guidelines on basic accounting principles and concepts

8/10/2019 Guidelines on Basic Accounting Principles and Concepts

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Guidelines on Basic Accounting Principles andConcepts

GAAP is the framework, rules and guidelines of the financial accounting profession with a purpose of

standardizing the accounting concepts, principles and procedures.

Here are the basic accounting principles and concepts under this framework:

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 owners personal transaction involves adding and/or withdrawing resources from the

business.

2. Going ConcernIt 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.

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.

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.

5. Matching

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.

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.


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7. Conservatism

This principle states that given two options in the valuation of business transactions, the amount

recorded should be the lower rather than the higher value.

8. Consistency

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.

9. Materiality

Ideally, business transactions that may affect the decision of a user of financial information are

considered important or material, thus, must be reported properly. This principle allows errors or

violations of accounting valuation involving immaterial and small amount of recorded business

transaction.

10. Objectivity

This principle requires recorded business transactions should have some form of impartial supporting

evidence or documentation. Also, it entails that bookkeeping and financial recording should be

performed with independence, thats free of bias and prejudice.

11. Accrual

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.


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What is Business Transaction?

When operating abusiness,there will be several economic activities or events that arises what we call

as business transactions.

A business transaction is best defined as follow:

Business transaction is an economic activity or event which affects and changes the financial condition and

performance of an individual, business or organization. It involves an exchange of values wherein one value is

received in exchange for another value given up. Furthermore, a recorded business transaction should only include

activity or event that pertains to the business, and should not include those personal transactions of the owner, in

compliance to the accounting principle named business entity concept which states that the business transaction is

separate and distinct from the owner or owners.

Three Important Rules in Recording BusinessTransactions

In order for a business transaction to be valid and recorded in the accounting books, it must meet all

of the following rules and criteria:

1. Financial in Nature

A recorded business transaction must be financial in nature. Financial refers to something with

equivalent moneys worth. The moneys worth may be in a form of cash, receivable, investment,

inventory, stock, property, equipment, land, building, vehicle, right, franchise, patent, payable, bond,

equity, etc.

Example:

Scenario:

Joe Smith is a lawyer whos opening his own law firm named, Joe Smith Law Consulting Firm. Joe invested $10,000

personal cash to be used in starting and operating the law consulting firm.

Analysis:

This activity or event is considered a business transaction valid for recording in the accounting books of the business,

Joe Smith Law Consulting Firm. And the moneys worth amounts to $10,000 cash and capital investment.
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2. Exchange of Values

In recording a valid business transaction, the next rule and criteria is that it must involve an exchange

of values. The exchange means that when you receive something you give up another thing. Like

when you record an increase, you must also record an equivalent decrease.

Example: We will use the same example in rule no. 1.

Scenario:



Analysis:

This sample business transaction met the first criteria, now well check if it meets the second rule and criteria, which

is, it must involve an exchange of value. As we can see, the business, Joe Smith Law Consulting Firm, got $10,000

cash from the owner, Joe Smith, which represents the value received. And the equivalent value given up is the

ownership claim of Joe Smith to the business assets represented by capital amounting to $10,000. In exchange for the

amount of cash received from the owner, Joe Smith, the business has given up its ownership and right to the business

assets amounting to $10,000.

3. Business Entity Concept

Last but not the least important rule and criteria in recording business transaction is to abide with the

business entity concept, which mandates that recorded information in the business accounting books

should be treated separately from the owner. It means any personal transaction of the owner should

not be included in the records of the business, and vice versa.

Example: We will still use the same example in rule no. 1 and 2

Scenario:



Analysis:

This is sample business transaction has met the first and second criteria, now well check if it meets the last third rule

and criteria, which is, the transaction must pertain to the business and not for the owner. The $10,000 cash received

from the owner, Joe Smith, is a valid business transaction to be recorded in the accounting books because the cash

will be used in starting and operating the business.


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Example of tasks and reports includes sales forecasting reports, budget and comparative analysis,

merger and consolidation reports, etc.

3. Cost Accounting

Cost Accounting is an area of accounting that captures and accumulates manufacturing or production

costs for internal use of an entitys management, used in decision making purpose. The reports

prepared in cost accounting are helpful tools for management use in budgeting, product costing or

pricing, which can improve the future net margins or profits of the business.

Example of cost accounting reports and tasks includes marginal costing, cost-volume-profit analysis,

activity-based accounting, standard cost accounting, lean accounting, etc.

4. Budgetary Accounting

Budgetary Accounting is an area of accounting that deals in setting up a tool or control device to help

management measure performance against its approved budget or plan. Its primary purpose is to

control expenditures of the business or organization. Unlike financial accounting which is based on

historical cost, budget accounting looks forward with future values, similar to managerial accounting.

It measures the cost of planned acquisitions and the use of economic resources in the future.

5. Auditing and Assurance Services

Auditing and Assurance Services is an area of accounting that deals with providing independent

opinion on the completeness and fairness of the financial statements of a business or organization.Also, it involves testing the internal controls of the business or organizations accounting system.

Auditing and assurance services is an independent professional service with the goal to improve the

financial information, being reported to internal or external users, in order to make a better and risk-

free decision making. An example of assurance services includes internal and external auditing.

6. Tax Accounting

Tax Accounting is an area of accounting that provides the preparation and filing of required tax returns

of a business or organization imposed by local, state and federal government. It also includes

understanding of tax amendments and determination of tax consequences of business decisions or

future plans. Tax rules and regulations are governed by the specific countrys Internal Revenue.

7. Government Accounting

Government Accounting is an area of accounting that focuses on the accounting development and

communication of government agencies financial affairs. It uses an accounting system based on fund


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accounting system. It has a separate set of accounts used for managing resources or funds that are

assigned to specific government unit for specific purposes based on regulations and limitations.

Government accounting is different on financial accounting because it focuses on measuring inflow and

outflow of government financial resources rather than measuring the economic activities. It also has

different way of measuring financial performance because it records revenue when theres cash

available to pay liabilities while records expense when funds are drained.

8. Non-Profit Accounting

Non-Profit Accounting is an area of accounting with primary purpose of recording and reporting

financial information of a business or organization formed for other purposes other than profit. Similar

to government accounting, its accounting system is based on fund accounting. Example of Not for

Profit Organization are cooperatives, charities, medical institutes, non-profit hospitals, etc.

9. Forensic Accounting

Forensic Accounting is an area of accounting which provides accounting and auditing analysis used in

litigation or public dispute in suitable courts. Its a specialized field of accounting which includes an

understanding of business information and financial reporting systems, accounting and auditing

standards and procedures, evidence gathering and investigative techniques, and litigation processes

and procedures.

10. International Accounting

International Accounting is an area of accounting that focuses on the accounting issues related to

international business activities and foreign operations. It is concerned on accounting international

trade and multinational companies. It includes matters such as accounting principles and reporting

practices in different countries, patterns of accounting development based on international and

regional accounting regulations, foreign currency translation, foreign exchange risk, performance

evaluation of foreign subsidiaries, and many more.

11. Accounting Information System

Accounting Information System is an area of accounting which deals in the collection, analysis, design

and implementation of accounting and management information system. It is generally a computer-

based method for recording accounting informations using information technology resources. Once in

place, the main purpose of accounting information system is to collect, store and process financial and

accounting information to be used by internal and external users in decision making.


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12. Accounting Education

Accounting Education is an area of accounting that deals with upgrading, researching and teaching

accounting knowledge to students, aspiring accountants or accounting professionals seeking

continuous education and updates.

Business

is an organization in which basic resources, called inputs, are assembled and processed

to provide goods or services, calledoutputs, to customers. People who are engaged in business activity

are calledEntrepreneursor Businessman.

In general, a business can be defined as follows:

Business consist of an individual, group of individuals or organizations engaged in the trade of goods, services, or

both to consumers, in exchange for money or other items of equivalent value, and for profit.

Types of Business Operations

There are three (3) different nature and types of businesses that are operated with the purpose of

earning profit. Each type of business has distinctive features.

1. Service Business

This type of business operation provides services, instead of product, to its customers. It includes, but

not limited, to the following:

Professionals such Lawyers, Doctors, Accountant, Engineer, etc.

Consultation

Hospital

Hotel and Lodging

Restaurant

Transportation

Entertainment

Banking and Financial

2. Merchandising Business

This type of business operation sells products to its customers. However, they dont make the

products they sell; instead, they buy or purchase it from other business. It includes, but not limited, to

the following:
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General merchandise such as grocery store and retail business

Toy stores

Electronic stores

Apparel stores

Online stores such asAmazon.com, iTunes.com, Audible.com, eBay, etc.

3. Manufacturing Business

This type of business operation converts basic inputs, such as materials, labor and overhead, into

finished products which are sold to customers. It includes, but not limited, to the following:

Computer and electronic manufacturer

Car, trucks and vans manufacturer

Shoe and clothes manufacturer

Canned goods manufacturer

Soda or beverage manufacturer

Types of Business Organizations

Once youve identified the nature and type of operation the business runs, the next thing you need to

know is what type of organization the business was formed.

Manufacturing, merchandising and service businesses are commonly organized and formed as either

of the following:

1. Proprietorship

Its a type of business organization that is owned by a single individual. The individual or person who

owns this type of business is referred to as Proprietor.

It is the most common and popular type of business organization because it is easier and cheaper to

organize. However, the primary disadvantage of proprietorship is that the business resources are

limited to the single owners resources. Also, the owner assumes all the risk, liability and decision

making of the business.

Small businesses like repair shops, laundries, restaurants, and professional services are organized as

proprietorship.

2. Partnership

As a business grows bigger, it needs more financial, people and managerial resources. Two or more

individuals may join together and form a business called partnership. The group of individuals who

own the partnership business is referred to as Partners.


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Partnership is a type of business organization that is owned by two or more individuals. It is a little

harder and more expensive to organize than the proprietorship. The benefit, however, is that the risk,

liability and management is shared by group of individuals, depending on the percentage of ownership

agreed upon.

There are many small and medium-size businesses such as repair shops, laundries, and professional

firms that are organized as partnership. The difference it has from proprietorship is that it is owned by

more than one individual and the requirements of organizing a partnership is more tedious than a

proprietorship.

3. Corporation

Its a type of business organization that is owned by shareholders and it is structured as a separate

legal entity under the operation of law. The ownership of a corporation is divided into shares of stock.

A corporation issues the stock to individuals or other businesses, who then become owners or

stockholders, of the corporation.

The benefit of the corporation is that the risk and liability is not shouldered by the owners called as

stockholders. And the management or decision making is shared by the board of directors. Also, it is

easier to increase resources of the business by means of issuing stock.

Large size businesses usually form a corporation because of its complexity and high need of resources.

What is the Basic Accounting Equation?

Basic Accounting Equation is an accounting principle and rule which states that the business resources

(assets) are attributable to the amount owed to creditors (liabilities) and capital invested by the

owners (equity). It is formulated as follows:

ASSET = LIABILITY + EQUITY

Assetpertains to the resources available and used in sustaining the operation of the business. It

includes cash, accounts receivable, inventory, office supplies, equipment, building, land, goodwill,

patent, etc.

Liabilityrefers to the amount of debts owed to outside person or entity, known as creditors. It

represents the claim of creditors in the assets of the business. It includes accounts payable, loans

payable, notes payable, bonds payable, unearned revenue, etc.


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Equityis the amount of capital or resources invested in the business by the owner(s). It represents

the claim of owners in the assets of the business. It consist of capital, drawing, common stock,

additional paid in capital, preferred stock, retained earnings, net income, net loss.

Rules on Basic Accounting Equation

1. Both side of the Basic Accounting Equation should be equal and balance.

Example:

The business, XYZ Company, has total assets amounting to $1,000, amount of debt and capital

totaling $250 and $750, respectively.

Asset = Liability + Equity

$1,000 = $250 + $750

$1,000 = $1,000

Note: Total amounts on both sides are equal.

2. For every valid business transaction recorded should affect or change two accounts. It means that

in every value received, another value is given up. This is also referred to as double-entry recording.

Look at the following instances:

a. Increase in asset account should have an equivalent increase in liability or equity account. As

shown in Example 1 and 2.

Example # 1:

Joe Smith, sole proprietor of XYZ Company, invested cash amounting to $10,000 to start and operate

his accounting software company.


Cash $10,000 = 0 + $10,000 J.Smith, Capital

Note: The cash invested affected two accounts which are cash (asset) and capital (equity) account.

Example # 2:

XYZ Company was granted a bank loan from ABC Bank amounting to $4,000.


Cash $4,000 = $4,000 Loans Payable + 0

Note: The cash loan received from bank affected two accounts which are cash (asset) and loans

payable (liability) account.

b. Decrease in asset account should have an equivalent decrease in liability or equity account. As

shown in Example 3 and 4.

Example # 3:

Joe Smith withdraws cash amounting to $500 from the business for his personal use.


Cash ($500) = 0 + ($500) J.Smith, Capital


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Note: The cash withdrawal of Joe indicates that it was used for personal purposes, as such, it is

considered as capital withdrawal.

Parenthesis () represents decrease in amount or value.

Example # 4:

XYZ Company paid in cash the partial amount of its loan to ABC Bank amounting to $2,500.


Cash ($2,500) = ($2,500) Loans Payable + 0

Note: The amount of cash paid to ABC Bank represents payment of bank loans. As such, there will be

an equivalent decrease on both cash (asset) and loans payable (liability) account.

c. Increase or decrease may affect two accounts on one side of the equation. As shown in Example #

5.

Example #5:XYZ Company purchased office supplies amounting to $250 paid on cash.


Cash ($250) = 0 + 0

Office Supplies $250 = 0 + 0

Note: The example affected both asset accounts. Cash decreased by $250 while office supplies

increased by $250.

Forms of Business Organization(provided by the Missouri Small Business and Technology Development Centers)

One of the first decisions that you will have to make as a business owner is how the business should

be structured. All businesses must adopt some legal configuration that defines the rights and

liabilities of participants in the businesss ownership, control, personal liability, life span, and financial

structure. This decision will have long-term implications, so you may want to consult with an

accountant and attorney to help you select the form of ownership that is right for you. In making a

choice, you will want to take into account the following:

Your vision regarding the size and nature of your business.

The level of control you wish to have.

The level of structure you are willing to deal with.

The businesss vulnerability to lawsuits.

Tax implications of the different organizational structures.


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Expected profit (or loss) of the business.

Whether or not you need to re-invest earnings into the business.

Your need for access to cash out of the business for yourself.

An overview of the four basic legal forms of organization: Sole Proprietorship; Partnerships;

Corporations and Limited Liability Company follows.

Sole Proprietorship

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 responsibility for running the business. Sole

proprietorships 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.

Profits from the business flow-through directly to the owners 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 owners medical insurance premiums are not directly deductible

from business income (only partially as an adjustment to income).

Partnerships

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, or

what steps will be taken to dissolve the partnership when needed; Yes, its hard to think about a

break-up 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


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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 return.

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 PartnershipPartners 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 decision, 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 general partnership.

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, and distribute accumulated partnership assets upon dissolution of the entity.

Corporations

A Corporation, chartered by the state in which it is headquartered, is considered by law to be a

unique entity, separate and apart from those who own it. A Corporation can be taxed; it can be

sued; it can enter into contractual agreements. The owners of a corporation are its shareholders.

The shareholders elect a board of directors to oversee the major policies and decisions. The

corporation has a life of its own and does not dissolve when ownership changes.

Advantages of a Corporation

Shareholders have limited liability for the corporations debts or judgments against the corporation.

Generally, shareholders can only be held accountable for their investment in stock of the


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company. (Note however, that officers can be held personally liable for their actions, such as the

failure to withhold and pay employment taxes.

Corporations can raise additional funds through the sale of stock.

A Corporation may deduct the cost of benefits it provides to officers and employees.

Can elect S Corporation status if certain requirements are met. This election enables company to

be taxed similar to a partnership.

Disadvantages of a Corporation

The process of incorporation requires more time and money than other forms of organization.

Corporations are monitored by federal, state and some local agencies, and as a result may have

more paperwork to comply with regulations.

Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible

from business income; thus this income can be taxed twice.

Subchapter S Corporation

A tax election only; this election enables the shareholder to treat the earnings and profits asdistributions, and have them pass through directly to their personal tax return. The catch here is that

the shareholder, if working for the company, and if there is a profit, must pay his/herself wages, and

it must meet standards of reasonable compensation. This can vary by geographical region as well

as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your

job, as long as there is enough profit. If you do not do this, the IRS can reclassify all of the earnings

and profit as wages, and you will be liable for all of the payroll taxes on the total amount.

Limited Liability Company (LLC)

The LLC is a relatively new type of hybrid business structure that is now permissible in most states.

It is designed to provide limited liability features of a corporation and the tax efficiencies andoperational flexibility of a partnership. Formation is more complex and formal than that of a general

partnership.

The owners are members, and the duration of the LLC is usually determined when the organization

papers are filed. The time limit can be continued if desired by a vote of the members at the time of

expiration. LLCs must not have more than two of the four characteristics that define corporations:

Limited liability to the extent of assets; continuity of life; centralization of management; and free

transferability of ownership interests.

Federal Tax Forms for LLC

Taxed as a partnership in most cases; corporation forms must be used if there are more than 2 of

the 4 corporate characteristics, as described above.

In summary, deciding the form of ownership that best suits your business venture should be given

careful consideration. Use your key advisors to assist you in the process.

Source: Kenner & Speck, LC

guidelines on basic accounting principles and concepts

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