Accounting Philosophy, part 1

Hello readers, in this series of posts I will discuss some of the basic foundations of accounting theory. Specifically I will talk about the principles, assumptions and constraints of accounting. From these we can find justification for every rule. Also with the transition from the US GAAP to the International accounting standards (IFRS) which is more so principle based than our current system, I though it would be a good topic to write about.

Assumptions

Let’s start with the assumptions in accounting. As you no doubt already know in life sometimes you just have to assume some facts, which you may not know. Accounting is no different. In order to ‘account’ for something we have to assume that some points are true. In accounting we have four assumptions. They are: Economic entity, Monetary unit, and the Time period assumption.

Economic entity assumption

The economic entity assumption requires that we account for the activities of one distinct and independent enterprise. In other words we need to draw the line between a firm and its owners, employees, vendors, customers etc. To illustrate this consider the following example. Silda owns a consulting business called Silda’s Consulting. The business has a few employees but provides Silda with the means to live on (i.e. its her only job). Every two weeks she pays her employees and draws out some money for her self. In addition to her business she owns a summer home in Milan which she uses only for personal recreation. If you were the accountant for Silda’s Consulting you would need to separate the activities of the firm from the activities of its owner. For example, the mortgage on Silda’s summer home is a personal expense, and should not be an expense of the company, likewise office supplies (for company use) should be expensed through the companies books and not through her personal accounts. This can sometimes be a challenge, some small firms don’t mind paying their personal bills through their company…while that is not necessarily wrong it does create some difficultly in determine the success of the business. In general, we must define what entity we are going to account for before we can account for it.

Monetary unit assumption

This is an easy one! Everything we account for is going to be measured in money. Transactions will be measured in dollars, not some other unit like time. And that only transactions that can be measured in money will be reflected in the accounting records. Some text books give problems where they list a series of events and the student selects which will be accounted for. For example select the one which won’t be accounted for:

A) Purchase of a truck

B) Payment of the electrical bill

C) Death of the company’s president

If you selected C you’ve got a great hold on the monetary unit assumption. The company president’s passing, while tragic, isn’t an event that can be measured in money, while the other two events clearly involve the exchange of money and thus can be measured through that exchange.

Time period assumption

Last but most certainly not least. The time period assumption states that the activities of an entity can be divided into artificial time periods such as months, years, or even accounting cycles. This assumption while simply creates the most headaches for auditors, salespeople and many others affected by an enterprise. Most business operate on a calendar year. In other words, on January 1st they begin a new accounting cycle, and look at the transactions to see how the previous year preformed. This is closely tied to the accounting function of Closing which is the end of the accounting cycle. While well known time measurements such as a year are common accounting cycles some business run their books through a production cycle or a sales cycle. For example, a ship builder who spends 2 years building one ship and only builds one ship at a time, may only close their books after completing the ship. This way they can closely match the economic events to the production of the one ship.

 

Well that concludes assumptions stay tuned for constraints and principles!

The Accounting Cycle

Happy New Year! This year we should all resolve to learn a little bit more about accounting huh?

In today’s entry we’re going to look at the accounting cycle. This is a relatively simple concept, and shouldn’t take long to explain. Some of these concepts will be expanded upon in future entries, but I’ll try to provide concise enough explanations for today’s blog.

The accounting cycle consists of 10 steps, though some textbooks may have fewer or more.

The steps are:

1. Identify the Transaction
2. Analyze the Transaction
3. Record in the Journal
4. Post to the Ledger
5. Create a Trial Balance
6. Make Adjusting Entries
7. Create the Adjusted Trial Balance
8. Create the Financial Statements
9. Make Closing Journal Entries
10. Create the Post-Closing Trial Balance

Taken one at a time

Identify the Transaction: this is the recognition that a transaction has taken place, it usually begins with something we call a Source Document. Simply put a source document is what will identify a transaction has (or is) taking place. Examples of source documents which involve transactions include receipts, invoices (bills), purchase orders, etc.

Analyze the Transaction: Since we have identified a transaction as taking place, for example our boss gave us a receipt, now we have to examine the transaction (receipt) to see what accounts might be involved. For example if the receipt in question was for office supplies and she paid in cash we have all the information we need. The accounts in question are going to be Office Supply Expense, and Cash. Other pieces we have/need are the amount, and the date—all present on the receipt.

Record in the Journal: This is creating the entry from the information we determined above. For more info on this step see my entry on double entry bookkeeping.
Post to the Ledger: This step is deceptively simply. First off the ledger (or general ledger) is simply a record of an individual account. It contains a running total of the individual accounts balance. I’ll go into more detail on ledgers in a future entry, for now just stick with my explanation.

Create the Trial Balance: The trial balance is a report which shows the balance of every account. Since some accounts have Debit balances and others have Credit balances and we have learned that Debits = Credits, the trial balance serves to prove that we are indeed in balance. This step may seem trivial; however it is crucial that we are in balance before we move into the next steps.

Make Adjusting Entries: In this step we are going to make any necessary adjustments to the journal for end of the year/period/accounting cycle etc. These might be overwhelming right now, mostly because I haven’t yet introduced the concept of accrual (vs. cash) accounting. Although a common adjustment would be adding any additional (but unpaid) interest on a loan.

Create the Adjusted Trial Balance: Similar to the first trial balance however this time, we are again checking to ensure we are in balance. Further more from this trial balance we will use it to create the financial statements.

Create the Financial Statements: This process will require its own blog entry however; the basic financial statements are the Income Statement, Balance Sheet, Statement of Cash Flows, and the Statement of Retained Earnings. Together these statements reflect the financial condition and position of the firm.

Make Closing Entries: We the completion of the statements we have to close the temporary (income statement) accounts so that they are ready to record transactions in the next cycle.

Create the Post Closing Trial Balance: Yes, I know by now you don’t want to create another trial balance, but this again is needed to verify that the accounting system is in balance going into the new cycle.

Thanks for your reading, please comment, and tune in for the next blog entry!