Professional Documents
Culture Documents
You may have already noticed the use of some form of accounting in your daily life.
My mom for example is the chief accountant and treasurer of our house. She
keeps a simple diary to record major home expenses such as grocery, utilities, fees
and so on. It gives her peace of mind knowing where she has spent the monthly
income. The diary also serves as a reminder in case she forgets whether she has
already paid someone. She keeps all the receipts in a folder. At the start of each
month, she prepares a small budget that lists all major payments expected to be
made in the following month. Even though my mom doesn't realize, she is basically
performing functions of accounting to manage the home finances.
Accounting, what we normally refer to, is a more formal, efficient and effective
version of such processes in a business context.
Importance of Accounting
How much they owe to suppliers, tax authorities, banks, employees and
others?
Such information is necessary for a business to fulfill its legal obligations and
asserting its own legal rights. Without proper accounting, it would be very difficult
for a business to determine for example the exact amount (net of any discounts,
VAT, etc.) it needs to pay a certain supplier (who could be one of dozens of
suppliers for that business) from whom they may have made several purchases in
last month alone. Organizations need to have a reliable way of recording
information relating to transactions and that is where accounting is so vital.
Historical accounting information is summarized to produce financial statements.
Financial Statements provide an overview of financial activities of a business
during a period (e.g. income and expenses) as well as information relating to
its financial position on a certain date (e.g. the amount of cash and inventory).
Financial Statements help owners in assessing the performance and position of
their business can guide their investment decisions (e.g. whether they should
invest more in the business, diversify or dispose their investment).
Variance Analysis
Investment Appraisal
Ratio Analysis
Accounting has evolved into different specialties to address the diverse information
needs of its users.
Objectives of Accounting
Recording
Business transactions and balances once recorded can be summarized in the form
of financial statements. Financial statements provide key information relating to a
business such as:
Such information is not only useful for managers (e.g. to keep track of the financial
health and profitability of the business) but is also important for other stakeholders
as discussed in the article: users of financial statements.
Planning
Organizations need to plan how they intend to allocate their limited resources (e.g.
cash, labor, materials, machinery and equipment) towards competing needs in the
future. An effective way of doing so is by using various forms of budgets.
Variance Analysis
Investment Appraisal
Disinvestment Decisions
Ratio Analysis
Accountability
Accounting provides a basis for analysis of the performance over a period of time
which promotes accountability across several tiers of an organization.
Shareholders can ultimately hold the directors responsible for the overall
performance of their company through performance appraisal on the basis of
accounting information published in the financial statements.
Introduction to Accounting
Owners: for analyzing the viability and profitability of their investment and
determining any future course of action.
Tax Authourities: for determining the credibility of the tax returns filed on
behalf of the company.
Accounting is a vast and dynamic profession and is constantly adapting itself to the
specific and varying needs of its users. Over the past few decades, accountancy
has branched out into different types of accounting to cater for the diversity of
needs of its users.
Tax Accounting refers to accounting for the tax related matters. It is governed by
the tax rules prescribed by the tax laws of a jurisdiction. Often these rules are
different from the rules that govern the preparation of financial statements for
public use (i.e. GAAP). Tax accountants therefore adjust the financial statements
prepared under financial accounting principles to account for the differences with
rules prescribed by the tax laws. Information is then used by tax professionals to
estimate tax liability of a company and for tax planning purposes.
Project Accounting refers to the use of accounting system to track the financial
progress of a project through frequent financial reports. Project accounting is a vital
component of project management. It is a specialized branch of management
accounting with a prime focus on ensuring the financial success of company
projects such as the launch of a new product. Project accounting can be a source
of competitive advantage for project-oriented businesses such as construction
firms.
Statement of Financial Position, also known as the Balance Sheet, presents the
financial position of an entity at a given date. It is comprised of the following three
elements:
Equity: What the business owes to its owners. This represents the amount
of capital that remains in the business after its assets are used to pay off its
outstanding liabilities. Equity therefore represents the difference between
the assets and liabilities.
2. Income Statement
Income Statement, also known as the Profit and Loss Statement, reports the
company's financial performance in terms of net profit or loss over a specified
period. Income Statement is composed of the following two elements:
Income: What the business has earned over a period (e.g. sales revenue,
dividend income, etc)
Expense: The cost incurred by the business over a period (e.g. salaries and
wages, depreciation, rental charges, etc)
Cash Flow Statement, presents the movement in cash and bank balances over a
period. The movement in cash flows is classified into the following segments:
Investing Activities: Represents cash flow from the purchase and sale of
assets other than inventories (e.g. purchase of a factory plant)
Net Profit or loss during the period as reported in the income statement
Dividend payments
Statement of Financial Position, also known as the Balance Sheet, presents the
financial position of an entity at a given date. It is comprised of three main
components: Assets, liabilities and equity.
Example
Non-current assets
Property, plant & equipment 9 130,000 120,000
Goodwill 10 30,000 30,000
Intangible assets 11 60,000 50,000
220,000 200,000
Current assets
Inventories 12 12,000 10,000
Trade receivables 13 25,000 30,000
Cash and cash equivalents 14 8,000 10,000
45,000 50,000
TOTAL ASSETS 265,000 250,000
EQUITY AND LIABILITIES
Equity
Share capital 4 100,000 100,000
Retained earnings 50,000 40,000
Revaluation reserve 5 15,000 10,000
Total equity 165,000 150,000
Non-current liabilities
Long term borrowings 6 35,000 50,000
Current liabilities
Trade and other payables 7 35,000 25,000
Short-term borrowings 8 10,000 8,000
Current portion of long-term borrowings 6 15,000 15,000
Current tax payable 9 5,000 2,000
Total current liabilities 65,000 50,000
Total liabilities 100,000 100,000
TATAL EQUITY AND LIABILITIES 265,000 250,000
Classification of Components
Assets
Assets are also classified in the statement of financial position on the basis of their
nature:
Trade receivables include the amounts that are recoverable from customers
upon credit sales. Trade receivables are presented in the statement of
financial position after the deduction of allowance for bad debts.
Cash and cash equivalents include cash in hand along with any short term
investments that are readily convertible into known amounts of cash.
Liabilities
Liabilities are also classified in the statement of financial position on the basis of
their nature:
Trade and other payables primarily include liabilities due to suppliers and
contractors for credit purchases. Sundry payables which are too insignificant
to be presented separately on the face of the balance sheet are also
classified in this category.
Short term borrowings typically include bank overdrafts and short term bank
loans with a repayment schedule of less than 12 months.
Equity
Equity is what the business owes to its owners. Equity is derived by deducting total
liabilities from the total assets. It therefore represents the residual interest in the
business that belongs to the owners.
Equity is usually presented in the statement of financial position under the following
categories:
Share capital represents the amount invested by the owners in the entity
Retained Earnings comprises the total net profit or loss retained in the
business after distribution to the owners in the form of dividends.
The balance sheet is structured in a manner that the total assets of an entity equal
to the sum of liabilities and equity. This may lead you to wonder as to why the
balance sheet must always be in equilibrium.
Assets of an entity may be financed from internal sources (i.e. share capital and
profits) or from external credit (e.g. bank loan, trade creditors, etc.). Since the total
assets of a business must be equal to the amount of capital invested by the owners
(i.e. in the form of share capital and profits not withdrawn) and any borrowings, the
total assets of a business must equal to the sum of equity and liabilities.
Income Statement, also known as Profit & Loss Account, is a report of income,
expenses and the resulting profit or loss earned during an accounting period.
Example
Basis of preparation
This means that income (including revenue) is recognized when it is earned rather
than when receipts are realized (although in many instances income may be
earned and received in the same accounting period).
Conversely, expenses are recognized in the income statement when they
are incurred even if they are paid for in the previous or subsequent accounting
periods.
Income statement does not report transactions with the owners of an entity.
Components
Revenue
Revenue includes income earned from the principal activities of an entity. So for
example, in case of a manufacturer of electronic appliances, revenue will comprise
of the sales from electronic appliance business. Conversely, if the same
manufacturer earns interest on its bank account, it shall not be classified as
revenue but as other income.
Cost of Sales
Cost of sales represents the cost of goods sold or services rendered during an
accounting period.
Hence, for a retailer, cost of sales will be the sum of inventory at the start of the
period and purchases during the period minus any closing inventory.
In case of a manufacturer however, cost of sales will also include production costs
incurred in the manufacture of goods during a period such as the cost of direct
labor, direct material consumption, depreciation of plant and machinery and factory
overheads, etc.
You may refer to the article on cost of sales for an explanation of its calculation.
Other Income
Other income consists of income earned from activities that are not related to the
entity's main business. For example, other income of an entity that manufactures
electronic appliances may include:
Distribution Cost
Distribution cost includes expenses incurred in delivering goods from the business
premises to customers.
Administrative Expenses
Other Expenses
This is essentially a residual category in which any expenses that are not suitably
classifiable elsewhere are included.
Finance Charges
The effect of present value adjustments of discounted provisions are also included
in finance charges (e.g. unwinding of discount on provision for decommissioning
cost).
Income tax
Prior period financial information is presented along side current period's financial
results to facilitate comparison of performance over a period.
For example, if an organization is preparing income statement for the six months
ending 31 December 2013, comparative figures of prior period should relate to the
six months ending 31 December 2012.
Income Statement provides the basis for measuring performance of an entity over
the course of an accounting period.
Performance can be assessed from the income statement in terms of the following:
Change in gross profit margin, operating profit margin and net profit margin
over the period
Increase or decrease in net profit, operating profit and gross profit over the
period
Income statement also forms the basis of important financial evaluation of an entity
when it is analyzed in conjunction with information contained in other financial
statements such as:
Statement of Cash Flows, also known as Cash Flow Statement, presents the
movement in cash flows over the period as classified under operating, investing
and financing activities.
Example
ABC PLC
Statement of Cash Flows for the year ended 31 December 2013
2013 2012
Notes
USD USD
Basis of Preparation
Statement of Cash Flows presents the movement in cash and cash equivalents
over the period.
Cash at bank
Short term investments that are highly liquid and involve very low risk of
change in value (therefore usually excludes investments in equity
instruments)
As income statement and balance sheet are prepared under the accruals basis of
accounting, it is necessary to adjust the amounts extracted from these financial
statements (e.g. in respect of non cash expenses) in order to present only the
movement in cash inflows and outflows during a period.
All cash flows are classified under operating, investing and financing activities as
discussed below.
Operating Activities
Cash flow from operating activities presents the movement in cash during an
accounting period from the primary revenue generating activities of the entity.
For example, operating activities of a hotel will include cash inflows and outflows
from the hotel business (e.g. receipts from sales revenue, salaries paid during the
year etc), but interest income on a bank deposit shall not be classified as such (i.e.
the hotel's interest income shall be presented in investing activities).
Profit before tax as presented in the income statement could be used as a starting
point to calculate the cash flows from operating activities.
Following adjustments are required to be made to the profit before tax to arrive at
the cash flow from operations:
Cash flow from investing activities includes the movement in cash flow as a result
of the purchase and sale of assets other than those which the entity primarily
trades in (e.g. inventory). So for example, in case of a manufacturer of cars,
proceeds from the sale of factory plant shall be classified as cash flow from
investing activities whereas the cash inflow from the sale of cars shall be presented
under the operating activities.
Financing activities
Cash flow from financing activities includes the movement in cash flow resulting
from the following:
Cash outflow expended on the cost of finance (i.e. dividends and interest
expense)
Statement of cash flows provides important insights about the liquidity and
solvency of a company which are vital for survival and growth of any organization.
It also enables analysts to use the information about historic cash flows to form
projections of future cash flows of an entity (e.g. in NPV analysis) on which to base
their economic decisions. By summarizing key changes in financial position during
a period, cash flow statement serves to highlight priorities of management. For
example, increase in capital expenditure and development costs may indicate a
higher increase in future revenue streams whereas a trend of excessive investment
in short term investments may suggest lack of viable long term investment
opportunities. Furthermore, comparison of the cash flows of different entities may
better reveal the relative quality of their earnings since cash flow information is
more objective as opposed to the financial performance reflected in income
statement which is susceptible to significant variations caused by the adoption of
different accounting policies.
Statement of Changes in Equity
Definition
Example
ABC Plc
st
Statement of changes in equity for the year ended 31 December 2012
Share Retained Revaluation Total
Capital Earnings Surplus Equity
USD USD USD USD
Balance at 1 January 2011 100,000 30,000 - 130,000
Changes in accounting policy - - - -
Correction of prior period
- - - -
error
Restated balance 100,000 30,000 - 130,000
Changes in equity for the
year 2011
Issue of share capital - - - -
Income for the year - 25,000 - 25,000
Revaluation gain - - 10,000 10,000
Dividends - (15,000) - (15,000)
Balance at 31 December
100,000 40,000 10,000 150,000
2011
Changes in equity for the
year 2012
Issue of share capital - - - -
Income for the year - 30,000 - 30,000
Revaluation gain - - 5,000 5,000
Dividends - (20,000) - (20,000)
Balance at 31 December
100,000 50,000 15,000 165,000
2012
Components
Opening Balance
This represents the balance of shareholders' equity reserves at the start of the
comparative reporting period as reflected in the prior period's statement of financial
position. The opening balance is unadjusted in respect of the correction of prior
period errors rectified in the current period and also the effect of changes in
accounting policy implemented during the year as these are presented separately
in the statement of changes in equity (see below).
Restated Balance
Issue of further share capital during the period must be added in the statement of
changes in equity whereas redemption of shares must be deducted therefrom. The
effects of issue and redemption of shares must be presented separately for share
capital reserve and share premium reserve.
Dividends
Dividend payments issued or announced during the period must be deducted from
shareholder equity as they represent distribution of wealth attributable to
stockholders.
This represents the profit or loss attributable to shareholders during the period as
reported in the income statement.
Revaluation gains and losses recognized during the period must be presented in
the statement of changes in equity to the extent that they are recognized outside
the income statement. Revaluation gains recognized in income statement due to
reversal of previous impairment losses however shall not be presented separately
in the statement of changes in equity as they would already be incorporated in the
profit or loss for the period.
Any other gains and losses not recognized in the income statement may be
presented in the statement of changes in equity such as actuarial gains and losses
arising from the application of IAS 19 Employee Benefit.
Closing Balance
This represents the balance of shareholders' equity reserves at the end of the
reporting period as reflected in the statement of financial position.
Financial Statements reflect the effects of business transactions and events on the
entity. The different types of financial statements are not isolated from one another
but are closely related to one another as is illustrated in the following diagram.
Balance Sheet
Assets, liabilities and equity balances reported in the Balance Sheet at the period
end consist of:
The increase (or decrease) in net assets as a result of the net profit (or loss)
reported in the income statement;
The increase (or decrease) in net assets as a result of the net gains (or
losses) recognized outside the income statement and directly in the
statement of changes in equity (e.g. revaluation surplus);
The increase in net assets and equity arising from the issue of share capital
as reported in the statement of changes in equity;
The decrease in net assets and equity arising from the payment of dividends
as presented in the statement of changes in equity;
Income Statement
The increase or decrease in net assets of an entity arising from the profit or loss
reported in the income statement is incorporated in the balances reported in the
balance sheet at the period end.
The profit and loss recognized in income statement is included in the cash flow
statement under the segment of cash flows from operation after adjustment of non-
cash transactions. Net profit or loss during the year is also presented in the
statement of changes in equity.
Statement of Changes in Equity
Cash flow statement therefore reflects the increase or decrease in cash flow
arising from:
Change in share capital reserves arising from share capital issues and
redemption;
Change in non current assets due to receipts and payments upon the
acquisitions and disposals of assets (i.e. investing activities)
Purpose of Financial Statements
Shareholders use Financial Statements to assess the risk and return of their
investment in the company and take investment decisions based on their analysis.
Employees use Financial Statements for assessing the company's profitability and
its consequence on their future remuneration and job security.
Competitors compare their performance with rival companies to learn and develop
strategies to improve their competitiveness.
Accounting estimates
Professional judgment
Verifiability
Audit is the main mechanism that enables users to place trust on financial
statements. However, audit only provides 'reasonable' and not absolute assurance
on the truth and fairness of the financial statements which means that despite
carrying audit according to acceptable standards, certain material misstatements in
financial statements may yet remain undetected due to the inherent limitations of
the audit.
Historical cost is the most widely used basis of measurement of assets. Use of
historical cost presents various problems for the users of financial statements as it
fails to account for the change in price levels of assets over a period of time. This
not only reduces the relevance of accounting information by presenting assets at
amounts that may be far less than their realizable value but also fails to account for
the opportunity cost of utilizing those assets.
The effect of the use of historical cost basis is best explained by the use of an
example
Company A purchased a plant for $100,000 on 1st January 2006 which had a
useful life of 10 years.
At the end of the reporting period at 31st December 2010, the balance sheet of
Company B would show a fixed asset of $200,000 while A's financial statement
would show an asset of $50,000 (net of depreciation).
The scenario above presents an accounting anomaly. Even though the plant
presented in A's financial statements is capable of producing economic benefits
worth 50% of Company B's asset, it is carried at a historical cost equivalent of just
25% of its value.
Moreover, the depreciation charged in A's financial statements (i.e. $10,000 p.a.)
does not reflect the opportunity cost of the plant's use (i.e. $20,000 p.a.). As a
result, over the course of the asset's life, an amount of $100,000 would be charged
as depreciation in A's financial statements even though the cost of maintaining the
productive capacity of its asset would have notably increased. If Company A were
to distribute all profits as dividends, it will not have the resources sufficient to
replace its existing plant at the end of its useful life. Therefore, the use of historical
cost may result in reporting profits that are not sustainable in the long term.
Due to the disadvantages associated with the use of historical cost, some
preparers of financial statements use the revaluation model to account for long-
term assets. However, due to the limited market of various assets and the cost of
regular valuations required under revaluation model, it is not widely used in
practice.
An interesting development in accounting is the use of 'capital maintenance' in the
determination of profit that is sustainable after taking into account the resources
that would be required to 'maintain' the productivity of operations. However, this
accounting basis is still in its early stages of development.
Measurability
Accounting only takes into account transactions that are capable of being
measured in monetary terms. Therefore, financial statements do not account for
those resources and transactions whose value cannot be reasonably assigned
such as the competence of workforce or goodwill.
Financial statements are susceptible to fraud and errors which can undermine the
overall credibility and reliability of information contained in them. Deliberate
manipulation of financial statements that is geared towards achieving
predetermined results (also known as 'window dressing') has been a unfortunate
reality in the recent past as has been popularized by major accounting disasters
such as the Enron Scandal.
Elements of the financial statements include Assets, Liabilities, Equity, Income &
Expenses. The first three elements relate to the statement of financial position
whereas the latter two relate to the income statement.
The first three elements relate to the statement of financial position while the latter
two relate to income statements.
Assets
Definition
Asset is a resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity (IASB
Framework).
Explanation
Classification
Assets may be classified into Current and Non-Current. The distinction is made on
the basis of time period in which the economic benefits from the asset will flow to
the entity.
Current Assets are ones that an entity expects to use within one-year time from the
reporting date.
Non Current Assets are those whose benefits are expected to last more than one
year from the reporting date.
Following are the most common types of Assets and their Classification along with
the economic benefits derived from those assets.
It is worth noting that the framework defines asset in terms of control rather than
ownership. While control is generally evidenced through ownership, this may not
always be the case. Therefore, an asset may be recognized in the financial
statement of the entity even if ownership of the asset belongs to someone else. For
instance, if a machine is leased to a company for the entire duration of its useful
life, the machine may be recognized in its Statement of Financial Position (Balance
Sheet) since the entity has control over the economic benefits that would be
derived from the use of the asset. This illustrates the use of Substance Over Form
whereby the economic substance of the transaction takes precedence over the
legal aspects of a transaction in order to present a true and fair view.
Explanation
Apart from meeting the above definition, the Framework has advised the following
recognition criteria that ought to be met before an asset is recognized in the
financial statements.
Recognition Criteria
With regard to the first criteria, it makes sense to only recognize an asset if the
benefits from its use or sale are likely.
The second test ensures that the financial statements present assets that can be
measured objectively. For instance, how does a person place value on something
subjective such as customer loyalty or a dedicated employee?
Liabilities
Definition
Explanation
Liability could for instance be a bank loan, which obligates the entity to pay loan
installments over the duration of the loan to the bank along with the associated
interest cost. Alternatively, an entity's liability could be a trade payable arising from
the purchase of goods from a supplier on credit.
Classification
Liabilities may be classified into Current and Non-Current. The distinction is made
on the basis of time period within which the liability is expected to be settled by the
entity.
Current Liability is one which the entity expects to pay off within one year from the
reporting date.
Non-Current Liability is one which the entity expects to settle after one year from
the reporting date.
Following are examples the common types of liabilities along with their usual
classifications.
Liability Classification
Long Term Bank Loan Non-current
Bank Overdraft current
Short Term Bank Loan current
Trade Payables current
Debenture Non-current
Tax Payble Current
It may be appropriate to break up a single liability into their current and non current
portions. For instance, a bank loan spanning two years and carrying 2 equal
installments payable at the end of each year would be classified half as current and
half as non-current liability at the inception of loan.
Recognition Criteria of Liabilities
Definition
In order for a liability to be recognized in the financial statements, it must meet the
following definition provided by the framework:
As is clear from the above definition, the obligation must be a present one, arising
from past events. In case of a bank loan for instance, the past event would be the
receipt of loan principal. The obligation to pay off the loan would be present from
the day the entity receives the loan principal (i.e. when an obligating event occurs).
Conversely, a liability may not be recognized in anticipation of a future obligation
such a bank loan expected to be taken in two year's time.
Explanation
The obligation to transfer economic benefits may not only be a legal one. Liability
in respect of a constructive obligation may also be recognized where an entity, on
the basis of its past practices, has a created a valid expectation in the minds of the
concerned persons that it will fulfill such obligations in the future. For example, if an
oil exploration company has a past practice of restoring oil rig sites after they are
dismantled in spite of no legal obligation to do so, and it advertises itself as an
environment friendly organization, then this gives rise to a constructive liability and
must therefore be recognized in the financial statements of the company. This is
because a valid expectation has been created that the company will restore oil rig
sites in the future.
Recognition Criteria
Apart from satisfying the definition of liability, the framework has also advised the
following recognition criteria to be met before a liability could be shown on the face
of a financial statement:
With regard to the first test, it is logical to recognize a liability only if it is likely that
the entity will be required to settle it. The second test ensures that only liabilities
that can be objectively measured are recognized in the financial statements.
If an obligation meets the definition of a liability but fails to meet the recognition
criteria, it is classified as a contingent liability. Contingent liability is not presented
as a liability in the statement of financial position but is instead disclosed in the
notes to the financial statements.
Equity
Definition
Equity is the residual interest in the assets of the entity after deducting all the
liabilities (IASB Framework).
Explanation
Equity therefore includes share capital contributed by the shareholders along with
any profits or surpluses retained in the entity. This is what the owners take home in
the event of liquidation of the entity.
This illustrates that equity is the owner's interest in the Net Assets of an entity.
Examples
Retained Earnings
Revaluation Surpluses
Income
Definition
Income is increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity
participants (IASB Framework).
Explanation
Income is therefore an increase in the net assets of the entity during an accounting
period except for such increases caused by the contributions from owners. The first
part of the definition is quite easy to understand as income must logically result in
an increase in the net assets (equity) of the entity such as by the inflow of cash or
other assets. However, net assets of an entity may increase simply by further
capital investment by its owners even though such increase in net assets cannot
be regarded as income. This is the significance of the latter part of the definition of
income.
Types
Gains: Income that does not arise from the core operations of the entity.
For instance, sale revenue of a business whose main aim is to sell biscuits is
income generated from selling biscuits. If the business sells one of its factory
machines, income from the transaction would be classified as a gain rather than
sale revenue.
Examples
Expenses are the decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants
(IASB Framework).
Explanation
Expense is simply a decrease in the net assets of the entity over an accounting
period except for such decreases caused by the distributions to the owners. The
first aspect of the definition is quite easy to grasp as the incurring of an expense
must reduce the net assets of the company. For instance, payment of a company's
utility bills reduces cash. However, net assets of an entity may also decrease as a
result of payment of dividends to shareholders or drawings by owners of a
business, both of which are distributions of profits rather than expense. This is the
significance of the latter part of the definition of expense.
Types
Utility expenses
Administration expenses
Finance costs
Depreciation
Impairment losses
Accruals Principle
Expense is accounted for under the accruals principal whereby it is recognized for
the whole accounting period in full, irrespective of whether payments have been
made or not.
As expense is an element of the income statement, it is calculated over the entire
accounting period (usually one year) unlike balance sheet items which are
calculated specifically for the year end date.
Every transaction has two effects. For example, if someone transacts a purchase
of a drink from a local store, he pays cash to the shopkeeper and in return, he gets
a bottle of dink. This simple transaction has two effects from the perspective of
both, the buyer as well as the seller. The buyer's cash balance would decrease by
the amount of the cost of purchase while on the other hand he will acquire a bottle
of drink. Conversely, the seller will be one drink short though his cash balance
would increase by the price of the drink.
Traditionally, the two effects of an accounting entry are known as Debit (Dr) and
Credit (Cr). Accounting system is based on the principal that for every Debit entry,
there will always be an equal Credit entry. This is known as the Duality Principal.
Debit entries are ones that account for the following effects:
Increase in assets
Increase in expense
Decrease in liability
Decrease in equity
Decrease in income
Credit entries are ones that account for the following effects:
Decrease in assets
Decrease in expense
Increase in liability
Increase in equity
Increase in income
Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or increase
in liability or equity (Cr) and vice-versa. Hence, the accounting equation will still be
in equilibrium.
Explanation
In a typical accounting ledger (often referred to as a T-Account) the debit and credit
sides are split horizontally as shown below:
12,500 12,500
According to the dual aspect principle, each accounting entry is recorded in 2 equal
debit and credit portions. In other words, the total amount that will be recorded in
the left side (debit) of accounting ledgers will always equal to the total amount
recorded on the right side (credit).
For example, you may consider how the accounting entries have been recorded in
the Receivable A/C shown above.
The ledger has been debited on account of credit sales amounting $12,500 and
(as can be ascertained from the particulars) the same amount has
been credited in the Sales A/C. Similarly, the credit entries in the Receivable A/C
relating to discount allowed and bank receipts are matched with equal amounts
recorded on the debit sides of Discount Allowed A/C and Bank A/C respectively.
In case of any confusion, please refer Accounting for Sales section for more
thorough explanation of the accounting entries discussed above.
Now the question arises, how do we know what to record on the debit side of
an account and what to record on the credit side?
Accounting has specific rules regarding what should be debited and what should
be credited as summarized in the chart below:
Assets, expenses, liabilities, income & equity are the 5 elements of financial
statements. For explanation and examples of the various elements, please
refer elements of financial statements section.
As with accounting ledgers, all accounting statements are based on the rules of
debit and credit. For example, in a balance sheet, assets are reported on the debit
side whereas liabilities and equity are presented on the credit side. Although
traditional accounts and statements are presented in a T-Account format as above
(which makes understanding debits and credits a bit easier for beginners) many
accounts and statements nowadays are reported in a vertical format.
But fear not! As long as you master the rules of debit and credit, you shall have no
problem in understanding their application and presentation.
Example
Account $ Effect
b) Performance Bonus
Account $ Effect
c) Credit Sales
Account $ Effect
Account $ Effect
If you face any problem in understanding the double entries, please refer double
entry accounting section.
Ledger Accounts
Accounting Entries are recorded in ledger accounts. Debit entries are made on the
left side of the ledger account whereas Credit entries are made to the right side.
Ledger accounts are maintained in respect of every component of the financial
statements. Ledger accounts may be divided into two main types: balance sheet
ledger accounts and income statement ledger accounts.
Balance Sheet ledger accounts are maintained in respect of each asset, liability
and equity component of the statement of financial position.
Receivable Account
Debit $ Credit
These are credit sales made during the period. Receivables account is
debited because it has the effect of increasing the receivable asset. The
corresponding credit entry is made to the Sales ledger account. The account
in which the corresponding entry is made is always shown next to the
amount, which in this case is the Sales ledger.
This is the amount of cash received from the debtor. Receiving cash has the
effect of reducing the receivable asset and is therefore shown on the credit
side. As it can seen, the corresponding debit entry is made in the cash
ledger.
This represents the balance due from the debtor at the end of the
accounting period. The figure has been arrived by subtracting the amount
shown on the credit side from the sum of amounts shown on the debit side.
This accounting period's closing balance is being carried forward as the
opening balance of the next period.
Similar ledger accounts can be made for other balance sheet components such as
payables, inventory, equity capital, non current assets and so on.
Debit $ Credit
This is the amount of cash paid against electricity bill. The expense ledger is
being debited to account for the increase in expense. The corresponding
credit entry has been made in the cash ledger.
Similar ledger accounts can be made for other income statement components.
Accounting Equation
Note:
For all the examples on the next pages, it will be assumed that before any
transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are
$5,000 each.
Accounting Equation
Transactions that only affect Assets of the entity
Since Assets, and other components of the equation, will be the same as before
the transaction, the Accounting Equation will be in equilibrium.
Example 1
Example 2
ABC LTD receives $500 cash from a receivable DEF LTD in respect of goods sold
on credit.
* Assets $10,000 = $10,000 Plus $500 (Cash) Less $500 (Trade Receivable)