Accounting Principles

What Is Accounting ?

vAccounting: is the language of the business and it is

essential that you understand this language.
vAccounting: is the way to convey information about business
to users.
vAccounting: Records, classifies, summarizes, analyzes
Economic events of business and interpret the results for the
users.
What are Economic Events?

vEconomic events are business’s transactions recorded by

Bookkeepers or accountants.
Accounting Activities
 Bookkeeping vs Accounting

v Bookkeeping: involves only the recording of financial transactions

(Economic Events).
v Accounting: involves the entire process of accounting Activities.
v Bookkeeper: Bookkeepers handle the day-to-day tasks of recording
financial transactions.
v Accountant: Provide insight and analysis of that data and generate
accounting reports.
The Basic Accounting Equation
Assets
Current Assets & Fixed Assets
vCurrent Asset: is anything which can be converted into cash quickly,
usually 1 year.
vFixed assets: are resources purchased for long term use in the
business and are not likely to be converted into cash within 12
months.
Liabilities

v Liabilities: are debts the company owes to others.

 Short-term and Long-term liabilities
v Short- term liabilities: Are debts the company must pay over the
next 12 months.
v Long-term liabilities: Are debts the company must pay over a period
of time longer than the next 12 months.
 Owner’s Equity

v Owner’s equity: is equal to total assets minus total liabilities.

Expanded Accounting Equation
Debits and Credits

v The Term Debit indicates the left side of an account.

v The Term Credit indicates the right side.
v They are commonly abbreviated as Dr. for debit and Cr. for credit
Double-Entry System

vEach transaction, debits must equal credits. The equality of

debits and credits provides the basis for the double-entry
system of recording transactions.
Debit And Credit Effects
 What is an account?
vAn account consists of three parts: (1) a title, (2) a left or debit
side, and (3) a right or credit side. Because the format of an
account resembles the letter T, we refer to it as a T-account
 Normal Account Balances

vAsset accounts and Expenses normally show debit balances.

vliability accounts, Owner’s equity and Revenue Accounts
normally show credit balances.
Transaction identification process
 Transaction Analysis 01
v Each transaction must have a dual effect on the accounting equation.
vTransaction (1). Investment By Owner. He starts a smartphone app
development company with the name SoftSmart and invested $15,000 cash in
the business.
Transaction Analysis 02
v Transaction (2). Purchase Of Equipment For Cash. SoftSmart
purchases computer equipment for $7,000 cash.
 Transaction Analysis 03
v Transaction (3). SoftSmart Purchases Supplies on Credit/ on account for
$1,600 from Mobile Solutions headsets and other computer accessories
expected to last several months. Mobile Solutions agrees to allow SoftSmart
to pay this bill in October.
 Transaction Analysis 04

v Transaction (4). SoftSmart receives $1,200 cash from

customers for app development services it has performed.
Transaction Analysis 05

v Transaction (5). SoftSmart receives a bill for $250 from the Daily
News for advertising on its online website but postpones payment
until a later date.
 Transaction Analysis 06
v Transaction (6). Services Performed For Cash $1,500 And Credit $2,000.
SoftSmart performs $3,500 of app development services for customers.
 Transaction Analysis 07

v Transaction (7). Payment Of Expenses. SoftSmart pays the following

expenses in cash for September: office rent $600, salaries and wages
of employees $900, and utilities $200.
 Transaction Analysis 08

v Transaction (8). Payment Of Accounts Payable. SoftSmart

pays its $250 Daily News bill in cash.
 Transaction Analysis 09

v Transaction (9). Receipt Of Cash On Account. SoftSmart receives

$600 in cash from customers who had been billed for services.
 Transaction Analysis 10

v Transaction (10). Withdrawal Of Cash By Owner. The Owner

withdraws $1,300 in cash from the business for his personal use.
Tabular Summary of SoftSmart transactions
 Income Statement

vThe income statement reports the revenues and expenses for

a specific period of time.
SoftSmart
Owner’s Equity Statement

vOwner’s Equity Statement summarizes the changes in owner’s

equity for a specific period of time
SoftSmart
 Balance Sheet

vBalance Sheet reports the assets, liabilities, and owner’s

equity at a specific date. SoftSmart
 Statement of Cash flows
v Statement of Cash flows summarizes information about the cash inflows (receipts) and
outflows (payments) for a specific period of time.
SoftSmart
Who Uses Accounting Data/Information
 Questions Asked by Internal Users

Ø Managerial accounting answers these questions. It provides detailed information and

internal reports to help users make decisions about their companies.
Questions Asked by External Users

Ø Financial accounting answers these questions. It provides economic and

financial information to create financial statements for external users.
 Tabular Analysis
vTransactions made by Virmari & Co., a public accounting firm, for the month
of August are shown below. Prepare a tabular analysis which shows the effects
of these transactions on the expanded accounting equation.
1. The owner invested $25,000 cash in the business.
2. The company purchased $7,000 of office equipment on credit.
3. The company received $8,000 cash in exchange for services
performed.
4. The company paid $850 for this month’s rent.
5. The owner withdrew $1,000 cash for personal use.
Solution
The Recording Process
Every business uses the basic steps shown below:
1. Analyse each transaction in terms of its effect on the accounts.
2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger
 The Journal and Journalizing
v Companies initially record transactions in chronological order (the order in which they occur). Thus, the
journal is referred to as the book of original entry. For each transaction, the journal shows the debit and
credit effects on specific accounts. Companies may use various kinds of journals, but every company has
the most basic form of journal, a general journal.
v Entering transaction data in the journal is known as journalizing. See the format of the journal as below:
 Simple and Compound Entries
v Some entries involve only two accounts, one debit and one credit. This type of entry is
called a simple entry. To illustrate, assume that on OCT 1, the owner of AGC Company
invested again$20,000 cash in the business transactions.
v Some entries require more than two accounts in journalizing. An entry that requires
three or more accounts is a compound entry. To illustrate, assume that AGC Company
purchases a delivery truck costing $14,000. It pays $8,000 cash now and agrees to pay the
remaining $6,000 on account.
v In a compound entry, the standard format requires that all debits be listed before the
credits.
The Ledger
The entire group of accounts maintained by a company is the ledger. The ledger provides the
balance in each of the accounts as well as keeps track of changes in these balances.
Companies may use various kinds of ledgers, but every company has a general ledger. A
general ledger contains all the asset, liability, and owner’s equity accounts, as shown in below:
 Posting
v The procedure of transferring journal entries to the ledger accounts is called posting. This
phase of the recording process accumulates the effects of journalized transactions into the
individual accounts. Posting involves the following steps.
Chart of Accounts
v Most companies have a chart of accounts. This chart lists the accounts and the account numbers that
identify their location in the ledger. The numbering system that identifies the accounts usually starts with
the balance sheet accounts and follows with the income statement accounts.
Trail Balance
v A trial balance is a list of accounts and their balances at a given time. Companies usually prepare a trial
balance at the end of an accounting period. They list accounts in the order in which they appear in the
ledger. Debit balances appear in the left column and credit balances in the right column. The totals of the
two columns must equal.
Limitations of a Trial Balance

§ A trial balance does not guarantee freedom from recording errors.

§ The trial balance does not prove that the company has recorded
all transactions or that the ledger is correct.
§ The trial balance may balance even when:
1. A transaction is not journalized.
2. A correct journal entry is not posted.
3. A journal entry is posted twice.
4. Incorrect accounts are used in journalizing or posting.
Locating Errors
v Errors in a trial balance generally result from mathematical mistakes, incorrect postings, or simply transcribing data
incorrectly. What do you do if you are faced with a trial balance that does not balance? First, determine the amount
of the difference between the two columns of the trial balance. After this amount is known, the following steps are
often helpful:
1. If the error is $1, $10, $100, or $1,000, re-add the trial balance columns and recompute the account balances.
2. If the error is divisible by 2, scan the trial balance to see whether a balance equal to half the error has been entered
in the wrong column.
3. If the error is divisible by 9, retrace the account balances on the trial balance to see whether they are incorrectly
copied from the ledger. For example, if a balance was $12 and it was listed as $21, a $9 error has been made.
Reversing the order of numbers is called a transposition error.
4. If the error is not divisible by 2 or 9, scan the ledger to see whether an account balance in the amount of the error
has been omitted from the trial balance, and scan the journal to see whether a posting of that amount has been
omitted
Prepare a trial balance
Fiscal and Calendar Years
§ Both small and large companies prepare financial statements periodically in
order to assess their financial condition and results of operations.
Accounting time periods are generally a month, a quarter, or a year. Monthly
and quarterly time periods are called interim periods.
§ Most large companies must prepare both quarterly and annual financial
statements. An accounting time period that is one year in length is a fiscal
year. A fiscal year usually begins with the first day of a month and ends 12
months later the last day of a month. Many businesses use the calendar year
(January 1 to December 31) as their accounting period. Some do not.
The Need for Adjusting Entries

§ Adjusting entries are necessary because the trial balance may not
contain up-to-date and complete data.
§ Adjusting entries are required every time a company prepares
financial statements. The company analyses each account in the
trial balance to determine whether it is complete and up-to-date
for financial statement purposes.
§ Every adjusting entry will include one income statement account
and one balance sheet account.
Accrual- versus Cash-Basis Accounting
§ Under the accrual basis, companies record transactions that change a company’s financial
statements in the periods in which the events occur. For example, using the accrual basis to
determine net income means companies recognize revenues when they perform services
(rather than when they receive cash). It also means recognizing expenses when incurred
(rather than when paid).
§ Under cash-basis accounting, companies record revenue at the time they receive cash. They
record an expense at the time they pay out cash.
§ Accrual-basis accounting is therefore in accordance with generally accepted accounting
principles (GAAP). The cash basis is justified for small businesses because they often have
few receivables and payables. Medium and large companies use accrual-basis accounting.
Revenue and Expenses Recognition Principle
Types of Adjusting Entries
§ Adjusting entries are classified as either Deferrals or Accruals. As shows, each of these
classes has two subcategories.
Deferrals:
1. Prepaid expenses: Expenses paid in cash before they are used or consumed.
2. Unearned revenues: Cash received before services are performed.
Accruals:
1. Accrued revenues: Revenues for services performed but not yet received in cash or
recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded
Prepaid Expenses

§ When companies record payments of expenses that will benefit

more than one accounting period, they record an asset called prepaid
expenses or prepayments
§ When expenses are prepaid, an asset account is increased
(debited) to show the service or benefit that the company will
receive in the future.
§ Prepaid expenses are costs that expire either with the passage of
time (e.g., rent and insurance) or through use (e.g., supplies).
Accounting for Prepaid Expenses

§ If a figure on an account is overstated, the amount that is reported on

the financial statement is more than it should be.
§ If an account or a figure on an account is understated, the amount that
is reported on the financial statement is less than it should be.
Prepaid Insurance

§ Companies purchase insurance to protect themselves from losses due to fire,

theft, and unforeseen events. Insurance must be paid in advance, often for
multiple months.
§ The cost of insurance (premiums) paid in advance is recorded as an increase
(debit) in the asset account Prepaid Insurance. At the financial statement
date, companies increase (debit) Insurance Expense and decrease (credit)
Prepaid Insurance for the cost of insurance that has expired during the period
Adjustment for Insurance
 Depreciation

§ Depreciation is the process of allocating the cost of an asset to expense over

its useful life. The period of service is referred to as the useful life of the asset.
Accumulated Depreciation Account

§ Accumulated Depreciation is called a contra asset account. Such

an account is against an asset account on the balance sheet. Thus,
the Accumulated Depreciation—Equipment account off sets the
asset Equipment.
§ This account keeps track of the total amount of depreciation
expense taken over the life of the asset.
§ The normal balance of a contra asset account is a credit.
Adjustment For Depreciation
 Unearned Revenues
§ When companies receive cash before services are performed,
they record a liability by increasing (crediting) a liability account
called unearned revenues.
§ In other words, a company now has a performance obligation
(liability) to transfer a service to one of its customers. Items like
rent, magazine subscriptions, and customer deposits for future
service may result in unearned revenues.
§ Airlines such as United, and Delta, for instance, treat receipts
from the sale of tickets as unearned revenue until the flight
service is provided.
Adjusting Entry for Unearned Revenues
§ The adjusting entry for unearned revenues results in a decrease (a debit) to a liability
account and an increase (a credit) to a revenue account.
§ UTL Advertising Company received $1,200 on October 2 SoftSmart for advertising services
expected to be completed by December 31. UTL credited the payment to Unearned Service
Revenue. This liability account shows a balance of $1,200 in the October 31 trial balance.
§ From an evaluation of the services UTL performed for SoftSmart October, the company
determines that it should recognize $400 of revenue in October. The liability (Unearned
Service Revenue) is therefore decreased, and owner’s equity (Service Revenue) is
increased.
Service Revenue Accounts after Adjustment
Accounting for Unearned Revenues
DO IT! - Adjusting Entries for Deferrals
Solution For DO IT! 01
Accrued Revenues

§ Revenues for services performed but not yet recorded at

the statement date are accrued revenues.
§ Accrued revenues may accumulate (accrue) with the
passing of time, as in the case of interest revenue. These
are unrecorded because the earning of interest does not
involve daily transactions.
§ Companies do not record interest revenue daily because
it is often impractical to do so.
Accounting for Accrued Revenues
 Adjusting Entry for Accrued Revenues

§ Adjusting entry for accrued revenues results in an increase (a debit)

to an asset account and an increase (a credit) to a revenue account.
§ In October, UTL Advertising performed services worth $200 that
were not billed to clients on or before October 31. Because these
services were not billed, they were not recorded.
§ The accrual of unrecorded service revenue increases an asset
account, Accounts Receivable. It also increases owner’s equity by
increasing a revenue account, Service Revenue.
ILLUSTRATION Adjustment for accrued revenue
Accrued Expenses
§ Expenses incurred but not yet paid or recorded at the
statement date are called accrued expenses. Interest, taxes,
and salaries are common examples of accrued expenses.
§ Prior to adjustment, both liabilities and expenses are
understated. Therefore, an adjusting entry for accrued
expenses results in an increase (a debit) to an expense
account and an increase (a credit) to a liability account.
Accounting for Accrued Expenses
ILLUSTRATION - Adjustment for accrued salaries and wages
Summary of Basic Relationships
§ Take some time to study and analyse the four basic types of adjusting
entries. Be sure to note that each adjusting entry affects one balance sheet
account and one income statement account
DO IT! Adjusting Entries for Accruals and Solution
DO IT! 2 Adjusting Entries for Accruals and Solution
Closing the Books
§ At the end of the accounting period, the company makes the accounts ready for the next
period. This is called closing the books. In closing the books, the company distinguishes
between temporary and permanent accounts.
§ Temporary accounts/Nominal accounts are all income statement accounts and the owner’s
drawings account.
§ Permanent accounts/real accounts are all balance sheet accounts, including the owner’s
capital account.
Closing Process

v Closing entries produce a zero balance

in each temporary account.
DO IT! Closing Entries
Solution
 Merchandising Companies

§ Wal-Mart, and Amazon.com are called merchandising companies because

they buy and sell merchandise.
§ Merchandising companies that purchase and sell directly to consumers are
called retailers. Prepaid Expenses

§ Merchandising companies that sell to retailers are known as wholesalers.

§ The primary source of revenue for merchandising companies is the sale of
merchandise, often referred to simply as sales revenue or sales.
§ A merchandising company has two categories of expenses: cost of goods sold
and operating expenses.
 Cost of goods sold

§ Cost of goods sold is the total cost of merchandise sold during the period.
§ This expense is directly related to the revenue recognized from the sale of goods.

Income measurement process for a

Prepaid Expenses merchandising company
 Operating Cycles – Merchandising Company
§ The operating cycle of a merchandising company ordinarily is longer than that of a service
company.

Prepaid Expenses
Operating cycle for a service company

Prepaid Expenses
Flow of Costs
Perpetual System
Periodic System
 Freight Costs – FOB Shipping Point

§ Freight terms are expressed as either FOB shipping point or FOB destination.
The letters FOB mean free on board.
Freight Costs – FOB Destination
Freight Costs Incurred by the Buyer

§ When the buyer incurs the transportation costs, these costs are considered part of
the cost of purchasing inventory. Therefore, the buyer debits (increases) the
Inventory account. For example, if Ali (the buyer) pays Public Carrier Co. $150 for
freight charges on May 6, the entry on Ali's books is:
Freight Costs Incurred by the Seller

§ freight costs incurred by the seller on outgoing merchandise are an operating

expense to the seller. These costs increase an expense account titled Freight-
Out (sometimes called Delivery Expense). For example, if the freight terms
on the invoice had required Mr Abdo(the seller) to pay the freight charges,
the entry by Abdo would be:
Purchase Returns and Allowances

§ A Purchaser may be dissatisfied with the merchandise received because the goods
are damaged or defective, of inferior quality, or do not meet the purchaser’s
specifications.
§ In such cases, the purchaser may return the goods to the seller for credit if the sale
was made on credit, or for a cash refund if the purchase was for cash. This
transaction is known as a purchase return.
§ Alternatively, the purchaser may choose to keep the merchandise if the seller is
willing to grant an allowance (deduction) from the purchase price. This transaction is
known as a purchase allowance.
Entry for Purchase Returns and Allowances
§ Assume that Ali ’shop returned goods costing $300 to PW Supply on May 8. The following
entry by Ali ’shop for the returned merchandise decreases (debits) Accounts Payable and
decreases (credits) Inventory.

§ Because Ali ’shop increased Inventory when the goods were received, Inventory is decreased when Ali
’shop returns the goods.
§ Suppose instead that Ali ’shop chose to keep the goods after being granted a $50 allowance (reduction
in price). It would reduce (debit) Accounts Payable and reduce (credit) Inventory for $50.
Purchase Discounts

§ The credit terms of a purchase on account may permit the buyer to claim a
cash discount for prompt payment. The buyer calls this cash discount a
purchase discount.
§ This incentive offers advantages to both parties. The purchaser saves money,
and the seller can shorten the operating cycle by converting the accounts
receivable into cash.
§ Credit terms specify the amount of the cash discount and time period in which
it is offered. They also indicate the time period in which the purchaser is
expected to pay the full invoice price.
Credit Terms

§ Credit terms such as this 2/10, n/30, which is read “two-ten, net thirty”. This means that the
buyer may take a 2% cash discount on the invoice price, if payment is made within 10 days of the invoice
date (the discount period). Otherwise, the invoice price, is due 30 days from the invoice date.
§ Alternatively, the discount period may extend to a specified number of days following the month in
which the sale occurs. For example, 1/10 EOM (end of month) means that a 1% discount is available if
the invoice is paid within the first 10 days of the next month.
§ When the seller elects not to offer a cash discount for prompt payment, credit terms will specify only
the maximum time period for paying the balance due. For example, the invoice may state the time
period as n/30, n/60, or n/10 EOM. This means, respectively, that the buyer must pay the net amount in
30 days, 60 days, or within the first 10 days of the next month.
Entry for Purchasing discounts
§ Assume that Abdo pays the balance due of $3,500 (gross invoice price of $3,800 less
purchase returns and allowances of $300) on May 14, the last day of the discount
period. Since the terms are 2/10, n/30, the cash discount is $70 ($3,500 × 2%), and
Abdo pays $3,430 ($3,500 − $70)..
Sales Returns and Allowances/Discounts
§ We now look at the “flip side” of purchase returns and allowances, which the seller records
as sales returns and allowances.
§ These are transactions where the seller either accepts goods back from the buyer (a
return) or grants a reduction in the purchase price (an allowance) so the buyer will keep
the goods.
§ Sales Returns and Allowances is a contra revenue account to Sales Revenue. The normal
balance of Sales Returns and Allowances is a debit.
§ The seller may offer the customer a cash discount—called by the seller a sales discount—
for the prompt payment of the balance due. Sales Discounts is a contra revenue account to
Sales Revenue. Its normal balance is a debit.
Classifying and Determining Inventory

§ Two important steps in the reporting of inventory at the end of the

accounting period are the classification of inventory based on its degree of
completeness and the determination of inventory amounts.
§ How a company classifies its inventory depends on whether the firm is a
merchandiser or a manufacturer.
§ No matter whether they are using a periodic or perpetual inventory system,
all companies need to determine inventory quantities at the end of the
accounting period.
 Classifying Inventory
§ In a merchandising company, inventory consists of many different items and need only
one inventory classification, merchandise inventory, to describe the many different items
that make up the total inventory.
§ In a manufacturing company, manufacturers usually classify inventory into three
categories: finished goods, work in process, and raw materials.
Ø Finished goods inventory is manufactured items that are completed and ready for sale.
Ø Work in process is that portion of manufactured inventory that has been placed into
the production process but is not yet complete.
Ø Raw materials are the basic goods that will be used in production but have not yet
been placed into production.
Determining Inventory Quantities

§ Determining inventory quantities involves two steps:

Ø Taking a physical inventory of goods on hand and

Ø Determining the ownership of goods.

§ Companies take a physical inventory at the end of the accounting period. Taking a
physical inventory involves actually counting, weighing, or measuring each kind of
inventory on hand.
§ To determine ownership of goods, two questions must be answered: Do all of the goods
included in the count belong to the company? Does the company own any goods that
were not included in the count
Cost flow methods
There are three assumed cost flow methods:
§ The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the
first to be sold. Under the FIFO method, therefore, the costs of the earliest goods
purchased are the first to be recognized in determining cost of goods sold.
§ Last-In, First-Out (LIFO) method assumes that the latest goods purchased are the first to
be sold. Under the LIFO method, the costs of the latest goods purchased are the first to
be recognized in determining cost of goods sold.
§ The average-cost method allocates the cost of goods available for sale on the basis of
the weighted-average unit cost incurred.
Allocationof costs—FIFO method
Allocationof costs—LIFO method
Allocationof costs—Average-cost method