Principle Accounting Concepts

An interesting article for the benefit of Management Students

Guide to Principle Accounting Concepts

By: Jeffrey Glen, dated October 30th, 2013

Accounting can seem overwhelming at times with all the terminology, concepts, and rules that make it a full time job to understand.  This quick guide will highlight some of the main principles of accounting, and help you understand things a bit better the next time your accountant calls.

Types of Financial Statement Accounts & Statements

There are 5 types of accounts in the financial statements:

·         Assets: Items of value to a company and which it controls

·         Liabilities: Amounts owed by the company to third parties

·         Equity: Amounts contributed to the firm by owners, or accumulated as retained earnings in the company

·         Income: Amounts earned by the company for whatever goods or services it sells

·         Expenses: Amounts paid out or assets used by the entity in the process of earning income

The balance sheet of a company is a snap shot of the value of the company’s assets, liabilities, and equity at a given point in time.  Balance sheets are typically seen monthly, quarterly, and annually.  Total assets will always equal total liabilities plus total equity.  This recognizes that all the value in the company is either owed to debtors (a liability) or is owed to the ownership.

The income statement is a summary of the financial activity of a company for a given period of time, again typically monthly, quarterly, and annually.  All of the income and expenses of the company over that period of time would be indicated here.  The final amount (either a net income or net deficit) would be added to the retained earnings of the company and be shown as a reduction or increase in the owner’s equity.

The Statement of Cash Flows is another account that summarizes the cash impact of all the items from the two statements above to reconcile your cash balance at the beginning of a period to the end of the period.  This is often required as there are many non-cash items in the financial statements (see the Accounting Methods article).

Debit = Credit

Double entry accounting is a principle of modern accounting practices and has been used since the 15^th century as a way of clearly tracking the impact of various transactions and recognizing that no transaction a business takes is one sided from an accounting perspective.  For every debit, there will be a credit, and vice versa.  This is referred to as double entry accounting.

In terms of the account types listed above debits and credits impact those types of accounts differently, see the table below.

Account Type	Debit	Credit
Asset	Debits increase this account	Credits decrease this account
Liability	Debits decrease this account	Credits increase this account
Equity	Debits decrease this account	Credits increase this account
Income	Debits decrease this account	Credits increase this account
Expense	Debits increase this account	Credits decrease this account

So a journal entry to book a cash sale would be:

Debit Cash (Asset Account)                                 $1,000

Credit Sales (Income Account)                                                                          $1,000

As a result of the journal entry posted above you are increasing your cash balance and you are increasing your sales. Journal entries refer to the adjustments made to the company’s financials, in the format seen above, to record financial transactions.

Why is Double Entry Accounting Important?

As seen above in the sales transaction no financial transaction will only impact one aspect of the financial statements. A sale either generates cash or an asset representing that a third party owes you money (an account receivable). Purchasing office supplies (an expense) either means you paid out cash (reduced an asset) or you recognized the need to pay someone later (a liability).  By using double entry accounting you are sure that the full financial impact of a transaction is being recorded.  This also acts as a form of quality check in that by requiring yourself to post both sides of the transaction at the same time you prevent errors from occurring (for example you recognize the expense one day and forget to put the amount owed to another party the following week).

Accounting Systems

Most company’s use some form of accounting system to record all of their financial transactions (i.e.Quick books or Simply Accounting) as they allow you to store all of the information related to your financial operations and have many reporting structures for one to see things like the income statement of balance sheet. Additionally, they have controls in place whereby a concept like double entry accounting is required (you can’t just debit an account without crediting another).

That said, double entry accounting can be used on a piece of paper also.  500 years ago they didn’t have Quick books to help figure out their net worth.