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Why Do We Need Accounting?

            Asking that question of an accountant is like asking a farmer why we need rain.  We
need accounting because it’s the only way for business to grow and flourish.  Accounting is
the backbone of the business financial world.   After all, accounting was created in response
to the development of trade and commerce during the medieval times.

            Italy is our first recorded source for accounting entries, and the first published
accounting work in 1494 was by a Venetian monk.  So you see accounting as an organized
method for record-keeping has been around almost as long as the trade and business
industries.  Another interesting fact is the knowledge and principles upon which the first
accounting practices were established, have changed very little in the many hundreds of
years that accounting has been in use.  The concepts of assets, liabilities, and income and
the need to reconcile these areas is still the basis for all accounting functions today.

            The process for recording those transactions, and the many reports generated by
the compilation of that information has evolved over the last two hundred years.  Thanks to
the creation of computers, many of the bookkeeping functions that are vital to accounting,
but somewhat repetitive are performed by data entry clerks, and the reports generated
come from the IS Department.  The end result is still the same: accounting gives us the
financial snapshot we need in order to make solid business decisions about the current
status or projected future health of our businesses.

            There are two basic categories of accounting: financial accounting and

managerial accounting.  Financial accounting is comprised of information that companies
make available to the general public:  stockholders, creditors, customers, suppliers, and
regulatory commissions.  Managerial accounting deals with information that is not made
public.  Information such as salary costs, Cost of goods produced, profit targets, and
material control information.  The knowledge supplied by managerial accounting is for the
use of department heads, division managers, and supervisors to help them make better
decisions about the day-to-day operations of the business.

            Now, what about the “accountability” part of the accounting process?  Why do we
need that and how do we enforce it?  Businesses need to be held accountable for the
methods they use to run a business because the potential for greed, theft, and dishonesty
exist in every business.  You have only to read the current events section of the newspaper
to realize how rampant corporate abuse is in business today.  We have Enron,
HEALTHSOUTH, and Martha Stewart examples to show us just how extensive the problem
has become.  There are specialized areas of accounting, that when correctly enforced,
eliminate the possibility for fraud.  Auditing and income taxation, when used correctly, force
business to account for all business income, transactions, and transfers, and then to pay
their fair share of the tax burden.  The catch here is that the principles must be correctly
enforced.

Accounting is the conscious of the business world.  When handled with care and with
respect, it performs as expected.  When abuse occurs, and the system is circumvented or
overridden because of dishonesty and greed, it doesn’t work correctly. Accounting is much
like all other systems in place, they are only as good as the people using them
 WHAT IS ACCOUNTING?
a language that provides information about the financial position of an
organization. Accounting is a language, By learning this language you can
communicate and understand the financial operations of any and all types
of organizations.

This is because the information required by most organizations is very

similar and can be broken down into three main categories:

ACCOUNTING INTRODUCTION
 
Operating Information
This is the information that is needed on a day-to-day basis in order for the
organization to conduct its business. Employees need to get paid, sales
need to be tracked, the amounts owed to other organizations or individuals
need to be tracked, the amount of money the organization has needs to be
monitored, the amounts that customers owe the organization need to be
checked, any inventory needs to be accounted for: the list goes on and on.
Operating information is what constitutes the greatest amount of
accounting information and it provides the basis for the other two types of
accounting information.
 
Financial Accounting Information
This is the information that is used by managers, shareholders, banks,
creditors, the government, the public, etc… to make decisions involving the
organization and its operations. Shareholders want information about what
their investment is worth and whether they should buy or sell shares,
bankers and other creditors want to know whether the organization has an
ability to pay back money lent, managers want to know how the company
is doing compared to other companies. This type of information would be
very difficult to extract if every company used a different system for
recording their financial position. Financial accounting information is
subject to a set of ground rules that dictate how the information is
reported and this ensures uniformity.
 
Managerial Accounting Information
In order for the managers of a company to make the best decisions for a
company they need to have specific information prepared. They use this
information for three main management functions: planning,
implementation and control. Financial information is used to set budgets,
analyze different options on a cost basis, modify plans as the need arises,
and control and monitor the work that is being done.
 
As you can see, accounting is a multifaceted system involving different
people with different needs and after analyzing the various uses and
applications of accounting information the American Accounting Association
has come up with this definition: “the process of identifying, measuring,
and communicating economic information to permit informed judgments
and decisions by users of the information.”
 
In order to facilitate the informed use of this financial information,
accounting has come to be based on specified rules or conventions called
“principles.” These principles provide general laws or rules that are used to
guide accounting activity and are called Generally Accepted Accounting
Principles, or GAAP for short. These principles are established by the
Financial Accounting Standards Board (FASB) which is a nongovernmental
agency funded by the accounting profession and contributions from
business organizations. While there is no legal obligation for companies to
adhere to GAAP, there are strong practical reasons to do so. From auditing
to reporting earning to the US Securities Exchange Commission to applying
for a loan, there are very compelling reasons for organizations to conform
to the generally accepted standard.
 
What Is The End Result Of All This Accounting Information?We’ve
talked about the reason for maintaining accounting information and the
end result of all of this recording is the preparation of financial statements.
These statements let people see, at a glance, the financial position of an
organization. These statements provide summaries of the operating
information and are used extensively by people within and external to the
company. The statements fall into one of two categories:
 Status/Stock – these statements show the financial status of an
organization at one specified instant in time. Stock reports = a
snapshot.
 Flow Report – these statements show the flow of financial
information over a period of time. Flow reports = motion picture
GAAP requires the preparation of three different statements:
 
Balance Sheet
A Balance Sheet is a status report that shows information about the
organization’s resources at one given time. Examples of information found
on a balance sheet are how much cash is in the bank, what is owed to
creditors, and the value of the company’s assets.
 
Income Statement
An Income Statement (also called a Statement of Earnings, Statement of
Operations, or a Profit and Loss Statement) is a report that shows the flow
of revenues (amounts earned from business activity) and expenses
(amounts paid in the course of operations) over a given period of time,
typically a month, quarter, or year.
 
Statement of Cash Flow
As the name suggests, this is also a flow statement that details the
movement of cash through the organization over a specified period.
 
The whole purpose of accounting is to provide information that is useful
and relevant for interested parities when making decisions regarding the
company and its operations. In order to do that effectively, a specific
language and subsequent rules have been developed for users of the
information. By learning accounting you learn these rules and can then
communicate financial information with others in a comprehensible and
comparable manner.
Additional Materials:
 Sample Balance Sheet
 Sample income Statement
 Sample Cash Flow Statement
Lesson Activity:
1. Begin by talking about the idea of accounting as a language.
 Solidify this concept using an example of computer programming as
another “language” used in a professional setting that facilitates
communication and understanding.
 Ask students for their own examples of other professional
“languages.”
2. Discuss the different types of accounting information and use detailed
examples.
 Operating information: discuss the need to track how much cash you
have in your bank. When you pay bills or when you receive cash for
sales you need to account for the changes in your financial records.
 Financial information: discuss the need to communicate your
financial position to the bank. If you apply for a loan the bank needs
to know if you have the ability to repay it.
 Managerial information: discuss the need for managers to use
financial information when making business decisions. Talk about the
need to prepare a budget.
3. Briefly introduce GAAP
 
4. Discuss the different accounting reports using examples of each. Talk
about the difference between status and flow reports and point out the
terminology used in the report heading “as at Dec 31” on a Balance Sheet
versus “for the period ending Dec 31” on the Income and Cash Flow
Statements.

FUNDAMENTAL CONCEPTS
OF ACCOUNTING
 
Accounting is the language of business and it is used to communicate financial information. 
In order for that information to make sense, accounting is based on 12 fundamental
concepts.  These fundamental concepts then form the basis for all of the Generally Accepted
Accounting Principles (GAAP).  By using these concepts as the foundation, readers of
financial statements and other accounting information do not need to make assumptions
about what the numbers mean.

For instance, the difference between reading that a truck has a value of $9000 on the
balance sheet and understanding what that $9000 represents is huge.  Can you turn around
and sell the truck for $9000? If you had to buy the truck today, would you pay $9000? Or,
perhaps the original purchase price of the truck was $9000.     All of these assumptions lead
to very different evaluations of the worth of that asset and how it contributes to the
company’s financial situation.

For this reason it is imperative to know and understand the eleven key concepts.

ELEVEN KEY ACCOUNTING CONCEPTS

 

Entity 
Accounts are kept for entities and not the people who own or run the company.  Even in
proprietorships and partnerships, the accounts for the business must be kept separate from
those of the owner(s).

Money-Measurement

For an accounting record to be made it must be able to be expressed in monetary terms. 

For this reason, financial statements show only a limited picture of the business.  Consider a
situation where there is a labor strike pending or the business owner’s health is failing;
these situations have a huge impact on the operations and financial security of the company
but this information is not reflected in the financial statements. 

Going Concern
Accounting assumes that an entity will continue to operate indefinitely.  This concept implies
that financial statements do not represent a company’s worth if its assets were to be
liquidated, but rather that the assets will be used in future operations.  This concept also
allows businesses to spread (amortize) the cost of an asset over its expected useful life. 

Cost
An asset (something that is owned by the company) is entered into the accounting records
at the price paid to acquire it.  Because the “worth” of an asset changes over time it would
be impossible to accurately record the market value for the assets of a company.  The cost
concept does recognize that assets generally depreciate in value and so accounting practice
removes the depreciation amount from the original cost, shows the value as a net amount,
and records the difference as a cost of operations (depreciation expense.)  Look at the
following example:

Truck                 $10,000   purchase price of the truck

Less depreciation  $  1,000   amount deducted as a depreciation expense 
Net Truck:          $  9,000   net book-value of the truck

The $9000 simply represents the book value of the truck after depreciation has been
accounted for.  This figure says nothing about other aspects that affect the value of an item
and is not considered a market price.

Dual Aspect
This concept is the basis of the fundamental accounting equation: 

Assets = Liabilities + Equity

1. Assets are what the company owns.

2. Liabilities are what the company owes to creditors against those assets
3. Equity is the difference between the two and represents what the company owes to
its investors/owners. 

All accounting transactions must keep this equation balanced so when there is an increase
on one side there must be an equal increase on the other side or an equal decrease on the
same side. 

Objectivity
The objectivity concept states that accounting will be recorded on the basis of objective
evidence (invoices, receipts, bank statement, etc…). This means that accounting records will
initiate from a source document and that the information recorded is based on fact and not
personal opinion. 

Time Period

This concept defines a specific interval of time for which an entity’s reports are prepared. 
This can be a fiscal year (Mar 1 – Feb 28), natural year (Jan 1 – Dec 31), or any other
meaningful period such as a quarter or a month.

Conservatism
This requires understating rather than overstating revenue (income) and expense amounts
that have a degree of uncertainty.  The rule is to recognize revenue when it is reasonably
certain and recognize expenses as soon as they are reasonably possible.  The reasons for
accounting in this manner are so that financial statements do not overstate the company’s
financial position.  Accounting chooses to err on the side of caution and protect investors
from inflated or overly positive results. 

Realization
Revenues are recognized when they are earned or realized.  Realization is assumed to occur
when the seller receives cash or a claim to cash (receivable) in exchange for goods or
services.  This concept is related to conservatism in that revenue (income) is only recorded
when it actually occurs and not at the point in time when a contract is awarded.  For
instance, if a company is awarded a contract to build an office building the revenue from
that project would not be recorded in one lump sum but rather it would be divided over time
according to the work that is actually being done.  

Matching
To avoid overstatement of income in any one period, the matching principle requires that   
revenues and related expenses be recorded in the same accounting period.  If you bill
$20,000 of services in a month, in order to accurately represent the income for the month
you must report the expenses you incurred while generating that income in the same
month. 

Consistency
Once an entity decides on one method of reporting (i.e. method of accounting for inventory)
it must use that same method for all subsequent events.  This ensures that differences in
financial position between reporting periods are a result of changed in the operations and
not to changes in the way items are accounted for.  

Materiality
Accounting practice only records events that are significant enough to justify the usefulness
of the information.  Technically, each time a sheet of paper is used, the asset “Office
supplies” is decreased by an infinitesimal amount but that transaction is not worth
accounting for. 

By understanding and applying these principles you will be able to read, prepare, and
compare financial statements with clarity and accuracy.  The bottom-line is that the ethical
practice of accounting mandates reporting income as accurately as possible and when there
is uncertainty, choosing to err on the side of caution. 

FUNDAMENTAL CONCEPTS OF ACCOUNTING

Introduce each accounting concept and discuss its relevance and application. Use or
modify the following situations and ask the students how the concept applies:

Entity – the owner of a painting company takes some paint to use in his home
renovations.  Is this paint recorded as a business expense?

Money-Measurement – a printing business is about to be sold to new owners who

have no experience in the industry. Is this information recorded in the financial
statements?

Going Concern – a company’s stock price has plummeted 70% in the past six
months due to increased industry competition.  Do we assume the company is still in
business?
Cost – A construction company owns two excavators and is preparing to sell both of
them in order to buy one brand new one.  The book value of the two used
excavators is $10,000, is that the price that the owner should expect to get as a
trade-in value?

Dual Aspect – A company has $40,000 in assets, owes the bank $12,000, and
owes creditors an additional $8,000.  How much equity does the owner have in the
company?

Objectivity – Have students name five different types of source documents used
for accounting purposes.  Invoice, checks, bank statement, purchase orders, cash
receipts, bill of lading, loan certificate

Time Period – department stores often have fiscal years that end Jan 31.  Ask
students to explain why that is the case. 

Conservatism – discuss the pros and cons of choosing to be prudent when

reporting income and expenses. 

Realization – if a toy manufacturer receives an order for 96,000 yoyo’s at $2 each

to be delivered in equal installments over the next year, when would the revenue
from the order be recorded?  What would the amount(s) be? 

Matching – a dry-cleaning company sells $5000 worth of services in October.  They

pay $3000 for their dry-cleaning fluid and supplies every quarter in March, June,
September, and December.  What expense, if any, would be recorded in October for
dry-cleaning supplies?

Consistency – discuss the importance of consistent accounting between reporting

periods. 

Materiality – discuss the impracticality of accounting for every change that occurs
within a business on a day-to-day basis.  Use office supplies as the most obvious
example.

INTRODUCTION TO TRANSACTION ANALYSIS:

THE BASIC ACCOUNTING EQUATION

 
Accounting is built upon the fundamental accounting equation:

Assets = Liabilities + Owner's Equity

This equation must remain in balance and for that reason our modern accounting system is
called a dual-entry system.  This means that every transaction that is recorded in accounting
records must have at least two entries; if it only has one entry the equation would
necessarily be unbalanced.
The equation’s three parts are explained as follows:

1. Assets = what the business has or owns (equipment, supplies, cash, accounts
receivable)
2. Liabilities = what the business owes outsiders (bank loan, accounts payable)
3. Owner’s Equity = what the owner owns (investment and business profit)

THE ACCOUNTING EQUATION

From the equation we can see that what the business owns (assets) equals what it owes
both creditors (liabilities) and the owners (equity).

1. The business owes creditors for loans made and other obligations to pay for goods
or services.
2. The business owes the owner for any money or other assets that the owner invests
in the business
3. The business also owes the owner the profit that is realized from business
operations.

The accounting equation can be expressed in 3 ways: 

Assets = Liabilities + Owners' Equity 
Liabilities = Assets - Owners' Equity 
Owners' Equity = Assets - Liabilities

If you know any two of the amounts you can calculate the third.

Business Transactions occur on a daily basis as a result of doing business.  Items are

purchased or sold, credit is extended or borrowed, income is made or expenses are
assumed.  These business transactions result in changes to the three elements of the basic
accounting equation.

1. A transaction that increases total assets must also increase total liabilities or owner's
equity.
2. A transaction that decreases total assets must also decrease total liabilities or
owner's equity.
3. Some transactions may increase one account and decrease another on the same side
of the equation i.e. one asset increases and another decreases.

Assets = Liabilities + Owner's Equity

+ +  

+   +

- -  

-   -

+ and -    
  
Regardless of the nature of the specific transaction, the accounting equation
must stay in balance at all times.

Transaction Analysis is the process of reconciling the differences made to each side of
the equation with each financial transaction occurs.  Let’s look at some sample transactions
to get a better understanding of how the analysis and equation work.

The accounting equation for a brand new company will look like this:

Assets = Liabilities + Owner's Equity

$0              $0                      $0

Transaction 1:  The owner deposits $5000 in the checking account to begin operations

Assets = Liabilities + Owner's Equity

+$5000          $0                  +$5000

The asset “Cash” is increased by $5000 and the Owner’s Equity is increased $5000.  The
business owes the owner $5000. 

Transaction 2:  The business purchases a computer, on credit, for $2500.

Assets = Liabilities + Owner's Equity

+$2500      +$2500                  $

The asset “Computers” is increased by $2500 and the liability is also increased $2500
because the business now owns the store $2500.

Transaction 3:  The business purchases office supplies using $550 cash.

Assets = Liabilities + Owner's Equity

+$550
-$550

The asset “Office Supplies” is increased $550 and the asset “Cash” is decreased $550.
Transaction 4:  A business purchases a building for $100,000 with a $25,000 cash down-
payment and a loan for the $75,000 outstanding. 

Assets = Liabilities + Owner's Equity

+$100,000   +75,000                   
-$25,000

More than two accounts are affected by this transaction.  The asset “Building” increases by
$100,000, the asset “Cash” decreases by $25,000, and the liability “Bank Loan” increases by
$75,000. The net result is that both sides of the equation increase by $75K.

As you can see, regardless of the transaction, the accounting equation must stay balanced.

The Expanded Accounting Equation breaks out the Owner’s Equity section into two
components:  Revenues and Expenses.

Revenues = what the business earns for providing goods or services 

Expenses = the cost of assets the business uses to generate revenues (payroll, depreciation,
rent, utilities, taxes)

The business’ Profit or Loss equals the Revenues - Expenses. If Revenues are more

than Expenses, there is Profit. If Expenses are more than Revenues, there is Loss. The
owner of the company also has the option to withdraw equity from the company in the form
of drawings (proprietorships and partnerships) or dividends (corporations).

When you look at these relationships to Owner’s Equity in terms of the accounting equation
you see that

1. Revenues increase Owner's Equity
2. Expenses decrease Owner's Equity
3. Drawings or Dividends decrease Owner’s Equity:

The expanded Accounting Equation looks like this:

 Assets = Liabilities + Owner's Equity + Revenues – Expenses - Drawings

Let’s analyze some transactions involving these types of accounts:

Transaction 5:  The business sells goods for $1,200 cash. 

Assets = Liabilities + Owner's Equity

+$1200                       +$1200 (Revenue)

The asset “Cash” is increased $1200 and the revenue increases Owner’s Equity $1200. 
Transaction 6:  The business pays its rent monthly rent of $950 using a company check.   

Assets = Liabilities + Owner's Equity

-$950                          -$950 (Expense)

The asset “Cash” is decreased $950 and the expense decreases Owner’s Equity $950.

Transaction 7:  The business’ owner withdraws $2,000 for his personal use.

Assets = Liabilities + Owner's Equity

+$1200                       +$1200 (Revenue)

The asset “Cash” is decreased $2000 and the drawing decreases Owner’s Equity $2000. 

The accounting cycle is the sequence of procedures used to keep track of what has
happened in the business and to report the financial effect of those things. The financial
reports will only make sense if the accounts have been analyzed correctly and the
accounting equation remains balanced.  This is the fundamental building block of accounting
and you must learn and apply transaction analysis before continuing further.

TRANSACTION ANALYSIS LESSON PLAN

Understanding this part of accounting is critical.  It helps to use as many visual cues
as possible as this grounds the lesson and provides concreteness to an otherwise
conceptual practice.  Use the overhead projector to draw relationships between the
components of the accounting equation and also for solving example problems.

1. Introduce the Accounting equation – talk about keeping it balanced.

2. Introduce the three main components.
3. Have students identify different asset categories.  Discuss and give your own
examples.
4. Have students identify different liability categories.  Discuss and give your
own examples.
5. Discuss the concept of equity – it is the amount the business owes to the
owners.
6. Talk about the mathematical relationship between the components and how
the equation can be rearranged three ways.  Have students solve simple
problems: when given two values of the equation, solve for the third.
7. Discuss what a business transaction is.  Recall the objectivity concept and the
notion that transactions originate from a source document.
 8. Provide many examples of business transactions and have students identify
the changes to the three main components.
9. Introduce the expanded accounting equation.
10.Talk about revenues – have students discuss different forms of revenue.
11.Talk about expenses - have students discuss different expense categories.
12.Using office supplies as an example, discuss the difference between an
expense and an asset.
13.Discuss the difference between a drawing and a dividend but emphasize that
the effect on Equity is the same.
14.Provide many examples of business transactions that involve revenue,
expense, and drawing/dividends.

THE ACCOUNTING PROCESS

Transaction Example: On August 2, 2005 Tom’s Plumbing purchased a truck for $25,000
with a $5,000 cash deposit and a $20,000 bank loan. 
There are three accounts affected:

 The asset account “Truck”

 The asset account “Cash”
 The liability account “Bank Loan”

These specific accounts can be found in what is called the Chart of Accounts. The titles,
“Truck” “Cash” and “Bank Loan” are not random these are specific accounts that have been
identified as relevant to the entity before it began operations.

Chart of Accounts

The Chart of Account is list of all the accounts used by an entity to record financial
transactions.   The accounts are grouped according to type and then numbered using the
following conventions: 

Asset 101-199
Liability 200-299
Equity 300-399
Revenue 400-499
Expense 500-599 (some systems use 600’s)

When numbering accounts it is important to leave gaps between the numbers in order to

accommodate additional accounts as required.

Tom’s Plumbing
Chart of Accounts

Asset Accounts Revenue Accounts 

101 Cash 410 Repair Revenue 
105 Accounts Receivable 420 Supply Sales Revenue
110 Prepaid Insurance
115 Supplies Expense Accounts
120 Equipment 501 Advertising Expense
125 Truck 505 Equipment Rental Expense
510 Insurance Expense

Liability Accounts 520 Interest Expense

200 Bank Loan 525 Maintenance Expense
205 Accounts Payable 530 Miscellaneous Expense
210 Taxes Payable 535 Supplies Used
540 Rent Expense
Equity Accounts 545 Utilities Expense
301 Common Stock 550 Truck Expense 
305 Retained Earnings 555 Wages and Salary Expense
310 Drawings 
360 Income Summary

Once you have identified the proper accounts involved, you need to apply the rules of
transaction analysis: 

1. Asset and Expense accounts are increased by a debit and decreased by a

credit. 
2. Liabilities, Equity, and Revenue accounts are increased by a credit and
decreased by a debit.

Using the same transaction example:  On August 2, 2005 Tom’s Plumbing purchased a truck
for $25,000 with a $5,000 cash deposit and a $20,000 bank loan:

The Truck account is DR $25,000

The Cash Account is CR   $5,000
The Bank Loan is CR      $20,000

Rather than show these transactions in separate t-accounts, we use a General Journal that
records business transactions in a chronological order.  The journal also allows us to make
notes and is a source of reference should an issue with a transaction arise later.

The General Journal

The General Journal is called the book of original entry and the process of recording
transactions in the journal is called journalizing.  The following are the steps for journalizing
transactions:

1. The year is recorded at the top of the page and the month is recorded on the first
line in the first column of the date section.  This information is repeated for every
new journal page.
 
2. The date of the first transaction is entered in the second column in the date section.
 
3. The name of the account(s) to be debited is entered in the description column and
the amount of the debit is recorded in the Debit column.  When more than two
accounts are involved in the transaction the entry is called a compound entry.
 
 4. The name of the account(s) to be credited is entered on the next line and indented. 
The amount of the credit is recorded in the Credit column.
 
5. An explanation of the transaction is included in the description column on the line
below the credit entry. 

GENERAL JOURNAL

Date 2005 Description F Debit Credit

Aug 2 Truck   25,000  

                Cash          5,000

                Bank Loan        20,000
    Purchase of truck with $5000 cash      
and
    $20,000 in loan      

           

On August 5, Tom’s Plumbing made revenue from repair service of $1,000 and from supply sales of $255.  $560 was received in cash and the rest was in
accounts receivable. 

GENERAL JOURNAL

Date 2005 Description F Debit Credit

Aug 2 Truck   25,000  

                Cash          5,000

                Bank Loan        20,000
    Purchase of truck with $5000 cash      
and
    $20,000 in loan      

           

  5 Cash        560  

    Accounts Receivable        695  

                       Repair Revenue          1000

                Supply Sales Revenue            255
         
Record revenue for the day
         
 
Having a chronological record of the business’ transactions is very useful should you need to
go back and review a particular transaction at a later date.  The problem with keeping
information in this format though, is that there is no way to determine what the actual
balance in each account is after each transaction.  For example, business owners and
managers need to know how much cash is actually in the cash account, and thus in the
bank account, at any given time.  To keep track of account balances, accountants use what
is called a General Ledger.

General Ledger

The General Ledger is the formalization of the t-accounts.  The General Ledger consists of
ledger accounts, one for each account set up in the Chart of Accounts.   Debits and credits
to each account are posted to the ledger from the journal and the balance is kept current. 
Posting is the process of transferring amounts from the general journal to specific general
ledger accounts.  Because entries are recorded in the ledger after the journal, the general
ledger is often called the book of final entry. 

The posting process is as follows:

 The date and amount of a journal transaction are posted to the appropriate ledger
account.
 
 The journal page number is recorded in the ledger account’s folio (F) column as a
cross-reference. 
 
 The appropriate ledger account number is recorded in the folio (F) column in the
journal after the posting has been made.
 
 The balance of the ledger account is calculated and recorded in the Balance column
with a DR or CR in the appropriate column indicating what type of balance it is.
 
 The description column is used to record anything noteworthy that should be
immediately available to readers of the ledger.
Note the account balances from the previous month in the Cash and Bank Loan accounts. 
The “Balance” column is used to keep a running total of the account balances.

The journalizing and posting process are the first two steps of the entire accounting cycle. 
The remaining two steps are to take the account balances in the ledger and prepare a Trial
Balance and then use those account balances to prepare the financial statements.

RECORD KEEPING AND THE ACCOUNTING PROCESS

Accounting is a process-oriented task and this lesson details the steps involved in
keeping track of and recording the accounting transactions of an entity. Use your
prepared transactions and the projector/overhead/blackboard, etc. to work through
the transactions and illustrate the formal record keeping process.

1. Review the t-account concept and basic transaction analysis.

2. Introduce the Chart of Accounts

 Discuss the numbering system

 Note the Income Summary account

3. Introduce the general journal

 Practice recording transactions in the general journal

 Discuss compound entries

4. Introduce the general ledger

 Discuss the posting process

 Note that this is a formal t-account that keeps track of the account
balance and is as current as the latest round of posts

5. Discuss the accounting cycle from journalizing, to posting, to preparing a trial

balance, to preparing the financial statements.
THE INCOME STATEMENT AND BALANCE SHEET

Income Statement

The income statement communicates the inflows and outflows of assets, where inflows are the
revenues generated and outflows are the expenses.  An excess of inflows over outflows is called net
income, and an excess of outflows over inflows is called a net loss.

The income statement can be expressed as an equation:

Revenue – Expenses = Net Income (Loss)

The income statement is a summary of the sources of revenues and expenses that result in a profit or
a loss for a specified accounting period.  Typically that period is one year but it can be a month or a
quarter as well.   Income statements are always prepared for a period of time and the term “for the
period ended…” is included in the title.

Revenue:  The sources of revenue for any business depend on the type of business being operated. 
A company that manufactures or resells a product would generate sales revenue.  A service company
on the other hand might generate fees revenue or service revenue.

Expense:  Examples of typical expenses encountered are salaries, utilities, rent, insurance, and office
supplies.  Here again, each entity will have its own unique set of expenses depending on the type of
business being operated.

Net Income (Loss):  The difference between revenues and expenses is expressed as a positive or
negative depending on whether revenues were greater or less than expenses.

If revenues for the month are $5000 and expenses are $3500, then the entity has a net income of
$1500.  If the expenses were instead $5500, then the entity would have a net loss of $500.

Balance Sheet

The balance sheet communicates what the entity owns in terms of assets, what it owes in terms of
liabilities, and the difference between those two which represents what the owners of the company
are entitled to.  The owner’s portion is called equity.   

The balance sheet can be expressed as the fundamental accounting equation:

Assets = Liabilities + Equity

The balance sheet shows a snapshot of an organization’s assets, liabilities, and equity at one point in
time and it demonstrates the accounting equation.  Balance sheets are always prepared for a point in
time and the term “as at …” is included in the title.

Assets:  The assets of a company represent the resources owned by the company.  These assets can
be in the form of cash or things that can be converted to cash like accounts receivable and they can
also be fixed assets like cars and office equipment.

Liabilities:  What a company owes to creditors is reported in the liabilities section of the balance
sheet.  Creditors are banks and other lending institutions as well as suppliers that are owed money in
the form of accounts receivable as well as money that is owed but not yet paid (accruals).  A
common example of an accrued liability is yearly taxes.

Equity:  The difference between what the entity owns and what it owes represents the owners’
share of the company.  For sole proprietorships this equity is usually called capital and for public
companies it is often referred to as common stock or share capital.  The equity in a company is the
owners’ claim against the assets owned.

The income statement and balance sheet of a company are linked through the net income for a
period and the subsequent increase, or decrease, in equity that results.  The income that an entity
earns over a period of time is transcribed to the equity portion of the balance sheet.  The income
represents an increase in the owners’ claim against the assets:  Income is NOT a cash asset.   It is
through the income and equity accounts that the balance sheet and income statement reflect the
total financial picture of the entity

LINKING THE INCOME STATEMENT

AND BALANCE SHEET

Understanding the balance sheet and its relationship with the income statement is
an important concept in accounting. This lesson introduces the relationship and is a
precursor to the next two lessons which look at each statement and associated
accounts in more detail

1. Have students look at the Financial Statements prepared in the annual report.

2. Discuss the various income statement Accounts

 Look at the types of revenues.

 Discuss the various expenses.
 Discuss net income and explain how it is calculated.

3. Discuss the various balance sheet account entries

 Look at each section (assets, liabilities, equity) in detail.

 Briefly discuss the entries and explain concepts such as depreciation,
accrued liabilities, and retained earnings.
4. Have students identify the common link between the balance sheet and the
income statement: earnings

5. Discuss where earnings are shown on the balance sheet and what earnings
represent: an increase in the equity of the company.

TRIAL BALANCE AND

FINANCIAL STATEMENT PREPARATION

The last two steps in the accounting process are preparing a trial balance and then
preparing the balance sheet and income statement. This information is provided in
order to communicate the financial position of the entity to interested parties.

TRIAL BALANCE
A trial balance is a list and total of all the debit and credit accounts for an entity for a given period – usually a month.   The format of the trial balance is a
two-column schedule with all the debit balances listed in one column and all the credit balances listed in the other.  The trial balance is prepared after all the
transactions for the period have been journalized and posted to the General Ledger. 

Key to preparing a trial balance is making sure that all the account balances are listed under the correct column.  The appropriate columns are as follows:

Assets = Debit balance

Liabilities = Credit balance
Expenses = Debit Balance
Equity = Credit balance
Revenue = Credit balance

Should an account have a negative balance, it is represented as a negative number in the appropriate column.  For example, if the company is $500 into the
overdraft in the checking account the balance would be entered as -$500 or ($500) in the debit column.  The $500 negative balance is NOT listed in the
credit column.

Example Trial Balance:

The trial balance ensures that the debits equal the credits.  It is important to note that just because the trial balance balances, does not mean that the
accounts are correct or that mistakes did not occur.  There might have been transactions missed or items entered in the wrong account – for example
increasing the wrong asset account when a purchase is made or the wrong expense account when a payment is made.  Another potential error is that a
transaction was entered twice.  Nevertheless, once the trial balance is prepared and the debits and credits balance, the next step is to prepare the financial
statements. 

Income Statement

The income statement is prepared using the revenue and expense accounts from the trial balance.  If an income statement is prepared before an entity’s
year-end or before adjusting entries (discussed in future lessons) it is called an interim income statement.  The income statement needs to be prepared
before the balance sheet because the net income amount is needed in order to fill-out the equity section of the balance sheet.  The net income relates to
the increase (or in the case of a net loss, the decrease) in owner’s equity.

Now that the net income for the period has been calculated, the balance sheet can be prepared using the asset and liability accounts and by including the
net income with the other equity accounts.

 
 
When preparing balance sheets there are two formats you can use.  The format above is called the Report form and the Account form lists assets on the left
side and liabilities and equity on the right side. 

ACCRUAL ACCOUNTING AND ADJUSTING ENTRIES

Businesses go through a series of financial transactions that

occur on a continuous basis within an accounting period.
This sequence of transactions is referred to as an operating
cycle and it goes like this:

1. At the beginning of the period, the entity has a certain

amount of cash

2. This cash is used to purchase supplies and pay for

expenses
3. Revenue is earned that either results in a cash
transaction or an account receivable

4. Finally, cash is collected on accounts receivable

   

ACCRUAL ACCOUNTING AND ADJUSTING ENTRIES

Due to the continuous nature of these events, figuring out the exact balance in any account affected
by the operating cycle for a specific period is challenging. It would be nice if all the accounts
receivable generated in a month were also collected within that month, but that is not realistic.
Neither is buying just enough supplies to generate revenue for a specific month. This is the basis of
accrual accounting – not every transaction can be completely accounted for within the period the
transaction occurs.

There will always be some overlap in the accounts related to the operating cycle. These overlaps
occur in two main categories of transactions:

1. Recording revenue: transactions involving revenue generation and identifying at what point the
revenue is “earned”

2. Recording expenses: transactions involving payments and expenses incurred to generate those
revenues.

The GAAP principles that explain why these types of transactions are not straightforward nor are they
easily accounted for include the Revenue Recognition principle and theMatching principle

Recording Revenue

Revenue recognition establishes the point at which revenue is actually earned – it is not necessarily
earned when cash changes hands. GAAP says that revenue is earned when the service is completed
or the goods are sold. In practice, this means that revenue is recognized when an invoice has been
sent. The accounting issue that arises from this convenience is how to record revenue when an
advance payment or deposit is received.

In this situation, the money is received but the revenue has not been “earned.” If the service is
expected to be complete by the end of the accounting period then the receipt is recorded as revenue.

Example: 
On July 1, Paul’s Computing receives a $250 advance payment for a network installation project
expected to be complete by the end of the month.

Journal Entry:
     DR Cash $250 
          CR Revenue $250

In the case where money is received for services that are NOT expected to be complete before the
end of the accounting period, the receipt is recorded as a liability. The liability account involved is
titled Unearned Revenue.

Example: 
On July 1, Paul’s Computing enters into a 6-month network service contract totaling $2400 and
receives an $800 advance payment.
Journal Entry:
     DR Cash $800 
          CR Unearned Revenue $800

Recording Cost Outlays and Expenses

When a company purchases something (on account or with cash), that item can be recorded as either
an Asset or an Expense. Some of these are obvious: the purchase of a truck is an Asset and the
payment of the utility bill is an expense, however, others are a mixture of the two. Consider the
purchase of office supplies. They can be considered an asset or an expense. The asset portion is the
amount of supplies left after the accounting period and the expense portion is the amount used up
during the accounting period. Items like insurance, rent or taxes are considered assets because they
are pre-paid and thus their usefulness has not been used up yet. The rule is as follows:

    • If the cost is used to purchase something that will help to produce revenue in     future
accounting periods it is an Asset.

    • If the cost is used to purchase something that will be used up in the current     accounting period
it is an Expense.

Example: 
On February 1, Phil’s Photography purchases a one-year insurance policy for $1200.

That purchase would be considered an Asset purchase. The insurance policy will be used up over the
course of the year but at the time of purchase, that $1200 represents an asset of the company.

Journal Entry: 
DR Prepaid-Insurance $1200 
CR Cash $1200

Accrual Accounting and Matching

Accrual accounting matches revenues with expenses for a particular period and this is the basis of the
matching principle. Accrual accounting demands that expenses be matched with the revenue that was
generated from those expenses. The expenses for a period, therefore, must include the portion of
assets that was used up during the period. This matching is done so that the net income reported is
as accurate as possible. With accrual accounting there are two different categories of expenses:

1. Cost of goods (services provided or items sold) that are directly aligned to the revenue of the
period i.e. the cost of repair supplies for a repair service business.

2. The cost of assets partially consumed during the period i.e. the amount of the supply inventory
used in one month.

Adjusting Entries

To make sure that the expenses of an accounting period are matched with the revenues, entries are
made at the end of an accounting period to “adjust” the account balances accordingly. There are two
types of adjusting entries:

1. The amount of an asset that is used up during the accounting period is transferred to a
corresponding expense account.

2. The amount of a liability that has been earned during the accounting period is transferred to the
corresponding revenue account.
The accounts that are affected by adjusting entries are called mixed accounts. That means that these
accounts have both a balance sheet portion and an income statement portion. To report net income
accurately, the income statement portion must be removed by an adjusting entry.

Example: Transfer an Asset to an Expense

Previously we learned that on February 1 Phil’s Photography purchased a one-year insurance policy
for $1200. The journal entry on Feb. 1 was:

     DR Prepaid-Insurance $1200 

          CR Cash $1200

At the end of February, one month’s insurance has been used. The monthly portion of insurance is
$100, therefore $100 must be removed from the asset account Pre-paid Insurance and transferred to
the expense account Insurance Expense. This adjusting entry will match the expenses incurred in
February with the revenues received in February.

Adjusting entry: 
     DR Insurance Expense $100 
          CR Pre-Paid Insurance $100 
    To record insurance expense for February.

The balance in the Pre-paid Insurance account is now $1100 and each month another $100 will be
removed until it is time to purchase next year’s policy.

Example: Transfer a Liability to a Revenue

When on July 1 Paul’s Computing entered into a 6-month network service contract for $2400 and
received an $800 advance payment the following journal entry was made:

     DR Cash $800 

          CR Unearned Revenue $800

At the end of July 1 month of revenue from that contract was earned. Each month Paul’s Computing
earns $400 from the contract, therefore $400 must be removed from the liability account of Unearned
Revenue and transferred to “earned” Revenue account.

Adjusting entry: 
     DR Unearned Revenue $400 
          CR Revenue $400

The balance in the Unearned Revenue account is now $400. At the end of August, the remaining
$400 will be transferred and future payments for the contracted service can be recorded directly into
the Revenue account.

The adjusting entries require additional steps in the Accounting Process:

    • Analyze the account balances and prepare adjusting entries

    • Post the Adjusting entries to the Ledger accounts

    • Prepare an Adjusted Trial Balance to prove that the Debits and Credits still match

CALCULATING DEPRECIATION
Assets that a company owns, which are expected to last more than one year, are
called Fixed Assets. These assets include such things as automobiles, computers,
furniture, office buildings, and equipment. These fixed assets that a company owns
have a set amount of useful life. This means that a fixed asset is not expected to last
forever, and thus its value depreciates over time. The definition of depreciation is
the decline in the useful life of a fixed asset.

The only fixed asset that does not decline, except in very rare circumstances, is land.
Land retains its value and most often appreciates, so deprecation is not applicable in
most cases.

Depreciation represents an expense for a business. The business’ fixed

assets are decreased by a certain value each year and because the
accounting equation must always remain in balance, this decrease must be
accounted for somehow. Even though the dollar amount of depreciation is
not paid for in cash, the loss in value of the fixed asset must be balanced
out and this is done by using two accounts:

1. Depreciation Expense
2. Accumulated Depreciation

The Depreciation Expense account is used to capture the dollar value

of depreciation for an accounting period.

Accumulated Depreciation is used to show a running total of how

much a fixed asset has depreciated.

This account is called a contra account because it relates to an asset

account. In the case of accumulated deprecation, the account is
called a contra-asset account and it always has a credit value. The
balance in the accumulated depreciation account is the amount of
the fixed asset that has already expired. Rather than simply decrease
the value of the original asset account, the accumulated depreciation
account is used.

When a company purchases a fixed asset, the purchase amount is

posted to the fixed asset account and that original purchase price is
recorded on the balance sheet. When a reader looks at the financial
statements, he/she wants to know both the original purchase price
and the amount of depreciation that has been accounted for. The
reason for this is that the amount for a fixed asset shown on the
Balance Sheet is not the market price or the amount that asset is
worth. It is the amount, which was originally paid less the
accumulated deprecation.
Example:

Ted’s trucking has a truck that was purchased for $15,000 on

January 1, 2005. As of December 31, the truck has depreciated
$1500. The following shows the journal entries involved:

Original entry Jan 1 

DR Truck      $15,000 
      CR Cash      $15,000 
Purchased truck

Adjusting entry Dec 31

DR Depreciation Expense       $1500
      CR Accumulated Depreciation      $1500
To record depreciation for the year

After this transaction, the balance in the Truck account is still

$15,000 and therefore the amount on the Balance Sheet is $15,000
but the net value of the Truck is $13,500. This is shown on the
Balance Sheet like this:

Fixed Assets
Truck                                         $15,000
Less: Accumulated Depreciation        1,500
Net Truck                                    $13,500 

The net value of an asset is called its book value. This is the value it
has on the balance sheet. This has nothing to do with how much the
asset costs, how much it is worth, or how much you would earn from
selling it.

Calculating Depreciation
Depreciation is calculated in two main ways:

Straight-line depreciation: This method assumes equal

amounts of depreciation over an asset’s useful life. This
translates to equal depreciation expense amounts every period.

The formula for calculating straight-line depreciation is:

            Cost - Saving Value

            Useful Life 

Where:
 Cost = purchase price 

Useful Life = estimated amount of time that the asset will be

used by the company. This is sometimes called service life. 

Salvage value = estimated amount the asset can be sold for

at it end of its useful life. This is sometimes called residual
value.

Example:

The truck that Ted’s Trucking purchased for $15,000 is expected to

be used by the company for 8 years and then sold for $3,000.
Depreciation is calculated as follows:

Depreciation per year = 15000 -13000 = $1500

                                            8

Accelerated depreciation: Under this method, the asset

depreciates at a greater rate at the beginning of its life and the rate
slows as the asset ages. Depreciation expense is greater up front.

There are many ways to calculate accelerated deprecation but one

common method is to develop a table of declining depreciation
values. The total depreciation remains the same but the yearly
deprecation expense is gradually lessened as follows:

Year Accel. Dep.

1 $4,000
2 3,000
3 2,000
4 1,000
5 500
6 500
7 500
8 500
Total 12,000

The reason for using accelerated depreciation is for income tax

purposes to lessen net income. This makes sense because the higher
the expenses in a given period the lower the net income.
CLOSING THE BOOKS LESSON PLAN
 
Teaching Materials
 Lesson - Closing the Books (see below for printable lesson)
 Overhead
 Prepared Examples

Lesson Activity

1. Introduce closing entries

 Stress the need to return account to a zero balance

2. Introduce temporary accounts

 Explain what they are – accumulate a balance for one accounting

period
 Give examples

3. Discuss Permanent accounts

 Explain that these account balances carry over accounting periods

 Mention retained earnings as the fourth type of permanent account

4. Discuss retained earnings

 Relate concept to net income

 Discuss placement on the Balance Sheet
 Use a detailed example to demonstrate

5. Present how to prepare a Statement of Retained Earnings

 Continue with detailed example to illustrate

6. Discuss Closing entries

 Explain the Income Summary account

 Present closing entries for revenues, expenses, and income summary
using detailed examples

7. Next steps

 Talk about the Post Closing Trial Balance

What is Accounting?
Quite simply, accounting is a language: a language that provides information about the
financial position of an organization. When you study accounting you are essentially
learning this specialized language. By learning this language you can communicate and
understand the financial operations of any and all types of organizations. This is because
the information required by most organizations is very similar and can be broken down
into three main categories:
Operating Information:
This is the information that is needed on a day-to-day basis in order for the organization
to conduct its business. Employees need to get paid, sales need to be tracked, the
amounts owed to other organizations or individuals need to be tracked, the amount of
money the organization has needs to be monitored, the amounts that customers owe the
organization need to be checked, any inventory needs to be accounted for: the list goes
on and on. Operating information is what constitutes the greatest amount of accounting
information and it provides the basis for the other two types of accounting information.
Financial Accounting Information
This is the information that is used by managers, shareholders, banks, creditors, the
government, the public, etc… to make decisions involving the organization and its
operations. Shareholders want information about what their investment is worth and
whether they should buy or sell shares, bankers and other creditors want to know
whether the organization has an ability to pay back money lent, managers want to know
how the company is doing compared to other companies. This type of information
would be very difficult to extract if every company used a different system for
recording their financial position. Financial accounting information is subject to a set
of ground rules that dictate how the information is reported and this ensures uniformity.
Managerial Accounting Information
In order for the managers of a company to make the best decisions for a company they
need to have specific information prepared. They use this information for three main
management functions: planning, implementation and control. Financial information
is used to set budgets, analyze different options on a cost basis, modify plans as the
need arises, and control and monitor the work that is being done.
As you can see, accounting is a multifaceted system involving different people with
different needs and after analyzing the various uses and applications of accounting
information the American Accounting Association has come up with this definition: “the
process of identifying, measuring, and communicating economic information to permit
informed judgments and decisions by users of the information.”
In order to facilitate the informed use of this financial information, accounting has come
to be based on specified rules or conventions called “principles.” These principles
provide general laws or rules that are used to guide accounting activity and are called
Name__________________________ Date_________________
Copyright 2005 Money Instructor
Generally Accepted Accounting Principles, or GAAP for short. These principles are
established by the Financial Accounting Standards Board (FASB) which is a
nongovernmental agency funded by the accounting profession and contributions from
business organizations. While there is no legal obligation for companies to adhere to
GAAP, there are strong practical reasons to do so. From auditing to reporting earning to
the US Securities Exchange Commission to applying for a loan, there are very
compelling reasons for organizations to conform to the generally accepted standard.
What Is The End Result Of All This Accounting Information?
We’ve talked about the reason for maintaining accounting information and the end result
of all of this recording is the preparation of financial statements. These statements let
people see, at a glance, the financial position of an organization. These statements
provide summaries of the operating information and are used extensively by people
within and external to the company. The statements fall into one of two categories:
Status/Stock – these statements show the financial status of an organization at one
specified instant in time. Stock reports = a snapshot.
Flow Report – these statements show the flow of financial information over a
period of time. Flow reports = motion picture
GAAP requires the preparation of three different statements:
Balance Sheet
A Balance Sheet is a status report that shows information about the organization’s
resources at one given time. Examples of information found on a balance sheet are how
much cash is in the bank, what is owed to creditors, and the value of the company’s
assets.
Income Statement
An Income Statement (also called a Statement of Earnings, Statement of Operations, or a
Profit and Loss Statement) is a report that shows the flow of revenues (amounts earned
from business activity) and expenses (amounts paid in the course of operations) over a
given period of time, typically a month, quarter, or year.
Statement of Cash Flow
As the name suggests, this is also a flow statement that details the movement of cash
through the organization over a specified period.
The whole purpose of accounting is to provide information that is useful and relevant for
interested parities when making decisions regarding the company and its operations. In
order to do that effectively, a specific language and subsequent rules have been
developed for users of the information. By learning accounting you learn these rules and
can then communicate financial information with others in a comprehensible and
comparable manner.