Financial Accounting

What is Financial Accounting?

Accounting in general deals with identifying business activities, like sales to
customers, recording these activities, like journalizing, and communicating these
activities with people outside the organization with financial statements.

Financial accounting, however, is a subsection of the general field of accounting that

focuses on gathering and compiling data in order to present it to external users in a
usable form. So what does that mean? Basically, financial accounting’s main purpose
is to provide useful, financial information to people or groups outside of companies
often called external users.

Who Uses Financial Accounting?

Unlike company management or internal users, external users of financial information
are not directly involved in running the business or organization. They are outsiders to
the business and only have limited information about companies’ operations, financial
position, and wellbeing. In other words, external users need financial information
about companies in order to support their financial decisions.

The ultimate goal of financial accounting is to compile business transactions and other
input documents like invoices and sales receipts in the form of general purpose financial
statements that can be understood by external users.
The key concept here is that external users must be able to understand and use this
financial information when they are making decisions about the company. If the
information can’t be used, it is worthless. That is why the FASB has created a series
of accounting principles and concepts to make sure financial statements are comparable and
understandable.
Different Types of Financial Statement Users

There are many different types of external users who want or need financial
information for different purposes. All of these external users have something in
common. They are interested in doing business with a company but only have limited
access to the company’s financial information. Financial accounting aims as providing
financial information that is reliable, relevant, and comparable to these external users.

Here is a list of the most common external users of financial information and how
they use it.

Shareholders or Investors
Shareholders and other investors are usually the first group of external users that
comes to mind. Investors in general want to assess the value of a company in order to
decide whether it is worth buying, selling, or holding their stock. Investors read
financial statements to help predict future performance and company worth.

Lenders or Creditors
Lenders or creditors also use financial statements to base the decisions on because
they want to know if a company is creditworthy enough to pay off its current loans or
borrow additional funds. Creditors study financial statements in order to analyze the
liquidity and sustainability of a company.

Customers
It might sound unlikely, but many customers study financial statements before making
major purchases. For instance, large companies like GM will study financial
statements of their potential suppliers in order to make sure they are fiscally sound. A
company, like GM, benefits from long-term relationships with its suppliers. It wants
to make sure of potential suppliers’ longevity before it goes into business with them.

Suppliers
Suppliers also use the financial statements of customers to judge whether they are
creditworthy enough to extend credit. For example, if a customer orders 100,000 units
from a supplier, the supplier wants to know whether the customer will be able to pay
for these units before the supplies incurs the expense of producing them.

Regulators
Regulators like the SEC, PCAOB, and IRS use company financial statements to make
sure the companies are following applicable laws. The SEC and PCAOB monitor
publicly traded companies to reduce fraudulent business activities; whereas, the IRS is
mainly focused on tax collection and compliance.

Unions
Labor unions use financial information to judge whether employee wage rates and
benefit packages are fair. They also use this information to assess future job prospects
and bargain for higher wages and better benefits.

Brokers and Analysts

Brokers and analysts are often potential investors that use financial information about
companies to chart performance trends and growth rates. These external users create
reports that influence current investors opinions and actions.

Press
Finally, the last main external user is the press. Although the press doesn’t use
financial information for its decision bases, it does report on the financial information
of companies. Networks like Yahoo Finance and MSN Money are multi-million dollar
businesses that simply report financial information about other companies.

As you can see, the list of external users is almost endless. Financial accounting aims
to provide all of these groups with information that can be useful for them in their
individual decision making processes.

Accounting Equation
Home » Financial Accounting Basics » Accounting Equation

What is the Accounting Equation?

The accounting equation, also called the basic accounting equation, forms the
foundation for all accounting systems. In fact, the entire double entry accounting
concept is based on the basic accounting equation. This simple equation illustrates
two facts about a company: what it owns and what it owes.

The accounting equation equates a company’s assets to its liabilities and equity. This
shows all company assets are acquired by either debt or equity financing. For
example, when a company is started, its assets are first purchased with either cash the
company received from loans or cash the company received from investors. Thus, all
of the company’s assets stem from either creditors or investors i.e. liabilities and
equity.

Basic Accounting Equation Formula

Here is the basic accounting equation.

As you can see, assets equal the sum of liabilities and owner’s equity. This makes
sense when you think about it because liabilities and equity are essentially just sources
of funding for companies to purchase assets.

The equation is generally written with liabilities appearing before owner’s equity
because creditors usually have to be repaid before investors in a bankruptcy. In this
sense, the liabilities are considered more current than the equity. This is consistent
with financial reporting where current assets and liabilities are always reported before
long-term assets and liabilities.

This equation holds true for all business activities and transactions. Assets will always
equal liabilities and owner’s equity. If assets increase, either liabilities or owner’s
equity must increase to balance out the equation. The opposite is true if liabilities or
equity increase.

Now that we have a basic understanding of the equation, let’s take a look at each
accounting equation component starting with the assets.
Accounting Equation Components
Assets
An asset is a resource that is owned or controlled by the company to be used for future
benefits. Some assets are tangible like cash while others are theoretical or intangible
like goodwill or copyrights.

Another common asset is a receivable. This is a promise to be paid from another

party. Receivables arise when a company provides a service or sells a product to
someone on credit.

All of these assets are resources that a company can use for future benefits. Here are
some common examples of assets:

 Current Assets
 Cash
 Accounts Receivable
 Prepaid Expense
 Fixed Assets
 Vehicle
 Buildings
 Intangible Assets
 Goodwill
 Copyrights
 Patents

Liabilities
A liability, in its simplest terms, is an amount of money owed to another person or
organization. Said a different way, liabilities are creditors’ claims on company assets
because this is the amount of assets creditors would own if the company liquidated.
A common form of liability is a payable. Payables are the opposite of receivables.
When a company purchases goods or services from other companies on credit, a
payable is recorded to show that the company promises to pay the other companies for
their assets.

Here are some examples of some of the most common liabilities:

 Accounts payable
 Bank loans
 Lines of Credit
 Personal Loans
 Officer Loans
 Unearned income

Equity
Equity represents the portion of company assets that shareholders or partners own. In
other words, the shareholders or partners own the remainder of assets once all of the
liabilities are paid off.

Owners can increase their ownership share by contributing money to the company or
decrease equity by withdrawing company funds. Likewise, revenues increase equity
while expenses decrease equity.

Here are some common equity accounts:

 Owner’s Capital
 Owner’s Withdrawals
 Officer Loans
 Unearned income
 Common stock
 Paid-In Capital
Example
How to use the Accounting Equation
Let’s take a look at the formation of a company to illustrate how the accounting
equation works in a business situation.

Ted is an entrepreneur who wants to start a company selling speakers for car stereo
systems. After saving up money for a year, Ted decides it is time to officially start his
business. He forms Speakers, Inc. and contributes $100,000 to the company in
exchange for all of its newly issued shares. This business transaction increases
company cash and increases equity by the same amount.

After the company formation, Speakers, Inc. needs to buy some equipment for
installing speakers, so it purchases $20,000 of installation equipment from a
manufacturer for cash. In this case, Speakers, Inc. uses its cash to buy another asset,
so the asset account is decreased from the disbursement of cash and increased by the
addition of installation equipment.

After six months, Speakers, Inc. is growing rapidly and needs to find a new place of
business. Ted decides it makes the most financial sense for Speakers, Inc. to buy a
building. Since Speakers, Inc. doesn’t have $500,000 in cash to pay for a building, it
must take out a loan. Speakers, Inc. purchases a $500,000 building by paying
$100,000 in cash and taking out a $400,000 mortgage. This business transaction
decreases assets by the $100,000 of cash disbursed, increases assets by the new
$500,000 building, and increases liabilities by the new $400,000 mortgage.
As you can see, all of these transactions always balance out the accounting equation.
This is one of the fundamental rules of accounting. The accounting equation can never
be out of balance. Assets will always equal liabilities and owner’s equity.

Expanded Accounting
Equation
Home » Financial Accounting Basics » Expanded Accounting Equation

What is the Expanded Accounting Equation?

The expanded accounting equation takes the basic accounting equation and splits
equity into its four main elements: owner’s capital, owner’s withdrawals, revenues,
and expenses. Both the assets and liabilities section of the basic equation remains the
same in the expanded equation.

Expanding the equity section shows how equity created from two main sources:
investors’ contributions and company profits. Conversely, equity it decreased by
investors leaving the company and company losses.

The expanded accounting equation also demonstrates the relationship between

the balance sheet and the income statement by seeing how revenues and expenses flow
through into the equity of the company.
Since corporations, partnerships, and sole proprietorships are different types of entities,
they have different types of owners. For instance, corporations have stockholders and
paid-in capital accounts; where as, partnerships have owner’s contribution and
distribution accounts. Thus, all of these entities have a slightly different expanded
equation.
Different Types of the Expanded Accounting
Equation
Here is the expanded accounting equation for a corporation.

Here is the expanded accounting equation for a partnership.

Here is the expanded accounting equation for a sole proprietorship.

Notice that all of the equations’ assets and liabilities remain the same—only the
ownership accounts are changed.

Examples
How to use the Expanded Accounting Equation
Let’s take a look at a few example business transactions for a corporation to see how
they affect its expanded equation.

— At the beginning of the year, Corporation X was formed and 1,000, $10 par value
stocks were issued. X receives the cash from the new shareholders and also grants
them equity in the company. Thus, assets increase and common stock increases.
— X uses $2,000 of its cash to purchase a new equipment. This transaction decreases
assets when the cash is distributed and increases assets when the new equipment is
received.

— X hires an employee to start producing products with its new equipment. After two
weeks, X cuts a payroll check to its employee. The cash disbursement reduces assets
and the payroll expense is recorded as a reduction of equity.

— At the end of the year, X ends up with large profits and the management decides to
issue dividends to its shareholders. X issues a $10,000 dividend to its shareholders.
When dividends are issued, cash is disbursed to shareholders reducing assets while the
dividends reduce equity.

As you can see from all of these examples, the expanded equation always balances
just like the basic equation.
Accounts
Home » Financial Accounting Basics » Accounts

What is an Account?
Accounts are at the foundation of financial accounting. Each business transaction
increases or decreases balances in one account or another. The entire accounting
concept is based on maintaining a chart of accounts, but what is an account?

An account is simply a record of all changes to a specific asset, liability, or equity

item. You can think of an account like a notepad. Each accounting item has its own
notepad that is used to document all of the increases and decreases to that item over
time.

For instance, the asset account records all of the changes in assets over time like asset
purchases and sales.

Accounts are typically named and numbered in order to categorize and keep track of
them. Accounts can also have sub-accounts. For example, the vehicle account is a
sub-account inside the main asset account.

All accounts are kept or recorded in the general ledger. You could think of this as a
folder that you keep all of your account notepads in.

Types of Accounts
All accounting in the chart of accounts or general ledger fall into three main
categories: asset, liability, or equity.

Asset accounts have a debit balance and represent the resources a company has at its
disposal.
Liability accounts have a credit balance and represent the money that a company
owes to other entities.
Equity accounts also have a credit balance and they represent the owners’ stake in
the company.
Account Format
There are many different ways to format or display an account, but the most common
way is by using T-accounts. T-accounts format account balances by keeping the debits
on the left side and the credits on the right. The overall account balance is then
calculated at the bottom. T-accounts also have a title or heading that displays the
name and number of the account.
Here is an example of a T-account.

Accounts can also be displayed as a listing of transactions in the general ledger. In

other words, the cash account might just have a list of all the transactions that affected
the cash account during that period.

Although the list format ultimately works, T-accounts and similar reports are much
easier to read and use. T-accounts are also helpful in the accounting cycle before
preparing trial balances.

Asset Accounts
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What is an Asset Account? – Definition

An asset is defined as a resource that is owned or controlled by a company that can be
used to provide a future economic benefit. In other words, assets are items that a
company uses to generate future revenues or maintain its operations.
Assets accounts generally have a debit balance. This means that entries created on the
left side (debit entries) of an asset T-account increase the asset account balance while
journal entries created on the right side (credit entries) decrease the account balance.

Types of Asset Accounts – Explanation

Pretty much all accounting systems separate groups of assets into different accounts.
These accounts are organized into current and non-current categories. A current asset
is one that has a useful life of one year or less. Non-current assets have a useful life of
longer than one year.

List of Assets Accounts – Examples

Here’s a list of some of the most common asset accounts fond in a chart of accounts:

Current Assets
Cash – Cash is the most liquid asset a company can own. It includes any form of
currency that can be readily traded including coins, checks, money orders, and bank
account balances.
Accounts Receivable – Accounts Receivable is an asset that arises from selling goods
or services to someone on credit. The receivable is a promise from the buyer to pay
the seller according to the terms of the sale. This is an unusual asset because it isn’t an
asset at all. It is more of a claim to an asset. The seller has a claim on the buyer’s cash
until the buyer pays for the goods or services.
Notes Receivable – A note is a written promise to repay money. A company that
holds notes signed by another entity has an asset recorded as a note. Unlike accounts
receivable, notes receivable can be long-term assets with a stated interest rate.
Prepaid Expenses – Prepaid expenses, like prepaid insurance, are expenses that have
been paid in advanced. Like accounts receivable, prepaid expenses are assets because
they are a claim to assets. If six months worth of insurance is paid in advance, the
company is entitled to insurance (a service) for the next six months in the future.
Inventory – Inventory consists of goods owned a company that is in the business of
selling those goods. For example, a car would be considered inventory for a car
dealership because it is in the business of selling cars. A car would not be considered
inventory for a pizza restaurant looking to selling it delivery car.
Supplies – Many companies have miscellaneous assets that are entire in product
production that are too small and inexpensive to capitalize. These assets are expenses
when they are purchased. A good example is car factory’s bolts. It’s difficult to
account for each bolt as it is used in the assembly process, so they are just expensed.

Long-term Assets
Fixed Assets – Fixed assets include equipment, vehicles, machinery, and even
computers. These assets generally have a useful life of more than one year and are
usually more expensive business purchases.
Intangible Assets – Not all assets are physical. Some assets like goodwill, stock
investments, patents, and websites can’t be touched. These intellectual assets can be
quite substantial, however.
There are many more types of assets that aren’t mentioned here, but this is the basic
list. We will discuss more assets in depth later in the accounting course. Right now
it’s important just to know the basic concepts.

Liability Accounts
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What is a Liability Account? – Definition

Liabilities are defined as debts owed to other companies. In a sense, a liability is a
creditor’s claim on a company’ assets. In other words, the creditor has the right to
confiscate assets from a company if the company doesn’t pay it debts. Most state laws
also allow creditors the ability to force debtors to sell assets in order to raise enough
cash to pay off their debts.

Debt financing is often used to fund operations or expansions. These debts usually
arise from business transactions like purchases of goods and services. For example, a
business looking to purchase a building will usually take out a mortgage from a bank
in order to afford the purchase. The business then owes the bank for the mortgage and
contracted interest.

Liability accounts have a credit balance. This means that entries created on the left side
(debit entries) of a liability T-account decrease the liability account balance while
journal entries created on the right side (credit entries) increase the account balance.

Types of Liability Accounts – Examples

There are many different kinds of liability accounts, although most accounting
systems groups these accounts into two main categories: current and non-current.
Current liabilities are debts that become due within the year, while non-current
liabilities are debts that become due greater than one year in the future. Here are some
examples of both current and non-current liabilities:

Current Liabilities
Accounts Payable – Many companies purchase inventory on credit from vendors or
supplies. When the supplier delivers the inventory, the company usually has 30 days
to pay for it. This obligation to pay is referred to as payments on account or accounts
payable. No written contract needs to be in place. The promise to pay can either be
oral or even implied.
Accrued Expenses – Since accounting periods rarely fall directly after an expense
period, companies often incur expenses but don’t pay them until the next period.
These expenses are called accrued liabilities. Take utilities for example. The current
month’s utility bill is usually due the following month. Once the utilities are used, the
company owes the utility company. These utility expenses are accrued and paid in the
next period.
Non-current Liabilities
Bonds Payable – Many companies choose to issue bonds to the public in order to
finance future growth. Bonds are essentially contracts to pay the bondholders the face
amount plus interest on the maturity date. Bonds are almost always long-term
liabilities.
Notes Payable – A note payable is a long-term contract to borrow money from a
creditor. The most common notes payable are mortgages and personal notes.
Unearned Revenue – Unearned revenue is slightly different from other liabilities
because it doesn’t involve direct borrowing. Unearned revenue arises when a
company sells goods or services to a customer who pays the company but doesn’t
receive the goods or services. In effect, this customer paid in advance for is purchase.
The company must recognize a liability because it owes the customer for the goods or
services the customer paid for.
That was a brief list of liability accounts. We will discuss more liabilities in depth
later in the accounting course. Right now it’s important just to know the basic
concepts.

Equity Accounts
Home » Financial Accounting Basics » Equity Accounts

What is an Equity Account? – Definition

Equity is defined as the owner’s interest in the company assets. In other words, upon
liquidation after all the liabilities are paid off, the shareholders own the remaining
assets. This is why equity is often referred to as net assets or assets minus liabilities.
Equity can be created by either owner contributions or by the company retaining its
profits. When an owner contributes more money into the business to fund its
operations, equity in the company increases. Likewise, if the company produces net
income for the year and doesn’t distribute that money to its owner, equity increases.
Equity accounts, like liabilities accounts, have credit balances. This means that entries
created on the left side (debit entries) of an equity T-account decrease the equity
account balance while journal entries created on the right side (credit entries) increase
the account balance.
Types of Equity Accounts – Explanation
There are several types of equity accounts illustrated in the expanded accounting
equation that all affect the overall equity balance differently. Here are the main types
of equity accounts.
Capital – Capital consists of initial investments made by owners. Stock purchases or
partnership buy-ins are considered capital because both are comprised of cash
contributions made by the owners to the company. Capital accounts have a credit
balance and increase the overall equity account.
Withdrawals – Owner withdrawals are the opposite of contributions. This is where the
company distributes cash to its owners. Withdrawals have a debit balance and always
reduce the equity account.
Revenues – Revenues are the monies received by a company or due to a company for
providing goods and services. The most common examples of revenues are sales,
commissions earned, and interest earned. Revenue has a credit balance and increases
equity when it is earned.
Expenses – Expenses are essentially the costs incurred to produce revenue. Costs like
payroll, utilities, and rent are necessary for business to operate. Expenses are contra
equity accounts with debit balances and reduce equity.

Examples
Unlike assets and liabilities, equity accounts vary depending on the type of entity. For
example, partnerships and corporations use different equity accounts because they
have different legal requirements to fulfill. Here are some examples of both sets of
equity accounts.

Partnership Equity Accounts

Owner’s or Member’s Capital – The owner’s capital account is used by partnerships
and sole proprietors that consists of contributed capital, invested capital, and profits
left in the business. This account has a credit balance and increases equity.
Owner’s Distributions – Owner’s distributions or owner’s draw accounts show the
amount of money the owner’s have taken out of the business. Distributions signify a
reduction of company assets and company equity.

Corporate Equity Accounts

Common Stock – Common stock is an equity account that records the amount of
money investors initially contributed to the corporation for their ownership in the
company. This is usually recorded at the par value of the stock.
Paid-In Capital – Paid-in capital, also called paid-in capital in excess of par , is the excess
dollar amount above par value that shareholders contribute to the company. For
instance, if an investor paid $10 for a $5 par value stock, $5 would be recorded as
common stock and $5 would be recorded as paid-in capital.
Treasury Stock – Sometimes corporations want to downsize or eliminate investors
by purchasing company from shareholders. These shares that are purchased by the
company are called treasury stock. This stock has a debit balance and reduces the
equity of the company.
Dividends – Dividends are distributions of company profits to shareholders.
Dividends are the corporate equivalent of partnership distributions. Both reduce the
equity of the company.
Retained Earnings – Companies that make profits rarely distribute all of their profits
to shareholders in the form of dividends. Most companies keep a significant share of
their profits to reinvest and help run the company operations. These profits that are
kept within the company are called retained earnings.
There is a basic overview of equity accounts and how their interact with the overall
equity of the company.

Contra Account
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What is a Contra Account? Definition

A contra account is an account with a balance opposite the normal accounts in its
category. Contra accounts are usually linked to specific accounts on the balance
sheet and are reported as subtractions from these accounts. In other words, contra
accounts are used to reduce normal accounts on the balance sheet.
Types of Contra Accounts – Explanation
There are a few different types of contra accounts in the chart of accounts. Each one is
tied to their respective asset, liability, or equity account to reduce their carrying
balance on the balance sheet. Here’s a list of the main types of contra accounts:

Contra Asset Account – A contra asset account is an asset that carries a credit
balance and is used to decrease the balance of another asset on the balance. An
example of this is accumulated depreciation. This account decreases the fixed asset
carrying balance.
Contra Liability Account – A contra liability account is a liability that carries a debit
balance and decreases other liabilities on the balance sheet. An example of this is a
discount on bonds payable.
Contra Equity Account – A contra equity account has a debit balance and decreases
a standard equity account. Treasure stock is a good example as it carries a debit
balance and decreases the overall stockholders’ equity.

Example
How are Contra Accounts Used and Reported?
Take the equipment account for example. Equipment is a long-term asset account that
has a debit balance. Equipment is depreciated over its useful. This depreciation is
saved in a contra asset account called accumulated depreciation. The accumulated
depreciation account has a credit balance and is used to reduce the carrying value of
the equipment. The balance sheet would report equipment at its historical cost and
then subtract the accumulated depreciation.
By reporting contra accounts on the balance sheet, users can learn even more
information about the company than if the equipment was just reported at its net
amount. Balance sheet readers cannot only see the actual cost of the item; they can
also see how much of the asset was written off as well as estimate the remaining
useful life and value of the asset.
The same is true for other asset accounts like accounts receivable. Accounts
receivable is rarely reported on the balance sheet at its net amount. Instead, it is
reported at its full amount with an allowance for bad debts listed below it. This shows
investors how much receivables are still good. Maybe more importantly, it shows
investors and creditors what percentage of receivables the company is writing off.

Here is an example of a depreciation journal entry.

Revenue Accounts
Home » Financial Accounting Basics » Revenue Accounts

What is a Revenue Account?

Revenues are the assets earned by a company’s operations and business activities. In
other words, revenues include the cash or receivables received by a company for the
sale of its goods or services.

The revenue account is an equity account with a credit balance. This means that a
credit in the revenue T-account increases the account balance. As shown in
the expanded accounting equation, revenues increase equity. Unlike other accounts,
revenue accounts are rarely debited because revenues or income are usually only
generated. Income is rarely taken away from a company.
The revenue account is only debited if goods are returned and sales are refunded. In
this case, the recorded sale must be reversed because the original sale is canceled.

Types of Revenue Accounts – Examples

There are many different kinds of revenue accounts, but they all represent the same
basic concepts: a company receives cash or a claim to cash for the sale or use of its
assets. Revenues are typically separated into two different categories: operating
revenues and non-operating revenues or other income.
Operating Revenues
Operating revenues are generated from a company’s main business activities. In other
words, this is the area of activities that a company earns most of its income and
chooses to operate. Microsoft’s operating revenue comes from software development
and creation because it is a software company.

Here are some examples of operating revenues:

Sales – A sale is an exchange of goods for cash or a claim to cash. Sales are typically
made by manufacturers, wholesalers, and retailers when they sell their inventory to
customers. For example, a clothing retailer would record the income from selling a
shirt to a customer as a sale or a merchandise sale
Rents – Rental income is earned by a landlord for allowing tenants to reside in his or
her building or land. The tenants often have to sign a rental contract that dictates the
details of the rental payments. According to the accrual method of accounting, the
landlord records rental income when it is earned – not paid.
Consulting Services – Consulting service or professional services include all income
from providing a service to a customer or client. For example, a law firm records
professional service revenues when it provides legal services for a client.

Non-operating Revenues or Other Income

Other income includes all revenues generated by a company outside of its normal
operations. Usually non-operating revenues are only a fraction of operating revenues.

Here is an example of non-operating revenues:

Interest income – Interest income is the most common form of non-operating income
because most businesses earn small amounts of interest from their savings and
checking accounts. Interest income isn’t only limited to bank account interest. It can
also include interest earned from accounts receivable or other contracts.
There are many more types of revenues, but this is the basic list. We will discuss more
revenues in depth later in the accounting course. Right now let’s move on to talk
about expense accounts.
Expense Account
Home » Financial Accounting Basics » Expense Account

What is an Expense Account?

Expenses are the costs incurred to generate revenues. In other words, a firm records an
expense when it disburses cash or promises to disburse cash for an asset or service
used to generate income. A manufacturer would record an expense when it pays its
employees for producing its products.
Expenses accounts are equity accounts with a debit balance. Expense accounts are
considered contra equity accounts because their balance decreases the overall equity
balance. In other words, debiting an expense account increases the balance instead of
decreasing it like most other equity accounts.
Expenses are subtracted from revenues to calculate overall equity in the expanded
accounting equation and calculate net income on the income statement.

Types of Expense Accounts – Examples

There are tons of different expense accounts. Think about how many costs a business
incurs to produce and sell a product. Everything from production costs to selling costs
is included in the main expense account.

Just like revenues, expenses are generally separated into two main categories:
operating and non-operating.

Operating Expenses
Operating expenses include all costs that are incurred to generate operating revenues
like merchandise sales. Here are some examples of common operating expenses.

Rent – Businesses that can’t afford to purchase a space to operate usually rent a space
from another company. These monthly rental payments are recorded as an expense.
Buildings and floor space aren’t the only thing rented, however. Equipment and
vehicles are also commonly rented by businesses.
Wages – Employers have to pay their employees to perform operations in the
company. Some employees produce goods while others perform administrative
functions like bookkeeping. The company pays all of these employees for their time
and efforts. These payments are recorded as wages or salary expenses.
Utilities – Utilities costs include electricity, water, heat, and even telephone services.
These payments are necessary any business to operate.
Advertising – Advertising consists of payments made to another company to promote
products or services. Just about every company advertises their products or services in
one way or another. These payments are recorded as operating expenses because they
help sell generate operating revenues.

Non-operating Expenses
Non-operating expenses include costs that can’t be linked back to operating revenues.
Interest expense is the most common non-operating expense.

Interest Expense – Interest is the cost of borrowing cash for a period of time. Loans
from banks or bonds usually require regular interest payments to compensate the
lender. These payments don’t generate operating income, so they are recorded as a
non-operating expense.
There are many more types of expenses, but this is the basic list. We will discuss more
expenses in depth later in the accounting course. Right now let’s move on to talk
about accounting ledgers.

General Ledger
Home » Financial Accounting Basics » General Ledger

What is the General Ledger?

A general ledger or accounting ledger is a record or document that contains account
summaries for accounts used by a company. In other words, a ledger is a record that
details all business accounts and account activity during a period. Remember our
notebook analogy in the account explanation? You can think of an account as a
notebook filled with business transactions from a specific account, so the cash notebook
would have records of all the business transactions involving cash.
By this same analogy, a ledger could be considered a folder that contains all of the
notebooks or accounts in the chart of accounts. For instance, the ledger folder could
have a cash notebook, accounts receivable notebook, and notes receivable notebooks
in it. In a sense, a ledger is a record or summary of the account records.

A ledger is often referred to as the book of second entry because business events are
first recorded in journals. After the journals are complete for the period, the account
summaries are posted to the ledger.

List of General Ledger Accounts and Content

Accounting Ledger
The general ledger is often called the accounting ledger because it contains a listing of
all general accounts in the accounting system’s chart of accounts. Here are the main
types of general ledger accounts:

 Asset Accounts (Cash, Accounts Receivable, Fixed Assets)

 Liability Accounts (Accounts Payable, Bonds Payable, Long-Term Debt)
 Stockholders’ Equity Accounts (Common Stock, Retained Earnings)
 Revenue Accounts (Sales, Fees)
 Expense Accounts (Wages Expense, Utilities Expense, Depreciation Expense)
 Other Gain and Loss Accounts (Interest Expense, Investment Income,
Gain/Loss on Disposal of Asset)
These accounts are debited and credited to record transactions throughout the year.
Most modern companies use a computerized GL, like the one in Quickbooks software
packages, to track their business transactions. This way reports can be automatically
generated and there

Example
How to Use the General Ledger
Accounts are usually listed in the general ledger with their account numbers and
transaction information. Here is what an general ledger template looks like in debit and
credit format.

As you can see, columns are used for the account numbers, account titles, and debit or
credit balances. The debit and credit format makes the ledger look similar to a trial
balance. Other ledger formats list individual transaction details along with account
balances.
Accounting ledgers can be displayed in many different ways, but the concept is still
the same. Ledgers summarize the balances of the accounts in the chart of accounts.

Subsidiary Ledgers
The general ledger is not the only ledger in an accounting system. Subsidiary ledgers
include selective accounts unlike the all-encompassing general ledger. Sometimes
subsidiary ledgers are used as an intermediate step before posting journals to the
general ledger.

For instance, cash activity is usually recorded in the cash receipts journal. The account
details can then be posted to the cash subsidiary ledger for management to analyze
before it gets posted to the general ledger for reporting purposes.

Now let’s move on to talk about debits vs. credits and how they work in an accounting
system.

Debits and Credits

Home » Financial Accounting Basics » Debits and Credits

Debit vs Credit – What’s the Difference?

The double entry accounting system is based on the concept of debits and credits. This
is an area where many new accounting students get confused. Often people think
debits mean additions while credits mean subtractions. This isn’t the case at all.

Debits and credits actually refer to the side of the ledger that journal entries are posted
to. A debit, sometimes abbreviated as Dr., is an entry that is recorded on the left side
of the accounting ledger or T-account. Conversely, a credit or Cr. is an entry on the
right side of the ledger.
This right-side, left-side idea stems from the accounting equation where debits always
have to equal credits in order to balance the mathematically equation.

If you will notice, debit accounts are always shown on the left side of the accounting
equation while credit accounts are shown on the right side. Thus, debit entries are
always recorded on the left and credit entries are always recorded on the right.

So debits and credits don’t actually mean plusses and minuses. Instead, they reflect
account balances and their relationship in the accounting equation.

Debit and Credit Accounts and Their Balances

There are several different types of accounts in an accounting system. Each account is
assigned either a debit balance or credit balance based on which side of the accounting
equation it falls. Here are the main three types of accounts.

Assets
All normal asset accounts have a debit balance. This means that asset accounts with a
positive balance are always reported on the left side of a T-Account. Assets are
increased by debits and decreased by credits.
Liabilities
All normal liabilities have a credit balance. In other words, these accounts have a
positive balance on the right side of a T-Account. Liabilities are increased by credits
and decreased by debits.

Equity Accounts
Equity accounts like retained earnings and common stock also have a credit balances.
This means that equity accounts are increased by credits and decreased by debits.

Contra Accounts
Notice I said that all “normal” accounts above behave that way. Well, what is an un-
normal account? Contra accounts are accounts that have an opposite debit or credit
balance. For instance, a contra asset account has a credit balance and a contra equity
account has a debit balance. These accounts are used to reduce normal accounts. For
example, accumulated depreciation is a contra asset account that reduces a fixed asset
account.

Credit vs Debit Examples

— Bob’s Furniture needs to buy a new delivery truck because their current truck is
started to fall apart. Bob purchases the new truck for $5,000, so he writes a check to
the car company and receives the truck in exchange. Bob’s cash is being reduced by
the $5,000 and his fixed assets are being increased by $5,000. Bob would record this
entry like this:
As you can see, Bob’s cash is credited (decreased) and his vehicles account is debited
(increased).

— Now let’s take the same example as above except let’s assume Bob paid for the
truck by taking out a loan. Bob’s vehicle account would still increase by $5,000, but
his cash would not decrease because he is paying with a loan. Instead, his liabilities
account would increase.

As you can see, Bob’s liabilities account is credited (increased) and his vehicles
account is debited (increased).

— Now let’s assume that Bob’s Furniture didn’t purchase the truck at all. It couldn’t
afford to buy a new one, so Bob just contributed his personal truck to the company. In
this case, Bob’s vehicle account would still increase, but his cash and liabilities would
stay the same. Bob’s equity account would increase because he contributed the truck.

As you can see, Bob’s equity account is credited (increased) and his vehicles account
is debited (increased).

Double Entry Accounting

Home » Financial Accounting Basics » Double Entry Accounting

What is Double-Entry Accounting?

Double entry accounting, also called double entry bookkeeping, is the accounting
system that requires every business transaction or event to be recorded in at least
two accounts. This is the same concept behind the accounting equation. Every debit that is
recorded must be matched with a credit. In other words, debits and credits must also be
equal in every accounting transaction and in their total.
Every modern accounting system is built on the double entry bookkeeping concept
because every business transaction affects at least two different accounts. For
example, when a company takes out a loan from a bank, it receives cash from the loan
and also creates a liability that it must repay in the future. This single transaction
affects both the asset accounts and the liabilities accounts.
Example
How to Use Double Entry Accounting
Let’s take a look at the accounting equation to illustrate the double entry system. Here
is the equation with examples of how debits and credit affect all of the accounts.

As you can see from the equation, assets always have to equal liabilities plus equity.
In other words, overall debits must always equal overall credits. For example, if an
asset account is increased or debited, either a liability or equity account must be
increased or credited for the same amount.

This is always the case except for when a business transaction only affects one side of
the accounting equation. For example, if a restaurant purchases a new delivery vehicle
for cash, the cash account is decreased by the cash disbursement and increased by the
receipt of the new vehicle. This transaction does not affect the liability or equity
accounts, but it does affect two different assets accounts. Thus, assets are decreased
and immediately increased resulting in a net effect of zero.
The concept of double entry accounting is the basis for recording business transaction
and journal entries. Make sure you have a good understanding of this concept before
moving on past the accounting basics section.

Now that we have talked about the double entry bookkeeping system, let’s move on to
recording journal entries.

Business Events
Home » Financial Accounting Basics » Business Events

What is a Business Event?

A Business event, also called a business transaction, is an exchange of value between
two different groups. The exchange is usually called an event when it impacts
the accounting equation in one way or another. In other words, a business transaction or
event occurs when the assets, liabilities, or owner’s equity of a company is changed.
We are all familiar with transaction. For example, when you purchase groceries, you
give the cashier money and you leave with a bag of groceries. Business transactions
work the same way.

An event always impacts the accounting equation of a company because it is an

exchange of financial statement elements for other financial statement elements.

Journal Entry Format

All accounting events are recorded in a company’s accounting system as journal
entries as they occur. These journal entries simply record the changes to the
accounting equation based on the business transaction. Taking our grocery example
above, a journal entry would be recorded to decrease the cash account by the amount
paid to the cashier and increase the supplies account by the same amount.
The journal entry system is based on debits and credits to increase or decrease account
balances. Every journal entry’s debits and credits must balance. This is the same
concept behind the accounting equation. For every dollar debited to one account in an
entry, the same amount must be credited to a different account. This way the
accounting equation is always in balance.

Example
How are Business Events Recorded?
Here is an example of the journal entry format for our grocery purchase transaction.

As you can see, the supplies account is debited or increased by the event while the
cash account is credited or decreased by the event. A standard journal entry always
shows the date of business transaction, names of the accounts effected, amounts to be
debited and credited, as well as a brief description of the event.

When you are first learning how to make journal entries it is helpful to look at how
these entries affect the accounting equation. Here’s a look at the same transaction’s
effect on the accounting equation.
As you can see, both accounts in the journal entry are asset accounts. Thus, total
assets are increased from newly purchases supplies and decreased by the disbursement
of cash. In other words, there is no net change to the equation. However, notice that
the equation is still in balance after the transaction is made.

Since there are so many different kinds of journal entries in accounting, I just wanted to
cover the basics in this article. Go to the journal entries section for examples of just
about every journal entry you can think of.

General Journal
Home » Financial Accounting Basics » General Journal

What is a General Journal?

The general journal, also called the book of first entry, is a record of business
transactions and events for a specific account. In other words, this journal
chronologically stores all the journal entries for a specific account or group of account
in one place, so management and bookkeepers can analyze the data.
Accounting journals are often called the book of first entry because this is where
journal entries are made. Once a business transaction is made, the bookkeeper records
that event in the form of a journal entry in one of the accounting journals. Then, at the
end of a period, the journals are posted to accounting ledgers for reporting purposes.
Companies use many different journals depending on their accounting system and
industry, but all companies use the general journal.

General Journal Contents

The general journal is an accounting journal used to record journal entries for all types
of transactions. Many companies use this journal exclusively to record all of their
journal entries in the entire accounting system. There are pros and cons to this
approach as it tends to make the journal extremely large and is difficult to search.
Even the smallest businesses’ GL would be 200-500 pages.

Having something this large typically isn’t practical, so most companies use the GL
only to record general items like depreciation. Transactions that can fit into a more
specific categories can be recorded in special accounting journals. We’ll talk more
about these in a bit.

You can think of it like this. The General Journal is a catch-all journal where
transactions that don’t fit into special categories are recorded. All modern GLs are
computerized with accounting software like Quickbooks, so GL maintenance is pretty
simple. Now that we know what is in the GL, let’s take a look at how it is formatted.

Format and Template

Most journals are formatted the same way with columns for the transaction dates,
account names, debit and credit amounts, as well as a brief description of the
transaction. Does this sound familiar? It should. This is a typical journal entry format.
That’s all a journal is. It’s just a list of journal entries recorded in one place.
Here’s a general journal template example.

Example
How to Use the General Journal
Throughout the accounting period, a business enters into transactions with customers,
vendors, suppliers, the government, and other entities. All of these transactions must
be recorded in order to accurately show the financial standings of the company at the
end of the period.

In order to do this, a bookkeeper makes journal entries in the general journal

recording changes in the corresponding accounts for a given transaction. For example,
if a business purchased a new company vehicle for cash, the bookkeeper would record
a journal entry that debits the vehicle account and credits the cash account.

At the end of the period, all of the entries in the general journal are tallied up in their
corresponding accounts and are reported on the trial balance.

Special Journals
Accounting Journals
In addition to the general journal, there are several special journals or subsidiary
journals that are used to help divide and organize business transactions.

Here’s a list of the special accounting journals used:

 Cash Receipts Journal

 Cash Disbursements Journal
 Purchases Journal
 Sales Journal
 Purchase Return Journal
 Sales Return Journal
 General Journal
Each of these journals has a special purpose and are used to record specific types of
transactions. For example, the cash receipts journal contains all of the cash sale
transactions. The accounts receivable or credit sales journal contains all the
transactions for credit sales.
Other journals like the sales journal and cash disbursements journal are also used the
help management organize and analyze accounting information.

Now that you understand the GL and how it’s used, let’s look at how to create a trial
balance.

Trial Balance
Home » Financial Accounting Basics » Trial Balance

What is a Trial Balance?

A trial balance sheet is a report that lists the ending balances of each account in the
chart of accounts in balance sheet order. Bookkeepers and accountants use this report
to consolidate all of the T-accounts into one document and double check that
all transactions were recorded in proper journal entry format.
Bookkeepers typically scan the year-end trial balance for posting errors to ensure that
the proper accounts were debited and credited while posting journal entries. Internal
accountants, on the other hand, tend to look at global trends of each account. For
instance, they might notice that accounts receivable increased drastically over the year
and look into the details to see why.

Tax accountants and auditors also use this report to prepare tax returns and begin the
audit process. The TB format lends itself to a wide variety of uses.

Trial Balance Format

The trial balance format is easy to read because of its clean layout. It typically has
four columns with the following descriptions: account number, name, debit balance,
and credit balance. It’s always sorted by account number, so anyone can easily scan
down the report to find an account balance. This order also tends to be in balance
sheet order since the average chart of accounts follows the accounting equation
starting with the assets.
Not all accounts in the chart of accounts are included on the TB, however. Usually
only active accounts with year-end balance are included in the TB because accounts
with zero balances don’t make it on the financial statements. For example, if a
company had a vehicle at the beginning of the year and sold it before year-end, the
vehicle account would not show up on the year-end report because it’s not an active
account.

The report also totals the debit and credit columns at the bottom. As with all financial
accounting, the debits must equal the credits. If it’s out of balance, something is
wrong and the bookkeeper must go through each account to see what got posted or
recorded incorrectly.

This step saves a lot time for accountants during the financial statement preparation
process because they don’t have to worry about the balance sheet and income
statement being off due to an out-of-balance error. Keep in mind, this does not ensure
that all journal entries were recorded accurately. It just means that the credits and
debits balance.
A journal entry error can still exist. For instance, in our vehicle sale example the
bookkeeper could have accidentally debited accounts receivable instead of cash when
the vehicle was sold. The debits would still equal the credits, but the individual
accounts are incorrect. This type of error can only be found by going through the trial
balance sheet account by account.

Since most companies have computerized accounting systems, they rarely manually
create a TB or have to check for out-of-balance errors. They computer system does
that automatically.

Preparation and Process

How is the Trial Balance Prepared?
When the accounting system creates the initial report, it is considered an unadjusted
trial balance because no adjustments have been made to the chart of accounts. This is
simply a list of all the account balances straight out of the accounting system.
As the bookkeepers and accountants examine the report and find errors in the
accounts, they record adjusting journal entries to correct them. After these errors are
corrected, the TB is considered an adjusted trial balance.
We still aren’t done with this report yet though. The errors have been identified and
corrected, but the closing entries still need to be made before this TB can used to
create the financial statements. After the closing entries have been made to close the
temporary accounts, the report is called the post-closing trial balance.
Let’s take a look at an example.

Example
How to use the Trial Balance
Here’s an example trial balance. As you can see, the report has a heading that
identifies the company, report name, and date that it was created. The accounts are
listed on the left with the balances under the debit and credit columns.
Since the debit and credit columns equal each other totaling a zero balance, we can
move in the year-end financial statement preparation process and finish the
accounting cycle for the period.

Accounting Principles
Home » Accounting Principles
 What are Accounting Principles?
Definition: Accounting principles are the building blocks for GAAP. All of the
concepts and standards in GAAP can be traced back to the underlying accounting
principles. Some accounting principles come from long-used accounting practices
where as others come from ruling making bodies like the FASB.
It’s important to have a basic understanding of these main accounting principles as
you learn accounting. This isn’t just memorizing some accounting information for a
test and then forgetting it two days later. These principles show up all over the place
in the study of accounting. Trust me. After you know the basic accounting principles,
most accounting topics will make more sense. You will be able to reference these
principles and reason your way through revenue, expense, and any other combination
of problems later on in the study course.

Contents [hide]
 1 What are Accounting Principles?
 2 List of 10 Basic Accounting Principles
o 2.1 Historical Cost Principle
o 2.2 Revenue Recognition Principle
o 2.3 Matching Principle
o 2.4 Full Disclosure Principle
o 2.5 Cost Benefit Principle
o 2.6 Conservatism Principle
o 2.7 Objectivity Principle
o 2.8 Consistency Principle
 3 List of Key Accounting Assumptions
o 3.1 Monetary Unit Assumption
o 3.2 Periodicity Assumption
 4 Fundamental Accounting Concepts and Constraints
o 4.1 Business Entity Concept
o 4.2 Going Concern Concept
o 4.3 Materiality Concept
o 4.4 Industry Practices Constraint
 5 Why Are Accounting Principles Important?
 6 What is the Purpose of Accounting Principles?
List of 10 Basic Accounting Principles
Here’s a list of more than 5 basic accounting principles that make up GAAP in the
United States. I wrote a short description for each as well as an explanation on how
they relate to financial accounting.
 Historical Cost Principle
 Revenue Recognition Principle
 Matching Principle
 Full Disclosure Principle
 Cost Benefit Principle
 Conservatism Principle
 Consistency Principle
 Objectivity Principle
 Accrual Principle
 Economic Entity Principle

 Historical Cost

Principle
Home » Accounting Principles » Historical Cost Principle
 The historical cost principle states that businesses must record and account for
most assets and liabilities at their purchase or acquisition price. In other words,
businesses have to record an asset on their balance sheet for the amount paid
for the asset. The asset cost or price is then never adjusted for changes in the
market or economy and changes due to inflation.
 The historical cost principle is a trade off between reliability and usefulness.
The historical cost of an asset is completely reliable. After all, that’s how much
the company paid for the asset. It might not be very useful however. Knowing
that a company purchased a piece of land in 1950 for $10,000 does not really
tell financial statement users how much the land is currently worth.
 In this case a fair market value would be more useful. Since fair market values
and replacement costs are left up to estimates and opinions, the FASB has
decided to stick with the historical cost principle because it is reliable and
objective. In current years, the FASB as well as the IASB has become more
open to fair value information.
 Liabilities are also accounted for using the historical cost principle. When
bonds or other debts are issued or received, they are recorded on the balance
sheet at the original acquisition price.


 Examples
 – Pam’s Restaurant, LLC was formed in 1945. It purchased a building soon
after in 1946 for $20,000. Total, some 50 plus years later, Pam’s is still in
business. The original building is still on the balance sheet for $20,000 even
though the current fair market value of the building is well over $200,000.
Pam’s will keep the building on its balance sheet for $20,000 until it is either
retired or sold.
 – Jeff’s Construction, LLC bought a piece of equipment in 2001 for $10,000.
Today this piece of equipment is only worth $2,000. Jeff would still report the
equipment at its purchase price of $10,000, less depreciation, even though its
current fair market value is only $2,000.
 – Bill’s investment firm purchases several pieces of property in Brazil as an
investment. Over the last five years, the Brazilian currency has been in double-
digit inflation and the investment is not worth nearly what Bill paid for it. The
historical cost principle does not adjust asset values based on currency
fluctuations, so the property would still be reported as the original purchase
price.

 Revenue Recognition
Principle
 The revenue recognition principle states that revenue should be recognized and
recorded when it is realized or realizable and when it is earned. In other words,
companies shouldn’t wait until revenue is actually collected to record it in their
books. Revenue should be recorded when the business has earned the revenue.
This is a key concept in the accrual basis of accounting because revenue can be
recorded without actually being received.
 Revenues are realized or realizable when a company exchanges goods or
services for cash or other assets. So if a company enters into a transaction to
sell inventory to a customer, the revenue is realizable. A specific amount of
 cash is identified in the transaction. The revenue is not recorded, however, until
it is earned. In this case, the retailer would not earn the revenue until it transfers
the ownership of the inventory to the customer.
 There are three main exceptions to the revenue recognition principle.
Some manufacturers may recognize revenue during the production process.
This is common in long-term construction and defense contracts that take years
to complete. The revenue in these cases is considered earned at various stages
of job completion.
 Some companies recognize revenue after the manufacturing process but before
the sale actually takes place. Mining, oil, and agricultural companies use this
system because the goods are marketable and effectively sold as soon as they
are mined.
 The last exception to the revenue recognition principle is companies that
recognize revenue when the cash is actually received. This is a form of cash
basis accounting and is most commonly found in installment sales.


 Examples
 – Bob’s Billiards, Inc. sells a pool table to bar on December 31 for $5,000. The
pool table was not paid for until January 15th and it was not delivered to the bar
until January 31. According to the revenue recognition principle, Bob’s should
not record the sale in December. Even though the sale was realizable in that the
sale for $5,000 was initiated, it was not earned until January when the pool
table was delivered.
 – Johnson and Waldorf, LLC is an accounting firm that provides tax and
consulting work. During December, JW provides $2,000 of consulting work to
one of its clients. The client does not pay for the consulting time until the
following January. According to the revenue recognition principle, JW should
record the revenue in December because the revenue was realized and earned in
December even though it was not received until January.
 – Pat’s Retail, Inc. sells clothing from its retail outlets. A customer purchases a
shirt on June 15th and pays for it on a credit card. Pat’s processes the credit
card but does not actually receive the cash until July. The credit card purchase
is treated the same as cash because it is a claim to cash, so the revenue should
be recorded in June when it was realized and earned.



Matching Principle
Home » Accounting Principles » Matching Principle
 The matching principle states that expenses should be recognized and recorded
when those expenses can be matched with the revenues those expenses helped
to generate. In other words, expenses shouldn’t be recorded when they are paid.
Expenses should be recorded as the corresponding revenues are recorded. This
matches the revenues and expenses in a period. In this sense, the matching
principle recognizes expenses as the revenue recognition principle recognizes
income.
 In general, there are two types of costs: product and period costs. Product costs
can be tied directly to products and in turn revenues. Period costs, on the other
hand, cannot.
 Period costs do not have corresponding revenues. Administrative salaries, for
example, cannot be matched to any specific revenue stream. These expenses
are recorded in the current period.
 The matching principle also states that expenses should be recognized in a
“rational and systematic” manner. This is the key concept behind depreciation
where an asset’s cost is recognized over many periods.
 In short, the matching principle states that where expenses can be matched with
revenues, we should do so because the benefits of an asset or revenue should be
linked to the costs of that asset or revenue.


 Examples
 – Angle Machining, Inc. buys a new piece of equipment for $100,000 in 2015.
This machine has a useful life of 10 years. This means that the machine will
produce products for at least 10 years into the future. According to the
matching principle, the machine cost should be matched with the revenues it
creates. Thus, the machine is depreciated over its 10-year useful life instead of
being fully expensed in 2015.
 – Bajor Art Studio produces picture frames and sells them to wholesalers like
Michaels and Hobby Lobby. Bajor pays its employees $20 an hour and sells
every frame produced by its employees. Since the payroll costs can be directly
linked back to revenue generated in the period, the payroll costs are expensed
in the current period.
 – Big Appliance has sold kitchen appliances for 30 years in a small town. It
purchases a large appliance from wholesalers for $5,000 and resells it to a local
restaurant for $8,000. At the end of the period, Big Appliance should match the
$5,000 cost with the $8,000 revenue.
 Full Disclosure

Principle
Home » Accounting Principles » Full Disclosure Principle
 The full disclosure principle states that information that would “make a
difference” to financial statement users or would be useful in decision-making
should be disclosed in the financial statements. This way investors or creditors
can see a total picture of the company before they choose to take any action.
 Companies use the full disclosure principle as a guide to understand what
financial and non-financial information should be included in their financial
statements. The full disclosure principle states that disclosed information
should make a difference as well as be understandable to the financial
statement users.
 This information is either disclosed in the footnotes of the financial statements
or the supplemental information. The financial statement footnotes usually
explain the information presented in the body of the financial statements. If an
item on the balance sheet is unclear, the notes can be used to explain it. For
instance explanations of lawsuits and contingencies might be mentioned in the
notes as well as accounting methods used for inventory.
 Supplemental information, on the other hand, is extra information that
companies may want to show potential investors. This information is usually
relevant but is often not very reliable. For instance, management might include
its own analysis of the financial statements and the company’s financial
position in the supplemental information.
 As you can see, these disclosures would be essential for investors, creditors,
and other readers of the financial statements to properly view a company’s
overall financial position; although, no amount of disclosures can make up for
bad accounting. Companies cannot be negligent with their records and disclose
everything.


 Examples
 – Guitar Emporium is a nationwide guitar retailer. It reports $10.5M in guitar
inventory last year. In the notes of its financial statements, GE should disclose
its significant accounting policies. This would include its inventory evaluation
methods. GE should disclose whether its financial statements are prepared
uses FIFO or LIFO inventory cost methods.
 – Lake Real Estate, LLC purchased a piece of property from a foreclosure. A
few months after the purchase, someone slipped and fell on the property and
became seriously injured. The injured party is currently suing Lake Real Estate
for negligence. It is probably that LRE will lose the lawsuit. In this case, LRE
should disclose the lawsuit in the footnotes.
 – Some other examples of transactions and events that need to be disclosed in
the financial statement footnotes include encumbered or pledged assets, related
party transactions, going concerns, and goodwill impairments.



Cost Benefit Principle
Home » Accounting Principles » Cost Benefit Principle
 The cost benefit principle or cost benefit relationship states that the cost of
providing financial information in the financial statements must not outweigh
the benefit of that information to the users. In other words, financial
information is not free. Companies spend millions of dollars every year
gathering and organizing financial information to assemble into financial
statements.
 Ideally, investors and creditors would like to know every piece of information
about a company as possible. Unfortunately, this level of disclosure would
place a huge financial burden on the company. Some financial information
external users don’t receive a large benefit from knowing such as how much
money Apple spends giving the public tours of its headquarters. Other
information would be far too costly to obtain like audit, potential litigation, and
competitor’s information.
 Essentially, the cost benefit principle is a common sense rule. Management can
ask, “does it make sense to gather this financial information to put it in
financial statement? Do the costs of gathering this information outweigh the
benefit to the users?” Essentially, do users need this information enough to
spend this money getting it? If the answer is yes, the company can leave the
information out of the financial statements.
 The cost benefit principle also applies to internal company processes.


 Examples
 – Big Towing, Inc. issues financial statements in January for its prior year.
These statements correct an error in the previous year’s financial statements.
The error was estimated to be $200,000. The exact error amount is unknown
and would cost approximately $50M to exactly pinpoint. The cost benefit
principle states that Big Towing does not have to find the exact amount of the
 error. A reasonable estimate is acceptable due to the high cost of researching
the actual cost of the error.
 – Paul’s Retail, LLC discovered that an employee was stealing from its cash
register. The amount is suspected to be over $1,000, but Paul is not sure. It’s
estimated that Paul would pay his accountant and attorney $5,000 to dig
through his records and discover the exact amount of the theft. In this case, it
would not be beneficial for Paul to do further research and sue his former
employee.
 – Lisa’s Salad Shop, a restaurant, is under audit with the IRS. The IRS assets
that Lisa’s expenses were only $15,000– not the $30,000 that Lisa reported on
her tax return. Lisa’s accountant estimates that it will cost $10,000 in research
costs to find the receipts and documentation for these expenses. If the tax
returns are restated with only $15,000 of expenses, the additional taxes will
only be $1,000. The cost of researching the expenses outweighs the benefit of
lowering the potential tax bill.



Conservatism Principle
Home » Accounting Principles » Conservatism Principle
 The principle of conservatism gives guidance on how to record uncertain
events and estimates. The principle of conservatism states that you should
always error on the most conservative side of any transaction. Most of the time
this means minimizing profits by recording uncertain losses or expenses and
not recording uncertain or estimated gains.
 Since accounting standards and GAAP are always concerned with the
usefulness of financial data to financial statement users, you can understand
why the FASB doesn’t want financial information to over estimated or error on
the high side. This could sway users’ decisions.
 The principle of conservatism also applies to estimates. Generally, a more
conservative estimate should always be used. When estimating allowance for
doubtful accounts, casualty losses, or other unknown future events you should
always error on the side of conservatism. In other words, you should tend to
take the position that is records the most expenses and least income. This is the
main principle behind the lower of cost or market concept for recording
inventory.
 Remember when there is a event with an uncertain outcome, you want to
recognize revenues when they are actually earned and recognize expenses when
they are reasonably probable.

 Examples
 – Assume Gold Guitar, Inc. is in the middle of a patent lawsuit. GGI is suing
Blue Guitar, Inc. for patent infringement and anticipates winning a large
settlement. Since the settlement is not certain, GGI does not record the gain on
the financial statements. Why? Because of the GGI might not actually see this
gain. It might not win, or they might not win as much as it expected. Since a
large winning settlement might skew the financial statements and mislead the
users, the gain is left off the books.
 – Assume the same example above except GGI anticipates losing the lawsuit
instead of winning it. If Blue Guitar, Inc. expects to lose the suit; they should
record the loss in the footnotes of its financial statements. This would be the
most conservative approach because financial statement users want to know if
the company will have to pay out a large some of money in the near future.
 – Red Brick Records is getting ready to release a new album and is unsure as to
whether it owes a few artists on the record royalties due to contracts and legal
disputes. Red Brick should report the contingent liability in the footnotes of the
financial statements. If the record is a hit, the record label could owe a large
amount of money to its artists. To be conservative, this should be shown in the
notes.



Objectivity Principle
Home » Accounting Principles » Objectivity Principle
 The objectivity principle states that accounting information and financial
reporting should be independent and supported with unbiased evidence. This
means that accounting information must be based on research and facts, not
merely a preparer’s opinion. The objectivity principle is aimed at making
financial statements more relevant and reliable.
 The concept of relevance implies that financial statements can have predictive
value and feedback value. This means the financial statements are accurate and
can be used to predict future company performance.
 The concept of reliability implies that financial information can be verified by
many sources with evidence and that all financial information is presented. In
other words, the favorable and unfavorable financial information is presented in
the financial statements.
 The two concepts of relevance and reliability encompass the objectivity
principle. By making financial statements more relevant and reliable, the
objectivity principle makes the financial information more usable for investors
and creditors.
 The objectivity principle extends to internal auditors and CPA firms as well.
Although auditors must adhere to GAAS, auditors must be independent of the
 company they are auditing. This helps ensure that the financial reporting and
audits are done objectively. Since investors and creditors rely on auditor’s
reports, the reports should be independent. If management or current
shareholders wrote reports and audits, they would tend to be too optimistic and
not rely on pure facts.


 Examples
 – A company is trying to get financing for an extra plant expansion, but the
company’s bank wants to see a copy of its financial statements before it will
loan the company any money. The company’s bookkeeper prints out an income
statement from its accounting system and mails it to the bank. Most likely the
bank will reject this financial statement because an independent party did not
prepare it. In other words, this income statement violates the objectivity
principle.
 – Jim is an accountant who is the CFO of Fisher Corp. He leaves the company
after he is offered a partnership position in DHI and Associates, an audit firm.
After six months of working at the firm, he is assigned to the head auditor
position on the Fisher Corp audit. This is a violation of many GAAS rules, but
it is also a violation of the objectivity principle.
 – Nancy is an accountant in charge of preparing financial statements for Big
Ben, Inc. Nancy asks for Big Ben’s records to support its payables and
receivables, but Big Ben says it will be too much work to get. Big Ben says to
go with the numbers in the accounting system. This is a violation of the
objectivity principle because the financial statements must be based on
verifiable and reliable records– not someone’s opinion.

Consistency Principle
Home » Accounting Principles » Consistency Principle
The consistency principle states that companies should use the same accounting
treatment for similar events and transactions over time. In other words, companies
shouldn’t use one accounting method today, use another tomorrow, and switch back
the day after that. Similar transactions should be accounted for using the same
accounting method over time. This creates consistency in the financial information
given to creditors and investors.
The consistency principle does not state that businesses always have to use the same
accounting method forever. Companies are allowed to switch accounting methods if
the company can demonstrate why the new method is better than the old method. The
company then must disclose the change in its financial statement notes along with the
effect of the change, date when the change occurred, and the justification for the
accounting method change.

As you can see, the consistency principle is intended to keep financial statements
similar and comparable. If companies changed accounting methods for valuing
inventory every single year, investors and creditors wouldn’t be able to compare the
company’s financial performance or financial position year after year. They would
have to recalculate everything to make the financial statements equivalent to each
other.

Examples
– Bob’s Computers, a computer retailer, has historically used FIFO for valuing its
inventory. In the last few years, Bob’s has become quite profitable and Bob’s
accountant suggests that Bob switch to the LIFO inventory system to minimize
taxable income. According to the consistency principle, Bob’s can change accounting
methods for a justifiable reason. Whether minimizing taxes is a justifiable reason is
debatable.

– Assume Bob’s Computers switched from FIFO to LIFO in year 2. In year 3, Bob’s
income is extremely loan and Bob is trying to show a profit to get another bank loan.
Bob asks his accountant to switch from LIFO back to FIFO. This is a violation of the
consistency principle. Bob can make a justifiable change in accounting method like in
the first example, but he cannot switch back and forth year after year.

– Ed’s Lakeshore Real Estate buys software licenses for its property listing programs
every year. Ed usually has to buy at least 10 licenses that cost $15,000 a piece. Ed’s
capitalizes these licenses and amortizes them in the years he doesn’t need a deduction
and he expenses them in the years that he needs a tax deduction. This violates the
consistency principle because Ed uses different accounting treatments for the same or
similar transactions over time.
List of Key Accounting Assumptions
Here is a list of the key accounting assumptions that make up generally accepted
accounting principles:
 Monetary Unit Assumption
 Periodicity Assumption

Monetary Unit Assumption

Monetary Unit Assumption – assumes that all financial transactions are recorded in a
stable currency. This is essential for the usefulness of a financial report. Companies
that record their financial activities in currencies experiencing hyper-inflation will
distort the true financial picture of the company.

Periodicity Assumption
Periodicity Assumption – simply states that companies should be able to record their
financial activities during a certain period of time. The standard time periods usually
include a full year or quarter year.

Fundamental Accounting Concepts and Constraints

Here is a list of the four basic accounting concepts and constraints that make up the
GAAP framework in the US.
 Business Entity Concept
 Going Concern Concept
 Materiality Concept
 Industry Practices Constraint
Business Entity Concept
Business Entity Concept – is the idea that the business and the owner of the business
are separate entities and should be accounted for separately. This concept also applies
to different businesses. Each business should account for its own transactions
separately.

Going Concern Concept

Going Concern Concept – states that companies need to be treated as if they are going
to continue to exist. This means that we must assume the company isn’t going to be
dissolved or declare bankruptcy unless we have evidence to the contrary. Thus, we
should assume that there will be another accounting period in the future.

Materiality Concept
Materiality Concept – anything that would change a financial statement user’s mind or
decision about the company should be recorded or noted in the financial statements. If
a business event occurred that is so insignificant that an investor or creditor wouldn’t
care about it, the event need not be recorded.

Industry Practices Constraint

Industry Practices Constraint – some industries have unique aspects about their
business operation that don’t conform to traditional accounting standards. Thus,
companies in these industries are allowed to depart from GAAP for specific business
events or transactions.

Monetary Unit
Assumption
Home » Accounting Principles » Monetary Unit Assumption
The monetary unit assumption assumes that all business transactions and relationships
can be expressed in terms of money or monetary units. Money is the common
denominator in all economic activity and financial transactions. That is why we
assume that money is a good basis for comparing companies and other accounting
measurements. In other words, accounting looks at transactions that can be
communicated in money or monetary units.

GAAP assumes that the monetary unit is stable, reliable, relevant, and useful to all
companies. It is also universally available. All currencies are openly exchanged in
world markets with varying exchange rates. Monetary units like the US dollar and
English pound can be easily exchanged for the European Union Euro, Mexican peso,
or the Japanese yen.
Currently the FASB does not recognize the affects of inflation in financial reporting.
This is mainly because the US has enjoyed low inflationary rates for decades. If the
US economy changes and the US inflation rates become hyperinflationary similar to
countries like Brazil and South Africa, the FASB might change SFAC No. 5 which
states that the US dollar is expected to be used for financial statements in the future.

Examples
– A manufacturing plant is started in 1955. It acquires a piece of land and builds a
small factory on the land costing $50,000 in 1955. Today, this piece of land and
building is worth over $1,000,000 because of inflation. The monetary unit assumption
does not take into consideration inflation. The balance sheet of this company will still
show the land and building at historical cost unadjusted for inflation.

– During the middle of the night a retailer’s store is vandalized. The sign is spray-
painted over, the windows are broken, and some merchandise is stolen. The retailer’s
financial statements will only report a loss on the damaged property. It will not report
lost potential sales due to down time wait for repairs or additional inventory because
of the monetary unit assumption. Lost sales are hypothetical and can’t be measured in
real monetary units.

– One of Nike’s famous athletes is caught in a scandal and many people stop buying
Nike products in protest of the athlete. Nike does not report a loss at all on its
financial statements because of the monetary unit assumption. Since a boycott
involves no business transactions, the monetary unit dictates that Nike shouldn’t
report anything.

Periodicity Assumption or
Time Period Assumption
Home » Accounting Principles » Periodicity Assumption or Time Period Assumption
The periodicity assumption or time period assumption states that businesses can
divide up their activities into artificial time periods. Since outside financial statement
users want timely financial information, the time period assumption allows us to
prepare financial statements on a monthly, quarterly, and annually basis.

Even though the going concern assumption dictates that businesses should be treated
as if they will continue indefinitely, it is helpful to view business performance in
shorter time frames. The periodicity assumption is important to financial accounting
because it allows businesses to show current performance to investors and creditors
for shorter periods of time.
Investors and creditors want the most current information possible to base their
financial decisions on. For instance, investors often look at quarterly financial
statements in order to predict what the business performance might be in the next
quarter. Without the time period assumption, businesses wouldn’t be able to issue
these timely reports.
Examples
– The periodicity assumption is an interesting compromise between accounting
relevance and reliability. Outside users of financial statements want financial
information as soon as possible in order for it to be relevant in their decision-making.
Unfortunately, the more frequent the information is issued, the less reliable it is. For
instance, monthly financial statements give investors great performance information
in a timely manner. Although, a single month financial statement shows a far less
accurate picture of the business compared to an annual financial statement. Investors
either have to wait for reliability or compromise with relevance.

– The matching concept and revenue recognition principle also contribute to the
periodicity assumption. Both of these accounting principles allow businesses to
allocated expenses and record revenues for specific periods of time. For instance, the
revenue recognition principle requires that revenue be recorded when earned. If a
company issues monthly financial statements and earns $1,000 of revenue on the 31st
of the month but doesn’t get paid until the first of the following month, the company
must include that revenue in its current month financial statements.
– The income statement is the financial statement that best shows the periodicity
assumption. The income statement presents the business performance for a given time
period. A year-end income statement shows the income and expense performance for
the company for the entire year. Monthly and quarterly income statements are often
issued as well. The balance sheet, on the other hand, only shows a picture of the
company on a single date in time. The balance sheet does not reflect a period of time
but rather a moment in time.

Fundamental Accounting Concepts and Constraints

Business Entity Concept
Home » Accounting Principles » Business Entity Concept
The business entity concept, also known as the economic entity assumption, states that
all business entities should be accounted for separately. In other words, businesses,
related businesses, and the owners should be accounted for separately. Even though
the tax law looks at a sole proprietorship and the owner as one
entity, GAAP disagrees. The owner and the business are two separate entities and
should be accounted for separately. The same goes for partnership and corporations.
The partners and shareholders’ activities should be kept separate from the partnership
and corporate transactions because they are separate economic entities.
The economic entity assumption does not always apply to a legal entity. For instance,
a parent corporation and its subsidiaries can issue consolidated financial statements
without contradicting the economic entity principle. A single company can also
segregate business operations by department if the definition of “entity” is deemed to
be within a company.
This business separation is useful for financial statement users. They can differentiate
between the actual company activity and the ownership involvement. In other words,
an investor can see if the business has good cash flow from it’s profitable operations
or because the owner keeps funding the business with owner contributions.

Examples
– Mike, a partner in Big House Realty, LLC, often uses his company credit card for
personal expenses like dry cleaning and new clothes. He insists that these are business
expenses because he must wear new clothes in order to show houses. Unfortunately,
these are not business expenses. Clothing is a personal expense and can’t be recorded
in the company financial statements. This would violate the business entity concept.
Instead, these transactions should be accounted for as an owner withdrawal.
– Assume Bob, a local landscaping business owner, decides to branch out and buy
another existing business: a concrete company. This way his concrete company can
pour footings and walkways and his landscaping business can landscape around them.
Since Bob owns both companies personally, he thinks that he can combine both
companies accounting records into one Quickbooks file. According to the business
entity concept, both of these companies are separate entities and must be accounted
for separately even though Bob is the owner of both companies. If Bob’s landscaping
company had bought the concrete company, both companies would have merged and
could be reported together.

– Jim, an owner of a pizza shop, decides to buy a new delivery car. Since the company
was low on cash, Jim decided to pay for the car himself out of his personal bank
account. Jim intends to add the car to the balance sheet of the pizza shop. The
economic entity principle requires Jim and his company to keep activities separated,
so the car must remain a personal vehicle unless Jim contributes it to the company or
the company buys it from Jim personally.

Going Concern Concept

Home » Accounting Principles » Going Concern Concept
The going concern concept or going concern assumption states that businesses should
be treated as if they will continue to operate indefinitely or at least long enough to
accomplish their objectives. In other words, the going concern concept assumes that
businesses will have a long life and not close or be sold in the immediate future.
Companies that are expected to continue are said to be a going concern. Companies
that are expected to close in the near future are not a going concern.

The going concern concept is extremely important to generally accepted accounting

principles. Without the going concern assumption, companies wouldn’t have the
ability to prepay or accrue expenses. If we didn’t assume companies would keep
operating, why would be prepay or accrue anything? The company might not be there
long enough to realize the future expenses.
One of the most significant contributions that the going concern makes to GAAP is in
the area of assets. The entire concept of depreciating and amortizing assets is based on
the idea that businesses will continue to operate well into the future. Assets are also
reported on the balance sheet at historical costs because of the going concern
assumption. If we disregard the going concern and assume the business could be
closed within the next year, a liquidation approach to valuing assets would be more
appropriate. Assets would be recorded at net realizable values and all assets would be
considered current assets rather than being segregated into current and long-term
categories.
Some businesses, however, do close and do go bankrupt. If the business is in a
financial position that suggests the going concern assumption can’t be followed (the
business might go bankrupt), the financial statements should have a disclosure
discussing the going concern.

Examples
– In the early 2000s, General Motors was experiencing great financial difficulties and
was ready to declare bankruptcy and close operations all over the world. The Federal
government stepped in and gave GM a bailout as well as a guarantee. In normal
circumstances, GM would not be considered a going concern, but since the Federal
government stepped in, we have no reason to believe that GM will cease to operate.

– Assume Microsoft is currently suing a small tech company for copyright violation
over its software package. Since this software package is the only operation the small
tech company does, losing this lawsuit would be detrimental. There is a 95 percent
expectation that Microsoft will win the lawsuit. The small tech company is not a
going concern because it is probable they will be out of business after the lawsuit is
settled.

– In 2011, Gibson Guitar Factory was raided by the Federal government for illegally
smuggling endangered wood into the country. The Federal government took more
than $250,000 worth or Gibson’s inventory and slapped them with large fines for
violating international laws. Gibson is still considered a going concern, because it is
not likely the fines and punishment will stop its operations.

Materiality Concept
Home » Accounting Principles » Materiality Concept
The materiality concept, also called the materiality constraint, states that financial
information is material to the financial statements if it would change the opinion or
view of a reasonable person. In other words, all important financial information that
would sway the opinion of a financial statement user should be included in the
financial statements.

The concept of materiality is relative in size and importance. Some financial

information might be material to one company but might be immaterial to another.
This is somewhat obvious when you think about a small company verses a large
company. A large and material expense to a small company might be small an
immaterial to a large company because of their size and revenue. The main question
that the materiality concept addresses is does the financial information make a
difference to financial statement users. If not, the company doesn’t have to worry
about including it in their financial statements because it is immaterial.

Most of the time financial information materiality is judged on qualitative and

quantitative characteristics. Professionals are often left up to their experience and
good judgment to understand what is material and what isn’t.
Examples
– A large company has a building in the hurricane zone during Hurricane Sandy. The
company building is destroyed and after a lengthy battle with the insurance company,
the company reports an extra ordinary loss of $10,000. The company has net income
of $10,000,000. The materiality concept states that this loss is immaterial because the
average financial statement user would not be concerned with something that is
only .1% of net income.

– Assume the same example above except the company is a smaller company with
only $50,000 of net income. Now the loss is 20% of net income. This is a substantial
loss for the company. Investors and creditors would be concerned about a loss this
big. To the smaller company, this $10,000 would be considered material.

– A small company bookkeeper doesn’t do a very good job of keeping track of

expenses. Most random expenses get recorded in the miscellaneous expense account.
At the end of the year the miscellaneous expense account has a total of $1424.25 in it.
The total net income of the company is $36,940. The miscellaneous account is
immaterial to the overall financial picture of the company and there is no need to
reclassify the expenses in it.

Industry Practices
Constraint
Home » Accounting Principles » Industry Practices Constraint
The industry practices constraint, also called the industry practices concept, states that
the nature of certain industries and their practices can require the departure of
traditional accounting theory. In other words, some industries have practices unlike
any other that require specialized accounting or reporting. The industry practices
constraint allows these industries to go outside of traditional accounting principles as
long as it is infrequent and justifiable.
Most industry practices that depart from traditional GAAP only conflict with one or
two accounting principles. In other words, an industry can’t completely disregard
GAAP because of their specialized practices. They can bend one or two accounting
principles for good reasons.
This makes sense because every industry is different and faces different financial
reporting challenges. Every industry wouldn’t be able to follow the same exact
guidelines and rules without incurring significant costs. The industry practices
constraint goes hand in hand with the cost benefit principle. Sometimes conforming to
GAAP is too costly for some industries, so they have adopted slightly modified
practices.

Examples
– The agriculture industry reports its crops at their fair market value on the balance
sheet instead of the traditional historical cost or production cost. This is common
because calculating the actual cost per crop is too difficult and costly. Its easier for
farmers to value and report their crops at the current market price.

– Most public utility companies report all non-current assets before current assets on
their balance sheets. The utility industry presents its balance sheet this way to
emphasize the fact that it is highly capitalized. In other words, utility companies want
to show financial statement users that they have large investments in long-term assets,
so they report them first on the balance sheet.

Why Are Accounting Principles Important?

Generally Accepted Accounting Principles are important because they set the rules for
reporting and bookkeeping. These rules, often called the GAAP framework, maintain
consistency in financial reporting from company to company across all industries.

Remember, the entire point of financial accounting is to provide useful information to

financial statement users. If everyone reported their financial information differently,
it would be difficult to compare companies. Accounting principles set the rules for
reporting financial information, so all companies can be compared uniformly.
What is the Purpose of Accounting Principles?
The purpose of accounting principles is to establish the framework for how financial
accounting is recorded and reported on financial statements. When every company
follows the same framework and rules, investors, creditors, and other financial
statement users will have an easier time understanding the reports and making
decisions based on them.

Accounting Cycle
Home » Accounting Cycle

What is the Accounting Cycle?

The accounting cycle is a series of steps starting with recording business
transactions and leading up to the preparation of financial statements. This financial
process demonstrates the purpose of financial accounting–to create useful financial
information in the form of general-purpose financial statements. In other words, the
sole purpose of recording transactions and keeping track of expenses and revenues is
turn this data into meaning financial information by presenting it in the form of a
balance sheet, income statement, statement of owner’s equity, and statement of cash
flows.
The accounting cycle is a set of steps that are repeated in the same order every period.
The culmination of these steps is the preparation of financial statements. Some
companies prepare financial statements on a quarterly basis whereas other companies
prepare them annually. This means that quarterly companies complete one entire
accounting cycle every three months while annual companies only complete one
accounting cycle per year.

Accounting Cycle Steps

This cycle starts with a business event. Bookkeepers analyze the transaction and
record it in the general journal with a journal entry. The debits and credits from the
journal are then posted to the general ledger where an unadjusted trial balance can be
prepared.

After accountants and management analyze the balances on the unadjusted trial
balance, they can then make end of period adjustments like depreciation expense and
expense accruals. These adjusted journal entries are posted to the trial balance turning
it into an adjusted trial balance.

Now that all the end of the year adjustments are made and the adjusted trial balance
matches the subsidiary accounts, financial statements can be prepared. After financial
statements are published and released to the public, the company can close its books
for the period. Closing entries are made and posted to the post closing trial balance.

At the start of the next accounting period, occasionally reversing journal entries are
made to cancel out the accrual entries made in the previous period. After the reversing
entries are posted, the accounting cycle starts all over again with the occurrence of a
new business transaction.

Here are the 9 main steps in the traditional accounting cycle.

1. — Identify business events, analyze these transactions, and record them

as journal entries
2. — Post journal entries to applicable T-accounts or ledger accounts
3. — Prepare an unadjusted trial balance from the general ledger
4. — Analyze the trial balance and make end of period adjusting entries
5. — Post adjusting journal entries and prepare the adjusted trial balance
6. — Use the adjusted trial balance to prepare financial statements
7. — Close all temporary income statement accounts with closing entries
8. — Prepare the post closing trial balance for the next accounting period
9. — Prepare reversing entries to cancel temporary adjusting entries if applicable
Some textbooks list more steps than this, but I like to simplify them and combine as
many steps as possible.

Accounting Cycle Flow Chart

After this cycle is complete, it starts over at the beginning. Here is an accounting
cycle flow chart.

As you can see, the cycle keeps revolving every period. Note that some steps are
repeated more than once during a period. Obviously, business transactions occur and
numerous journal entries are recording during one period. Only one set of financial
statements is prepared however.

Throughout this section, we’ll be looking at the business events and transactions that
happen to Paul’s Guitar Shop, Inc. over the course of its first year in business.
 Financial Statements
Home » Financial Statements

What are Financial Statements?

Financial statements are reports prepared and issued by company management to give
investors and creditors additional information about a company’s performance and
financial standings. The four general purpose financial statements include:

 Income Statement
 Balance Sheet
 Statement of Stockholders Equity
 Statement of Cash Flows
These reports are prepared in this order and are issued to the public as a full set of
statements. This means they are not only published together, but they are also
designed and intended to be read and used together. Since each statement only gives
information about specific aspects of a company’s financial position, it is important
that these reports are used together.

For instance, the balance sheet shows the debt levels of the company, but it can’t
show what the debt coverage costs. Both the balance sheet and the income statement
are needed to calculate the debt coverage ratio for investors and creditors to see a true
picture of the debt burden of a company.

The purpose of these reports is to provide useful financial information to users outside
of the company. In essence, these reports complete the fundamental purpose
of financial accounting by providing information that is helpful in the financial decision-
making process.
Understanding these business financial statements is the first critical step investors,
creditors, and you can take to learning about a company’s earnings, profitability, asset
management, financial leverage, cash flow, and current shareholders’ stake. Once you
understand all of these aspects of a company, you can gauge its relative
financial health and determine whether it is worth investing in or loaning money to.

Here are all of the financial statements prepared by companies:

 Income Statement
 Multi-Step Income Statement
 Profit and Loss
 Comprehensive Income
 Extraordinary Items
 Statement of Stockholders Equity
 Balance Sheet
 Classified Balance Sheet
 Statement of Financial Position
 Statement of Cash Flow
 Cash Flows – Direct Method
 Cash Flows – Indirect Method
 Statement of Retained Earnings
 Pro Forma Financial Statements

Who Issues Financial Statements?

Companies issue different types of business financial statements for a variety of
reasons at a variety of times during the year. Public companies are required to issue
audited financial statements to the public at least every quarter. These regulated
reports must meet SEC and PCAOB guidelines and often must be reported in a
consolidated fashion.

Non-public or private companies generally issue financial sheets to banks and other
creditors for financing purposes. Many creditors will not agree to loan funds unless a
company can prove that it is financially sound enough to make its future debt
payments.

Both public and private companies issue at least 4 financial statements to attract new
investors and raise funding for expansions.
Different Types of Financial Statements
Interim Statements
Financial sheets that are issued for time periods smaller than one year are called
interim statements because they are used as temporary statements to judge a
company’s financial position until the full annual statements are issued.

Interim financial statements are most commonly issued quarterly or semi-annually,

but it is not uncommon for companies to issue monthly reports to creditors as part of
their loan covenants. Quarterly statements, as the name implies, are issued every
quarter and only include financial data from that three-month span of time. Likewise,
semi-annual statements include data from a six-month span of time.

Since these interim statements cover a smaller time period, they also track less
financial history. This is why annual financial statements are generally more reliable
and better represent a company’s true financial position.

Annual Statements
The annual financial statement form is prepared once a year and cover a 12-month
period of financial performance. Generally, these statements are issued at the end of a
company’s fiscal year instead of a calendar year. A company with a June year-end
would issue annual statements in July or August; where as, a company with a
December year-end would issue statements in January or February.
Public companies are required by the SEC and the PCAOB to issue both interim and
annual statements. A CPA firm must always audit annual statements, but some interim
statements can simply be reviewed by a qualified firm.

Financial Statement Analysis

Who Uses Financial Statements and What Are They Used For?
Financial statements are mainly prepared for external users. There users are people who
are outside of the company or organization itself and need information about it to base
their financial decisions on. These external users typically fall into four main
categories:
 Investors
 Creditors
 Competitors
 Regulators
Investors and creditors analyze this set of statements to base their financial decisions
on. They also look at extra financial reports like financial statement notes and the
management discussion.

The income statement and balance sheet accounts are compared with each other to see
how efficiently a company is using its assets to generate profits. Company debt and
equity levels can also be examined to determine whether companies are properly
funding operations and expansions.

Most investors and creditors use financial ratios to analyze these comparisons. There is
almost no limit to the amount of ratios that can be combined for analysis purposes.
These ratios by themselves rarely give outside users and decision makers enough
information to judge whether or not a company is fiscally sound, however. Investors
and creditors generally compare different companies’ ratios to develop an industry
standard or benchmark to judge company performance.

Financial Statement Template and Form

Here’s a sample financial statement template that shows the order of how each
statement works together to report the full economic position of a company beginning
with the balance sheet.

Assets
Home » Accounting » Assets » Assets

What are Assets in Accounting?

Definition: An asset is a resource that has some economic value to a company and
can be used in a current or future period to generate revenues.
These resources take many forms from cash to buildings and are recorded on the
balance sheet until they are used. Once these resources are used or spent, they are
transferred from the balance sheet to the income statement and called expenditures.
Here are some of the most common examples.

 Current
 Cash and Equivalents
 Accounts Receivable
 Inventory
Still asking yourself, what is an asset? Let’s look at each with an example of a
business formation because a company can acquire its resources in a number of
different ways.

Example
Tom and Bob are starting a machine shop that will do general fabrication. When a
company is first started, it doesn’t have any resources. Thus, the Tom and Bob must
invest their own money or equipment to get the company started. This initial
investment is considered owner’s equity. Both Tom and Bob contribute a piece of
machinery to the new company.

Once the business receives the equipment, it can start using that resource to generate
income. When the company sells its parts, it receives cash. As the business brings in
more jobs, Tom and Bob start to use their profits to purchases more equipment to
fulfill additional orders.

Tom and Bob work throughout the year growing the business until they run out of
room at their current location. They need to look for a new building, but they don’t
have enough money to purchase it with the cash they have in the bank, so they get a
loan. The bank lends the enough capital to purchase a building where they can keep
their operations going.

In our short example, we saw three ways three different assets were acquired. First,
the company acquired equipment by a contribution from its owners. Second, the
company used its own assets to purchases more assets when it bought additional
equipment with its cash. Third, the company took out a loan to purchase a building.

It’s important to note that nowhere in the assets definition do I say that the company
must own these resources. Remember the asset definition, it’s simply a resource that
the company has control of and can use to generate revenues. Many businesses have
loans, notes, and leases on equipment that either directly or indirectly eliminates their
true ownership of the resources, but they still have control of it.

Now that you know how assets are acquired, let’s look at how they are classified.

Types of Asset Classes

So what is an asset class? When assets are presented on the balance sheet, they are
typically divided into different classes or categories based on when they will be used.
Resources that are expected to be consumed within the current period are classified as
current assets while resources that expected to be used in future periods are called
non-current assets. Another class of resources is intangible assets. There resources
typically consist of intellectual property. Resources that don’t fit into any of these
three classes are simply called other assets.

Let’s take a look at a common list of assets and a few examples in each class.

Current Assets
Cash and equivalents – Cash is any currency in the possession of the business. This
could be cash in a register, money in the bank, or treasure bills in a safe deposit box.
These liquid assets can be used to purchase any other resource, settle debts, or pay
investors.
Accounts Receivable – Accounts receivable is an IOU from a customer. Many
businesses allow customers to purchase goods on account and pay for them at a future
date. Accounts receivable is the acknowledgement that the customer owes the
company money for the goods.
Inventory – Inventory is merchandise that the company intends to sell for a profit. This
merchandise could be purchased or manufactured by the company.
Investments – Investments that management intends to sell in the current period are
considered current resources. These investments typically consist of stocks and bonds.

Long-Term Assets
Land – Property is a resource that is considered long-term in nature because it will be
used over time and will not be consumed in the current period.
Buildings – A building is obviously a resourced used over time. Many companies stay
in the same building for decades. Thus, it is considered a long-term resource.
Equipment – Equipment like machinery, vehicles, and furniture all has a useful life
of more than one year.

Intangible Assets
Patents/Trademarks/Copyrights – These are all examples of intellectual property
that a company can own or control to generate revenues over time. In fact, some of the
most value assets in the world are intangible in nature. Think about Walt Disney’s
Mickey Mouse or Apple’s iPhone designs.

Other Assets
Investments – Investments like stocks, bonds, and property that are intended to be
held for more than one year are typically listed separately from the investments that
management believes will sell in the current period.

Short-Term vs. Long-Term

Short term assets, also called current assets, are resources that are expected to be used
or could be used in the current period. These resources include examples like cash and
accounts receivable. Keep in mind that a company might doesn’t always use all of its
cash every period, but it could. That’s what makes it short-term.

Long term assets, on the other hand, are resources that are expected to last more than
one accounting period. Some examples include fixed assets, equipment, and buildings.
All of these resources have longer useful lives than one period.

Tangible vs. Intangible

Tangible assets include any resources with a physical presence. Some examples
include cash, fixed assets, and equipment. Some of these resources are depreciated
while others are not.

Intangible assets are resources that don’t have a physical presence. You can think of
these like ideas. You can’t touch an idea, but it is real and it’s a thing. Some examples
include patents, copyrights, and trademarks. Most of these resources are amortized
over their useful lives or periodically checked for impairment losses.
How are Assets Valued and Recorded in
Accounting?
Notice when I define assets, I didn’t talk about how they were valued or recorded on
the books of a company. Each resource is valued somewhat differently depending its
nature and how it was acquired.

According to the historical cost principle, assets are recorded on the books at the price
the company paid for them. This is true for all assets except for a few different types
of investments that are adjusted to fair market value and some intangible assets that
are purchased indirectly like goodwill.
Since a company depends on its resources to generate revenues, many businesses are
often valued by their level of asset ownership. In other words, an investor could
calculate a rough value of a business by subtracting the outstanding loans from the
assets of the company to see what resources the company actually owns.

A company with more resources is generally deemed to be worth more than one with
fewer resources. This isn’t always the case, however. Most investors predict return
rates on assets. If the company doesn’t perform well, the company valuation could go
down simply because it isn’t using its resources effectively.

Assets and Depreciation

In accrual accounting, if an resource can be used for more than one period, it
shouldn’t be expensed immediately. Instead, it is capitalized and the cost of the asset
is recognized over the life of the assets. Depreciation is a way to assign the cost of the
an asset over its useful lives. It’s also a way to recognize the use of the asset and
record the devaluation of it over time.

Fixed assets and other long-term assets like buildings are depreciated while land is
not. Other assets, like intangibles, are amortized.
 Here’s a list of the most common assets in the chart of accounts. I talk about how each
should be accounted for with examples and explanations in each article.

 Current
 Cash and Equivalents
 Accounts Receivable
 Inventory
Contents [hide]
 1 What are Assets in Accounting?
 2 Example
 3 Types of Asset Classes
o 3.1 Current Assets
o 3.2 Long-Term Assets
o 3.3 Intangible Assets
o 3.4 Other Assets
 4 Short-Term vs. Long-Term
 5 Tangible vs. Intangible
 6 How are Assets Valued and Recorded in Accounting?
 7 Assets and Depreciation
Here are some of the most common examples.