Cash vs. Accrual Accounting

Learn which accounting method is better for your business.

The cash method and the accrual method (sometimes called cash basis and accrual basis) are the two principal methods of keeping track of a business's income and expenses. In most cases, you can choose which method to use. Learn how they work and the advantages and disadvantages of each so you can choose the better one for your business.

In a nutshell, these methods differ only in the timing of when transactions, including sales and purchases, are credited or debited to your accounts. Here's how each works:

The accrual method. The accrual method is the more commonly used method of accounting. Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the money for them (receivables) is actually received or paid. In other words, income is counted when the sale occurs, and expenses are counted when you receive the goods or services. You don't have to wait until you see the money, or actually pay money out of your checking account, to record a transaction.

The cash method. Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid.

Example

Your computer installation business finishes a job in November, and doesn't get paid until three months later in January. Under the cash method, you would record the payment in January. Under the accrual method, you would record the income in your November books.

You purchase a new laser printer on credit in May and pay $1,000 for it in July, two months later. Using the cash method, you would record a $1,000 payment for the month of July, the month when the money is actually paid.Under the accrual method, you would record the $1,000 payment in May, when you take the laser printer and become obligated to pay for it.

by Attorney Stephen Fishman

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The Accounting Equation

The resources controlled by a business are referred to as its assets. For a new business, those assets originate from two possible sources:

• Investors who buy ownership in the business
• Creditors who extend loans to the business

Those who contribute assets to a business have legal claims on those assets. Since the total assets of the business are equal to the sum of the assets contributed by investors and the assets contributed by creditors, the following relationship holds and is referred to as the accounting equation:

Asset =	Liabilities + Owners'Equity
Resources	Claims on the Resources

Initially, owner equity is affected by capital contributions such as the issuance of stock. Once business operations commence, there will be income (revenues minus expenses, and gains minus losses) and perhaps additional capital contributions and withdrawals such as dividends. At the end of a reporting period, these items will impact the owners' equity as follows:

Asset = Liabilities	+ Owners'Equity
	+ Revenues
	- Expenses
	+ Gains
	- Losses
	+ Contributions
	+ Withdrawals

These additional items under owners' equity are tracked in temporary accounts until the end of the accounting period, at which time they are closed to owners' equity.

The accounting equation holds at all times over the life of the business. When a transaction occurs, the total assets of the business may change, but the equation will remain in balance. The accounting equation serves as the basis for the balance sheet, as illustrated in the following example.

The Accounting Equation - A Practical Example

To better understand the accounting equation, consider the following example. Mike Peddler decides to open a bicycle repair shop. To get started he rents some shop space, purchases an initial inventory of bike parts, and opens the shop for business. Here is a listing of the transactions that occurred during the first month:

Date	Transactions
Sep 1	Owner contributes $7500 in cash to capitalize the business.
Sep 8	Purchased $2500 in bike parts on account, payable in 30 days.
Sep 15	Paid first month's shop rent of $1000.
Sep 17	Repaired bikes for $1100; collected $400 cash; billed customers for the $700 balance.
Sep 18	$275 in bike parts were used.
Sep 25	Collected $425 from customer accounts.
Sep 28	Paid $500 to suppliers for parts purchased earlier in the month.

These transactions affect the accounting equation as shown below.

Note that for each date in the above example, the sum of entries under the "Assets" heading is equal to the sum of entries under the "Liabilities + Owner's Equity" heading. In most of these cases, the transaction affected both sides of the accounting equation. However, note that the Sep 25 transaction affected only the asset side with an increase in cash and an equal but opposite decrease in accounts receivable.

At the end of the month of September, the net income (revenues minus expenses) is closed to capital and the balance sheet for the business would appear as follows:

The bike parts are considered to be inventory, which appears as an asset on the balance sheet. The owner's equity is modified according to the difference between revenues and expenses. In this case, the difference is a loss of $175, so the owner's equity has decreased from $7500 at the beginning of the month to $7325 at the end of the month.

Debits and Credits

The above example illustrates how the accounting equation remains in balance for each transaction. Note that negative amounts were portrayed as negative numbers. In practice, negative numbers are not used; in a double-entry bookkeeping system the recording of each transaction is made via debits and credits in the appropriate accounts.

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Luca Pacioli: The Father of Accounting

Fra Luca Bartolomeo de Pacioli (sometimes Paciolo) (1446/7–1517) was an Italian mathematician and Franciscan friar, collaborator with Leonardo da Vinci, and seminal contributor to the field now known as accounting. He was also called Luca di Borgo after his birthplace, Borgo Santo Sepolcro, Tuscany.

Life

Luca Pacioli was born in 1446 or 1447 in Sansepolcro (Tuscany) where he received an abbaco education. [This was education in the vernacular (i.e. the local tongue) rather than Latin and focused on the knowledge required of merchants.] He moved to Venice around 1464 where he continued his own education while working as a tutor to the three sons of a merchant. It was during this period that he wrote his first book -- a treatise on arithmetic for the three boys he was tutoring. Between 1472 and 1475, he became a Franciscan friar. In 1475, he started teaching in Perugia and wrote a comprehensive abbaco textbook in the vernacular for his students during 1477 and 1478. It is thought that he then started teaching university mathematics (rather than abbaco) and he did so in a number of Italian universities, including Perugia, holding the first chair in mathematics in two of them. He also continued to work as a private abbaco tutor of mathematics and was, in fact, instructed to stop teaching at this level in Sansepolcro in 1491. In 1494, his first book to be printed, Summa de arithmetica, geometria, proportioni et proportionalita, was published in Venice. In 1497, he accepted an invitation from Lodovico Sforza ("Il Moro") to work in Milan. There he met, collaborated with, lived with, and taught mathematics to Leonardo da Vinci. In 1499, Pacioli and Leonardo were forced to flee Milan when Louis XII of France seized the city and drove their patron out. Their paths appear to have finally separated around 1506. Pacioli died aged 70 in 1517, most likely in Sansepolcro where it is thought he had spent much of his final years.

Mathematics

Pacioli published several works on mathematics, including:

Summa de arithmetica, geometria, proportioni et proportionalita (Venice 1494)

a textbook for use in the abbaco schools of Northern Italy. It was a synthesis of the mathematical knowledge of his time and contained the first printed work on algebra written in the vernacular (i.e. the spoken language of the day). It is also notable for including the first published description of the method of bookkeeping that Venetian merchants used during the Italian Renaissance, known as the double-entry accounting system. Although Pacioli codified rather than invented this system, he is widely regarded as the "Father of Accounting". The system he published included most of the accounting cycle as we know it today. He described the use of journals and ledgers, and warned that a person should not go to sleep at night until the debits equalled the credits. His ledger had accounts for assets (including receivables and inventories), liabilities, capital, income, and expenses — the account categories that are reported on an organization's balance sheet and income statement, respectively. He demonstrated year-end closing entries and proposed that a trial balance be used to prove a balanced ledger. Also, his treatise touches on a wide range of related topics from accounting ethics to cost accounting.

De viribus quantitatis (Ms. Università degli Studi di Bologna, 1496–1508)

a treatise on mathematics and magic. Written between 1496 and 1508 it contains the first reference to card tricks as well as guidance on how to juggle, eat fire and make coins dance. It is the first work to note that Da Vinci was left-handed. De viribus quantitatis is divided into three sections: mathematical problems, puzzles and tricks, and a collection of proverbs and verses. The book has been described as the "foundation of modern magic and numerical puzzles", but it was never published and sat in the archives of the University of Bologna, seen only by a small number of scholars since the Middle Ages. The book was rediscovered after David Singmaster, a mathematician, came across a reference to it in a 19th-century manuscript. An English translation was published for the first time in 2007.

Geometry (1509)

a Latin translation of Euclid's "Elements".

De divina proportione (written in Milan in 1496–98, published in Venice in 1509)

Two versions of the original manuscript are extant, one in the Biblioteca Ambrosiana in Milan, the other in the Bibliothèque Publique et Universitaire in Geneva. The subject was mathematical and artistic proportion, especially the mathematics of the golden ratio and its application in architecture. Leonardo da Vinci drew the illustrations of the regular solids in De divina proportione while he lived with and took mathematics lessons from Pacioli. Leonardo's drawings are probably the first illustrations of skeletonic solids, which allowed an easy distinction between front and back. The work also discusses the use of perspective by painters such as Piero della Francesca, Melozzo da Forlì, and Marco Palmezzano. As a side note, the "M" logo used by the Metropolitan Museum of Art in New York City is taken from De divina proportione.

"The Ancients, having taken into consideration the rigorous construction of the human body, elaborated all their works, as especially their holy temples, according to these proportions; for they found here the two principal figures without which no project is possible: the perfection of the circle, the principle of all regular bodies, and the equilateral square.

The first printed illustration of a rhombicuboctahedron, by Leonardo da Vinci, published in De divina proportione.

Translation of Piero della Francesca's work

The majority of the second volume of Summa de arithmetica, geometria, proportioni et proportionalita was a slightly rewritten version of one of Piero della Francesca's works. The third volume of Pacioli's De divina proportione was an Italian translation of Piero della Francesca's Latin writings On [the] Five Regular Solids. In neither case, did Pacioli include an attribution to Piero. He was severely criticized for this and accused of plagiarism by sixteenth-century art historian and biographer Giorgio Vasari. R. Emmett Taylor (1889–1956) said that Pacioli may have had nothing to do with the translated volume De divina proportione, and that it may just have been appended to his work. However, no such defence can be presented concerning the inclusion of Piero della Francesca's material in Pacioli's Summa.

Chess

Pacioli also wrote an unpublished treatise on chess, De ludo scacchorum (On the Game of Chess). Long thought to have been lost, a surviving manuscript was rediscovered in 2006, in the 22,000-volume library of Count Guglielmo Coronini. A facsimile edition of the book was published in Pacioli's home town of Sansepolcro in 2008. Based on Leonardo da Vinci's long association with the author and his having illustrated De divina proportione, some scholars speculate that Leonardo either drew the chess problems that appear in the manuscript or at least designed the chess pieces used in the problems.

The Father of Accounting

In 1994, accountants from around the world gathered in an Italian village called San Sepulcro to celebrate the 500th anniversary of the first book written on double-entry accounting. The book was written by an Italian friar, Luca Pacioli (pronounced pot-CHEE-oh-lee).

The first accounting book actually was one of five sections in Pacioli's mathematics book titled "Everything about Arithmetic, Geometry, and Proportions." This section on accounting served as the world's only accounting textbook until well into the 16th century.

Because Pacioli was a Franciscan friar, he might be referred to simply as Friar Luca. While Friar Luca is often called the "Father of Accounting," he did not invent the system. Instead, he simply described a method used by merchants in Venice during the Italian Renaissance period. His system included most of the accounting cycle as we know it today. For example, he described the use journals and ledgers, and he warned that a person should not go to sleep at night until the debits equalled the credits! His ledger included assets (including receivables and inventories), liabilities, capital, income, and expense accounts. Friar Luca demonstrated year-end closing entries and proposed that a trial balance be used to prove a balanced ledger. Also, his treatise alludes to a wide range of topics from accounting ethics to cost accounting.

Pacioli was about 49 years old in 1494 - just two years after Columbus discovered America - when he returned to Venice for the publication of his fifth book, Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion). It was written as a digest and guide to existing mathematical knowledge, and bookkeeping was only one of five topics covered. The Summa's 36 short chapters on bookkeeping, entitled De Computis et Scripturis (Of Reckonings and Writings) were added "in order that the subjects of the most gracious Duke of Urbino may have complete instructions in the conduct of business," and to "give the trader without delay information as to his assets and liabilities" (All quotes from the translation by J.B. Geijsbeek, Ancient Double Entry Bookkeeping: Lucas Pacioli's Treatise, 1914).

Numerous tiny details of bookkeeping technique set forth by Pacioli were followed in texts and the profession for at least the next four centuries, as accounting historian Henry Rand Hatfield put it, "persisting like buttons on our coat sleeves, long after their significance had disappeared." Perhaps the best proof that Pacioli's work was considered potentially significant even at the time of publication was the very fact that it was printed on November 10, 1494. Guttenberg had just a quarter-century earlier invented metal type, and it was still an extremely expensive proposition to print a book.

Accounting practitioners in public accounting, industry, and not-for-profit organizations, as well as investors, lending institutions, business firms, and all other users for financial information are indebted to Luca Pacioli for his monumental role in the development of accounting.

Source: wikipedia, www.acct.tamu.edu

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Welcome to the World of Accounting

GOALS

Your goals for this "welcoming" chapter are to learn about:

• The nature of financial and managerial accounting information.
• The accounting profession and accounting careers.
• The fundamental accounting equation: Assets = Liabilities + Owners' Equity.
• How transactions impact the fundamental accounting equation.
• The four core financial statements.

DISCUSSION


ACCOUNTING INFORMATION

You likely have a general concept of what accountants do. They capture information about the transactions and events of a business, and summarize that activity in reports that are used by persons interested in the entity. But, you likely do not realize the complexity of accomplishing this task. It involves a talented blending of technical knowledge and measurement artistry that can only be fully appreciated via extensive study of the subject. The best analogy is to say that you probably know what a heart surgeon does, but you no doubt appreciate that considerable knowledge and skill is needed to successfully treat a patient. If you were studying to be a surgeon, you would likely begin with some basic anatomy class. In this chapter, you will begin your study of accounting by looking at the overall structure of accounting and the basic anatomy of reporting.

Be advised that a true understanding of accounting does not come easily. It only comes with determination and hard work. But, if you persevere, you will be surprised at what you discover about accounting. Knowledge of accounting is very valuable to business success. And, once you conquer the basics, accounting is actually quite an interesting subject.

ACCOUNTING DEFINED: It seems fitting to begin with a more formal definition of accounting: Accounting is a set of concepts and techniques that are used to measure and report financial information about an economic unit. The economic unit is generally considered to be a separate enterprise. The information is potentially reported to a variety of different types of interested parties. These include business managers, owners, creditors, governmental units, financial analysts, and even employees. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity. Business managers need accounting information to make sound leadership decisions. Investors hold out hope for profits that may eventually lead to distributions from the business (e.g., "dividends"). Creditors are always concerned about the entity's ability to repay its obligations. Governmental units need information to tax and regulate. Analysts use accounting data to form their opinions on which they base their investment recommendations. Employees want to work for successful companies to further their individual careers, and they often have bonuses or options tied to enterprise performance. Accounting information about specific entities helps satisfy the needs of all these interested parties.

The diversity of interested parties leads to a logical division in the discipline of accounting: financial accounting and managerial accounting. Financial accounting is concerned with external reporting of information to parties outside the firm. In contrast, managerial accounting is primarily concerned with providing information for internal management. You may have some trouble seeing why a distinction is needed; after all aren't we just reporting financial facts? Let's look closer at the distinctions.

FINANCIAL ACCOUNTING: Consider that financial accounting is targeted toward a broad base of external users, none of whom control the actual preparation of reports or have access to underlying details. Their ability to understand and have confidence in reports is directly dependent upon standardization of the principles and practices that are used to prepare the reports. Without such standardization, reports of different companies could be hard to understand and even harder to compare. As a result, there are well organized processes to bring consistency and structure to financial reporting. In the United States, a private sector group called the Financial Accounting Standards Board (FASB) is primarily responsible for developing the rules that form the foundation of financial reporting. With the increase in global trade, the International Accounting Standards Board (IASB) has been steadily gaining prominence as a global accounting rule setter.

Financial reports prepared under the generally accepted accounting principles (GAAP) promulgated by such standard setting bodies are intended to be general purpose in orientation. This means they are not prepared especially for owners, or creditors, or any other particular user group. Instead, they are intended to be equally useful for all user groups. As such, attempts are made to keep them free from bias (neutral).

MANAGERIAL ACCOUNTING: In sharp contrast to financial accounting, managerial accounting information is intended to serve the specific needs of management. Business managers are charged with business planning, controlling, and decision making. As such, they may desire specialized reports, budgets, product costing data, and other details that are generally not reported on an external basis. Further, management may dictate the parameters under which such information is to be accumulated and presented. For instance, GAAP may require that certain research costs be deducted immediately in computing a business's externally reported income; on the other hand, management may see these costs as a long-term investment and stipulate that internal decision making be based upon income numbers that exclude such costs. This is their prerogative. Hopefully, such internal reporting is being done logically and rationally, but it need not follow any particular set of guidelines.

A QUALITY INFORMATION SYSTEM: Both financial accounting and managerial accounting depend upon a strong information system to reliably capture and summarize business transaction data. Information technology has radically reshaped this mundane part of the practice of accounting during the past 30 years. The era of the "green eye-shaded" accountant has been relegated to the annals of history. Now, accounting is more of a dynamic, decision-making discipline, rather than a bookkeeping task.

INHERENT LIMITATIONS: Accounting data is not absolute or concrete. Considerable amounts of judgment and estimation are necessary to develop the specific accounting measurements that are reported during a particular month, quarter, or year (e.g., how much pension expense should be reported now for the future benefits that are being earned by employees now, but the amounts will not be known with certainly until many years to come?). About the only way around the problem of utilizing estimation in accounting is to wait until all facts are known with certainty before issuing any reports. However, by the time any information could be reported, it would be so stale as to lose its usefulness. Thus, in order to timely present information, it is considered to be far better to embrace reasonable estimations in the normal preparation of ongoing financial reports.

In addition, accounting has not yet advanced to a state of being able to value a business (or a business's assets). As such, many transactions and events are reported based upon on the historical cost principle (in contrast to fair value). This principle holds that it is better to maintain accountability over certain financial statement elements at amounts that are objective and verifiable, rather than opening the door to random adjustments for value changes that may not be supportable. For example, land is initially recorded in the accounting records at its purchase price. That historical cost will not be adjusted even if the fair value is perceived as increasing. While this enhances the "reliability" of reported data, it can also pose a limitation on its "relevance."

THE ACCOUNTING PROFESSION AND CAREERS

THE ACCOUNTING PROFESSION: To decide to be an accountant is no more descriptive than deciding to be a doctor. Obviously, there are many specialty areas. Many accountants engage in the practice of "public" accounting, which involves providing audit, tax, and consulting services to the general public. To engage in the practice of public accounting usually requires one to be licensed as a CPA (Certified Public Accountant). Auditing involves the examination of transactions and systems that underlie an organization's financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. Tax services relate to the providing of help in the preparation and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. Consulting services can vary dramatically, and include such diverse activities as information systems engineering to evaluating production methods. Many accountants are privately employed directly by small and large businesses (i.e., "industry accounting") and not-for-profit agencies (such as hospitals, universities, and charitable groups). They may work in areas of product costing and pricing, budgeting, and the examination of investment alternatives. They may focus on internal auditing, which involves looking at controls and procedures in use by their employers. Objectives of these reviews are to safeguard company resources and assess the reliability and accuracy of accounting information and accounting systems. They may serve as in-house tax accountants, financial managers, or countless other occupations. And, it probably goes without saying that many accountants work in the governmental sector, whether it be local, state, or national levels. You would expect to find many accountants at the Internal Revenue Service, General Accounting Office, Securities and Exchange Commission ("SEC" -- the USA governmental agency body charged with regulating accounting and reporting by companies whose shares of stock is bought and sold in public markets), and even the Federal Bureau of Investigation.

ACCOUNTING AND PROFESSIONAL ETHICS: Because investors and creditors place great reliance on financial statements in making their investment and credit decisions, it is imperative that the financial reporting process be truthful and dependable. Accountants are expected to behave in an entirely ethical fashion, and this is generally the case. To help insure integrity in the reporting process, the profession has adopted a code of ethics to which its licensed members must adhere. In addition, checks and balances via the audit process, government oversight, and the ever vigilant "plaintiff's attorney" all serve a vital role in providing additional safeguards against the errant accountant. If you are preparing to enter the accounting profession, you should do so with the intention of behaving with honor and integrity. If you are not planning to enter the profession, you will likely rely upon accountants in some aspect of your personal or professional life.

You have every right to expect those accountants to behave in a completely trustworthy and ethical fashion. After all, you will be entrusting them with your financial resources and confidential information.

THE FUNDAMENTAL ACCOUNTING EQUATION

THE ACCOUNTING EQUATION: The basic features of the accounting model we use today trace their roots back over 500 years. Luca Pacioli, a Renaissance era monk, developed a method for tracking the success or failure of trading ventures. The foundation of that system continues to serve the modern business world well, and is the entrenched cornerstone of even the most elaborate computerized systems. The nucleus of that system is the notion that a business entity can be described as a collection of assets and the corresponding claims against those assets. The claims can be divided into the claims of creditors and owners (i.e., liabilities and owners' equity). This gives rise to the fundamental accounting equation:

Assets = Liabilities + Owners' Equity

ASSETS: Assets are the economic resources of the entity, and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible assets like patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner.

LIABILITIES: Liabilities are amounts owed to others relating to loans, extensions of credit, and other obligations arising in the course of business.

OWNERS' EQUITY: Owners' equity is the owner's "interest" in the business. It is sometimes called net assets, because it is equivalent to assets minus liabilities for a particular business. Who are the "owners?" The answer to this question depends on the legal form of the entity; examples of entity types include sole proprietorships, partnerships, and corporations. A sole proprietorship is a business owned by one person, and its equity would typically consist of a single owner's capital account. Conversely, a partnership is a business owned by more than one person, with its equity consisting of a separate capital account for each partner. Finally, a corporation is a very common entity form, with its ownership interest being represented by divisible units of ownership called shares of stock. These shares are easily transferable, with the current holder(s) of the stock being the owners. The total owners' equity (i.e., "stockholders' equity) of a corporation usually consists of several amounts, generally corresponding to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends (dividends are distributions to shareholders as a return on their investment). Earnings give rise to increases in "retained earnings," while dividends (and losses) cause decreases.

BALANCE SHEET: The fundamental accounting equation is the backbone of the accounting and reporting system. It is central to understanding a key financial statement known as the balance sheet (sometimes called the statement of financial position). The following illustration for Edelweiss Corporation shows a variety of assets that are reported at a total of $895,000. Creditors are owed $175,000, leaving $720,000 of stockholders' equity. The stockholders' equity section is divided into the $120,000 originally invested in Edelweiss Corporation by stockholders (i.e., capital stock), and the other $600,000 that was earned (and retained) by successful business performance over the life of the company.

Does the stockholders' equity total mean the business is worth $720,000? No! Why not? Because many assets are not reported at current value. For example, although the land cost $125,000, the balance sheet does not report its current worth. Similarly, the business may have unrecorded resources to its credit, such as a trade secret or a brand name that allows it to earn extraordinary profits. If one is looking to buy stock in Edelweiss Corporation, they would surely give consideration to these important non-financial statement based valuation considerations. This observation tells us that accounting statements are important in investment and credit decisions, but they are not the sole source of information for making investment and credit decisions.

HOW TRANSACTIONS IMPACT THE ACCOUNTING EQUATION

THE IMPACT OF TRANSACTIONS: The preceding balance sheet for Edelweiss was static. This means that it represented the financial condition at the noted date. But, each passing transaction or event brings about a change in the overall financial condition. Business activity will impact various asset, liability, and/or equity accounts; but, they will not disturb the equality of the accounting equation. So, how does this happen? To reveal the answer to this question, let's look at four specific transactions for Edelweiss Corporation. You will see how each transaction impacts the individual asset, liability, and equity accounts, without upsetting the basic equality of the overall balance sheet.

EDELWEISS COLLECTS AN ACCOUNT RECEIVABLE: If Edelweiss Corporation collected $10,000 from a customer on an existing account receivable (i.e., not a new sale, just the collection of an amount that is due from some previous transaction), then the balance sheet would be revised as follows:


This illustration plainly shows that cash (an asset) increased from $25,000 to $35,000, and accounts receivable (an asset) decreased from $50,000 to $40,000. As a result total assets did not change, and liabilities and equity accounts were unaffected. Thus, assets still equal liabilities plus equity.

EDELWEISS BUYS EQUIPMENT WITH LOAN PROCEEDS: Now, if Edelweiss Corporation purchased $30,000 of equipment, agreeing to pay for it later (i.e. taking out a loan), then the balance sheet would be further revised as follows:

This illustration shows that equipment (an asset) increased from $250,000 to $280,000, and loans payable (a liability) increased from $125,000 to $155,000. As a result, both total assets and total liabilities increased by $30,000, but assets still equal liabilities plus equity.

EDELWEISS PROVIDES SERVICES TO A CUSTOMER ON ACCOUNT: What would happen if Edelweiss Corporation did some work for a customer in exchange for the customer's promise to pay $5,000? This requires further explanation; try to follow this logic closely! You already know that retained earnings is the income of the business that has not been distributed to the owners of the business. When Edelweiss Corporation earned $5,000 (which they will collect later) by providing a service to a customer, it can be said that they generated revenue of $5,000. Revenue is the enhancement to assets resulting from providing goods or services to customers. Revenue will bring about an increase income, and income is added to retained earnings. Can you follow that?

As you examine the following balance sheet, notice that accounts receivable and retained earnings went up by $5,000 each, indicating that the business has more assets and more retained earnings. And, guess what: assets still equal liabilities plus equity.


EDELWEISS PAYS EXPENSES WITH CASH: It would be nice if you could run a business without incurring any expenses. However, such is not the case. Expenses are the outflows and obligations that arise from the producing goods and services. Imagine that Example Corporation paid $3,000 for expenses:


GENERALIZING ABOUT THE IMPACT OF TRANSACTIONS: There are countless types of transactions that can occur, and each and every transaction can be described in terms of its impact on assets, liabilities, and equity. What is important to know is that no transaction will upset the fundamental accounting equation of assets = liabilities + owners' equity.

DISTINGUISHING BETWEEN REVENUE AND INCOME: In day-to-day conversation, some terms can often be used casually and without a great deal of precision. Words may be treated as synonymous, when in fact they are not. Such is the case for the words "income" and "revenue." Each term has a very precise meaning, and you should accustom yourself to the correct usage. It has already been pointed out that revenues are enhancements resulting from providing goods and services to customers. Conversely, expenses can generally be regarded as costs of doing business. This gives rise to another "accounting equation":

Revenues - Expenses = Income

Revenue is the "top line" amount corresponding to the total benefits generated from business activity. Income is the "bottom line" amount that results after deducting the expenses from revenue. In some countries, revenue is also referred to as "turnover."

THE CORE FINANCIAL STATEMENTS

Your future will undoubtedly be marked by numerous decisions about investing money in the capital stock of some corporation. Another option that will present itself is to loan money to a company, either directly, or by buying that company's debt instruments known as "bonds." Stocks and bonds are two of the most prevalent financial instruments of the modern global economy. The financial press and television devote seemingly endless coverage to headline events pertaining to large public corporations. Public companies are those with securities that are readily available for purchase/sale through organized stock markets. Many more companies are private, meaning their stock and debt is in the hands of a narrow group of investors and banks.

If you are contemplating an investment in a public or private entity, there is certain information you will logically seek to guide your decision process. What types of information will you desire? What do you want to know about the companies in which you are considering an investment? If you were to prepare a list of questions for the company's management, what subjects would be included? Whether this challenge is posed to a sophisticated investor or to a new business student, the listing almost always includes the same basic components.

What are the corporate assets? Where does the company operate? What are the key products? How much income is being generated? Does the company pay dividends? What is the corporate policy on ethics and environmental responsibility?

Many such topics are noted within the illustrated "thought cloud." Some of these topics are financial in nature (noted in blue). Other topics are of more general interest and cannot be communicated in strict mathematical terms (noted in red).

Financial accounting seeks to directly report information for the topics noted in blue. Additional supplemental disclosures frequently provide insight about subjects such as those noted in red. But, you would also need to gain additional information by reviewing corporate web sites (many have separate sections devoted to their investors), filings with the securities regulators, financial journals and magazines, and other such sources. Most companies will have annual meetings for shareholders and host web casts every three months (quarterly). These events are very valuable in allowing investors and creditors to make informed decisions about the company, as well as providing a forum for direct questioning of management. You might even call a company and seek "special insight" about emerging trends and developments. Be aware, however, that the company will likely not be able to respond in a meaningful way. Securities laws have very strict rules and penalties that are meant to limit selective or unique disclosures to any one investor or group (in the United States: Regulation Full Disclosure/Reg. FD). It is always amusing, but rarely helpful, to review "message boards" where people anonymously post their opinions about a particular company.

FINANCIAL STATEMENTS: Financial accounting information is conveyed through a standardized set of reports. You have already been introduced to the balance sheet. The other fundamental financial statements are the income statement, statement of retained earnings, and statement of cash flows. There are many rules that govern the form and content of each financial statement. At the same time, those rules are not so rigid as to preclude variations in the exact structure or layout. For instance, the earlier illustration for Edelweiss was first presented as a "horizontal" layout of the balance sheet. The subsequent Edelweiss examples were representative of "vertical" balance sheet arrangements. Each approach, and others, is equally acceptable. The basic form and content of each core financial statement is as follows:

INCOME STATEMENT: A summary of an entity's results of operation for a specified period of time is revealed in the income statement, as it provides information about revenues generated and expenses incurred. The difference between the revenues and expenses is identified as the net income or net loss. The income statement can be prepared using a single-step or a multiple-step approach, and might be further modified to include a number of special disclosures relating to unique items. These topics will be amplified in a number of subsequent chapters. For now, take careful note that the income statement relates to activities of a specified time period (e.g., year, quarter, month), as is clearly noted in its title:


THE STATEMENT OF RETAINED EARNINGS: The example balance sheets for Edelweiss revealed how retained earnings increased and decreased in response to events that impacted income. You also know that retained earnings is reduced by dividends paid to shareholders.

The statement of retained earnings provides a succinct reporting of these changes in retained earnings from one period to the next. In essence, the statement is nothing more than a reconciliation or "bird's-eye view" of the bridge between the retained earnings amounts appearing on two successive balance sheets:

If you examine very many sets of financial statements, you will soon discover that many companies provide an expanded statement of stockholders' equity in lieu of the required statement of retained earnings. The statement of stockholders' equity portrays not only the changes in retained earnings, but also changes in other equity accounts such as capital stock. The expanded statement of stockholders' equity is presented in a subsequent chapter.

BALANCE SHEET: The balance sheet focuses on the accounting equation by revealing the economic resources owned by an entity and the claims against those resources (liabilities and owners' equity). The balance sheet is prepared as of a specific date, whereas the income statement and statement of retained earnings cover a period of time. Accordingly, it is sometimes said that balance sheets portray financial position (or condition) while other statements reflect results of operations. Quartz's balance sheet is as follows:


STATEMENT OF CASH FLOWS: The statement of cash flows details the enterprise's cash flows. This operating statement reveals how cash is generated and expended during a specific period of time. It consists of three unique sections that isolate the cash inflows and outflows attributable to (a) operating activities, (b) investing activities, and (c) financing activities. Notice that the cash provided by operations is not the same thing as net income found in the income statement. This result occurs because some items hit income and cash flows in different periods. For instance, remember how Edelweiss (from the earlier illustration) generated income from a service provided on account. That transaction increased income without a similar effect on cash. These differences tend to even out over time.

Suffice it to say that the underpinnings of the statement cash flows require a fairly complete knowledge of basic accounting. Do not be concerned if you feel like you lack a complete comprehension at this juncture. A future chapter is devoted to the statement.


ARTICULATION: It is important for you to take note of the fact that the income statement, statement of retained earnings, and balance sheet articulate. This means they mesh together in a self-balancing fashion. The income for the period ties into to the statement of retained earnings, and the ending retained earnings ties into the balance sheet. This final tie-in causes the balance sheet to balance. These relationships are illustrated in the following diagram.

UNLOCKING THE MYSTERY OF ARTICULATION: It seems almost magical that the final tie-in of retained earnings will exactly cause the balance sheet to balance. This is reflective of the brilliance of Pacioli's model, and is indicative of why it has survived for centuries. This link jumps to a series of web pages that comprehensively illustrate how transactions impact the income statement, statement of retained earnings, and balance sheet. To conclude this chapter, you should click through the pages and study the impact of each transaction on the financial statements.

Source: principles of accounting

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What is Accounting?

Accounting can be defined as follows:

Accounting is the art of recording, summarizing, reporting, and analyzing financial transactions.
[American Institute of Certified Public Accountant]

Accounting is a service activity which provides financial quantitative information about economic entity that can be useful in decision making.
[American Principle Board]

Accounting is the process of keeping track of the changes a user implemented in a computing system.
[techFAQ]

Accountancy or accounting is the system of recording, verifying, and reporting of the value of assets, liabilities, income, and expenses in the books of account (ledger) to which debit and credit entries (recognizing transactions) are chronologically posted to record changes in value
[Wikipedia]

Quite simply, accounting is a language: a language that provides information about the financial position of an organization. When you study accounting you are essentially learning this specialized language. By learning this language you can communicate and understand the financial operations of any and all types of organizations.
[MoneyInstructor]

Accountancy (profession) or accounting (methodology) is the measurement, disclosure or provision of assurance about financial information that helps managers, investors, tax authorities and other decision makers make resource allocation decisions.
[School of Business Administration]

To put it simply, accounting is about keeping track of the money. Accounting is how businesses monitor income, expenses, and assets over a given period of time. Accounting often is referred to as "the language of business" because of its role in maintaining and processing all relevant financial information that an entity or company requires for its managing and reporting purposes. Accounting is a field of specialization critical to the functioning of all types of organizations.

Accounting is also a body of principles and conventions, as well as an established general process for capturing financial information related to an organization’s resources. Accounting is a service function that provides information of value to all operating units and to other service functions, such as the headquarters offices of a large corporation.
[TopAccountingDegrees]

Accounting refers to the practice of tracking a business's income and expenses and using those figures to evaluate its financial status.
[allbusiness]

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