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Business LibreTexts

3.7.1: Summary

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  • 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements

    • The Financial Accounting Standards Board (FASB) is an independent, nonprofit organization that sets the standards for financial accounting and reporting standards for both public- and private-sector businesses in the United States, including generally accepted accounting principles (GAAP).
    • GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial statements.
    • The Securities and Exchange Commission (SEC) is an independent federal agency that is charged with protecting the interests of investors, regulating stock markets, and ensuring companies adhere to GAAP requirements.
    • The FASB uses a conceptual framework, which is a set of concepts that guide financial reporting.
    • The revenue recognition principle requires companies to record revenue when it is earned. Revenue is earned when a product or service has been provided.
    • The expense recognition principle requires that expenses incurred match with revenues earned in the same period. The expenses are associated with revenue generation.
    • The cost principle records assets at their value at the date of acquisition. A company may not record what it estimates or thinks the value of the asset is, only what is verifiable. This verification is typically represented by an actual transaction.
    • The full disclosure principle requires companies to relay any information to the public that may affect financials that are not readily available on the financial statements. This helps users of information make decisions that are more informed.
    • The separate entity concept maintains that only business activities, and not the owner’s personal financials, may be reported on company financial statements.
    • Conservatism prescribes that a company should record expenses or losses when there is an expectation of their existence but only recognize gains or revenue when there is assurance that they will be realized.
    • Monetary measurement requires a monetary unit be used to report financial information, such as the US dollar. This makes information comparable.
    • The going concern assumption assumes that a business will continue to operate in the foreseeable future. If there is a concern the business will not continue operating, this needs to be disclosed to management and other users of information.
    • Time period assumption presents financial information in equal and short time frames, such as a month, quarter, or year.
    • The accounting equation shows that assets must equal the sum of liabilities and equity. Transactions are analyzed with this equation to prepare for the next step in the accounting cycle.

    3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions

    • The expanded accounting equation breaks down the equity portion of the accounting equation into more detail to show common stock, dividends, revenue, and expenses individually.
    • The chart of accounts is a numbering system that lists all of a company’s accounts in the order in which they appear on the financial statements, beginning with the balance sheet accounts and then the income statement accounts.

    3.3 Define and Describe the Initial Steps in the Accounting Cycle

    • Step 1 in the accounting cycle: Identifying and analyzing transactions requires a company to take information from an original source, identify its purpose as a financial transaction, and connect that information to an accounting equation.
    • Step 2 in the accounting cycle: Recording transactions to a journal takes financial information identified in the transaction and copies that information, using the accounting equation, into a journal. The journal is a record of all transactions.
    • Step 3 in the accounting cycle: Posting journal information to a ledger takes all information transferred to the journal and posts it to a general ledger. The general ledger in an accumulation of all accounts a company maintains and their balances.
    • Step 4 in the accounting cycle: Preparing an unadjusted trial balance requires transfer of information from the general ledger (T-accounts) to an unadjusted trial balance showing all account balances.

    3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements

    • Both the basic and the expanded accounting equations are useful in analyzing how any transaction affects a company’s financial statements.

    3.5 Use Journal Entries to Record Transactions and Post to T-Accounts

    • Journals are the first place where information is entered into the accounting system, which is why they are often referred to as books of original entry.
    • Journalizing transactions transfers information from accounting equation analysis to a record of each transaction.
    • There are several formatting rules for journalizing transactions that include where to put debits and credits, which account titles come first, the need for a date and inclusion of a brief description.
    • Step 3 in the accounting cycle posts journal information to the general ledger (T-accounts). Final balances in each account must be calculated before transfer to the trial balance occurs.

    3.6 Prepare a Trial Balance

    • The trial balance contains a listing of all accounts in the general ledger with nonzero balances. Information is transferred from the T-accounts to the trial balance.
    • Sometimes errors occur on the trial balance, and there are ways to find these errors. One may have to go through each step of the accounting process to locate an error on the trial balance.

    Key Terms

    abnormal balance
    account balance that is contrary to the expected normal balance of that account
    record showing increases and decreases to assets, liabilities, and equity found in the accounting equation
    accounting cycle
    step-by-step process to record business activities and events to keep financial records up to date
    book of original entry
    journal is often referred to as this because it is the place the information originally enters into the system
    chart of accounts
    account numbering system that lists all the accounts a business uses in its day-to-day transactions
    compound entry
    more than one account is listed under the debit and/or credit column of a journal entry
    conceptual framework
    interrelated objectives and fundamentals of accounting principles for financial reporting
    concept that if there is uncertainty in a potential financial estimate, a company should err on the side of caution and report the most conservative amount
    contributed capital
    owner’s investment (cash and other assets) in the business which typically comes in the form of common stock
    cost principle
    everything the company owns or controls (assets) must be recorded at its value at the date of acquisition
    records financial information on the right side of an account
    records financial information on the left side of each account
    double-entry accounting system
    requires the sum of the debits to equal the sum of the credits for each transaction
    ending account balance
    difference between debits and credits for an account
    expanded accounting equation
    breaks down the equity portion of the accounting equation into more detail to see the impact to equity from changes to revenues and expenses, and to owner investments and payouts
    expense recognition principle
    (also, matching principle) matches expenses with associated revenues in the period in which the revenues were generated
    full disclosure principle
    business must report any business activities that could affect what is reported on the financial statements
    general ledger
    comprehensive listing of all of a company’s accounts with their individual balances
    going concern assumption
    absent any evidence to the contrary, assumption that a business will continue to operate in the indefinite future
    record of all transactions
    entering information into a journal; second step in the accounting cycle
    monetary measurement
    system of using a monetary unit by which to value the transaction, such as the US dollar
    normal balance
    expected balance each account type maintains, which is the side that increases
    original source
    traceable record of information that contributes to the creation of a business transaction
    one operating cycle of a business, which could be a month, quarter, or year
    takes all transactions from the journal during a period and moves the information to a general ledger (ledger)
    prepaid expenses
    items paid for in advance of their use
    revenue recognition principle
    principle stating that a company must recognize revenue in the period in which it is earned; it is not considered earned until a product or service has been provided
    separate entity concept
    business may only report activities on financial statements that are specifically related to company operations, not those activities that affect the owner personally
    simple entry
    only one debit account and one credit account are listed under the debit and credit columns of a journal entry
    stockholders‛ equity
    owner (stockholders‛) investments in the business and earnings
    graphic representation of a general ledger account in which each account is visually split into left and right sides
    time period assumption
    companies can present useful information in shorter time periods such as years, quarters, or months
    business activity or event that has an effect on financial information presented on financial statements
    trial balance
    list of all accounts in the general ledger that have nonzero balances
    unadjusted trial balance
    trial balance that includes accounts before they have been adjusted
    unearned revenue
    advance payment for a product or service that has yet to be provided by the company; the transaction is a liability until the product or service is provided