Principles Of Accounting

 

What is the full disclosure principle?

 For a business, the full disclosure principle requires a company to provide the necessary information so that people who are accustomed to reading financial information can make informed decisions concerning the company.
The required disclosures can be found in a number of places including the following:
- the company’s financial statements including any supplementary schedules and notes (or footnotes).
- Management’s Discussion and Analysis that is included in a publicly-traded corporation’s annual report to the U.S. Securities and Exchange Commission.
- Quarterly earnings reports, press releases and other communications.
The first note or footnote in a company’s financial statements will disclose the significant accounting policies such as how and when revenues are recognized, how property is depreciated, how inventory and income taxes are accounted for, and more.
Other disclosures in the notes to the financial statements include the effects of foreign currencies, contingent liabilities, leases, related-party transactions, stock options, and much more.
Judgement is used in deciding the amount of information that is disclosed. For example, in 1980 large U.S. corporations were required to report as supplementary information the effects of inflation and changing prices on its inventory and property (and cost of goods sold and depreciation expense). After several years, the disclosure became optional since the cost of providing the information exceeded the benefits.

What are the accounting principles, assumptions, and concepts?

The basic or fundamental principles in accounting are the cost principle, full disclosure principle, matching principle, revenue recognition principle, economic entity assumption, monetary unit assumption, time period assumption, going concern assumption, materiality, and conservatism. The last two are sometimes referred to as constraints. Rather than distinguishing between a principle or an assumption, I prefer to simply say that these ten items are the basic principles or the underlying guidelines of accounting. (My reason is that accounting principles also include the statements of financial accounting standards and the interpretations issued by the Financial Accounting Standards Board and its predecessors, as well as industry practices.)
There are also “qualities” of accounting information such as reliability, relevance, consistency, comparability, and cost/benefit. These are discussed in the Statement of Financial Accounting Concepts No. 2, which can be found on the Financial Accounting Standards Board’s website www.FASB.org/st.

What is principles of accounting?

Three meanings come to mind when you ask about principles of accounting…
1. Principles of Accounting was often the title of the introductory course in accounting. It was also common for the textbook used in the course to be entitled Principles of Accounting.
2. Principles of accounting can also refer to the basic or fundamental accounting principles: cost, matching, full disclosure, materiality, going concern, economic entity, and so on. In this context, principles of accounting refers to the broad underlying concepts which guide accountants when preparing financial statements.
3. Principles of accounting can also mean generally accepted accounting principles (GAAP). When used in this context, principles of accounting will include both the underlying basic accounting principles and the official accounting pronouncements issued by the Financial Accounting Standards Board (FASB) and its predecessor organizations. The official pronouncements are detailed rules or standards for specific topics.

Prepaid Expenses-Accounting

What are prepaid expenses?

Prepaid expenses are future expenses that have been paid in advance. You can think of prepaid expenses as costs that have been paid but have not yet been used up or have not yet expired. The amount of prepaid expenses that have not yet expired are reported on a company’s balance sheet as an asset. As the amount expires, the asset is reduced and an expense is recorded for the amount of the reduction. Hence, the balance sheet reports the unexpired costs and the income statement reports the expired costs. The amount reported on the income statement should be the amount that pertains to the time interval shown in the statement’s heading.

A common prepaid expense is the six-month premium for insurance on a company’s vehicles. Since the insurance company requires payment in advance, the amount paid is often recorded in the current asset account Prepaid Insurance. If the company issues monthly financial statements, its income statement will report Insurance Expense that is one-sixth of the amount paid. The balance in the account Prepaid Insurance will be reduced by the amount that was debited to Insurance Expense.

 

When do you adjust the amount of prepaid expenses?

The balance in the current asset account Prepaid Expenses should be adjusted prior to issuing a company’s financial statements. If the company issues financial statements for each calendar month, you will need to adjust the balance in Prepaid Expenses as of the end of each month. If your company issues only quarterly financial statements, you will need to adjust the balance at the end of each quarter.
The goal is to have the balance in Prepaid Expenses be equal to the amount of the unexpired costs as of the end of the accounting period (which is also the date appearing in the heading of the balance sheet).
Usually the adjusting entry for prepaid expenses will be a credit to Prepaid Expenses and a debit to the appropriate expense account(s). For instance, if Prepaid Expenses involve the prepayment of insurance premiums the adjusting entry will include a debit to Insurance Expenses.

What are the two methods for recording prepaid expenses?

The two methods for recording prepaid expenses have to do with the general ledger account that is initially debited at the time of the cash payment. The two methods or approaches are:
1. debit an asset account (such as Prepaid Insurance) which is the balance sheet method, or
2. debit an expense account (such as Insurance Expense) which is the income statement method.
The use of either method will almost always require an adjusting entry prior to issuing the company’s financial statements. However, the amount, the account that will be debited, and the account that will be credited in the adjusting entry will depend on the method used.
In short, either the balance sheet method or the income statement method for recording prepaid expenses may be used as long as the asset account balance is equal to the unexpired or unused cost as of the balance sheet date.

How should the cost of a yearly subscription for a newspaper be recorded?

In theory, the payment in advance for a one-year subscription should initially be recorded as a debit to Prepaid Expenses and a credit to Cash. During the subscription period, you would debit Subscription Expense and would credit Prepaid Expenses.
For example, if the annual subscription cost is $240 and it is paid in advance, you would initially debit Prepaid Expenses for $240 and credit Cash for $240. If your company issues monthly financial statements, then each month during the subscription period you would debit Subscription Expense for $20 and credit Prepaid Expenses for $20. This results in 1) the matching of $20 to expense on each of the monthly income statements, and 2) the balance sheet reporting the amount that is prepaid or not yet expired.
At a large company, the annual cost of $240 will usually be an immaterial amount. The materiality concept will allow you to violate the matching principle, and to avoid the monthly adjusting entry, by simply debiting Subscription Expense for the entire $240 at the beginning of the one-year subscription period.

Statement of Cash Flow

English: Statement of Cash Flows of San Narciso, Zambales (Photo credit: Wikipedia)

Statement of Cash Flows

The third financial statement that Joe needs to understand is the Statement of Cash Flows. This statement shows how a company cash amount has changed during the time interval shown in the heading of the statement. Joe will be able to see at a glance the cash generated and used by his company's operating activities, its investing activities, and its financing activities. Much of the information on this financial statement will come from Direct Delivery's balance sheets and income statements.


The three financial reports that Marilyn introduced to Joe—the income statement, the balance sheet, and the statement of cash flows—represent one segment of the valuable output that good accounting software can generate for business owners.
Marilyn now explains to Joe the basics of getting started with recording his transactions.

Whats the Double Entry System

The field of accounting—both the older manual systems and today's basic accounting software—is based on the 500-year-old accounting procedure known as double entry. Double entry is a simple yet powerful concept: each and every one of a company's transactions will result in an amount recorded into at least two of the accounts in the accounting system.

The Chart of Accounts
To begin the process of setting up Joe's accounting system, he will need to make a detailed listing of all the names of the accounts that Direct Delivery, Inc. might find useful for reporting transactions. This detailed listing is referred to as a chart of accounts. (Accounting software often provides sample charts of accounts for various types of businesses.)

As he enters his transactions, Joe will find that the chart of accounts will help him select the two (or more) accounts that are involved. Once Joe's business begins, he may find that he needs to add more account names to the chart of accounts, or delete account names that are never used. Joe can tailor his chart of accounts so that it best sorts and reports the transactions of his business.

Because of the double entry system all of Direct Delivery's transactions will involve a combination of two or more accounts from the balance sheet and/or the income statement. Marilyn lists out some sample accounts that Joe will probably need to include on his chart of accounts:

Balance Sheet accounts:

• Asset accounts (Examples: Cash, Accounts Receivable, Supplies, Equipment)
• Liability accounts (Examples: Notes Payable, Accounts Payable, Wages Payable)
• Stockholders' Equity accounts (Examples: Common Stock, Retained Earnings)

Income Statement accounts:

• Revenue accounts (Examples: Service Revenues, Investment Revenues)
• Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation Expense)

To help Joe really understand how this works, Marilyn illustrates the double entry with some sample transactions that Joe will likely encounter.

Sample Transactions #1

On December 1, 2011 Joe starts his business Direct Delivery, Inc. The first transaction that Joe will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of Direct Delivery's common stock. Direct Delivery's accounting system will show an increase in its account Cash from zero to $20,000, and an increase in its stockholders' equity account Common Stock by $20,000. Both of these accounts are balance sheet accounts. There are no revenues because no delivery fees were earned by the company, and there were no expenses.

After Joe enters this transaction, Direct Delivery's balance sheet will look like this:

Direct Delivery, Inc. Balance Sheet December 1, 2011 Assets Liabilities & Stockholders' Equity Cash $ 20,000 Liabilities Stockholders' Equity                Common Stock $ 20,000 Total Assets $ 20,000 Total Liab. & Stockholders' Equity $ 20,000

Marilyn asks Joe if he can see that the balance sheet is just that—in balance. Joe looks at the total of $20,000 on the asset side, and looks at the $20,000 on the right side, and says yes, of course, he can see that it is indeed in balance.

Marilyn shows Joe something called the basic accounting equation, which, she explains, is really the same concept as the balance sheet, it's just presented in an equation format:

Assets	=	Liabilities	+	Stockholders' (or Owner's) Equity
$20,000	=	$0	+		$20,000

The accounting equation (and the balance sheet) should always be in balance.



Debits and Credits
Did the first sample transaction follow the double entry system and affect two or more accounts? Joe looks at the balance sheet again and answers yes, both Cash and Common Stock were affected by the transaction.

Marilyn introduces the next basic accounting concept: the double entry system requires that the same dollar amount of the transaction must be entered on both the left side of one account, and on the right side of another account. Instead of the word left, accountants use the word debit; and instead of the word right, accountants use the word credit. (The terms debit and credit are derived from Latin terms used 500 years ago.)

Debit means left.
Credit means right.

Joe asks Marilyn how he will know which accounts he should debit—meaning he should enter the numbers on the left side of one account—and which accounts he should credit—meaning he should enter the numbers on the right side of another account. Marilyn points back to the basic accounting equation and tells Joe that if he memorizes this simple equation, it will be easier to understand the debits and credits.

Memorizing the simple accounting equation will
help you learn the debit and credit rules for
entering amounts into the accounting records.

Let's take a look at the accounting equation again:

Assets

=

Liabilities

+

Stockholders' (or Owner's) Equity

Just as assets are on the left side (or debit side) of the accounting equation, the asset accounts in the general ledger have their balances on the left side. To increase an asset account's balance, you put more on the left side of the asset account. In accounting jargon, you debit the asset account. To decrease an asset account balance you credit the account, that is, you enter the amount on the right side.

Just as liabilities and stockholders' equity are on the right side (or credit side) of the accounting equation, the liability and equity accounts in the general ledger have their balances on the right side. To increase the balance in a liability or stockholders' equity account, you put more on the right side of the account. In accounting jargon, you credit the liability or the equity account. To decrease a liability or equity, you debit the account, that is, you enter the amount on the left side of the account.

As with all rules, there are exceptions, but Marilyn's reference to the accounting equation may help you to learn whether an account should be debited or credited.

Since many transactions involve cash, Marilyn suggests that Joe memorize how the Cash account is affected when a transaction involves cash: if Direct Delivery receives cash, the Cash account is debited; when Direct Delivery pays cash, the Cash account is credited.

When a company receives cash, the Cash account is debited.

When the company pays cash, the Cash account is credited.

Marilyn refers to the example of December 1. Since Direct Delivery received $20,000 in cash from Joe in exchange for 5,000 shares of common stock, one of the accounts for this transaction is Cash. Since cash was received, the Cash account will be debited.

In keeping with double entry, two (or more) accounts need to be involved. Because the first account (Cash) was debited, the second account needs to be credited. All Joe needs to do is find the right account to credit. In this case, the second account is Common Stock. Common stock is part of stockholders' equity, which is on the right side of the accounting equation. As a result, it should have a credit balance, and to increase its balance the account needs to be credited.

Accountants indicate accounts and amounts using the following format:

Account Name

Debit

Credit

Cash

20,000

Common Stock

20,000

Accountants usually first show the account and amount to be debited. On the next line, the account to be credited is indented and the amount appears further to the right than the debit amount shown in the line above. This entry format is referred to as a general journal entry.

(With the decrease in the price of computers and accounting software, it is rare to find a small business still using a manual system and making entries by hand. Accounting software has made the process of recording transactions so much easier that the general journal is rarely needed. In fact, entries are often generated automatically when a check or sales invoice is prepared.)