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Accounting is called the language of business that which communicates the financial condition and performance of a business to interested users, also referred to as stakeholders. In order to become effective in carrying out the accounting procedure, as well as in communicating the financial information of the business, there is a widely accepted set of rules, concepts and principles that governs the application of the accounting procedures, and it is referred to as the Generally Accepted Accounting Principles or GAAP.
1. Business Entity
A business is considered a separate entity from the owner(s) and should be treated separately. Any personal transactions of its owner should not be recorded in the business accounting book, vice versa. Unless the owner's personal transaction involves adding and/or withdrawing resources from the business.
A CPA has 3 rooms in a house he has rented for $3,000 per month. He has setup a single-member accounting practice and uses one room for the purpose. Under the business entity concept, only 1/3rd of the rent or $1,000 should be charged to business, because the other 2 rooms or $2,000 worth of rent is expended for personal purposes.
The CPA received $900 bill for utilities. He paid the whole amount using his business account. $600 is to be considered a withdrawal because only $300 (1/3rd) related to business and the other $600 was for domestic purpose.
Assuming each public accounting business is required to pay $100 to a local association of CPAs each month. If the CPA pays that amount from a personal bank account the amount shall be considered additional capital.
2. Going Concern
It assumes that an entity will continue to operate indefinitely. In this basis, assets are recorded based on their original cost and not on market value. Assets are assumed to be used for an indefinite period of time and not intended to be sold immediately.
For Example: - where the venture is for a specific purpose like setting up a stall in an exhibition or fair or the construction of a building or bridge etc. under a contract, the business comes to an end on the completion of the project.
Experience indicates that in spite of several business failures, enterprises have a fairly high continuance rate; certain entities have been in existence for more than a century even though the owners have changed. The business entities are therefore going concerns in the majority of the cases and it has proved useful to adopt continuity assumption for accounting purposes.
3. Monetary Unit
The business financial transactions recorded and reported should be in monetary unit, such as US Dollar, Canadian Dollar, Euro, etc. Thus, any non-financial or non-monetary information that cannot be measured in a monetary unit are not recorded in the accounting books, but instead, a memorandum will be used.
The monetary unit principle states that you only record transactions that can be expressed in terms of currency . Thus, you cannot record such non-quantifiable items as employee skill levels or the quality of customer service.
The monetary unit principle also assumes that the value of the unit of currency in which you record transactions remains stable over time. However, given the amount of persistent currency inflation in most economies, this assumption is not correct - for example, a dollar invested to buy an asset 20 years ago is worth considerably more than a dollar invested today, because the purchasing power of the dollar has declined during the intervening years. The assumption fails completely if an entity records transactions in the currency of a hyperinflationary economy.
4. Historical Cost
All business resources acquired should be valued and recorded based on the actual cash equivalent or original cost of acquisition, not the prevailing market value or future value. Exception to the rule is when the business is in the process of closure and liquidation. For example :
a company acquires an asset in year 1 for $100;
the asset is still held at the end of year 1, when its market value is $120;
the company sells the asset in year 2 for $115.
At the end year 1 the asset is recorded in the balance sheet at cost of $100. No account is taken of the increase in value from $100 to $120 in year 1. In year 2 the company records a sale of $115. The cost of sales is $100, being the historical cost of the asset. This gives rise to a profit of $15 which is wholly recognised in year 2.
This principle requires that revenue recorded, in a given accounting period, should have an equivalent expense recorded, in order to show the true profit of the business.
$2,000,000 worth of sales are made in 2010. Total purchases of inventory were $1,000,000 of which $100,000 remained on hand at the end of 2010. The cost of earnings is $2,000,000 revenue is $900,000 [$1,000,000 minus $100,000] and this should be recognized in 2010 thereby yielding a gross profit of $1,100,000.
A hospital pays $20,000 per month to 5 of its doctors. Monthly sales are $500,000. $100,000 worth of monthly salaries should be matched with $500,000 of revenue generated.
6. Accounting Period
This principle entails a business to complete the whole accounting process of a business over a specific operating time period. It may be monthly, quarterly or annually. For annual accounting period, it may follow a Calendar or Fiscal Year. Suppose ABC Ltd, a UK resident company is incorporated on 1 August 20X1. It acquires a source of income (an interest-bearing bank account) on 1 September 20X1 and commences trading on 1 October 20X1 and continues trading throughout all other periods under review. It draws up its accounts for the following periods:
1 August 2001 to 31 December 2001
1 January 2002 to 31 December 2002
1 January 2003 to 30 June 2003
1 July 2003 to 31 December 2004
Then ABC Ltd would have the following accounting periods:
1 September 2001 to 30 September 2001 (from when it came into charge to corporation tax to the commencement of trade)
1 October 2001 to 31 December 2001 (to the end of a period of account)
1 January 2002 to 31 December 2002 (to the end of a period of account)
1 January 2003 to 30 June 2003 (to the end of a period of account)
1 July 2003 to 30 June 2004 (to the expiry of 12 months)
1 July 2004 to 31 December 2004 (to the end of a period of account)
This principle ensures consistency in the accounting procedures used by the business entity from one accounting period to the next. It allows fair comparison of financial information between two accounting periods. It implies that a business must refrain from changing its accounting policy unless on reasonable grounds. If for any valid reasons the accounting policy is changed, a business must disclose the nature of change, the reasons for the change and its effects on the items of financial statements. Consistency concept is important because of the need for comparability , that is, it enables investors and other users of financial statements to easily and correctly compare the financial statements of a company.
Company A has been using declining balance depreciation method for its IT equipment. According to consistency concept it should continue to use declining balance depreciation method in respect of its IT equipment in the following periods. If the company wants to change it to another depreciation method, say for example the straight line method , it must provide in its financial report, the reason(s) for the change, the nature of the change and the effects of the change on items such as accumulated depreciation.
This principle requires that revenue should be recorded in the period it is earned, regardless of the time the cash is received. The same is true for expense. Expense should be recognized and recorded at the time it is incurred, regardless of the time that cash is paid.
For example, when a company sells a TV to a customer who uses a credit card, cash and accrual methods will view the event differently. The revenue generated by the sale of the TV will only be recognized by the cash method when the money is received by the company. If the TV is purchased on credit, this revenue might not be recognized until next month or next year.
Accrual accounting, however, says that the cash method isn't accurate because it is likely, if not certain, that the company will receive the cash at some point in the future because the sale has been made. Therefore, the accrual accounting method instead recognizes the TV sale at the point at which the customer takes ownership of the TV. Even though cash isn't yet in the bank, the sale is booked to an account known in accounting lingo as "accounts receivable," increasing the seller's revenue.
As we know there are lots of different businesses vary in size from the small one-man business (newspaper kiosk) to the gigantic companies (Mc Donald). But how could the small shops stand next to the giants? We should know the conditions. Why is it good for the people to have a small shop if not far from them there is a big supermarket?
The vast majority of small businesses start out as sole proprietorships. These firms are owned by one person, usually the individual who has day-to-day responsibilities for running the business. Sole proprietors own all the assets of the business and the profits generated by it. They also assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the public, you are one in the same with the business.
Advantages of a Sole Proprietorship:
Easiest and least expensive form of ownership to organize. Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit. Sole proprietors receive all income generated by the business to keep or reinvest. Profits from the business flow directly to the owner's personal tax return. The business is easy to dissolve, if desired.
Disadvantages of a Sole Proprietorship:
Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk. May be at a disadvantage in raising funds and are often limited to using funds from personal savings or
consumer loans. May have a hard time attracting high-caliber employees or those that are motivated by the opportunity to own a part of the business. Some employee benefits such as owner's medical insurance premiums are not directly deductible from business income (only partially deductible as an adjustment to income).
In a Partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, and what steps will be taken to dissolve the partnership when needed. Yes, it's hard to think about a breakup when the business is just getting started, but many partnerships split up at crisis times, and unless there is a defined process, there will be even greater problems. They also must decide up-front how much time and capital each will contribute, etc.
Advantages of a Partnership:
Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement. With more than one owner, the ability to raise funds may be increased. The profits from the business flow directly through to the partners' personal tax returns. Prospective employees may be attracted to the business if given the incentive to become a partner. The business usually will benefit from partners who have complementary skills.
Disadvantages of a Partnership:
Partners are jointly and individually liable for the actions of the other partners.
Profits must be shared with others. Since decisions are shared, disagreements can occur. Some employee benefits are not deductible from business income on tax returns. The partnership may have a limited life; it may end upon the withdrawal or death of a partner.
Types of Partnerships that should be considered:
1. General Partnership
Partners divide responsibility for management and liability as well as the shares of
profit or loss according to their internal agreement. Equal shares are assumed
unless there is a written agreement that states differently.
2. Limited Partnership and Partnership with limited liability
Limited means that most of the partners have limited liability (to the extent of their
investment) as well as limited input regarding management decisions, which
generally encourages investors for short-term projects or for investing in capital
assets. This form of ownership is not often used for operating retail or service
businesses. Forming a limited partnership is more complex and formal than that of a
3. Joint Venture
Acts like a general partnership, but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such as well as distribute accumulated partnership assets upon dissolution of the entity.
Definition of the Accounting Equation
In essence, the accounting equation is:
Assets = Liabilities + Shareholders' Equity
The assets in the accounting equation are the resources that a company has available for its use, such as cash , accounts receivable , fixed assets , and inventory . The company pays for these resources by either incurring liabilities (which is the Liabilities part of the accounting equation) or by obtaining funding from investors (which is the Shareholders' Equity part of of the equation). Thus, you have resources with offsetting claims against those resources, either from creditors or investors. All three components of the accounting equation appear in the balance sheet , which reveals the financial position of a business at any given point in time.
The Liabilities part of the equation is usually comprised of accounts payable that are owed to suppliers , a variety of accrued liabilities, such as sales taxes and income taxes , and debt payable to lenders .
The Shareholders' Equity part of the equation is more complex than simply being the amount paid to the company by investors. It is actually their initial investment, plus any subsequent gains, minus any subsequent losses, minus any dividends or other withdrawals paid to the investors.
Accounting Equation Example
ABC International engages in the following series of transactions:
ABC sell shares to an investor for $10,000. This increases the cash (asset) account as well as the capital (equity) account.
ABC buys $4,000 of inventory from a supplier. This increases the inventory (asset) account as well as the payables (liability) account.
ABC sells the inventory for $6,000. This decreases the inventory (asset) account and creates a cost of goods sold expense that appears as a decrease in the income (equity) account.
The sale of ABC's inventory also creates a sale and offsetting receivable. This increases the receivables (asset) account by $6,000 and increases the income (equity) account by $6,000.
ABC collects cash from the customer to which it sold the inventory. This increases the cash (asset) account by $6,000 and decreases the receivables (asset) account by $6,000.
These transactions appear in the following table:
Note how every transaction is balanced within the accounting equation - either because there are changes on both sides of the equation, or because a transaction cancels itself out on one side of the equation (as was the case when the receivable was converted to cash).
Recording accounting transactions with the accounting equation means that you use debits and credits to record every transaction, which is known as double-entry bookkeeping. See the debits and credits article for more information about double-entry bookkeeping.
You can see this relationship between assets, liabilities, and shareholders' equity in the balance sheet , where the total of all assets always equals the sum of the liabilities and shareholders' equity sections.
The reason why the accounting equation is so important is that is always true - and it forms the basis for all accounting transactions . At a general level, this means that whenever there is a recordable transaction, you choices for recording it all involve keeping the accounting equation in balance.