Principles of Accounting Chapter 1: Accounting in Action

Assumptions under GAAP:

Accounting – “language of business”
▪ is an information system that identifies, records and ▪ Monetary unit assumption – requires that only
communicates the economic event of an entity to transaction data that can be expressed in terms of
interested users. money be included in the accounting records. This
▪ A means of communication as it provides information enables accounting to quantify economic events.
that assists users to make informed decisions. ▪ Economic entity assumption - requires that the
activities of the entity be kept separate and distinct
Identification  Recording  Communication
from the activities of its owner and all other entities.
Classify, (Prepare acctg reports) Types of business:
Summarize (Analyze and interpret
for users) Proprietorship – owned by one person.

Partnership – owned by two or more persons associated

Corporate Governance – system in which entities are as partners. Each partner generally has unlimited personal
directed or controlled, managed and administered. liability for the debts of the partnership.

Agency Theory – principal shareholders delegates its Company – a business organized as a separate legal entity
decision rights to the agent (management) to act in under the corporations’ law and having ownership divided
principal’s best interest. into transferable shares is a company. The shareholders
enjoy limited liability (not personally liable for debts).
Good corporate governance principles and practices such
as effective monitoring and disclosure of information Basic Accounting Equation:
means shareholders may be protected from divergent
behavior. 𝐴 = 𝐿 + 𝑂𝐸

Who uses accounting data: Assets – resources controlled by an entity. Used in

1) Internal users – managers who plan, organize and run carrying out such activities as production, consumption
a business. and exchange. Has capacity to provide future services or
2) External users – investors (use accounting inro to benefits.
make decisions to buy, hold or sell shares), creditors
(suppliers and bankers). Liabilities – claims against assets. These are existing debts
and obligations.

Owner’s Equity – ownership claim on total assets.

Luca Pacioli – “Father of double entry accounting”. Italian
Renaissance mathematician. INCREASE in owner’s equity

Bookkeeping – only the recording of economic events. A Investments by owner

part of the accounting process. Income – gross increase in owner’s equity resulting from
business activities entered into for the purpose of earning
Accounting – involves the entire process of identifying, income. This includes:
recording, and communicating economic events. ▪ Revenue -arises in the course of ordinary activities of
▪ Financial accounting – provides economic financial business.
information for investors, creditors, and other ▪ Gains – gains on disposal of non-current assets and
external users. unrealized gains on revaluing assets.
▪ Management accounting - provides economic and
financial info for managers and other internal users. DECREASE in owner’s equity
Drawings – owner may withdraw cash for personal use.
▪ Withdrawals – taking back investments. recorded
as direct decrease of owner’s equity.
Ethics – the standards of conduct by which your actions ▪ Drawings – taking money from accumulated
are judged as right or wrong, honest or dishonest, fair or profits.
not fair. Expenses – cost of assets consumed or services used in
Generally Accepted Accounting Principles (GAAP) – the process of earning income.
national standard setting body that develops accounting
standards. Transactions - (aka. Business transactions) are the
Financial Accounting Standards Board (FASB) – board economic events of an entity that are recorded. Identified
responsible for standard setting in the United States. as Internal or external.

Cost Principle – states that assets should be recorded at

their cost.
Chapter 2: The Recording Process
Financial Statements:
1) Statement of Comprehensive Income – presents
the income and expenses and resulting profit or Account – an individual accounting record of increases
loss for a specific period of time. and decreases in a specific asset, liability or owner’s
2) Statement of Changes in Equity - summarizes equity item.
the changes in owner’s equity for a specific
period of time. T-account – a standard shorthand in accounting that helps
3) Statement of Financial Position - reports the make clear the effects of transactions on individual
assets, liabilities, and owner’s equity at a specific accounts.
date. Debit – left; comes from Latin word “debere” (Dr)
4) Statement of Cash flows – summarizes
information about the cash inflows (receipts) and Credit – right; comes from Latin word “credere” (Cr)
outflows (payments) for a specific period of time.
Account balance – difference between the sum of debits
Public Accounting – you would offer expert service to the and credits.
general public. A major portion includes Auditing. An account will have a debit balance if total of
 debit amounts exceeds the credits. Credit
In this area, public accountants such as CPA or CA balance if credit amounts exceed debits.
examine the financial statements of entities and
express an opinion as to the fairness of Double-entry system – the dual effect of each transaction
presentation. is recorded in appropriate accounts. Means of proving
accuracy of the recorded amounts.
Taxation - another major area of public accounting.
The work Includes tax advice and planning preparing Source documents – provide written evidence of a
tax return and representing clients. transaction; used a support for entries recorded.
Management consulting – third area of public
accounting. Ranges from the installing of basic acctg Journal – original book of entry;
systems to helping entities, development of business General journal – most basic form of journal
plans. Journalising – entering transaction data in the journal.

Private accounting – being an employee of a business If an entry involves only two accounts, it is
entity. You would be involved in general accounting, cost considered simple entry. If it involves 3 or more
accounting, budgeting, ais, tax accounting, internal accounts, it is a compound entry.
auditing.
Ledger – entire group of accounts maintained by a
Not-for profit accounting – non profit entities also need
business. Keeps all info about changes in specific account
sound financial reporting and control. e.g. Red cross.
balances.
Another area is government accounting.
General Ledger – contains all assets, liabilities and
owner’s equity accounts.
Three-column form – standard form in ledger;
has three money columns: debit, credit, balance

Posting – procedure of transferring journal entries to the

ledger. Should be in chronological order.

Chart of accounts – lists the accounts and the account

numbers that identify their location in the ledger.

Trial Balance – list of accounts and their balances at a

given time. Prepared at the end of an accounting period.
Chapter 3: Adjusting the Accounts
Accumulated Depreciation- office equipment – normal
Time period assumption – accountants divide the balance is credit. a contra-asset account.
economic life of a business into artificial time periods. 
one that is offset against an asset account on the
Accounting time periods are generally a month, a quarter, statement of the financial position.
semi-annual or a year. Monthly and quarterly time period
are called Interim periods. A financial report must be Carrying amount – the difference between the cost of any
prepared and presented on an annual basis. depreciable asset and its related accumulated
depreciation
Financial year (July 1 to June 30)
Calendar year (Jan 1 to Dec 31)
Summary of relationships:
- annual reporting period used by most entities.
Annual reporting period may be shorter or longer Acc before adj Adjusting entry
than 12 months by a period of no more than 7
Prepaid Assets overstated Dr Expenses
days.
expenses Expenses understated Cr Assets

Accrual-basis accounting – transactions are recorded in Unearned Liabilities overstated Dr Liabilities

the periods in which the events occur. revenue Revenue understated Cr Revenue
Accrued Assets understated Dr Asset
Cash-basis accounting – revenue is recorded when cash is revenue Revenue understated Cr Revenue
received, and expense is recorded when cash is paid. Accrued Expenses understated Dr Expense
expense Liabilities understated Cr Liabilities
Revenue recognition principle –revenue should be
recognized in the accounting period when an increase in
future economic benefit has occurred.
Expense recognition principle – expenses should be
recognized in an accounting period when a decrease in
economic benefits has occurred.

Adjusting Entries – ensures that the revenue and expense

recognition principles are followed. Made at the end of
the accounting period.
Failing to make adjustment entries will over or
underestimate the elements in the financial
statements.

Types of adjusting entries:

1) Prepayments
Prepaid expenses – expenses paid in cash and
recorded as assets before used or consumed.
Unearned revenue – cash received and recorded as
liabilities before revenue is earned
2) Accruals
Accrued revenue – revenue earned but not yet
received in cash or recorded
Accrued expenses – expenses incurred but not yet
paid in cash or recorded.

Depreciation – allocation of the cost of an asset to

expense over its useful life in a rational and systematic
manner. Represents the future economic benefit that has
been used in the period. It is an estimate rather than a
factual measurement.

𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡
Calculating depreciation:
𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
Chap 4: Completion of the Accounting Cycle
Accounting Cycle
Worksheet
- a multicolumn form that may be used in the
adjustment process and in preparing financial Analyze business
transactions
statements.
- Not a permanent accounting record; Optional Prepare a post- Journalise the
- Necessary in large entities closing trial balance transactions

Closing the Books

- Accounts are made ready for the next period;
distinguishing between temporary and permanent Journalise and
Post to ledger
post-closing
acc accounts
entries

Temporary/ nominal accounts – relate only to a given

accounting period. Include all income statement accounts,
and owner’s drawings. All closed.
Prepare a trial
Prepare financial balance
Permanent/ real accounts – relate only to one or more statements
future accounting periods. Include financial position
accounts and owner’s capital. Not closed
Prepare and Journalize and
adjusted trial post adjusting
Closing entries balance entries
- Temporary account balances are transferred to the
permanent owner’s equity account, owner’s capital.
Current assets – cash and other resources that are
- Formally recognize the transfer of profit (or loss) and
reasonably expected to be realized in cash or sold or
owner’s drawings to owner’s capital.
- Performed after financial statements have been consumed within 1 year.
prepared. Journalized and posted at the end of
Operating cycle – average time that is required to go from
annual acctg period.
cash to cash in producing revenue.
Profit and loss summary (income summary) – revenue
Financial assets – cash and accounts receivable.
and expense are closed this temporary account.
Investment property – investing in non-current assets.
How to close entries:
1. Debit each revenue, credit income summary
Property, plant and equipment – tangible resources;
2. Debit income summary, credit each expense account
3. Debit income summary, credit owner’s capital permanent nature; not intended for sale.
4. Debit owner’s capital, credit owner’s drawings.
Intangible assets – non-current resources that do not
Posting closing entries have physical substance.
- All temp accounts should have zero balance after
posting closing entries. Current liabilities – debts related to the operating cycle
- Balance in owner’s capital should always be the same
Non-current liabilities – obligations expected to be paid
as the total equity of the owner at the end of acctg
period. after 1 year or after an operating cycle. Such as: bonds
payable, mortgages payable, long-term notes payable,
- As part of the closing process, temp accounts in T-
etc.
account are totalled, balanced and double-ruled.
- Permanent accounts are not closed. A single-rule is
Reversing Entries – most often used to reverse two types
drawn beneath the current period entities, and acc
of adjusting entries: accrued revenue, accrued expenses.
balance carried forward to the next period is entered
below the single rule.

Post-closing trial balance – lists permanent accounts and

their balances after closing entries have been journalized.

Reversing entries - an optional step; it is made at the

beginning of the next accounting period.

Correcting entries – an avoidable step; errors should be

corrected as soon as they are discovered. Must be posted
before closing entries.
Chapter 5: Accounting for Retail Operations Purchase discounts – permits the buyer to claim a cash
discount for prompt payment. The Buyer calls this cash
Sales revenue/sales – primary source or revenue for retail discount a Discount received.
operations. credit 
Expenses are divided into 2 categories:
Advantages: purchaser saves money; seller is able to
✓ Cost of sales – total cost of inventory sold during the
shorten operating cycle.
period.
✓ Other expenses
Trade discount (aka. Quantity discount) – offered to
purchasers of buyers who purchase large quantities of
Gross profit – sales revenue less cost of sales.
item or inventory.
 The ordinary cycle or a retailed is longer than that of Sales invoice – provides support for a credit sale.
a service business. The purchase of inventory/stock
and its eventual sale lengthen the cycle Sales returns and allowances – when customers return
goods, the seller may give a cash refund or a credit note.
Inventory – current asset; there are two systems that is If the goods returned were faulty or damaged,
used to account for inventory: damaged goods cannot be returned to inventory
for resale.  Inventory write-down
1. Perpetual inventory system – detailed records of the 
cost of each inventory purchase and sales are Can also be used to record inventory shrinkage
maintained. It shows inventory that should be on (e.g. evaporation of inventories such as fuel)
hand every period.
(Provide better control over inventories) Sales Discount – seller may offer the customer cash
discount.
2. Periodic inventory system – no detailed inventory
records. Cost of sales is determined only at the end of Contra revenue account – normal balance is debit.
the acctg period. At that time physical inventory 1. Sales returns and allowances
count is taken. To determine cost of sales during 2. Sales discounts
periodic inventory system:
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 + Adjusting entries: a retailer with perpetual system may
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑑 − 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑒𝑛𝑑 encounter that their unadjusted balance in inventory will
not agree with the actual amount of inventory at hand.
Could be due to errors, theft or waste. This is adjusted by:
Purchase invoice – this document indicates the total
purchase price and other relevant information. Each Debit – Cost of sales
credit purchase should be supported by this. Credit – Inventory
Purchase return – purchaser may return goods to seller
when not satisfied. Purchaser is granted credit (if made on
credit) or cash refund (if purchased on cash).

Purchase allowance – when seller grants an

allowance (deduction) from the purchase price.

Freight cost – cost of transporting goods.

FOB delivery point – goods are placed free on board the

carrier by the seller, and buyer pays the freight costs.

FOB destination – goods are placed free on board to the

buyer’s place of business, and the seller pays the freight.

Freight-in – when the purchaser directly incurs the freight

cost.
Freight-out (delivery expense) – when the seller incurs
the freight cost.