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Boundless Accounting

Accounting Information and the Accounting Cycle

The Basics of Accounting

Terminology of Accounting

Important terminology in accounting includes cash

vs. accrual basis, assets, liabilities, and equity.

LEARNING OBJECTIVES

Distinguish between the two primary accounting

methods

KEY TAKEAWAYS

Key Points

The cash basis of accounting records revenue when

cash is received and expenses when they are paid in
cash.

The accrual method records income items when they

The accrual method records income items when they
are earned and records deductions when expenses
are incurred, regardless of the flow of cash.

Assets are economic resources. Anything capable

of being owned or controlled to produce value is
considered an asset.

A liability is an obligation of an entity arising from

past transactions, the settlement of which may result
in the transfer of assets, provision of services, or
other yielding of economic benefits in the future.

Equity is the residual claim or interest of the most

junior class of investors in assets after all liabilities
are paid.

Key Terms

intangible assets:
assets: non-monetary assets that cannot
be seen, touched or physically measured, are created
through time and effort, and are identifiable as a
separate asset

There are two primary accounting methods –

cash basis and accrual basis. The cash basis of
accounting, or cash receipts and disbursements
method, records revenue when cash is received and
expenses when they are paid in cash. In contrast,
the accrual method records income items when they
are earned and records deductions when expenses
are incurred, regardless of the flow of cash. Accrual
are earned and records deductions when expenses
are incurred, regardless of the flow of cash. Accrual
accounts include, among others, accounts payable,
accounts receivable, goodwill, deferred tax liability
and future interest expense.

The term accrual is also often used as an abbreviation

for the terms accrued expense and accrued revenue.
Accrued revenue (or accrued assets) is an asset,
such as unpaid proceeds from a delivery of goods
or services, when such income is earned and a
related revenue item is recognized, while cash is
to be received in a later period, when the amount is
deducted from accrued revenues. An example of an
accrued expense is a pending obligation to pay for
goods or services received from a counterpart, while
cash is to be paid out in a latter accounting period
when the amount is deducted from accrued expenses.

In financial accounting, assets are economic

resources. Anything capable of being owned or
controlled to produce value is considered an asset.
Simply stated, assets represent value of ownership
that can be converted into cash. Two major asset
classes are intangible assets and tangible assets.
Intangible assets are identifiable non-monetary
assets that cannot be seen, touched or physically
measured, are created through time and effort, and
are identifiable as a separate asset. Tangible assets
contain current assets and fixed assets. Current
assets include inventory, while fixed assets include
such items as buildings and equipment.
assets include inventory, while fixed assets include
such items as buildings and equipment.

Assets and liabilities:

liabilities: Differences between assets and
liabilities

A liability is an obligation of an entity arising from

past transactions, the settlement of which may result
in the transfer of assets, provision of services, or
other yielding of economic benefits in the future. A
liability is defined by the following characteristics:

Any type of borrowing from persons or banks for

improving a business or personal income,

A responsibility to others that entails settlement by

future transfer of assets, provision of services, or
other transactions,

A responsibility that obligates the entity to another,

leaving it little or no discretion to avoid settlement, or

A transaction or event obligating the entity that has

already occurred.

In accounting and finance, equity is the residual claim

or interest of the most junior class of investors in
assets after all liabilities are paid. If liability exceeds
assets, negative equity exists. In an accounting
assets after all liabilities are paid. If liability exceeds
assets, negative equity exists. In an accounting
context, shareholders ‘ equity represents the
remaining interest in assets of a company, spread
among individual shareholders in common or
preferred stock.

Debits and Credits

Credit and debit are the two fundamental aspects

of every financial transaction in the double-entry
bookkeeping system.

LEARNING OBJECTIVES

Define how the terms debit and credit are used in

accounting

KEY TAKEAWAYS

Key Points

The English words credit and debit come from the

Latin words credre and debere, respectively. Credre
means “to entrust,” and debere means “to owe”.

In financial accounting or bookkeeping, “Dr” (Debit)

indicates the left side of a ledger account and
“Cr” (Credit) indicates the right.

The rule that total debits equal total credits applies

when all accounts are totaled.
The rule that total debits equal total credits applies
when all accounts are totaled.

An increase (+) to an asset account is a debit. An

increase (+) to a liability account is a credit.

Conversely, a decrease (-) to an asset account is a

credit. A decrease (-) to a liability account is a debit.

It is important for us to consider perspective when

attempting to understand the concepts of debits and
credits.

Key Terms

debit: an entry in the left hand column of an account

debit:
to record a debt; debits increase asset and expense
accounts and decrease liability, income, and equity
accounts

credit: an entry in the right hand column of an

credit:
account; credits increase liability, income, and equity
accounts and decrease asset and expense accounts

double-entry bookkeeping system:

system: A double-entry
bookkeeping system is a set of rules for recording
financial information in a financial accounting system
in which every transaction or event changes at least
two different nominal ledger accounts.

The difficulty with accounting has less to do with the

math as it does with its concepts. There is no more
The difficulty with accounting has less to do with the
math as it does with its concepts. There is no more
difficult yet vital concept to understand than that
of debits and credits. Debits and credits are at the
heart of the double-entry bookkeeping system that
has been the foundation stone on which the financial
world’s accounting system has been built for well over
500 years. Given the length of time, is it any wonder
that confusion has surrounded the concept of debits
and credits? The English language and its laws have
morphed to bring new definitions for two words that,
in the accounting world, have their own significance
and meaning.

For a better conceptual understanding of debits

and credits, let us look at the meaning of the
original Latin words. The English translators
took theirs word credit and debit from the Latin
words credre and debere,respectively. Credre means
“to entrust,” and debere means “to owe. ” When we
look closely into these two concepts we see that they
are actually two sides of the same coin. In a closed
financial system, money cannot just materialize. If
money is received by someone it must have come
from someone. That is, if someone entrusts an
amount of money to someone else, then that person
receiving the entrusted money would owe the same
amount of money in return (i.e., the credre must equal
the debere).

The Accounting Definition

The Accounting Definition

Debits and credits serve as the two balancing aspects

of every financial transaction in double-entry
bookkeeping. Debits are entered on the left side of
a ledger, and credits are entered on the right side of
a ledger. Whether a debit increases or decreases an
account depends on what kind of account it is. In the
accounting equation Assets = Liabilities + Equity, if an
asset account increases (by a debit), then one must
also either decrease (credit) another asset account or
increase (credit) a liability or equity account.

Another way to help remember debit and credit rules,

is to think of the accounting equation as a tee (T),
the vertical line of the tee (T) goes between assets
and liabilities. Everything on the left side (debit side)
increases with a debit and has a normal debit balance;
everything on the right side (credit side) increases
with a credit and has a normal credit balance. (Note:
a normal balance does not always mean the accounts
balance will be on that side, it’s simply a way of
remembering which side increases it).

Accounting Equation:
Equation: The extended accounting
equation allows for revenue and expenses as well.

Assets = Liabilities + Owner’s Equity + Revenue –

Expenses
Assets = Liabilities + Owner’s Equity + Revenue –
Expenses

As you already know the first part of the equation, let’s

focus on the new classifications, revenue and

expenses.

Revenue is treated like capital, which is an owner’s

equity account, and owner’s equity is increased with
a credit, and has a normal credit balance.

Expenses reduce revenue, therefore they are just the

opposite, increased with a debit, and have a normal
debit balance.

Each transaction (let’s say $100) is recorded by a

debit entry of $100 in one account, and a credit entry
of $100 in another account. When people say that
“debits must equal credits” they do not mean that the
two columns of any ledger account must be equal. If
that were the case, every account would have a zero
balance (no difference between the columns), which
is often not the case. The rule that total debits equal
the total credits applies when all accounts are totaled.

Perspective

It is important for us to consider perspective when

attempting to understand the concepts of debits and
credits. For example, one credit that confuses most
newcomers to accounting is the one that appears on
credits. For example, one credit that confuses most
newcomers to accounting is the one that appears on
their own bank statement. We know that cash in the
bank is an asset, and when we increase an asset we
debit its account. Then how come the credit balance
in our bank accounts goes up when we deposit
money? The answer is one that is fundamental to
the accounting system. Each firm records financial
transactions from their own perspective.

Think about the bank’s perspective for a moment.

How do they view the money we have just deposited?
Whose money is it? It’s ours; therefore, from the
bank’s perspective the deposit is viewed as a liability
(money owed by the bank to others). When we
deposit money into our accounts, the bank’s liability
increases, which is why the bank credits our account.

In summary: An increase (+) to an asset account is

a debit and an increase (+) to a liability account is a
credit; conversely, a decrease (-) to an asset account
is a credit and a decrease (-) to a liability account is a
debit.

What is debited and credited is also a matter of

transaction type. In accounting, these are divided into
three types of accounts. The rule of debit and credit
depends on the type of account you are talking about:

Personal account: Debit the receiver and credit the

giver
giver

Real account: Debit what comes in and credit what

goes out

Nominal account: Debit all expenses & losses and

credit all incomes & gains

Debit and credit rules:

rules: Debit and credit rules

Fundamental Accounting Equation

To ensure that a company is “in balance,” its assets

must always equal its liabilities plus its owners’
equity.

LEARNING OBJECTIVES

State the fundamental accounting equation

KEY TAKEAWAYS

Key Points

The accounting equation displays that all assets are

either financed by borrowing money or paying with the
money of the company’s shareholders.

The balance sheet is a complex display of this

The balance sheet is a complex display of this
equation, showing that the total assets of a company
are equal to the total of liabilities and shareholder
equity. Any purchase or sale has an equal effect on
both sides of the equation or offsetting effects on the
same side of the equation.

A mark in the credit column will increase a company’s

liability, income, and capital accounts but decrease
its asset and expense accounts. A mark in the debit
column will increase a company’s asset and expense
accounts, but decrease its liability, income, and
capital account.

Key Terms

debit: an entry in the left hand column of an account

debit:
to record a debt; debits increase asset and expense
accounts and decrease liability, income, and equity
accounts

credit: an entry in the right hand column of an

credit:
account; credits increase liability, income, and equity
accounts and decrease asset and expense accounts

double-entry bookkeeping system:

system: A double-entry
bookkeeping system is a set of rules for recording
financial information in a financial accounting system
in which every transaction or event changes at least
two different nominal ledger accounts.
two different nominal ledger accounts.

The fundamental accounting equation can actually

be expressed in two different ways. A double-
entry bookkeeping system involves two different
“columns;” debits on the left, credits on the right.
Every transaction and all financial reports must have
the total debits equal to the total credits. A mark in the
credit column will increase a company’s liability, in‐
come and capital accounts, but decrease its asset and
expense accounts. A mark in the debit column will
increase a company’s asset and expense accounts,
but decrease its liability, income and capital account.

For example, if a person buys a computer for $945.

He borrows $500 from his best friend and pays for the
rest using cash in his bank account. To record this
transaction in his personal ledger, the person would
make the following journal entry.

Computer (Increase in asset) $945

Cash (Decrease in an asset) $445

Loan from friend (Increase in debt ) $500

As you can see, the total amount of the debits (the

amount on the left) equal the credits (the total amount
on the right). The transaction is in “balance. ”

An extension of that basic rule involves the balance

sheet. The total assets listed on a company’s balance
An extension of that basic rule involves the balance
sheet. The total assets listed on a company’s balance
sheet must equal the company’s total liabilities,
plus its owners’ equity in the company. This identity
reflects the assumption that all of a company’s assets
are either financed through debt or through the
contribution of funds by the company’s owners.

A simple balance sheet example:

Assets

Cash $100,000

PP&E $200,000

Liabilities & Equity

Mortgage $150,000

Equity $150,000

As you can see, the business’s total assets equal the

company’s total liabilities and equity. This company is
“balanced. ”

An Expanded Equation

Preparing financial statements requires preparing an

adjusted trial balance, translating that into financial
reports, and having those reports audited.
reports, and having those reports audited.

LEARNING OBJECTIVES

Demonstrate how to prepare the financial statements

KEY TAKEAWAYS

Key Points

The purpose of financial statements are to provide

both business insiders and outsiders a concise, clear
picture of the current financial status in the business.
Therefore, the people who use the statements must
be confident in its accuracy.

Closing the books is simply a matter of ensuring

that transactions that take place after the business’s
financial period are not included in the financial
statements.

Adjusting entries are generally made in relation to

prepaid expenses, prepayments, accruals, estimates
and inventory.

When an audit is completed, the auditor will issue a

report regarding whether the statements are accurate.
To ensure a positive reports, some companies try
to participate in opinion shopping. This practice is
generally prohibited..

Key Terms
Key Terms

opinion shopping:
shopping: The process of contracting or
rejecting auditors based on the type of opinion report
they will issue on the auditee.

audit: An independent review and examination

audit:
of records and activities to assess the adequacy
of system controls, to ensure compliance with
established policies and operational procedures,
and to recommend necessary changes in controls,
policies, or procedures

adjusting entry:
entry: Journal entries usually made at
the end of an accounting period to allocate income
and expenditure to the period in which they actually
occurred.

Preparing Financial Statements

When a business enterprise presents all the relevant

financial information in a structured and easy to
understand manner, it is called a financial statement.
The purpose of financial statements are to provide
both business insiders and outsiders a concise, clear
picture of the current financial status in the business.
Therefore, the people who use the statements must
be confident in its accuracy.

Adjusted Trial Balance – Closing the Books

Adjusted Trial Balance – Closing the Books

The process of preparing the financial statements

begins with the adjusted trial balance. Preparing the
adjusted trial balance requires “closing” the book and
making the necessary adjusting entries to align the
financial records with the true financial activity of the
business.

Closing the books is simply a matter of ensuring

that transactions that take place after the business’s
financial period are not included in the financial
statements. For example, assume a business is
preparing its financial statements with a December
31st year end. It acquires some property on January
14th. If the books are properly closed, that property
will not be included on the balance sheet that is being
prepared for the period on December 31st.

Adjusted Trial Balance – Adjusting Entries

An adjusting entry is a journal entry made at the end

of an accounting period that allocates income and ex‐
penditure to the appropriate years. Adjusting entries
are generally made in relation to prepaid expenses,
prepayments, accruals, estimates and inventory.
Throughout the year, a business may spend funds or
make assumptions that might not be accurate regard‐
ing the use of a good or service during the accounting
period. Adjusting entries allow the company to go
back and adjust those balances to reflect the actual
financial activity during the accounting period.
back and adjust those balances to reflect the actual
financial activity during the accounting period.

For example, assume a company purchases 100 units

of raw material that it expects to use up during the
current accounting period. As a result, it immediately
expenses the cost of the material. However, at the
end of the year the company discovers it only used
50 units. The company must then make an adjusting
entry to reflect that, and decrease the amount of
the expense and increase the amount of inventory
accordingly.

Translate the Adjusted Trial Balance to Financial

Statements

Using the trial balance, the company then prepares

the four financial statements. These statements are:

The Balance Sheet: A summary of the company’s

assets, liabilities and equity;

The Income Statement: A summary of the business’s

income, expenses, and profits

The Statement of Cash Flows: A report on a

company’s cash flow activities, particularly its
operating, investing and financing activities; and

The Statement of Changes in Equity: A report that

explains the changes of the company’s equity
throughout the reporting period
explains the changes of the company’s equity
throughout the reporting period

The company may also provide Notes to the Financial

Statements, which are disclosures regarding key
details about the company’s operations that may not
be evident from the financial statements.

Financial statement:
statement: Financial statement from
Wachovia National Bank, 1906.

Audit the Financial Statements

Once the company prepares its financial statements,

it will contract an outside third party to audit it. An
audit is an independent review and examination
of records and activities to assess the adequacy
of system controls, to ensure compliance with
established policies and operational procedures,
and to recommend necessary changes in controls,
policies, or procedures. It is the audit that assures
outside investors and interested parties that the
content of the statements are correct.

When an audit is completed, the auditor will issue

a report with the findings. The findings can state
anything from the statements are accurate to
statements are misleading. To ensure a positive
reports, some companies try to participate in opinion
statements are misleading. To ensure a positive
reports, some companies try to participate in opinion
shopping. This is the process that businesses use to
ensure it gets a positive review. Since Enron and the
accounting scandals of the early 2000s, this practice
has been prohibited.

Types of Transactions

Transactions include sales, purchases, receipts, and

payments made by an individual or organization.

LEARNING OBJECTIVES

Distinguish between the four transactions that occur

in the accounting cycle

KEY TAKEAWAYS

Key Points

Sales – A sale is a transfer of property for money or

credit. Revenue is earned when goods are delivered or
services are rendered. In double-entry bookkeeping, a
sale of merchandise is recorded in the general journal
as a debit to cash or accounts receivable and a credit
to the sales account.

Purchase transactions results in a decrease in the

finances of the purchaser and an increase in the
benefits of the sellers. Purchases can be made
by cash or credit. As credit purchases are made,
benefits of the sellers. Purchases can be made
by cash or credit. As credit purchases are made,
accounts payable will increase.

Receipts refer to a business getting paid by another

business for delivering goods or services. This trans‐
action results in a decrease in accounts receivable
and an increase in cash/ cash or equivalents.

Payments refer to a business paying to another

business for receiving goods or services. This
transaction results in a decrease in accounts payable
and an decrease in cash/ cash or equivalents.

Key Terms

double-entry bookkeeping:
bookkeeping: A double-entry
bookkeeping system is a set of rules for recording
financial information in a financial accounting system
in which every transaction or event changes at least
two different nominal ledger accounts.

Transactions include sales, purchases, receipts, and

payments made by an individual or organizations.

Overview of Sales

A sale is a transfer of property for money or credit.

Revenue is earned when goods are delivered or
services are rendered. In double-entry bookkeeping,
a sale of merchandise is recorded in the general
journal as a debit to cash or accounts receivable and
a sale of merchandise is recorded in the general
journal as a debit to cash or accounts receivable and
a credit to the sales account. The amount recorded
is the actual monetary value of the transaction, not
the list price of the merchandise. A discount from
list price might be noted if it applies to the sale. Fees
for services are recorded separately from sales of
merchandise, but the bookkeeping transactions for
recording sales of services are similar to those for
recording sales of tangible goods.

Bookkeeping:: Purchases and sales in an old ledger

Bookkeeping

Overview of Purchases

Purchasing refers to a business or organization

acquiring goods or services to accomplish the
goals of its enterprise. This transaction results in
a decrease in the finances of the purchaser and an
increase in the benefits of the sellers. Purchases can
be made by cash or credit. As credit purchases are
made, accounts payable will increase.

Overview of Receipts

Receipts refer to a business getting paid by another

business for delivering goods or services. This
transaction results in a decrease in accounts
receivable and an increase in cash or equivalents.
transaction results in a decrease in accounts
receivable and an increase in cash or equivalents.

Overview of Payments

Payments refer to a business paying another business

for receiving goods or services. The business that
makes the payment will decrease its accounts
payable as well as its cash or equivalents. On the
other hand, the business that receives the payment
will see a decrease in accounts receivable but an
increase in cash or equivalents.

LICENSES AND ATTRIBUTIONS

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