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Review of Accounting Concepts
Review of Accounting Concepts
Review of Accounting Concepts
Definition of Accounting
Purpose of Accounting
Cost principle – this principle requires that assets should be recorded at original or
acquisition cost.
Objectivity principle – this principle requires that accounting records should be based
on reliable and verifiable data as evidence of transactions.
Consistency principle – this principle requires that accounting methods and procedures
should be applied on a uniform basis from period to period to achieve comparability in the
financial statements.
Adequate disclosure principle – this principle requires that financial statements should
be free from any material misstatement; that if there is any, proper disclosure should be
made.
Primary users are the parties to whom general purpose financial reports are primarily
directed. They are the existing and potential investors, lenders and creditors.
Other users are composed of the employees, customers, government and its agencies
and the general public.
The objective of general purpose financial reporting is “to provide financial information
about the reporting entity that is useful to existing and potential investors, lenders and other
creditors in making decisions about providing resources to the entity”.
The management of an entity has the primary responsibility for the preparation and
presentation of its financial statements.
o Statement of Cash Flows – provides information about cash receipts and cash
payments of an entity during a period. It is a formal statement that classifies cash
receipts (inflows) and cash payments (outflows) into operating, investing and
financing activities.
Accrual Accounting
Financial statements portray the financial effects of transactions and other events by
grouping them into broad classes according to their economic characteristics. These broad
classes are termed as the elements of financial statements.
Assets are the resources controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity.
Liabilities are the financial obligations of an entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying
economic benefits.
Equity or Capital is the residual interest in the assets of an entity after deducting all its
liabilities. In other words, whatever is left, that belongs to the owner of a business.
It refers to the various steps of the accounting process which are being passed-through in
a repetitive manner from the start up to the end of every accounting period regardless of some
variations in the account procedures. The steps in the accounting cycle are:
Transactions are those events that are recorded as part of the accounting process.
Accounting focuses on certain events that have an economic impact on the entity. There are two
types of transactions:
1. External transactions are exchanges of value between the business and the
outside party or parties which yield changes in the accounting equation.
2. Internal transactions are exchanges within an entity and they have a measurable
effect in the accounting equation.
The rules of debit and credit and the normal balances of the various types of accounts are
summarized as follows:
The recording process begins with the occurrence of a transaction. Source documents
provide written evidence of a transaction and are used by the accounting department as support
for entries recorded. Some of the more common source documents are sales invoices, checks,
purchase orders, sales order, official receipts, bank deposit slips, bank statements, cash register
tapes, time cards, contract and statement of account.
Books of original entry – these pertains to the journal – general and special journals
Books of final entry – these pertains to the ledger – general and subsidiary ledger
Aside from the general journal, some companies maintain the following special journals:
The first entry made in the general journal is called an opening entry. It is the recording
of the initial investments of a proprietor who is engaged in the business for the first time, or the
recording of the beginning balances of accounts in the preparation for the next accounting period.
If an entry involves only two accounts, one debit and one credit, it is called a simple entry.
A journal entry is referred to as a compound entry when it involves more than two accounts in
journalizing. In a compound entry, the standard format requires that all debit accounts are listed
before any credit accounts.
The General Ledger
A ledger is a group of accounts and the ledger that contains all the accounts needed to
prepare the financial statements is called the general ledger. The ledger is also called the book
of final entry because it is the last accounting record where a transaction is recorded. The
transactions recorded in the journal must be transferred to the appropriate accounts in the ledger,
the book of final entry.
An account is a record in the general ledger that is used to collect and store debit and
credit amounts. A simplified format of an account referred to as a T account resembles the letter
T as shown below. An account consists of three parts: (1) the title of the account; (2) a left or
debit side and (3) a right or credit side. The account is debited or charged when amounts are
recorded on the left side of the account and the account is credited when amounts are entered
on the right side of the account.
A chart of accounts is a listing of all the accounts and their account numbers in the
ledger. The accounts are listed in the order they appear in the ledger which is usually the order
in which they appear on the financial statements.
A subsidiary ledger is the device used in storing the details of certain general ledger
accounts. The general ledger accounts are actually the controlling account supported by the
details in the subsidiary ledger. Examples include accounts receivable subsidiary ledger and
accounts payable subsidiary ledger.
The trial balance is a list of accounts and their balances at a given time. The primary
purpose of a trial balance is to prove that the debits equal the credits after posting. The accounts
are listed in the order in which they appear in the ledger.
There are two alternative forms of a trial balance, namely: (1) trial balance of balances,
and (2) trial balance of totals. The trial balance that lists the total debit footings and the total credit
footings of each account posted in the GL is called the trial balance of totals. The trial balance
that lists only the balance of each open account in the ledger is called the trial balance of
balances. Generally, companies will prepare the trial balance of balances.
An inequality of the totals of the debits and credits would automatically signal the presence of an
error.
Adjustments are needed because some revenue and expense accounts may relate to
more than one accounting period or some items have been earned or incurred in a given period
but not yet entered into the accounts (commonly called accruals). At the end of an accounting
period, some open accounts in the ledger do not reflect their true balances and therefore require
updating. The journal entries that bring these accounts up to date at the end of the accounting
period is called the adjusting entries.
All adjusting entries affect at least one income statement account (nominal account) and
one balance sheet account (real account). The following are the year-end adjustments:
Prepaid expenses or deferred expenses are charges or debits recorded in the books
for goods or services that are not to be used up or consumed currently. At the end of the
accounting period, the portion of such charges applicable to future periods is recognized.
There are two alternative methods in recording prepayments:
o Asset method – an asset account was originally debited to record the expenditure.
The adjusting entry is a debit to an expense account for the amount of expense
applicable to the current period and a credit to the asset account. The debit balance
that remains in the asset account is the amount applicable to future periods.
Unearned Income or deferred income are credits recorded in the books for the cash
received in advance from customers prior to delivery of goods or services. At the end of
an accounting period, an adjusting entry is made to recognize the portion of such credit
that are applicable to future periods. There are two alternative methods available in
recording unearned income or income collected in advance:
o Income method – an income account was originally credited to record the amount
received in advance. The adjusting entry is a debit to the income account and a
credit to the liability account for the amount of income applicable to future periods.
The credit balance that remains in the income account is the amount earned during
the current period.
Accrued Expenses or Unpaid Expenses refer to expenses incurred by the business but
not yet paid when the accounting period ends. These expenses are recognized by debiting
the expense account and crediting a liability account.
Accrued Income or Uncollected Income are amounts earned but not yet received in
cash or recorded until a subsequent period. At the end of an accounting period, the income
is recognized by a debit to an asset account and a credit to a revenue account.
Depreciating Fixed Assets. Plant assets are a special type of deferred expense. The
gradual decrease in value of fixed assets due to use, inadequacy or obsolescence is called
depreciation. It is an operating expense whose balance will be reflected in the income
statement. To depreciate means to allocate or distribute the cost of a fixed asset within
its estimated useful life. All fixed assets will be subject to depreciation except Land and
Art Collections (like antiques).
Estimated Uncollectible Accounts. The estimate for doubtful accounts may be based
on either sales or the outstanding receivables at the end of an accounting period.
The Worksheet
o For the Adjusting Method, there are two entries: 1) to close merchandise inventory
beginning, we debit Income Summary and credit Merchandise Inventory beginning 2) to
set up merchandise inventory end, we debit Merchandise Inventory for its ending balance
and credit Income Summary.
o For the Closing Method or Direct Extension Method we extend merchandise inventory
beginning to adjusted trial balance column debit and income statement column debit while
merchandise inventory end is set up in the income statement column credit and balance
sheet column debit.
After posting the adjusting entries to the general ledger, the entity’s books are ready to be
closed in preparation for a new accounting period. In closing the books, it is necessary to
distinguish between temporary and permanent accounts.
Income statement accounts and owner’s drawings are temporary or nominal accounts. All
balance sheet accounts are referred to as permanent or real accounts. Temporary accounts
relate only to a given accounting period and are closed at the end of the accounting period.
Permanent accounts are not closed and their balances are carried forward into the next
accounting period.
Closing entries are entries that transfer the balances of one account to another account,
resulting in a zero balance to the account that is closed. The recording of closing entries can be
facilitated by reference to the income statement debit and credit columns and debit column of the
statement of owner’s equity in the worksheet. The procedures in closing the nominal accounts
include the following steps:
1. Close all nominal accounts with credit balances
2. Close all nominal accounts with debit balances
3. Close income summary account to capital or retained earnings
4. Close drawing account (for sole and partnership) to capital.
Another trial balance called a post-closing trial balance is prepared from the ledger after all
closing entries have been journalized and posted. The post-closing trial balance lists permanent
accounts and their balances. Its purpose is to prove the equality of permanent account balances
that are carried forward into the next accounting period. The post-closing trial balance contains
the list of Balance Sheet accounts with open balances; thus, it is being defined as a “balance
sheet in trial balance form”.
A reversing entry is a general journal entry made on the first day of the next accounting
period. It is the exact reverse of an adjusting entry made at the end of the previous accounting
period
The use of reversing entries generally simplifies the analysis of transactions and reduces
the likelihood of errors in the subsequent recording of transactions. They are made for
convenience and consistency in the handling of accrued and deferred items. Only the following
adjusting entries will be reversed:
o Accrued or Unpaid Expenses
o Accrued or Uncollected Revenues
o Unearned Income under the Income Method
o Prepaid Expenses under the Expense Method