx
Capital, new partner (amount calculated) xxx
Bonus is allocated to existing partners using their P & L percentages
Retiring a Partner
Payment Exceeds Partners Balance Bonus Method
Capital, retiring partner (existing balance) xxx
Capital, remaining partners (difference bonus) xxx
Cash (amount paid) xxx
Bonus is allocated to existing partners using their P & L percentages
Partnership Liquidation 5 steps
1) Combine each partners capital account with loans to or from that partner
2) Allocate gain or loss on assets sold to partners
3) Assume remaining assets are total loss allocate to partners
4) Eliminate any partners negative balance by allocating to remaining partners using their
P & L percentages
5) Resulting balances will be amounts to be distributed to remaining partners
CORPORATIONS
The Corporate Form of Organization
Corporation
Entity created by law
Separate and distinct from its owners
Continued existence is dependent upon the statutes of the state in which it is
incorporated
Two common bases for classification of corporations are:
1. By purpose
2. By ownership
Classifications of Corporations (Purpose)
To earn a profit
Or nonprofit
Classification by ownership
Publicly-held corporations
Privately-held corporations
Publicly-held corporations
May have thousands of stockholders
Stock is regularly traded on a national securities exchange.
Privately-held corporations
Often referred to as closely held corporations, usually have only a few stockholders
Does not offer its stock for sale to the general public
CHARACTERISTICS OF A CORPORATION
Separate legal existence from its owners
Stockholders have limited liability
Ownership held in shares of capital stock o transferable units.
Ability to acquire capital through the issuance of stock
Continuous life
Characteristics of a Corporation
Corporate management o is at the discretion of the board of directors who are elected by the
stockholders
Subject to numerous government regulations
Must pay an income tax on its earnings
Stockholders required to pay taxes on the dividends they receive: the result is double taxation
Forming a Corporation
1. File application with the Secretary of State in the state in which incorporation is desired
2. Articles of Incorporation charter creates the corporation
3. By-laws establishes the internal rules and procedures for conducting the affairs of the
corporation and indicates the powers of parties involved
Organization Costs
Costs incurred in forming a corporation
Includes legal fees, state fees and promotional expenditures
Expensed as incurred since it is so difficult to determine the amount and timing of future
benefits.
Ownership Rights of Stockholders
1. Vote
2. Share in corporate earnings through the receipt of dividends
3. Pre-emptive right maintain the same percentage ownership when additional shares of
common
4. Residual claim Share in assets upon liquidation
Par Value & No-Par Value Stock
Par value stock
capital stock that has been assigned a value per share in the corporate charter
represents the legal capital per share that must be retained in the business for the
protection of corporate creditors
No-par stock
capital stock that has not been assigned a value in the corporate charter In many states
the board of directors can assign a stated value to the shares which then becomes the
legal capital per share. When there is no assigned stated value, the entire proceeds are
considered to be legal capital.
CORPORATE CAPITAL
Stockholders equity, shareholders equity, or corporate capital. o
Owners equity in a corporation
Stockholders equity section of a corporations balance sheet
Paid-in (contributed) capital
o Total amount of cash and other assets paid in to the corporation by stockholders
in exchange for capital stock.
Retained earnings
o Net income that is retained in a corporation.
