Comprehensive Guide to Basic Accounting Concepts
DEVELOPING AS AN ENTREPRENEUR & CREATOR
Efecan Buzkır
5/22/2024
Comprehensive Guide to Basic Accounting Concepts
1. The Accounting Equation
Explanation
The accounting equation reflects the relationship between a company's assets, liabilities, and owner's equity:
Assets=Liabilities+Owner’s Equity
Assets: Resources controlled by a business expected to provide future benefits (e.g., cash, inventory, buildings).
Liabilities: Obligations the business owes to external parties (e.g., loans, accounts payable).
Owner's Equity: The owner’s claims on the business after all liabilities have been deducted (e.g., owner’s capital, retained earnings).
Detailed Examples
Basic Example:
A business has:
Cash: $10,000
Inventory: $5,000
Equipment: $15,000
Loan Payable: $8,000
Accounts Payable: $2,000
Total Assets=$10,000+$5,000+$15,000=$30,000
Total Liabilities=$8,000+$2,000=$10,000
Total Liabilities=$8,000+$2,000=$10,000
Owner’s Equity=$30,000−$10,000=$20,000
Complex Example:
A business also has:
Accounts Receivable: $7,000
Building: $50,000
Mortgage Payable: $30,000
Calculation:
Total Assets=$10,000+$5,000+$15,000+$7,000+$50,000=$87,000
Total Assets=$10,000+$5,000+$15,000+$7,000+$50,000=$87,000
Total Liabilities=$8,000+$2,000+$30,000=$40,000
Total Liabilities=$8,000+$2,000+$30,000=$40,000
Owner’s Equity=$87,000−$40,000=$47,000
2. Double-Entry Bookkeeping
Explanation
Each financial transaction affects at least two accounts to keep the accounting equation balanced. Transactions are recorded as both debits and credits.
Detailed Examples
Purchase Example:
A company buys office supplies for $500 on credit.
Debit: Office Supplies (Asset) $500
Credit: Accounts Payable (Liability) $500
Sales Example:
A company sells merchandise for $1,200 cash.
Debit: Cash (Asset) $1,200
Credit: Sales Revenue (Equity) $1,200
Expense Example:
A company pays $1,000 for rent.
Debit: Rent Expense (Expense) $1,000
Credit: Cash (Asset) $1,000
Mixed Example:
A company receives $3,000 from a customer on account.
Debit: Cash (Asset) $3,000
Credit: Accounts Receivable (Asset) $3,000
3. Financial Statements
Explanation
Financial statements summarize a company's financial performance and position. The main types are the Income Statement, Balance Sheet, and Cash Flow Statement.
Income Statement (Profit & Loss Statement)
Shows revenues, expenses, and net profit or loss over a period.
Detailed Example
For the year ended December 31, 2023:
Revenue: $100,000
Cost of Goods Sold: $60,000
Gross Profit: $40,000
Operating Expenses:
Rent: $10,000
Salaries: $15,000
Utilities: $3,000
Advertising: $2,000
Total Operating Expenses: $30,000
Net Profit:
Gross Profit−Total Operating Expenses=$40,000−$30,000=$10,000
Balance Sheet
Snapshot of a company’s financial position at a specific point in time, showing assets, liabilities, and owner's equity.
Detailed Example
As of December 31, 2023:
Assets:
Cash: $15,000
Accounts Receivable: $10,000
Inventory: $20,000
Equipment: $30,000
Land: $25,000
Total Assets: $100,000
Liabilities:
Accounts Payable: $10,000
Loan Payable: $25,000
Mortgage Payable: $30,000
Total Liabilities: $65,000
Owner’s Equity:
Owner’s Capital: $35,000
Cash Flow Statement
Shows inflows and outflows of cash over a period, categorized into operating, investing, and financing activities.
Detailed Example
For the year ended December 31, 2023:
Operating Activities:
Cash received from customers: $120,000
Cash paid to suppliers and employees: -$90,000
Net Cash from Operating Activities: $30,000
Investing Activities:
Purchase of equipment: -$10,000
Sale of old equipment: $2,000
Net Cash from Investing Activities: -$8,000
Financing Activities:
Borrowed funds: $15,000
Repayment of loan: -$5,000
Net Cash from Financing Activities: $10,000
Net Increase in Cash:
$30,000−$8,000+$10,000=$32,000
4. Accrual vs. Cash Basis Accounting
Explanation
Accrual Basis: Revenues and expenses are recognized when they are earned or incurred, regardless of when cash is exchanged.
Cash Basis: Revenues and expenses are recognized only when cash is received or paid.
Detailed Examples
Accrual Basis Example:
A company provides services worth $5,000 in December 2023 but receives payment in January 2024. Under accrual accounting, revenue is recognized in December 2023.
Cash Basis Example:
Using the same scenario, revenue is recognized in January 2024 when the cash is received.
Expense Example:
A company incurs utility expenses of $600 in December 2023 but pays the bill in January 2024.
Accrual Basis: Expense is recorded in December 2023.
Cash Basis: Expense is recorded in January 2024.
5. Revenue Recognition Principle
Explanation
Revenue should be recognized when it is earned and realizable, regardless of when cash is received. This aligns with the accrual basis of accounting.
Detailed Examples
Software License Example:
A company sells a one-year software license for $1,200 on January 1st. Revenue is recognized monthly at $100.
Service Contract Example:
A consulting firm enters a six-month contract for $6,000. Revenue is recognized monthly at $1,000.
Product Sales Example:
A retailer sells goods worth $5,000 on credit. Revenue is recognized when the goods are delivered to the customer.
6. Matching Principle
Explanation
Expenses should be matched with the revenues they help generate, recorded in the same period as the related revenue. This ensures that income statements accurately reflect profitability.
Detailed Examples
Insurance Expense Example:
A company pays $12,000 for a year's insurance on January 1st. Expense is recorded monthly at $1,000.
Depreciation Example:
A company buys equipment for $10,000 with a useful life of 10 years. Depreciation expense is recorded annually at $1,000.
Wages Example:
Employees earn $5,000 in wages in December 2023 but are paid in January 2024. Expense is recorded in December 2023.
7. Historical Cost Principle
Explanation
Assets should be recorded at their original purchase cost, not their current market value. This provides consistency and reliability in financial reporting.
Detailed Examples
Building Example:
A building purchased for $200,000 is recorded at that amount, even if its market value increases to $250,000.
Equipment Example:
Machinery bought for $50,000 is recorded at purchase cost, even if its current resale value is $40,000.
Land Example:
Land acquired for $100,000 is recorded at that amount, irrespective of an increase in market value to $120,000.
8. Conservatism Principle
Explanation
When in doubt, accountants should choose the solution that does not overstate assets or income. This principle helps ensure that financial statements are not overly optimistic.
Detailed Examples
Lawsuit Example:
A company faces a potential lawsuit with an estimated loss of $50,000. The company should record the liability if the loss is probable and can be reasonably estimated.
Inventory Valuation Example:
Inventory purchased for $20,000 has a market value of $18,000. The inventory should be recorded at $18,000 to reflect the lower value.
Accounts Receivable Example:
A company has accounts receivable of $100,000 but expects that 5% may be uncollectible. An allowance for doubtful accounts of $5,000 should be recorded.
9. Consistency Principle
Explanation
Accounting methods and practices should be applied consistently from period to period. This allows for comparability of financial statements over time.
Detailed Examples
Depreciation Method Example:
If a company uses the straight-line method for depreciating assets, it should continue using this method unless a change is justified and fully disclosed.
Inventory Valuation Example:
A company uses FIFO (First In, First Out) for inventory valuation. This method should be used consistently unless a change to LIFO (Last In, First Out) is justified and disclosed.
Revenue Recognition Example:
If a company recognizes revenue at the point of sale, it should consistently apply this method unless a change is necessary and disclosed.
10. Materiality Principle
Explanation
Only information that could influence the decision-making of users of the financial statements should be included. Materiality depends on the size and nature of the item.
Detailed Examples
Small Expense Example:
A company with annual revenue of $10 million discovers a $500 error. This is likely immaterial and may not need adjustment.
Significant Error Example:
The same company discovers a $100,000 error. This is material and must be corrected.
Disclosure Example:
A $50,000 lawsuit settlement should be disclosed if it is material to the company’s financial position.
11. Going Concern Principle
Explanation
Assumes that a business will continue to operate indefinitely. This principle affects the valuation of assets and liabilities, as it assumes the business will not be liquidated soon.
Detailed Examples
Asset Valuation Example:
Machinery is recorded at cost and depreciated over its useful life, not its immediate sale price.
Inventory Valuation Example:
Inventory is valued based on its use in the business, not its liquidation value.
Liability Example:
Long-term debt is recorded at its present value, assuming the business will continue to make payments as scheduled.
12. Full Disclosure Principle
Explanation
All relevant financial information should be disclosed in the financial statements or the accompanying notes. This ensures that users have a complete understanding of the financial situation.
Detailed Examples
Lawsuit Example:
If a company has a significant pending lawsuit, it should disclose the details in the notes to the financial statements.
Contingent Liability Example:
A company guarantees the debt of another entity. This contingent liability should be disclosed.
Significant Contract Example:
A company signs a significant long-term contract. The terms and potential impact should be disclosed in the notes.
13. Additional Concepts
Economic Entity Principle
The transactions of a business must be kept separate from those of its owners or other businesses.
Detailed Examples
Personal vs. Business Expenses Example:
The owner's personal expenses should not be recorded as business expenses.
Subsidiary Transactions Example:
Transactions between a parent company and its subsidiary should be recorded separately.
Time Period Principle
A business should report its financial results over a standard time period, such as monthly, quarterly, or annually.
Detailed Examples
Monthly Reporting Example:
A company prepares monthly financial statements to monitor performance.
Annual Reporting Example:
A company prepares annual financial statements for tax purposes.
Monetary Unit Principle
Only transactions that can be expressed in monetary terms should be included in accounting records.
Detailed Examples
Non-Monetary Items Example:
Employee skill levels are not recorded, but their salary expenses are.
Quantifiable Items Example:
Inventory quantities are recorded in monetary terms, not physical units.
