Five Generally Accepted Accounting Principles Since businesses rely on accounting to convey meaningful and understandable financial information

to their stakeholders, the accounting profession has developed generally accepted accounting principles (GAAP) to respond to the need for standardization. These principles guide accounting procedures, and understanding them is essential to producing accurate and meaningful records. The success of any business, big or small, begins with an understanding of accounting. Larger businesses require more complex accounting systems, but a fundamental knowledge is still required for smaller companies. Businesses are categorized as three basic types according to the owner's responsibility to the business's debts.

Sole proprietorship. A sole proprietorship is a business that is owned by an individual. Proprietors typically use their own money to finance the business; therefore, they are solely responsible for any debts and profits. Sole proprietorship is the most common legal form of business. Partnership. A partnership is a business owned by two or more persons. They have pooled their resources to finance the business; therefore, they share the profits and the responsibility of any debts. Corporation. A corporation is a separate, legal entity and is owned by stockholders. However, stockholders are not responsible for the business's debts. An elected board of directors is responsible for managing the corporation.

The Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants (AICPA), and the Securities and Exchange Commission (SEC) have all played an influential role in developing generally accepted accounting principles. Five GAAPs are described below.

The Business Entity Principle. The Business Entity Principle states that a business must be considered a separate entity, and only the transactions carried out by the business may be recorded. This ensures an undistorted financial picture of the business. The Cost Principle. The Cost Principle states that anything a business purchases is recorded as the amount paid, regardless of its real or perceived value. This eliminates guesswork or the possibility of recording inaccurate information. The Objectivity Principle. The Objectivity Principle states that accounting operates on objective evidence. All transactions must have proof that they were carried out. The only reliable proof that a transaction occurred is found in source documents such as a sales slip or an invoice. The Continuing-concern Principle. The Continuing-concern Principle states that a business is a continuing enterprise and that its buildings, land, or equipment cannot be sold without disrupting the business. So unless the buildings, land, or equipment are for sale, as in the case of a liquidation, their market value is not recorded. This prevents distortion in the objective value of the business. The Stable Dollar Principle. The Stable Dollar Principle states that the value of the dollar does not change. This ensures that the dollar is kept as a stable unit of measure for accounting purposes. It also makes it easier to compare financial statements over time.

Accounting is not bound to regulated standards, only guidelines. People who are privy to a business's financial information should exercise confidentiality, accuracy, and integrity. By applying generally accepted accounting principles in your accounting practices, you know your work will be consistent and meaningful to others. Applying the Accounting Equation Businesses conduct transactions by exchanging goods or services for money. Transactions can take various forms, depending on the company, but whatever kind of transaction has occurred, it impacts the business's resources. The resources of a business refer to its supply of goods, services, information, or expertise that allow the business to operate and grow. In accounting, the resources of a business are categorized under the terms assets, liabilities, and owner's equity. These terms also refer to the three types of accounts in which a business records its transactions. Businesses exchange items of equal value, real or perceived. Imagine that an exchange is like balancing a scalethe left side goes down (a service is given) and the right side reacts (cash is received) to maintain the balance of the scale. Accounting uses a technique to show how a transaction changes the business's resources while maintaining a balance, or showing the equal value of the exchange. The accounting equation is a tool that is applied throughout accounting activities to show how transactions affect the asset, liability, and owner's equity accounts. Every transaction will affect at least two of these accounts. If a transaction causes one side of the equation (assets) to increase, then the other side of the equation (liabilities or owner's equity) must also increase to keep the equation in balance. You can apply the accounting equation by

determining that the total of the asset accounts equals the total of the liability accounts plus the total of the owner's equity accounts. The equation is also balanced when formatted as:

Assets - Liabilities = Owner's Equity Assets - Owner's Equity = Liabilities

All transactions will affect the business's assets, liabilities, and owner's equity accounts. The accounting equation is applied to check that these three accounts balance. Keep this fundamental rule in accounting in mind when you need to determine how a transaction affects your business's resources. Applying the Rule of Credit and Debit The rule of debit and credit is a fundamental theory behind accounting procedures. Also called double-entry accounting, it states that transactions are recorded in two or more accounts, where an amount is entered on the debit side and an equal amount is entered on the credit side. The practice of recording amounts on two sides is intended to minimize errors. To apply the rule of debit and credit, and properly record amounts, every transaction is first analyzed to determine the following:

What is being exchanged? To begin analyzing the transaction, first determine what items are exchanged. Remember that a transaction is defined as the sale or exchange of goods or services. What accounts are affected? The next step in analyzing the transaction is to identify the affected accounts. The three categories of accounts in which a business records its transactions are assets, liabilities, and owner's equity. Common types of asset accounts include Cash, Accounts Receivable, Equipment, Office Supplies, and Prepaid Expenses. Common types of liability accounts include Accounts Payable, Unearned Fees (money received in advance), and Notes Payable (money a business promises to pay at a future date). Common types of owner's equity accounts include Capital, Withdrawals, Revenue, and Expenses. Which of the accounts is increasing or decreasing? Most transactions benefitor increasethe business's resources in one area, and create a disadvantageor decreasein another. But a transaction does not always cause this effect. A transaction can result in just an increase or just a decrease. Are the amounts debits or credits? The final step in the analysis is to determine whether to record the amounts on the debit side or the credit side of the affected accounts. For example, a purchase of computers would increase the Equipment account and decrease the Cash account.

The rule of debit and credit states that for whatever amount is entered in the debit side, an equal amount must be recorded on the credit side. To determine whether accounts are debited or credited, an analysis of the effect of the transaction must occur first. An understanding of the rule of debit and credit is fundamental to performing accurate accounting procedures Recording Transactions in the General Journal Most businesses keep some form of diary or log of their activities. For accounting purposes, a general journal is a book that records all a business's transactions in chronological order. The general journal is also called "a book of original entry" because all transactions are entered here first. Then the transactions are sorted into their appropriate accounts in the general ledger. Before learning about how to make entries in the general journal, you should understand the source of a transaction. Transactions must be supported with proof, such as source documents. The use of source documents is explained in two generally accepted accounting principles. The Objectivity Principle states that accounting information must be based on objective data. The Cost Principle states that all goods and services are recorded at cost rather than any other perceived value. Source documents are also called "business papers," and they represent the source of each transaction. Source documents provide objective proof that the transaction was carried out, and they contain useful information. Source documents include checks, invoices, sales slips, purchase orders, bank statements, and employee earnings statements. Once source documents are collected, the transactions are recorded, or journalized. The general journal is organized to record transaction information in a very efficient way. Only the necessary information is entered, such as the date of the transaction, a description of the transaction, the titles of the affected accounts, and the dollar amount of each debit and credit. Some additional guidelines to keep in mind when journalizing are listed below.

The same year is entered once at the top of each new page. The placement of the entries in the "Description of Entry" column is important.

One line is skipped after each transaction. Transactions are entered chronologically.

The general journal is an accounting record that documents all transactions chronologically. The format of the general journal facilitates efficiency and organization in your accounting activities.

Posting to the General Ledger Just as the general journal is also referred to as "the book of original entry," the general ledger is also called "the book of final entry." Although a ledger can be maintained on its own, these two accounting books are interdependent. The general journal and the general ledger both record transactions, but it is the ledger that groups similar transactions into accounts. Transactions are first recorded in the general journal and then transferred, or posted, to the ledger, which stores all the accounts of a business. An account is defined as a record that shows the increases and decreases in a single asset, liability, or owner's equity item. In addition, the ledger shows the balance of each account, and records the effects of the transactions. Financial statements can then be generated from the ledger. Like the general journal, the general ledger uses a standard format that categorizes information. This ensures that the data is organized and easily accessible when it comes time to prepare the financial statements. The rule of debit and credit and the accounting equation still apply. The general ledger contains:

the chart of accounts the account's title the Date column the Particulars column the Post Reference (P.R.) column the Debit column the Credit column the Debit Credit Balance (DR./CR.) column the Balance column.

The chart of accounts is a list of all the accounts and their numbers contained in the ledger. The accounts are listed in the following order: assets, liabilities, owner's equity, revenue, and expenses. Each account is recorded on a separate page in the ledger and arranged in numerical order. An important feature of the ledger is the "Balance" column, which keeps a running balance of each account. For this reason, the ledger is referred to as a "balanced column account." The data in the general journal is transferred periodically to the columns in the general ledger. The volume of transactions carried out by a business will indicate how often to post. A busier company may post daily, while other companies may post weekly or monthly. Periodic postings is required to ensure balances for accounts are current, so the business has the up-to-date financial information it needs to make quick decisions. Whether posting occurs daily, weekly, or monthly, all transactions must be posted to the ledger at the end of an accounting period. Some businesses operate on quarterly periods, others on a yearly basis. Regardless of when posting occurs, the standard procedure is to:

identify the affected debit account enter the date of the transaction enter the journal page of the transaction's entry enter the debit amount calculate and enter the account's new balance identify whether the new balance is a debit or credit copy the ledger account number in the Post Reference (Post. Ref.) column of the journal repeat the steps for the credit entries.

The purpose of the general ledger is to sort transaction information into meaningful categoriesaccounts. The general ledger sorts information from the general journal and holds all the necessary information to prepare financial statements. Its standard format helps you organize financial

information in one place. By following the procedures described above, you can minimize the possibility of making errors in your accounting procedures. Performing a Trial Balance Contrary to popular belief, bookkeeping is not the same as accounting. By definition, bookkeeping is the act of recording transactions, while accounting includes bookkeeping activities plus the preparation, analysis, and interpretation of financial information. Because of the volume of data manipulated when bookkeeping, errors are easy to make, since numbers are constantly being added or subtracted. To reduce bookkeeping errors, you can perform a procedure called a trial balance. A trial balance checks the equality of the debits and credits. Taking a trial balance is done after posting to the ledger, but can also be performed throughout accounting activities. Accounting is based on the rule of debit and credit. Taking a trial balance helps to prove that the debits equal the credits. When a trial balance is taken, the convention is to calculate the debits and then the credits. The trial balance procedure involves five steps: 1. 2. 3. 4. 5. Identify the accounts and their balances. List the accounts and enter their balances. Add the debit balances. Add the credit balances. Compare the sum of the debits and the credits.

If the balances equal in a trial balance, there still may be an error. Errors can easily be made because numbers are transferred so many times. During accounting activities, wrong amounts can be recorded, numbers transposed, and amounts debited instead of credited. Sometimes errors occur without affecting the balance. If the trial balance shows that the debits do not equal the credits, then another trial balance should be taken. If the debits still do not equal the credits, then an error exists and must be found. The first method you can use to locate an error is to take the trial balance in reverse order. If backtracking fails to find the error, there are a few other techniques available to help you locate the error. An analysis of the difference between the sum of the debits and the sum of the credits can help locate the error. Three techniques you can use are described below.

Equal to an account balance. If the difference is equal to an account balance, then an error in posting to the wrong side of the account has occurred. Divisible by nine. If the difference is divisible by nine, then numbers have been transposed. To locate the error, compare the data in the trial balance against the data in the ledger to make sure numbers were copied correctly. Divisible by ten. If the difference is divisible by ten, then an error in addition or subtraction has occurred. In this case, recalculate the sums in the debits and credits in the trial balance.

An important skill in accounting is the ability to quickly locate errors. An analysis of the sums in a trial balance can guide you to the error Generating the Income Statement One way to determine financial progress is to look at the profit gained by a business. And one way to determine whether a business is making a profit is to generate an income statement. The income statement reports whether or not profit has been gained by comparing revenues gained and expenses incurred over a specific period of time. The procedures that guide the preparation of income statements are based on three generally accepted accounting principles (GAAP): the Time Period Principle, the Realization Principle, and the Matching Principle. These GAAPs ensure that the income statements generated by a business are consistent and that the information is meaningful to the readers. Companies generate income statements on a regular basis, so that management can closely monitor revenues and expenses. The data necessary to generate an income statement can be taken from the general ledger or from a trial balance, which presents the required data at a glance. Common elements of an income statement are listed below.

The heading. The heading includes the date, which indicates the time period covered by the statement. The information is only meaningful if the amounts represent a specific span of time. Revenues. The income statement shows revenues earned during the time period. Revenues are gained from providing services or selling goods.

Expenses. To continue generating revenue and to keep the company operating, expenses are incurred. Expenses include the costs of necessary goods or services. These expenses are indicated on the income statement. Net income. When the revenues are greater than the expenses, the difference is the net income, which is reported on the income statement. Net loss. When the expenses are greater than the revenues, the difference is the net loss, which is reported on the income statement.

Remember, an income statement compares a business's revenues and expenses to determine a profit or a loss. Properly prepared income statements will successfully help you communicate the financial performance of a business. In turn, the information will help others make crucial decisions about the business and its people. Generating the Statement of Owner's Equity To analyze the profit or loss position of a business, you can generate a statement of owner's equity. This financial statement summarizes the changes in the owner's capital by comparing the business's investments and withdrawals. When business owners invest in the company or make withdrawals, the owner's equity is changed. Owner's equity is the financial interest of the owner. To record the owner's deposit and withdrawal transactions, two accounts are set up: a Capital account and a Withdrawals account. These two accounts are categorized as Owner's Equity accounts. Along with the income statement, which reports the business's revenues and expenses, the statement of owner's equity summarizes the increases or decreases in the owner's Capital and Withdrawals accounts over a specific period of time. The formula used to generate this statement is: Total Capital - Total Withdrawals = Change in Capital. The data to prepare the statement of owner's equity is obtained from the general ledger or a trial balance and from the income statement. Common elements in the statement of owner's equity are listed below.

The date. The time period that the statement of owner's equity covers is important for comparing changes from one accounting period to another. When an income statement is prepared, a statement of owner's equity is also prepared for the same accounting period. Previous capital. The first amount in the statement is the capital amount carried over from the last statement of owner's equity, so that the balance of the capital account from the previous accounting period can be compared to the capital amount for the current accounting period. Investments by owner. Investments by the owner are any deposits made during the accounting period. The balance is taken from the general ledger's Capital account. Net income. When the revenues exceed the expenses, the difference is the net income, or the amount of profit the business has made. The balance of net income is taken from the income statement. Withdrawals by the owner. Withdrawals are instances when cash is taken from the business by the owner for personal use. The balance is taken from the general ledger's Withdrawals account. Change in capital. The total increase in investments minus the withdrawals represents the change in capital.

Remember, the statement of owner's equity is a financial statement that summarizes the changes in the owner's capital by comparing the investments and withdrawals over a specific period of time. The information in a statement of owner's equity can help the business's owners or management analyze the profit or loss position of a business, and ultimately provide important information they need to make crucial business decisions.

Generating the Balance Statement The balance statement is the most common financial statement prepared by businesses. It describes the financial situation of a business at a specific point in time by looking at its asset, liability, and owner's equity accounts. This information can be of great interest to many people both inside and outside the business. For example, the balance statement can answer a number of important questions, including:

What assets does the company hold? How much debt does it owe? Does it have enough cash to pay its creditors? How financially sound is the company?

The balance statement follows the principles of the accounting equation, and shows how the two sides of a business are balanced: Assets = Liabilities + Owner's equity. The data contained in the balance statement is taken from the general ledger or the trial balance. The elements of a balance statement are listed below.

The heading. The date indicated on the balance statement is important, since the statement reports a business's financial position on that given date. The asset accounts. The asset accounts are listed first, and their balances appear in the left amount column. The sum of the assets appear in the right amount column. The liability accounts. The liability accounts are listed under the assets, and their balances appear in the left amount column. The sum of the liabilities appears in the right amount column. The owner's equity accounts. The owner's equity accounts are listed under the liabilities and their balances appear in the left amount column. The sum of the owner's equity appears in the right amount column. The totals. The totals for the assets, and the totals for the liabilities plus owner's equity are double-ruled. The two totals must always equal to show the assets and how the assets are supplied. The balanced totals follow the accounting equation, where Assets = Liabilities + Owner's Equity.

Remember, the balance statement describes the financial situation of a business at a specific point in time by looking at its asset, liability, and owner's equity accounts. This standard reporting tool in accounting can help you communicate the financial position of a business to people with a vested interest in that business. Generating the Cash Flow Statement The cash flow statement is an informative financial statement that reports a business's cash position by comparing the cash receipts and disbursements over a given period of time. It will help you communicate the performance of a business based on the availability and use of cash, and can answer a number of questions about a business, such as: How is the cash spent? How much cash is borrowed? How are loans being repaid? A business receives and distributes cash through the transactions that are carried out in its normal operations. These transactions can be categorized into three activities:

Operating activities. Operating activities are transactions that affect the net income, or the revenues and expenses. Cash flows in from selling goods or services. Cash flows out from expenses incurred to operate the business, such as rent, wages, insurance, payments to suppliers, and buying office supplies. Investing activities. Investing activities are transactions that affect the assets. Cash flows in from selling land, buildings, plants, equipment, or intangible assets. Cash flows out from purchasing land, buildings, plants, equipment, or intangible assets. Financing activities. Financing activities are transactions that affect the owner's equity and long-term creditors. Cash flows in from borrowing cash on a short-term basis, investments made by the owner, or issuance of notes payable. Cash flows out because of the owner's withdrawals or repayment of cash loans.

The cash flow statement compares the cash balance between accounting periods. Therefore, the statement must refer to a specific period of time. The statement also shows the net cash for the operating, investing, and financing activities. The data is taken from the Cash account in the general ledger, the income statement, the statement of owner's equity, and the balance statement. Elements of the cash flow statement are listed below.

Cash flows from operating activities. The operating activities section lists the revenues and the expenses. The expenses are subtracted from the revenues to determine the net cash flows from operating activities. Outflow of cash is indicated by brackets. Cash flows from investing activities. The investing activities section lists the assets sold and the assets purchased. The purchases are subtracted from the sales to determine the net cash from investing activities. Outflow of cash is indicated by brackets. Cash flows from financing activities. The financing activities section lists the investments by the owner, the withdrawals, and the repayment of debts. The withdrawals and repayment of debts are subtracted from the investments to determine the net cash from financing activities. Outflow of cash is indicated by brackets. Net cash. The net cash section shows an increase or a decrease after operating, investing, and financing activities are calculated. Outflow of cash, or a negative amount, is indicated by brackets. Cash balance, previous period. The cash balance from the previous accounting period shows the amount that is subtracted from the net cash. Cash balance, current period. The current cash balance shows the change in cash.

The cash flow statement is an informative financial statement that reports a business's cash position by describing the inflow and outflow of cash. The information provided by this reporting tool can help the business's owners or its management make crucial business decisions.