Basic

accounting
concepts – Q&A
Peter Baskerville

Nowmaster Pty Ltd.

Nowmaster Pty. Ltd.
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Published in Australia by Nowmaster
PO Box 960 Spring Hill Queensland, 4000
www.nowmaster.com
©Peter Baskerville 2013
ISBN 978-0-9922949-0-8
The moral rights of the author have been asserted.
First published 2013
All rights reserved. No part of this publication may be reproduced, stored in a
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BASIC ACCOUNTING CONCEPTS –
Q&A
About the book and the author.........................................................................................vi
Introduction to accounting................................................................................................. 1
What is accounting?.................................................................................................. 1
What is the difference between accounting and accountancy?.................................2
Where did accounting start?.....................................................................................4
What was accounting like before double-entry bookkeeping?...................................5
What is the difference between financial accounting and management accounting?
.................................................................................................................................. 6
What is the purpose of accounting?..........................................................................9
Role of accountants and bookkeepers..............................................................................11
Why do we need accounting?..................................................................................11
What is the difference between a bookkeeper and an accountant?........................12
Why do we need accountants?................................................................................14
Accounting concepts and conventions.............................................................................18
What are the accounting concepts and conventions?.............................................18
What is the accounting entity assumption?.............................................................20
What is the going concern concept in accounting?.................................................22
What is the revenue recognition principle?.............................................................23
What is the matching principle in accounting?........................................................26
What is the time period assumption in accounting?................................................30
Types of account group classifications.............................................................................33
The five account groups..........................................................................................33
What are assets in accounting?...............................................................................33
Assets and the accounting equation.......................................................................33
What are liabilities in accounting?...........................................................................37
What is owner’s equity in accounting?....................................................................41

Basic accounting concepts—Q&A

3

What is revenue in accounting?..............................................................................43
What is the difference between revenue and income?............................................45
What are expenses in accounting?..........................................................................48
What are expense classifications and functions in accounting?..............................50
What is the accounting difference between an expense and an investment?.........52
What is the difference between capitalisation and expensing?...............................53
What is the difference between a cost and an expense in accounting?..................54
What are overheads in accounting?........................................................................56
Double-entry bookkeeping with debits and credits..........................................................59
What is the double-entry bookkeeping system?......................................................59
Why is double-entry bookkeeping such a big deal?.................................................61
How is the accounting equation formed?................................................................62
What are debits and credits in the bookkeeping system?.......................................64
How do you apply debits and credits in bookkeeping?............................................66
How do you make sense of debits and credits in accounting?.................................68
How can I better understand debit and credit?.......................................................75
The accounting process................................................................................................... 77
What is the accounting cycle?.................................................................................77
What are the steps in the accounting process?.......................................................79
What are source documents in accounting?............................................................80
What is the Chart of Accounts in accounting?.........................................................83
What are journals in accounting?............................................................................85
What is a ledger account in accounting?.................................................................87
What are subsidiary ledgers in accounting?............................................................88
What is posting in accounting?...............................................................................91
What is the general ledger in accounting?..............................................................93
What is a trial balance in accounting?.....................................................................94
What is an audit trail in accounting?.......................................................................96
What are end-of-period adjustments in accounting?...............................................98

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Basic accounting concepts—Q&A

Accounting methods: cash vs accrual............................................................................101
What is cash accounting?......................................................................................101
What is accrual accounting?..................................................................................103
What are the advantages and disadvantages of Cash VS Accrual accounting?.....105
If there were no tax benefits, would there be any advantages for
accrualaccounting?...............................................................................................107
Financial transactions and special accounts...................................................................109
What are accruals in accounting?..........................................................................109
What are prepaid expenses in accounting?...........................................................111
What is a contra account in accounting?...............................................................113
What is amortisation in accounting?.....................................................................115
What is Cost of Goods Sold?..................................................................................118
What are bad debts in accounting?.......................................................................119
What are doubtful debts in accounting?................................................................122
What is the difference between bad debts and doubtful debts in accounting?......124
What is a 10-column worksheet in accounting?....................................................126
Financial statements and standards...............................................................................129
How is IFRS different from GAAP?..........................................................................129
Who are the stakeholders of a business?..............................................................129
What are financial statements in accounting?.......................................................131
How do you read and understand a Balance Sheet?.............................................133
How do you read and understand the Income Statement?....................................137
What is the financial ratio analysis?......................................................................139
List of accounting terms and abbreviations....................................................................142
Glossary of Accounting Terms........................................................................................151

Basic accounting concepts—Q&A

5

ABOUT THE BOOK AND THE AUTHOR
This e-book is a guide and reference resource for students of accounting (and its
subsidiary, bookkeeping). In simple language, it explains the basic accounting
concepts and why they are important in the process and application of
accounting/bookkeeping.
Basically, the mechanics of accounting is little more than adding and subtracting
figures, and sometimes applying a percentage. So, it is not usually the maths of
accounting that students find difficult to grasp. Rather, it is the WHY of
accounting.
This book compiles answers provided by Peter Baskerville to questions about the
WHY of basic accounting. It is designed as a learning resource that users can ‘dip
in and out of’ as they seek answers to specific questions, rather than as a book
to be read sequentially from cover to cover. As a result, there is some necessary
repetition to ensure answers to all questions are contained and comprehensive.
Peter has taught bookkeeping and accounting for many years at a technical
college, and has first-hand experience in helping students to understand basic
accounting concepts.
Peter explains the background and first principles that underpin each concept.
The answers are grouped and ordered according to the standard learning process
in accounting, but their focus is on the WHY: why accounting and bookkeeping
operate as they do.

6

Basic accounting concepts—Q&A

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Basic accounting concepts—Q&A

INTRODUCTION TO ACCOUNTING
WHAT IS ACCOUNTING?
Accounting is a financial recording and reporting system (see Figure 1).
Accounting identifies and classifies financial transactions; it then summarises
these financial transactions into financial reports. Financial reports communicate
relevant financial information to interested persons called stakeholders. This
information allows stakeholders to decide how to best use the economic
resources of the accounting entity (that is, the business or enterprise).

Identify
and classify
financial
transaction
s

Summarise
transaction
s in
financial
reports

Send
financial
reports to
stakeholder
s

Stakeholde
rs decide
how to use
economic
resources
of
accounting
entity

Figure 1 The accounting system
DEFINITION OF ACCOUNTING
Here is a simple definition:
Accounting is a system that provides numeric information about the finances
of an accounting entity.
Here is another definition:
Accounting is the systematic recording, reporting and analysis of the financial
transactions of a business.
Yet another definition is as follows:
Accounting is a tool for recording, reporting and evaluating—in monetary
terms—the transactions, events and situations that impact on an enterprise.
The American Accounting Association defines accounting as: the process of
identifying, measuring and communicating information to permit judgment and
decision by users of accounts.

Basic accounting concepts—Q&A

1

An even simpler definition is this: accounting is the language of business.

KeyFACTS


Accounting is a system that operates for as long as the accounting entity exists.
Accounting is interested only in the financial or monetary transactions of the accounting entity.
The first phase of accounting is to identify, collect, measure, classify and record financial
transactions; a second phase is to calculate, summarise, report and evaluate financial

information.
The intent of accounting is to communicate the financial information of the accounting entity to

decision makers.
Accounting deals with maintaining and storing financial results.

Accounting is not an end in itself. It is not, like art in a museum, to be displayed
as a ‘beautiful set of numbers’ (even if you hear businesspeople speaking this
way). Accounting is primarily a means to an end. This means that accounting is a
process.
Accounting provides the most relevant and reliable financial information possible
so that the real work of an accounting entity (for example, a business) can be
done. The real work is to make the best possible decisions about how to use the
economic resources of the entity.

SUMMARY—DEFINITION OF ACCOUNTING
Based on the above definitions and conclusions, accounting can be divided into two broad
elements:
1.

Accounting is an information process that identifies, classifies and summaries the

2.

financial events and transactions that impact on a business.
Accounting is a reporting system that communicates relevant financial information
to interested person (stakeholders). This information allows stakeholders to assess
performance, make decisions about and/or control the economic resources of a
financial entity.

WHAT IS THE DIFFERENCE BETWEEN ACCOUNTING AND ACCOUNTANCY?
Accounting is the action or process of keeping financial accounts. Accountancy
describes the duties of an accountant, the person whose job is to keep, inspect
and interpret financial accounts.
In relation to business, accountancy is, in effect, the total of all actions taken by
a business to:

to record financial transactions
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Basic accounting concepts—Q&A

to produce reports that allow stakeholders (such as managers, investors,
funders, owners) of the business to make informed decisions about the
financial resources under their control.

The main reasons why a business has a vital interest in accountancy are listed in
Figure 2.

Basic accounting concepts—Q&A

3

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Government compliance: Tax
laws require a business to report
to the government on its revenue
and income. Accountancy
provides a process to meet this
requirement.
Funding: Banks, investors and
finance institutions require
reports on the financial
performance and position of a
business before they invest in, or
loan funds to, that business.
Accountancy provides these
reports in the form of an Income
Statement and a Balance Sheet.
Financial performance: A
prime function of management is
to ensure that the business will
endure. Accountancy provides a
reporting mechanism (by way of
an Income Statement) that
details a business’s revenue,
expenses and resulting profit.
Managers can use this statement
to make informed decisions to
ensure the sustainability of the
business.
Budgeting and control:
Financial information provided by
the accountancy system allows
managers to prepare budgets
that become a benchmark for
performance and a means of
controlling the finances under
their control.

Comparison: Accountancy,
because it is universally applied
using accounting standards,
Figure 2 Main reasons why a business is interested
allows businesses to be
in accountancy
compared. This comparison

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Basic accounting concepts—Q&A

WHERE DID ACCOUNTING START?
The accounting system we use today had its beginning in systems used by
merchants in Venice over 500 years ago.
HISTORY OF ACCOUNTING
Generally, historians agree that the Renaissance period began in what we now
call Italy during the late 1200s AD. The Renaissance was well established by
about 1450. It saw a huge increase in trade with some merchants becoming very
wealthy. Some merchants lent money even to kings. This rapid increase in trade
and wealth led to the development of early banking systems. The city–state of
Venice went even further, developing an accounting system to record complex
financial dealings.
Most accountants today regard the Franciscan friar and mathematician Luca
Pacioli (1446–1517) as the ‘father of accounting’. Pacioli did not claim to have
invented the accounting system as such, but he did present the system in a way
that others could easily understand. Da Vinci, a colleague of Pacioli, helped
Pacioli to illustrate his second most important manuscript, De divina proportione
[Of divine proportions]. Da Vinci mentions Pacioli many times in his notes.
FIRST ACCOUNTING TEXTBOOK
Pacioli’s most important manuscript was the five-section book called (translated
into English) The collected knowledge of arithmetic, geometry, proportion and
proportionality. The book was published in 1494, about the same time that
Columbus was said to have discovered America. This book by Pacioli was one of
the earliest books printed on the Gutenberg press.
This is how is all started for Pacioli. Guidobaldoda Montefeltro (1472–1508), the
wealthy Duke of Urbino, asked Pacioli to help him to manage his financial affairs.
Pacioli did so, and was the first person to codify and publish the Venetian
accounting system. This accounting system is explained in one section (made up
of 36 short chapters) of Pacioli’s five-section book (see above).
For the next century, The collected knowledge of arithmetic, geometry,
proportion and proportionality was the only accounting textbook available. Most
of the principles, processes and concepts described in this book have been
adopted by accountants right up to today. These principles, processes and
concepts include the:



accounting cycle
use of journals and ledgers
duality of financial transactions (that is, debits equalling credits, or ‘doubleentry bookkeeping’)
formation of account groups: Assets (including Receivables and Inventories),
Liabilities, Owner’s equity, Income/Revenue, and Expenses


year-end closing entries
the trial balance, which Pacioli believed should be used to prove a balanced
ledger.

The system Pacioli described in his book has become known as the ‘double-entry
accounting’ system.
WHAT WAS ACCOUNTING LIKE BEFORE DOUBLE-ENTRY BOOKKEEPING?
Before Pacioli codified the double-entry bookkeeping system, accounting systems
of a sort did exist in some societies. These systems are today described as
‘primitive accounting’. Some of these primitive accounting systems date back
more than 7,000 years to the time of ancient Babylon, Assyria and Sumeria. Over
time, these primitive accounting systems led to the invention of more
sophisticated numerical systems and the accounting principles in use today.
In fact, it has been difficult for comparative philologists (people who study
language) to identify exactly where numbering (and hence accounting) systems
started and where they then separated into uniquely different fields.
EARLY METHODS OF COUNTING
The use of counting systems goes back to the dawn of intelligence among
human beings. Ancient peoples in different parts of the world developed their
own counting systems. Many used their fingers and toes to help them to count.
Hence, the bases of many of these early counting systems were 5, 10 or 20.
For example, the ancient Mexicans used 20 as their number base. The
Peruvians, who used knotted strings called quipus, had a decimal system
(based on 10) as did the early Greeks. The Chinese, Tibetans and Hottentots
used the concepts of ears and hands, respectively, to denote 2 and the
forebears of the Brazilians generally counted by the joints of the fingers,
and consequently counted in lots of 3.
Further developments in numbering systems, and hence accounting, included
the use of:
• Pebbles and twigs: Apart from using body parts to help them count, some
people began using pebbles and twigs, where each item represented an
animal or item of economic value.
• Bullae and tokens: The bullae were round or cylindrical-shaped clay objects,
either hollow or solid. They were used over 3,000 years ago to help keep
track of shipped goods, or to calculate inventory. The variety of differently
shaped tokens inserted inside the hollow bullae (or described in script on the
outside surface of solid bullae) represented the items being accounted for.
• Clay tablets: Over time, the use of tokens and bullae evolved into depicting
symbols on clay surfaces. At first, sellers would imprint their tokens onto wet
clay tablets as a form of recorded accounting. But not all tokens transferred
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Basic accounting concepts—Q&A

their imprint clearly onto wet clay. So, in time, some merchants began
drawing the token symbols on the clay tablets. This drawing of token symbols
became the first documented accounting system in history.
• Abacus: The abacus was invented in ancient China. Its use later spread
throughout the world. The abacus consists of a wooden frame with wires
threaded through strings of beads. Adding, subtracting, multiplying or
dividing calculations were carried out by sliding the beads in certain ways
across the wires. Merchants could not only perform complex calculations on
their abacus this way, but also keep the results of these calculations on their
abacus as a record of financial transactions.
WHAT IS THE DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND
MANAGEMENT ACCOUNTING?
Financial accounting prepares a limited number of prescribed financial reports in
accordance with statutory standards and the needs of external stakeholders.
Financial accounting summarises the consequences of past decisions on the
performance of the business as a whole.
Management accounting prepares an unlimited number of financial reports in
accordance with business requirements and the needs of management.
Management accounting analyses the performance of units within the business
by comparing results with pre-set budgets. Management accounting thus assists
management in its future planning and control functions.
WHY DO WE HAVE TWO TYPES OF ACCOUNTING?
Business managers need accounting information to help them make sound
decisions about the organisation. Investors look for business profits in the hope
of dividends. Creditors and lenders watch an organisation’s ability to meet its
financial obligations. Governmental agencies need information to ensure that the
correct tax is collected and to regulate business activities. Brokers and business
analysts use financial information to form an opinion on investment
recommendations. Employees chose successful companies that enhance their
career prospects, and they often have bonuses or share options that are tied to
enterprise performance. These examples are but a small sample of the sorts of
people who are interested in the financial information of an organisation (that is,
the organisation’s stakeholders). For simplicity in reporting, accountants group
these stakeholders into two main user groups, as shown in Figure 3.

External users
(not directly involved
in daily activities of the
organisation)

Internal users
(directly involved in
daily activities of the
organisation)






government agencies
lenders and investors (owners)
creditors
suppliers and customers
trade associations
society at large

• Board of Directors
• Chief Executive Officer /Chief Financial
Officer
• entrepreneurs
• vice-presidents
• employees
• line managers (for example, business
unit managers, plant and store
managers)

Figure 3 Two main user groups of accounting information
In general, accounting information and financial reports designed for external
users are prepared in accordance with Financial Accounting Standards.
Managerial accounting, on the other hand, provides accounting information to
internal users according to their specific needs. While the reporting styles for
each branch of accounting are vastly different, the underlying objective is the
same—to satisfy the information needs of the user.
FINANCIAL ACCOUNTING
Financial accounting focuses on producing a limited set of specific prescribed
financial statements in accordance with generally accepted accounting principles
(GAAP). The central outputs from financial accounting are audited financial
statements. These financial statements include the Balance Sheet and Income
Statement, which provide a ‘scorecard’ by which the overall past performance of
a business can be judged by outsiders.
This branch of accounting targets those external stakeholders with an interest in
the reporting enterprise, but who are not involved in the day-to-day operations of
the business. The reports produced by this branch of accounting are used for so
many different purposes that it is often called ‘general-purpose accounting’. In
addition to the financial statements, external stakeholders also have access to
financial reporting via press releases. These press releases are sent directly to
investors and creditors or via the open communications of the internet.

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Basic accounting concepts—Q&A

The emphasis in financial accounting is on summaries of financial consequences
of past activities and decisions. So, only summarised data is prepared which
covers the entire organisation. The data prepared must be objective, precise and
verifiable (usually by an outside auditor).
This style of reporting must follow the generally accepted accounting principles
set by peak accounting bodies in conjunction with government agencies. The
numbers used in financial accounting are historical in nature. While the figures in
financial statements seem to be fixed and not able to be changed, they are
actually based on estimates, judgments and assumptions. This is why financial
statements usually include ‘Notes to the Accounts’. These notes (from
management) explain and help users to interpret the numerical information. A
more specialised area of financial accounting is tax accounting.
MANAGEMENT ACCOUNTING
Management accounting deals with information that is not made public; the
information is used for internal decision making only. These reports are far more
detailed than those for financial accounting; they can cover performances and
activities by departments, products, customers and employees. Management
accounting is an accounting system that helps management to achieve the goals
and objectives of the organisation. The emphasis is on the measurement,
analysis, communication and control of financial and non-financial information.
Management accounting is primarily interested in helping the organisation’s
department heads, division managers and supervisors to make better decisions
about the daily operations of the business—in particular, those relating to
planning and control decisions.
The essential data is conveyed in a wide variety of reports specifically targeted
at those who direct and control the organisation. These reports help to promote
more efficient and effective planning; they also help to organise resources, direct
personnel and motivate staff, as well as being useful ‘tools’ in performance
evaluation and operations control.
Unlike financial accounting, there are no external rules for management
accounting. The emphasis in management accounting is on making decisions
that affect the future. Results are compared with budgets, activity-based costing,
financial planning or industry benchmarks. Reports are delivered frequently and
in a timely way to meet the needs of management. Most reports are analytical,
and emphasise variations in the key indicators that monitor the financial
performance of the business unit. A more specialised area of management
accounting is cost accounting.

Table 1 Main differences between financial and management
accounting
Area of difference

Financial

Management accounting

accounting
Number of financial
reports

Limited number—
specifically Balance
Sheet and Income
Statement

Unlimited number—set by needs of
management

Rules governing
preparation of
financial reports

Government-backed
accounting
standards (that is,
GAAP)

No rules

Financial reports

Generally required

Not required

Financial reports
primarily prepared
for ...

External
stakeholders not
involved in day-today operations of the
entity

Internal stakeholders involved in day-today operations of the entity

Are financial reports
made public?

Yes

No

Financial information
in reports contains ...

Organisational
summaries

Detailed performances and activities of the
organisation’s business units, products,
customers or employees

Financial information
in reports
emphasises ...

Objectivity,
preciseness and is
verifiable

Analytical aspects that identify variations
in key performance indicators

Financial reports
assist stakeholders
with ...

Evaluation,
assessment and
investment decisions

Planning, resource allocation and control
decisions

Frequency of
financial report
preparation

Typically half-yearly
and annually
according to
statutory
requirements

Typically daily, weekly, monthly according
to needs of management

Financial
performance is
compared with ...

Prior periods

Pre-set budgets and industry benchmarks

Emphasis of financial
performance

Historical, being a
consequence of past
activities and
decisions

Analytical, in making future decisions

A specialised area is

Tax accounting

Cost accounting

WHAT IS THE PURPOSE OF ACCOUNTING?
The purpose of accounting is to provide financial information about economic
entities (for example, businesses) in the form of financial statements and other
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Basic accounting concepts—Q&A

reports. Financial statements allow internal and external stakeholders to evaluate
the performance of the business and its management.
This evaluation permits stakeholders to make informed judgments and decisions
about the entity and their engagement with the entity.
FINANCIAL STATEMENTS
Each stakeholder is interested in gaining knowledge about the financial position
and performance of the enterprise or business. Financial statements provide this
information and help stakeholders make economic decisions in relation to their
involvement with the enterprise.
The accounting information system is designed to produce financial statements
that fulfil the key purposes and objectives of accounting (see Table 2).

Table 2 Key purposes and objectives of accounting
To provide a
management
information system
(MIS) that …


To enable
organisations to
comply with the
statutory
requirements of
governments and
other institutions
(e.g. stock
exchanges)

Systematically records business transactions created
from business activities (the record-keeping function)
Communicates to managers and other stakeholders
financial information that identifies the profitability,
viability and financial position of the business
Assists managers to make decisions and to control
activities that protect the property of the business
from unjustified and unwarranted use
Enables management to plan short- and long-term
business activities by analysing historical financial
information to predict future outcomes communicated
via budgets and strategic plans
Compliance relates to providing financial information
as a basis for taxation, corporate regulations,
industrial relations and environmental assessment

Financial statements prepared for external stakeholders give insights into the
following:
• accountability of the managers: (that is, ask the following question: Have the
finances of the business been appropriately used to benefit the business
rather than the personal interests of the managers?)
• capital position of the business: (that is, the amount of money distributed to
the owners and the amount of capital remaining to settle the debts of the
business (loan funds, creditors))
• valuation of an business’s equity: (that is, to provide enough information for
others to assess the value of an business from their perspective)

• financial strength: (that is, the business’s ability to pays its current bills as
they become due, the debt to equity ratio and interest cover)
• financial sustainability: (that is, its profitability, its return on investment or
return on assets employed, the efficiency of the asset use by management).

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Basic accounting concepts—Q&A

ROLE OF ACCOUNTANTS AND BOOKKEEPERS
WHY DO WE NEED ACCOUNTING?
Do you know what would happen if the accounting function were removed from
the business and the economic system?
• A government would not have access to tax income from business. Taxes could,
of course, still be raised in other ways, but they would be unlikely to be
enough to provide the standard of community services we enjoy today. It is
unlikely, too, that other tax methods would be as equitable (that is, with an
entity’s ability to pay based on a percentage of profits). History records what
has often happened in societies where taxes imposed on the people are not
equitable.
• Investors would be ‘flying blind’ and would thus be likely to withhold vital capital
needed for businesses to survive and grow. Banks, investors and finance
institutions require verifiable and accurate reports on a business’s financial
performance and position before they can trust it, invest in it or provide it
with loan funds. Accountancy provides these reports in the form of an Income
Statement and a Balance Sheet and makes transparent the financial
performance and position of a business and its management decisions.
No accounting = no investment/trust = no capitalist
economy

• Business owners and managers could not track their current financial
performance in an accurate and timely way. A key function of business
management is to ensure that the business will endure. Accountancy
provides a reporting mechanism by way of an Income Statement that details
the revenue, expenses and resulting profit that managers can use to make
informed decisions to ensure the sustainability of the business.
No accounting = ill-informed decisions = poor use of
resources and the failure of the business to survive

• Banks as the core component of the global financial system could not facilitate
the means of economic exchange. Trade between entities would therefore
eventually cease. Businesses would not offer credit, turning the efficiency of
our current financial system back to the ‘dark ages’ of barter and localised
subsistence living.
• Business and economic planners would have ‘no instruments with which to fly’.
Financial information provided by the accountancy system allows managers
to prepare budgets that become instruments, gauges and benchmarks of
performance and a means of controlling the finances under their control.
No accounting = no ability to plan = end of economic
growth and development

• Comparisons that promote productivity and improved performance—and that are
the key drivers in maximising the use of the world’s limited resources—would
disappear. Accountancy, because it is applied using international accounting
standards, provides a means of comparing businesses. This comparison
provides benchmarks by which under- or over-performance of a business can
be judged relative to an industry average, previous periods or against the
entire business world.
Furthermore, the three key reports produced by the accounting system provide
answers to the fundamental questions that go to the heart of a business’s ability
to survive (see Figure 4).

Is the business
currently profitable?
Does it continue to
have the capacity to
endure? Which way is
the profit trending?

• Answered by comparing last month's
operating profit with that for the
previous month
• Displayed on the Profit and Loss
Statements created by the accounting
system

Can the business pay
its bills as they fall
due? Can the business
remain solvent into
the near future and
avoid bankrupcy?

• Answered by the cash flow forecast
produced by analysing the Profit and
Loss Statement and changes to the
Balance Sheet created by the
accounting system

What is the financial
strength of the
business? What is its
net worth and how
much value has the
business created for
the owners?

• Answered by the value of the owner’s
equity section of the Balance Sheet

Figure 4 How the accounting system answers fundamental
questions about business viability
WHAT IS THE DIFFERENCE BETWEEN A BOOKKEEPER AND AN
ACCOUNTANT?
Bookkeeping is a task-oriented function that routinely and systematically records
an organisation’s day-to-day financial transactions.
Accounting is more results-oriented than bookkeeping. Accounting is involved
more with interpreting and using financial information than in preparing it.
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Basic accounting concepts—Q&A

BOOKKEEPERS
Bookkeeping is generally the tedious, clerical and exacting role in the accounting
system. Today bookkeepers use computer and accounting software to do much
of this work.
The bookkeeper function is performed primarily by skilled clerical personnel who
may or may not have any formal accounting training. They will, however, have a
basic knowledge of the ‘double- entry system’, which ensures that financial
transactions are recorded correctly.
Bookkeepers are required to classify transactions into the correct ledger
accounts as previously determined by the accountant and business owner. A final
check in the bookkeeping process is called a ‘trial balance’. This summary
ensures that financial transactions have been correctly recorded. At this point,
the bookkeeper usually hands the system over to the accountant who performs
the second element of the accounting function: analysis and reporting.
ACCOUNTANTS
Quite often the terms bookkeeper and accountant are used interchangeably.
Certainly, they both play a role in the accounting process. However, they each
perform quite different functions.
Let’s revisit a definition of accounting to help us understand these differences:
Accounting consists of two key elements:


an information process that identifies, classifies and summarises the
financial events that take place within an organisation
a reporting system that communicates relevant financial information
to interested persons, which allows them to assess performance, make
decisions and/or control the economic resources in the organisation.

As a rule, bookkeepers do only the first element described above. Accountants,
who are trained and able to do both, generally do the second element. This is
because accountants are uniquely specialised professionals whose time would be
poorly invested in tasks that a computer—together with accounting software and
a competent bookkeeper—could easily perform. So, accountants deal with the
big picture. They set up the overall structure and design for both the financial
information capture and the appropriate financial reporting functions.

KeyFACTS

Accountants are responsible for reporting to governments and statutory requirements. These

reports include the Statement of Financial Performance and the Statement of Financial Position.
Accountants also prepare reports and advise business managers in developing their businesss.
This advice may relate to:

resolution of complex financial reporting issues




cash flow and profit forecasting
auditing to check the accuracy of information
tax planning and lawful tax minimisation
redesigning business accounting systems to ensure maximum efficiency.

Generally, accountants need to be highly qualified with a university degree plus
membership of a peak accounting body that is maintained by the accountant’s
continuous professional development.
WHY DO WE NEED ACCOUNTANTS?
People might seek the services of an accountant for many different reasons;
these reasons may include:

to seek the advice of someone who is appropriately qualified in trying to
understand and interpret the 70,000 or so pages of taxation law and then
apply it to a business. Many people in business do not have the time or
expertise to so that and are happy to pay for an accountant’s professional
services to ensure that:
– the business complies with the law and avoids penalties, legal costs and
potential criminal charges
– the business and related transactions are structured in a tax-effective way
to ensure that tax is not overpaid. This might happen simply by getting the
timing of payments and the signing of agreements in the wrong order.
– business personnel spend their time doing what they do best, which is
building the business, not being involved in something where they have no
specialised expertise

16

to help businesses fully understand the financial performance and position
of their business on a continual basis. Qualified accountants have
significant experience in business and can help set up a specialised chart
of accounts and a management information system that helps to identify
under-performing aspects of the business. Their networks give them
access to industry benchmarks which they can use to identify these areas
of under-performance.
to enhance credibility when applying for bank loans and when seeking
investment partners. Accountants give such external parties confidence,
particularly if the accountant has prepared the financial statements
according to GAAP and gives assurances to that fact. Accountants can also
‘talk the language’ that financiers and investors speak. If the accountant is
not at the negotiation table, there is a chance a business will not
effectively communicate its message and that its access to funds
therefore is limited.

Basic accounting concepts—Q&A

Of course, an accountant is not needed anymore to ‘keep the books’ of a
business. Modern computerised accounting systems allow many businesses to do
their own bookkeeping. The vast majority of accountants are happy with this
development because they can now spend so much more of their time giving
clients the value-added advice and analysis that are really needed.

F

or many business owners and
managers, the accountant is
always their first appointed and
primary ongoing adviser in
business. Most owners and
managers will report that they have always
saved more money from their accountant’s
advice than they have ever paid for their
service.
What advice do you have for someone who is interested in working in the
accounting field but not sure where to get started?

C

ase study: Wray Rives, qualified
accountant

Wray Rives is a qualified accountant and an active Quora participant. He may well
wish to add to what is said below if contacted on Quora. This is what he says about
becoming an accountant …
‘I studied accountancy at university as part of a degree in business and
quickly saw its value in contributing to the success of my entrepreneurial
dreams. I don’t have the temperament to be an accountant but I did see the
value of financial/accounting skills for entrepreneurs in regard to financial
modelling in business plans, structuring corporate/accounting entities,
keeping your own books with computerised bookkeeping, understanding
financial statements, adopting managerial accounting in regard to cash flow
budgets, accessing finance options and conducting valuation analysis. See my
answer on this at: Which specialty within accounting is more beneficial to a
career in entrepreneurship—Tax or Audit? So, I didn't work directly in a
recognised accountancy field but I have embraced accountancy skills in all my
entrepreneurial endeavours and in my advisory roles.
If you are interested in working in any of the specialised accounting fields, you
must begin with an understanding of accounting/finance theory via a formal
education. If you wish to eventually become a qualified accountant (rather
than just acquire the accounting skills as I have) you will need to firstly
complete an accounting or business or finance degree at a university and
then complete additional specialised accounting studies as required by the
professional accounting association that you may be required to join.

Check with the peak accounting body in your country in regard to their
membership requirements before choosing your formal education pathway.’

SPECIALISED FIELDS OF ACCOUNTING
• Bookkeeping: This sub-set of accounting could be performed by a paraprofessional who has completed formal vocational education (diploma or
certificate level) at a college. Generally, a person does not need to have
completed a degree or belong to one of the peak accounting bodies to work
in bookkeeping. It would be necessary, though, to apply your formal
education to implanting and maintaining leading industry computerised
accounting packages.
• Financial accounting jobs: People in these roles primarily prepare financial
reports for shareholders, government agencies/departments, stock
exchanges and corporate regulators; they must be a member of one of the
peak accounting bodies. In Australia, these bodies are represented as CAs
(Charted Accountants) and CPAs (Certified Practicing Accountants). This field
requires current and complete knowledge of tax law and accounting
standards, provided through membership of a selected peak professional
accounting body. Auditing is a specialised role in financial accounting that
also requires membership of a peak accounting body.
• Management accounting: This field of accounting is primarily interested in
helping the organisation’s department heads, division managers and
supervisors make better decisions about the day-to-day operations of the
business and, in particular, those relating to planning and control decisions.
The emphasis is on making decisions that affect the future, with results being
compared with budgets, activity-based costing, financial planning or with
industry benchmarks. These analytical reports emphasise variances in the
key indicators that monitor the financial performance of the business unit.
Experience counts significantly in getting jobs in this field but entry generally
requires, as a minimum, a degree in accountancy/finance.
TYPES OF ACCOUNTING CAREER JOBS
So you are an accountant! Where might you seek a career in accounting?

Table 3 Opportunities for a career in accounting
Location

Employer role

Career benefits

Requirements

Public accounting
firms

Responsible for
providing accounting
services to
individuals,
businesses and
government. The ‘big
4’ in this area are:
PricewaterhouseCoop

Useful way to start
an accounting
career. Provides
foundation
knowledge before
moving into more
specialised areas.

Candidates with a
degree in
accounting/finance

18

Basic accounting concepts—Q&A

Firms will generally
assist employees in
qualifying for peak
body membership.

ers, Deloitte and
Touché, KPMG, and
Ernst & Young.
Government

Responsible for
preparing budgets,
tracking costs and
analysing government
initiatives.

Working at any level
of government,
prospects for
advancement are
generally good, due
to the size of the
organisation. The
slow-paced, noninnovative,
bureaucratic
environment and
politicised decision
making are
‘downsides’.

Preferred candidates
generally have 5+
years of ‘big 4’
industry experience.

Corporations (of all
sizes)

Responsible for
preparing (or helping
to prepare) financial
statements, for
tracking costs, for
handling tax returns
and for working on
major transactions.

The work is more
dynamic than
government work,
and career
prospects are good.

Preferred candidates
will generally have
industry experience
and have
membership of a
peak body.

Independent

Responsible, as a selfemployed accountant
for creating one’s own
business.

Benefits flow from
good customer
contact,
independence and
good financial
returns;
disadvantages when
business is not so
good.

Clients will often
choose an
accountant who is a
member of a peak
body when perusing
independent service
providers.

Entrepreneurship

Opts to pursue own
entrepreneurial
dreams, using
accounting/finance
skills only to build and
manage a business
outside of accounting.
practice

Prospects for
becoming a valuable
founding member of
any business startup team.

Formal qualifications
and peak body
membership are a
distinct advantage
but not critical.

SUMMARY—BEING AN ACCOUNTANT
If you wish to work in any field of accountancy, start with a formal education. This
should preferable be an accounting/finance degree at a university.

ACCOUNTING CONCEPTS AND CONVENTIONS
WHAT ARE THE ACCOUNTING CONCEPTS AND CONVENTIONS?
Accounting is based on generally accepted accounting principles (GAAP). These
principles summarise the assumptions, practices, principles and concepts that
provide the basis for measuring financial values and for reporting on the results
of business activities.
Accounting concepts and conventions guide accountants when reporting on the
financial performance and position of a business. Accounting principles and
assumptions greatly influence the reported financial position and performance of
a business.
WHY IS THERE A NEED FOR ACCOUNTING PRINCIPLES AND
CONVENTIONS?
Accounting deals almost exclusively with numbers. Yet it is not purely a science
of objective measurement or assessment. Accounting also involves a degree of
subjective judgement because values are involved, and anyone in business will
tell you that value is definitely ‘in the eye of the beholder’. What one
businessperson holds to be important, or values, another one won’t.
Either way, in order for the stakeholders of a business to make sound decisions,
they need financial information that—as accurately as possible—reflects the ‘true
and fair view’ of the financial performance and position of the business.
TOWARDS A ‘TRUE AND FAIR VIEW’
The concepts and conventions that accountants have adopted to guide the
preparation of financial statements for a business help to support them in taking
a ‘true and fair view’ approach. These concepts and conventions are sometimes
called assumptions or principles.
Whatever we call them, or however they are grouped, it is important that these
concepts and conventions be appropriately applied by those responsible for
preparing the financial statements of a business. The concepts and conventions
that need to be applied in this regard are listed in Figure 5. These key concepts
explained in more detail in the text that follows.
Accounti
ng
entity
assumpt
ion

20

Going
concern
concept

Monetary
measure
ment
assumpti
on

Time
period
conventi
on

Basic accounting concepts—Q&A

Historic
al cost
convent
ion

Matchin
g (or
accruals
)
principl
e

Realisat
ion of
income
conventi
on

Full
disclosu
re
concept

Material
ity
principl
e

Prudence
(or
conservat
ism)
principle

Consiste
ncy
conventi
on

Dual
aspect
concept

Objectiv
ity
concept

Substan
ce over
form
principl
e

Figure 5 Accounting concepts and conventions

• Accounting entity assumption: The accounting entity assumption states that
the business is an entity (perceived to have its own existence) that is
separate from its owner. Therefore business records should be separated and
kept distinct from the personal records of the business owner(s).
– This is also known as the economic entity concept or the separate
business entity principle.
• Going concern concept: Accountants assume, unless there is evidence to the
contrary, that a company is not going broke and will continue to operate for
an indefinite period of time or at least into the foreseeable future. This
assumption allows businesses to spread (amortise) the cost of a fixed asset
over its expected useful life.
• Monetary measurement assumption: Accountants do not account for items
unless they can be quantified in monetary terms (that is, money was
exchanged to acquire the item or a market exists that would be prepared to
exchange money for it). A business may have other valuable resources (like
workforce skills, business morale, market leadership, brand recognition,
quality of management) but these do not get recorded in the financial
statements because they cannot be quantified in monetary terms.
• Time period convention: This convention allows for the performance
evaluation of a going concern business to be broken up into specific period of
time such as a month, a quarter or a year.
– This is also known as the accounting period convention.
– This short time period of assessment allows internal and external users to
adjust their strategy for the business. Also, using the time period
assumption, the accountant and other users can compare like to like
financial results over a similar period of time.
• Historical cost convention: This convention requires that the assets of a
business be recorded in the ledger accounts at the price paid to acquire
them. No account is taken of the changing values of these assets in the
marketplace.
• Matching principle or Accruals principle: This principle holds that expenses
should be ‘matched’ against revenues that they enabled, and should be
recorded in the same period in which the revenue is earned. This approach is
supported by the accrual accounting method. To do this, accountants need to
prepare accruals at the end of each reporting period to take account of
expenses incurred but for which there is no source document. These are part
of the end-of-period adjustments.

• Realisation of income convention (revenue recognition): With this
convention, accountants recognise financial transactions (and any profits
arising from them) at the point of sale or at the transfer of legal ownership.
This may be different from the point when cash actually changes hands.
• Full disclosure concept: The full disclosure concept requires that financial
statements provide sufficient information to help users of the information to
make knowledgeable and informed decisions about the business.
• Materiality principle: Accountants only record events significant enough to
justify the usefulness of the information. Only items deemed significant for a
given size of operation are recorded. Otherwise the accounts will be
burdened down with minute details.
• Prudence/Conservatism principle: The rule is to recognise revenue only when
it is reasonably certain of happening and recognise expenses as soon as they
are incurred (whether paid or not). Accounting in this manner ensures that
financial statements do not overstate the business’s financial position. As a
rule, accounting chooses to err on the side of caution and to protect investors
from acting on inflated or overly positive results.
• Consistency convention: According to this convention, transaction
classification and valuation methods should remain unchanged from one
period to the next. This allows for more meaningful comparisons of financial
performance between periods by the stakeholders.
• Dual aspect concept: The dual aspect concept is based on the accounting
equation:
Assets = Liabilities + Owners Equity

All transactions recorded in the accounts must keep this equation in balance.
To do this, financial transactions are allocated both a debit side and a credit
side of equal amounts.
• Objectivity concept: The objectivity concept states that transactions must be
recorded on the basis of objective evidence. This means that accounting
records will initiate from a source document to ensure that the information
recorded is based on fact and not on personal opinion.
• Substance over form principle: In accounting, real substance takes precedent
over legal form. This means that accountants consider the economic or
accounting point of view rather than just the legal point of view when
recording transactions. This helps to explain the difference between a legal
entity and an accounting entity.
WHAT IS THE ACCOUNTING ENTITY ASSUMPTION?
It is important to understand the principle of keeping the personal financial
affairs of the business owners separate from the businesses they operate.
Applying the accounting entity assumption helps produce meaningful and
relevant financial reports for decision makers.
LEGAL ENTITY

22

Basic accounting concepts—Q&A

An entity is something that is perceived, known or inferred to have its own
separate existence.
For example, the law recognises people as legal entities because they have
their own separate existence. Under the law, this status allows people to
sue other legal entities and to also be sued by them.
The law in most countries of the world also recognises some non-persons or nonliving things as legal entities. Registered companies are a good example: while
they are non-persons and non-living, they are recognised legal entities. These
non-person legal entities have the same rights and obligations under the law as
an individual person.
However, not all non-person activities are recognised as legal entities. For
example, a sole trader’s business (for example, a plumbing business) or a local
social club (for example, a Darts Club) are not recognised as legal entities.
This is because under the law they are not perceived to be separate and distinct
from the owners or they have not been registered as a separate legal structure.
ACCOUNTING ENTITY
Accounting takes the concept of entity one step further than the law. In
accounting, every business (including sole traders) becomes its own accounting
entity. So, while the law does not recognise the sole trading business as a
separate legal entity distinct from its owner/s, accounting does recognize the
sole trader’s business as a separate accounting entity.
The accounting system records the financial affairs of each accounting entity
separately, as shown in Figure 6.
Financial transactions are separated between:

the business owner’s financial affairs
the financial affairs of the sole trading firm, which the owner may operate.

Under the accounting entity assumption, a business entity, regardless of its legal
status, is treated as being separate and distinct from the owners or managers of
that business.

The owner of the firm
• shown in the accounting system as one 'accounting entity'

The firm itself
• shown in the accounting system as a separate and distinct 'accounting
entity'

Figure 6 How the accounting system records the financial affairs
of each ‘accounting entity’
PURPOSE OF THE ACCOUNTING ENTITY ASSUMPTION
One of the key reasons for creating separate accounting entities is to enable the
accounting system to provide more useful and relevant financial reports to assist
decision making in relation to each specific ‘accounting entity’.
For example, if the owner’s financial affairs are separated from the financial
affairs of the business, decision makers like financiers and managers can
clearly assess the business' s financial performance, position and
sustainability.
WHAT IS THE GOING CONCERN CONCEPT IN ACCOUNTING?
One fundamental concept of the GAAP is the going concern concept. (The term
concern here means a business or enterprise. It started being used to mean a
business or enterprise in the early 1900s.) The going concern concept reflects
the desire of stakeholders for realistic financial statements that accurately reflect
the financial performance of a business over short and consecutive time periods.
The going concern concept directs accountants to prepare financial statements
on the assumption that the business is not about to go broke or be liquidated
(that is, where the business closes and sells all assets for whatever price it can
get). The opposite view to the going concern concept is that the business will
cease trading shortly and that all the assets will be sold off within the current
year.

24

Basic accounting concepts—Q&A

A

ccountants adopt the going
concern concept so they can
prepare realistic financial
reports. Otherwise,
accountants would have to
write off all assets in the current period
including long-term assets that still have
an economic benefit for future periods.
So, unless there is significant evidence to the contrary, accountants base their
valuations and their reporting of financial data on the assumption that the
business will remain in existence for an indefinite period.

An indefinite period means the foreseeable future or long enough for the
business to meet its objectives and to fulfil its commitments. It is important
to note that the going concern concept does not imply or guarantee that the
business is profitable or that it will remain so for the foreseeable future.

In other words, the going concern concept assumes that when a business buys
assets such as land, equipment and buildings, it does so with the intent that
these assets will produce income over a number of years. The business does not
purchase these assets with the intention to close operations soon after purchase
and then resell them.
For example, let’s assume that a business recently purchased equipment
costing $5,000, which had 5 years of productive/useful life. Under the going
concern concept, the accountant would write off only 1 year’s value $1,000
(1/5th) this year, leaving $4,000 to be treated as a fixed asset with future
economic value for the business.
IMPLICATIONS OF THE GOING CONCERN CONCEPT
The going concern concept has significant implications for the valuation of assets
and the liabilities of a business. By applying the going concern concept,
accountants are able to value and include long-term assets in a Statement of
Financial Position (Balance Sheet).
If the going concern assumption was not applied, the accountant would need to
write these assets off as costs within the year of purchase. Applying the going
concern concept also allows accountants to properly allocate transactions that
overlap 2 or more consecutive years. As well, by applying the concept of a going
concern, accountants can record assets at historical costs. Recording assets at
historical cost means the accountant does not need to constantly assess the
liquidated value of business assets when preparing the financial statements.

For example, partly completed manufactured goods like work in progress
would have little value in a liquidation. However, under the going concern
concept, work-in-process assets are recorded at their current costs, which
would be significantly greater than the liquidated value.
GOING CONCERN IN COMPANY LAW
Another aspect of going concern affects the directors of companies. This is a
slightly different concept to the going concern concept in accounting.
Corporation laws generally require directors of companies to declare that their
business continues to be a going concern. In this context, it means that the
directors believe that the business they manage is able to pay its bills as they
become due. These directors are required to disclose to the shareholders in the
Notes to the Financial Statements if there are any factors that may put in doubt
the company’s status as a going concern.
WHAT IS THE REVENUE RECOGNITION PRINCIPLE?
The revenue recognition principle is a set of guidelines that helps accountants to
identify when a revenue event has taken place and how to appropriately record
cash exchanges before, during and after the revenue event. The revenue
recognition principle also helps to determine the accounting period in which the
revenue is to be recorded.
BACKGROUND TO THE REVENUE RECOGNITION PRINCIPLE
The primary purpose of accounting is to provide the necessary information for
sound economic decision making to take place. A key piece of that information is
the calculation of net income (that is, revenues less expenses). The growth and
size of the net income informs decision makers about the sustainability, financial
strength and growth capacity of the business. Growth can be determined only by
comparing net income results over a series of accounting periods made up of
similar durations (that is, monthly, quarterly or yearly).

I

dentifying when revenue can be
legitimately recorded into the books
of the business, and the accounting
period that it should be recorded
against, are important considerations
for accountants and decision makers alike.
The revenue recognition principle guides accountants on how the revenue timing
issues should be managed and treated in the financial statements. (Note: The

26

Basic accounting concepts—Q&A

term recognition means the moment when a financial transaction should be
recorded in the bookkeeping system of a business.)
The rule underpinning the revenue recognition principle is that revenue should
be recorded in the books of a business only when:

payment is assured (realisable) and measurable
revenue has been actually earned (final delivery and completion of work).

These rules must be adhered to before an event can be recorded as revenue in
the bookkeeping system of a business. Figure 7 summaries these principles.

Revenues are realised when
measurable cash or claims to
cash (Accounts Receivable)
are received in exchange for
goods or services.

Revenues are earned when
such goods are transferred
and services have been
provided (that is, when the
revenue generation process
has been substantially
completed or as soon as the
customer has a legal right of
ownership over the goods).

Revenues are considered
realisable when the assets
received in such an exchange
are readily convertible to cash
or have a clear claim to cash.

Figure 7 Accounting rules for treatment of revenue
THE ISSUE WITH REVENUE RECOGNITION IN ACCOUNTING
Let’s look at the following situation to try and understand what the revenue
recognition principle sets out to solve.

C

ase study: revenue recognition
principle and Blake’s Furniture
Store

Blake's Furniture Store issues a purchase order for 20 timber chairs @ $125
each in December and includes a check for $500 as a deposit. According to
the agreement, the chairs are to be delivered in January with the remaining
$2,000 to be paid in February.

This financial event takes place over three monthly accounting periods:
December, January and February. So, the question is ... ‘In what month should
the revenue be recorded (recognised) and how much should be recorded?’
The answer to this question is determined by the bookkeeping method being
used by the business, and then applying the revenue recognition principle
There are two bookkeeping methods: the cash accounting method and the
accrual accounting method. Large corporations and for-profit companies must
use the accrual accounting method while small businesses and associations
can choose one or the other.
Using the cash accounting method to determine when revenue should be
recognised is relatively easy because under the cash accounting method
revenue is recognised (recorded) when the cash from the customer is actually
received(that is, revenue recorded in the books of the business is $500 in
December and $2,000 in February).
The accrual accounting method records the revenue in the month that it
was earned, without regard to when cash is actually received. Under the
accrual accounting method, revenue is earned when either the goods are
delivered or the service has been performed/completed (revenue recorded in
the books of the business is $2,500 in January).
(Note: The deposit in December is initially treated as a liability because the
deposit money remains owing to the customer until the legal transfer of
ownership of the chairs takes place in January with the delivery of the good.)

TYPES OF TRANSACTION INVOLVING REVENUE
The revenue recognition principle impacts on the four primary ways that a
business can earn revenue. These are illustrated in Figure 8.

28

Basic accounting concepts—Q&A

Providing services: These
revenues are recognised when the
service is completed. It is common
practice to use the date on the
invoice to determine the revenue
recognition (recording) date.

Selling inventory: These
revenues are recognised at the date
of the sale but commonly
interpreted as the date of delivery.
The date is taken from the invoice
or cash receipt.

Earning
Granting permission torevenue
use

Selling an asset other than

recognised at the
agreed/negotiated time intervals
or as the assets are actually used.

inventory: These could be fixed
assets that are disposed of during
the conduct of a business and
revenues are recognised when the
sale takes place or when the invoice
has been sent.

business assets (e.g. interest
for borrowed/invested money,
rent for use of fixed assets of
business, and royalties for use
of intangible assets like
patents): These revenues are

Figure 8 Four primary ways that a business can earn revenue

SUMMARY—REVENUE RECOGNITION PRINCIPLE

Revenues are realised when measurable cash or claims to cash (Accounts
Receivable) are received in exchange for goods or services. Revenues are
considered realisable when the assets received in such an exchange are readily

convertible to cash, or have a clear claim to cash.
Revenues are earned when goods are transferred and services have been provided
(that is, when the revenue generation process has been substantially completed, or
as soon as the customer has a legal right of ownership over the goods).

WHAT IS THE MATCHING PRINCIPLE IN ACCOUNTING?
The matching principle is a fundamental accounting concept in the measurement
of net income. The matching principle directs those preparing financial
statements to ensure that revenues and all their associated expenses are
recorded in the same accounting period. This is done to ensure that a net income
is not distorted by time differences in billing and cash exchanges.
The matching principle is the basis on which the accrual accounting method of
bookkeeping is built.
BACKGROUND TO THE MATCHING PRINCIPLE

One key purpose of accounting is to provide the information needed for sound
economic decision making. Sound economic decisions can be made only if a
business is able to measure and report accurately on its profitability.
Profitability for a business directly determines the sustainability, financial
strength and growth capacity of the business. Profitability is calculated as the
amount remaining after revenue has been offset by all the expenses incurred in
earning that revenue.

S

o, it is vitally important that
business decision makers
identify all the revenues earned
for an accounting period and
that these revenues are offset
by all the associated expenses incurred in
earning that revenue.
This requirement led to the development of the matching principle. The matching
principle helps avoid the possibility of mis-stating the net income for a given
period.
The choice of bookkeeping method impacts significantly on the matching
principle. There are two methods of bookkeeping allowable under tax laws and
accounting standards: the cash accounting method and the accrual accounting
method.
THE MATCHING PRINCIPLE AND CASH ACCOUNTING
The cash accounting method does not apply the matching principle. This is
because the cash accounting method is designed as a simpler bookkeeping
system for use by small sole proprietor businesses or small associations primarily
for tax purposes. The cash accounting method delays recording revenue and
expenses until the cash actually exchanges (that is, the cash is received or paid).
Under the cash accounting method, no regard is taken to the period in which the
revenue was earned or the expense legally incurred.
THE MATCHING PRINCIPLE AND ACCRUAL ACCOUNTING
On the other hand, the accrual accounting method does adhere to the matching
principle. The accrual accounting method also recognises revenue (revenue
recognition principle) as soon as a product has been sold or a service has been
performed, regardless of when the money is actually received by the business.

30

Basic accounting concepts—Q&A

Unlike the cash accounting method, the accrual accounting method eliminates
the timing mismatches that can occur when expenses paid and revenue received
happen in different accounting periods.
WHEN DOES THE MATCHING PRINCIPLE BECOME AN ISSUE?
The matching principle becomes an issue when accountants wish to report on
the financial performance of a business for a specific period. This specific period
in accounting is created under the accounting period convention.
The accounting period convention incorporates the desire by decision makers to
receive regular and comparable updates on the performance of their business on
a per month, per quarter or on an annual basis (that is, for tax purposes).
The matching principle ensures that the financial reports for these short
accounting periods accurately measure the net income.
APPLYING THE MATCHING PRINCIPLE
So, to apply the matching principle appropriately, an accountant would need to:


choose an accounting period
apply the accrual accounting method of bookkeeping
simultaneously adhere to the revenue recognition principle.

Businesses that adopt these principles are able to more accurately evaluate their
actual profitability and financial performance for specific periods of time by
eliminating the disparities in the accounting entry timings.

ase study: Build Rite and the matching
and revenue recognition principle
C

The following case study presents examples of the matching principle and the
revenue recognition principle under the two bookkeeping methods:


cash accounting method, or cash basis
accrual accounting method, or accrual basis.

Table 4 Comparison between cash accounting and accrual
accounting methods

Method
A business is paid $1,000
in January for ABC
consulting work
completed and invoiced in
December.

Cash accounting
method
Records $1,000 as
Consultancy revenue in
January.

Accrual
accounting
method
Records $1,000
as Consultancy
revenue in
December.

A business pays a printing
bill of $500 in February for
printing used in December
for ABC consultancy work.

Records $500 as printing
expense in February.

Records $500 as
printing expense
in December.

The impact on net income reporting using the cash method is:

no impact on December net income with these transactions. Profitability is
understated for the month.
net income for January increased by the cash revenue received of $1,000.
Profitability is overstated for the month.
net income for February decreased by the paid expense of $500. Profitability is
understated for the month.
matching principle and revenue recognition principle are not applied.



The impact on net income reporting using the accrual method is:

net income for December increased by $500 (that is, $1,000 revenue less $500
expense)
no impact on net income for January or February with these transactions
net income for all months accurately stated
matching principle and revenue recognition principle are applied.



IMPACT OF THE MATCHING PRINCIPLE ON FINANCIAL TRANSACTIONS
Before producing the financial statements for a business, accountants need to
scrutinise the transactions and source documents to ensure that all revenue has
been identified under the revenue recognition principle and that all associated
expenses incurred have been identified, matched and recorded.
Invariably, this scrutiny identifies end-of-period adjustments that need to be
made to the ledger accounts. These adjustments are needed to ensure that the
ledger accounts comply with the matching principle and to produce meaningful
reports that accurately describe the financial performance and position of the
business.
These end-of-period adjustments create transactions known as accruals. There
are four types of accruals that create transactions in the end-of-period process in
order to comply with the matching principle.
These four types of accrual are described in Table 5.

Table 5 Four types of accruals
Type of
revenue

Description

Accrued revenue

Adding transactions for
revenue that has not
yet been invoiced

A staged monthly invoice for partially
completed work $1,000 in a six (6)
month contract worth $6,000

Accrued expense

Adding transactions for
expenses that have

The electricity used in the current
reporting period that has not yet been

32

Basic accounting concepts—Q&A

Example

not yet been
recognised

billed by the supplier.

Deferred
revenue

Transferring to future
periods income
transactions that,
while recorded in the
current period,
actually belong to
future periods. These
amounts become
liabilities of the
business because the
business has not yet
performed the work
and so has no claim to
the customer
payment.

$1,000 cash received by the business as
a deposit for work that has not yet been
commenced

Deferred
expense

Transferring to future
periods expense
transactions that,
while recorded in the
current period,
actually belong to
future periods. These
amounts become
assets of the business
because the value of
the expense has not
yet been used up or
utilised.

Transferring the remaining time covered
under a 12- month insurance payment

Note: A special type of accrued expense
is depreciation. Depreciation expense
apportions the cost of a fixed asset over
its useful life. The useful life of a fixed
asset will cover a number of accounting
periods.

SUMMARY—MATCHING PRINCIPLE IN ACCOUNTING
In summary, the matching principle in accounting:
 is used by accountants to calculate net income
 is vital for providing decision makers with the accurate financial performance of a

business
reports the revenues and the associated expenses incurred in earning that revenue

in the same accounting period
accounts for revenue and expenses when they happen regardless of the cash


exchange timings (that is, when cash is received or paid)
is the basis on which the accrual accounting method of bookkeeping is built
does not apply for the cash accounting method of bookkeeping

is closely aligned with the revenue recognition principle and the accounting period

convention
leads to additional accrual transactions being created from the end-of-period
adjustments that need to be made to the accounts of the business before the

financial statements are distributed
eliminates the disparities that can occur in entry timings in the books of the
business.

WHAT IS THE TIME PERIOD ASSUMPTION IN ACCOUNTING?
The time period assumption is also known as the periodicity assumption or
accounting period assumption. The time period assumption allows accountants
to subdivide the entire economic life of a business into specified time intervals.
It is assumed that accounting can manage the varying time-period impacts of
financial transactions, and so produce financial statements that accurately
reflect the financial performance of business in a specific time period.
BACKGROUND TO THE TIME PERIOD ASSUMPTION IN ACCOUNTING
As businesses have grown and become more complex over the last few
centuries, so did the growing need for, and importance of, accounting. The need
for the accounting function to provide regular financial information about a
business’s performance grew as:



professional managers took over from owners–operators in managing large
businesses
business owners (shareholders) became more detached from the day -to-day
operations of the business
more complex business structures were created
governments increased their legislative requirements of business (for
example, through tax and corporate law).

TIME PERIOD ASSUMPTION
The primary purpose of accounting is to provide the necessary information for
sound economic decision making. In the fast-changing world of business,
decision makers need this information to be provided in a timely manner. What a
‘timely manner’ means, however, may vary according to business needs. Figure
9 outlines some possible timeframe scenarios.

34

Basic accounting concepts—Q&A

Daily
Daily sales
sales report
report
for
for aa salesperson
salesperson

Weekly
Weekly gross
gross
profit
profit report
report for
for aa
business
business unit
unit
manager
manager

Quarterly
Quarterly and
and
half-yearly
half-yearly Profit
Profit
and
and Loss
Loss
Statement,
Statement,
Balance
Balance Sheet
Sheet and
and
Statement
of
Cash
Statement of Cash
Flows
Flows reports
reports for
for
shareholders
shareholders

Monthly
Monthly profit
profit and
and
loss
report
for
loss report for aa
company
company CEO
CEO

Yearly
Yearly tax
tax and
and
annual
company
annual company
reports
reports for
for
government
government
agencies
agencies and
and
statutory
statutory authorities
authorities

Figure 9 Examples of timeframes for the reporting of financial
information
So, while a business may be expected to exist for a long period of time,
stakeholders in the business need reports on business activities and financial
performance to be provided in shorter time periods. Stakeholders also require
that these reports be regular and sequential. This is so that performance with
prior like periods can be compared, and so that business strategies can be
changed in regard to any identified trends. This enables decisions makers to
makes changes to business strategies in a timely fashion to take account of any
identified trends, whether they be positive trends to be exploited or negative
trends to be mitigated.
In responding to this information need of stakeholders, accountants assume that
the entire economic life of a business can be subdivided into stakeholderspecified time periods. In making the time period assumption, accountants also
assume that it is possible to prepare financial statements that will accurately
reflect the financial performance of a business for the specified time period.

I

n fact, the going concern assumption,
the accrual accounting method, endof-period adjustments, accruals, the
revenue recognition principle and the
matching principle have all
developed from this push by stakeholders
to accurately reflect the entity’s financial

performance for shorter specified time
periods.
THE ACCOUNTING PERIOD
A term deriving from the time period assumption is the accounting period. The
accounting period is the period of time over which net income/profits are
calculated and reported. The common accounting periods are months and
quarters for internal stakeholders and years for external stakeholders, either
fiscal (July–June) or calendar (January–December).
The time period covered by the statements (accounting period) will be shown in
the header area of the Income Statement, the Statement of Cash Flows, and the
Statement of Stockholders’ Equity (that is, the Income Statement for the month
ended 31 March 20xx or the Statement of Stockholders’ Equity for the year
ended 31 December 20xx).

SUMMARY—TIME PERIOD ASSUMPTION IN
ACCOUNTING
The time period assumption:
 grew from the need to provide regular reports on financial performance to both

internal and external stakeholders
allows accountants to subdivide the entire economic life of a business into specified
time intervals. This is vital in providing decision makers with accurate financial

performance of a business.
assumes that time periods can be set by stakeholders according to their needs (for

example, monthly for managers and yearly for government tax departments)
allows for performance comparisons to be made with like for like periods to

identify any trends (opportunities to exploit, or threats to mitigate)
is identified as the accounting period and is stated in the header of the Income

Statement, the Statement of Cash Flows and the Statement of Stockholders’ Equity
is closely related to the going concern concept, the accrual accounting method,
balance-day adjustments, accruals, and the revenue recognition principle in regard
to accurately reflecting the financial performance of businesses for these specified
time periods.

36

Basic accounting concepts—Q&A

TYPES OF ACCOUNT GROUP CLASSIFICATIONS
THE FIVE ACCOUNT GROUPS
The five account groups have been a part of the accounting system for the past
500 years. Every financial transaction can be categorised by accounts belonging
to these groups. The five account groups are shown in Figure 10.

Assets - items of
economic value over
which the firm has
legal control (for
example, land, cash,
equipment)

Liabilities - monies
owed by the firm to
external entities (for
example, trade
creditors, loan
providers,
government
agencies)

Revenue - monies paid by
others for goods and services
provided by the firm (for
example, merchandise sales,
professional fees earned)

Owner's equity monies owed by the firm
to internal entities (for
example, investors,
owners)

Expenses - assets that were
consumed and the cost of
services used in earning the
revenue (for example, rent, cost
of goods sold, wages)

Figure 10 The five account groups
WHAT ARE ASSETS IN ACCOUNTING?
Assets are those items of financial value that the business will use to make
profits for the owners. The formal definition of an asset as described by the
International Accounting Standards Board is as follows:
An asset is a resource controlled by the enterprise as a result of past events
and from which future economic benefits are expected to flow to the
enterprise.
It is important to understand that, in an accounting sense, an asset is not the
same as ownership. While the business has control over its assets, the business
is not the ultimate owner of their inherent monetary value.
ASSETS AND THE ACCOUNTING EQUATION

Assets are one of the three elements in the accounting equation; the other two,
as mentioned earlier, are liabilities and owner’s equity.
The accounting equation, as mentioned earlier, states:
Assets = Liability + Owners Equity

Assets

Accounting
equation

Liabilities

Owner’s
equity

Figure 11 The three elements in the accounting equation
What the account equation means for a business is this:

If the business ceases trading and sells its assets, the money from that
sale would be used to first pay out the obligations of the business
(liabilities), with the remaining money going to the owners (owner’s
equity).

ACCOUNTING ENTITY ASSUMPTION AND THE ACCOUNTING EQUATION
To help to clarify this important point—namely, the relationship of assets to a
business— let us first revisit the accounting entity assumption. Previously, we
saw that a business is set up to make profits for the owners. We also saw that
when operating under the accounting entity assumption, the business is treated
in accounting as separate and distinct from the owner/s of the business.
When the business is first formed, it owns nothing in its own right and it owes
nothing to anyone. Once the business receives initial funds (capital) from the
owners and other lenders (liabilities), it is able to use those funds to purchase

38

Basic accounting concepts—Q&A

items of economic value that the business can use to produce profits for the
owners.
These items are known in accounting as the assets of the business.

S

o assets in accounting are
anything that a business legally
controls that has both inherent
monetary or exchange value and
is capable of producing future
profits for the business.
The business will uses both the equity funds (owner’s equity) and the debt funds
(liabilities) to purchase assets. Figure 12 lists some typical assets.

Equipment

Inventory

Cash reserves

Figure 12 Some typical assets
So, from the business perspective, the value of the assets the business controls
must be equal to the combined value of the equity funds (owner’s equity) and
the debt funds (liabilities).
The relationship between assets, liabilities and owner’s equity is known as the
accounting equation.
TYPES OF ASSETS IN ACCOUNTING
Assets are categorised in different ways.

KeyFACTS

Assets can be tangible and intangible.


Tangible assets can be touched or handled (for example, land, buildings, equipment, vehicles).
Intangible assets cannot be touched (for example, patents, trademarks, copyrights, franchises,
goodwill, web sites). But intangible assets still have a monetary value and a business can control

them.
Assets can be represented on the Statement of Financial Position (or Balance Sheet) as current
assets or non-current (fixed) assets.

CURRENT ASSETS
Current assets are cash and other assets expected to be converted to cash, sold
or consumed either within 1 year or in the operating cycle (whichever is longer).
These asset values continually change in the normal course of business activity.
There are five major sub-groups detailed in the Figure 13.

Cash and cash
equivalents

Accounts
receivables

Short-term
investments

Sub-groups of
current
assets

Pre-paid
expenses

Inventory

Notes
1. Cash and cash equivalents include currency, petty cash, bank deposit accounts and negotiable
instruments (for example, money orders, cheque, bank drafts).

40

Basic accounting concepts—Q&A

2. Short-term investments include securities bought and held for sale in the near future to
generate income on short-term price differences (trading securities).
3. Accounts receivables is money owed to the business by its customers who purchased goods
and/or services on account.
4. Inventory is merchandise held to sell to customers. Also includes work in progress for a
manufacturing business.
5. Pre-paid expenses are expenses paid in advance. They still have asset value as the value has
not yet been exhausted or used.

Figure 13 Sub-groups of current assets
NON-CURRENT/FIXED ASSETS
Non-current or fixed assets have value beyond the next 12 months and do not
constantly change in value as current assets do. They are classified as noncurrent or fixed assets as long as they remain for use within the business and are
not items that are purchased with the intent to sell.

KeyFACTS

Fixed asset accounts may include land, buildings, furniture, fixtures, equipment, vehicles,

computers, furniture and appliances.
Long-term investments are investments that are held for many years and are not intended to be

disposed of in the near future (that is, bonds, common stock, or long-term notes).
Intangible assets are items of economic value that are not physical in nature (that is, patents,
goodwill and trademarks).

OTHER ASPECTS OF ASSETS IN ACCOUNTING
Assets are recorded in the Statement of Financial Position (Balance Sheet) as
monetary values. This statement is the detailed description of the accounting
equation and so also lists the liabilities and the owner’s equity.
Fixed assets are written off against profits over the asset’s expected life. This is
done by depreciating a proportional amount of the asset value each accounting
period. The accumulated depreciation since the asset was purchased is displayed
as a negative amount alongside the asset in the Statement of Financial Position
(Balance Sheet).
WHAT ARE LIABILITIES IN ACCOUNTING?
Liabilities are the financial obligations and debts of an entity arising from past
transactions and occurring during the course of business operations. These
financial obligations are paid by the accounting entity to external parties over
time via the transfer of economic benefits including money, goods or services.
The external parties of an accounting entity include banks, other financial
institutions, creditors and government agencies.

Liabilities include credit card debt, overdrafts, accounts payable, term loans and
mortgages.
DEFINITION OF LIABILITIES IN ACCOUNTING
The Australian Accounting Research Foundation defines liabilities as follows:
the future sacrifice of economic benefits that the entity is presently obliged
to make to other entities as a result of past transactions and other past
events.
Liabilities are the monies that a business is obliged to repay to others. Some
characteristics of liabilities are detailed in Figure 14.

Liabilities
Liabilities are
are funds
funds
provided
provided to
to a
a
business
business mostly
mostly by
by
non
non owners
owners..

Liabilities
Liabilities are
are also
also
known
as
the
known as the debts
debts
of
of a
a business.
business.

Liability
Liability funders
funders
are
are not
not entitled
entitled to
to
the
the profits
profits of
of a
a
business.
business.

Liability
Liability funders
funders are
are
sometimes
sometimes entitled
entitled
to
to interest
interest on
on the
the
unpaid
debt.
unpaid debt.

The
The business
business uses
uses
liability
liability funders
funders to
to
purchase
purchase assets.
assets.

Liability
Liability funders
funders
have
have certain
certain claims
claims
over
the
assets
over the assets of
of
the
the business.
business.

Liabilities
Liabilities are
are
typically:
typically:
1.
1. loans
loans owing
owing to
to
financial
institutions
financial institutions
2.
2. money
money owing
owing to
to
suppliers
suppliers (creditors)
(creditors)
3.
3. payments
payments
owning
owning to
to
governments
governments
(taxes)
(taxes)

Figure 14 Some features of liabilities and liability funders (also
known as debt funders)
When the assets of a business are liquidated, the debts are paid first. The equity
funders are entitled to what money is left over.

KeyFACTS

A business uses liabilities (debt funds) to purchase assets.

42

Basic accounting concepts—Q&A

Liability funders (debt funders) are not entitled to the profits of the business, are sometimes
entitled to interest on the unpaid debt, and have certain claims over the assets of the business.

ACCOUNTING ENTITY ASSUMPTION AND LIABILITIES
To understand liabilities, let us first revisit the accounting entity assumption. The
accounting entity assumption states that, in accounting, a business must be
treated as a distinct entity. The business, as a distinct entity, will record its
financial transactions in a separate book of accounts to that of the owners of the
business. By applying the accounting entity assumption, the business is able to
give accurate reports on its own financial position and performance. The
accounting entity assumption also determines the perspective that the business
will take when recording financial transactions.
A business is created to make profits for the owners of that business. When the
business is first created, it owns nothing in its own right and it owes nothing to
anyone. It is an empty shell. However, from this point on, the business will view
every financial transaction from its own perspective. It will not record
transactions from the owner’ s perspective. The funding of a business is
illustrated in Figure 15, and explained further in the text that follows.

Step 3:
Step 2:

Step 1:
investm ent of
funds by
business owners,
called owner's
equity

Business
then
receives
funds from
non-owners,
called
liabilities

Business
uses
owner's
equity
(equity
funds) and
liabilities
(debt funds)
to purchase
assets

Figure 15 The funding of a business
STEP 1—INVESTMENT BY BUSINESS OWNERS (OWNER’S EQUITY)
The first transaction a business records into its books of account is the initial
investment of funds by the owners of the business. These investment funds—
provided to the business by the owners—are called owner’s equity (or equity
funds).

Owner’s equity funds remain in the business until the business ceases to trade.
The business views these funds as belonging to the owners but the business is
not obliged to repay them. Owner’s equity funds are investment funds.
Investment funds entitle the owners to all the profits that the business makes.
STEP 2—FUNDS RECEIVED FROM NON-OWNERS (LIABILITIES)
Soon after the business is created it also receives funds provided by non-owners.
Banks and suppliers are typical non-owners who provide funds to the business.
Funds provided to the business by non-owners are called liabilities. The business
acknowledges that these funds belong to the non- owners and understands that
the business is obliged to repay them.
Liability funds are known as debt funds. Debt funds do not entitle the fund
providers to any profits that the business makes. However, sometimes debt fund
providers will receive an interest payment for the funds provided.
STEP 3—USE OF EQUITY AND DEBT FUNDS TO PURCHASE ASSETS
The business uses both the equity funds (owner’s equity) and the debt funds
(liabilities) to purchase assets. Assets, as we saw earlier, are those items of
financial value that the business will use to make profits for the owners. Typically
assets include equipment, inventory and cash reserves. So, from the business
perspective, the value of the assets the business controls must be equal to the
combined value of the equity funds (owner’s equity) and the debt funds
(liabilities). The relationship between these three elements— assets, liabilities
and owner’s equity— is, as stated earlier, known as the accounting equation.
TYPES OF LIABILITIES IN ACCOUNTING
There are three main types of liabilities in accounting:


current liabilities
non-current liabilities (sometimes known as long-term liabilities)
contingent liabilities.

CURRENT LIABILITIES
Current liabilities are short-term financial obligations. Short term in this context
is defined as obligations that are required to be paid off within one year. Current
liabilities are recorded in the Statement of Financial Position (Balance Sheet).
Typical current liabilities include:



expenses due but not yet paid (wages, taxes, and interest payments)
accounts payable to suppliers
short-term notes
revenues collected in advance.

44

Basic accounting concepts—Q&A

NON-CURRENT LIABILITIES
Non-current liabilities are long-term financial obligations. Long-term liabilities are
not required to be paid off within 1 year. Long-term liabilities often involve large
sums of money that allowed the business to open or expand or to purchase a
significant asset. Non-current liabilities are recorded in the Statement of Financial
Position (Balance Sheet). These debts will typically take the business a long time
to repay. Typical long-term liabilities include:


mortgages over property
a bank term loan
lease obligations for vehicles or equipment.

CONTINGENT LIABILITIES
Contingent liabilities are type of liability that typically affects large public
companies. A contingent liability is a non-measurable liability that a company
has for an adverse event, transaction or incident that has already taken place.
Contingent liabilities are reported in the Notes to the Accounts. Contingent
liabilities are not usually recorded in the Statement of Financial Position (Balance
Sheet) of the business.
Typical contingent liabilities could be:


a lawsuit taken against a company
an environmental clean-up responsibility
new regulations or penalties that could impact on the company.

WHAT IS OWNER’S EQUITY IN ACCOUNTING?
Owner’s equity is one of the three elements in the accounting equation; the
other two, discussed earlier, are assets and liabilities.
ACCOUNTING ENTITY ASSUMPTION AND OWNER’S EQUITY
To understand owner’s equity, let us first revisit the accounting entity
assumption. The accounting entity assumption states that, in accounting, a
business must be treated as a distinct entity. The business, as a distinct entity,
will record its financial transactions in a separate book of accounts to that of the
owners of the business. By applying the accounting entity assumption, the
business is able to give accurate reports on its own financial position and
performance. The accounting entity assumption also determines the perspective
that the business will take when recording financial transactions.
Earlier, we saw that a business is created to make profits for the owners of that
business. The business owns nothing in its own right when it is first created and
it owes nothing to anyone. However, from this point on, the business will view
every financial transaction from its own perspective. It will not record
transactions from the owner’s perspective.

FUNDS PROVIDED BY THE OWNERS OF A BUSINESS
The first transaction a business records into its books of account is the initial
investment of funds by the owners of the business. These investment funds,
provided to the business by the owners, are called owner’s equity. Owner’s
equity funds remain in the business until the business ceases to trade. The
business views these funds as belonging to the owners but the business is not
obliged to repay them.
Owner’s equity funds are investment funds. Investment funds entitle the owners
to all the profits that the business makes. Owner’s equity funds are also known
as equity funds.
FUNDS PROVIDED BY NON-OWNERS OF A BUSINESS
Soon after the business is created it also receives funds that are provided by
non-owners. Banks and suppliers are typical non-owners who provide funds to
the business. Funds provided to the business by non-owners are called liabilities.
The business will then use both the equity funds (owner’s equity) and the debt
funds (liabilities) to purchase assets. Assets are those items of financial value
that the business will use to make profits for the owners. Typically, assets include
equipment, inventory and cash reserves.
So, from the business perspective, the value of the assets the business controls
must be equal to the combined value of the equity funds (owner’s equity) and
the debt funds (liabilities).
The relationship between assets, liabilities and owner’s equity is known as the
accounting equation.
DEFINITION OF OWNER’S EQUITY IN ACCOUNTING
Owner’s equity represents the resources invested by the owners in the business.
It is often known as the ‘residual’ claim over the assets because the claim of the
debt funders (liabilities) must be satisfied before the claim of the owners.
Owner’s equity has also been defined as follows:
Owner’s equity is an accounting term used to describe the net investment
of owners or stockholders in a business. Under the accounting equation,
equity also represents the result of assets less liabilities.
Owner’s equity:



represents investment funds that the business is not required to repay
equals Assets less Liabilities
is also called net assets, or just ‘equity’, or the book value of the company
is the funds provided to a business by its owners.

46

Basic accounting concepts—Q&A

When the assets of a business are liquidated, the debts are paid first. The equity
funders (owners) are entitled to what money is left over.

Owner’s equity increased by:
1. additional investments by owners
2. current earnings (profits of the business)
3. previous period's profits not being
distributed to owners (retained earnings)

Owner’s equity decreased by:
1. equity withdrawals in the form of:
- drawings by sole proprietors
- dividends by shareholders of
companies
- losses from the business operations

Figure 16 Financial impacts on owner’s equity

SUMMARY—OWNER’S EQUITY




Owner’s equity represents investment funds that the business in not required to repay.
Under the accounting equation: Owner’s equity = Assets less Liabilities.
Owner’s equity is also called net assets, or simply ‘equity’, or the book value of the business.
Owner’s equity is funds provided to a business by its owner/s.
When the assets of a business are liquidated, the debts are paid first. Equity funders are entitled
to what money is left over.

WHAT IS REVENUE IN ACCOUNTING?
Revenues or revenue in business is the gross income received by an entity from
its normal business activities before any expenses have been deducted. Income
may be received as cash (or cash equivalent).
Income is typically generated from the sale of goods or the rendering of services
for a particular period of time.
BACKGROUND TO REVENUE IN ACCOUNTING
The purpose of business is to earn a profit from the sale of products (revenue).
These products may be tangible in nature (that is, goods) or intangible (that is,
services). Profit is the money left over after deducting from the gross sales of
these products, the cost of the activities required to generate those sales
(expenses).

KeyFACTS

A business generates revenue when it exchanges its goods or services with customers in return
for money or other assets.

A business incurs expenses by exchanging its assets for the goods and service activities needed to
generate that revenue.

A business makes a profit if its revenues exceed its expenses. However, if the costs of generating
the revenue (expensed assets and service activities) are greater than the revenue received, the
business makes a loss. (Note: Sometimes a business receives assets (cash) from lenders (loans
provided to the business) or from its owners (capital investment). This receipt of assets is not
revenue. Only those assets received from customers or clients in exchange for goods or services
are treated as revenue in accounting.)

Over the 500 years or so of applied accounting, the terminology of the word
revenue has evolved, being given labels such as ‘turnover’, ‘top line’, ‘sales’,
‘gross receipts’, ‘fees earned’ or even ‘income’. Unfortunately, the term income
also has a meaning in some circumstances of profit (that is, after expenses have
been deducted) and this can be confusing for some.
Revenue is referred to as the ‘top line’ because that’s where revenue is reported
on the Income Statement (Statement of Financial Performance). Net income or
net profit on the other hand is referred to as the ‘bottom line’ because it is
reported in the last line of this same statement. Non-profit organisations may
refer to revenue as gross receipts.
Revenue in the double-entry bookkeeping system is one of the five account
groups where financial transactions can be recorded. The other four are Assets,
Liabilities, Owner’s equity, and Expenses. Revenue accounts are created in the
General Ledger to record the various ways that the entity earns revenue.
TYPES OF REVENUE IN ACCOUNTING
Business revenue is gross income generated from the normal/ordinary activities
of a business entity (whatever its type). This revenue may come from:
• sale of goods: For businesses such as manufacturers, wholesalers and retailers,
most revenue is generated from the sale of goods.
• provision of services: Service businesses (for example, accounting firms,
doctors, hairdressers) generate most of their revenue from providing
(rendering) services.
• loan of fees and investment: Financial services businesses, such as car
rentals and banks, receive most of their revenue from fees and interest
generated by lending assets to other organisations or individuals, or from
royalties earned for the use of intellectual property. Investment firms may
receive revenue from dividends paid to them by other companies based on
their shareholdings.

48

Basic accounting concepts—Q&A

• Other: Non-profit organisations generate revenue that includes donations from
individuals and corporations, support from governments, income from
fundraising activities or membership dues. Other income in the for-profit
sector could be the profit made on the sale of assets.
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Figure 17 Main features of revenue
NET REVENUE AND OTHER REVENUE
Revenue is the gross sales/fees earned. Net revenue is the gross revenue minus
any product returns, allowances and any discounts for the early payment of
invoices. (Note: Revenue should not include tax collected by the business in
relation to a value-adding tax. This cash received should not be recorded as
revenue but rather as a liability because it is monies owed to the government.)
While revenue is the gross income received from the normal operations of a
business, other revenue (that is, non-operating revenue) is revenue received
from the non-core operations of a business. This could be:

profit on the sale of equipment used by the business to generate sales
interest income earned from keeping a checking account with a bank.

Other revenue/income is usually separated and reported at the bottom of the
Income Statement. This is because it may otherwise distort the view about the
sustainable financial performance of the business, which should be based on its
normal operations.
REVENUE RECOGNITION IN CASH ACCOUNTING AND ACCRUAL
ACCOUNTING

One further complication with the concept of revenue is that revenue reported
for a particular period will depend on the accounting method a business has
adopted. This complication is dealt with under the revenue recognition principle
where generally accepted accounting principles or International Financial
Reporting Standards determine what is to be reported as revenue in a given
period.
Each of the accounting methods (cash accounting and accrual accounting) uses
a different approach to measure revenue.

Accrual accounting records (recognises) revenue as soon as the legal
obligation to pay has been transferred to the customer, regardless of when
the cash is exchanged.
Cash accounting delays the recording (recognising) of the revenue until the
cash payment is received by the customer.

WHAT IS THE DIFFERENCE BETWEEN REVENUE AND INCOME?
Revenue is the gross sales or cash receipts received by a business from its
customers in the ordinary course of business that involves selling goods or
providing services. Revenue is also known as turnover, sales, or fees earned.

Revenue is the first line detailed on an Income Statement.

Income is the increase in economic benefit available to the business owners from
the net result of the revenues less the expenses incurred in earning that revenue
for a previous period. Income is also known as net profit or earnings.

Income is the last line detailed on an Income Statement, which is why it is
also called the ‘bottom line’.

BACKGROUND TO THE REVENUE AND INCOME
Over the past 500 years of accounting, many terms have developed around the
concept of income. These terms are often used interchangeably in everyday life
without consequence. However, some of these terms in accounting describe
different aspects of the profitability of a business.
Adding to the confusion for accounting students is the fact that some accounting
teachers, textbooks and even some accountants themselves may use these
words interchangeably in general conversation.
The important thing to understand is that there are two distinct accounting
concepts here that need to be understood, and named in a consistent manner.
REVENUE VERSUS INCOME

50

Basic accounting concepts—Q&A

Generally, the terms turnover, sales and revenue mean the same thing. These
terms refer to the sale of goods or the provision of services that arise from the
core activity of the business.

This item (revenue) appears as the first line on an Income Statement.

On the other hand, income (or net income), earnings and profit (or net profit)
generally mean the same thing. These terms refer to the net increase in
economic benefit made available to the business after expenses have been
deducted from the revenue/turnover/sales in a given accounting period.

This item appears as the last entry on the Income Statement, which is why
income is often referred to as the ‘bottom line’.

Gains are special revenue items that do not arise from the core activity of the
business (for example, gains from the disposal of a fixed asset or gains from
movements in the exchange rates involving international transactions).

I

ncome then encompasses both revenue
and gains and is the increase in the
owner’s equity arising from the activities
of the business (that is, revenues less the
costs involved in generating that revenue).
It should be noted that income does not include increases in equity that are
contributed by owners. In accounting practice, income is always used in the
context of net income and is the same as net profit.)
DEFINITIONS OF REVENUE, GAINS, GROSS PROFIT, NET PROFIT AND
INCOME IN ACCOUNTING
Definitions and explanation of some key terms associated with revenue and
income are detailed in Table 6.

Table 6 Revenue and income—definitions and explanations
Term

Definition

Explanation

Revenue

The gross increase
in cash, receivables
and other assets
that arise in the
ordinary course
business

Revenue could include:





sales of goods by a retailer (merchandise sales)
tuition fees by educational institutions
accounting fees by an accounting firms (rendering
of services)
lease income by a property developer
interest earned by banks
dividends received by investment firms.

Revenues result from activities that define the reason

for the existence of the business—the sale of goods
or provision of services for which the customers pays.
Gains

Represent other
items considered as
income but that do
not arise in the
ordinary course of
business

Gains may be sales from the disposal of resources
other than products. This includes:


gain on the sale of investments
gain on the sale of property, plant and equipment
gains on the sale of intangible assets.

They may also be foreign exchange gains (that is,
gains resulting from foreign currency exchange
transactions and translations).
The key difference between revenue and gains is that
revenues are earned from the regular activities of the
business (its primary reason for existence) and gains
are earned from a peripheral (non-core) activity of the
business.
Income

The increase in
economic benefit
for the owners of a
business that arises
during an
accounting period

The economic benefit may result in an increase in
assets (cash/receivables) or a decrease in liabilities
(payables, loans) but always with a corresponding
increase in owner’s equity.

Gross
profit

The profit before
indirect costs like
overheads have
been deducted

Gross profit is the amount left over from the revenue
after the direct costs of making a product or providing
a service have been deducted.

Net profit

The amount left
over after
deducting indirect
costs from gross
profit

Indirect costs include such expenses as depreciation,
distribution, selling and administrative costs,
taxation, and interest payments.

Income in accounting means the amount left over
after revenue has been reduced by the expenses
incurred in earning that revenue (that is, the cost of
doing business). Income is the same as net profit.

WHAT ARE EXPENSES IN ACCOUNTING?
An expense in accounting is the money spent or cost incurred in an entity’s
efforts to generate revenue. Expenses represent the cost of doing business
where doing business is the sum total of the activities directed towards making a
profit.
BACKGROUND TO EXPENSES IN ACCOUNTING
It is important to firstly be quite clear about the difference between a cost and an
expense. This is because, as explained below, these elements have different
meanings in accounting.
52

Basic accounting concepts—Q&A


A cost is a monetary measure of the resources that have been sacrificed to
acquire an asset.
An expense is that part of the cost that has expired and been used up by
activities directed at generating revenue.

While all expenses are costs, not all costs are expenses.

KeyFACTS
Expenses can take the form of:


cash payments (such as wages and salaries, rent, advertising)
an expired portion of an asset (for example, calculated depreciation/amortisation)
a reduction in revenue (such as bad debts).

Expenses are summarised and included in the Income Statement as deductions
from the revenue. Revenue minus expenses calculates the net profit for the
business for a given period.
(Note: Cash payments do not always mean that an expense has occurred.
For example, a business might pay $10,000 to the bank to reduce its bank
loan. This payment will reduce the cash holding of the business but it is not
an expense. It is rather a reduction in the amount of the loan and liability
the business has to the bank.)
In double-entry bookkeeping, expenses are one of the five key account groups by
which financial transactions can be categorised. The other four account groups
are assets, liabilities, owner’s equity and revenue.
Expenses, under the double-entry bookkeeping system debit/credit rules, are
recorded as:

a debit to the specific expense account
a corresponding credit entry as either a decrease in an asset (exhausting
something of economic value, usually cash) or an increase in a liability
(creating an obligation to pay for goods or services used in the generation of
revenue, usually accounts payable).

(Note: The purchase of such things as vehicles, equipment or buildings is not an
expense. These purchases are known as capital expenditure items and are
treated initially as an asset to be expensed over its useful life—that is, by
depreciation/amortisation.)
EXPENSES IN CASH AND ACCRUAL ACCOUNTING

Expenses are recorded in the ‘books of a business’ according to the
method/basis of accounting chosen by the business: cash accounting or accrual
accounting (also called cash basis and accrual basis, respectively).

Under accrual accounting: The expense will be recorded in the
accounting system at the point when a legal obligation has been created.
This is usually at the date of goods shipped/received or the date that the
service was performed.
Under cash accounting: The recording of the expense is delayed until the
cash payment is made (for example, an electricity bill for the month of April
but paid in May will be recorded as an electricity expense in April under
accrual accounting but recorded as an electricity expense in May under
cash accounting).

ACCRUAL ACCOUNTING AND THE MATCHING PRINCIPLE
Accrual accounting is built on the matching principle in accounting. The matching
principle tries to accurately report the profits for each accounting period. This
requires matching the revenue for a given period directly with the expenses
incurred in earning that revenue in the same period.
For example, under accrual accounting, sales commission expense will
appear on the Income Statement in the same period that the related sales
are reported, regardless of when the commission is actually paid.
EXPENSES AND TAX LAW
Tax law can also influence the type and amount of expenses that can be claimed
as a deduction when determining the income tax payable for a business.
For example, while legal expenses may be paid by a business, not all legal
expenses are deductible expenses under tax law. There are many other
examples of business-related expenses that may not qualify under tax law
as deductible expenses. Accountants and tax agents usually have the job of
sifting through the business expenses to remove the expenses that cannot
be claimed, before lodging a tax return or report.
Each country sets its own tax laws. However, there are some common elements
when deciding the question: Which expenses qualify as a tax deduction?
Common elements include the fact that the expenses must be:



part of the ordinary course of doing business
necessary for the development of the business
paid or incurred during the taxable year
not paid before the start of a business or in creating it (these would be treated as
capital expenditure costs)

54

Basic accounting concepts—Q&A

• be a trade or business activity that is continuous, regular and one where profit is
the primary motive.
WHAT ARE EXPENSE CLASSIFICATIONS AND FUNCTIONS IN ACCOUNTING?
By applying expense classifications and functions to financial reports, the
decision maker can identify:

the real, primary and underlining profitability of the business
 functional areas where expenses are either within or outside of
predetermined norms or targets for the business.
BACKGROUND TO EXPENSES IN ACCOUNTING
The purpose of accounting, as explained earlier, is to provide meaningful
financial information that can be used to make decisions about the management
and performance of a business.
Two financial statements provide this key financial information: the Income
Statement (Statement of Financial Performance) and the Balance Sheet
(Statement of Financial Position).

The Balance Sheet provides details about the financial strength or net worth
of the business by presenting the assets, liabilities and owner’s equity at a
point in time.
The Income Statement provides details about the sustainability or
profitability of the business by presenting the revenue and expenses for a
past accounting period.

EXPENSES BY CLASSIFICATION AND FUNCTION
Expenses are divided into two main classifications: operating and non-operating.
Operating expenses are associated with the main activity of the business
(primary activities) while expenses associated with a peripheral activity of a
business are classified as non-operating (secondary activities).
For example, interest expense for the majority of businesses is regarded as
a non-operating expense because it involves the finance function of the
business, rather than the primary activities of buying/producing and selling.
Non-operating expenses may also be recorded as other expenses.
Expenses can be further sub-classified according to their function; that is,
reporting expenses according to the activity for which the expenses were
incurred. Each business will group their expenses by the functions that are the
most relevant to them.
Some businesses may group Employee expenses, Vehicle expenses or
Occupancy expenses depending on their significance to the business.

Generic classifications for all businesses may include those listed in Table 7.

Table 7 Generic expense classifications
Type of expense

Description

OPERATING EXPENSES
Cost of goods sold (or Cost of sales
expense)

This represents expenses that can be
directly linked to the goods produced and
sold by a business (that is, raw materials
in manufacturing, product purchases in
retail, and charge-out staff expenses in
professional practices).

Selling

This represents expenses required to sell
the products (for example, salaries of
salespeople, commissions and travel
expenses, advertising, shipping).

General administrative

This represents expenses required to
manage the business (salaries of officers /
executives, legal and professional fees,
utilities, insurance, office rents, office
supplies).

Depreciation/amortisation

This represents the expense that records
the loss in value over time of
fixed/intangible assets.

For example, a vehicle purchased for
$50,000 with 5 years of useful life will
create a depreciation expense of
$10,000 each year for 5 years until it
is written off—using the straight line
method of depreciation. The same
treatment would be applied when
amortising an intangible asset like a
patent.

NON-OPERATING EXPENSES
Financing

This represents the costs of borrowing
funds from various financiers (for example,
interest expenses).

Extraordinary item

This represents other expenses or losses
that are not part of the ordinary business
operations (for example, foreign exchange
loss, loss on sale of an asset).

Income tax

This represents the tax payable to tax
authorities in the current reporting period.

EXPENSES AND THE CHART OF ACCOUNTS
56

Basic accounting concepts—Q&A

A Chart of Accounts sets out all the ledger accounts into which financial
transactions will be recorded.
A Chart of Accounts generally includes the five main account groups (shaded
yellow in Figure 18 below) and are allocated the number of the group. Three
additional groups (and their respective numbers 5, 7 and 8, and shaded green in
Figure 18) are added to help provide meaningful financial information for
decision makers.

1

ASSETS

2

LIABILITIES

3

OWNER'S EQUITY

4

REVENUE

5

COST OF GOODS SOLD

6

EXPENSES

7

NON-OPERATING REVENUE

8

NON-OPERATING EXPENSES

Figure 18 Components in the Chart of Accounts
WHAT IS THE ACCOUNTING DIFFERENCE BETWEEN AN EXPENSE AND AN
INVESTMENT?
An expense is that economic portion of an asset that has been used up within
the accounting period. An investment is that portion of an asset that continues to
have future economic value at the point of reporting.
C

ase study: expenses and investments
A small business spent $10,000 on merchandise items at the start of the year,
made quite a few sales, and had $5,000 left at the end of the year.

The financial report at the end of the year would show $5,000 ‘expensed’ as cost of
goods sold and a $5,000 ‘investment’ remaining as an Asset.
So, while $10,000 was paid out by the business in total, only $5,000 of it was
expensed in accounting terms (used up in the generation of sales) in that year. A
total of $5,000 continues to have future economic value (an asset).
Only the $5,000 expensed portion of the money spent on merchandise items is
subtracted from the revenue to calculate the profit.

Another answer to the question about differences between expenses and
investments might be as follows:

with an expense, the monetary value outlay is used up in generating revenue
with an investment, revenue is still generated but the value of the initial
monetary outlay remains.

Terminology is a difficult area of accounting, with many similar but significantly
different terms being used interchangeably. Blame the medieval Italian roots for
this, as well as the 500 or so years that accounting has had to accumulate all
sorts of variant English terms to describe the same or similar events.
So, another way you might describe the same outlay of money being treated
differently in accounting would be to compare an expense payment with an asset
purchase (that is, an outlay of $3,000 for shop rent is recorded in the accounting
system as an expense but an outlay of $3,000 for a computer is recorded in the
accounting system as an asset purchase or investment).
WHAT IS THE DIFFERENCE BETWEEN CAPITALISATION AND EXPENSING?
In accounting, when you capitalise an asset, you are reporting that it still has
economic value that will benefit future periods. It is therefore reported on the
Balance Sheet. However, if you expense an asset, you are reporting that its
economic value has been used up in the creation of revenue in the current
period. It is therefore reported on the Income Statement of the business.

c

ase study: capitalising and
expensing

Let’s take the case of a business purchase of a $60,000 boat to illustrate the
difference between capitalisation and expensing.
An accountant would normally capitalise the entire asset value of the boat when it
is first purchased but then expense a portion of the boat’s value each year based
on the useful economic life of the boat. For instance, if the boat was expected to
benefit the business (earn revenue) for say 10 years before it needed to be
replaced, the accountant would expense $6,000 of the boat’s value each year
($60,000/10 years).

58

Basic accounting concepts—Q&A

Accounting for the loss in value (expensing) of the boat reduces the capitalised
value of the boat as reported in the Balance Sheet as it equally reduces the profits
reported in the Income Statement each year by the same amount. After 10 years
the capital value is reduced to $0 because the entire value of the boat has been
expensed and it has no economic value left to benefit future periods. This expense
in accounting is called Depreciation.
For instance, if the boat was expected to benefit the business (earn revenue)
for say 10 years before it needed to be replaced, the accountant would
expense $6,000 of the boat’s value each year ($60,000/10 years).

The greatest implication in the choice between capitalising and expensing is on
the profit reported each period. Choosing to capitalise an asset rather than to
expense it ensures higher profits, which, in turn, leads to higher taxes and a
higher business value. Choosing expensing over capitalisation for an asset would
produce the opposite result.
While accounting standards are set by governments to guide accountants when
making this choice, this is an area where some ‘creative accounting’ takes place
depending on the needs of the business at the time (that is, to lower taxes
payable, then expense the asset; or to increase business value when securing
loans or investments, to then capitalise the asset).
WHAT IS THE DIFFERENCE BETWEEN A COST AND AN EXPENSE IN
ACCOUNTING?
The terms cost and expense are commonly used in the fields of business,
economics and accounting. In some fields, they can be used interchangeably
without issue. In accounting, however, the terms have quite different meanings.
Basically:

sacrificing resources (money) to acquire products is called a cost
using up the value of those products to generate revenue for a business is
called an expense.

Y

ou could say that expenses are costs
that have expired while costs are
potential future expenses that have
not yet expired.

BACKGROUND TO EXPENSE AND COSTS IN ACCOUNTING
Accounting as a system of recording and reporting on financial information has
been operating for over 500 years. During that time, the meaning of many words
used in English has also evolved. Students of accounting today must not only
deal with the fact that many terms describe the same accounting function but
also that words with similar meanings in everyday usage have quite different

meanings in accounting. The difference in meanings between cost and expense
is one terminology issue that students of accounting must be clear about.
What further complicates understanding the difference in meaning between cost
and expense is that accounting teachers and authors often follow established
language traditions and may use the words interchangeably.
Adding to this mix is the term expenditure, which is also frequently substituted
for both the terms cost and expense. We will see further in this outline that the
meaning of the term expenditure most closely equates to that for cost, and that
expense is actually a subset of both.
Another entity that influences the meaning of the terms cost and expense is
government tax laws and their interpretations. Tax law generally allows
businesses to claim deductions for expenses incurred in carrying on the business.
However, there is no definitive list of what a business can and cannot claim as an
expense, and not all expenditures/costs paid by a business are considered
claimable expenses under tax law.
A registered accountant is usually required to guide businesses through the
process that calculates the expenses a business can claim as a deduction against
income. These registered accountings may also seek to define expenses in terms
of claimable deductions under tax laws.
DEFINITION OF COSTS AND EXPENSE IN ACCOUNTING
A summary from one set of definitions provided by the Australian Accounting and
Standards Board explains that:

cost is the amount of cash or cash equivalents paid to acquire an asset
expenses are the decreases in economic benefits during the accounting
period ... that result in decreases in equity.

In other words, cost is a sacrifice of resources.
For example, when we buy something, we cease to have the ability to use that
resource to buy something else. A printing business may purchase for cash $1,000
worth of photocopy paper for this month with the intent of using it to generate
revenue. So the printer has sacrificed $1,000 of cash resources, which are now not
available to them, for other uses. The photocopy paper has ‘cost’ the printing
business $1,000 but it has also acquired an economic benefit to the same value.

Expenses are those costs used up in generating revenue for the same accounting
period.
For example, if the printing business used only $800 worth of the photocopy paper
in generating revenue for the month, it would, for accounting purposes, need to
record $800 as an expense for the month, with the remaining $200 being recorded
as an asset because it has future economic value. It could be said that the
economic benefit of the photocopy paper stock has decreased as has the potential
60

Basic accounting concepts—Q&A

profit (equity) due to the printer. (This is because expenses reduced the revenue,
which reduced the profit for the owners: Revenue less Expenses = Profit.)

So while a cost is the calculation of the monetary value of the resources
sacrificed to acquire an asset, an expense is the calculation of the monetary
value of the costs that were actually used up in generating revenue. Being able
to separate the meaning of expenses and costs is a key component of the
matching principle in accounting.

C

ase study: cost and expense in John
Smith Accountants

The business John Smith Accountants takes out a 12-month insurance cover
for $12,000 at the beginning of the current month. The cost of insurance was
$12,000.
At the end of the first month, the company has used up 1/12thof the
insurance cover but still has the economic benefit of 11/12th of the insurance
cover. So, in accounting terms, at the end of the first month, the business will
record an expense of $1,000 but will record the remaining cost of the
insurance as an asset of $11,000.
So the cost of insurance consisted of unexpired and expired portions, with the
expired portion being the expense.
So while cost is defined as the monetary value of the utility (or benefit),
expense is defined as the monetary value of the utility that has already
expired in business activities, provided those activities are directed towards
generating income.
This means that a cost when utilised becomes an expense.
So, the $1,000 mentioned above would appear as Insurance Expense in John
Smith Accountants’ Income Statement (Statement of Financial Performance)
and the $11,000 would appear as Prepaid Expense in the Current Asset
section of the Balance Sheet (Statement of Financial Position).
The used, utilised or expired portion of the insurance cost was expensed while
the unused or unexpired cost of the insurance is recorded as an asset because
it has future economic value.

CONFUSION WITH THE TERMS COST AND EXPENSE IN ACCOUNTING
As mentioned previously, significant confusion surrounds the use and meaning
of the terms cost and expense. This is because not only do some accountants,
teachers and authors use the terms interchangeably, but also so does the
accounting system itself.
Let’s consider the 500-year-old and embedded accounting phrase cost of goods
sold. Is the term cost here consistent with the definitions we have given above.
Unfortunately, no. This is because cost of goods sold is an expense.

Unfortunately, we cannot prevent words used in common language changing in
meaning over time, even if the terms used in accounting do not.
Other cost terms that are really expenses include:





finance costs (expenses applicable to financing companies which offers loans
and deposit services)
cost of services (expenses relating to the costs of services that are direct
costs attributable to the revenue gained from providing services)
direct costs (expenses that can be linked directly to a good/service being
sold)
indirect costs (expenses that cannot be linked directly to a good/service
being sold)
fixed costs (expenses that do not change in relation to any changes in
business activity)
variable costs (expenses that change proportionally in relation to any
changes in business activity).

WHAT ARE OVERHEADS IN ACCOUNTING?
Overheads in accounting are important when trying to calculate product costs in
the manufacture of goods or the provision of services. Overheads are those
expenses that do not relate directly to a specific product and so must be shared
equitably between all products produced by the business. Typical examples of
overheads in accounting include rent, insurance and utilities. Overheads in
accounting may also be known as indirect costs, fixed expenses or burden cost.
BACKGROUND TO OVERHEADS IN ACCOUNTING
The concept of overheads is used in both the manufacturing and distribution/sale
of a product. In manufacturing, cost accountants use overheads to establish the
actual cost of a product. In selling, cost accountants use overheads to establish
the gross profit achieved and to calculate the contribution to overheads achieved
from the sale of products.
As explained in the matching principle, accountants try to match revenue with
the expenses incurred in earning that revenue for a given period. Cost
accountants try to do the same for a given product when calculating the actual
cost of the product. Some expenses can be easily linked to a product like the raw
materials that were used in the product’s production. Other expenses like
overheads cannot be easily matched with the production or sale of a particular
product because— like rent, insurance and utilities—they relate to all products
produced or sold.
Expenses that can be directly matched with a particular product would include
the raw materials, direct labour and specific expenses (like freight) used in the
production/sale of the product. There is no accounting standard that clearly
identifies what expenses should be classified as overheads because overheads
62

Basic accounting concepts—Q&A

vary from industry to industry. Most businesses separate their overheads from
their total expenses in order to help business decision makers in areas such as:



cost valuation of finished goods and work-in-progress
pricing
budgeting
the analysis of financial performance or profitability of products and cost
centres.

The Income Statement is an example of overheads being separated from the
total costs. For example, the direct costs (cost of goods sold) are subtracted from
the sales to calculate the gross profit. Overheads (indirect costs) are then
subtracted from the gross profit to calculate the net profit. Gross profit is an
important key performance indicator for most businesses when monitoring and
setting their selling prices.
Identifying and allocating overheads is an important aspect of a cost
accountant’s work. Overheads are often seen as a ‘bad’ expense because they
do not directly relate to the production/sale of the business products. Still, a
certain amount of overheads are needed to run a business effectively. Businesses
will generally, however, want to separate out the overheads and monitor them
carefully. The concepts of cost and expense are often used interchangeably in
this area of accounting.
TYPES OF OVERHEAD
Overheads are a special type of expense. In accounting, expenses are all the
resources consumed in pursuit of revenue. While direct expenses (materials,
labour) relate specifically to the products being produced and sold, overheads
(indirect expenses) are those expenses that relate generally to all products being
sold and do not naturally link to a specific product.
Typical types of overhead are detailed in Figure 19.

Administration/
Administration/
office
office salaries
salaries

Stationery
Stationery and
and
office
office expenses
expenses

Accounting/
Accounting/ audit
audit
fees
fees

Brand
Brand advertising
advertising
and
and some
some selling
selling
expenses
expenses (e.g.
(e.g.
travel,
travel,
accommodation)
accommodation)

Depreciation
Depreciation of
of
fixed
fixed assets
assets

Insurance
Insurance

Interest
Interest of
of loans
loans

Legal
Legal fees
fees

Rent
Rent

T
axes
Taxes

Figure 19 Typical types of overhead

64

Basic accounting concepts—Q&A

Utilities
Utilities costs
costs

DOUBLE-ENTRY BOOKKEEPING WITH DEBITS AND CREDITS
WHAT IS THE DOUBLE-ENTRY BOOKKEEPING SYSTEM?
The double-entry bookkeeping system is a set of rules for recording an entity’s
financial transactions. It ensures that a balance is constantly maintained
between the value of the entity’s assets and the claims over those assets by the
entity’s owners, funders and creditors. To achieve this, a debit entry and a credit
entry (of equal value) must to be made for every financial transaction. Hence the
double entry.
HISTORY OF THE DOUBLE-ENTRY BOOKKEEPING SYSTEM
The concept of double-entry bookkeeping dates back more than 500 years. As
described earlier in this e-book, Franciscan friar and mathematician Luca Pacioli
(1446–1517) was the first (in 1494) to publish details of a Venetian accounting
system that included double-entry bookkeeping as its core feature. The doubleentry bookkeeping system is still followed by accountants today.
ACCOUNTING PRINCIPLES AND PROCESSES DETAILED IN PACIOLI’S BOOK
The key accounting principles and processes detailed in Pacioli’s book are listed
in Figure 20 and explained in more detail in the text that follows.

A
y
fg
o
s
U
jT
D
le
d
n
c
a
iv
F
p
u
r
t
Y
b

Figure 20 Key accounting principles and processes detailed in
Pacioli’s book
Accounting cycle: This is the complete accounting process of recording and
reporting on financial transactions. It starts with the financial transaction being
recorded and ends with the summarising and reporting of all the financial
transactions in the financial statements of the business.
Use of journals and ledgers: These are two separate processes in the
accounting cycle.
 Journals (that is, Cash Receipts Journal) record financial transactions as they
happen, in a date and time order.
 Ledgers (that is, the General Ledger) then classifies and groups these
transactions into their relevant account type (for example, Sales account).
Debits and credits: Debits and credits are the essence of the double-entry
bookkeeping system. What it means is this: every financial transaction has two
sides when recorded in the accounting system. One side has a debit value and
the other a credit value. The value of debit side must always equal the value of
the credit side.
For example, when $200 of inventory is purchased for cash, the Purchases
account records $200 on the debit side and the Cash account records $200
on the credit side of the transaction.
Five account groups: There are only five account groups into which financial
transactions are classified and recorded. (These were explained in some detail in
a previous section of this e-book.) These account groups are listed in Figure 21.

Assets

Liabiliti
es

Owner'
s
equity

Revenu
e

Expens
es

Assets are items of value such as equipment.
Revenue comprises payments
received from
Liabilities are monies owned to non-owners suchcustomers or business activities such
as merchandise
as bank loans.
sales and interest from bank deposits.
Owner’s equity are monies owed to owners such
Expenses are costs incurred in
generating the revenue
as the initial capital invested.
such as electricity.

Figure 21 The five account groups
66

Basic accounting concepts—Q&A

Year-end closing entries: These are the adjusting financial entries that need to
be calculated at the end of an accounting period and included in the financial
statement of the period in review. These transactions ensure that the financial
statements accurately reflect the performance and position of the business (for
example, at the close of every financial year when the income tax needs to be
calculated).
Trial balance: This is an internal check conducted on data entries in the General
Ledger to ensure that the accounting process was accurately completed (that is,
that a debit value and an equal credit value were recorded for every transaction).
This accuracy is confirmed when all the ledger accounts of the business are
listed and the total of the accounts with debit balances equals the total of the
accounts with credit balances.

SUMMARY—DOUBLE-ENTRY BOOKKEEPING
SYSTEM
The key things to remember about the double-entry bookkeeping system are:
 For every financial transaction recorded in the accounts of a business, there is a
debit entry and a credit entry. Furthermore, the total of the entries on the debit side

must always equal the total of the entries on the credit side.
The double-entry bookkeeping system ensures that the accounting equation always
remains in balance. That is, the total value of the assets of a business must always

equal the total combined values of the liabilities and the owner’s equity.
Double-entry booking was first documented over 500 years ago, yet its principles

are still followed today.
Double-entry bookkeeping provides a means of self-checking the accounting
system records in the form of a trial balance.

WHY IS DOUBLE-ENTRY BOOKKEEPING SUCH A BIG DEAL?
Well, for a start, double-entry bookkeeping is one of the few professional
processing systems that is as relevant today as it was 500 years ago when first
documented by Pacioli. The entire accounting profession and the financial
reporting of the biggest companies on the planet today continue to apply
Pacioli’s system.
Some people say that the growth in business size and complexity in the world
today could never have happened without the double-entry bookkeeping system.
They argue that this is because the system informs managers continuously of
their venture’s financial status and solvency. It thus helps to ensure the venture’s
economic survival. As well, under this system, investors are offered the degree of
transparency necessary to encourage continuing investment in the venture.
Over the five centuries that it has been used, the double-entry bookkeeping
system has proven to be the best way to accurately collate, classify and report
on the vast number of financial transactions that take place in a venture.
Accurate financial reports are produced because the double-entry bookkeeping

system emphasises the importance of accuracy in recording every single
transaction (that is, for every transaction, the total of the debit amounts must
equal the total of the credit amounts). This approach ensures that the accounting
equation always remains in balance; that is:
Assets = Liabilities + Owner’s equity.

Perhaps, though, double-entry bookkeeping has made an even more significant
contribution to business (and the world of finance). For a start, it is a financial
recording system that makes errors and fraud more difficult to be undetected. It
also correctly represents the reality—that in a closed system (like finance, there
are always two sides to every transaction.

In other words, if an enterprise receives investment money, not only are the
enterprise’s assets increased (cash) but also the enterprise has an obligation
to investors (owner’s equity) of equal proportion.
Likewise, the bank secures the purchase of property, the enterprise increases
its assets (property) and liabilities (loan from the bank) in equal amounts:
hence the double-entry system.

Some have humorously suggested that if double entry (writing it down twice) is
good...then triple entry (writing it down three times) must be even better!
Hopefully, the previous paragraph explains that double-entry bookkeeping is not
just about writing something down twice, but rather recognising that when a
financial transaction in a venture takes place, two quite different components of
the venture’s financial status are affected (not just one).
The double-entry bookkeeping allows all stakeholders in a venture to get an
accurate picture of the financial performance (Profit and Loss Statement) and
financial position (Balance Sheet) of the venture at any time. Such knowledge of
a venture’s financial sustainability and strength allows stakeholders to make
informed decisions about the efficient and effective allocation of scarce
resources—the fundamentals of sound business practice. This helps, in turn, to
ensure that businesses remain viable and that the most successful ventures
attract the appropriate amount and quality of resources.
Double-entry bookkeeping is such a big deal because, arguably, we may not
have had the Industrial Revolution nor our current global shareholder-based
corporations and stock exchanges without a financial system like it. The
successful growth of corporations could not have been sustained over time
without being underpinned by such a sound financial system.
HOW IS THE ACCOUNTING EQUATION FORMED?
The accounting equation is an integral part of the double-entry bookkeeping
system. Understanding this will help you to understand one of the first principles
on which accounting is based.

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Basic accounting concepts—Q&A

THE BUSINESS AS A SEPARATE ENTITY
A business is created to make money for the owners. In accounting, when a new
business is formed, a separate accounting entity is created. From this point on,
the financial recording and reporting are done so from the perspective of the new
business.

At this point, the new accounting entity owns nothing and it owes nothing.

This situation changes when funds are provided to the business by the owners in
the form of capital investment. Other funds may also be supplied to the business
by lenders (that is, bank loans) and/or creditors. Given access to these funds, the
business—as a separate accounting entity— can then buy assets which will be
used to make profits for the owners. These funds provided by the funders could
be used/employed by the business to buy land, buildings, plant, equipment,
merchandise inventory (goods to sell) or simply kept as cash reserves to provide
the new entity with working capital (money to pay bills with). These items are
categorised as the assets of the business.
While the business has control over the assets, it actually ‘owns’ nothing for its
own benefit. If all the assets were sold and business activities ceased, the
liabilities (banks and creditors) would be paid out in full first. Whatever money
was left over from the sale would be then given to the owners. This would leave
the business in the same position as it started: owning nothing and owing
nothing.
THE FIRM AS A SEPARATE ACCOUNTING ENTITY
Remember, a business has nothing when it is created. So, the value of the funds
that the business uses/employs will be equal to the value of the funds provided
to it. In this position, the business, as a separate accounting entity, now owes
money to the funders (that is, owners, banks and creditors) but has been given
control over (or ‘ownership’ of) assets that it has purchased. The total value of
the assets then must be the same value as the funds provided to the business.

... the value of
funds
provided to
the business

The values of
funds the
business uses
equals ...

Figure 21 A financial balance of business funds
DIFFERENT BUSINESS FUNDERS

Looking again at the business funders, there is a natural category break up, as
shown in Table 8. The accounting system treats these funding providers
differently: funds provided to the business by the owners in the first group is
called owner’s equity and the funds provided by non-owners in the second group
are called liabilities.

Table 8 Different business funders
Type of funder

Business investment strategy

Owners

Owners invest long term in the business to
secure unlimited profit potential and to
control the business entity’s activities.

Non-owners (such as banks and creditors)

These shorter term funders are not
provided with a profit share or control over
the business. They will, however, have an
agreement with the business to repay the
monies owed to them in their capacity as
debt funders of the business.

The formula known as the ‘accounting equation’ recognises the natural split in
the type of funding provider, and that all the assets of a business are financed by
the funders.
WHAT ARE DEBITS AND CREDITS IN THE BOOKKEEPING SYSTEM?
The terms debit and credit have many different meanings in our society. The
meaning of the term debit in the bookkeeping system has no relationship with
the term debt, which means ‘money that is owed to someone else’. Below, by
way of example, are some examples of different meanings for the term credit.
Note that all of these meanings are different from the meaning of the term credit
used in the bookkeeping system:

The word
credit

70

Recognition for
past
achievements:
She already
had several
performances
to her credit.

Basic accounting concepts—Q&A

Grading a level
of academic
achievement:
You received a
credit on that
exam paper.

Requirement to
identify a
source of
information:
You must credit
the original
author of that
work.

Taking goods
now and paying
for them later:
You can have
these goods on
credit.

Recognition for
work:
He gave her
credit for
trying.

Figure 22 Different (non-accountancy) meaning of the word credit
The important thing is to understand the terms debit and credit, as used in the
bookkeeping system:

debit does not mean ‘– ’, ‘negative’ or ‘bad’
credit does not mean ‘+’, ‘positive’ or ‘good’.

The terms debit and credit are used in the bookkeeping system simply as a way
to classify financial transactions. This method provides a way of recording the
changing values in the financial accounts of a business caused by monetary
transactions. It also properly captures, reflects and records the flow of economic
resources from a source to a destination.
At the same time, the debit and credit method of classification and recording
keeps the accounting equation in balance for each new entry; that is:
Assets = Liabilities + Owners Equity.

If you do not clearly understand the how the terms debit and credit are used in
the bookkeeping system, you will find bookkeeping impossible to use and apply.

To make it clear in accounting, Dr [for debit] and Cr [for credit] are used to
show that we are using the meaning of these terms as used in the
bookkeeping system.

ORIGIN OF THE TERMS DEBIT AND CREDIT IN THE BOOKKEEPING SYSTEM
When Pacioli first recorded the double-entry bookkeeping system in 1494, he
used the Latin terms credre and debere. The concept of negative numbers was
not generally accepted in mathematics in Europe when he first codified the
double-entry bookkeeping system. This may explain why he used debit and
credit rather than + and –. Pacioli was so convinced of the duality of financial
transactions that he declared that no bookkeeper should go to sleep at night
unless the total of the debit equalled the total of the credit!
In the 1500s, English translators described these Latin terms (credre and
debere ) as credit and debit, respectively. From this, the convention has grown to

use Dr (for debit) and Cr (for credit) in the bookkeeping system. (There is no ‘r’ in
the English word debit but there is an ‘r’ in the Latin term debere.)
The Latin term credre means to entrust something; debere means to owe
someone.
For example, if Person (A) entrusts USD$100 to Person (B), Person (B) owes
USD$100 to Person (A).
This example illustrates that financial transactions always have two sides.
Similarly, economic resources flow or transfer from a source to a destination.
Pacioli used the terms credre and debere to describe this principle: that every
financial transaction has two sides, with the source recorded as a Cr, or Credit,
and the destination recorded as a Dr, or Debit.
Traditional definitions of the concepts of debit and credit (in the bookkeeping
system) are as follows:

debit is one side of the entry in the bookkeeping system that is placed on the
left side of a T account
credit is the other side of the entry in the bookkeeping system (the other side
of the financial transaction) that is placed on the right side of a T account.

While this is not a very informative definition of the terms, it is the one you are
most likely to find in dictionaries.
In essence, the debit and credit method used in double-entry bookkeeping
captures and records the flow of economic resources in a financial transaction as
economic resources transfer from a source (credit) to a destination (debit). The
method also ensures that the accounting equation, which is the foundation stone
on which the entire double entry bookkeeping system is built, remains in balance
after each transaction is recorded.

SUMMARY—DEBIT AND CREDIT
The key things to remember about the debit and credit are:
 The terms debit and credit have many different meanings in English.
 In the 500-year-old system of double-entry bookkeeping, the terms debit and credit
are used to classify and record financial transactions. Their meaning comes from
the Latin terms originally used for them: debere (which means to owe someone)—
from which we get debit— and credre (which means to entrust something)—from

which we get credit.
The double-entry bookkeeping system ensures that the accounting equation always
remains in balance—that is, the total value of the assets of a business (or other
entity) must always equal the total combined values of the liabilities and the

owner’s equity.
Every financial transaction has two sides: the source of the economic resource and
the destination of the economic resource.

72

Basic accounting concepts—Q&A

The source of an economic resource is recorded as a credit or Cr, and the

destination of the economic resource is recorded as a debit or Dr.
The debit and credit method of classification and recording keeps the accounting
equation in balance.

HOW DO YOU APPLY DEBITS AND CREDITS IN BOOKKEEPING?
Debit and credit are the key elements of the double-entry bookkeeping system
which records the transfer of economic resources from the source (credit) to the
destination (debit).
RECORDING PERSPECTIVE
To record a financial transaction in a bookkeeping system for a business, you
need to understand the perspective of the recording entity. Each business
records financial transactions from the perspective of their own business.
For example, when Business A purchases stock from Business B, Business A
records an increase in Purchases and a decrease in Cash.
Business B records the same financial transaction quite differently. From the
perspective of Business B, there has been an increase in Sales and an
increase in Cash.
So, the first thing to determine when using the double-entry bookkeeping system
is: from whose perspective are you recording this financial transaction? In whose
books are you recording the financial transaction?
The next step is to follow the process outlined in Table 9.

Table 9 Steps to determine the debit and credit sides of a
financial transaction
Step
numb
er

Description of action
required

Example

1

Determine which ledger
accounts are involved in the
financial transaction. (There
should be at least two.)

A business uses $100 cash to pay an
electricity bill. This financial transaction
would involve the (1) Cash account and the
(2) Electricity account.

2

Identify to which account group
the accounts belong. (Each
account must belong to one of
the five detailed in Table 15
below.)

Looking at Table 15, we see that the Cash
account belongs to the Asset group and the
Electricity account belongs to the Expenses
group.

3

Identify the change in the
accounts. Has it increased or
decreased?

The Cash account has decreased by $100
and the Electricity account has increased by
$100.

4

5

Now apply the logic of the
(Dr/Debit) (Cr/Credit) in Table 17.

If an Asset decreases, you (Cr/Credit) it. If
an Expense increases, you (Dr/Debit) it. The
Cash account is an Asset so we (Cr/Credit)
it; the Electricity account is an expense so
we (Dr/Debit) it.

Make sure the (Dr/Debits) equal
the (Cr/Credits).

The Cash account $100 (Cr/Credit) = the
Electricity account (Dr/Debit).

ACCOUNT GROUPS
There are only five account groups in the bookkeeping system. These groups are
broken down into smaller sub-accounts.

Table 10 Account groups
Account group

Description

Example

Assets

Items of economic value
that the business legally
controls

Cash, equipment, land,
buildings

Liabilities

Monies owed by the
business to non-owners
(that is, bank loans,
creditors)

Bank loans or creditors
(suppliers who have yet to
be paid for the goods and
services they supplied to
the business)

Owner’s equity

The value of the business
owed to the owners (that is,
initial capital, retained
profits)

Includes the initial capital
investment and the retained
earnings. Calculated by
subtracting the value of the
liabilities from the value of
the assets.

Revenue

Monies paid by customers
for the goods, services and
investment activities of the
business

Merchandise sales, fees
charged, interest on bank
deposits

Expenses

The costs incurred in
earning the revenue

Cost of sales, overheads
such as electricity and rent,
financial expenses

Table 11 Dr/Debit and Cr/Credit sides of a financial transaction
recorded in the bookkeeping system
When you INCREASE the
$ amount in this account
group, you ... it

When you DECREASE the
$ amount in this account
group, you ... it

Asset

(Dr /Debit)

(Cr/Credit)

Liability

(Cr /Credit)

(Dr/Debit)

Account group

74

Basic accounting concepts—Q&A

Owner’s equity

(Cr/Credit)

(Dr/Debit)

Revenue

(Cr/Credit)

(Dr/Debit)

Expenses

(Dr/Debit)

(Cr/Credit)

RECORDING PERSPECTIVE REVISITED
One (Cr/Credit) that worries many students is the one that appears on their
statements from the bank. They have identified that the Cash at Bank account as
an asset for their business. Now according to Table 11, when you increase an
asset you (Dr/Debit) it.

So then they ask: Why does my statement from the bank show a
(Cr/Credit) balance when I have money in it and why are my deposits
treated as a (Cr /Credits)?

The answer is a basic one of perspective. Remember, each business records
financial transactions from its own perspective. Think about the deposited
financial transaction from the bank’s perspective. How does the bank view the
money that has just been deposited? Whose money is it?
That’s right, it is yours!
So the deposit is recorded from the bank’s perspective as a liability (money owed
by the bank to you) because when money is deposited into a customer’s
account, the bank’s liability increases.
This is why (using Table 11) banks will (Cr/ Credit) a customer’s account when
the customer deposits money into it and why a (Cr /Credit) balance on the bank
statement represents an asset to the business. The bank and the business each
record the same financial event— but from their own different perspectives.
HOW DO YOU MAKE SENSE OF DEBITS AND CREDITS IN ACCOUNTING?
CONFUSION ABOUT THE TERMS DEBITS AND CREDITS
The different between debits and credits is possibly one of the most difficult
concepts to understand in accounting. This is due in large part to the additional
meanings that have been added to these terms from the ones that were first
coined some 500 years ago in Venice.
The Latin text that described the Venetian accounting system was translated into
English in the 16th century. At that time, the Latin terms debere and credre were
translated into the words debits and credits (respectively) in English. Now while
debits and credits have a unique meaning in accounting, many other different
meanings have been given to these words in the English language.
It is these new meanings that cause the most confusion for students of
accounting. For example, the term credit has more than 10 different meanings in
English. Some of these are shown in Figure 24 below.

T
To
o ascribe
ascribe an
an
achievement
achievement to
to
someone
someone

T
To
o obtain
obtain goods
goods and
and
services
services before
before
paying
paying for
for them
them

The
The money
money lent
lent or
or
made
available
made available
under
under a
a credit
credit
arrangement
arrangement

Acknowledgement
Acknowledgement of
of
a
grade
level
in
an
a grade level in an
examination
examination

Source
Source of
of pride
pride that
that
reflects
reflects well
well on
on
another
another person
person or
or
organisation
organisation

Figure 23 Some different (non-accounting) meanings of the term
credit in English
The accounting meaning of the term credit should not be confused with any of
the above meanings. Nor should the term debit be equated with the concept of
debt. Furthermore, the terms debit and credit in accounting have no relationship
with the concepts of good and bad, nor positive and negative.

T

he first step to making sense of
debits and credits in accounting is
to understand these terms only
within their accounting meaning.

The definition of debits and credits as used in accounting is as follows:
… [it is] a classification method that is used in accounting to record the
financial transactions of a business. The debits and credits method records
the flow of financial resources from a source (credit) to a destination
(debit). Every accounting transaction in a business involves this flow of
financial resources.
The uniqueness of the debit and credit classification method is found in the fact
that while various individual account values may change with each new
transaction, the accounting equation that underpins the accounting system (as
stated below) …
76

Basic accounting concepts—Q&A

Assets = Liabilities + Equity

… always remains in balance.
RELATIONSHIP BETWEEN THE ACCOUNTING EQUATION AND DEBITS AND
CREDITS
The accounting equation reflects the economic reality of a business.
Let’s recall again why a business is created: it is created by owners to make a
profit for the benefit of owners. When that business is formed by the owners, the
accounting system sees the new business as a separate entity that is distinct
from the owners.
This means that the accounting system will record financial transactions from the
point of view of the business entity not the owner.

KeyFACTS

From an accounting point of view, when a new business is first formed by the owners, the new


business has zero assets.
The only way a new business can get to control assets is if the assets are provided by others.
Others ( in this case) may be external funders like banks who lend money to the business

(liabilities) or internal funders like owners who invest money in the business (owner’s equity).
Because all the assets of a business have been supplied by ‘others’ (namely, through liabilities and

owner’s equity), these ‘others’ have an economic claim over that business.
That claim is the equivalent of the value of the total assets that the business controls.

Hence, we have the founding principle underpinning the accounting equation:
Assets = Liabilities + Equity

It was obvious to the medieval Venetian merchants that a system was needed to
record the impact of the numerous financial transactions on a business without
upsetting this underlying economic principle explained by the accounting
equation.
So—you guessed it —they came up with the concept of classifying individual
transactions as debits and credits, although they referred to them using the Latin
terms: credre and debere, respectively.
This debit and credit classification method that the Venetians invented to record
individual financial transactions ensured that the fundamental accounting
equation, explained above, always remained in balance.
The debit and credit classification method achieves this by applying the rules
outlined in Figure 24.

Left side of the accounting equation
Changes in value to accounts on the left side of the accounting
equation (assets) will be a debit if the account values increase and a
credit if the account values decrease.

Right side of the accounting equation
Changes in value to accounts on the right side of the accounting
equation (liabilities and owner’s equity) will be a credit if the account
values increase and a debit if the account values decrease.

For each transaction ...
For each transaction, the total of the debits must equal the total of
the credits.

Figure 24 The debit and credit rules in accounting
WHY IS REVENUE RECORDED AS A CREDIT IN ACCOUNTING?
Revenue is treated as a credit in accounting because it is a sub-category of
equity, and equity accounts in accounting are credited when they increase.
BACKGROUND TO REVENUE IN ACCOUNTING
The accounting equation is:
Assets = Liabilities + Owners equity

Owner’s equity includes such accounts as Capital, Retained Earnings and Current
Earnings (also known as Net Profit). Current Earnings in the equity accounts is
the final result taken from the Income Statement and is calculated by the
formula:
Net Profit = Revenues – Expenses

According to the debit/credit rules below, increases in the equity accounts are
credited. So because an increase in revenue will increase the Net Profit, it must
78

Basic accounting concepts—Q&A

also increase the equity account called Current Earnings in the Balance Sheet.
Because the double-entry bookkeeping system requires that increases in equity
are credited, it follows that the revenue account must be credited when it
increases as well.
DEBIT AND CREDIT RULES
Another way to look at it is to understand that whenever revenue is generated,
assets are always affected.
For example, if a business sells goods in exchange for cash, assets (Cash or
Accounts Receivable) will increase. However, to maintain the basic
accounting equation, either the liability or the equity accounts must
increase by an equal amount. Now since no debt or liability to an external
entity is created when we sell goods, it must be the equity account that
increases. So, an increase in revenue must lead to an increase in equity.
It needs to be noted that sometimes a business will receive assets from lenders
(by way of loans) or from its owners (by way of capital investments). The receipt
of such assets by the business is not treated as revenue but rather as:
 assets with a corresponding liability in terms of loans, and
 assets with a corresponding owner’s equity in terms of capital investments.

O

nly those assets received from
customers or clients in exchange
for goods or services represent
revenue.

CONFUSION RELATING TO RECORDING REVENUE AS A CREDIT IN
ACCOUNTING
Many students of accounting are confused by treating revenue as a credit when
recording transactions in the accounting system. This is typically because
students associate debits as being good for business and credits as being bad for
business.

They perceive that receiving cash is good— and it is treated as a debit— so
why isn’t making sales (revenue), which is also good for business, also
treated as a credit?

To clarify, we need to look at these transactions from the point of view of the
business. Remember all accounting transactions are recorded from the
perspective of the business (that is, the business as a separate entity concept).
In a way, the business looks at all transactions in a completely neutral way.

There is no ‘good’ or ‘bad’ from the point of view of the business because, in
reality, it ‘owns’ nothing and does not benefit from the profits generated.

The business, in accounting terms, is simply a vehicle whose primary goal is to
make profits for the owners. Remember that it is the business owners (equity)
and other parties (liabilities), together, that have a 100% claim over the assets of
the business (that is, if all the assets of the business were sold, the liabilities
would be repaid and the remaining money would go to the owners, leaving the
business entity with what it started with—nothing).
This is the underpinning concept behind the accounting equation:
Assets = Liabilities + Owners equity

So, from the business perspective, revenue is considered potential profit. By
recording revenue as a credit (increased equity), the business is acknowledging
that the revenue potentially belongs to the owners.

In other words, the revenue received by the business increases the claims of
the owners over the assets.

In keeping the accounting equation in balance we will then increase assets (cash)
with a debit entry and increase equity (revenue) with a credit entry. The revenue
(credit entry) belonging to the owners of the business is reduced by (debit entry)
the costs associated with the activities needed to earn that revenue (that is,
expenses).
THE FINANCE SYSTEM
The final concept you need to fully understand to make sense of debits and
credits in accounting is to understand how this classification method relates to
the finance system.
Finance is a closed system. This means, that money does not just appear in your
bank account from time to time, nor does it just disappear into thin air.

I

n finance there is always a source and a
destination of funds—you cannot have
one without the other. In other words
financial resources ‘flow’ from one place
to another.

The debits and credits system completes this record of financial funds
movement.

The credit side of the transaction (or the credit entry) represents the
withdrawal from the source.
The debit side of the transaction (or the debit entry) represents a deposit in
the transaction’s ultimate destination.

80

Basic accounting concepts—Q&A

So, this classification system of debits and credits in accounting is very closely
related to the economic concept of duality in financial transactions (that is, for
every financial transaction, the debit entries must equal the credit entries.

The reason for this is that in a closed system there must be a source and
destination of an equal amount for each transaction.

Figure 25 Understanding debit or credit in accounting: the
decision tree
82

Basic accounting concepts—Q&A

While it is best to determine the debits and credits classification via the decision
tree shown in Figure 25, as a general rule, the source of a transaction is credited
and the destination is debited.
HOW CAN I BETTER UNDERSTAND DEBIT AND CREDIT?
It is the personal view of the author that fully understanding the debit and credit
concept in accounting is near impossible when you are first confronted with it.
Learning how to apply the debit and credit concept is far easier. You can be an
outstanding bookkeeper or accounting student by just learning the application
rules.
The author of this e-book has taught accounting students for many years and
‘kept the books’ for his own businesses. But he says he never really understood
the rationale behind the debit and credit concept in accounting. In his opinion,
the dictionary definitions, as detailed below, do very little to help that
understanding:
• Debit: an entry in the left-hand column of an account (‘T’ account) or the lefthand side of the Balance Sheet
• Credit: an entry in the right-hand side of an account (‘T’ account) or the righthand side of a Balance Sheet.
Adding to the confusion, is the fact that the debit and credit concept and
terminology was developed over 500 years ago, with the first accounting
textbook being written in Latin. English as a language has morphed substantially
over the past five centuries since the Venetian method of accounting was first
translated.
Many different meanings have been producing for the terms debit and credit
besides the meanings intended in accounting. Is it any wonder that the debit and
credit concept is a difficult one for students living in the 21st century to fully
grasp!
The following tips may help students trying to better understand the debit and
credit concept.

1.

Do not link the meanings of the terms debit and credit in accounting with any
other meanings of these words in everyday English.

2.

Debit and credit in accounting do NOT mean ‘plus and minus’, ‘good and bad’
or ‘increasing and decreasing’, respectively.

3.

The accounting terms debit and credit acknowledge and record the duality of
financial transactions. In other words, finance is a closed system; money just
doesn’t appear or disappear.
For example, if money is received by a business, it must have been given by
others and vice versa. (So, two entries of equal amounts are required to

record the transaction and the transaction’s effect on financial
resources.)This means that credit = the source of funds and debit = the
destination of funds

4.

Debit and credit are accounting concepts that capture in the books of a
business the flow of economic resources from a source (credit) to a
destination (debit).
For example, take a situation where a bank provides funds to a business as
a loan. The bank loan is the source of funds so it is recorded as a credit. The
Bank account of the business is the destination of the funds so it is recorded
as a debit.

5.

Applying this principle will help you identify the ‘credit = source’ and ‘debit =
destination’ of every transaction.
Debit and credit is a recording system that ensures that the accounting
equation always remains in balance after each and every transaction; that is:
Assets = Liabilities + Equity
The Venetian merchants who developed this system 500 years ago decided
that increases on the asset side would be called a debit and increases on the
liabilities and owner’s equity side would be called a credit—with
corresponding debit and credit entries for decreases.
If every transaction is recorded with an equal amount for the debit and the
credit, the accounting equation will always remain in balance.
A balanced accounting equation allows business managers to accurately
calculate and split the claims that all parties have over the assets of the
business (liabilities = external parties such as banks and suppliers; owner’s
equity = owners).

6. Debits and credits are always recorded from the perspective of the business.

This is why if the Cash at Bank account in the books of the business is a debit
balance then the bank balance on the Bank Statement will be a credit
balance.
This is because while cash is an asset to the business (an item of value that
the business owns), it is a liability for the bank (money owed to a customer).

84

Basic accounting concepts—Q&A

THE ACCOUNTING PROCESS
WHAT IS THE ACCOUNTING CYCLE?
The accounting cycle is the sequence of accounting procedures that is repeated
for each reporting period, where the closing balance of the previous period
becomes the opening balance of the new period.
ACCOUNTING CONCEPTS AND THE ACCOUNTING CYCLE
When reporting on the financial performance and financial position of a business,
accounting assumes that the business is a going concern—that it will continue to
trade indefinitely.
But stakeholders in the business (that is, people such as managers, owners and
financiers) need information about the business in much shorter periods so that
they can make informed decisions about their involvement with the business.
Different stakeholders have different reporting needs, and different periods by
which they need information.
For this reason, accounting has developed another concept called the
accounting period or time period. The accounting period concept allows for the
financial reports of the business to be made available to stakeholders in shorter
periods of time.
The common accounting periods accountants use are:



monthly
quarterly
half-yearly
annually (yearly).

It is these shorter and continuing time periods of reporting that have created the
accounting cycle.

KeyFACTS

The accounting cycle is the series of accounting activities that occur within a specific accounting


period.
This series of activities is repeated for each accounting period of time.
The accounting period starts with account balances taken from the Statement of Financial
Position (Balance Sheet) and ends with new balances on the same statement after all the
transactions for the period have been properly accounted for—this makes up the accounting

cycle.
The Statement of Financial Position (Balance Sheet) is the detailed summary of the accounting
equation, where the recorded value of the assets of the business is equal to the combined totals of
its liabilities and the equity (capital investment) of the owners.

THE BASIC ACCOUNTING CYCLE
The basic accounting cycle consists of a number of elements, as detailed in
Figure 27.

1:
1: Start
Start

2:
2:

5.
5. End
End

4.
4.

Statement
Statement
s
s

Transactio
Transactio
ns
ns

3.
3.

Adjustmen
Adjustmen
ts
ts

Key

1.

The accounting cycle starts with the balances from the previous accounting period’s
permanent ledger accounts (taken from the Statement of Financial Position (Balance Sheet)).

2.

This step records all financial transactions that occurred in the current period into the books or
accounting system.

3.

This step sees adjustments made at the end of the current period (that is, to match the
expenses with the revenues generated and make adjustments to inventory and accounts
receivable).

4.

The financial statements produced include the Statement of Financial Performance (Income
Statement or Profit and Loss Statement). The ‘bottom line’ or profit from this statement
becomes the current earnings in the owner’s equity section of the Statement of Financial
Position. (This is because the profits of the business belong to the owners of the business.)

5.

The current accounting period ends with the new balances for the permanent accounts
detailed in the Statement of Financial Position (Balance Sheet). These closing balances for the
current period now become the opening balances for next period’s accounting cycle.

86

Basic accounting concepts—Q&A

Figure 27 Steps in the accounting cycle (continued)
•Prepare the Financial Statements. The two main financial
statements created are the Statement of Financial Performance
(Income Statement) and the Statement of Financial Position
(Balance Sheet).
•Prepare an adjusted trial balance. As part of the 10-column
worksheet, a trial balance will be prepared of the adjusted entries
only. If these are in balance (debit entries = credit entries), a new
adjusted trial balance is compiled as a basis for the financial
statements.

Step
9
Step
8

Step
6

•Prepare a trial balance.**

Step
7

•Calculate and make adjusting entries in the journal..#

•Post the details from the journals to the general ledger where all
the accounts are kept. Summary details are transferred (posted)
from the journals to the general ledger. Ledgers are kept by
account types (for example, Electricity, Cash, Accounts Payable).

•Record the transaction details into the appropriate journal.*

•Analyse and classify the transaction. Determine (i) the transaction
amount in monetary terms (ii) the ledger accounts affected by the
transaction and (iii) the account(s) to be debited and the account(s)
to be credited.
•Prepare the source documents for the transaction (that is, receipts,
invoices and cheques).

•Identify that a financial transaction or event has occurred.

Step
5
Step
4
Step
3
Step
2
Step
1

There are a number of steps in the accounting process. Because these steps are
repeated every accounting period they are also referred to as the accounting
cycle. These steps are detailed in Figure 28.
WHAT ARE THE STEPS IN THE ACCOUNTING PROCESS?

Figure 26 Elements of the accounting cycle

• Close the temporary accounts and transfer the balances to
owner's equity.# #

Step
10
Step
11

• Prepare the after closing trial balance. The final trial
balance is calculated after the closing entries from the
temporary accounts are made. At this point, only the
permanent accounts (Assets, lLabilities and Owner's equity)
that make up the Statement of Financial Position appear in
the after closing trial balance.

Step
12

• Reverse the accrued journal entries. The accruals recorded
on the last day of the previous accounting period must be
reversed on the first day of the new accounting period. This
is done to avoid the possibility of double entries when the
actual transaction (that had previously been accrued)
occurs in the next period.

*

A journal records the debit and credit details of a transaction in a chronological (date and
time) order. It also records the account name and the account number allocated by the Chart
of Accounts. Common journals are: Cash Receipts Journal, Cash Payments (disbursement)
Journal, Sales Journal, Purchased Journal and General Journal.

**

The trial balance lists and summarises all the General Ledger account balances to ensure that
the total of the debit balances equals the total of the credit balances. The sum total is not
meaningful. The important thing is that the totals of both columns (debits and credits) agree.
A balanced trial balance ensures that there were no recording errors. However, it does not
guarantee that the amounts are correct (that is, the right amounts may have been posted to
the wrong accounts). Correct the discrepancies identified from trial balance if required.

#

Adjusting entries need to be made at the end of each accounting period to match the revenue
earned in that period with the expenses incurred in earning it. These adjustments are called
accruals and deferred items in accrual accounting. These entries are also journalised and
posted to the General Ledger. The source document used to record adjusting entries is
typically a 10-column worksheet.

## Temporary accounts are cleared by transferring the amounts in them to the Income Summary
Account. This account is part of the retained earnings as reported in the owner’s equity section
of the Statement of Financial Position. Temporary accounts are the revenue, expense,
dividend, owner’s drawings accounts as well as other gains or losses made. These temporary
accounts begin the next accounting period with a zero balance.
(a) Steps with text shaded green are those steps taken (sequentially) at the start of the
accounting period.
(b) The step with text shaded blue is the step taken at the start of the next accounting period.

Figure 28 Steps in the accounting cycle (continued)
WHAT ARE SOURCE DOCUMENTS IN ACCOUNTING?

88

Basic accounting concepts—Q&A

Source documents is an accounting term; the term describes the original records
that contain the details substantiating the financial transactions entered into the
internal accounting system of a business. Typical source documents include sales
invoices, cash receipts, cash register slips, credit notes and deposit slips. Source
documents provide the documentary evidence of a business deal or accounting
event. Source documents are a critical part of an audit trail that establishes the
authenticity and tracking history of an accounting system’s financial records.
BACKGROUND TO SOURCE DOCUMENTS IN ACCOUNTING
All manufacturing systems are identified by their three key elements: inputs,
processes and outputs.

Outputs are the financial statements
and reports produced for business
decision makers.

In accounting:

Inputs are the data taken from
source documents generated
whenever financial transactions
occur.

The process is known as the doubleentry bookkeeping system, which
accurately captures and categorises
inputs so that they can produce
meaningful reports.

Inputs
Proces
s
Outpu
ts

Figure 28 Relationship between inputs, process and outputs in
accounting

KeyFACTS
Source documents:


are the essential inputs that provide the details required by internal accounting systems
assist in the internal control of the resources of the business
ensure that there is documentary evidence to support the purchase or sale of items of value and

the receipt and payment of money
provide the evidence or proof that a transaction has occurred, which makes it difficult for people

to misappropriate or steal cash or other resource items from the business
are required by both company and tax auditors.

The details from the source document should be recorded in the appropriate
accounting journal as soon as possible after the transaction has occurred. After
recording the details, all source documents should be filed in a document system
from which they can be readily retrieved at a later date if required.
Government tax law requires that these source documents are kept for a number
of years (typically from 3 to 7years depending on the country).
In the event of an audit, these source documents should support the data
recorded in the accounting journals and the General Ledger by providing an
indisputable audit trail from source documents to journals to General Ledger to
trial balance to financial statement.
A source document should describe all the key aspects of the transaction such
as:





names and addresses of the entity buying/selling the good/services
date when the transaction occurred
amount of the transaction
amount of any taxes
nature and purpose of the transaction (that is, a description)
special terms and conditions of the transaction (that is, any discount, payment
and delivery details)
• authorised signature for payment or acceptance of goods/services.
COMMON SOURCE DOCUMENTS
Source documents are generally related to the particular activity as shown in
Table 12 below.

Table 12 Common source documents for business activities
Business activity

Source documents

Cash received by the business

Cash receipt (copy), cash register tapes, bank
statement, bank deposit slip

Cash paid by the business

Cheque butt, ATM or EFTPOS receipt, bank statement,
payroll records, cancelled cheque

Petty cash payments

Petty cash voucher, cash receipts

Business giving credit to
customer

Business invoice (copy), business credit/debit note

Business receiving credit from
a supplier

Supplier’s original invoice, supplier’s statement,
supplier’s debit/credit note, credit card statement and
receipts

Any activity not generating a
document

Memorandum

The various source documents are described below:
• Sales invoice: used to record the goods/services details and the amount owing
to the business by a customer. The original goes to the customer with the
copy held by the business.
• Purchase invoice: used to record the goods/services details and the amount
owing by the business to suppliers. The original is provided by the supplier to
the business.
• Credit note: used by a business/supplier to correct an overcharge in the invoice
• Debit note: used by a business/supplier to correct an undercharge in the invoice
• Petty cash voucher: used as evidence of cash payment to another party
• Cheque butt/stub: used to record the amount paid on a particular numbered
cheque to the payee
• Cash receipt: used to acknowledge money received from customers and cash
paid to suppliers
• Bank statement: used as a summary of cash movements through the business
bank account
• Memorandum: used as a note explaining a transaction if no other documents
exist
• ATM receipt: used as evidence that money was taken from the business bank
account via the ATM
• EFTPOS receipt: used as evidence of a purchase from a supplier using the
EFTPOS system.
• Supplier’s statement: issued by suppliers in regard to invoices unpaid at a
particular date
• Cash register tape: automatically generated by the cash register and provides
an unbroken sequence of cash transactions and events
• Bank deposit slip/form: used to record the monies deposited in the bank. The
original is provided to the bank with the copy retained by the business.
• Credit card receipt: used to verify transactions on a credit card statement that
relate to the business
• Payroll record: used to verify payments made to employees in the form of
salaries and wages and includes timesheets
• Cancelled cheque: used as an internal control to ensure that all cheques can
be accounted for.

SUMMARY—ACCOUNTING SOURCE DOCUMENTS

In summary, accounting source documents:
 provide evidence of the transactions recorded in the accounting system in the event
of an end-of-year financial audit

satisfy the requirements of the tax law in regard to proof of income and
expenditure.

WHAT IS THE CHART OF ACCOUNTS IN ACCOUNTING?
The Chart of Accounts is a structured list of all the accounts in the General
Ledger. These accounts are created by businesses to record the details of their
financial transactions in the accounting information system.
The Chart of Accounts groups and indexes the accounts by name and identifying
codes according to the structure of the financial reports (that is, Assets,
Liabilities and Owner’s equity for the Balance Sheet, and Revenue and Expenses
for the Income Statement).
A Chart of Accounts with its structured identifying codes provides accounting
staff with an efficient and effective tool when processing financial data in
computerised accounting programs.
BACKGROUND TO THE CHART OF ACCOUNTS IN ACCOUNTING
Financial data is processed in the accounting information system in two stages,
described below.
FIRST STAGE
The financial data is recorded in the journals in date and time order from the
details found on the transaction source documents. This financial data is
recorded in the journals according to the debit/credit principles of the doubleentry bookkeeping system.
SECOND STAGE
All the journalised financial data is then posted (transferred) to ledger accounts
in the General Ledger according to its type (that is, all the sales data from the
journals is posted to the Sales account and all the purchases details are
transferred to the Purchases account). These accounts receive both debit and
credit entries from the journals, creating a debit or credit balance at the end of
an accounting period. These balances are then used to prepare the financial
statements.
One of the primary purposes of accounting is to provide financial information in a
meaningful way so that decision makers can make informed decisions about
financial matters. To provide the information required by the many internal and
external stakeholders of the business, accountants will create hundreds of
accounts that capture, summarise and report on every aspect of the business. It
would be highly inefficient and ineffective if these accounts were not grouped
and indexed in some logical order. This logical order forms the basis of a Chart of
Accounts.

CHART OF ACCOUNTS STRUCTURE
Given the diversity of businesses operating in today’s world, it would be
impracticable to have one standard Chart of Accounts stipulated for use. So,
each business must create and index accounts according to the information
needs of its internal and external stakeholders.
The widespread use of computers has also had an impact, with accounts given
short identifying codes to make data entry more accurate and efficient. (It is
easier and quicker to type 10001 for Cash at Bank than to type the full account
descriptor.) These identifying codes form the basis of the accounting computer
software used to prepare the required financial statements.
Given that the account balances in the General Ledger form the basis of the two
key financial statements, it makes sense to index them in the Chart of Accounts.
So, the accounts are first grouped by Revenue and Expense (according to the
reporting requirements of the Income Statement) and by Assets, Liabilities and
Owner’s equity (according to the reporting requirements of the Balance Sheet).
The most common method for allocating account codes to these groups is via a
variation of the number sequence of the Dewey Decimal system that is typically
used by libraries to classify their books and other resources. The great
advantage of using this system is that it can be easily expanded without
upsetting the structure of the accounting system. (That is, it easily allows new
accounts to be added to the Chart of Accounts to more accurately reflect what
the business does and/or regulatory reporting requirements.)
Hence, the structure of a business’s Chart of Accounts will typically change a
little over time to reflect these developments. Some businesses include in the
code given to an account:



the
the
the
the

account group
account sub-group
relevant cost centre
specific project or program.

So, the Chart of Accounts provides:
• a logical index that makes it more efficient for data entry staff to find and enter
the appropriate account against the details of the financial transactions
being recorded in the journals
• the necessary coding for computerised accounting packages to report
appropriately on the accounts in the financial statements
• an ordered structure to guide accountants when introducing new accounts into
the General Ledger without upsetting the accuracy of the financial
statements.
WHAT ARE JOURNALS IN ACCOUNTING?

Journals in accounting were traditionally called the ‘day book’. This is due to the
origins of the English word journal. The English word comes from the French word
jour, which means day. It was also traditionally expected that journals would
record all of the financial transactions that occurred on each particular day.
Journals recorded transactions as they occurred (or as soon as possible
afterwards) in date and time order.
Journals became known as the ‘books of original entry’ because they were the
point at which financial information entered the accounting information system.
The financial information system manages the financial data as it is:



entered into the journal
transferred to the General Ledger
summarised in the trial balance
presented for stakeholders in the form of financial reports.

BACKGROUND TO JOURNALS IN ACCOUNTING
When the Franciscan friar and mathematician Luca Pacioli (1446–1517) first
published his book on the double-entry bookkeeping system in 1494, he outlined
the key role that journals would play in this process. Today accountants continue
to follow the concepts Pacioli outlined in recording financial transactions in the
accounting information system (even if Pacioli used quill pens and parchment
and today’s accountants use computer programs)!
The key objectives in recording financial transactions in the journals include:
• recording each entry with sufficient clarity and information to allow a person,
without the aid of memory, to understand in the future the exact nature and
purpose of the transactions
• classifying each entry so an aggregate can be easily extracted at the end of each
accounting period.
TYPES OF JOURNAL
The act of recording transactions in a journal is called journalising. While all
entries could conceivably be entered into the accounting information system via
the general journal alone, it would be a highly inefficient approach to
journalising.
So, due to the often huge volume of financial transactions that need to be
recorded on a daily basis, accountants have, over time, developed a range of
specific journals designed to record groups of transactions sharing common
characteristics. This grouping of transactions facilitated the creation of the
subsidiary ledger system. It also made the calculations and posting of the
summarised journal information to the General Ledger far more accurate and
efficient.

So, today, instead of a general journal supported by six specialised journals, we
have seven buttons or tabs on the computer screen that capture all the
information described below. The various journals that have been developed over
the years are described in Table 13.

Table 13 Types of journals used in accounting
Journal name

Description/purpose

Sales Journal

To record the sales made to credit account customers

Purchases Journal

To record the purchases from suppliers that are to be paid
at a later date

Cash Receipts Journal

To primarily record cash sales, and payments by
customers towards their credit account

Purchases Returns and
Allowances Journal

To record returns made to suppliers and allowances given

General Journal

To record any transaction that did not fit appropriately
into the other specialised journals (for example, a capital
injection by the business owners)

At pre-determined intervals (monthly, quarterly or annually) the journals entries
are summarised and the totals for each account are transferred (posted) to the
General Ledger.
JOURNAL ENTRIES IN ACCOUNTING
Data entries relating to business transactions and recorded in the journals are
called journal entries.

KeyFACTS

Business transactions are those events that will change the value of the assets and/or liabilities


and/or owner’s equity of a business.
Business transactions generate verifiable, tangible evidence in the form of source documents.
These source documents (such as sales invoices, supplier invoices, cheque butts and deposit
books) are the back-up documentation for the recording of the journal entry.

Journal entries are recorded in chronological order while applying the doubleentry bookkeeping system at all times and for each entry. Each journal entry will
include debit and credit amounts and will identify the ledger accounts (from the
Chart of Accounts) that the transaction has affected, as well as the date that the
transaction was recorded.
To assist reviewers of the entries (for example auditors), comments are also
included to detail the source of the financial information being recorded and any
relevant reasons for the entry (transaction). The initial journal entry is an

important component of the audit trail that stretches from the source document
all the way to the Balance Sheet.

J

ournal entries should be recorded as
the business event occurs, or as soon
as possible after it. The facts and
details are still fresh in the mind. If
the recording is done very soon after
the transaction occurs, relevant
documents, conversations and calculations
are still readily available to verify or
correct an entry.
WHAT IS A LEDGER ACCOUNT IN ACCOUNTING?
A ledger account is a separate accounting record in the General Ledger that
collects and stores the debit and credit details of a specific aspect of financial
activity. All the debit and credit details in a ledger account come from the
journals that initially recorded the details of financial transactions in a date and
time order. The process of transferring the transaction details from the journals
to the ledger accounts is known as posting.
BACKGROUND TO LEDGER ACCOUNTS IN ACCOUNTING
Businesses will typically have hundreds of ledger accounts. Businesses create
and name ledger accounts according to the reporting needs of their
stakeholders. These ledger accounts are coded and structured into five major
groups according to the pre-determined Chart of Accounts: Revenue, Expenses,
Assets, Liabilities and Owner’s Equity. The entire collection of ledger accounts is
known as the General Ledger. The double-entry bookkeeping system has two
major processing stages, described below.
STAGE 1
Details of source documents (in a date and time order) are recorded in the
journals according to the double-entry bookkeeping principles of debit and credit.
Ledger account codes are recorded in Stage 1 to ensure efficient and accurate
transfer (posting) of the transaction details from the journal to the ledger
accounts.
STAGE 2
All the debit and credit details from the journals are taken into ledger accounts
and summarised into groups by financial activity type (account type). In a

computerised accounting system, this transfer of details is done automatically
based on the account code entered in the journals.
T ACCOUNTS AS LEDGER ACCOUNTS
The best way to visualise a ledger account is as the letter T, where the account
title and account code run along the top line (the horizontal part of the letter T),
with a centred line (the vertical part of the letter T) separating debit entries on
the left and credit entries on the right. Each ledger account created by a
business will belong to one of the five account groups: Revenue, Expenses,
Assets, Liabilities and Owner’s equity.
A common use of T accounts is in preparing adjusting entries (accruals and
deferrals).

Step 1
Financial
transaction
details
recorded in
journals where
principles of
double-entry
bookkeeping
applied via the
debit and credit
rules

Step 2
Ledger accounts
receive
information from
the journals via
process known
as posting

Step 3
Debit details
from journals
recorded on left
of the
T
account and
credit details on
the right

Step 4
By subtracting
one side of the
T
account from
the other, one
can assess if a
specific account
has a current
debit or credit
balance*

* An account has a debit balance where the total of the debit amounts is greater than the total of
the credit amounts. It has a credit balance where the total of the credit amounts is greater than
the total of the debit amounts. Normally the Liabilities, Revenue and Owner’s equity ledger
accounts have a credit balance and the Assets sand Expense ledger accounts have a debit
balance.

Figure 29 From journals to ledgers
In a computerised system, an additional column is created in the ledger accounts
that keeps a running debit/credit balance based on the flow of transaction details
being posted from the journals. The closing balances of the individual ledger
accounts at the end of each accounting period will then become line entries on
the financial statements, with the Revenue and Expense ledger accounts being
reported on the Income Statement, and the Assets, Liabilities and Owner’s equity
accounts being reported on the Balance Sheet.

WHAT ARE SUBSIDIARY LEDGERS IN ACCOUNTING?
Subsidiary ledgers in accounting involve the grouping of individual accounts that
share a common element. Individual accounts that share a common element
include Suppliers, Customers, Inventory items and Fixed assets. These individual
accounts collectively add up to the value of the corresponding control account
reported as a total in the General Ledger.
For example, the Accounts Payable account is the control account for the
subsidiary ledger of Suppliers and known as the Creditors ledger. The
Accounts Receivable account is the control account for the subsidiary ledger
of Customers and known as the Debtors ledger.
BACKGROUND TO SUBSIDIARY LEDGERS IN ACCOUNTING
Accounting is defined, generally, as the process of recording financial
transactions so that reports can be produced that give stakeholders an accurate
view of the financial performance and position of the business. But accounting is
also more than that. Accounting is also about the control of those finances and
about managing the way in which financial transactions impact on the financial
performance and position of the business. This control function of accounting
also allows for the monitoring of the delegated responsibilities within the
accounting process, which incorporates the accountability of persons and the
tracking of financial assets and functions under their control.
Considering the vast volume of financial transactions that take place every day
in many businesses, it is perhaps no wonder that some financial functions over
time have been separated from the core accounting process and are now
handled by subsidiary departments. Two areas typically handled by subsidiary
departments are the Accounts Receivable and the Accounts Payable functions.

ACCOUNTS
RECEIVABLE

ACCOUNTS
PAYABLE

Accounts receivables
deals with the creation
and management of
debtor accounts that
allows customers to
purchase goods and
services from the
business on credit.

Accounts payables deals
with the creation and
management of creditor
accounts that allows the
business to purchase
goods and services from
suppliers on credit.

Figure 30 Accounts Receivable and Accounts Payable
Creating the subsidiary systems in accounting helps businesses efficiently and
effectively manage and monitor the status of individual supplier and customer

accounts. Recording all this information in just one account in the General Ledger
would make managing these functions very difficult.
So the accounting system sets up specialised journals and ledgers. These
specialised journals and ledgers make it easy to manage the goods and services
sold to individual customers on credit in the debtors subsidiary system and to
manage the goods and services purchased from individual suppliers on credit in
the creditors subsidiary system.

The debtors subsidiary system includes a Sales journal and a Debtors ledger
that is used to manage the sales on credit and the payments made by
individual customers in relation to their account.
The creditors subsidiary system includes a Purchases journal and a Creditors
ledger that is used to manage the purchases on credit and the payments
made by the business to the individual supplier accounts.

Businesses create subsidiary ledgers whenever they need to so as to monitor the
individual components of a controlling General Ledger account. So in addition to
the Accounts Receivable subsidiary ledger and the Accounts Payable subsidiary
ledger, a business may create an Inventory subsidiary ledger (which has
separate accounts for each product); and a Property, Plant and Equipment
subsidiary ledger (which has separate accounts for each long-lived asset).
Note: The concept of credit as it is used here is not to be confused with the
specialised meaning of credit as used in the double-entry bookkeeping system. In
this context here, credit means the ability of a customer or business to take
possession of goods before paying for them. So, the business extends credit to
customers (allowing them to take the goods now and pay for them later) and
buys goods on credit (allowing the business to take possession of goods or
services on the basis of agreed terms with the supplier, where the business will
pay for them later).
SUBSIDIARY LEDGERS AND THE GENERAL LEDGER
The General Ledger is the primary set of accounts used by accountants to
prepare the financial statements of a business. Where used, the subsidiary
ledgers contain the breakdown of the individual details that support the totals
reported in the General Ledger accounts. Accounts in the General Ledger that
have subsidiary ledgers in support are known as control accounts.
For example, the Accounts Receivable account in the General Ledger is the
control account for the Debtors subsidiary ledger and the Accounts Payable
subsidiary ledger account in the General Ledger is the control account for the
Creditors subsidiary ledger.

It is imperative that the total of all the individual account balances in the
subsidiary ledger is equal to the amount reported in the control account in the
General Ledger. The process used to verify this balance is known as a subsidiary
ledger reconciliation.

Discrepancies between the total of the subsidiary ledgers and the General
Ledger control accounts can occur because every transaction that deals with
sales/purchases on credit and cash received/paid on these accounts must be
recorded in two places, namely:

the appropriate individual customer/supplier in the subsidiary ledger
the appropriate control account in the General Ledger.

Computerised accounting systems go some way to eliminating this potential
discrepancy by automatically updating both the individual account in the
subsidiary ledger and the control account in the General Ledger, with one correct
recording of the transaction in the subsidiary journal.

SUMMARY—CREDITORS AND DEBTORS
SUBSIDIARY LEDGERS
In summary:
 Financial reports are produced from the General Ledger not the subsidiary ledgers.
 Subsidiary journals are set up to record transactions specifically related to the

subsidiary ledgers (for example, the Sales journal and the Purchases journal).
Apart from the general journal, all other journals need to post their details to both the
individual accounts in the subsidiary ledgers and the control accounts in the General

Ledger.
Customer payments processed through the Cash Receipts journal will need to be posted
to the Debtors ledger, while cash sales and other cash received like owner’s capital

invested will be posted directly to the appropriate General Ledger account.
Supplier payments made by the business and processed through the Cash Payments
journal will need to be posted to the Creditors ledger, while cash purchases and other
cash payments like loan repayments will be posted directly to the appropriate General

Ledger account.
The subsidiary ledgers are not part of the main accounting process but are simply a
listing of the individual accounts that explain and justify the total amount reported in

the relevant control account in the General Ledger.
Systematically, the subsidiary ledgers must be reconciled with the control account
balances in the General Ledger to ensure the accuracy of the financial information; that

is.

the total of the individual customer account balances must equal the Accounts

Receivable amount reported in the General Ledger
the total of the individual supplier account balances must equal the Account

Payable amount reported in the General Ledger.
Computerised accounting systems have automated (reduced the process to one
transaction) posting to both the subsidiary ledger and the General Ledger, provided the
proper journal is used. This has eliminated many of the errors that occurred with the
manual accounting system.

WHAT IS POSTING IN ACCOUNTING?

Posting in accounting refers to the process of transferring to the ledgers, the
details of financial transactions originally recorded in the journals of a business.
Posting is an important step in the double-entry bookkeeping system.
Posting transfers the debit and credit aspects of a financial transaction (recorded
chronologically in the journals) to the relevant accounts impacted by that
transaction in the ledger.
Postings take place between the general journal and the General Ledger as well
as from the subsidiary journals to both the Subsidiary and the General ledgers.
BACKGROUND TO POSTING IN ACCOUNTING
Accounting is a specially designed recording system that details the financial
events conducted by a business (or other financial entity). These financial events
are called transactions in accounting. The specially designed recording system is
known as the double-entry bookkeeping system. By following centuries-old
accounting principles of double-entry bookkeeping, the accounting system is
able to produce reports that constantly monitor and measure the financial
sustainability and financial strength of the business (or financial entity). The
financial sustainability of a business is reported in the Income Statement and the
financial strength of a business is reported in the Balance Sheet.
The accounting process begins with financial transactions that impact directly on
the monetary value of either the assets, liabilities or equity of a business. These
transactions are evidenced by source documents such as invoices, receipts,
deposit slips, memos and check butts. The details of these source documents are
entered into the journals of a business.

T

he process of entering the details
of financial events into the
accounting system is known as
journalising the transactions.

The journals record the details of the transaction chronologically in date and time
order. The accounting process then transfers the details contained in the journals
to those accounts specifically affected by the transaction. That is, the transaction
of paying an electricity bill would reduce the amount the business had in its Bank
account and increase the Electricity Expense account. Collectively, all these
accounts make up the General Ledger of the business.
The accounts of the General Ledger are the building blocks that produce the
financial reports of the business. The process of transferring the details of the
financial transaction recorded in the journals into the relevant accounts in the
General Ledger is called posting in accounting.
In today’s computerised accounting world, posting to the General Ledger takes
place automatically the moment that the transaction is correctly journalised and

saved. In a double-entry bookkeeping system, a transaction is correctly
journalised when the debit values of the transaction equal the credit values.
POSTING FROM SUBSIDIARY JOURNALS IN ACCOUNTING
Under the manual accounting system, it became very messy to list in the
financial reports all the customers who owed the business money and all the
amounts owed by the business to its suppliers. To tidy up the financial reports,
the accounting system grouped all the amounts owed by customers under the
single General Ledger account called Accounts Receivable and all the money
owed to suppliers in a single General Ledger account called Accounts Payable.
To deal with this, the accounting system set up the subsidiary ledgers called the
debtors ledger to keep all the individual account details of money owed by
customers, and the creditors ledger to keep all the details of money owed to
suppliers. Special subsidiary journals were also set up in the accounting system
to record these special transactions.

A Sales journal records those sales made to customers that have an account
that allows them to pay for the goods and services at a later date.
A Purchases journal records purchases made by the business of goods and
services for which it has taken possession but not yet paid for.

These Sales and Purchases journals continue to be part of the computerised
accounting systems. The details of transactions recorded in the Sales and
Purchases journals still need to be posted to both the Accounts Receivable and
Accounts Payable accounts in the General Ledger as well as to the individual
customer and supplier accounts in the subsidiary ledger. This two-step process in
the manual accounting system is now a one-step automated process in the
computerised system.
WHAT IS THE GENERAL LEDGER IN ACCOUNTING?
The General Ledger is the central core of the accounting information system.

KeyFACTS

The General Ledger is where all of the financial transactions of a business are categorised and

summarised into accounts.
The accounts in the General Ledger group similar transactions into individual records producing

a continually updated credit/debit balance for each.
The number and type of accounts that make up the General Ledger are determined by the Chart

of Accounts.
The General Ledger contains a permanent history of all the financial transactions that have taken

place in the business since its first day of operation.
The General Ledger is sometimes known as the nominal ledger and often abbreviated as GL.

BACKGROUND TO THE GENERAL LEDGER IN ACCOUNTING
Until the 1980s, all ledgers were books that recorded the financial information of
a business. Today, with the vast number of accounting software packages,
ledgers have become digital databases of financial information.
Under the double-entry bookkeeping system, financial transactions are initially
captured by the journals applying the principles of debit/credit. Journals, as the
original books of entry, record on a daily basis all the financial transactions of a
business in a date and time order. However, journals do not provide information
in one place about a specific account or aspect of the business.
For example, to calculate the cash balance with only the journals as records, one
would need to check all the journal entries in which cash was affected. Given the
vast amount of transactions involved, this undertaking would be very difficult and
prone to mistakes.

To streamline this process, accounting transfers these journalised transactions to
the specific account in the General Ledger according to the account type (that is,
Assets, Liabilities, Owner’s Equity, Revenue, and Expenses). The debit/credit
aspects of each transaction recorded in the journals are maintained by the
General Ledger accounts producing a current credit or debit balance.
The General Ledger also provides the basis for the preparation of the financial
reports.

The Income Statement is prepared from the closing balances of the Revenue
and Expense accounts.
The Balance Sheet is prepared from the closing balances of the Assets,
Liabilities and Owner’s equity accounts.

SUMMARY—THE GENERAL LEDGER

All the financial transactions of a business (or financial entity) are categorised and

summarised into accounts in the General Ledger.
The number and type of accounts that make up the General Ledger are determined

by the Chart of Accounts.
The General Ledger contains a permanent history of all the financial transactions of

a business.
With computerisation, General Ledgers have become digital databases of financial


information.
Journals post (transfer) all data captured to the General Ledger.
General Ledger accounts are grouped according to the account type (that is, Assets,

Liabilities, Owner’s equity, Revenue, and Expenses).
The double-entry bookkeeping system first applied in the journals is maintained in

the General Ledger.
The General Ledger provides the details required to prepare the financial
statements.

The General Ledger is sometimes known as the nominal ledger and often

abbreviated as GL.
The General Ledger makes it easy to track information and to quickly see account

balances.
Transactions cannot be recorded directly into the ledger; they must be routed

through the journal.
Transferring information from the journals to ledger accounts is called posting.

WHAT IS A TRIAL BALANCE IN ACCOUNTING?
A trial balance in accounting is prepared to verify that the double-entry
bookkeeping rules have been adhered to in recording the financial transaction
during a particular period.
This is done by totalling all the [Dr/Debit] balances in the General Ledger and
ensuring that this total agrees with the total of all the [Cr/Credit] balances in the
General Ledger.
DEFINITION OF TRIAL BALANCE IN ACCOUNTING
The accounting system is built on the concept of double-entry bookkeeping. The
double-entry bookkeeping system requires that a minimum of two entries are
made for each financial transaction that occurs in a business. The double-entry
bookkeeping system also requires that:

all financial transaction must have at least one [Dr/Debit] entry and one
[Cr/Credit] entry and for each financial transaction
the total of the [Dr/Debit] entries must equal the total of the [Cr/Credit]
entries.

The trial balance, then, is a summary report that tests whether all the financial
transactions entered into the accounting system over a specific period of time
have followed the double-entry bookkeeping rules in regard to [Dr/Debit] and
[Cr/Credit] entries.

I

f the double-entry bookkeeping rules
have been followed correctly, the
total of all the [Dr/Debit] account
balances in the General Ledger will
equal the total of all the [Cr/Credit]
account balances in the General Ledger.
PREPARATION OF A TRIAL BALANCE IN ACCOUNTING
A trial balance can be prepared at any time but it is mostly prepared just before
preparing the financial statements. (Note: While the financial statements are

prepared for both internal and external stakeholders, the trial balance is
prepared for, and used by, only the internal accounting team.)
The trial balance is simply a listing of all the accounts from the General Ledger
with their balances. The balances of the accounts will be either a [Dr/Debit] or a
[Cr/Credit] depending on their nature and financial activity.
For example, Asset and Expense accounts will most likely have a [Dr/Debit] balance
while Liabilities, Owner’s Equity and Revenue accounts will most likely
have[Cr/Credit] balances.

The total of accounts with [Dr/Debit] balances should be the same at the total of
accounts with [Cr/Credit] balances, provided that the double-entry bookkeeping
system was correctly applied. So, in essence, the trial balance is prepared to
confirm the accuracy of the postings to the General Ledger.
In a manual accounting system, it is necessary to prepare a trial balance
because of the many ways that the General Ledger could be out of balance (that
is, where the total of the [Dr/Debits] do not equal the total of the [Cr/Credits]).
Modern computerised accounting software systems enforce the double-entry
bookkeeping requirements at the data-entry level making it impossible for either
the General Ledger or the trial balance statement to be out of balance.
PRESENTATION OF THE TRIAL BALANCE
The trial balance statement consists of the header rows followed by a list of all
the general ledger accounts. The current balances of these general ledger
accounts are place in either the [Dr/Debit] or the [Cr/Credit] column. The
[Dr/Debit] and the [Cr/Credit] columns are then totalled and compared. They
should be the same.

SUMMARY—THE TRIAL BALANCE
The trial balance:
 tests to see if the double-entry bookkeeping rule has been correctly applied
 is a list of all the accounts with balances in the general ledger
 establishes that the total of all the accounts with a [Dr/Debit] balance is the same

as the total of all the accounts with a [Cr/Credit] balance
is prepared only for the internal accounting team
is prepared and checked before preparing the financial statements.

WHAT IS AN AUDIT TRAIL IN ACCOUNTING?
An audit trail is a process pathway built into a well-designed accounting system
that allows amounts reported in the financial statements to be traced back to
their original source.

KeyFACTS


An audit trail is a complete step-by-step history of every transaction in the accounting system.
An audit trail comprises a chronological sequence of records and source documents that provide

the evidence an auditor needs to reconstruct previous steps in the accounting system.
An audit trail facilitates defect analysis and so helps to verify the accuracy and reliability of
financial reports.

BACKGROUND TO AN AUDIT TRIAL IN ACCOUNTING
Financial statements are the end product of the bookkeeping/accounting system.
These financial statements are used by stakeholders (that is, shareholders,
managers, funders, suppliers and customers) to make financial decisions about
the allocation and use of resources under their control.
It is important to these stakeholders that the financial statements are accurate
and can be relied upon when making their decisions about resource allocations.
With this in mind, accountants map out a process that allows an independent
auditor to trace the amounts reported on the financial statements back to the
original source documents and transactions. This mapping process is known in
accounting as ‘providing an audit trail’.
Furthermore, with the separation of roles between business fund suppliers
(shareholders) and business fund controllers (management) that have come
about with the industrial age, shareholders need to verify the reports that
management prepares about the use of shareholder funds. This requirement led
to the rise of independent auditors who check the accuracy and reliability of the
books of the business on behalf of the shareholders.
The auditor follows the audit trail when carrying out this process, looking for
evidence to validate each step in the accounting process. This includes checking
the original source documents and transactions.
PURPOSE OF AN AUDIT TRAIL IN ACCOUNTING
The audit trail traces the transaction from the source documents that provide
evidence of a financial event through to the eventual reporting of the impact on
that transaction on the financial position of the business in the Balance Sheet.
The audit itself starts at the end, with the financial statements (Balance Sheet
and Income Statement). The account balances (from the General Ledger) in
these reports are identified. These account balances are made up of journal
entry summaries, which are, in turn, made up of individual transactions that can
be matched with the source documents via receipt/invoice number.
The fact that transactions can be chronologically sorted by date order and
journal summaries by sequenced numbers helps make the audit trail robust.

T

he audit trail is a process that
allows others to check the
accuracy and reliability of the
financial reports by tracing back
the trail that the transaction took as it
progressed through the accounting system
—all the way back to the source document
and financial event that caused the
transaction to be recorded.
This ability to check the accuracy and reliability of each transaction in the
accounting systems has a number of benefits:
• It helps to identify:
– any attempts at fraud or misappropriation of funds
– any attempts by management to misrepresent the financial performance
or position of a business
– incomplete or missing data, including any mathematical inaccuracies in
period-end accounting records
– weakness in the internal control system of assets implemented by
management.
• It provides evidence for tax authorities in regard to tax expense claims
• It helps auditors to detect instances of inappropriate record-keeping behaviours
or unlawful business practices.
WHAT ARE END-OF-PERIOD ADJUSTMENTS IN ACCOUNTING?
End-of-period-adjustments in accounting are journal entries made to the
accounts of a business immediately before financial statements for a given
accounting period are prepared and distributed. Financial statements are
prepared at the end of each accounting period; these can be monthly for large
corporations or annually for small to medium businesses. End-of-period
adjustments ensure that these financial statements reflect the true financial
position and performance of a business. They do this by allocating to the
appropriate period the income earned and expenses incurred.
End-of-period adjustments are also known as year-end-adjustments, adjustingjournal-entries and balance-day-adjustments. End-of-period-adjustments apply
the matching principle of accounting which includes accruals, deferrals and asset
value adjustments.
BACKGROUND TO END- OF-PERIOD-ADJUSTMENTS IN ACCOUNTING
The primary purpose of completing the balance-day-adjustments is to ensure
that the financial statements accurately reflect the financial position and

performance of the business. Stakeholders in a business venture use the
financial statements to make decisions, particularly about the best use of
financial resources under their control. It is therefore very important that the
financial statements presented to these stakeholders are accurate.
End-of-period adjustments become necessary in accounting to two key areas:
1. to take account of the different time impacts of the accounting period and
multi-period financial transactions (for example, a 12-month magazine
subscription that benefits the business over 12 different monthly accounting
periods)
2. to better reflect asset realities (for example, to adjust the inventory amount
in the accounts to reflect the value of an actual stocktake done at the end-ofperiod).
The mismatch between the accounting time periods for which stakeholders
require financial information on the one hand and the real life, conduct and
transaction times of a business on the other hand is one area requiring end-ofperiod adjustments.
For example, some transactions, like an insurance payment, may cover several
accounting periods. Not all transactions fit neatly within the monthly, quarterly, halfyearly or annual reporting periods that stakeholders require. Hence, end-of-period
adjustments must be made to the accounts of a business so that only that part of the
financial transaction that relates to the current period is included in the financial
reports for the current period.

Apart from making end-of-period adjustments for the timing mismatches
mentioned above, end-of-period adjustments must also be performed to
appropriately adjust asset values. Before distributing financial statements to the
stakeholders of the business, accountants and bookkeepers check to see that all
the asset values in the accounts reflect their real value according to either the
accounting standards, tax laws and/or organisational policies.
Typical assets that need to be checked and adjusted when necessary include
those detailed in Figure 31.

Merchandise
inventory

To make adjustments
to reflect the physical
or

Fixed assets

To make allowances
for their depreciation

Accounts
Receivable

To write-off bad debts
and provide for doubtful

Supplies or
stores

To record adjustments
to the supplies

stocktake valuation
according

debts

stores values
to the end-of-period
stocktake

Figure 31 Assets typically requiring end-of-period adjustments
END-OF-PERIOD ADJUSTMENTS AND ACCRUAL ACCOUNTING
There are two methods accountants and bookkeepers use to record and report
on the financial transactions of a business:

cash accounting
accrual accounting.

Under the cash accounting method, financial transactions are recorded in the
accounts of a business only when the cash is actually exchanged.
For example, revenue is recorded when the money is received and
expenses are recorded only when the actual payment is made.
Businesses using the accrual accounting method are required to record revenue
when a legal obligation on the customer/client is created and record expenses
when the business incurs a legal liability to pay—regardless of when the cash is
actually exchanged.
So by applying the accrual accounting method, the income earned in a given
accounting period will accurately match the expenses incurred in earning that
revenue. This is known in accounting as the matching principle. The matching
principle ensures that the financial reports accurately reflect the financial
performance and the financial position of the business for the given accounting
period.
The matching principle applied in accrual accounting requires that adjusting
entries are made to the accounts to ensure that all the revenue earned in an
accounting period, together with all the expenses incurred in earning that
revenue, are recorded and reported in the same accounting period.
END-OF-PERIOD ADJUSTMENTS—ACCRUALS AND DEFERRALS
The two key end-of-period adjustments that need to be made under the
matching principle are accruals and deferrals.
ACCRUALS
Accruals are end-of-period adjustments made under the matching principle that
recognise (bring to account) those revenues that have been earned and those
expenses that have accumulated in the current period but which have not yet
been recorded in the books of the business.

DEFERRALS
Deferrals are end-of-period adjustments made under the matching principle that
transfer to future accounting periods those revenues and expenses recorded in
the current period but which, in fact, belong to these future periods.
The different types of end-of-period adjustments are detailed in Table 14.

Table 14 Different types of end-of-period adjustments
Account type

End-of-period adjustment

Accrued revenue

Adding transactions for revenue that has not yet been
invoiced

Accrued expense

Adding transactions for expenses that have not yet been
recognised

Deferred revenue

for example, the electricity used in the current reporting
period that has not yet been billed by the supplier.
(Note: a special type of accrued expense is depreciation.
Depreciation expense apportions the cost of a fixed
asset over its useful life. The useful life of a fixed asset
will cover a number of accounting periods.)

Transferring to future periods income transactions that,
while recorded in the current period, actually belong to
future periods. These amounts become liabilities of the
business because the business has not yet performed the
work and so has no claim to the customer payment.

Deferred expense

for example, a staged monthly invoice for partially
completed work of $1,000 in a 6-month contract worth
$6,000

for example, $1,000 cash received by the business as a
deposit for work that has not yet been commenced

Transferring to future periods expense transactions that,
while recorded in the current period, actually belong to
future periods. These amounts become assets of the
business because the value of the expense has not yet
been used up or utilised.

for example, transferring the remaining time covered
under a 12-month insurance payment

ACCOUNTING METHODS: CASH VS ACCRUAL
WHAT IS CASH ACCOUNTING?
Cash accounting is a method of bookkeeping that delays recording the revenues
and expenses of a business until the cash is exchanged (that is, when cash is
actually received or paid out). By contrast, the accrual accounting method
records revenues at the point they are earned and records expenses when a
legal obligation to pay is created.
BACKGROUND TO CASH ACCOUNTING
Cash accounting exists primarily to provide a cost- and time-effective method of
recording and reporting on the financial events of predominantly small cashbased businesses. The majority of the users of financial information
(stakeholders) would prefer that the financial events of a business were recorded
and reported on using the accrual accounting method.
The accrual accounting method is generally preferred because it adheres to the
accounting concept of the matching principle and the revenue recognition
principle. The cash accounting method does not.
The matching principle ensures that the net income, for shorter accounting
periods (say months), is accurately calculated by ensuring that the revenues
earned in each period are matched with all the expenses incurred in earning that
revenue.
Still, stakeholders understand that the more complicated accrual accounting
method is not always an appropriate or feasible standard to place on all
businesses. This is particularly the case for small sole proprietor service-based
businesses which have very little inventory, which collect cash on completion of
the work, and which pay cash for the majority of their supplies.
Cash accounting is the appropriate method for recording and reporting on the
financial events of a business of this type because the additional costs of
complying with the accrual accounting method would not be justified in regard to
any benefits secured.
Basically, the accrual accounting method serves the purpose of accounting far
better than the cash accounting method because the accrual accounting method
is acknowledged as providing a truer and fairer representation of the financial
position and performance of the business. The purpose of accounting is to
provide the information that is needed for sound economic decision making to
take place.
The information provided by the cash accounting method is not as reliable as the
accrual accounting method for decision making because:

• there may be revenue earned by the business that has not yet been recorded
(for example, unpaid sales invoices)
• there may be expenses owed by the business that are not yet recorded because
the bill has not yet been received or paid (for example, an electricity bill or
rent for the past month)
• there may be payments made by customers that should not yet be recorded as
revenue (for example, deposits paid by customers for future work)
• there may be purchases for inventory that have not yet been sold and remain in
stock (under the cash accounting method, this amount would be expensed
even though the inventory asset remained)
• there may have been payments made by the business for some expenses that
still have future economic benefit (for example, insurance paid for 12 months
in advance).
Every cash-based small business could experience any or all of the above
situations, which would distort the net income results presented in their financial
statements. Government tax departments and accounting standards accept this
possible profit distortion for small cash-based business using the cash accounting
system because the extra cost and time required to use the accrual accounting
method cannot be commercially justified for them.
Large businesses, however, that reach certain legislated sales thresholds (for
example, $5 million per year of sales in the United Stated) are required by tax
law to record financial transactions and prepare financial reports based on the
more complicated accrual accounting method.

Table 15 Examples of the accrual and cash accounting methods
Method

Cash accounting method

Accrual accounting
method

A business is paid $1,000 in
January for consulting work
completed and invoiced in
December.

Records $1,000 as
Consultancy revenue in
January

Records $1,000 as
Consultancy revenue in
December

A business pays an
electricity bill of$500 in July
for electricity used in June.

Records $500 as Electricity
expense in July

Records $500 as Electricity
expense in June

SUMMARY—CASH ACCOUNTING METHOD OF
BOOKKEEPING
The cash accounting method of bookkeeping:
 is predominantly used by small sole-proprietor businesses and small associations

that do not have inventory and have a limited number of debtors/creditors
is a more cost- and time-effective method than the accrual accounting method
is accepted as a method of bookkeeping by tax law and accounting standards,
though NOT for larger corporations or for-profit public companies

does not adhere with the matching principle or the revenue recognition principle of

accounting
is not a reliable measure of net income when calculated for shorter time periods like

months.
is also known as the ‘cash basis’ when describing how the financial reports were
prepared (that is: They were prepared using the cash basis).

WHAT IS ACCRUAL ACCOUNTING?
Accrual accounting is a method of bookkeeping that records revenues and
expenses as they are earned or incurred. By contrast, the cash accounting
method delays the recording of revenues and expenses until the cash is actually
exchanged (received or paid).
BACKGROUND TO ACCRUAL ACCOUNTING
Businesses come in all shapes and sizes. At one end of the scale for business
size, are corporations large enough to employ teams of accountants and
bookkeepers to process their financial transactions. Sole proprietors, on the other
hand, cannot afford such expert service and are mostly forced to record their
own financial transactions. Yet every business, regardless of its size, is required
under tax law to prepare financial statements that calculate their net
profit/income. Government realise that it would be grossly unfair to set the same
reporting requirements for the sole proprietor as for the large publicly owned
corporation.
So, governments give small businesses a choice. Governments allow small
businesses to record their financial transactions and prepare their financial
reports for tax purposes using the simpler and less time-consuming cash
accounting method. Large businesses that reach certain legislated sales
thresholds (that is, $5 million per year in sales in the United States) do not have
this choice. These large businesses are required by tax law to record financial
transactions and prepare financial reports based on the more complicated
accrual accounting method. This is because the accrual accounting method is
regarded by accountants and government regulators as providing a truer
representation of the financial position and performance of the business. (Note: It
is common practice to substitute the term accrual basis when explaining how the
financial reports using the accrual accounting method have been prepared.)
ACCRUAL ACCOUNTING METHOD VS THE CASH ACCOUNTING METHOD
The major difference between the accrual accounting method and the cash
accounting method is the way in which revenue and expenses are recorded in
the accounts of the business.

ACCRUAL ACCOUNTING METHOD

CASH ACCOUNTING
METHOD
Revenue and expenses are
recorded ONLY when the cash
is exchanges (that is, when
revenue is received as cash

Revenue and expenses are recorded at
the moment a legal obligation is
created (for example, when goods are
shipped or service delivery completed
in the case of revenue, or when goods
are received or service delivery is
completed in the case of expenses).

Figure 32 Revenue and expenses: cash accounting method vs
accrual accounting method

The accrual accounting method also properly applies the accounting concept of
the matching principle; the cash accounting method does not. Applying the
matching principle in accounting, requires accountants to record, in the same
period, the revenue and all expenses incurred in earning that revenue. The
matching principle ensures that profits (revenue less expenses) are accurately
reported for each accounting period (that is, that revenue earned in one period is
accurately matched against the expenses that correspond to that period), so a
truer picture of net profit for each period is calculated.
The accrual accounting method therefore requires end-of-period adjustments to
be made to the business revenues and expenses while the cash accounting
method does not. These end-of-period adjustments create transactions known as
accruals.
Over the longer term, both the accrual accounting method and the cash
accounting method will produce similar total profit results. The key difference
between the two methods occurs in the different profit outcomes reported over
the shorter accounting periods (monthly, for example).
These different approaches can still create significant variances in annual results
as well. The cash accounting method will distort profit calculations significantly in
the shorter accounting periods if the business sells/buys on credit and/or keeps
an inventory of saleable products.

Table 16 Differences between the accrual and cash accounting
methods
Feature of accounting
method

Cash accounting method

Accrual accounting
method

Purpose

To track the movement of
cash

To more accurately report
on the financial
performance and position of
a business

Used by

Small businesses

Public companies,
businesses with Accounts
Payables and Accounts

Receivable, companies that
are required to do so by law
Revenue
recognition/recording

When cash is received

When economic exchange is
complete or legal obligation
created

Expense
recognition/recording

When cash is paid
sometimes relating to
previous accounting periods

Under the matching
principle, expenses must be
recorded in the same period
as the resulting revenue
earned from the expense
outlay.

Judgement

The movement of cash can
be measured objectively.

The allocation of revenues
and expenses to different
periods is subjective.

Table 17 Examples of the accrual and cash accounting methods
Method

Cash accounting method

Accrual accounting
method

A business is paid $1,000 in
January for consulting work
completed and invoiced in
December.

Records $1,000 as
Consultancy revenue in
January

Records $1,000 as
Consultancy revenue in
December

A business pays an
electricity bill of $500 in July
for electricity used in June.

Records $500 as Electricity
expense in July

Records $500 as Electricity
expense in June

SUMMARY—ACCRUAL ACCOUNTING METHOD OF
BOOKKEEPING
The accrual accounting method of bookkeeping:
 accounts for accounts for expenses when a legal obligation to pay is created

regardless of when the bill is actually paid
complies with the matching principle by ensuring that the revenues and all the
accompanying expenses incurred in earning that revenue are recorded in the same

accounting period
involves end-of-period adjustments to ensure that the revenue recognition principle


and the matching principle are appropriately applied to the financial statements
accurately measures and reports on the net income of a business
often referred to as the ‘accrual basis’ when describing how the financial statements

were prepared
is an option for small businesses but is the ONLY bookkeeping method allowed
under tax laws and accounting standards for large corporations and for-profit public
companies

has various advantages and disadvantages relative to the cash accounting method.

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF CASH VS
ACCRUAL ACCOUNTING?
Both the cash and accrual accounting methods of bookkeeping are accepted by
tax law and accounting standards as appropriate ways to record and report on
the financial events of a business. The advantages and disadvantages of each
method are relevant only to small businesses which can choose between these
methods. Large corporations and for-profit companies are required to report on
their financial position and performance using ONLY the accrual accounting
method.
Each bookkeeping method has advantages and disadvantages. If a business has
the option to choose, these advantages and disadvantages need to be weighed
up carefully before deciding which one is best for the business. It will probably be
necessary to seek the advice of an accountant in this regard.
DEFINITIONS OF CASH ACCOUNTING AND ACCRUAL ACCOUNTING
Cash accounting delays the recording of revenues and expenses until the time
that the cash actually exchanges (that is, revenues are recorded when the cash
is received, and expenses are recorded when the bills are actually paid).
Furthermore, cash accounting does not attempt to match the revenues with the
associated expenses incurred in earning that revenue and report them both
within the same accounting period.
Accrual accounting is a method of bookkeeping built on three key accounting
principles or conventions: the accounting period convention, the revenue
recognition principle and the matching principle. Accrual accounting sets out to
accurately report net income for each accounting period regardless of its length
(that is, monthly, quarterly or yearly). It achieves this objective by:
 recognising revenue at the point it is earned (that is, delivery of goods or
completion of service work) regardless of when the cash is exchanged
Cashrevenues
accounting
Accrual
accounting
 recording those
in the same period as the
associated
expenses
incurred in earning those revenues. Expenses are recorded at the point that a
• It is simpler to maintain. Data can
• It gives a truer and fairer
legal obligation to pay is created (that is, receipt of goods or completion of a
be taken from minimal sources
representation of the financial
service from a supplier).

(bank statements, check butts,
position and performance of the
deposit book).
business.
It is less time-consuming to prepare
• It complies with both tax law and
financial reports because
accounting standard
ADVANTAGES OF THE CASH ACCOUNTING
AND
minimal adjustment is needed
requirements.
• The financial
reports have more
ACCRUAL ACCOUNTING
METHODS
to cash records.
It is easier to understand and
credibility with financial
operate for people with limited
institutions and investors.
• It is a reliable financial analysis and
accounting knowledge and
decision-making tool which can
skills.
Taxes are paid only after cash is
make valid comparisons with
received so it do not cause the
prior periods and industry
cash flow problems that the
benchmarks.
• It positions the business for future
accrual accounting method can
growth where the accrual
create
Finalised financial reports can be
accounting system will
prepared on demand without
eventually need to be adopted.

Figure 33 Advantages of the cash accounting and accrual
methods of accounting

DISADVANTAGES OF THE CASH ACCOUNTING AND
ACCRUAL ACCOUNTING METHODS
Cash accounting
• Financial reports do not represent
the true financial position and
performance of the business.
• This method does not comply with
the accounting concept of the
matching principle.
• Financial institutions may not
accept this accounting method
when making loan applications.
• It is an unreliable tool for financial
analysis and decision-making.
• Performance comparisons are
difficult to make with prior
period results and industry
benchmarks.

Accrual accounting
• More transactions are required to
record the same number of
financial events.
• It is more complicated, with the need
to calculate and manage the
end-of-period adjustments.
• If often requires the additional
expense of an accountant to
help prepare the financial
statements.
• There is a more stringent
requirement to keep all source
documents to help identify the
timing and scope of revenues
and expenses.
• Financial reports take longer to
prepare due to the
income/expense adjustments

Figure 34 Disadvantages of the cash accounting and accrual
methods of account

IF THERE WERE NO TAX BENEFITS, WOULD THERE BE ANY ADVANTAGES
FOR ACCRUALACCOUNTING?
The personal view of the author is that tax is not the driving force behind a
decision to use accrual accounting. Simply put, the primary purpose of
accounting is to provide accurate information on the financial position and
financial performance of a business so that stakeholders can make informed
decisions about the allocation of scarce economic resources under their control.
Accrual basis accounting performs this role far better than cash basis accounting.




Accrual basis accounting is proper accounting in that it applies and adheres
to all the concepts, conventions and standards deemed necessary by
statutory/governing authorities to accurately report on the financial activities
of a business.
Cash basis accounting is a cost–benefit compromise allowed by governing
authorities which accept that, in certain circumstances, the cost of fully
complying with accounting standards (accrual basis accounting) far
outweighs the benefits of producing accurate financial reports. Cash basis
accounting is typically appropriate and allowed for:
sole traders (for example, tradespeople)
small businesses that do not extend credit to customers
non-profit organisations whose primary focus is to report funds received
and funds used rather than profits
government departments where cash management rather than profit is
the primary concern.

Generally any organisation that has many stakeholders, that engages in
complicated financial operations and whose primary purpose is profit would
benefit from accrual basis accounting. This is because stakeholders would be
able to make better decisions about the allocation of scarce economic resources
under their control. For the purpose of accuracy and accountability, publicly
traded entities, in particular, are required by law to use accrual basis accounting.
The concept of cash flow management, while absolutely vital to a business, is a
separate issue to the decision about which accounting basis to use.

Financial accounting is primarily concerned with preparing financial reports
that accurately report on past financial activities.
Management accounting focuses on interpreting the past financial reports to
plan future financial activities.

While profit plans could be based easily on accrual basis reports, the cash flow
budget would require the management accountant to analyse the cash
implications of accrual basis reports in order to set sound cash flow predictions.
While this does require extra work, the general consensus by stakeholders and
governing authorities is that if the costs are not too prohibitive, accrual basis
accounting is the preferred option when wanting accurate reports on the profit
performance and financial strength of a business.

FINANCIAL TRANSACTIONS AND SPECIAL ACCOUNTS
WHAT ARE ACCRUALS IN ACCOUNTING?
Accruals in accounting are special journal entries made by accountants and
bookkeepers at the end of each accounting period before the financial
statements are prepared and distributed. Accruals are the practical application of
the matching principle where income and expenses must be recorded in the
accounting period where they are, respectively, earned and incurred.
Accrual entries involve bringing to account revenue that has been earned
but not yet invoiced and expenses that have been incurred but not yet
billed.
BACKGROUND TO ACCRUALS IN ACCOUNTING
The key purpose of accounting is to provide stakeholders in a business with
relevant, accurate and timely financial information so that the stakeholders can
make sound decisions about the use of financial resources under their control.
Accounting provides this financial information by way of the financial statements
that give stakeholders a picture about the financial performance (Income
Statement) and financial position (Balance Sheet) of the business.
Business is a continuing and constantly changing entity. But stakeholders require
financial information to be provided in pre-determined and comparable set time
periods known as accounting periods. Typical accounting time periods are
monthly, quarterly, half-yearly and annually.
Also, relevant information for stakeholders can be provided only if the accounting
system matches all the revenue earned in these time periods with all the
expenses incurred in earning that revenue. This concept is known as the
matching principle in accounting and it is designed to give a true picture of the
profitability and sustainability of a business for any given period.
The issue for accountants and bookkeepers is that while the stakeholders need
the performance and position of the business to be reported in set accounting
periods, either many transactions affect multiple periods or the cash exchange
takes place outside of the current accounting period. In order to apply the
matching principle properly in each accounting period, accountants and
bookkeepers need to make a series of special journal entries at the end of each
period so that the correct amount of income earned is reported and the correct
amount of the expenses incurred is also reported in the same period.
ACCRUALS IN ACCOUNTING
Strictly speaking, accruals in accounting are those special journal entries made in
the end-of-period-adjustments that deal specifically with income earned in the
current period and expenses incurred in the current period that have not yet

OTHER END- OF-PERIOD ADJUSTMENTS

Figure 35 Types of accruals
reate accruals for both electricity and payroll so the financial reports prepared for 30 June truly reflects the

tnightly payroll was 28 June. So 2 days of wages were incurred between 28 and 30 June but not yet record

Involves recording expenses incurred in the current period but has not yet recorded in the books of accou

ACCRUED
EXPENSE

partial earning of income by creating an accrued revenue to ensure the financial reports reflect the true pi

t to build something. While the invoice may be raised at the end of the 3-month contract period, the reven

Involves recording revenue earned in the current period but not as yet recorded in the books of accou

ACCRUED
REVENUE

been entered into the accounts of the business. Over time, the concept of
accruals in everyday practice has come to mean processing all the end-of-period
adjustments—that also includes deferrals and asset value adjustments. The two
types of accruals are detailed in Figure 35.

Other end-of-period adjustments are often included in the accruals process and
these are detailed in Table 18.

Table 18 Some end-of-period adjustments often included in the
accruals process
Item

Comment

Example

Deferred revenue

Involves transferring to future
periods income transactions
that, while recorded in the
current period, belong to
future periods. These amounts
become liabilities of the
business because the business
has not yet performed the
work and so has no claim to
customer payment.

For example, $1,000 cash
received by the business as a
deposit for work that has not
yet started.

Deferred expense

Involves transferring to future
periods expense transactions
that, while recorded in the
current period, belong to
future periods. These amounts
become assets of the business
because the value of the
expense has not yet been
used up or utilised.

For example, transferring the
remaining time that is covered
under a 12-month insurance
payment.

Depreciation

This special end-of-period
adjustment journal entry
recognises in the books of a
business the loss in value of
fixed assets that occurred over
the accounting period.

For example, the loss in value of
a new motor vehicle after 1 year
‘on the road’.

Bad/doubtful debts

These special end-of-periodadjustments adjust the value
of the Accounts Receivable
and are designed to give an
accurate picture of the money
that can be expected from the
debtors of the business.

For example: A debtor has not
paid their account for over 120
days and it looks like they may
go into receivership.

Inventory
adjustment

This involves changing the
book value of inventory to
reflect the stocktake and
valuation done at the end of
the period.

For example: Writing off stock
that has now become obsolete.

WHAT ARE PREPAID EXPENSES IN ACCOUNTING?

Prepaid expenses are payments made for goods or services in the current
accounting period that will be used to generate revenue in a future

accounting period. A prepaid expense still has future economic benefit
that can be used to achieve future business objectives. Prepaid expenses
are typically recorded as a current asset on the Balance Sheet in the
current reporting period.
BACKGROUND TO PREPAID EXPENSES IN ACCOUNTING
Many payments made by a business are for costs that have already been
consumed.
For example, electricity, wages, professional services, telephone and
repairs are all examples of payments made for services after the business
has obtained the benefit. These payments where the costs have already
been used to generate income in the current accounting period are treated
in accounting as expenses.
There are, however, some payments that a business makes where the benefit
will be obtained in a future accounting period.
For example professional dues, insurance premiums, subscriptions to
magazines and journals, leases and memberships are all examples of
paying for services before the business receives the benefit. These
payments, where the costs have not yet expired and still retain future
economic benefit for the business, are treated in accounting as prepaid
expenses. This payment is expected to provide economic benefits in one or
more future accounting periods.
We can see from the definition of an asset in accounting that prepaid expenses
must be recorded as an asset. So, prepaid expenses will appear in the Balance
Sheet representing retained value and a future economic benefit for the
business. Prepaid expenses will not appear in the Income Statement as an
expense because the costs incurred in obtaining the prepaid expenses have not
yet been used to the benefit of the business. Prepaid expenses are usually
treated as short-term or current assets because they will be typically consumed
or utilised in less than a year after the end-of-period-adjustments.
The primary reason that accountants create what are called Prepaid Expenses
accounts is based on the accounting requirement to prepare reports that present
a true and fair view on the finances of the business. This requirement comes
from the need to apply the matching principle in accounting, which is
underpinned by the accrual basis of preparing financial reports. Without the
option of recognising some cost payments as prepaid expenses, the financial
reports would not accurately reflect the financial performance and position of the
business.
c

ase study: prepaid expenses

An account is preparing the financial statements for a small business for the year
ended 30 June 2011. The accountant notices that the small business owner paid a
$1,200 insurance premium on 1 June 2011; she includes it in the books for the
year as Insurance Expense: $1,200.
After reviewing the insurance contract, the accountant notices that the insurance
cover is for a 12-month period ending on 31 May 2012.
Applying the matching principle and the accrual method of accounting, the
accountant calculates that only 1/12th of the insurance costs has been used up by
30 June 2011 and that there is still 11 months of economic benefit remaining in
the policy as at 30 June 2011.
So, the accountant leaves $100 in the Insurance Expense account, which
represents 1 month’s worth of insurance cover that has been used up or expensed
by 30 June 2011.
The accountant then transfers the remaining $1,100—representing future
economic benefit that has not yet been used up or expensed—to a current asset
account called Prepaid Expense or Prepaid Insurance. To have left the books of the
business as they were presented to the accountant by the small business person
would have understated the profits and the assets of the business for the financial
year ended 30 June 2011.
The use of the Prepaid Expenses account has helped ensure that the financial
statements now represent a true and fair view of the financial performance and
position of the business.

WHAT IS A CONTRA ACCOUNT IN ACCOUNTING?
A contra account in accounting is any account that offsets another account.
Contra accounts are a special category of negative transactions that are
separated out from the main account and then summed collectively as an offset.
A contra account is set up by accountants to specifically highlight negative
amounts within the accounts of a business. Accountants do this because they
believe that these amounts are material enough for stakeholders to be
specifically informed about them.
If these transactions were not treated as a contra account, important information
relating to the business operations (for example, treating sales returns as an
expense) may be hidden from view within larger number sets. Instead of
reporting this category of transactions in their apparent natural class, contra
transactions are matched with the key account to which they directly relate to as
an offset.
Examples of a contra account include:




Accumulated Depreciation (offset Assets)
Sales Returns (offset Revenue)
Value-added Tax Paid (offset Liabilities)
Owner’s Drawings (offset Owner’s Equity)
Discounts Received (offset Expense).

BACKGROUND TO A CONTRA ACCOUNT IN ACCOUNTING
A key purpose of accounting is to provide stakeholders with meaningful
information about the performance and position of key elements of the business
so that they can make informed decisions about the allocation of resources under
their control. Sometimes, as already indicated above, this means highlighting a
particular category of transaction that might otherwise be hidden within a much
larger set of numbers.
For example, the Sales account of a business typically has a very large
volume because it represents the total inflow resulting from all the various
activities of the business. On the other hand, sales returns by customers
(that is, for example, for faulty goods) would typically represent only a very
small percentage of the total sales. If these sales returns were simply dealt
with as a sales reversal inside of the Sales account, it would have very little
impact on the overall sales result. However, treating sales returns inside the
Sales account would, in fact, hide a key performance indicator that is
important to every business— that performance indicator is customer
satisfaction.
Separating out the sales returns in this example and treating it in its own
category (negative sales) allows stakeholders to measure and monitor the
degree and change in customer satisfaction over subsequent accounting periods.

So instead of reporting net sales of $95,000, accountants will report gross
sales of $100,000 and include ‘less sales returns of $5,000’.

Treating the reporting in this way gives stakeholders a more informed view of the
financial performance of the business (that is, that there is a 95% customer
satisfaction with the items sold by the business). This information would
otherwise be hidden if not for this special offset account treatment.

This offset or negative account (that is, sales returns in this example) is
known in accounting as a contra account.

In terms of how the contra account is reported in the financial statements, here
is how the above situation would be reported:
Revenue
Gross sales
$100,000
Less sales returns $5,000
Net sales
$95,000
EXAMPLES OF A CONTRA ACCOUNT IN ACCOUNTING
There are five classifications of accounts in accounting:

(Assets
Liabilities



Owner’s Equity
Revenue
Expenses.

All five of these accounts can have contra accounts. If the Assets account (debit
balance by nature) has a contra, then the contra account will have a credit
balance.
On the other hand, if a Liabilities account (credit balance by nature) has a contra
account, the contra account will have a debit balance.
The contra account is not an asset or liability in itself, but is, in fact, an account
used to adjust the gross amount of the related Assets or Liabilities account. The
key effect of a contra account is to reduce the value of the gross account it is
offsetting.
Generally, any account that is reported in the Income Statement or Balance
Sheet that begins with ‘Less’ is a contra account.
Some of these are described in Table 19.

Table 19 Examples of contra accounts
Contra account

Offset

Explanation

Accumulated
Depreciation

Offset/negative/contra
Assets

Where the original/historical cost of
the fixed asset is offset/reduced by
the amount of the fixed asset that
has been expensed to date

Value-added Tax Paid

Offset/negative/contra
Liabilities

Where a value-added tax payable is
reduced/offset by the amount of tax
already paid

Owner’s Drawings

Offset/negative/contra
Owner’s Equity

Where the total capital invested by
the owners remains intact but is
offset/reduced by the amount of
money withdrawn from the business
by the owner’s drawings

Sales Returns

Offset/negative/contra
Revenue

Where the gross sales is
offset/reduced by the amount of
customer returns

Discounts Received

Offset/negative/contra
Expenses

Where purchases are offset/reduced
by the amount of the discounts
claimed under the terms of trade

WHAT IS AMORTISATION IN ACCOUNTING?
Amortisation in accounting is the process of expensing (writing off) the value of
the intangible (non-physical) assets of a business. Amortisation for intangible
assets is the same concept in accounting as depreciation is for fixed (physical)
assets. Amortisation of intangible assets takes place periodically over the period

covering the estimate useful economic life of the intangible assets. Intangible
assets typically include intellectual property costs and incorporation costs.
BACKGROUND TO AMORTIZATION IN ACCOUNTING
The term amortisation is used in both accounting and finance.

In finance, amortisation describes a process of gradually reducing debt
through systematic payments at regular intervals until the debt is gone.
In accounting, amortisation specifically refers to the process of expensing the
value of the intangible assets of the business over a period of time.

Not all the assets of a business are physical or tangible. Some assets are nonphysical and are called intangible assets.
For example, patents, trademarks, brands, goodwill, copyrights, licenses,
computer software, costs of incorporation and internet domains are all
intangible assets.
Even though these assets are invisible (or cannot be touched), they still
contribute to the revenue growth of a business and so must be expensed against
the revenues as they are earned. Intangible assets are treated in the same way
as physical assets that are depreciated (expensed) and so their value is
systematically transferred from an asset on the Balance Sheet item to an
expense item (Amortisation) on the Income Statement.

A

mortisation reflects the
consumption, expiration,
obsolescence or other decline
in value of the intangible asset
as a result of use or the
passage of time.

KeyFACTS

Amortisation is underpinned by the matching principle in accounting.

The matching principle in accounting ensures that the financial reports of the business give an
accurate view of the financial position and performance of the business to the decision-making

stakeholders of a business.
Under the matching principle, accountants are required to match the revenue for each accounting
period with the actual expenses incurred in earning that revenue for the period.

In the example in the ‘for example’ box on the next page, it would not give an
accurate view of the profitability of the business if the patent costs were
expensed only in the year the costs were paid. Also, a Balance Sheet that
showed a patent still worth $20,000 in the 19th year would not give an accurate

view of the value of that asset, given that its value is just 12 months away from
being worthless. So, instead of taking either of the two options listed above,
accountants will amortise the cost of the intangible asset over the estimated
useful economic life of the intangible asset.
The process of amortisation, then, gives a more accurate view of the financial
performance and position of the business to the decision-making stakeholders of
the business.
APPLICATION OF AMORTISATION IN ACCOUNTING
Under International Financial Reporting Standards, guidance on accounting for
the amortisation of intangible assets is contained in IAS 38.
Not all intangible assets are amortised. Some intangible assets may be
considered to have an indefinite useful economic life and are considered to offer
continual earning potential to the business for the foreseeable future. A domain
name and brands could be included in this category. Either way these intangible
assets with an indefinite useful economic life still need to be assessed each year
to make sure that their value in the Balance Sheet is not overstated. This
checking process is called the impairment test.
The method used to amortise those intangible assets with a set useful economic
life is the straight-line method—that is, where the cost of acquiring the intangible
asset is written off (amortised) over the estimated useful economic life of the
asset.
For example, if the business had spent $20,000 in legal fees to secure a patent that
gave the business certain rights over the next 20 years, the value of the intangible
asset (Patents) would be expensed or amortised by $20,000/20years = $1,000 each
year for the next 20 years. This means that $1,000 would appear each year in the
Income Statement as Amortisation expense, with a corresponding adjustment being
made directly to the intangible asset Patents in the Balance Sheet. (Note: Unlike
depreciation of tangible assets, intangible assets do not have a contra account
called Accumulated Amortisation. The unamortised/unimpaired cost of intangible
assets is positioned in a separate section of the Balance Sheet immediately
following Property, Plant and Equipment.)

AMORTISATION PERIODS OF INTANGIBLE ASSETS IN ACCOUNTING
The amortisation period selected can have a significant impact on the reported
income for a business. The shorter the estimated useful economic life, the
Patents
ownersexpense
an
greater
theprovide
amortisation
and therefore the lower the net profit reported.
exclusive
right
to
use
or
So, it is important that the amortisation period closely matches its revenue
manufacture
a particular
generation
capacity.
product. The cost of a patent
Copyrights give owners the
Figure
36be
presents
some
examples.
should
amortised
over
its
exclusive right to produce or sell
useful life but not exceeding the
an artistic work. While a
patent’s legal life of 20 years.
copyright has a legal life equal
The Patent account should
to the life of the creator + 70
include only the cost of a patent
years, the economic useful life
purchase and costs relating to
is usually much shorter. The
the registration of the patent,
shorter economic life is the
like legal fees.
appropriate amortisation period

A franchise license gives owners
the right to manufacture or sell
certain products or perform
certain services on an exclusive
basis. The cost of a franchise
license is recorded in the Balance
Sheet as an intangible asset, and
should be amortised over the
estimated useful life identified in
the franchise agreement.

Trademarks/brands/internet
domains have fairly short legal
lives; however, because they
can be continually renewed,
they are deemed to have an
indefinite life.

Goodwill is a unique intangible
asset that is deemed to have an
indefinite life.

Figure 36 Some examples of amortisation periods of intangible
assets
WHAT IS COST OF GOODS SOLD?
Cost of goods sold (COGS) is the total of the costs incurred in producing the
product. The COGS is also called cost of sales.
COGS is the total of those costs directly related to the costs of production. They
are the expenses associated with production activities. Some typical COGS are
shown in Figure 37.
The COGS does not include indirect costs (overheads such as rent and
administration costs) which are not directly related to the production of products.
COGS are typically included in financial statements for those businesses that
make money from the sale of inventory (whether this be in retail, wholesale or
manufacturing).
EXPENSES TO INCLUDE IN COGS
Expense items included in the COGS vary from business to business. Businesses
can obtain helpful advice from their accountant, industry association or

government tax agency in identifying those items to include in the COGS and
those to include as overheads.
Sometimes the accounting standards to which accountants adhere may even
include different COGS items from those required under tax law.
COGS - INVENTORY
However, there are general principles that all parties follow:
1. Firstly, COGS only applies where there is a sale of inventory. So those
business that sell only services (like, for instance, lawyers and accountants)
do not usually have COGS.
2. Secondly, COGS are the total direct cost incurred in acquiring or converting
inventories for sale (that is, in getting products into inventory and then
getting them ready for sale).
3. Finally, COGS expenses change in proportion to changes in sales or
production (as opposed to fixed costs/overheads/indirect costs such as rent
that do not change in proportion to changes in sales and production). So, if
the expense is likely to change in relation to changes in sales or production,
it is most likely a COGS.
Retail businesses will usually include the cost of buying inventory for resale plus
the freight inwards costs in the COGS. Manufacturing businesses will include the
cost of raw materials, cost of parts and direct labour costs used to manufacture
the product ready for sale.
By deducting COGS from the sales for a given accounting period, we can
determine the gross profit of the business.

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Figure 37 Some typical COGS
WHAT ARE BAD DEBTS IN ACCOUNTING?
Bad debts occur when customer debts owed to the business for goods or
services provided cannot be collected. Bad debts are usually the result of
customer bankruptcy, company liquidation or where the extra cost of pursuing
the debt is more than the amount of money that the business could ever collect.
When a customer debt is classified as ‘bad’, it is written off in the books of the
business. This transaction reduces the value of the Accounts Receivable in the
Balance Sheet as it increases the expenses of the business in the Income
Statement.
BACKGROUND TO BAD DEBTS IN ACCOUNTING
Very few businesses can operate on a cash-only basis. (‘Cash-only basis’ means
being able to get the cash payment for goods and services at the time they are
provided.)
For many reasons it has become the norm in most businesses to provide goods
and services on credit. (‘On credit’ means that the goods and services are given
to the customer on the understanding that the customer will pay for them at a
predetermined time in the future.)

T

he system of allowing customers
to pay for goods and services
after they have received them is
known as extending credit, or
buying on credit terms, or
charging goods and services to the
customer’s account.
Selling goods and services on credit has benefits for the business. But there are
also risks in extending credit to customers. The primary risk is that the customer
will not pay for the goods and services according to the prearranged payment
terms. This failure of the customer to pay for goods and services is often caused
by personal bankruptcy or company liquidation but can also be caused by
unethical business practices.
Businesses that extend credit to customers do all that they can to minimise this
risk of non-payment by doing background checks on the customer’s prior history
and gathering sufficient information about the customers to assess their financial
position and earning potential. In spite of the best possible checks, though,
unforeseen circumstances make it impossible to eliminate all the risk. So in the
normal course of business, there will be times when customers just cannot pay
their bills.
When the business extending the credit recognises this fact, the debt
outstanding will be written off as a bad debt in the books of the business, as
mentioned above.
What this means is this: the business will record details of the bad debt
adjustment in the financial accounting system. The bad debt adjustment
transaction will reduce:

the amount of money expected from the Accounts Receivables and reported
in the Balance Sheet
the profit expectation of the business by increasing the expenses in the
Income Statement.

The decision to write off bad debts is usually determined by the organisation’s
credit policy. This may be done in the month that the debt is recognised as bad,
or the bad debt may be written off systematically—quarterly, half yearly or
annually. Publicly listed companies will usually write off bad debts on a 6-monthly
cycle to coincide with their corporate governance and reporting requirements.
RECOGNISING BAD DEBTS IN ACCOUNTING
How long a debt has been outstanding and unpaid can be one indicator of bad
debt. Many businesses consider that a debt that is overdue by more than 6

months should be considered a bad debt. The truth is, any debt can become bad
at any time particularly if there is a liquidation of a company’s business due to,
say, unforseen natural disasters.
Recognising bad debts is a judgement of the management of the business. That
judgement is applied on an account-by-account basis. Deciding on and
recognising bad debt generally follows one or more of the guidelines listed in
Figure 38.

The business receives advice from a solicitor,
collection agent or insolvency practitioner
that the customer has gone bankrupt or the
company has gone into liquidation.
If a customer has not paid the debt and
the cost of recovering the debt is greater
than the potential benefits, it is more
profitable to write off the debt.
If the customer disputes the debt and
the business cannot produce
documentary 'proof of delivery', the
debt may need to be written off.
It may be the result of the credit
policy of the business that all
customer debts greater than 1 year
must be written off as bad debts.
The customer owing the money
has not contacted the business
and they cannot be contacted
so the debt is written off.

Figure 38 Deciding on and recognising bad debt
BAD DEBTS AND THE TAX DEPARTMENT
The decision to write off debts as bad reduces the income reported by the
business for the year. This reduction in income has a direct impact on the tax
payable by the business. For this reason, tax offices have set guidelines that
must be followed in order to claim bad debts as a deduction against assessable
income for tax purposes.
As a rule, when claiming bad debt as an expense of the business in tax reports, it
is best to have some written confirmation/advice from an independent third
party, like an external administrator, solicitor or collection agent, of the likely loss
to be incurred by the business.
For example, the tax office in Australia has issued a tax ruling (TR 92/18) that
clarifies the circumstances in which a deduction for bad debts will be allowable.
These circumstances are:




the debtor has died leaving no, or insufficient, assets out of which the debt may
be satisfied
the debtor cannot be traced and the creditor has been unable to ascertain the
existence of, or whereabouts of, any assets against which action could be taken
where the debt has become statute barred and the debtor is relying on this
defence (or it is reasonable to assume that the debtor will do so) for nonpayment
if the debtor is a company, it is in liquidation or receivership and there are
insufficient funds to pay the whole debt, or the part claimed as a bad debt
where, on an objective view of all the facts or on the probabilities existing at
the time, the debt, or a part of the debt, is alleged to have become bad, there
is little or no likelihood of the debt, or the part of the debt, being recovered.

WHAT ARE DOUBTFUL DEBTS IN ACCOUNTING?
Doubtful debts are part of the end-of-period adjustment made by accountants to
the financial accounts of a business. The doubtful debt adjustment is made to
reflect the likelihood that debts owed to the business by some customers may
not be collected. The doubtful debts concept is built on the accounting principle
of conservatism which directs accountants to ‘anticipate no profit, but anticipate
all losses’.
The doubtful debt adjustment made by the accountant will increase expenses
(Doubtful Debts expense) and reduce Accounts Receivable. The reduction in
Accounts Receivable is done by creating a separate contra account in the
Balance Sheet called Provision for Doubtful Debts.
BACKGROUND TO DOUBTFUL DEBTS IN ACCOUNTING
Accountants operate under a set of guidelines known as the accounting
principles, concepts and conventions. Most of these accounting principles,
concepts and conventions have been included in government-required
accounting standards that direct accountants on how they are to prepare the
financial statements for a business. One of these principles is known as the
conservatism principle.

T

heconservatism principle is best
summed up in the quote by Bliss
in 1924 — ‘anticipate no profit,
but anticipate all losses’. In
other words, accountants should
not recognise/record profits until there is a
legal claim to the revenues that generate
the profits, but they should
recognise/record losses if there is a

likelihood that either the revenues or the
assets of the business could be overstated.
One asset that could be overstated in the Balance Sheet of a business is the
Accounts Receivable. Accounts Receivable is the monies owed to the business by
customers who have purchased goods and services on credit. These customers
are called debtors of the business. Accounts Receivables can become overstated
because not all customers will pay all of the money they owe.
Before preparing the financial statements of a business, the accountant will
review the Accounts Receivables to determine which of the debtor accounts
should be recorded as bad debts or doubtful debts under the conservatism
principle. Businesses generally look on bad debts and doubtful debts as the cost
of doing business. There are significant profit benefits to be gained for a business
in extending credit to customers and so bad debts and doubtful debts are just
some of the costs that need to be offset against those benefits.
The matching principle in accounting directs accountants to record the bad and
doubtful debts in the period in which the revenue was recorded. This is why the
bad and doubtful debts are included in the end-of-period adjustments made at
the end of the accounting cycle, before the financial statements of the business
are prepared.
ESTIMATING DOUBTFUL DEBTS
The end of the accounting cycle for most businesses is annual; however, some
publicly listed companies may make this adjustment half-yearly or quarterly.
Accounting for doubtful debts varies from business to business, with some
businesses making a provision of 1/12th of the annual amount in each monthly
reporting period. Most businesses will have a policy on how the doubtful debts
are to be accounted for.
While bad debts are identified specifically and can be pinpointed to specific
accounts and invoices that will never be repaid (for example, due to bankruptcy),
doubtful debts are a provision based on past history and current trends. Doubtful
debts are accounted for where it can be reasonably estimated that a certain
amount of the current Accounts Receivable will not be collected—that is, where
today’s estimated doubtful debts will eventually materialise into specific bad
debts at some time in the future.
What accountants are trying to do by including doubtful debts in the financial
reports is to explain to business stakeholders that it is reasonable to assume that
not all the monies owed by customers will be collected. Accountants are saying
to shareholders that they should take doubtful debts into account when
assessing the financial performance and financial position of the business.
It should be remembered that while bad debts represent the actual monies owed
that will not be collected, doubtful debts are only an estimate. Based on previous

history and current trends, businesses may estimate the value of doubtful debts
in a number of ways as shown in Figure 39.

As a % of annual turnover made
on account
As a % of total current debtors
As a total of specifically identified
debtors
As a % of debtors using the
ageing analysis (i.e. over 90 days
overdue)
As a set value based on past bad
debt expenses

Figure 39 Some ways that businesses may estimate doubtful
debts
DOUBTFUL DEBTS
When making adjustments to the financial accounts of a business based on a
judgement, accountants prefer to highlight the adjustment as a contra account in
the financial statements rather than including it as just another transaction in the
main account.
So when recording doubtful debts, accountants create a contra account called
Provision for Doubtful Debts, which will be a negative offset account for the asset
—Accounts Receivable.
So the doubtful debts transaction that needs to be entered into the books of the
business via the general journal before preparing the financial statements is:
Doubtful Debts expense
$x,xxx Dr Provision for Doubtful Debts
$x,xxx Cr
This transaction then reduces the profit reported by the business and also
reduces the amount of money expected to be received from the customers of the
business.
The Balance Sheet will then display the following in the Current Assets section:

Accounts Receivables
$xx,xxx
Less Provision for Doubtful Debts
$x,xxx
This statement tells the stakeholders of the business that while $xx,xxx is the
amount of money that is owed to the business from customers, based on past
experience and current trends the business expects that $x,xxx of that money
will not be collected and will eventually become bad debts.
It should be noted that while doubtful debts are recognised as an expense of the
business when preparing financial reports for most stakeholders, tax laws do not
allow doubtful debts to be claimed as a cost until they become bad debts (that
is, until it is certain that they cannot be collected).
WHAT IS THE DIFFERENCE BETWEEN BAD DEBTS AND DOUBTFUL DEBTS
IN ACCOUNTING?
A bad debt is the ultimate recognition of loss created when a specific debtor(s) is
acknowledged as being unable to pay the debt they owe to the business. This
loss, recorded in the Income Statement of a business assesses that, at this point
in time, the money owed to the business will never be received.
Doubtful debts on the other hand are an interim recognition of possible losses
caused by an irrecoverable (bad) debt that may take place sometime in the
future.
Bad debts will be linked to specific debtors and written off in the period in which
the revenue was earned. Doubtful debts are an estimate only, and a provision for
future business losses—usually based on previous history.
BACKGROUND TO BAD DEBTS AND DOUBTFUL DEBTS IN ACCOUNTING
Accounting is a process of recording financial transactions so that financial
reports can be produced for the stakeholders of a business. Stakeholders use
these reports to make decisions about the allocation of the scarce resources
within their control. For this reason, it is important that the financial reports are
accurate and present a true picture of the financial performance and financial
position of the business. A key requirement for accountants then is to ensure
that the assets of the business are not overstated.
One asset that is looked at closely by accountants before preparing the financial
reports is the Accounts Receivable account or Debtors. Before producing the
financial reports, accountants want to make sure that the Accounts Receivable
(the money the business expects to collect from its debtors) is not overstated.
As we have already seen, many businesses need to extend credit to their
customers to keep their custom. Otherwise, businesses may lose them,
particularly if other business competitors are able to extend generous credit

terms to the customers. However, inevitably, there will be some of these
customers who will not be able to pay their debts.
So these irrecoverable debts (whether bad debts or doubtful debts) are a cost of
doing business and need to be declared as expenses so that the profit will not be
overstated in the financial reports to stakeholders. These debts are an attempt to
better match the cost of offering credit with the beneficial revenue that is
generated from a credit policy.
BAD DEBTS AND DOUBTFUL DEBTS IN ACCOUNTING
The Accounts Receivable account could be overstated if it was obvious that an
amount of money owed to the business by a customer (debtor) has no chance of
being collected or paid by the debtor. As already indicated, this mostly occurs
when a debtor goes bankrupt or their company goes into liquidation.

An accountant would not be presenting a true and accurate financial report
for stakeholders if they continued to report this debt as an asset of the
business and continued to report the sale that created the debt as revenue.

In this situation accountants will record the irrecoverable money as a loss in the
Income Statement to offset the revenue and will write-off the value of that
particular debt from the Accounts Receivable asset as reported in the Balance
Sheet.
When preparing accurate financial reports that present a true picture of the
financial performance and financial position of the business, accountants must
also consider the previous history of the business in relation to the debt
collection of the account receivables. If previous history indicates that, typically,
bad debts represent, say, 5% of the Accounts Receivable balance, it would not be
accurate to report 100% of the Accounts Receivable as an asset. So, accountants
provide for this potential loss from Accounts Receivables that history suggests
will ultimately turn into bad debts.
This involves creating an expense for doubtful debts to reduce the profit reported
for the period as well as making a provision for doubtful debts to the Accounts
Receivable to show that it is not expected that 100% of the accounts receivable
will be collected.
Providing or allowing for doubtful debts is an attempt to match the costs of
offering credit to customers with the revenue that a credit policy generates.

Table 20 Characteristics of bad and doubtful debts
Bad debts

Doubtful debts

Bad debts occur when a specific account
receivable has been clearly identified as
not being collectible.

Doubtful debts occur when an accountant
make an assessment, based on previous
history, that a % of the current accounts
receivables will eventually turn into bad

Bad debts occur when all reasonable

efforts have been exhausted to collect the
amount owned but they still remain
outstanding.

debt.

Bad debts are assessed as either never
being collectible or not cost-effective to
pursue.

So, as part of the accountant’s duty to
prepare accurate financial reports that
reflect a true picture of the financial
performance and position of the business,
the accountant will make a provision for
doubtful debts in the books of the
business.

Bad debts are treated as an expense that
reduces the profit of the business as
reported in the Income Statement.

Doubtful debts are treated as an expense
that reduces the profit of the business as
reported in the Income Statement.

Bad debts are losses that have actually
happened.

Doubtful debts are losses that have not yet
happened but they are anticipated.

Bad debts are deleted/written off directly
from the Debtors (Accounts Receivable).

Doubtful debts are not deleted/written off
directly from the Debtors (Accounts
Receivable) but are posted as a
contra/offset account of the Accounts
Receivable called Allowance for Doubtful
Debts.

Bad debts is a nominal account that is
closed every year.

Allowance for doubtful debts is a
permanent account that is carried over into
the new financial period.

Bad debts are tax deductible.

Doubtful debts are not tax deductible.

WHAT IS A 10-COLUMN WORKSHEET IN ACCOUNTING?
A 10-column worksheet is a columnar template that helps accountants and
bookkeepers plan and facilitate the end-of-period reporting process.
A 10-column worksheet is not a mandatory step in the accounting process but is
often completed to help eliminate errors associated with the end-of-period
adjustments.
The 10-column worksheet conveniently ensures that all of the details related to
the end-of-period accounting and statement preparation have been properly
accounted for at the end of each fiscal period.
BACKGROUND TO 10-COLUMN WORKSHEET IN ACCOUNTING
One of the most important support tools to assist accountants and bookkeepers
is the electronic worksheet (for example, Microsoft Excel). There are times in the
accounting process when tasks are best handled by the electronic spreadsheet.

This is because accounting software is designed as a database—a collection
of records organised and stored in formats that allow for easy access and
management.

Compared with spreadsheets, databases have very limited analysis functions and
are not suited for demonstrating on one form the effect of multiple transactions.
Apart from budget variance analysis and financial ratio analysis, you will often
see electronic spreadsheets being used by accountants and bookkeepers in
areas such as:


depreciation schedules
asset registers
end-of-period adjustments.

The spreadsheet used to assist accountants and bookkeepers in calculating the
end-of-period adjustments is called the 10-column worksheet.
PURPOSE OF THE 10-COLUMN WORKSHEET
The primary purpose of preparing a 10-column worksheet is to help eliminate
errors that can be created by the complications involved in identifying,
calculating and correctly allocating the journal entries required in the end-ofperiod adjustment process. These errors could include:


failing to include key end-of-period adjustments
failing to adhere to the double-entry bookkeeping process
allocating the end-of-period adjustments to the wrong account.

The 10-column worksheet gives an entire overview of all the end-of-period
adjustments that need to be made and the columns are totalled to ensure that
the double-entry bookkeeping system is properly applied. Also, the 10-column
worksheet, when approved by an appropriated authority, will provide source
document evidence for audit purposes.
Without the 10-column worksheet, these internally created end-of-period
transactions would not have a source document to support their entry into the
general journal.
STRUCTURE OF THE 10-COLUMN WORKSHEET
The 10-column worksheet covers five key areas relating to the end-of-period
adjustments that each have debit and credit components. So, five areas
multiplied by two columns each creates the 10-column worksheet.
The five key areas are explained in Table 21.

Table 21 Five key areas of the 10-column worksheet
Key area

Comment

Trial balance

These columns record the complete list of account
balances currently in the General Ledger.

End-of-period adjustments

These columns record the end-of-period adjustments and

involve such transactions as accruals, deferrals,
depreciation, bad and doubtful debts, and inventory
adjustments.
Adjusted trial balance

These columns calculate the new account balances based
on the effect of the end-of-period adjustments. (Note:
Some 10-column worksheets may change this column to
Trading account, which calculates the gross profit by
recording the revenue accounts and the cost of goods
sold accounts.)

Income Statement

These columns record the revenue and expense account
balances from the adjusted trial balance. In the 10column worksheet, the debit and credit totals in the
Income Statement column will not be equal. The
difference between the total debits and credits in the
Income Statement column is the net profit or loss for the
business in the period under review.

Balance Sheet

If the credit total in the Income Statement column is
greater than the debit total, the business has made a
profit. This amount should be then recorded in the
Current Period Earnings account in the Balance Sheet
as a credit.
If the debit total in the Income Statement column is
greater than the credit total, the business has made
a loss. This amount should then be recorded in the
Current Period Earnings account in the Balance Sheet
column as a debit.

These columns record the Assets, Liabilities and Owner’s
Equity account balances from the adjusted trial balance.
The total of the debits and credits in this column will
balance only if the difference between the debit and
credit totals in the Income Statement is recorded in the
equity account Current Period Earnings account.

FINANCIAL STATEMENTS AND STANDARDS
HOW IS IFRS DIFFERENT FROM GAAP?
The Generally Accepted Accounting Principles (GAAP) and the International
Financial Reporting Standards (IFRS) are the predominant accounting standards
used today. GAAP is the American standard and IFRS is the predominant
European standard, used in 120 countries. GAAP is moving toward IFRS. GAAP is
rule based, whereas IFRS is principle based. Under GAAP, the methodology to
assess an accounting treatment is more focused on the literature, whereas under
IFRS, the review of the facts pattern is more thorough. According to the website
<http://www.ifrs.com/ifrs_faqs.ht>:
‘The biggest difference between US GAAP and IFRS is that IFRS provides much less
overall detail. Its guidance regarding revenue recognition, for example, is
significantly less extensive than the US GAAP. IFRS also contains relatively little
industry specific instructions’.

WHO ARE THE STAKEHOLDERS OF A BUSINESS?
Stakeholders are those affected (in a good or bad way) by the activities of a
business. There are many stakeholders in a business, internal and external.
Internal stakeholders are directly involved with the day-to-day operations of the
business, while external users are not.

EMPLOYEES
Stakeholders engaged, for various
time periods, to help a business
achieve its objectives. Financial
statements help employees decide
their long-term commitment to the
business. A growing, profitable and
financially strong business is more
likely to attract and keep highly
valued employees. Financial
statements also help employees
when negotiating collective
bargaining agreements with
management.

Figure 40 Internal

MANAGERS AND
OWNERS/OPERAT
ORS

Stakeholders employed by the
Board of Directors and
responsible for managing
business resources to achieve
the objectives of the business’s
strategic plans. Analysing
financial statements helps
managers make informed
decisions about the economic
achievements of the business
and so adjust strategies to
exploit identified opportunities
and mitigate potential threats.
stakeholders

BOARD OF
DIRECTORS
Stakeholders who set the
strategic direction and
objectives for the business
and who engage managers
to achieve them. Financial
statements allow the Board
of Directors to review the
performance of the
management in respect to
achieving objectives.

Stakeholders of a business:

are vitally interested in knowing about the present condition and future
prospects of the business
need to make decisions about their involvement with the business

want to know how strong and sustainable the business is financially so they
can make good decisions.

Investors

Lenders

Stakeholders who buy shares in a
company. Shares entitle the investor to
a proportional share of the company’s
equity and profits. Shares in public
companies are traded on stock
exchanges and provide investors with
dividends. Investors use financial
statements to assess the financial
strength of a company, which impacts
on their investment decisions.

Stakeholders who supply
funds to the business on
short- and/or long-term
basis. Lenders are
typically financial
institutions that provide,
say, short-term
overdrafts, invoice
financing for debtors,
term loans for expansion
plans, leasing finance for
equipment purchases ,or
mortgages for property
purchases.

Suppliers and
customers
Suppliers are stakeholders who
provide products and services
to the business on credit terms
that allows the business to pay
for the goods and services at a
later time. Suppliers use
financial statements to assess
the creditworthiness of the
business.

Existing equity investors use
Customers are stakeholders
financial statements to monitor their
who use financial statements to
investments and evaluate
evaluate the financial strength
management performance .
and staying power of the
Financial Institutions use

Prospective equity investors use
business as a dependable
financial statements to
financial statements to decide if
resource for their business.
investing in the company. Investment decide if to grant a
Media
business fresh working
decisions are supported by
capital or to extend debt Stakeholders who use the
investment analysts who use
securities (such as a long- information supplied by enterprises
financial statements with their
term bank loan) to
buy/sell/hold recommendations.
to publish in their mass
finance expansion and

Rating agencies like Moody's use
communication outlets. The media
financial statements to assign credit other significant
use financial statements to analyse
ratings to companies—this also helps
and comment on the performance
investors make their investment
and position of an enterprise they
decisions.
think would interest their

Other investors who may use
readership.
financial statements in their decision
Competitors
making include potential joint
venture partners and either
Stakeholders who compete for customers in the same market as
franchisers or franchisees .
the enterprise. Competitors use financial statements to
Government
benchmark their own financial results to identify variances to
departments and
target for improvement or exploit as an opportunity. Potential
agencies
competitors may use financial statements to assess how
Stakeholders that
profitable it may be to enter an industry.
regulate the way
Supporters and opponents
companies conduct their Labour unions
business including the
Stakeholders who represent
Other external stakeholders include
payment of taxes and
the best interest of the
people who may support or oppose the
other duties owed. They
employees of an enterprise.
actions and activities of an enterprise.
use financial statements
They use financial statements
They include politicians, lobbyists, issue
to ascertain the propriety
to gauge how much of a pay
groups, consumer advocates,
and accuracy of taxes and
increase an enterprise is able
environmental lists, think tanks and
other duties declared and
to afford in an upcoming
foundations. They use financial
paid by a company.
wages negotiation.
statements to provide objective
evidence for their position.

Figure 41 External stakeholders

WHAT ARE FINANCIAL STATEMENTS IN ACCOUNTING?
Financial statements are a set of numeric records that summarise the financial
activities of a business and so describe the financial position and performance of
a business.
Financial statements are used by stakeholders (internal and external) to assess
the financial position and performance of a business. The information provided
by the financial statements helps supports their decisions and actions about the
allocation of resources within their control.
For example, financial statements:


help investors assess the viability and financial performance of the business
that they have invested in, particularly in relation to the profit/loss trends
help creditors/lenders determine their credit limits and loan exposures with
the business
help the internal managers respond to current opportunities and pinpoint
unexpected expense increases and to predict future performance via the
budgetary process
provide a basis for calculating the income tax liability of the business by the
government tax office.

The three statements that make up these financial reports are:
• Income Statement, or Profit and Loss Statement (also called Statement of
Financial Performance)
• Balance Sheet (also called Statement of Financial Position)
• Cash Flows Statement.
INCOME STATEMENT (STATEMENT OF FINANCIAL PERFORMANCE)
The Income Statement (besides the alternative terms given above, also
sometimes called the Revenue Statement, the Earnings Statement, the
Operating Statement or the Statement of Operations) describes the financial
sustainability of the business. That is, it lists and totals the revenue earned (for
example, from inventory sales or service fees), and takes away from the revenue
total the total of the costs (expenses) in earning that income, such as wages and
salaries, administration costs, financial and occupancy costs. This produces the
net profit or loss for the business.

A positive result is profit, which increases the net worth of the business and
makes the business more sustainable.
A negative result is a loss, which decreases the net worth of the business and
makes the business less sustainable.

In other words, the Income Statement measures the change in net worth and
sustainability of the business.

The Income Statement also provides information relating to the adequacy of the
selling prices (via the gross profit %) and the sufficiency of the profit in relation
to the owner’s investment (via a Return on Investment calculation). The net
profit for the period appears in the equity section of the Balance Sheet as
Current Earnings.
The Income Statement is produced annually so that the income tax owed by the
business to the tax office can be calculated. However, Income Statements are
also often produced monthly or quarterly to update management regularly and
help them with their decision making.
However frequently it is produced, the Income Statement is prepared for a past
period (yearly, quarterly or monthly). The statement is headed with the line: ‘for
the [period] ending [date]’.
EXTRA THINGS TO CONSIDER
While accounting attempts to produce a ‘true and fair’ picture of the financial
performance of a business via the Income Statement, there are some issues that
will impact of this goal. Some examples are given below.

There are some valuable items that while very relevant to a business are not
measured by the accounting system and so are not reported on the Income
Statement. These items could include such things as brand recognition,
organisational reputation or customer loyalty.
Different valuation methods allowable in accounting will produce different
profit results. For example the valuation of inventory using the FIFO (first in,
first out), LIFO (last in, first out) or Item Cost method will each produce a
different profit result.
Some values reported on the Income Statement depend on judgments and
estimates. For example, depreciation expense is calculated based on the
estimated useful life and estimated salvage value of the fixed asset.

BALANCE SHEET (STATEMENT OF FINANCIAL POSITION)
The Balance Sheet (also known as the Statement of Financial Position) describes
the financial strength of a business at a particular point in time. That is, it
identifies, at a specific point in time, the value of the assets controlled by the
business as well as the entities that have claims (creditors, funders and owners)
over those assets. It presents the accounting ‘net worth’ of the business that
demonstrates its financial status and strength.
All financial transactions of a business change values in this statement. The
Balance Sheet is, in effect, a detailed representation of the accounting equation.
The accounting equation lists the assets and then represents the liabilities and
owner’s equity that have a claim over these assets.

T

he strength of a business is
represented by the percentage of
the assets that are controlled by
the owners—and not by others.

Analysis of the Balance Sheet gives significant insights into the management of
the business. These ratios include liquidity, solvency and efficiency.
While the Balance Sheet looks back on a prior trading period (last month, last
quarter, last year), the Profit and Loss Statement looks at a business as a
‘snapshot‘ in time. This is why the Balance Sheet is headed up with the line: ‘as
at [date]’.
CASH FLOWS STATEMENT
Any movement of cash in or out of a business is referred to as cash flow.
The Cash Flows Statement ties together all the details from the Income
Statement and the Balance Sheet to summarise the overall picture of cash
inflows and outflows over a given period. In particular, it reports on the inflow
and outflow of cash in relation to operating activities, investing activities and
financing activities. It compares the opening balances with the closing balances
on cash or cash equivalent accounts.
One of the key interests by stakeholders is the net worth, and changes in net
worth of a business. Net worth is also known as owner’s equity (or equity) or net
assets. (Net worth is the money that would be left over if all the assets of the
business were sold and the liabilities fully repaid.)
The Cash Flows Statement informs decision makers about the movement of cash
funds between where the cash funds came from and how those funds have been
used.
This movement of cash in an organisation is calculated by comparing the
financial statements of two consecutive periods. By ignoring the non-cash
activity (that is, depreciation, credit sales and purchases, bad and doubtful debt,
prepayments and so on), the Cash Flows Statement is able to show in detail how
and where the cash balance of the business increased and decreased.

T

he Cash Flows Statement
demonstrates the source of funds and
how they were applied and the ability
of the business to pay its bills as they
become due.

A Cash Flow Statement is usually prepared alongside the Income Statement and
Balance Sheet. While the latter reports are about an organisation’s financial
sustainability and financial strength, respectively, the Cash Flow Statement
reports on the organisation’s ability to continue to pay its bills as they fall due.
HOW DO YOU READ AND UNDERSTAND A BALANCE SHEET?
As explained earlier, a Balance Sheet is a financial report supplied to the internal
and external stakeholders of the business. The Balance Sheet helps stakeholders
to determine a business’s financial strength. The Balance Sheet presents the
financial status of the business at a specific point in time.
BALANCE SHEET BASICS
The Balance Sheet is a financial statement or report that:

itemises the things of value that the business owns/controls (Assets)
lists the entities which have legal claims over those assets. These claims are
made by two groups: (1) the external funding entities (Liabilities) and (2) the
internal investors (Owner’s equity).

It is called a Balance Sheet (or Statement of Financial Position) because the total
value of the Assets will always equal the total value of the Liabilities and the
Owner’s Equity combined. This formula is known as the accounting equation.
The Assets and Liabilities listed on the Balance Sheet are further subdivided as:

current
non-current.

This separation helps stakeholders to understand the expected timeframes of
these amounts.
 Debts due within the next 12 months are categorised as current liabilities.
 Assets that can be readily converted into cash (usually within the next 12
months) are categorised as current assets.
 All other assets and liabilities as categorised as non-current.
The total amount of the Owner’s Equity is also known as the Net Worth of the
company. Net Worth is the amount of money that would be left over if all the
Assets were sold at Balance Sheet values and the external funders (Liabilities)
were paid out in full.
Total Owner’s Equity is the first and obvious read of a Balance Sheet in relation to
a business’s financial strength. Total Owner’s Equity quantifies how much the
business is worth from an accounting point of view. (Note: An accounting point of
view does not take into account any value for future profit potential. The
accounting point of view also values assets at the time of purchase, not at what
they might be worth today. Owner’s Equity is typically made up of the
shareholders/owners initial and additional investments (Capital), the profits from
previous periods that have not yet been distributed to the shareholders/owners

(Retained Earnings) and the profits earned from the current trading period
(Current Earnings).)
FINANCIAL RATIOS
Understanding the financial strength of a business from reading a Balance Sheet
generally requires a certain amount of analysis and comparison. It also requires
access to the Income Statement (also known as the Statement of Financial
Performance).
This analysis of the Balance Sheet is called the Financial Ratio and Trend
Analysis. By comparing this period’s calculated financial ratios with those of prior
periods, with industry benchmarks and with generally accepted sound operating
levels, healthy/unhealthy trends in the financial strength of the business can be
identified.

Whether
Whether returns
returns from
from the
the business
business are
are competitive
competitive with
with
other
other investment
investment options
options

Whether
Whether the
the company
company is
is becoming
becoming more
more or
or less
less
profitable
profitable

Whether
Whether the
the company
company is
is becoming
becoming more
more or
or less
less
dependent
dependent on
on external
external funders
funders
Whether
Whether the
the company
company is
is becoming
becoming better
better or
or less
less able
able to
to
meet
meet its
its financial
financial obligations
obligations when
when they
they become
become due
due or
or
more
more or
or less
less efficient
efficient at
at managing
managing the
the assets
assets of
of the
the
company.
company.

Figure 42 What stakeholders can determine by calculating and
comparing financial ratios
There are many different types of financial ratios but they are generally collated
into four groups, listed in Figure 43, and described further below.

Liquidity/solvency ratios

Leverage ratios

Types of financial
ratios
Profitability ratios

Operational ratios

Figure 43 Types of financial ratio
LEVERAGE RATIOS
These ratios calculate the extent to which the company uses external debt in its
capital structure rather than using equity funders. Over-relying on external debt
makes the profitability of a business more vulnerable to interest rate raises, and
the business more vulnerable to liquidation actions by creditors and financial
institutions during an economic downturn.
The most common leverage ratio is the debt to equity ratio.
For example, assume there is a total debt of $850,000 and a total owner’s equity of
$425,000. The debt to equity ratio here would be ... Total debt (850,000) / Total
owner’s equity (425,000) = 2.0. What this means is this: for every $1 that the
owners have invested in the business, external funders have committed $2. This
company would generally be considered highly geared or leveraged.

LIQUIDITY/SOLVENCY RATIOS
These ratios calculate the business’s ability to pay its debts as they become due.
Some businesses might be profitable but unable to pay critical payments, such
as staff salaries, loan repayments or rent, because the money of the business is
tied up in debtors (money owned to the company by customers) or in inventory.
The most common Liquidity/Solvency ratio is the quick ratio.
For example, assume that current assets total $355,000, Inventory totals $250,000
and current liabilities total $150,000. The quick ratio would be ... (Current assets
(355,000) less inventory (250,000) / Current liabilities (150,000) = 0.70.What this
means is this: for every $1 due for payment in the next month or so, the business
has $0.70 in liquid (cash or soon to be cash) assets. Generally a quick ratio of 1.00
is considered a safe operating ratio.

OPERATIONAL RATIOS
These ratios calculate the efficiency of a business’s management operations and
use of assets. Typical ratio efficiencies deal with stock turn and debtor days.

Stock turn measures the optimum amount of stock required to achieve sales
targets.
Debtor days measure how many days it takes for the business to get paid by
its customers.

Generally, a business would not want to overstock and would want its debtors to
pay in the shortest possible time.
PROFITABILITY RATIOS
These ratios calculate the profitable return on sales and capital tied up in the
business. These ratios are usually expressed as a % and monitored over timeconsecutive periods to help identify healthy or unhealthy trends. Typical
profitability ratios are:



gross profit as a % of sales
net profit as a % of sales
net profit as a % of assets
net profit as a % of owner’s equity.
For example, assume that current earnings total $75,000, total assets total
$1,275,000 and owner’s equity totals $425,000:
 net profit as a % of assets would be ... current earnings (75,000) / total assets
(1,275,000) = 5.9%
 net profit as a % of owner’s equity would be ... current earnings (75,000) / total
owner’s equity (425,000) = 17.6%. This means that if competing investment
opportunities provide a lower return than 17.6 %, then the investment in this
business remains worthwhile.

By comparing Balance Sheet report ratios with those for prior periods, with
commonly agreed safe operating levels and with industry benchmarks, the
changing financial strength/health of the business can be more easily
understood.
HOW DO YOU READ AND UNDERSTAND THE INCOME STATEMENT?
As indicated earlier in this section, the Income Statement, along with the Balance
Sheet, is a key financial report produced by the accounting information system.
These financial reports convey to management and other stakeholders a concise
picture of the profitability and financial position of a business.

The Balance Sheet reports on the financial position, strength and net worth
(Owner’s Equity) of a business at a specific point in time.

The Income Statement reports on the viability, profitability and ‘bottom line
(net profit/loss) of a business for a given accounting period. These
accounting periods are typically monthly, quarterly or annually.

So, while net profit results from deducting from the revenue the expenses
incurred in earning that revenue, net earnings for a period further deducts the
interest and tax expense and adds/subtracts gains/losses from non-core business
activities (for example, foreign exchange, asset sales). The net earnings amount
from the bottom line of the Income Statement is reported in the account Current
Year Earnings, which is part of the Owner’s Equity section of the Balance Sheet.

C

hanges in Owner’s Equity then
occur directly in proportion to
those transactions involving
earning revenue and incurring
expenses. This is why in
double-entry bookkeeping, increases in
revenue are treated in the same way as
increases in Owner’s Equity— as a credit—
because the potential profits that revenues
produce are due to the owners of the
business.
The Income Statement primarily addresses the question regarding the economic
performance of the business. The Income Statement answers the question: Did
the business do well (make a profit) or did it do badly (incur a loss)? Earning
revenue and incurring expenses is so critical to the viability of a business that it
requires this separate and detailed Income Statement report to periodically
monitor the operating results of a business.

KeyFACTS
An Income Statement describes:

firstly, the outcomes derived from a business generating revenue as it exchanges goods or

services with its customers in return for money or other assets
secondly, the outcomes in relation to the expenses incurred in exchanging its goods and services

with these customers in the pursuit of revenue
lastly, the net income or profit realised from offsetting the expenses against the revenues that
they generated. If the revenue exceeds the expenses, the business generates a profit. If the
expenses exceed the revenue, the business incurs a loss.

INCOME STATEMENT DETAILS
REVENUES EARNED AND EXPENSES INCURRED IN EARNING THAT REVENUE
The Income Statement summarises the revenues earned and subtracts the
expenses incurred in earning that revenue to calculate the resulting net profit or
loss for a given accounting period. The Income Statement contains the often
referred to ‘bottom line’ of a business in that it calculates the net profit or losses
for a given period and reports this as the last line on the Income Statement.
MONEY RECEIVED FROM SALE OF PRODUCTS OR PROVISION OF SERVICES
At the top of the Income Statement is the total amount of money received from
the sale of products or the provision of services. This top line may also be
referred to as sales or gross revenues because expenses have not yet been
deducted. If sales returns and allowances have been given in the period, these
will be deducted from gross sales to produce the net sales.
Not all Income Statements follow the exact same format due to the fact that not
all revenue and expense accounts are used by all businesses to produce net
profit. Businesses selling tangible goods will usually separate the cost of goods
sold from other expenses so that a gross profit result can be calculated. Other
manufacturing and service industries may deduct direct costs from the sales/fees
earned to calculate their gross profit or gross margin.
Gross profit directly reflects the pricing policies of a business, which can be easily
compared to industry benchmarks and competitor results. Other revenues are
then added to the gross profit to calculate the total revenue for the period.
OPERATING EXPENSES
Operating expenses is the next section summarised on the Income Statement.
These are the costs of doing business or the expenses incurred in earning the
revenue. Under the matching principle applied in accrual accounting, all
expenses incurred in earning the revenue for the given accounting period should
be included in the Income Statement regardless of their paid or unpaid status.
These expenses are typically summarised and reported by expense
classifications including:


Selling and Distribution (often referred to as ‘selling expenses’)
General and Administration Expense
Financial Expense.

These expenses are totalled and subtracted from the gross profit to produce the
net profit or EBIT. (Earnings Before Interest and Tax). This result is often called
Income from Operations. Net earnings (after interest and taxes have been
deducted) is the amount that is reported as Current Earnings in the Owner’s
Equity section of the Balance Sheet.

Non-profit organisations do not generally produce an Income Statement. They
produce a statement of activities which compares funding sources with program
expenses, administrative costs and other operating commitments to arrive at a
surplus or shortfall in funds.
WHAT IS THE FINANCIAL RATIO ANALYSIS?
Financial ratio analysis uses the information contained in the financial statement
of a business to assess the current financial performance and position of a
business relative to its prior years and industry benchmarks. Financial analysis
ratios are typically grouped into:




liquidity ratios
debt ratios
profitability ratios
efficiency ratios
value ratios.

Assessment of the financial performance and position of a business using
financial ratio analysis is usually made after reviewing multiple financial ratios
and calculations.
BACKGROUND TO FINANCIAL RATIO ANALYSIS
Most analysis of publicly traded companies is done via the computation of
financial ratios—that is, calculating the relationship between two sets of financial
numbers reported by the company in their financial statements. The two key
financial statements used in this regard are the Balance Sheet and the Income
Statement.

The Balance Sheet reports on the company's financial strength at a particular
point in time and the Income Statement reports on the financial performance
of the company over a past period of time (usually the past 12 months).

The calculated ratio for a particular period has only limited value in terms of
insight into the financial performance of a company, but when it is compared to
(a) prior years (b) same industry benchmarks (c) cross-industry benchmarks and
(d) company budgets, it can provide insights into both the immediate,
developing and structural problems of a company and the opportunities that
should be exploited.
There are hundreds of financial ratios that can be calculated; however, most can
be grouped into the one of the following aspects of diagnostics described below.

Liquidity: These ratios measure how quickly a company can convert assets
into cash to meet its immediate financial obligations.
Debt: These ratios measure the company’s reliance on debt funds and its
ability to meet the obligations of those funds.


Profitability: These ratios measure the growth and level of profitability in
relation to a company’s assets, sales and shareholder investment.
Efficiency: These ratios measure the performance of the company’s
executives in relation to the efficient management of the assets under their
control.
Value: These ratios measure the value of a company’s shares/stock from an
investors point of view.

These ratios should not be interpreted on a stand-alone basis, but each should
be assessed in combination with other ratios to help establish a picture of the
current and developing financial position and performance of the company.
TYPES OF FINANCIAL RATIO ANALYSIS
ANALYSING LIQUIDITY RATIOS
The most common financial ratios used when analysing a business’s liquidity are:

current ratio = (total current assets) / (total current liabilities)
quick ratio = (total current assets inventories) / (total current liabilities)

ANALYSING DEBT RATIOS
The most common financial ratios used when analysing a business’s debt
position are:

debt ratio = (total debt) / (total assets)
interest cover ratio = (earnings before interest tax) / (annual interest
expense)

ANALYSING PROFITABILITY RATIOS
There are many profitability ratios that can be calculated but the most common
ones used when analysing a business’s profitability are:


gross margin = (gross margin $) / (total sales)
EBIT % = (earnings before interest tax) / (net sales)
return on equity = (earnings after tax) / (shareholder equity)

ANALYSING EFFICIENCY RATIOS
There are many efficiency ratios that can be calculated but the most common
ones used when analysing a business’s efficiency are:

inventory turnover = (cost of goods sold) / (average inventory)
average collection period = ((Accounts Receivable) / (net sales)) x 365

ANALYSING VALUE RATIOS

The most common ratios used by shareholders when analysing a business’s
value are:

earnings per share = (net earnings) / (number of shares issued)
P/E = (market price per share) / (earnings per share)

LIST OF ACCOUNTING TERMS AND ABBREVIATIONS
The following is a list of accounting terms, and the alternative terms and
abbreviations that, while meaning the same thing, are commonly substituted for
these terms in accounting literature.
‘Keeping the books’: bookkeeping
The ‘bottom line’: earnings, net Income, net profit
The ‘top line’: turnover, revenue, fees earned, sales
A/C: account
A/P: Accounts Payable, Payables, Trade Creditors
A/R: Accounts Receivable, Receivables, Trade Debtors, Debtors Book
ABN: Australian Business Number
Account categories: elements of the accounts, five account groups
Account customers: trade debtors, debtors, A/R, Debtors Book
Accounting clerk: bookkeeper, accounting technician
Accounting entity: business entity, organisational entity
Accounting system: double-entry bookkeeping system, Venetian method
Accounting technician: accounting clerk, bookkeeper
Accounts receivable: receivables, trade debtors, A/R, debtors book
Acid test ratio: quick ratio, liquidity ratio
ACN: Australian Company Number
Adjusting journal entries: end-of-period adjustments, balance-day
adjustments, year-end adjustments
Allowance for bad and doubtful debts: provision for doubtful debts, bad
debts reserve, allowance for doubtful accounts
ARR: average rate of return
ATO: Australian Taxation Office
Bad debts: uncollectible debts, bad debt expense, uncollectable accounts
Bad debts reserve: provision for doubtful debts, allowance for bad and
doubtful debts, allowance for doubtful accounts

Balance day adjustments: adjusting journal entries, end-of-period
adjustments, year-end adjustments
Balance Sheet: Statement of Financial Position, Statement of Net Assets,
Statement of Financial condition
Balance Sheet accounts: permanent accounts, real accounts
BAS: Business Activity Statement, Australia
Book of accounts: General Ledger, nominal ledger
Book of final entry: nominal ledger, book of accounts, GL, General Ledger
Book of original Entry: journal, day book
Book value: carrying value, written-down value
Bookkeeper: accounting clerk, accounting technician
Bookkeeping: keeping the books
Burden cost: indirect costs, overheads, facilities and administrative costs
Business entity: accounting entity
CA: chartered accountant
Capital: net worth, equity, shareholder’s equity, owner’s equity
Capital asset: fixed asset, non-current asset, long-term asset, tangible asset
Carrying value: book value, written-down value
Cash accounting: cash method, cash basis
Cash basis: cash method, cash accounting
Cash book: cash receipts and cash payments journal
Cash Flow Statement: Statement of Cash Flows, Funds Flow Statement, Funds
Statement
Cash method: cash accounting, cash basis
Cash Receipts and Cash Payments Journal: cash book
CGT: Capital Gains Tax, Australia
COA: Chart of Accounts
COGS: cost of goods sold, cost of sales
Contra accounts: valuation allowances accounts

Cost of goods sold: COGS, cost of sales
Cost of sales: COGS, cost of goods sold
CPA: certified practicing accountant
Cr: credit
Current ratio: working capital ratio
Day book: journal, book of original entry
Debt service ratio: interest coverage ratio
Debt to equity ratio: gearing ratio, leverage ratio
Debtors: trade debtors, account customers
Debtors Book: receivables, accounts receivable, debtors, account customers,
trade debtors
Declining balance method: reducing balance method, diminishing balance
method, diminishing value method
Diminishing balance method: declining balance method, reducing balance
method, diminishing value method
Diminishing value method: reducing balance method, diminishing balance
method, declining balance method
Double-entry bookkeeping system: accounting system, Venetian method
Dr: debit
Earnings: net profit, net income, the ‘bottom line’
Earnings before taxes: net profit before tax, pre-tax book income, net
operating income before taxes, pre-tax income
Earnings statement: Profit and Loss Statement, Income Statement, P&L,
Operating Statement, Statement of Operations, Statement of Financial
Performance
EBDTA: earnings before depreciation, taxes and amortisation
EBIDTA: earnings before interest, depreciation, taxes and amortisation
EBIT: earnings before interest and tax
EBITDA: earnings before interest, tax, depreciation and amortisation
Elements of the accounts: five account groups, account categories

End-of-period adjustments: Balance day adjustments, adjusting journal
entries, year-end adjustments
EPS: earnings per share
Equity: net worth, owner’s equity, shareholders’ equity, capital
Equity Statement: Statement of Retained Earnings, Statement of Owner’s
Equity, equity report
EVA: economic value added
Exclusions: excluded income
Excluded income: exclusions
Expenses: expired costs, revenue expenditures
Expired costs: expenses, revenue expenditures
Facilities and administrative costs: indirect costs, overheads, burden cost
FBT: Fringe Benefit Tax, Australia
Fees earned: turnover, revenue, the ‘top line’, sales
FIFO: first in, first out
Five account groups: elements of the accounts, account categories
Fixed asset: non-current asset, long-term asset, capital asset, tangible asset
Fixed instalment: Straight-line method, prime cost method, flat rate method
Flat rate method: Straight-line method, prime cost method, fixed instalment
Funds Flow Statement: Statement of Cash Flows, Cash Flow Statement, Funds
Statement
Funds Statement: Statement of Cash Flows, Cash Flow Statement, Funds Flow
Statement
FYE: fiscal year end
GAAP: generally accepted accounting principles
Gearing: leverage
Gearing ratio: leverage ratio, debt to equity ratio
General Ledger: nominal ledger, book of accounts, GL, book of final entry
GL: nominal ledger, book of accounts, book of final entry, General Ledger
Going concern assumption: Going concern concept

Going concern concept: Going concern assumption
GST: Goods and Services Tax, Australia
IAS: Instalment Activity Statement, Australia
Imprest fund: petty cash
Income Statement: Profit and Loss Statement, Statement of Financial
Performance, P&L, Earnings Statement, Operating Statement, Statement of
Operations
Indirect costs: overheads, facilities and administrative costs, burden cost
Interest coverage ratio: debt service ratio
Inventory: stock, stock on hand, trading stock
Inventory turnover ratio: stock turn, stock turnover
Journal: book of original entry, day book
Leverage: gearing
Leverage ratio: gearing ratio, debt to equity ratio
LIFO: last in, first out
Liquidity ratio: acid test ratio, quick ratio
LOC: line of credit
Long-term asset: fixed asset, non-current asset, capital asset, tangible asset
Long-term liability: non-current liability
Mixed costs: semi-variable costs
Net income: net profit, net earnings, the ‘bottom line’
Net operating income before taxes: earnings before taxes, pre-tax book
income, pre-tax income, net profit before tax
Net profit: earnings, net income, the ‘bottom line’
Net profit before tax: earnings before taxes, pre-tax book income, net
operating income before taxes, pre-tax income
Net worth: equity, owner’s equity, shareholders’ equity, capital
Nominal accounts: temporary accounts
Nominal ledger: General ledger, book of accounts
Non-current asset: fixed asset, long-term asset, capital asset, tangible asset

Non-current liability: long-term liability
Non-operating revenue: other revenue
NOP: net operating profit
NOPAT: net operating profit after tax
NPAT: net profit after tax
NPBIT: net profit before interest and tax
NPBT: net profit before tax
NPV: net present value
Operating statement: Profit and Loss Statement, Income Statement, P&L,
Earnings Statement, Statement of Financial Performance, Statement of
Operations
Other revenue: non-operating revenue
Other revenue: non-operating revenue
Overheads: indirect costs, facilities and administrative costs, burden cost
Owner’s equity: net worth, equity, shareholders’ equity, capital
P&L: Profit and Loss Statement, Income Statement, Statement of Financial
Performance, Earnings Statement, Operating Statement, Statement of
Operations
Payables: accounts payable, A/P, trade creditors
PAYGI: Pay As You Go Instalment, Australia
PAYGW: Pay As You Go Withholding, Australia
Petty cash: imprest fund
Permanent accounts: real accounts, Balance Sheet accounts
PP&E: property, plant and equipment
Pre-payments: prior payments
Pre-tax book income: earnings before taxes, net profit before tax, net
operating income before taxes, pre-tax income
Pre-tax income: earnings before taxes, pre-tax book income, net operating
income before taxes, net profit before tax
Prime cost method: flat rate method, straight-line method, fixed instalment
Prior payments: pre-payments

Profit and Loss Statement: Income Statement, Statement of Financial
Performance, P&L, Earnings Statement, Operating Statement, Statement of
Operations
Provision for doubtful debts: allowance for bad and doubtful debts, bad debts
reserve, allowance for doubtful accounts
Quick ratio: acid test ratio, liquidity ratio
Real accounts: permanent accounts, Balance Sheet accounts
Receivables: accounts receivable, A/R, trade debtors, debtors book
Reducing balance method: declining balance method, diminishing balance
method, diminishing value method
Retained earnings: retentions
Retentions: retained earnings
Residual value: salvage value, trade-in value
Revenue: sales, turnover, fees earned, the ‘top line’
Revenue expenditures: expenses, expired costs
ROA: return on assets
ROE: return on equity
ROI: return on investment
Sales: turnover, revenue, fees earned, the ‘top line’
SAG expenses: selling, administrative and general expenses; SA&G
SA&G: selling, administrative and general expenses; SAG expenses
Salvage value: residual value, trade-in value
Semi-variable costs: mixed costs
SGC: Superannuation Guarantee Charge, Australia
Shareholders’ equity: net worth, owner’s equity, equity, capital
Statement of Cash Flows: Funds Flow Statement, Cash Flow Statement, Funds
Statement
Statement of Financial Condition: Balance Sheet, Statement of Financial
Position, Statement of Net Assets

Statement of Financial Performance: Profit and Loss Statement, Income
Statement, P&L, Earnings Statement, Operating Statement, Statement of
Operations
Statement of Financial Position: Balance Sheet, Statement of Net Assets,
Statement of Financial condition
Statement of Net Assets: Balance Sheet, Statement of Financial Position,
Statement of Financial Condition
Statement of Operations: Profit and Loss Statement, Income Statement, P&L,
Earnings Statement, Operating Statement, Statement of Financial Performance
Statement of Owner’s Equity: Statement of Retained Earnings, Equity
Statement, Equity report
Statement of Retained Earnings: Equity Statement, Statement of Owner’s
Equity, Equity report
Stock: inventory, stock on hand, trading stock
Stock on hand: inventory, stock, trading stock
Stock turn: stock turnover, inventory turnover ratio
Stock turnover: stock turn, inventory turnover ratio
Straight-line method: flat rate method, prime cost method, fixed instalment
Tangible asset: fixed asset, non-current asset, capital asset, long-term asset
Temporary accounts: nominal accounts
TFN: Tax File Number, Australia
Trade creditors: accounts payable, A/P, payables
Trade debtors: receivables, accounts receivable, debtors, account customers,
debtors book
Trade-in value: salvage value, residual value
Trading stock: inventory, stock, stock on hand
Turnover: sales, revenue, fees earned, the ‘top line’
Uncollectible debts: bad debts, bad debt expense, uncollectable accounts
Valuation allowances accounts: contra accounts
VAT: value added tax
Venetian method: double-entry bookkeeping system, accounting system

WIP: work-in-progress
Working capital ratio: current ratio
Written-down value: carrying value, book value
Year-of-end adjustments: end-of-period adjustments, balance day
adjustments, adjusting journal entries.

GLOSSARY OF ACCOUNTING TERMS
‘Account for’ or ‘bring to account: accounting phrase used to describe the
recording of a financial transaction that is required under the generally accepted
accounting principles.
‘The books’: accounting phrase use to describe the accounting records of a
business that are used to enter transactions into journals, then classify them into
ledger accounts and ultimately produce the financial statements.
Accounting: the process of recording, analysing, reporting and interpreting the
financial effect of business activities.
Accounting basis: refers to how financial transactions are measured for
recording purposes (that is,cash basis vs accrual basis, historical cost basis,
going concern basis).
Accounting cycle: the complete process from identifying and recording the
financial transactions of the business to their eventual summarisation in the
Balance Sheet at the end of an accounting period, which then forms the start
point for the financial activities in the next accounting period.
Accounting equation: Assets = Liabilities + Owner’s equity. It means that the
amount of money that owners (owner’s equity) and non-owners (liabilities) have
provided to the business will always be represented by the total value of the
assets that the business legally controls. The accounting equation is represented
in the Balance Sheet of the business.
Accounting entity: a business or organisation that is regarded as having a
separate identity from that of the owners and will only record and report on
financial transactions where it is a party (for example, sole proprietor,
partnership, company).
Accounting standards: the rules that guide the application of accounting
principles for specific situations.
Accounting system: that part of the MIS (Management Information System)
that provides financial information for management for decision making
purposes or to produce financial reports under compliance obligations.
Accounts payable:the money value of goods and services that a business has
acquired, but has not yet paid for.
Accounts Payable Ledger: a subsidiary ledger that holds the account details
and amounts owing to the suppliers of a business (essentially, the business’s
promise to pay a vendor for goods or services provided).
Accounts receivable: the amount of money customers owe a business for
products and services they have bought from the business, but have not yet paid
for.

Accounts Receivable Ledger: a subsidiary ledger that holds the account
details and amounts owed by the customers of the business.
Accounts: one part in a General Ledger devoted to recording details about a
single aspect of a business (for example, Cash at Bank account, Advertising
Expense account, Merchandise Sale account). Subcategories include Assets,
Liabilities, Equity, Revenue, and Expenses.
Accrual basis accounting: one of the bookkeeping processes that can be
followed in preparing a business’s financial statements. Accrual basis accounting
records revenue and expenses as they are earned or incurred regardless of when
the money exchanges (cash received or paid).
Accruals: transactions created under the accrual basis of accounting. Accruals
bring to account revenue and expenses that have been earned and incurred but
have not yet been invoiced (for example, prepaid expenses, unearned revenue).
Accumulated Depreciation Account: the total amount of depreciation
expense that has been written off against the asset from the time it was
purchased. It is a contra asset account that reflects depreciation expense taken
in the current and previous periods.
Accelerated depreciation: a method of depreciation in which a greater amount
of depreciation expense is recorded in the earlier years of an asset’s useful life
than in later years.
Aging schedule: a schedule that classifies accounts receivable by the amount
of days the receivable has been unpaid.
Amortisation: a process of writing off the value of intangible assets to
acknowledge their loss of value. Similar to depreciation for tangible assets.
Assets: items of future economic value that the business owns or controls (for
example, cash, inventory, equipment, patents). They are tangible or intangible
things that allow a firm to produce goods or services.
Audit trail: a chronological list of a transaction’s process through the accounting
system, from the source document to financial statements.
Audit: a set of tests and procedures applied by an independent accounting firm
to determine the accuracy of financial statement information. Audits are
designed to provide reasonable assurance to third parties that the financial
statements represent a true and fair view of the financial performance and
position of the business.
Bad Debts Account: an account in the nominal ledger to record the value of
unrecoverable debts from customers.
Balance Sheet: a financial statement that reflects the financial position of a
business on a specific date and outlined according to the accounting equation

(that is, Assets = Liabilities + Owner’s equity). It is one of the basic financial
statements used to assess the financial condition of a business.
Balance day adjustments: the procedure to ensure that all items of revenue
and expense are recorded in their correct accounting periods. Typically these
include accruals, depreciation, actual stocktakes, bad and doubtful debts.
Bank statement: a statement supplied by the bank that details the monies
received and paid for a customer’s account.
Bank reconciliation: a process that demonstrates how the cash details
recorded in the books of the business match the statement supplied by the bank.
Bookkeeping: the physical recording of the financial transactions of the
business.
Books of original entry: specially designed forms on which transactions are
initially recorded.
Book value: the historical cost of an asset less the value of the accumulated
depreciation. Also referred to as the written down value.
Business firm: an organisation established to earn a profit by the selling of
goods or services.
Capital expenditure: the expenditure on fixed assets that are expected to
provide economic benefits over several accounting periods (for example, the
purchase of a building, an upgrade to equipment).
Cash accounting: a simplified form of bookkeeping for small businesses that
delays the recording of revenue and expenses until the cash is actually
exchanged (that is, when cash for goods or services provided is actually received
or paid).
Cash at bank: an account kept in the books of a business that records the
amount of money held in the bank account.
Cash Flow Statement: a financial statement that reports cash flows from
operating, financing and investing activities.
Cash on hand: an account kept in the books of a business that records the
amount of money held on the business premises (usually undeposited funds or
cash register floats).
Cash register float: a term used to describe the amount of money perpetually
held in cash registers to provide change in relation to customer sales.
Chart of Accounts: a complete listing of every account in the accounting
system.
Company: a separate legal entity owner by shareholders that is created for the
purpose of conducting business activities.

Contra account: an account created in the same account group that is an offset
to another account (for example, accumulated depreciation, sales discounts).
Control account: an account held in a general ledger that summarises the
balance of all the accounts in the subsidiary ledger (for example, the Accounts
Receivable control account is the total of all the customer accounts held in the
Debtors Subsidiary Ledger).
Corporation: a common form of limited liability firm that is created and
recognised as a separate legal entity by the corporation’s law of the country.
Cost of goods sold: a formula for working out the direct costs of stock sold over
a particular period. The formula is: Opening stock + purchases closing stock; it
calculates all the direct costs associated with selling goods (inventory).
Credit: one of the two aspects of a double-entry bookkeeping system. For every
entry into the books of a business, there must be a credit entry and it must equal
the debit entry amount made to another account.
Creditors: a list of suppliers to whom the business owes money, typically listed
in the Creditors Ledger.
Current assets: assets that could be converted into cash easily (for example,
inventory, accounts receivable).
Current liabilities: monies owed to external parties and due for payment within
the next 12 months (for example, credit cards, trade creditors, tax payable).
Debit: one of the two aspects of a double-entry bookkeeping system. For every
entry into the books of a business, there must be a debit entry and it must equal
the credit entry amount made to another account.
Debtors: a list of the customers who owe money to the business, typically listed
in the Debtors Ledger.
Deferred revenue: cash collected from customers or clients before the delivery
of goods and services.
Depreciation expense: accounting for the loss of economic value of a fixed
asset . This is done by expensing (writing off) a portion of the fixed asset
according to its useful life. Also the portion of an asset’s cost allocated to the
current accounting period.
Direct costs: expenses that can be directly tracked to a specific job. If the job
did not happen, the direct costs would not have been incurred (for example,
materials, delivery costs, stock purchases).
Dissolution: the disposal of the assets of a sole trader that has ceased trading.
Dividends: cash distributions from corporate profits to the corporation’s
shareholders.

Double-entry accounting: an accounting system used to keep track of
business activities that requires a debit and credit entry to be made into two or
more accounts for every financial transaction.
Doubtful debts: a provision in the financial statements that identifies amounts
owed by debtors that may not be paid in part or in full.
Drawings: the money taken out of a business by its owner(s) for personal use.
EBIT: the abbreviation for ‘earnings before interest and tax’ (that is, profit before
any interest or taxes have been deducted).
Entry: part of a transaction recorded in a journal or posted to a ledger.
Equity: the value of the business owing to the owners of the business. It is made
up of the initial investment by the owners and the unpaid earnings of the
business to date—the difference between a firm’s assets and its liabilities.
Expense: goods or services purchased directly for the running of the business
that have completely spent their economic value at the time the financial
statements are prepated (for example, wages expense, bank charges, electricity
expense). It is the use of resources to produce the good and services sold to
customers and clients.
Extraordinary items: those items of revenue or expense that occur outside the
normal activities of the business (for example, the sale of equipment used to
produce products for the business).
FIFO: an abbreviation of ‘first in, first out’. FIFO is a flow assumption in valuing
ending inventories that assumes that the first goods sold were the first ones
purchased.
Financial accounting: a system of reporting on the financial activities of a
business according to the requirements of external stakeholders. The format and
information required is usually prescribed by governments agencies and
accounting standards.
Financial statements: reports provided to the stakeholders of the business
that detail the financial performance and position of the business. They key
financial statements are the Balance Sheet, the Income Statement and the Cash
Flow Statement.
Fiscal year: the term used for a business’s accounting year (calendar (31
December close) or financial (30 June close)).
Fixed assets: also known as non-current assets, these are tangible assets that
have a future economic value of greater than 1 year (for example, buildings,
equipment, vehicles, furniture).

Fixed Asset Schedule: a record of a firm’s assets that tracks acquisition dates
and costs, depreciation methods used and cumulative amounts of depreciation
taken.
Functional classification: a term to describe the grouping of expenses into
classifications when presenting the financial statements (for example, Financial,
Sales and distribution, Administration).
General Ledger: a place in the accounting system where all the individual
accounts from the Chart of Accounts are collected. Also, the collection of all
accounts used by a firm to record changes in assets, liabilities, revenue, expense
and equity.
Generally Accepted Accounting Principles: abbreviated as GAAP; the most
widely accepted rules of financial accounting.
Going concern: an assumption that a business will continue to sell products
and/or provides services into the foreseeable future.
Going concern value: the combined value of a firm’s assets that would be paid
by a purchaser who intended to continue operating the business.
Goodwill: the difference between a firm’s going concern value and its liquidating
value.
Gross margin: how much money is left after the direct costs are subtracted
from the selling price: when this calculation is expressed as a percentage, it is
called the gross margin. It is the difference between sales and cost of goods sold.
Historical cost: describes an accounting practice where assets are recorded in
the books of a business at the prices for which they were acquired. It is the
listing of asset values based upon their acquisition price rather than their current
market value.
Imprest: an amount of cash provided in advance to an authorised person that
allows them to make cash payments for incidental expenses (for example, petty
cash).
Income Statement: also known as the Profit and Loss Statement, the P&L or
the Statement of Financial Position. The Income Statement is a financial report
that shows the changes in the equity of the business as a result of its operations.
It lists the revenues, subtracts the expenses and so measures the economic
performance (profit or loss) of the business for a given accounting period.
Incurred: describes the act of becoming legally liable for something.
Indirect cost: also known as an overhead; an expense that is not directly
related to the services provided to customers.

Internal control: a system implemented and maintained by a business to
ensure the protection of its assets, the reliability of its financial information and
to prevent fraud.
Insolvent: describes an enterprise which has a total value of liabilities greater
than a total value of assets.
Intangible asset: an item of economic value that is of a non-physical or
financial nature (for example, patents, trademarks, goodwill).
Inventory: also known as stock; goods or materials held by the business with
the intent to sell them to customers for a profit.
Invoice: an original document either issued by a business for the sale of goods
on credit (a sales invoice) or received by the business for goods bought (a
purchase invoice).
Journal entries: the recording of transactions in a journal.
Journal: where in the accounting system transactions are first entered. A journal
records business activities in a chronological order ensuring that the debit
amount of each transaction is matched with a credit amount (for example, Sales
Journal, Purchases Journal, Cash Receipts Journal, Cash Payments Journal,
General Journal).
Legal entity: a person or non-person (for example, a company) who is
recognised by law as having the right to buy and sell property and to sue or be
sued.
Leverage: the degree to which a firm uses debt to finance its operations.
Liabilities: the value of monies owed to someone other than the owners (for
example, to creditors, tax department, a financial institution that provided a loan
to the business). Liabilities are an enterprise’s obligations to its creditors
LIFO: an abbreviation for ‘last in, first out’; an inventory flow assumption that
the most recently sold inventory is also the most recently purchased.
Limited liability firm: firms that is organised under special state statutes that
insure that the owners’ liabilities for the firm’s actions are limited to their
investment.
Liquidating value: the amount that would be paid for a firm’s assets on a piece
meal basis.
Liquidity: the availability of cash in a business.
Long-term liabilities: also known as non-current liabilities; typically, any debts
owed to funders or creditors that lasts for more than 1 year (for example, a
mortgage for a property purchase).
Loss: the excess of expenses over revenue.

Management accounting: a system of reporting on the financial activities of a
business according to the needs of the managers and other internal stakeholders
(for example, budgeting, variance reporting, weekly sales reports, business unit
profitability reports).
Matching principle: an accounting principle that directs accountants to prepare
the Income Statement so that the revenue and the expenses incurred in earning
that revenue are recorded and reported in the same accounting period. The
matching principle is the idea behind accrual accounting, which holds that
revenue should be recognised at the same time as associated expenses are
incurred.
Materiality: a threshold amount accountants use in deciding if adjustments are
needed to particular accounts.
MIS: an abbreviation of Management Information System; a system of reporting
that assists decision makers in their evaluation planning, organising, leading and
controlling functions.
Money: the medium used to exchange goods and services for other goods and
services.
Narrative: a comment added to an entry in a journal. It can describe the nature
of the transaction, or the other side of the debit/credit entry.
Net income: also known as net profit, net earnings, current earnings or bottom
line. Net income is the money left over in a specific period after deducting from
the revenue the expenses incurred in earning that revenue. This amount is
reported as the bottom line of the Income Statement and as current earnings in
the equity section of the Balance Sheet.
Net worth: also known as owner’s equity. It is the accounting value of a
business and is determined by subtracting the value of the liabilities of the
business from the total value of its assets. It represents the value of the owner’s
investment in the business.
Operating cycle: The stages involved and the time taken to turn purchased
goods into cash receipts from customers. e.g. purchase inventory from cash at
bank, Store inventory, Sell inventory on account, Accounts receivable collected
to cash at bank
Operating expenses: those expenses incurred in producing revenue from the
normal activities of the business (for example, wages expense, rent, electricity).
Overheads: also known as indirect costs; costs of a business that do not change
in proportion to business activity and cannot be directly attributed to a revenue
item (for example, rent, property insurance, land rates).
Owner’s equity: the value of the owner’s investment in the business (that is,
initial capital + retained earnings from past periods + current earnings).

Partnership: a form of unlimited liability firm with more than one owner.
Periodic inventory method: a method of recording inventory purchases that
reflects adjustments to the inventory account only at the end of an accounting
period.
Perpetual inventory method: a method of recording inventory purchases that
changes the inventory account balance as purchases are made.
Petty cash: a system designed to ensure the simple management of incidental
payments (for example, purchasing emergency stationery supplies or staff lunch
room supplies).
Posting: an accounting term used to describe the transfer of entries from one
part of the accounting process to the next (that is, from the journals to the
ledgers). Also, the process of transferring transaction information recorded in
books of original entry to general ledger ‘T’ accounts.
Provisions: one or more accounts set up to account for expected future costs
(that is, provision for doubtful debts to provide for possible non-payment of
customer debts).
Prepaid expenses: an accrual account created during the balance day
adjustment process that recognises as assets those expense amounts that still
have future economic value (for example, insurance paid in advance). Also, a
firm’s payment to vendors for goods and services to be provided at some later
point.
Profit: the excess of revenues over expenses.
Ratio analysis: a collection of calculations performed on the financial
statements that gives insights into the liquidity, profitability and management
efficiency of a business (for example, current ratio, gross profit %, inventory
stockturn).
Reconciling: the process of checking entries made in the books of a business
with those on a statement sent by a third person (that is, checking a bank
statement against a business’s own financial records).
Retained earnings: the amount of net income owed to the owners but still
retained by the business, usually to fund expansion of the business. Also, the
undistributed profits of a corporation.
Retainers: a form of deferred revenue collected by attorneys or other service
businesses.
Residual value: the estimated value of an asset that is likely to remain at the
end of its useful life.
Revenue: the monies received by a business for the goods and services
provided (that is, merchandise sales, fees earned, interest received from

investments). Also, cash or receivables received from customers or clients in
exchange for goods and services provided.
Segregation of duties: an internal control that insures that employees with
access to assets have no access to accounting records.
Shareholders: the owners of a business or corporation.
Shares: the official documentation issued by businesses to the owners of the
business. The percentage of shares held compared with the total shares issued
identifies the percentage of the company’s equity and profits that one is entitled
to. Shares can also be called ‘stock’.
SME: abbreviation for ‘small and medium enterprises’. The definition of what
quantifies an SME varies in each country.
Sole proprietor: the self-employed owner of a business.
Sole proprietorship: an unlimited liability firm with one owner.
Source document: the original documentation that evidenced the financial
event and becomes the basis for the entry of the financial transaction into the
books of the business (for example, deposit book, check butts, purchase and
sales invoices).
Straight-line depreciation: a method of depreciation expense that allocates
an asset’s purchase cost evenly over the asset’s expected useful life.
Statutory bodies: agencies established by the government to monitor and
control specific laws (for example, corporate regulators).
Subsidiary ledgers: ledgers used to record the details of the General Ledger’s
control accounts. They are typically used for individual customers (Debtors) and
individual suppliers (Creditors).
Suspense Account: a temporary account used to record that part of a
transaction that is not yet able to be recorded to a nominal account (that is, the
current unknown origin of a deposit in the Bank account). Also, special records
that detail the sales and payment histories for individual customers in the case
of accounts receivable, or purchase and payment histories for individual vendors,
in the case of accounts payable.
‘T’ accounts: General Ledger accounts that have a ‘T’ format that clearly
demarcate a left side and right side.
Tangible assets: assets or items of economic value that are of a physical nature
like land, buildings, vehicles and equipment.
Transaction: the original entry into the books of the business that records the
debit and credit aspects of the source documents that evidence a financial
event. Also, any event that causes a change in assets, liabilities, equity, revenue,
or expense.

Ten (10)-column worksheet: a device created to assist in identifying and
allocating the effects of the balance day adjustments on the preparation of
period-end financial statements (for example, accruals, depreciation, bad and
doubtful debts, inventory adjustments).
Trial balance: an internal report that checks to see if the double-entry
bookkeeping principles have been properly applied for all transactions. It is a list
of all the accounts from the General Ledger together with their individual debit or
credit balances. The General Ledger is said to be in balance if the total of the
debit balances is equal to the total of the credit balances.
Unearned revenue: an accrual account created as part of the balance day
adjustments to record as a liability that revenue that has not yet been earned
(for example, fees received in advance).
Unlimited liability firms: businesses whose owners remain liable for the
actions of a business beyond the amount they actually invest.
Working capital: the ongoing capital required by the business to pay its bills as
they become due. It is calculated by subtracting the current liabilities from the
currents assets of the business.
Weighted average cost method: an ending inventory valuation method based
upon the weighted average of purchase costs during the accounting period.
Work in progress: the value of partly finished goods. Typically found in
manufacturing businesses.

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