Accounting 101

The basis for accounting is the fundamental accounting equation which states that assets must equal liabilities plus owners' equity. Assets are the resources of the business, such as cash, inventory, accounts receivable, buildings, land, and equipment. Liabilities represent obligations the business owes to others, such as loans, notes payable, and accounts payable. Owners' equity is the interest the owner's have in the business.

Financial accounting is primarily concerned with providing financial information to external users, such as investors, government agencies, creditors, customers, suppliers, and financial intermediaries. The financial information is reported to these users via financial statements. The four core financial statements are the income statement, balance sheet, statement of retained earnings, and statement of cash flows (Spiceland et al.).

Financial Statements

The income statement is a summary of operating results indicating revenues and expenses for a specific period of time. When the difference between revenues and expenses is positive the result is net income, and when the difference between revenues and expenses is negative the result is a net loss.

The balance sheet reports the assets, liabilities, and owners' equity as of a specific date, instead of over a period of time. On the balance sheet the assets must equal the sum of the liabilities and owners' equity.

The statement of retained earnings reports the changes in retained earnings over a period of time. It shows the retained earnings at the beginning of the period plus net income earned during the period minus dividends paid to shareholders during the period.

The statement of cash flows reports the cash inflows and cash outflows over a period of time. The changes in cash flows are broken down into three separate sections based on type of activity: operating activities, investing activities, and financing activities.

There are four qualities that financial statements must possess in order to be useful to users. First, the information presented in the financial statement must be relevant, so that users can make decisions based upon the information. Second, the information must be reliable, so that it is free from error and bias. Third, the information must be comparable, so that users can compare information reported by different entities. Fourth, the information must be consistent, so that users can compare information about the same organization over different periods.

Four Basic Assumptions

Financial accounting is structured around four basic assumptions. The first assumption is the economic entity assumption, which is sometimes referred to as the separate entity assumption. The economic entity assumption assumes that the organization is separate and distinct from its owners or other similar entities. Based on the economic entity assumption, "revenues and expenses should be kept separate from personal expenses. This applies even for partnerships and sole proprietorships" (Wikipedia).

The second assumption is the going concern assumption, which assumes that the organization will continue operations for the foreseeable future and will not cease operations during the accounting period. The one time this assumption does not apply is when the liquidation of assets is unavoidable, such as when a company is sold.

The third assumption is the monetary unit assumption, which assumes that the unit of record is a stable currency. The U.S. dollar is the unit of measure used in accounting for all United States companies.

The fourth assumption is the periodic reporting assumption, which assumes that accounting information will be reported periodically in order to compare past and present business performance. The most common accounting reporting periods are months, quarters, and years.

Four Basic Generally Accepted Accounting Principles (GAAP)

In addition to the four basic assumptions, financial accounting is structured around four basic generally accepted accounting principles (GAAP). The first principle is the matching principle, which states that revenues must be recorded in the time period when earned and expenses are matched against the revenues in the same time period. "Only if no connection with revenue can be established, cost can be charged as expenses to the current period (e.g. office salaries and other administrative expenses)" (Wikipedia).

The second principle is the historical cost principle, which states that assets and liabilities must be reported at the original cost. Accountants must not make adjustments for changes in market value when reporting the cost of assets or liabilities.

The third principle is the revenue recognition principle, which is the basis for accrual accounting. This principle states that revenue is reported when earned, not necessarily when the cash has been received.

The fourth principle is the full disclosure principle. This principle states that all pertinent information about the organization that users may need must be disclosed in a form that is understandable. This information is reported "in the main body of financial statements, in the notes or as supplementary information" (Wikipedia).

Modifying Conventions

There are occasions when the application of GAAP may not be practical. Therefore, there are four modifying conventions that are also observed. The first convention is the materiality convention, which states that an item or event reported in a financial statement must be of significance to the users. The second convention is the cost-benefit relationship convention, which states that the benefit of providing the financial information must equal or exceed the cost of providing it. The third convention is the conservatism convention, which states that, when there is a choice between two equally acceptable options, the option chosen must be the one least likely to overstate income and assets. The fourth convention is the industry practices convention, which states that accounting procedures should follow accepted industry practices, even when they differ from GAAP.

References

Spiceland, J. D., Sepe, J. F., & Tomassini, L. A. (2007). "Intermediate Accounting." (4th ed.). Burr Ridge, IL: McGraw-Hill/Irwin.

"U.S. Generally Accepted Accounting Principles." Wikimedia website. URL: http://en.wikipedia.org/wiki/US_generally_accepted_accounting_principles