Preliminary Lesson -- Selected Accounting Concepts

Some students enter ACC 220 with some fear -- perhaps because ACC 210 was not as successful as it might have been, or because it was taken some time ago.  In either case, it will be helpful to review a few techniques of the beginning class, to alleviate concerns, and to assure you that you need not know 100% of ACC 210;  rather, if you can process about a dozen transactions, and know how a general ledger is arranged, you should be able to successfully navigate ACC 220.

Basic Accounting Categories

The basic accounting categories are Assets, Liabilities, and Owner's Equity.  Assets are resources owned by a business, including Cash, Accounts Receivable, Inventory, Equipment, Buildings, and Patents.   Liabilities are debts owed by the business.  Examples include Accounts Payable, Notes Payable, and Bonds Payable.  Owner's Equity represents the Owner's share of the business.  Owner's Equity can be divided into the following categories:

1.      Owner's Capital -- the owner's share of the business (as opposed to the share supplied by creditors).

2.      Owner's Drawing -- the amounts that the owner has withdrawn from the business over a period of time;

3.      Revenues -- increases in Owner's Equity brought about through the operation of the business.  A doctor earns revenue by providing medical services; a hairdresser earns revenue by styling hair.

4.      Expenses -- decreases in Owner’s Equity brought about by operating the business.

Account Relationships

The fundamental Accounting Equation is:  ASSETS = LIABILITIES + OWNER'S EQUITY.  When a transaction happens, you must first decide whether an Asset increased or decreased; whether a Liability increased or decreased; or whether one or more Owner's Equity accounts increased or decreased.  You must visualize the increases and decreases -- only then can you determine how to apply debits and credits.  Here are the rules:

If an Asset account increases, record that increase with a debit;

If an Asset account decreases, record that decrease with a credit;

If a Liability account increases, record that increase with a credit;

If a Liability account decreases, record that decrease with a debit;

An increase in Owner's Equity is recorded with a credit.  Examples:

a.  Owner invests more money in the business; b. a Revenue is earned.

 

A decrease in Owner's Equity is recorded with a debit.  Examples:

a.  Owner draws money from the business; b. an Expense is incurred.

Presented below is a diagram which depicts clearly how a general ledger is set up, complete with account titles and the rules for debit and credit.

ASSETS

 

   =

LIABILITIES

+ 

OWNER’S EQUITY

 

 

Increases

DEBIT

 

Increases

CREDIT

 

Increases

CREDIT

 

 

Decreases

CREDIT

 

Decreases

DEBIT

 

Decreases

DEBIT

 

 

CASH

 

ACCTS PAYABLE

 

Jones Drawing

JONES, CAPITAL

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ACCTS RECEIV.

 

 

 

 

 

OPERATIONS

 

 

 

 

NOTES PAYABLE

 

Advertising Expense

Service Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Rent Expense

Utilities Expense

SUPPLIES

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EQUIPMENT

 

 

 

 

Salaries Expense

Supplies Expense

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Notice in the diagram, that once each account has been situated in one of the basic categories (Asset, Liability, Owner's Equity), the rules for debit and credit are automatic; for example, if the account is a liability, and that liability increases, you will always credit the liability account.  If an expense is incurred, the expense decreases Owner's Equity -- and must result in a debit to the expense account. 

Visualizing Transactions

Believe it or not, there really aren't that many transactions you have to remember.  Not counting merchandising transactions (those involving selling inventory), the following  is a good basic list of transactions to know by heart:

1.      Owner invests $15,000 of personal assets in the business.

2.      Company purchases $7000 of equipment for cash.

3.      Purchase of supplies on account (account payable), $1600.

4.      Providing services for cash, $1200.

5.      Purchase of advertising on account, $250.

6.      Services provided to a customer for cash ($1500) and $2000 on account (receivable).

7.      Payment of expenses in cash (Rent $600, Salaries $900, Utilities $200).

8.      Payment of an account payable ("payment on account"), $250.

9.      Receipt of cash on account, $600.

10.  Owner withdraws cash, $1300.

11.  Consuming of supplies, $400.  (This is an adjusting entry.)

As you might remember, each transaction is entered in a journal.  For example, transactions 1 and 2 would be journalized as follows: 

 

General Journal

Dr.

Cr.

Jan 1

Cash

15,000

 

 

         Jones, Capital

 

15,000

 

 

 

 

2

Equipment

7,000

 

 

         Cash

 

7,000

 

Trial Balance, Adjustments, and Financial Statements

Each journalized transaction is posted to the general ledger.  The T-accounts on the previous page adequately model a general ledger.  If you were to post the transactions (1-11) listed earlier (and you should), the postings would appear as follows: 

ASSETS

 

   =

LIABILITIES

    +

OWNER’S  EQUITY

 

 

Increases

DEBIT

 

Increases

CREDIT

 

Increases

CREDIT

 

 

Decreases

CREDIT

 

Decreases

DEBIT

 

Decreases

DEBIT

 

 

CASH

 

ACCTS PAYABLE

 

Jones, Drawing

JONES, CAP

15,000

7,000

 

250

1,600

 

1,300

 

 

15,000

1,200

1,700

 

 

250

 

 

 

 

 

1,500

1,300

 

 

 

 

 

 

 

 

600

250

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ACCTS RECEIV.

 

 

 

 

 

OPERATIONS

 

2,000

600

 

NOTES PAYABLE

 

Advertising Expense

Service Revenue

 

 

 

 

0

 

250

 

 

1,200

 

 

 

 

 

 

 

 

 

3,500

 

 

 

 

 

 

 

 

 

 

SUPPLIES

 

 

 

 

Rent Expense

Utilities Expense

1,600

400

 

 

 

 

600

 

200

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EQUIPMENT

 

 

 

 

Salaries Expense

Supplies Expense

7,000

 

 

 

 

 

900

 

400

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

An adjusted trial balance would then be computed.  This exercise is left to you.   

The financial statements could be modeled as follows:

1.      Net Income = Revenues - Expenses.  Verify that net income = $2350, the difference between 4700 and 2350.

2.      Ending Owner's Equity = Beginning Owner's Equity + Net Income - Drawings.  Verify that the Ending Owner's Equity = $16,050, computed as follows:  15,000 + 2350 - 1300 = $16,050.

3.      Balance Sheet Equation:  Assets = Liabilities + Owner's Equity.  Total Assets = 17,650; Total Liabilities = 1600; Total Owner's Equity (per computation in number 2 above) is $16,050.

Accounting Principles/GAAP

Once the framework of accounting is understood, there is a set of theoretical concepts that will assist you when you run into a transaction that no one thought of before.  Some common accounting principles are listed below: 

1.      The Cost Principle -- we record assets at their cost, and the cost is not adjusted to the market value that could be realized if the asset were sold;

2.      The Matching Principle -- An income statement should reflect the revenues earned, which should be matched with the expenses incurred;

3.      The Entity Assumption -- we don't mix up the transactions of the business with the private transactions of the owner's household;

4.      The Monetary Unit Assumption -- accounts are measured in dollars, and we assume that the purchasing power of the dollar is constant;

5.      The Periodicity Assumption -- the life of a business can be broken down into shorter periods -- years, quarters, months, weeks, etc. 

Please note that in financial accounting (ACC 210 and ACC 220) we focus solely upon accrual accounting, not cash-basis accounting.  This is a highly important point.  In accrual accounting, we record revenues when we earn them, not necessarily when cash is received.  Often, we receive cash payment before we perform the services, or some time after we perform the services. The revenue is recorded, however at the moment we provide the service. 

Similarly, under accrual accounting, expenses are recorded at the moment they are incurred; not necessarily when cash is paid.  For example, if an insurance policy is purchased on January 1 for the entire year, January's Insurance Expense is not fully incurred until the end of January, even though cash has already been paid out. 

Keep in mind that some expenses are recorded that do not involve cash payment at all.  A typical example is that of the adjusting entry for depreciation expense.  Suppose a piece of equipment is purchased for $10,000 and is expected to last ten years.  Depreciation could be allocated at the rate of $1,000 per year.  At the end of the first year, the following entry would be made:


General Journal

Dr.

Cr.

 

 

 

 

Dec 31

Depreciation Expense

1,000

 

 

          Accum. Depreciation, Equip.

 

1,000

The adjustment shown above recognizes the cost of equipment used up during the year.  The entry represents a reduction in Owner's Equity (the expense), and a reduction in Assets (the credit to the Accumulated Depreciation account).  No entry is made to the Cash account.  In fact, Cash is not affected in any of the adjustments that you learned in ACC 210. 

Looking Ahead to Acc 220

Of course, this rendition of  the accounting cycle is highly compressed and abbreviated.  The whole process is explained in painful detail in Chapters 1-4 of your text.  In ACC 220, we will not deal so much with the process of accounting (i.e., the Accounting Cycle).  Rather, there will be a focus on each of a number of account categories. 

If the examples shown thus far are understood, then the new accounts to be introduced in ACC 220, once placed into the framework, should be easier to grasp.  From the standpoint of topics and chapters, you could fit most of ACC 220's work into a Balance Sheet: 

ASSETS

 

LIABILITIES

 

OWNER'S EQUITY

 

Current Assets

 

Current Liabilities (Ch 11)

 

Partner's Equity  (Ch 13)

 

 

 

 

 

 

 

Investments (Ch 17)

 

Long Term Liabilities (Ch 16)

 

Stockholders' Equity

(Ch 14, 15)

 

 

 

 

 

 

 

Property Plant & Equipment (Ch 10)

 

 

 

 

 

At this point in your study, you have completed the chapters on the Accounting Cycle, as well as a separate chapter each on Cash, Accounts Receivable, and Inventory.  ACC 220 continues in the same pattern, with a chapter on the remaining Assets, and two chapters on Liabilities.  In terms of Owner's Equity, the focus will be upon different forms of ownership -- specifically, partnerships and corporations.  There are three other chapters not listed in the diagram above which are more global in nature:

1.      Chapter 12 -- Accounting Principles;

2.      Chapter 18 -- Cash Flows;

3.      Chapter 19 -- Financial Statement Analysis 

Chapter 19 is a chapter you will need to read on your own.  Its major purpose is to help you to  complete your Financial Analysis Project.