Basic Accounting

Conceptual Framework

Whenever you hear the term Accounting most of you might equate it to Math and
very complex principles. However, it is a principle that can be learned quite easily.
Since Accounting is the language of business which communicates the financial
condition and performance of your company, it is important that as a businessman, you
have to know its basic principles.

The first thing you should understand about Accounting is that it has a widely accepted
set of rules, concepts and principles that governs the applications of all the procedures
in accounting. These accepted guidelines are referred to as Generally Accepted
Accounting Principles (GAAP).

We will introduce you to some concepts which are relevant for you to understand and
perform accounting procedures. By knowing these, you will be more familiar with how
accounting works. Here are the basic accounting guide for non-accountants:

Business Entity

The first concept to learn is that a business is a separate entity from its owner(s). In this
case the business should always be treated separately from personal transactions.
Only business transactions are recorded in the accounting books except in cases
where the owner withdraws money directly from the business.

Going Concern

A business should be viewed as something operating continuously through time. Using

this principle, all assets are recorded bases on their original cost and non on their
current market value. The same way, these assets are assumed to be used
continuously and not to be sold.

For your easy understanding let us define some key words:

Assets it is a resource with economic value that a business owns or controls with the
expectation that it will provide future benefits.

Liabilities in laymans term it is the business legal debt or obligation acquired during
its business operations. These liabilities are paid over time by means of money, goods
or services.

Capital it can be in the form of money or assets which are taken as a sign of the
financial strength of the business. In general, it is the money invested in a business to
generate income. You can determine capital by deducting liabilities from the assets of
your business.

Monetary Unit

Accounting only records transactions that can be measured using a monetary unit such
as the Philippine Peso (Php). Any other transaction that cannot be measured in this
unit or in any other equivalent currency should not be recorded.

Historial Cost

All resources acquired by your business should be valued and recorded in your books
of accounts on the actual cash equivalent or original acquisition cost. It should never be
valued using the current market value or any future value. Current market value can
only be used if the business is already in the process of closure where your business
assets will be sold.

Matching

Basic accounting principle states that for every debit there should be a credit and vise
versa. Accounting is all about debit and credit, for everything received there is
something parted with. This principle therefore requires that revenue recorded in a
given accounting period, should have an equivalent expense recorded, in order to
determine the real profit of your business.

Accounting Period
Businesses should have a period where the whole accounting process is to be
completed. This accounting period can be monthly, quarterly or annually. There are
two types of annual accounting period Calendar Year or Fiscal Year.

Conservatism

If you are recording any business transaction and you are given two options, the
amount recorded should be the lower rather than the higher value for assets and the
higher value for expenses.

Consistency

Your business should apply the same principle and policies used for your accounting
every year so that your accounting date would be fair and consistent for comparison
purposes.

Materiality

All material transactions that can affect the business should be reported properly and
reflected in your accounting. A 1 peso difference may or may not be material for a
business, thus if depends on how you treated it.

Objectivity

Every transaction in your business should have supporting evidence and documentation
such as receipts, invoices, etc. It also requires that bookkeeping and financial recording
should be done with independence which is free of bias and prejudice.

Accrual

This last principle is very basic. Your business income and expenses should be
recorded at the time when you actually earned or incurred them regardless of when
cash transfer is involved. If you have a sale today but it is in credit, you should record it
today, likewise, if your electricity bill comes today, you should record it today and not at
the time of payment.
The above basic accounting guide for non-accountants should help you understand
more about how accounting works. These principles are recognized in all of our
Philippine accounting solutions.

Steps of the Accounting Cycle

1. Analyze and measure transactions.
Obviously in this phase, your business collects their transactions for
analysis, measurement, and recording. But here's the first hang-up:
what do you have to record?

As a general rule of thumb, a business should minimally record:

1. All cash sales.

2. All purchases (no matter how small).
3. Anything that's measurable, relevant, or reliable.
4. All events:
o External transactions: are between the entity and its environment,
such as exchanges with another company or a change in the cost of
goods your business purchases.
o Internal transactions: are exchanges that occur within the
organization.
In short, a company records as many transactions as possible that
affect its financial position.
 2. Record transactions in the journal.
This is also known as journalizing. A journal chronologically lists
transactions and other events in terms of debits and credits to
accounts. Each journal entry consists of four parts:

1. The accounts and amounts to be debited.

2. The accounts and amounts to be credited.
3. The date of transaction.
4. A transaction explanation.

3. Post information from the journal to the

ledger.
This is the act of transferring information from the journal to the ledger.
Posting is needed in order to have a complete record of all accounting
transactions in the general ledger, which is used to create a
company's financial statements.

4. Prepare an unadjusted trial balance.

The unadjusted trial balance is a list of the accounts and their
balances at a given time, before any adjusting entries are made to
create financial statements. The accounts are listed in the order which
they appear in the ledger, with debit balances listed in the left column
and credit balances in the right column. The totals of these two
columns must match.

5. Preparing adjusting entries.

Adjusting entries are journal entries recorded at the end of an
accounting period that alter the final balances of various general
ledger accounts. These adjustments are made in order to more
closely align the reported results and the actual financial position of a
business. Adjusting entries follow the principles of revenue recognition
and matching.

6. Prepare an adjusted trial balance.

After journalizing and posting all adjusting entries, many businesses
prepare another trial balance from their ledger and accounts. This is
called the adjusted trial balance. It shows the balance of all accounts,
including those adjusted, at the end of the accounting period.
Therefore, the end result of this adjusted trial balance demonstrates
the effects of all financial events that occurred during that particular
reporting period.

7. Prepare financial statements.

Financial statements can be prepared directly from the adjusted trial
balance. A financial statement is an organization's financial results,
condition, and cash flow.

8. Prepare closing entries.

In the closing phase, temporary balances are reduced to zero in order
to prepare the accounts for the next period's transactions. This
process empties the entity's temporary accounts and deposits
anything remaining into a permanent account.

9. Prepare a post-closing trial balance.

The post-closing balance consists only of assets, liabilities, and
owners' equity, also known as real or permanent accounts. This
balance provides evidence that the company has properly journalized
and accurately posted the closing entries.

Now that your company has performed a complete accounting cycle,

it's ready for the next reporting period.
 Basic Accounting Formula

The basic accounting formula forms the logical basis for double entry
accounting. The formula is:

Assets = Liabilities + Shareholders' Equity

The three components of the basic accounting formula are:

Assets. These are the tangible and intangible assets of a business, such as cash,
accounts receivable, inventory, and fixed assets.
Liabilities. These are the obligations of a business to pay its creditors, such as
for accounts payable, accrued wages, and loans.
Shareholders' equity. This is funds obtained from investors, as well as
accumulated profits that have not been distributed to investors.
In essence, a business uses liabilities and shareholders' equity to obtain
sufficient funding for the assets its needs to operate.

The basic accounting formula must balance at all times. If not, a journal
entry was entered incorrectly, and must be fixed before financial
statements can be issued. This balancing requirement is most easily seen in
the balance sheet (also known as the statement of financial position), where the
total of all assets must equal the combination of all liabilities and all
shareholders' equity.

The basic accounting formula is one of the fundamental underpinnings of

accounting, since it forms the basis for the recordation of all accounting
transactions. In essence, if both sides of the basic accounting formula do not
match at all times, there is an error in the accounting system that must be
corrected.

The following table shows how a number of typical accounting transactions

are recorded within the framework of the accounting equation:

Balance sheets: the basics

A balance sheet is a financial statement at a given point in time. It provides
a snapshot summary of what a business owns or is owed.

It states what assets the business ownes and what it owes liabilities, at a
particular date.

The balance sheet is uded to show how the business is being funded and
how those funds are being used.

The balance sheet is used in three ways:

for reporting purposes (limited company's annual accounts)

help interested parties assess the worth of your business at a given

moment - such as investors, creditors or shareholders

helps you analyse and improve the management of your business

You must consider who is the best person to produce balance sheets and
when. This document shows the different elements to inlude in a balance
sheet and and how to use the information from to assess and manage
business performance.

Who must produce a balance sheet?

Limited companies and limited liability partnerships must produce a

balance sheet as part of their annual accounts.

The balance sheet will then need to be submitted to:

Companies House

HM Revenue & Customs (HMRC)

shareholders - unless agreed otherwise

The other annual document you must produce is the profit and loss account.
Other parties who may wish to see the accounts are:

potential investors or lenders (banks)

potential purchasers of the business

employees

trade unions

There are strict deadlines for submitting annual accounts and returns to
Companies House and HMRC - penalties will apply if they are received late.
Their websites can be found in the useful links section.

Other business structures

Self-employed people, partners and partnerships are not required to submit

formal accounts and balance sheets on their tax return. You should still
produce a balance sheet so that you are aware of your business activity.

Contents of the balance sheet

A balance sheet shows:

1. fixed assets - long-term

2. current assets - short-term

3. current liabilities - what the business owes and must repay in the short term

4. long-term liabilities - including owner's or shareholders' capital

The balance sheet is so-called because there is a debit entry and a credit
entry for everything, so the total value of the assets is always the same
value as the total of the liabilities.

Fixed assets
 tangible assets - eg buildings, land, machinery, computers, fixtures and
fittings. Show them at their resale value.

intangible assets - eg goodwill, intellectual property rights (such as patents,

trademarks and website domain names) and long-term investments

Current assets

These are short-term assets whose value can fluctuate from day to day.

For example:

stock

work in progress

money owed by customers

cash in hand or at the bank

short-term investments

pre-payments - eg advance rents

Current liabilities

These are amounts owed to you and due within one year. These include:

money owed to suppliers

short-term loans, overdrafts or other finance

taxes due within the year - VAT, PAYE (Pay As You Earn) and National
Insurance

Long-term liabilities include:

creditors due after one year - the amounts due to be repaid in loans or
financing after one year, eg bank or directors' loans, finance agreements
 capital and reserves - share capital and retained profits, after dividends (if
your business is a limited company), or proprietors capital invested in
business (if you are an unincorporated business)

By law the balance sheet must include the elements shown above in bold.
However, what each includes will vary from business to business. The
firm's external accountant will usually decide how to present the information,
although if you have a qualified accountant on staff, they may make this
decision.

Interpreting balance sheet figures

A balance sheet shows:

how solvent the business is

how liquid its assets are - how much is in the form of cash or can be easily
converted into cash, ie stocks and shares

how the business is financed

how much capital is being used

A balance sheet is only a snapshot of a business' financial position on one

particular day. The individual figures can change dramatically in a short
space of time but the total net assets (assets less liabilities) would only
change dramatically if the business was making large profits or losses. For
example:

If you hold large inventories of finished products, a change in market

conditions might mean their value is reduced. You may even need to sell at a
loss.

Customers sometimes have payment problems. If they are unable to pay,

you may need to revalue your assets by making allowances for bad debts.
Current liabilities - money you owe

This section might include money owed for goods or services received but
not yet paid for.

Debtors - money owed to you

This figure assumes that debtors will pay up on time. Where there are
doubts about being paid, a provision can be made to reduce the value of the
debts in the business' accounts.

Intangible assets

The value of goodwill, patents and intellectual property can fluctuate with
market trends, so the balance sheet value should be updated annually.

Fixed assets

These are shown at their depreciated rates. There are two main approaches
to calculating depreciation of an asset:

Write off the same charge over the calculated life of the asset. For example,
you may decide that a computer bought for 2,000 has a useful life of five
years and that you will write off 20 per cent of its value each year.

Apply a steeper depreciation rate in the first few years of an asset's value.
For example, you may decide to offset 30 per cent of the value of the same
computer in the first two years, 20 per cent in the third year and 10 per cent
in the final two years. This method may allow your business to keep pace
with trends in the market value and replacement cost of assets where value
falls rapidly at the beginning.

Depreciation costs must be realistic and you may wish to approach your
accountant for further help.
You cannot offset the annual depreciation charge against taxable profits, but
you can claim capital allowances, using rates fixed by HM Revenue &
Customs.

Relationship between balance sheet and profit and loss account

The profit and loss (P&L) account summarises a business' trading

transactions - income, sales and expenditure - and the resulting profit or
loss for a given period.

The balance sheet, by comparison, provides a financial snapshot at a

given moment. It doesn't show day-to-day transactions or the current
profitability of the business. However, many of its figures relate to or are
affected by the state of play with P&L transactions on a given date.

Any profits not paid out as dividends are shown in the retained profit
column on the balance sheet.

The amount shown as cash or at the bank under current assets on the
balance sheet will be determined in part by the income and expenses
recorded in the P&L. For example, if sales income exceeds spending in the
quarter preceding publication of the accounts, all other things being equal,
current assets will be higher than if expenses had outstripped income over
the same period.

If the business takes out a short-term loan, this will be shown in the
balance sheet under current liabilities, but the loan itself won't appear in the
P&L. However, the P&L will include interest payments on that loan in its
expenditure column - and these figures will affect the net profitability figure
or bottom line.
Using balance sheet and P&L figures to assess performance

Many of the standard measures used to assess the financial health of a

business involve comparing figures on the balance sheet with those on the
P&L.

Compare balance sheets to assess business performance

There are some simple balance sheet comparisons you can make to assess
the strength or performance of your business against earlier periods, or
against direct competitors. The figures you study will vary according to the
nature of the business. Some comparisons draw on figures from the profit
and loss (P&L) account.

Internal comparisons

If inventory (stock) levels are rising from one period to the next, but
sales in your P&L are not, some of your stock might be out of date. You may
also have a cashflow problem developing.

If the amount trade debtors owe you is growing faster than sales, it could
indicate poor internal credit controls. Find out whether any of your
customers are having problems with cashflow, which could pose a threat to
your business.

A positive relationship with your trade creditors is essential. Key to this is

managing your cashflow well, so that payments can be made on time. For
example, trade creditors are more likely to be flexible about extending terms
of credit if you have built up a good payment record.

Making early payments may qualify you for a discount. However, early
payment for the sake of it will have a negative impact on your cashflow.
Good payment controls will help prevent imbalances in what you owe
suppliers and in levels of stock and inventory.

Borrowing as a percentage of overall financing (gearing) is

important - the lower the figure, the stronger your business is financially.
It's common for start-up businesses to have high borrowing requirements,
but if the gearing figure reaches 50 per cent you may have difficulty getting
further loans.

External comparisons

You can also compare the above balance sheet figures with those of direct or
successful competitors to see how you measure up. This exercise will
highlight weaknesses in your business operation that may need attention. It
will also confirm strong business performance.

Use accounting ratios to assess business performance

Ratio analysis is a good way to evaluate the financial results of your

business in order to gauge its performance. Ratios allow you to compare
your business against different standards using the figures on your balance
sheet.

Accounting ratios can offer an invaluable insight into a business'

performance. Ensure that the information used for comparison is accurate -
otherwise the results will be misleading.

There are four main methods of ratio analysis - liquidity, solvency, efficiency
and profitability.
Liquidity ratios

There are three types of liquidity ratio:

Current ratio - current assets divided by current liabilities. This assesses

whether you have sufficient assets to cover your liabilities. A ratio of two shows
you have twice as many current assets as current liabilities.

Quick or acid-test ratio - current assets (excluding stock) divided by current

liabilities. A ratio of one shows liquidity levels are high - an indication of solid
financial health.

Defensive interval - liquid assets divided by daily operating expenses. This

measures how long your business could survive without cash coming in. This
should be between 30 and 90 days.

Solvency ratios

Gearing is a sign of solvency. It is found by dividing loans and bank

overdrafts by equity, long-term loans and bank overdrafts.

The higher the gearing, the more vulnerable the company is to increasing
interest rates. Most lenders will refuse further finance where gearing
exceeds 50 per cent.

Efficiency ratios

There are three types of efficiency ratio:

Debtors' turnover - average of credit sales divided by the average level of

debtors. This shows how long it takes to collect payments. A low ratio may
mean payment terms need tightening up.

Creditors' turnover - average cost of sales divided by the average amount of

credit that is taken from suppliers. This shows how long your business takes to
pay suppliers. Suppliers may withdraw credit if you regularly pay late.
 Stock turnover - average cost of sales divided by the average value of stock.
This ratio indicates how long you hold stock before selling. A lower stock
turnover may mean lower profits.

Profitability ratios

Divide net profit before income tax by the total value of capital employed to
see how good your return on the capital used in your business is. This can
then be compared to what the same amount of money (loans and shares)
would have earned on deposit or in the stock market.

Accounting periods

A balance sheet normally reflects a business' position on its Accounting

Reference Date (ARD), which is the last day of its accounting reference
period. The accounting reference period, also known as the financial year, is
usually 12 months. However, it can be longer or shorter in the first year of
trading, or if the ARD is subsequently changed for some reason.

Companies House automatically sets the first ARD. Thus the end of the first
financial year is the first anniversary of the last day of the month in which
the company was formed. If you decide to change this, you will need to
notify Companies House.

You should also notify HM Revenue & Customs (HMRC) if you change your
ARD.

Internal accounts
Your business may decide to draw up accounts to help you monitor business
performance as frequently as monthly. In this case the figures - often known as
management accounts - are for internal use only. You do not need to file them with
Companies House or HMRC.
Introduction to the Accounting
Equation
From the large, multi-national corporation down to the corner beauty salon, every business
transaction will have an effect on a company's financial position. The financial position of a company
is measured by the following items:

1. Assets (what it owns)

2. Liabilities (what it owes to others)
3. Owner's Equity (the difference between assets and liabilities)

The accounting equation (or basic accounting equation) offers us a simple way to understand how
these three amounts relate to each other. The accounting equation for a sole proprietorship is:

The accounting equation for a corporation is:

Assets are a company's resourcesthings the company owns. Examples of assets include cash,
accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and
goodwill. From the accounting equation, we see that the amount of assets must equal the combined
amount of liabilities plus owner's (or stockholders') equity.

Liabilities are a company's obligationsamounts the company owes. Examples of liabilities include
notes or loans payable, accounts payable, salaries and wages payable, interest payable, and
income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two
ways:

(1) as claims by creditors against the company's assets, and

(2) a sourcealong with owner or stockholder equityof the company's assets.

Owner's equity or stockholders' equity is the amount left over after liabilities are deducted from assets:

Assets - Liabilities = Owner's (or Stockholders') Equity.

Owner's or stockholders' equity also reports the amounts invested into the company by the owners
plus the cumulative net income of the company that has not been withdrawn or distributed to the
owners.
If a company keeps accurate records, the accounting equation will always be "in balance," meaning
the left side should always equal the right side. The balance is maintained because every business
transaction affects at least two of a company's accounts. For example, when a company borrows money
from a bank, the company's assets will increase and its liabilities will increase by the same amount.
When a company purchases inventory for cash, one asset will increase and one asset will decrease.
Because there are two or more accounts affected by every transaction, the accounting system is
referred to as double-entry accounting.

A company keeps track of all of its transactions by recording them in accounts in the
company's general ledger. Each account in the general ledger is designated as to its type: asset,
liability, owner's equity, revenue, expense, gain, or loss account.

We created a visual tutorial to demonstrate how a variety of transactions will affect the accounting equation
and the financial statements. It is available in AccountingCoach PRO along with test questions that pertain to
the accounting equation.

Balance Sheet and Income Statement

The balance sheet is also known as the statement of financial position and it reflects the accounting
equation. The balance sheet reports a company's assets, liabilities, and owner's (or stockholders')
equity at a specific point in time. Like the accounting equation, it shows that a company's total
amount of assets equals the total amount of liabilities plus owner's (or stockholders') equity.

The income statement is the financial statement that reports a company's revenues and expenses and
the resulting net income. While the balance sheet is concerned with one point in time, the income
statement covers a time intervalor period of time. The income statement will explain part of the
change in the owner's or stockholders' equity during the time interval between two balance sheets.

Examples
In our examples in the following pages of this topic, we show how a given transaction affects the
accounting equation. We also show how the same transaction affects specific accounts by providing
the journal entry that is used to record the transaction in the company's general ledger.

Our examples will show the effect of each transaction on the balance sheet and income statement.
Our examples also assume that the accrual basis of accounting is being followed.

Parts 2 - 6 illustrate transactions involving a sole proprietorship.

Parts 7 - 10 illustrate almost identical transactions as they would take place in a corporation.

Accounting Equation for a Sole

Proprietorship: Transactions 12
We present nine transactions to illustrate how a company's accounting equation stays in balance.

When a company records a business transaction, it is not entered into an accounting equation, per
se. Rather, transactions are recorded into specific accounts contained in the company's general
ledger. Each account is designated as an asset, liability, owner's equity, revenue, expense, gain, or
loss account. The general ledger accounts are then used to prepare the balance sheets and income
statements throughout the accounting periods.

In the examples that follow, we will use the following accounts:

Cash
Accounts Receivable
Equipment
Notes Payable
Accounts Payable
J. Ott, Capital
J. Ott, Drawing
Service Revenues
Advertising Expense
Temp Service Expense

(To view a more complete listing of accounts for recording transactions, see the Explanation of Chart
of Accounts.)

Sole Proprietorship Transaction #1.

Let's assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On
December 1, 2016, J. Ott invests personal funds of $10,000 to start ASC. The effect of this
transaction on ASC's accounting equation is:

As you can see, ASC's assets increase by $10,000 and so does ASC's owner's equity. As a result,
the accounting equation will be in balance.

You can interpret the amounts in the accounting equation to mean that ASC has assets of $10,000
and the source of those assets was the owner, J. Ott. Alternatively, you can view the accounting
equation to mean that ASC has assets of $10,000 and there are no claims by creditors (liabilities)
against the assets. As a result, the owner has a claim for the remainder or residual of $10,000.

This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,
Capital. The general journal entry to record the transactions in these accounts is:
After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASC's
financial position at the end of December 1, 2016:

The purpose of an income statement is to report revenues and expenses. Since ASC has not yet
earned any revenues nor incurred any expenses, there are no transactions to be reported on an
income statement.

Sole Proprietorship Transaction #2.

On December 2, 2016 J. Ott withdraws $100 of cash from the business for his personal use. The
effect of this transaction on ASC's accounting equation is:

The accounting equation remains in balance since ASC's assets have been reduced by $100 and so
has the owner's equity.

This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,
Drawing. The general journal entry to record the transactions in these accounts is:

Since the transactions of December 1 and 2 were each in balance, the sum of both transactions
should also be in balance:
The totals indicate that ASC has assets of $9,900 and the source of those assets is the owner of the
company. You can also conclude that the company has assets or resources of $9,900 and the only
claim against those resources is the owner's claim.

The December 2 balance sheet will communicate the company's financial position as of midnight on
December 2:

Withdrawals of company assets by the owner for the owner's personal use are known as "draws."
Since draws are not expenses, the transaction is not reported on the company's income statement.

Accounting Equation for a Sole

Proprietorship: Transactions 34
Sole Proprietorship Transaction #3.

On December 3, 2016 Accounting Software Co. spends $5,000 of cash to purchase computer
equipment for use in the business. The effect of this transaction on the accounting equation is:
The accounting equation reflects that one asset increases and another asset decreases. Since the
amount of the increase is the same as the amount of the decrease, the accounting equation
remains in balance.

This transaction is recorded in the asset accounts Equipment and Cash. Equipment increases by
$5,000, and Cash decreases by $5,000. The general journal entry to record the transactions in
these accounts is:

The combined effect of the first three transactions is shown here:

The totals tell us that the company has assets of $9,900 and the source of those assets is the
owner of the company. It also tells us that the company has assets of $9,900 and the only claim
against those assets is the owner's claim.

The balance sheet dated December 3, 2016 will reflect the financial position as of midnight on
December 3:
The purchase of equipment is not an immediate expense. It will become part of depreciation
expense only after it is placed into service. We will assume that as of December 3 the equipment
has not been placed into service, therefore, no expense will appear on an income statement for
the period of December 1 through December 3.

Sole Proprietorship Transaction #4.

On December 4, 2016 ASC obtains $7,000 by borrowing money from its bank. The effect of this
transaction on the accounting equation is:

As you can see, ASC's assets increase and ASC's liabilities increase by $7,000.

This transaction is recorded in the asset account Cash and the liability account Notes Payable as
shown in this accounting entry:
The combined effect on the accounting equation from the first four transactions is available here:

The totals indicate that the transactions through December 4 result in assets of $16,900. There
are two sources for those assetsthe creditors provided $7,000 of assets, and the owner of the
company provided $9,900. You can also interpret the accounting equation to say that the
company has assets of $16,900 and the lenders have a claim of $7,000 and the owner has a claim
for the remainder.

The balance sheet dated December 4 will report ASC's financial position as of that date:
The proceeds of the bank loan are not considered to be revenue since ASC did not earn the
money by providing services, investing, etc. As a result, there is no income statement effect from
this transaction.

Accounting Equation for a Sole

Proprietorship: Transactions 56
Sole Proprietorship Transaction #5.

On December 5, 2016 Accounting Software Co. pays $600 for ads that were run in recent days. The
effect of this advertising transaction on the accounting equation is:

Since ASC is paying $600, its assets decrease. The second effect is a $600 decrease in owner's
equity, because the transaction involves an expense. (An expense is a cost that is used up or its
future economic value cannot be measured.)

Although owner's equity is decreased by an expense, the transaction is not recorded directly into the
owner's capital account at this time. Instead, the amount is initially recorded in the expense account
Advertising Expense and in the asset account Cash.

The general journal entry to record the transaction is:

The combined effect of the first five transactions is available here:

The totals now indicate that Accounting Software Co. has assets of $16,300. The creditors provided
$7,000 and the owner of the company provided $9,300. Viewed another way, the company has
assets of $16,300 with the creditors having a claim of $7,000 and the owner having a residual claim
of $9,300.

The balance sheet as of the end of December 5, 2016 is:

**The income statement (which reports the company's revenues, expenses, gains, and losses during a specified
time interval) is a link between balance sheets. It provides the results of operationsan important part of the
change in owner's equity.
Since this transaction involves an expense, it will involve ASC's income statement. The company's
income statement for the first five days of December is:

Sole Proprietorship Transaction #6.

On December 6, 2016 ASC performs consulting services for its clients. The clients are billed for the
agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting
equation is:

Since ASC has performed the services, it has earned revenues and it has the right to receive $900
from the clients. This right (known as an account receivable) causes assets to increase. The earning
of revenues causes owner's equity to increase.

Although revenues cause owner's equity to increase, the revenue transaction is not recorded into the
owner's capital account at this time. Rather, the amount earned is recorded in the revenue account
Service Revenues. This will allow the company to report the revenues on its income statement at
any time. (After the year ends, the amount in the revenue account will be transferred to the owner's
capital account.)

The general journal entry to record the transaction is:

The combined effect of the first six transactions can be viewed here:
The totals tell us that at the end of December 6, the company has assets of $17,200. It also shows
the sources of the assets: creditors providing $7,000 and the owner of the company providing
$10,200. The totals also reveal that the company has assets of $17,200 and the creditors have a
claim of $7,000 and the owner has a claim for the remaining $10,200.

Below is the balance sheet as of midnight on December 6:

**The income statement (which reports the company's revenues, expenses, gains, and losses during a specified
time interval) is a link between balance sheets. It provides the results of operationsan important part of the
change in owner's equity.

The Income Statement for Accounting Software Co. for the period of December 1 through December
6 is:
Accounting Equation for a Sole
Proprietorship: Transactions 78
Sole Proprietorship Transaction #7.

On December 7, 2016 ASC uses a temporary help service for 6 hours at a cost of $20 per hour.
ASC will pay the invoice when it is due in 10 days. The effect on its accounting equation is:

ASC's liabilities increase by $120 and the expense causes owner's equity to decrease by $120.

The liability will be recorded in Accounts Payable and the expense will be reported in Temp Service
Expense. The journal entry for recording the use of the temp service is:

The effect of the first seven transactions on the accounting equation can be viewed here:
The totals show us that the company has assets of $17,200 and the sources are the creditors with
$7,120 and the owner of the company with $10,080. The accounting equation totals also tell us that
the company has assets of $17,200 with the creditors having a claim of $7,120. This means that the
owner's residual claim is $10,080.

The financial position of ASC as of midnight on December 7, 2016 is:

**The income statement (which reports the company's revenues, expenses, gains, and losses for a specified
time interval) is a link between balance sheets. It provides the results of operationsan important part of the
change in owner's equity.

Accounting Software Co.'s income statement for the first seven days of December is:

Sole Proprietorship Transaction #8.

On December 8, 2016 ASC receives $500 from the clients it had billed on December 6, 2016. The
collection of accounts receivables has this effect on the accounting equation:

The company's asset (cash) increases and another asset (accounts receivable) decreases.
Liabilities and owner's equity are unaffected. (There are no revenues on this date. The revenues
were recorded when they were earned on December 6.)

The general journal entry to record the increase in Cash, and the decrease in Accounts Receivable
is:

The combined effect of the first eight transactions is shown here:

The totals for the first eight transactions indicate that the company has assets of $17,200. The
creditors provided $7,120 and the owner provided $10,080. The accounting equation also indicates
that the company's creditors have a claim of $7,120 and the owner has a residual claim of $10,080.

ASC's balance sheet as of midnight December 8, 2016 is:

**The income statement (which reports the company's revenues, expenses, gains, and losses during a specified
period of time) is a link between balance sheets. It provides the results of operationsan important part of the
change in owner's equity.
The income statement for ASC for the eight days ending on December 8 is shown here:

Double-entry system
Every transaction has two effects. For example, if someone transacts a
purchase of a drink from a local store, he pays cash to the shopkeeper and in
return, he gets a bottle of dink. This simple transaction has two effects from
the perspective of both, the buyer as well as the seller. The buyer's cash
balance would decrease by the amount of the cost of purchase while on the
other hand he will acquire a bottle of drink. Conversely, the seller will be one
drink short though his cash balance would increase by the price of the drink.

Accounting attempts to record both effects of a transaction or event on the

entity's financial statements. This is the application of double entry concept.
Without applying double entry concept, accounting records would only reflect
a partial view of the company's affairs. Imagine if an entity purchased a
machine during a year, but the accounting records do not show whether the
machine was purchased for cash or on credit. Perhaps the machine was
bought in exchange of another machine. Such information can only be gained
from accounting records if both effects of a transaction are accounted for.
Traditionally, the two effects of an accounting entry are known as Debit (Dr)
and Credit (Cr). Accounting system is based on the principal that for every
Debit entry, there will always be an equal Credit entry. This is known as the
Duality Principal.

Debit entries are ones that account for the following effects:

Increase in assets

Increase in expense

Decrease in liability

Decrease in equity

Decrease in income

Credit entries are ones that account for the following effects:

Decrease in assets

Decrease in expense

Increase in liability

Increase in equity

Increase in income

Double Entry is recorded in a manner that the Accounting Equation is always

in balance.

Assets - Liabilities = Capital

Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or

increase in liability or equity (Cr) and vice-versa. Hence, the accounting
equation will still be in equilibrium.

Examples of Double Entry

1. Purchase of machine by cash
Debit Machine Increase in Asset

Credit Cash Decrease in Asset

2. Payment of utility bills

Debit Utility Expense Increase in Expense

Credit Cash Decrease in Asset

3. Interest received on bank deposit account

Debit Cash Increase in Asset

Credit Finance Income Increase in Income

4. Receipt of bank loan principal

Debit Cash Increase in Asset

Credit Bank Loan Increase in Liability

5. Issue of ordinary shares for cash

Debit Cash Increase in Asset

Credit Share Capital Increase in Equity

What are debits and credits?

Debit and Credit are the respective sides of an account.

Debit refers to the left side of an account.

Credit refers to the right side of an account.

Explanation
In accounting, every account or statement (e.g. accounting ledger, trial
balance, profit and loss account, balance sheet) has 2 sides known as debit
and credit.

In a typical accounting ledger (often referred to as a T-Account) the debit and

credit sides are split horizontally as shown below:

XYZ Receivable A/C

Date Particulars $ Date Particulars

01-Dec-14 Sales 12,500 10-Dec-14 Discount allowed

10-Dec-14 Bank

12,500

Debit Side Credit Side

According to the dual aspect principle, each accounting entry is recorded in 2

equal debit and credit portions. In other words, the total amount that will be
recorded in the left side (debit) of accounting ledgers will always equal to the
total amount recorded on the right side (credit).

For example, you may consider how the accounting entries have been
recorded in the Receivable A/C shown above.

The ledger has been debited on account of credit sales amounting $12,500
and (as can be ascertained from the particulars) the same amount has
been credited in the Sales A/C. Similarly, the credit entries in the Receivable
A/C relating to discount allowed and bank receipts are matched with equal
amounts recorded on the debit sides of Discount Allowed A/C and Bank A/C
respectively.

In case of any confusion, please refer Accounting for Sales section for more
thorough explanation of the accounting entries discussed above.

Now the question arises, how do we know what to record on the debit side
of an account and what to record on the credit side?

Accounting has specific rules regarding what should be debited and what
should be credited as summarized in the chart below:

Debit Entries account for: Credit Entries account for

Increase in assets Decrease in assets

Increase in expenses Decrease in expenses

Decrease in liabilities Increase in liabilities

Decrease in income Increase in income

Decrease in equity Increase in equity

Assets, expenses, liabilities, income & equity are the 5 elements of financial
statements. For explanation and examples of the various elements, please
refer elements of financial statements section.

As with accounting ledgers, all accounting statements are based on the rules
of debit and credit. For example, in a balance sheet, assets are reported on
the debit side whereas liabilities and equity are presented on the credit side.
Although traditional accounts and statements are presented in a T-Account
format as above (which makes understanding debits and credits a bit easier
for beginners) many accounts and statements nowadays are reported in
a vertical format.

But fear not! As long as you master the rules of debit and credit, you shall
have no problem in understanding their application and presentation.

Example
Record the debit and credit entries of the following transactions:

a) Purchase of an office building for $1 million via funds transfer

b) Bonus payable to various employees amounting $5 million

c) Credit Sales during the period amounting $7 million

d) Issuance of ordinary shares at par for $10 million

a) Purchase of an office building

Account $ Effe

Debit Office Building 1,000,000 Increase i

Credit Bank 1,000,000 Decrease i

b) Performance Bonus

Account $ Effe

Debit Salaries, wages and benefits 5,000,000 Increase in

 Credit Bonus Payable 5,000,000 Increase in

c) Credit Sales

Account $ Effe

Debit Accounts Receivables 7,000,000 Increase i

Credit Sales Revenue 7,000,000 Increase in

d) Issuance of ordinary shares

Account $ Effe

Debit Bank 10,000,000 Increase i

Credit Share Capital 10,000,000 Increase i

If you face any problem in understanding the double entries, please

refer double entry accounting section.

Ledger Accounts

Home >
Double Entry Accounting >
Ledger Accounts

Accounting Entries are recorded in ledger accounts. Debit entries are made
on the left side of the ledger account whereas Credit entries are made to the
right side. Ledger accounts are maintained in respect of every component of
the financial statements. Ledger accounts may be divided into two main types:
balance sheet ledger accounts and income statement ledger accounts.

Balance Sheet Ledger Accounts

Balance Sheet ledger accounts are maintained in respect of each asset,
liability and equity component of the statement of financial position.

Following is an example of a receivable ledger account:

Receivable Account

Debit $ Credit

Balance b/d 1 500 Cash 3

Sales 2 1,000 Balance c/d 4

1,500

Balance brought down is the opening balance is in respect of the

receivable at the start of the accounting period.

These are credit sales made during the period. Receivables account is
debited because it has the effect of increasing the receivable asset. The
corresponding credit entry is made to the Sales ledger account. The
account in which the corresponding entry is made is always shown next
to the amount, which in this case is the Sales ledger.

This is the amount of cash received from the debtor. Receiving cash
has the effect of reducing the receivable asset and is therefore shown
 on the credit side. As it can seen, the corresponding debit entry is made
in the cash ledger.

This represents the balance due from the debtor at the end of the
accounting period. The figure has been arrived by subtracting the
amount shown on the credit side from the sum of amounts shown on the
debit side. This accounting period's closing balance is being carried
forward as the opening balance of the next period.

Similar ledger accounts can be made for other balance sheet components
such as payables, inventory, equity capital, non current assets and so on.

Income Statement Ledger Accounts

Income statement ledger accounts are maintained in respect of incomes and
expenditures.

Following is an example of electricity expense ledger:

Electricity Expense Account

Debit $ Credit

Cash 1 1,000 Income Statement 2

1,000

This is the amount of cash paid against electricity bill. The expense
ledger is being debited to account for the increase in expense. The
corresponding credit entry has been made in the cash ledger.

This represents the amount of expense charged to the income

statement. The balance in the ledger has been recycled to the income
statement which is being debited by the same amount. Unlike balance
sheet ledger accounts, there is no balance brought down or carried
forward. Instead, the income statement ledger is closed each
accounting period end with the balancing figure representing the charge
to income statement.
Similar ledger accounts can be made for other income statement components.

Accounting Equation

Home >

Double Entry Accounting >

Accounting Equation

Double entry is recorded in a manner that the accounting equation is always

in balance:

Assets = Liabilities + Equity

Assets of an entity may be financed either by external borrowing (i.e.

Liabilities) or from internal sources of finance such as share capital and
retained profits (i.e. Equity). Therefore, assets of an entity will always equal to
the sum of its liabilities and equity.

The accounting equation may be re-arranged as follows:

Assets - Liabilities = Equity

We may test the Accounting Equation by incorporating the effects of several

transactions to see whether it still balances as theorized in the accountancy
literature. For the purpose of this test, we may classify accounting transaction
into the following generic types:

1. Transactions that only affect Assets of the entity

2. Transactions that affect Assets and Liabilities of the entity
3. Transactions that affect Assets and Equity of the entity
4. Transactions that affect Liabilities and Equity of the entity

Note:

For all the examples on the next pages, it will be assumed that before any
transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are
$5,000 each.
Accounting Equation

Home >

Double Entry Accounting >

Accounting Equation

Transactions that only affect Assets of the entity

These transactions result in an increase in one asset which is equally offset
by a decrease in another asset and vice versa.

Since Assets, and other components of the equation, will be the same as
before the transaction, the Accounting Equation will be in equilibrium.

Example 1
ABC LTD purchases a machine costing $1000 for cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000* - Liabilities $5,000 = Equity $5,000

* Assets $10,000 = $10,000 Plus $1,000 (Machine) Less $1,000 (Cash)

Example 2
ABC LTD receives $500 cash from a receivable DEF LTD in respect of goods
sold on credit.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000* - Liabilities $5,000 = Equity $5,000

* Assets $10,000 = $10,000 Plus $500 (Cash) Less $500 (Trade Receivable)

Transactions that affect Assets and Liabilities of the

entity
These transactions result in the increase in Assets and Liabilities of the entity
simultaneously. Conversely, the transactions may cause a decrease in both
Assets and Liabilities of the entity.

Any increase in the assets will be offset by an equal increase in liabilities and
vice versa causing the Accounting Equation to balance after the transactions
are incorporated.

Example 1
ABC LTD receives $2,500 bank loan in cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $12,500* - Liabilities $7,500* = Equity $5,000

*Assets $12,500 = $10,000 Plus $2,500 (Cash)

*Liabilities $7,500 = $5,000 Plus $2,500 (Bank Loan)

Example 2
ABC LTD pays $500 cash to XYZ LTD for goods purchased on credit.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $9,500* - Liabilities $4,500* = Equity $5,000

*Assets $10,000 = $10,000 Less $500 (Cash)

*Liabilities $4,500 = $5,000 Less $500 (Trade Payable)

Transactions that affect Assets and Equity of the

entity
These transactions result in the increase in Assets and Equity of the entity
simultaneously. Conversely, the transactions may cause a decrease in both
Assets and Equity of the entity.

Any increase in the assets will be matched by an equal increase in equity and
vice versa causing the Accounting Equation to balance after the transactions
are incorporated.
Example 1
ABC LTD issues share capital for $2,500 in cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $12,500* - Liabilities $5,000 = Equity $7,500*

*Assets $12,500 = $10,000 Plus $2,500 (Cash)

*Equity $7,500 = $5,000 Plus $2,500 (Share Capital)

Example 2
ABC LTD pays dividend of $500 in cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $9,500* - Liabilities $5,000 = Equity $4,500*

*Assets $9,500 = $10,000 Less $500 (Cash)

*Equity $4,500 = $5,000 Less $500 (Divident)

ransactions that affect Liabilities and Equity of the

entity
These transactions result in the increase in Liabilities which is offset by an
equal decrease in Equity and vice versa.
Any increase in liability will be matched by an equal decrease in equity and
vice versa causing the Accounting Equation to balance after the transactions
are incorporated.

Example 1
ABC LTD incurs utility expense of $500 which remains unpaid at the period
end.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000 - Liabilities $5,500* = Equity $4,500*

*Liability $5,500 = $5,000 Plus $500 (Accrued Liability)

*Equity $4,500 = $5,000 Less $500 (Accrued Expense)

Example 2
ABC LTD recognizes rent income for the period of $500 which it received in
advance in the last accounting period.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000 - Liabilities $4,500* = Equity $5,500*

*Liabilities $4,500 = $5,000 Less $500 (Accrued Income)

*Equity $5,500 = $5,000 Plus $500 (Rent Income)

 Ordinary Share Capital represents equity of a company and therefore its
issuance is recorded as part of the equity reserves in the balance sheet.

Ordinary Shares are also known as common stock and equity shares.

Initial Issue
Issue of ordinary shares is accounted for by allocating the proceeds between
the following accounts:

To account for the proceeds from the issue of

Share Capital Account shares up totheir nominal value (face value).

To account for the proceeds from the issue of

Share Premium Account shares over and above their nominal value (face
value).

Following journal entries need to be recorded to account for the issue of

ordinary shares for cash:

Debit Bank The total amount of cash received.

Credit Share Capital Account Amount up to nominal value

Credit Share Premium Account Amount in exccess of nominal valu

Example 1
ABC PLC issued 1 million ordinary shares on 1 January 20X4 having face
value of $1 each at an issue price of $1.5 per share.

As per the terms of the issue, $1.25 per share had been received by the
Company on 1 January 20X4 while the remaining amount was received in full
on 30 June 20X4.

State the journal entries required to account for the above transactions.

Solution
1 Jan 20X4 Debit Bank $1,250,000 ($1.25 x 1 million)

Credit Share Capital $1,000,000 ($1.00 x 1 million)

Credit Share Premium $250,000 ($0.25 x 1 million)

30 June
Debit Bank $250,000 ($0.25 x 1 million)
20X4

Credit Share Premium $250,000 ($0.25 x 1 million)

Note

The total amount recognized in the share capital account is $1 million which
equates to the nominal value of the issued shares (i.e. $1 per share) whereas
the cash proceeds over and above the nominal value amounting $500,000
(i.e. $0.5 per share) has been credited to the share premium account.

Subscription Account
Company law of many jurisdictions such as USA and UK prohibit public
companies from issuing shares to investors before all legal requirements for
the issuance of shares have been met (e.g. minimum amount of subscription
mentioned in the prospectus must be received). If the requirements for the
issue of shares are not met, companies are obliged to return the subscription
money received from applicants (subscribers).

To account for the shares issue in such cases, it will be necessary to create a
temporary liability account (e.g. Subscription Account) in addition to the 2
accounts discussed above in order to account for the cash advanced in
respect of the subscription of shares until the date of issuance of shares or the
return of subscription money to applicants.

Following journal entries shall be recorded to account for the issue of ordinary
shares involving subscription account:

Debit Bank The total amount of cash received.

Credit Subscription Account The total amount of cash received t

recognized as liability.
 Liability is recognized because the
obliged to issue shares to applicant
shares are not to be issued, to retu
subscription money to applicants.

Amount of cash inflow in respect of

which have either been issued or w
amount has been returned to subsc
Debit Subscription Account
to for example unsuccessful applica
excess subscription, non-fulfillment
requirements for issue of shares, e

Credit Bank Amount returned to subscribers

Credit Share Capital Account Nominal value of shares issued

Amount in exccess of nominal valu

Credit Share Premium Account
shares issued

Example 2
ABC PLC offered 1 million ordinary shares for issue to public on 1 January
20X4 having face value of $1 each at an issue price of $1.5 per share.

ABC PLC requires the equity injection to finance a new project. The minimum
amount of subscription necessary for the project is $1,250,000.

As per the terms of the issue of shares, $1.5 per share was to be received in
full from the applicants on 30 November 20X3.

A total amount of $3,000,000 was received. The oversubscription of

$1,500,000 was returned to unsuccessful applicants on 20 December 20X3.

State the journal entries required to account for the above transactions.

Solution
 Total amount
30 Nov 20X3 Debit Bank $3,000,000
received

(Amount recognized
as a temporary
Credit Subscription Account $3,000,000 liability until issuance
of shares or refund to
applicants)

Amount of
oversubscription
20 Dec 20X3 Debit Subscription Account $1,500,000 returned to
unsuccessful
applicants)

Credit Bank $1,500,000

(This represents
subscription proceeds
30 June in respect of which
Debit Subscription Account $1,500,000
20X4 shares have been
alloted to succesful
applicants.)

(Nominal value of
Credit Share capital $1,000,000 issued shares $1 x 1
million)

(Proceeds from issue

of shares in excess of
Credit Share Premium $500,000
their face value $0.5
x 1 million)
Note:

As with Example 1, $1 million has been recognized in the share capital

account which equals to the face value of issued shares (i.e. $1 per share)
whereas the excess over the face value amounting $500,000 (i.e. $0.5 per
share) has been credited to the share premium account. Both equity accounts
have been credited on the date of issuance of shares (i.e. 1 Jan 20X4). The
subscription advance received on 30 Nov 20X4 had not been credited directly
to equity reserves until the actual issuance of shares.

Sales

Home >

Accounting for Sales >

Sales

Definition
Revenue is the gross inflow of economic benefits during the period
arising in the course of the ordinary activities of an entity when those
inflows result in increase in equity,other than increases relating to
contributions from equity participants (IAS 18).

Explanation
Sale Revenue is the gross inflow of economic benefits. It must not be netted
off against expenses. Sale is generated through the ordinary activities of the
business. Incomes generated through activities that are not part of the core
business operations of the business are not classified as sale revenue but are
classified instead as gains. For instance, sale revenue of a business whose
main aim is to sell biscuits is income generated from selling biscuits. If the
business sells one of its factory machines, income from the transaction would
be classified as a gain rather than sale revenue.

Sale revenue is an increase in equity during an accounting period except for

such increases caused by the contributions from owners (equity participants).
Sale revenue must result in increase in net assets (equity) of the entity such
as by inflow of cash or other assets. However, net assets of an entity may
increase simply by further capital investment by its owners even though such
increase in net assets cannot be regarded as sale revenue.

Sale revenue may arise from the following sources:

Sale of goods

Provision of services

Revenue from use of entity's assets by third parties such as interest,

royalties and dividends.

Accounting for Sales

As sale results in increase in the income and assets of the entity, assets must
be debited whereas income must be credited. A sale also results in the
reduction of inventory, however the accounting for inventory is kept separate
from sale accounting as will be further discussed in the inventory accounting
section.

A sale may be made on cash or on credit.

Cash Sales
When a cash sale is made, the following double entry is recorded:

Debit Cash

Credit Sales Revenue (Income Statement)

Cash is debited to account for the increase in cash of the entity.

Sale Revenue is credited to account for the increase in the income.

Credit Sale
In case of a credit sale, the following double entry is recorded:

Debit Receivables
 Credit Sales Revenue (Income Statement)

The double entry is same as in the case of a cash sale, except that a different
asset account is debited (i.e. receivable).

When the receivable pays his due, the receivable balance will have be
reduced to nil. The following double entry is recorded:

Debit Cash

Credit Receivables

Recognition of Sales
It may be confusing to identify the point when a sale occurs. Do we recognize
sale when the goods are dispatched to customers, when the customer
receives those goods, or when we receive the payment in respect of those
goods? In case of sale of goods, sale is generally said to occur when the
seller transfers the risks and rewards pertaining to the asset sold to the buyer.
This generally happens when buyer has received the asset. The receipt of
payment from the customer is not relevant to the recognition of sale since
income is recorded under the accruals basis.