Key Accounting Concepts and Principles

How do organizations communicate vital business and finance information? Achieving the utmost clarity in
communication requires knowledge of financial management and a strong understanding of accounting basics.
Accounting an internal function that involves identifying, recording, summarizing, and reporting business
transactions and financial events in an organization.

In this course, you’ll learn the core concepts and financial essentials of accounting, such as the accounting
equation and its components, as well as the rule of debits and credits. You'll also develop your financial acumen
by exploring the accounting cycle, and the effect of cash and accrual-based accounting systems.

Table of Contents
1. Key Accounting Concepts and Principles
2. Basic Accounting Practices
3. Assets, Liabilities, and Shareholders Equity
4. Understanding The Accounting Equation
5. The Rule of Debits and Credits
6. The Accounting Cycle
7. Cash or Accrual Accounting?

Key Accounting Concepts and Principles

[Course title: Key Accounting Concepts and Principles] Accounting is the universal language used by
businesses to communicate their financial position. The accounting function involves identifying, recording,
summarizing, and reporting business transactions and financial events in an organization. In this course, you'll
learn about the basic concepts and practices of accounting. You'll also learn about the accounting equation and
its components, and learn to use the rule of debits and credits. And you'll explore the accounting cycle, and the
effect of cash and accrual-based accounting systems.

Basic Accounting Practices

[Topic title: Basic Accounting Practices] Transactions in a global business environment can be challenging,
when dealing with diverse customs, traditions, and languages. But everyone talks the same language when it
comes to accounting. It creates a common ground, allowing global business partners and competitors to
communicate unambiguously.
In accounting, common, universal practices are used to prepare financial statements. They prescribe how to
record, present, interpret, and compare financial data. Underlying these common practices are assumptions,
conventions, and principles understood by everyone who speaks the language of accounting.
A fundamental assumption of accounting is that a business is a separate entity – meaning the finances of the
business are completely independent of the personal finances of the owners or stakeholders.
Suppose a company will continue to operate in the foreseeable future…in other words, the company's assets will
continue to be used. This is the Going Concern assumption. Based on this, the cost of an asset can be spread
over its useful lifetime, instead of being recorded as a one-time expense.
Then we have the Fixed Time Period assumption. The expectation that financial statements will be prepared for
a specific time period – with a defined beginning and end. It can be any time period, but typically statements are
prepared monthly, quarterly, and annually.
But how do you treat financial data? Let's look at some conventions that support common accounting practices.
Everyone understands and uses money, right? So, because money is a universal and objective way to
communicate financial information, the Money Measurement convention is at the heart of accounting. That's
why accounting records are expressed in monetary terms.
There's also a Conservatism convention. So when there's uncertainty between two reasonable alternatives, be
conservative rather than optimistic. How? Report less revenue and a lower asset amount, or higher liability
amount. So an inventory item has an acquisition cost of $1,000, but it can also be replaced for $850. Do you
record $1,000 or $850? Well, according to the convention, report the item in inventory at $850, and report a loss
of $150.
Next up, we have the Cost convention…how to handle the depreciation of a company's assets. You initially
record an asset at the price you paid to acquire it. But…that asset depreciates in value, so you subtract the
depreciation value from the acquisition cost as a depreciation expense. Then record the remaining value as a net
amount or net book-value. And continue to subtract any further depreciation from the existing net amount.
Many principles guide accounting, but the Matching principle is key to preparing financial statements. Basically,
expenses must be matched with revenues in the period being reported…to prevent the overstatement of income
in a period. Also, expenses must be recorded when they occur – no matter when cash is paid out. And offset
expenses by the revenues they generate.
Get to know the common assumptions, conventions, and principles of accounting so you can make sense of
financial data.

Assets, Liabilities, and Shareholders Equity

[Topic title: Assets, Liabilities, and Shareholders' Equity] In every business transaction exchange, something is
given and something is received. Every transaction affects a business's resources – supply of goods, services,
information, or expertise. All of this can be explained in terms of the three basic elements of accounting: assets,
liabilities, and shareholders' equity.
Everyone values different things. In terms of business, the things of value of business owns are called assets.
Assets can be tangible items such as cash, goods for sale, investments, inventories, equipment, and land. Or
assets can be intangible – property rights such as patents, franchises, and copyrights. Accounts receivable is also
intangible – credits to customers who promise to pay later, for services or products they get now.
Liabilities, on the other hand, are creditors' claims to the business's assets. They're the debts or obligations the
business owes to others. This might include money owed to suppliers, interest, taxes, and payroll owed – but not
yet paid. Other examples of business liabilities are loans, notes payable, and mortgages payable. With loans and
mortgages, banks have claims against the business. Any amount of an original loan that's still outstanding is a
liability.
Then there's shareholders' equity. That's the owner's claim on the assets of the business, which is also called
proprietorship or net worth. It's what the business owes the owner, assuming all liabilities have been paid. When
you're talking about an incorporated business, shareholders' equity becomes stockholders' equity. Or owner's
equity, when referring to a proprietorship.
Equity is the net assets of a company. The assets remaining after deducting the business's liabilities. You can
think of shareholders' equity in a business in much the same way as personal home equity. Home equity is what
you'd get if you sold your house and paid off any mortgage on the property.
Business transactions are like weights on a balance scale. What happens when one side goes down? For
example, services or goods are sold by a business. The other side of the scale reacts…goes up…as cash, or a
promise to be paid – a credit note – is received. Likewise, when the same business buys goods and services from
others…one side of the scale goes up…and the other side goes down, as the business pays out cash, or promises
to pay the supplier. In this way, assets, liabilities, and equity are always interrelated – changes in one element
cause changes to one or all the other elements.
Know your assets, liabilities, and shareholders' equity – these are the building blocks of accounting and the key
to understanding your business records.

Understanding The Accounting Equation

[Topic title: Understanding the Accounting Equation] Similar to Newton's third law of motion…for every
action, there's an equal but opposite reaction, in accounting, assets, liabilities, and equity are closely linked. A
change in one, brings about a change in another. This relationship is described in the accounting equation: assets
equal liabilities plus shareholders' – or owners' – equity.
Basically, you measure the financial position of a business in terms of assets – what a company owns – and
liabilities – what a company owes. The amount left over after liabilities are deducted from assets is equity.
But we're talking about an equation here, right? So, the left side must always equal the right side. No matter how
it's expressed or which component you're trying to determine. In practice, if a transaction causes one side of the
equation – let's say assets – to increase, then the other side of the equation – liabilities or shareholders' equity –
must also increase. [A set of three equations are shown: Assets equal liabilities plus equity; liability equals
assets minus equity; equity equals assets minus liability] Every business transaction affects at least two accounts
from the same or different sides of the equation.
Say a company buys $50,000 in raw materials on credit. The assets side of the equation goes up by $50,000. The
liabilities side – accounts payable, in this case – must also increase by $50,000 to balance it out.
Consider a simple example of a small delivery business with a bank balance of $20,000. The business owns a
van valued at $7,000, so its assets are $27,000. There's $2,000 in payroll…still to be paid. It's also paying off a
long-term start-up loan of $15,000. So its liabilities add up to $17,000. In this case, the shareholders' equity must
be $27,000 minus $17,000, which equals $10,000.
What happens if an owner contributes $20,000 cash to the business? The increase in equity is balanced by an
equal increase in cash – an asset. There's no effect on liabilities. And if an owner draws $2,000 from the
company's account? The equity and assets both decrease and the liabilities amount remains the same. In both
cases, the equation remains balanced.
If a company buys an asset, such as machinery, with cash, the transaction doesn't affect the accounting equation.
It just changes the composition of the assets themselves. For example, if $3,000 worth of equipment is bought
with cash, the decrease in the cash asset of $3,000 is balanced by an increase of $3,000 in equipment assets. As
you can see, there's no overall effect on assets, liabilities, or equity.
This surprisingly simple way of balancing the accounting equation will help you balance your books as well!

The Rule of Debits and Credits

[Topic title: The Rule of Debits and Credits] Usually, we think of debit as a bad thing…it's money we give out.
And we think of credit as a good thing, because it's money we get in.
But in double-entry accounting, it just means that something is recorded on either the left or right side of a T
account. Ever heard of a T account? It's simply a T-shaped visual aid that represents an account in the journal or
ledger. On the left of a T account are debit amounts, and on the right are credits.
So how does double-entry work exactly? It's simple…you record transactions in two or more accounts, and enter
the same amount on the debit side and credit side. Just like the accounting equation: assets equals liabilities plus
owners' equity.
Generally, anything that increases the left side or decreases the right side of the equation is a debit. And anything
that increases the right side or decreases the left side of the equation is a credit.
But how do you know whether a debit or a credit increases or decreases an account balance? That depends on
the type of account.
Revenues include amounts received from sales of products and services. And expenses include payments made
to meet obligations.
Other types of accounts include assets like cash or equipment. Accounts payable and wages payable are
liabilities. And equity includes contributed capital and retained earnings.
So how can you be sure you're recording transactions accurately? An easy rule of thumb is to credit the account
that gives value, and debit the account that receives value. The rule of debit and credit states that credits result in
account decreases for assets and expenses…and account increases for liabilities, equity, and revenues. Debits
result in account increases for assets and expenses, and account decreases for liabilities, equity, and revenues.
Suppose a company borrows $200,000 from the bank. This affects the cash account – because cash in hand
increases by $200,000. Cash is an asset, right? So the account is debited $200,000. The company also has an
obligation to repay the loan, which is a liability. So $200,000 is credited to the notes payable account, which is
the account where loans are recorded.
So what happens if the company makes a sale for $100,000 worth of product on credit? The company is now
owed $100,000. Accounts receivable is an asset account. So it's debited, since assets are increased by debit. And
how does this transaction affect the sales account? Since the sales account is a revenue account, sales is credited
$100,000.
And suppose the company buys $50,000 of supplies on credit. It owes more and therefore has a greater liability.
Accounts payable is credited $50,000 and inventory is debited $50,000.
So when you're lost in a sea of transactions and have no idea which way to steer, remember the rule of debits and
credits to help get you on your way.

The Accounting Cycle

[Topic title: The Accounting Cycle] How do you get from business transaction to financial report? You follow
what's known as the accounting cycle to identify, record, and report financial information about a business
during a specific period. Like a month or fiscal year. [The steps of the Accounting Cycle are shown. Step 1:
Identify and analyze the transaction. Step 2: Make journal entries. Step 3: Post to ledger. Step 4: Do trial
balance. Step 5: Prepare financial statements. Step 6: Make closing entries.]
Start by identifying and analyzing business transactions. How much? Which accounts must be debited and
which must be credited? Source documents, like receipts and invoices, answer both these questions.
Next you make journal entries. So long as the entries balance, you can use as many lines as you need to record
the transaction. Let's see how you'd post a $2,000 mortgage payment to the journal. First enter the date and a
description of the transaction. Then add the posting references – the account names and codes. Finally, enter the
matching debit and credit amounts.
After the journal, you post to the ledger. Remember the $2,000 mortgage payment? This journal entry affects
two ledger accounts - mortgage payment and cash…each account with its own account code. You post the debit
part of the journal entry to the left side of the Mortgage account. Then post the credit part of the journal entry to
the right side of the Cash account.
Since we're dealing with double-entry accounting, remember that for every credit there must be an equal debit. If
debits don't equal credits, there's an error. You can detect errors using a trial balance. Basically a list of all the
organization's ledger accounts and their balances.
You total the debits and credits for each account. The difference in the totals is the account's final balance. Then,
add up the final balances for all the individual accounts. If the debit total equals the credit total, your trial
balance is successful. But if not…find the errors and fix them, until the debits and credits balances. This marks
the end of your first trial balance.
Next you make adjusting entries. Now normally, transactions are recorded in the accounting period where they
actually occurred. But what about the depreciation of equipment and consumption of inventory? These expire
with time, right? Adjusting entries takes care of those transactions that span various accounting periods.
Once you've taken care of the adjusting entries, do the trial balance again. This is called the adjusted trial
balance.
At this point, use the information from the ledger accounts, to prepare the financial statements – a record of how
a business has performed financially over the accounting period. There's an Income Statement, Cash Flow
Statement, and Balance Sheet.
Once the ledger accounts have been reconciled and adjusted, it's time to close the accounting books. This locks
the data – so no more changes or additional postings for the accounting period covered by the financial
statements. You close the books by making several closing entries to the ledger accounts.
If you don't want your financials jumbled, follow the steps in the accounting cycle to make sense of them all.

Cash or Accrual Accounting?

[Topic title: Cash or Accrual Accounting?] One of the biggest decisions in accounting isn't how…but when
transactions are recorded. The system for making these decisions is known as revenue recognition – in other
words, when is income recognized as revenue in the accounting books?
The answer to this question forms the foundation of the two basic accounting systems: the cash method and the
accrual method.
Revenue recognition under the cash-based method means that sales revenues and expenses are recognized at the
point when cash is exchanged.
And under the accrual-based method…here revenues and expenses are recognized at the point they‘re earned or
incurred. They're also included in financial statements for that accounting period. And when cash is actually
received or paid out, it doesn't affect the financial position of the organization.
But which one is best? Of course, there are advantages to both cash- and accrual-based accounting. The main
advantage of cash-based accounting is how simple it is to use. It's easy to understand and keep records – because
the only time you need to record a transaction is when cash has been received or expended. In fact, a simple
spreadsheet may be all you need to record the transaction history of the business. This simplicity means it's also
less expensive to implement and maintain.
On the other hand, even though cash-based accounting is easy to use and understand, the accrual method
provides a better analysis of an organization's financial position and health. It's better for handling cash flow,
anticipating liabilities, and gauging profit.
When you handle cash flow using the accrual method, you record receivables on the books as soon as they
happen. You can then use this to predict future streams of income.
Liabilities are more transparent in accrual accounting, which means you can anticipate a company's future
obligations. Like how much money it needs and when it'll need that money. If you can predict future inflows and
outflows of cash, you can do a better job of planning your investing and borrowing activities.
Accrual systems also help gauge profitability. Because they match revenues to the expenses incurred to generate
them. For example, raw materials bought on credit may only be paid for some time in the future. And the
products made from those materials will also be sold over a long period. Under accrual accounting, you record
both transactions in the period when they occur. This way you can determine whether production was profitable.
Because most organizations buy and sell on credit, the accrual method is accepted worldwide as the standard for
conducting business.
Cash or accrual? Weigh the pros and cons of both accounting methods to determine what's best for your
business.