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 resources—things 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 obligations—amounts 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 source—along with owner or stockholder equity—of 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has not been withdrawn or distributed to the owners.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.

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.
Expanded Accounting Equation for a Sole Proprietorship
The owner's equity in the basic accounting equation is sometimes expanded to show the
accounts that make up owner's equity: Owner's Capital, Revenues, Expenses, and Owner's
Draws.

Instead of the accounting equation, Assets = Liabilities + Owner's Equity, the expanded
accounting equation is:

The eight transactions that we had listed under the basic accounting equation Transaction 8, are
shown in the following expanded accounting equation:

With the expanded accounting equation, you can easily see the company's net income:

A current asset is cash or any asset that can be reasonably converted to

cash within one year.

How it works (Example):

Current assets typically include categories such as cash, marketable
securities, short-term investments, accounts receivable , prepaid
expenses, and inventory.
 Restricted cash (that is, cash that cannot be withdrawn or used for
current operations), depreciable assets, receivables that are not due
in 12 months or less, and land are examples of things that are not
current assets.

Why it Matters:
Current assets are important because they indicate how
much cash a company essentially has access to within the next 12
months outside of third-party sources. It is indicative of how the
company funds its ongoing, day-to-day operations, and how liquid a
firm is. The ratio of current assets to current liabilities is particularly
important in judging liquidity.

What is a post-dated cheque?

Definition of a Post-dated Check

A post-dated cheque (or postdated check) is a check written with a future date.

Example of a Post-dated Check

To illustrate, let's assume that on May 22 Jim owes a supplier $2,000 for purchases made 40
days ago. Since Jim does not have the money to pay the supplier, he offers to mail the
supplier two $1,000 checks: one check dated for June 20 and the other check dated for July
20.

The supplier agrees to hold the checks and deposit them on the dates shown on the checks.
Jim assures the supplier that the checks will be paid by his bank on those dates.

On June 4, when the supplier receives Jim's postdated checks, the supplier should not debit
cash nor credit accounts receivable. The reason is that the checks cannot be turned into cash
prior to the dates shown on the checks.

An intangible asset is a non-physical asset having a useful life greater than one year.
These assets are generally recognized as part of an acquisition, where the acquirer is allowed
to assign some portion of the purchase price to acquired intangible assets. Few internally-
generated intangible assets can be recognized on an entity's balance sheet. Examples of
intangible assets are:

 Marketing-related intangible assets

o Trademarks
o Newspaper mastheads

o Internet domain names

o Noncompetition agreements

 Customer-related intangible assets

o Customer lists

o Order backlog

o Customer relationships

 Artistic-related intangible assets

o Performance events

o Literary works

o Musical works

o Pictures

o Motion pictures and television programs

 Contract-based intangible assets

o Licensing agreements

o Service contracts

o Lease agreements

o Franchise agreements

o Broadcast rights

o Employment contracts

o Use rights (such as drilling rights or water rights)

 Technology-based intangible assets

o Patented technology

o Computer software

o Trade secrets (such as secret formulas and recipes)

Accounting Principles Definition
Accounting is governed by a series of 10 principles or rules. These rules are
often referred to as GAAP (pronounced “gap”)—which stands for generally
accepted accounting principles. The accounting principles definition references
these rules or guidelines that your business must follow when preparing
financial statements.

The more you understand about the purpose of generally accepted accounting
principles, the more you’ll know why (and how) these principles of
accountancy help protect business owners, consumers, and investors from
fraud. They also guarantee a measure of consistency in the accounting reports
among all businesses. In order to work in harmony with their accountants,
small business owners need to at least know the spirit of these rules!

The 10 Most Important Basic Accounting Principles Defined

1. Economic Entity Assumption

Ever wonder why your accountant harps on you about keeping your business
transactions separate from your personal transactions? This isn’t because
your business accountant wants to make their job easier (although, yes,
separate transactions definitely do help!).

The reason they won’t budge on this? The economic entity assumption
principle. It basically means that a business is an entity unto itself, and should
be treated as such (which is also why this is sometimes called the “separate
entity assumption”). If you know this basic accounting principle definition,
you’ll better under the reason why your accountant insisted you open a
separate business bank account when you opened your business. This is
business 101.

Even in a sole proprietorship, where your business activity appears on your

personal tax return, the economic entity assumption still applies. This is
because, legally, your business can exist independently of you. And, another
plus is that this will make your life easier if you ever decide to incorporate
down the road.

2. Monetary Unit Assumption

The monetary unit assumption principle dictates all activity be recorded in the
same currency. This is why you have to go through the extra effort to complete
your business bookkeeping for foreign transactions.

Another assumption under this basic accounting principle is that the

purchasing power of currency remains static over time. In other words,
inflation is not considered in the financial reports of a business, even if that
business has existed for decades.

3. Specific Time Period Assumption

An accounting balance sheet always reports information as of a certain date.

Profit and loss statements, also called income statements, encompass a date
range. All financial statements have to indicate the time period for the activity
reported in order for them to be meaningful to those reviewing them.

In short: Dates are really, really important. Always check your financial
statements for dates. A balance sheet will indicate the report is “as of” or “at”
a certain date. Profit and loss statements will indicate they are for a specific
date range.

4. Cost Principle

The cost principle in accounting outlines that the cost of an item doesn’t
change on the financial reporting. So, even if you’ve bought something within
the year that’s skyrocketed in value—let’s say a building, for instance—even
though its relative market value has changed, accountants will still always
report the asset at the amount for which it was obtained.
Knowing this basic accounting principle definition teaches something pretty
important for small business owners in general: It’s important not to confuse
cost with value. The value of things does change over time, and this is reflected
in the gain or loss on sale of assets as well as in depreciation entries. If you
need a true valuation of your business without selling off your assets, you’ll
need to bring in an expert in business valuations rather than relying on your
financial statements.

5. Full Disclosure Principle

The full disclosure principle is the generally accepted accounting principle that
grabs the most headlines. Under this basic accounting principle, a business is
required to disclose all information that relates to the function of its financial
statements in notes accompanying the statements. This principle helps make
sure stockholders and investors are not misled by any aspect of the financial
reports.

6. Going Concern Principle

Also referred to as the “non-death principle,” the going concern

principle assumes the business will continue to exist and function with no
defined end date. Knowing this basic accounting principle will help you
understand why you defer the recognition of expenses to a later accounting
period. If an accountant is concerned the business might be forced to liquidate,
they have to disclose this under GAAP principles.

7. Matching Principle

For tax purposes, many small businesses choose to operate on a cash basis,
meaning revenue is reported when cash is received and expenses are reported
when cash is spent (or when your business’s credit card is charged). But, many
businesses are required to report all financial information on an accrual basis,
largely due to the matching principle.
Under the matching accounting principle, sales and the expenses used to
produce those sales are reported in the same accounting period. These
expenses can include wages, sales commissions, certain overhead costs, etc.

Even if your tax return is on a cash basis, your accountant might prepare your
financial reports on an accrual basis. Accrual basis reports reflect the matching
principle and provide a better analysis of your business’s performance and
profitability than cash basis statements.

8. Revenue Recognition Principle

Under the accrual basis of accounting, revenue is reported when it’s earned,
regardless of when payment for the product or service is actually received.
Similar to the matching principle, the basic accounting principle of revenue
recognition accurately reports income, or revenue, when the sale was made,
even if you bill your customer or receive payment at a later time.

9. Materiality

The materiality principle is one of two basic accounting principles that lets the
accountant use their best judgment in recording a transaction or addressing an
error.

We often see the materiality principle at play when an accountant is

reconciling a set of books or completing a tax return. If the account is off by a
relatively small amount in relation to the overall size of the business, the
discrepancy may be deemed immaterial. Immaterial discrepancies can be
disregarded, but material discrepancies must be addressed. Similarly,
immaterial expenses can be recognized at the time of purchase, but material
expenses must be depreciated over time.

It’s important here for the accountant to be empowered to use their

professional opinion. Since businesses come in all sizes, an amount that might
be significant—or material—for one business may be insignificant—or
immaterial—for another.

10. Conservatism

The principle of conservatism is the other principle that lets the accountant use
their best judgment in a situation. When there’s more than one acceptable
way to record a transaction, the principle of conservatism instructs the
accountant to choose the option that’s best for the business they’re working
with.

It’s important to understand this basic accounting principle is only invoked

when either way the accountant can record the transaction is acceptable.
It doesn’t allow the accountant to completely disregard other accounting
principles.

How These Accounting Principles Will Improve Your Relationship with Your
Accountant

So, not every business is required by law to comply with GAAP. However, most
accountants will insist on following them, regardless of whether your business
is bound by law to comply with GAAP. And as your business tax
deadline approaches, we can imagine the idea of getting an audit is incredibly
scary—so adherence to these basic accounting principles ensures there’s never
a question about the integrity of your financial statements.

Also, think of these principles like a language. You may not work with the same
accountant or bookkeeper throughout your business’s entire lifetime, but
understanding these principles will help you communicate with whoever is in
this position, as you’ll always understand the language they speak, the
decisions they make, and why.
All in, understanding the basics of these accounting principles will help
demystify some of those requests your accountant makes, or help you
understand why a process is set up as it is. Plus, you’ll be armed to identify
when something seems amiss in your financial records, so you can address
issues as they arise rather than when they become insurmountable.

Accounting formulas should be next on your checklist for understanding the

inner workings of accounting.