Basic Accounting Concepts and Terms
Accounting Principles, Part I
Basic Accounting Concepts and Terms
Accounting Principles, Part I
Must knows for analyzing and successfully answering most accounting principles questions
Accounting. Identifying, recording, and communicating a company’s financial information; information used in the decision process of many stakeholders.
Basic Accounting Equation. Assets = Liabilities + Owner's Equity (A = L + OE)
Expanded Accounting Equation (Sole Proprietor). Assets = Liabilities + Owner’s Capital + Revenue – Expenses – Owner’s Withdrawals.
Expanded Accounting Equation (Corporation). Assets = Liabilities + Capital Stock (Paid-In Capital) + Revenue – Expenses – Dividends – Treasury Stock.
Assets. Resources owned by a business (potential future benefits, based on past transactions) such as cash, inventory, accounts receivable, equipment, and buildings. Assets are included on the balance sheet.
Liabilities. Accounts used to document creditor claims on assets. Debts/amounts owed by a business (future asset/resource sacrifices, based on past transactions). Accounts such as accounts payable, notes payable, and salaries payable. Liabilities are included on the balance sheet.
Owner’s Equity. Accounts used to document owner’s claims on assets. For Sole Proprietor, one account, titled Capital. For Corporations, two accounts, including Paid-in Capital (Issuance of Stock) and Retained Earnings. Owner’s Equity accounts are included on the balance sheet.
Revenues. The dollar amount of assets a business takes in from the sale of goods or services. Revenues are included on the income statement.
Expenses. The dollar amount of costs incurred to earn revenue (rent expense, wage expense, utilities expense, etc.). Expenses are included on the income statement.
Retained Earnings (RE). The amount of net income (revenues – expenses = NI) that is retained in the business (i.e., earnings retained for future business expansion or payment back to owners).
Withdrawals (Sole Proprietor). An account to record the cash an owner takes back out of the business, or monies that the owners pay themselves back from the business.
Dividends (Corporations). An account to record distributions of Retained Earnings to owners.
Four events that change a Sole Proprietor’s Owner's Equity (A = L + OE [Capital]):
Increases: (1) Owner’s Investments in company (contribute capital) and (2) Earn Revenue
Decreases: (3) Incur Expenses and (4) Owner’s Withdrawals
Four events that change a Corporation’s Owner's Equity (A = L + OE [Capital Stock + REs]):
Increases: (1) Issuance of stock (Paid-in/contribute capital) and (2) Earn Revenue
Decreases: (3) Incur Expenses and (4) Pay dividends to owners
(Use Accounting Class Help.com's one-page accounting equation guide to help you learn the accounting equation, primary accounts, and how accounts change).
Note: A corporation reacquiring its own stock (called treasury stock), or the retirement or subsequent sale of treasury stock can also affect owner’s equity. The 4 primary events that change owner’s equity; however, are listed here.
Journal. A record of original entry for every financial transaction occurring throughout the accounting period (related terms…journal entries, journalizing).
Business Financial Transactions. Business activities involving the exchange of one item of value for another. Must have an affect the accounting equation (an asset, liability, or owner equity account); otherwise, not considered a transaction for accounting purposes.
Ledger. Summary accounts (“T” accounts including all asset, liability, owner’s equity, revenue, expense, and dividend accounts) where transactions from journal entries are transferred to or “posted.” T accounts will have increases, decreases, and an ending balance. Called a T account, as entries are made on the left and right side of a record that’s in the shape of a “T.”
Normal Account Balance. The “normal” ending balance for a T account is on the side (left or right) that increases or the “+” side of the account. For asset T accounts, the “+” is on the left side. For Liability and Owner Equity accounts the “+” is on the right side.
Debit versus Credit. Debit (Dr) simply means an entry on left side of a “T” account; a Credit (Cr) entry is on the right side. Debit/Credit does not necessarily mean an increase or decrease to an account…simply left and right side…that’s it!
T Account Balance. The ending dollar balance in a T account is equal to the difference between the sum of all the Debit and the sum of all Credit entries made to the account (add up the left side, add up the right side, and determine the difference…Dr’s exceeding Cr’s = a Dr balance (and vice versa).
Three debit and credit rules. For every accounting transaction: (1) Dr’s will be on the left side of T account, Cr’s on right. (2) At least one Dr and one Cr. And (3) Dr’s must equal Cr’s.
T Account Debit and Credit Rules
Net Profit. Occurs when revenues exceeds expenses during an accounting period.
Net Loss. Occurs when expenses exceed revenues during an accounting period.
Accounting Period. The period of time reflected in financial statements (Income Statement, Retained Earnings Statement, Balance Sheet, and Statement of Cash Flows). Typically, the accounting period is either the calendar year or a quarter.
Accounts Payable. An account used to document short-term debts owed for credit purchases. Bought “on account” equals an adjustment to an accounts payable T account. Part of the current liability section on the Balance Sheet.
Notes Payable. An account used to document the amount of principal due on a formal written promise to pay such as a loan from bank. Part of the current liability section on the Balance Sheet.
Accounts Receivable. Money which is owed to a company by a customer for products and services provided on credit. “Billed customer” equals an adjustment to an accounts receivable account. Included as a current asset account on the Balance Sheet.
Inventory. Merchandise purchased by merchandisers (retailers, wholesalers, distributors) for the purpose of being sold to customers. The cost of the merchandise purchased but not yet sold is reported as a current asset account (Inventory) on the Balance Sheet.
Cost of Goods Sold (COGS). Cost of the merchandise inventory that was sold to customers. Expense account included on the Income Statement.
Gross Profit. Sales Revenue minus cost of goods sold. Gross profit is a company's residual profit after selling a product.
Gross Profit Rate. Net sales divided gross profit (Gross profit/Net Sales). This is a measure of the profitability of the company's products.
Depreciation. Allocating the cost of fixed assets over a number of accounting periods (see notes on adjusting journal entries below). Expense account included on the Income Statement.
Accumulated Depreciation. An asset account to document the total depreciation expense charged for a particular asset. This amount will increase over time. Remember, this is a “contra” asset account, meaning that it appears on the Balance Sheet as a reduction from assets, and its debit and credit properties are the opposite of a normal asset (i.e., debits decrease this account and credits increase the account).
Fixed Asset Carrying Value (Book Value). An asset's original acquisition cost minus its accumulated depreciation. The asset’s net value shown on the balance sheet.
Current Assets. Assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. Current assets (accounts) are listed in order of liquidity (ability to turn into cash) on the Balance Sheet.
Current Liabilities. Obligations that the company is to pay within the coming year or operating cycle, whichever is longer. Listed on the balance sheet.
Trial Balance. A listing of all Ledger T accounts and their balances at a given time. The primary purpose of the trial balance is to quickly test/prove the mathematical equality of debits and credits after posting.
Accrual Basis Accounting. System of accounting in which revenue and expenses are recognized (recorded) when earned and incurred, not necessarily when the cash is received or paid. (GAAP Compliant).
Cash Basis Accounting. System of accounting in which revenues and expenses are recognized (recorded) only when cash is received or paid. (Not GAAP Compliant)
Adjusting Journal Entries. Journal entries required at the end of each accounting period (any time you want to prepare financial statements) to recognize, on an accrual basis, revenues and expenses for the reporting period. Asset accounts such as supplies, prepaid rent, prepaid insurance, and fixed assets (though accumulated depreciation) need to be adjusted to record the amount of the asset used (expensed) during the accounting period. This process will reduce the asset account balance and increase a corresponding expense account (e.g., decrease supplies account and increase supplies expense account to record amount of supplies used during the accounting period). Similarly, other expense accounts such as interest and wage expense accounts must be adjusted prior to preparing financial statements to document increases in these accounts that have not yet been recorded during the accounting period (e.g., an increase to a wage expense account and a corresponding increase in wages payable account is necessary to record wages earned, but not yet recorded during the accounting period). Adjusting entries help ensure revenue recognition and matching principles are followed, and will affect a balance sheet account and an income statement account.
Adjusted Trial Balance. A listing of all Ledger T accounts and their balances after end-of-accounting-period adjusting journal entries have been posted. The primary purpose of the trial balance is to quickly test/prove the mathematical equality of debits and credits after posting.
Closing Journal Entries. Journal entries necessary to transfer net income (or net loss) and dividends to Retained Earnings. This process “zeros out” temporary accounts (Revenue, Expense, Income Summary, and Dividend accounts). There are 4 closing entries (corporation).
1. Close Revenue account by debiting revenue and crediting Income Summary for total revenues (zero out the revenue account).
2. Close Expense accounts by debiting Income Summary for the total expenses and crediting each expense account by their ending balance (zero out the expense accounts).
3. Close income summary account to retained earnings account. Note: depending on the income summary balance, normally a credit balance, need to zero out the account with a debit or credit, as necessary).
4. Close dividend account directly to retained earnings (Debit retained earnings and credit dividends - zero out the dividend account).
Accounting Cycle. (1) Journalize accounting period financial transactions, (2) post journal entries to general ledger T accounts, (3) prepare trial balance from ending balances in T accounts, (4) journalize end of accounting period adjusting entries, (5) post adjusting journal entries to general ledger T accounts, (6) prepare an adjusted trial balance from ending balances in T accounts, (7) prepare financial statements (Income Statement, Retained Earnings Statement, and Balance Sheet) from adjusted trial balance, (8) prepare closing journal entries for temporary accounts (revenues, expenses, and dividends (or withdraws), and (9) prepare a post closing trial balance from ending balances in T accounts. See the Accounting Class Help.com 9-step accounting cycle guide for detailed help with this process.
Income Statement. Communicates a company’s profitability (net income or net loss) over an accounting period. Revenues – Expenses = Net Income (R – E = NI). Statement dated “For Period Ended”
Retained Earnings Statement. Communicates changes in a company’s Retained Earnings (RE) during a given period. Beginning RE + NI – Dividends = Ending RE (BRE + NI – D = ERE). Statement dated “For Period Ended”
Balance Sheet. Communicates a company’s resources (listing of assets) and claims against those resources (liabilities [creditor claims] + owner's equity [owner’s claims]) on a certain date. Assets = Liabilities + Owner’s Equity. Statement dated “As of xxx”.
Cash Flow Statement. Communicates where a company’s cash came from and how cash was used over an accounting period. Statement illustrates cash inflows and outflows from operating activities, investing activities, and financing activities. Statement dated “For Period Ended”
Financial Statement Articulation. The 1st “Financial Statement” (documents used to communicate T account information to interested users) is the Income Statement. This statement summarizes Revenue and Expense T accounts (R – E = NI), or profitability. Profit amount (NI) is used to prepare the 2nd Statement, Retained Earnings Statement. This statement shows the changes in the RE T account. Remember, the RE T account is increased by revenues and decreased by expenses (R – E = NI). RE account is also decreased by dividends. Accordingly, the RE statement is summarized as Beginning RE or BRE + NI – D = Ending RE (ERE). ERE is used to complete the 3rd statement, Balance Sheet, a summary of Assets (asset T accounts) and creditor claims (Liability T accounts) + owner claims (OE T accounts) to those assets.
Basic Accounting Concepts and Terms
Accounting Principles, Part II
Basic Accounting Concepts and Terms
Accounting Principles, Part II
Allowance for Doubtful Accounts. A contra asset account (meaning the normal balance is a credit) used to document a company’s estimate of uncollectable accounts receivable. Some accounts receivable established from sales during the accounting period will likely not be collectable; accordingly, need to try and match these bad debt expenses with the revenue recognized during the period (matching principle…don’t wait for account to be uncollectable before writing off). Journal entry to record band debt expense: Debit to bad debt expense and credit to allowance for doubtful accounts.
Long-Term Notes Payable. Similar to short-term interest-bearing notes payable except that the term of the notes exceeds one year…meaning we’ll have a carrying value of notes payable on the balance sheet. Recall, those notes payable due for payment within one year of the balance sheet date are classified as current liabilities on the BS. Accordingly, the portion of LT-NP due within 1 year must be recorded as a “current” liability. The principle amount of a NP is reduced each accounting cycle (total payments minus total interest). Use the below accounting class help.com notes payable teaching tool to making teaching and learning long-term notes a snap!
Interest Expense Calculation Note Payable. Principle x Rate x Time.
Build in Microsoft Excel®, this Accounting Class help.com Note Payable teaching tool will not only help introduce business software, but provide a simple way to comprehensively teach long-term notes payable accounting concepts.
Bonds. Debt securities (LT Liabilities) issued by corporations, with long-term maturities. Bonds pay periodic interest, and the principal is returned to the bond holder at maturity.
Bond Accounting Concepts (see below accounting class help.com bond teaching tool). Bonds, like notes payable, require the issuer to pay periodic interest payments to the bond holder. However, these periodic payments are for interest only (the principle balance is returned or paid at bond maturity).
This Accounting Class help.com Bond Payable teaching tool covers required terminology such as bond face amount, discounts, and premiums, along with simple steps to present interest expense/amortization calculations and recording of associated debits and credits.
Bond Face/Par Value. Amount of principal the issuing company must pay at the maturity date.
Bond Contract/Stated Interest Rate. Rate used to determine amount of interest the borrower pays and the investor receives each interest period.
Market Interest Rate. Current/effective interest rate investors demand for loaning funds…likely different from the contract rate as market rates frequently change.
Issuing Bonds at a Discount. Contract interest rate is lower than market interest rate, requiring bonds be issued at an amount lower (discount) than face amount. Discounts increase cost of borrowing money.
Issuing Bonds at a Premium. Contract interest rate is higher than market interest rate, allowing bonds to be issued at an amount higher (premium) than face amount. Premiums decrease cost of borrowing money.
Bond Carrying Value (Balance Sheet Presentation). Bond face amount "-" unamortized discount, or "+" unamortized premium.
Bond Discount/Premium Amortization. A process to allocate a portion of the total discount or premium to recorded bond interest expense over applicable accounting periods.
Steps to amortize Discounts/Premiums (see accounting class help.com bond teaching tool).
Shareholders’ Equity. A + L + SE. SE = “paid in” capital accounts and “earned” capital account.
Paid-in capital. Total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock.
Earned Capital. Retaining earnings.
Stock Authorized / Issued / Outstanding. Outstanding stock means the number of shares of issued stock (from total authorized) that are being held by stockholders. The quantity difference between issued and outstanding will equal number of repurchased shares in the treasury.
Treasury Stock. A corporation’s stock reacquired from shareholders, but not retired. Contra stockholders’ equity account, not an asset (normal balance = debit)
Dividends. Distribution of retained earnings to shareholders. Cash dividends decrease SE. As oppose to stock dividend, which decrease retained earnings and increase capital stock…so no affect on overall shareholder equity amount.
And the list of accounting terms and concepts goes on and on. Accounting Class help.com tools will help you bring all this information together, help you understand how and why record financial transactions are recorded, and how these transactions translate into financial statements!