Basic Accounting

Text-only Preview

Basic Accounting
Supplement for Using Simply Accounting Version 8.0 for Windows
M. Purbhoo and D. Purbhoo

Basic Accounting
Accounting Theory 3
Basic Accounting 3
Balance Sheet 3
Income Statement 4
Debits and Credits 5
Journal Entries 6
Ledgers 6
Trial Balance 8
Audit Trail 9
Generally Accepted Accounting Principles (GAAP ) 9
Summary: Accounting Transactions 13
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 2 of 13
Purbhoo & Purbhoo

Basic Accounting
Accounting is a systematic method (it follows rules) of recording the economic transactions of a
business so that the information can be used by both insiders (owners and managers) and
outsiders (investors, suppliers and creditors) to make financial decisions.
Business information is generally summarized in two statements, the Balance Sheet and the
Income Statement. The Balance Sheet summarizes the financial position or company’s wealth at a
given point in time, providing a static picture. The Income Statement shows the changes in net
worth (over a given period) that result from conducting the business or how much the business
has earned, thus providing a dynamic picture.
Balance Sheet
The Balance Sheet and Income Statement are divided into sections, and each section is divided
into accounts. Similar items are grouped together under a single account name for each section.
Different kinds of items are separated into different accounts. It is important to know not only
how much the business owns, but also whether this amount consists of bank deposits,
investments, inventory, or buildings and equipment. These differences determine how readily the
business has access to its wealth and, therefore, its ability to repay its creditors. Similarly, it is
significant whether the liabilities consist of bank loans, money owed to suppliers and long term
notes, bonds and mortgages. These differences can be reflected by using different accounts.
Descriptive account names help to provide a more detailed financial picture of the business.
The Balance Sheet has three sections of accounts — assets, liabilities and equity.
Assets : Assets are the economic resources of a company. They are owned by the company, and
have cash value or can be converted to cash. Bank accounts, receivables (money owed to the
business by customers), supplies, inventory, equipment, buildings and land are typical assets for
most businesses. Assets are always recorded at their historic cost, not at the current market value,
because historic costs are invariant and indisputable. Their order on the balance sheet represents
liquidity, that is, how easily the asset can be converted to cash. Cash is most liquid and therefore
appears first. Fixed assets such as plant, equipment and land appear at the end of the asset list.
Liabilities: Liabilities are the debts of the business, the money owed to various creditors, or
payables. They include bank loans, mortgages, and payables to vendors that supply goods and
services to the business or to various government agencies for tax liabilities. Current liabilities,
those that are due within the next year, are listed before long term liabilities.
Equity: Equity is defined as residual ownership — what’s left from the assets after all creditors
have been paid — Assets minus Liabilities. Equity includes capital contributed by the owners,
plus any amounts of surplus income from doing business, or less any losses from previous
business periods. Assets are equal to the liabilities plus equity, the sources of the assets. This is
the basic accounting equation (amounts are taken from the Balance Sheet that follows):

(511 734.90) =
(278 668.00) +
(233 066.90)
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 3 of 13
Purbhoo & Purbhoo

The following is a typical example of a Balance Sheet.
Overview Company
Balance Sheet as at 04-30-2001

Current Assets
Current Liabilities
Cash in Bank
76 245.90
Bank Loan
39 840.00
Accounts Receivable
Accounts Payable
21 445.40
Construction Materials
1 600.00
Vacation Payable
Office Supplies
EI Payable
1 401.67
Total Current Assets
78 759.90
CPP Payable
1 065.24
Inventory Assets
Income Tax Payable
4 273.25
Base Materials
4 875.00
Receiver General Payable
6 740.16
Cobble Pavestones
8 560.00
EHT Payable
Edging Stone Blocks
1 500.00
CSB Plan Payable
Patio Stone Blocks
5 860.00
WCB Payable
1 416.85
Paver Slabs
3 860.00
PST Payable
4 976.00
Stone Slabs
11 920.00
GST Collected on Sales
4 354.00
Wall Building Blocks
8 900.00
GST Paid on Purchases –1 575.00
Total Inventory Assets
45 475.00
GST Owing (Refund)
2 779.00
Plant & Equipment
Total Current Liabilities
78 768.00
Computers & Peripherals
5 000.00
Long Term Liabilities
Construction Equipment
78 500.00
Mortgage Payable
199 900.00
Delivery Truck
51 000.00
Total Long Term Liabilities
199 900.00
Furniture & Fixtures
3 000.00
150 000.00
278 668.00
100 000.00
Total Plant & Equipment
387 500.00
R. S., Capital
219 670.00
R. S., Drawings
–2 000.00
Current Earnings
15 396.90
233 066.90
511 734.90
511 734.90
Notice that each section of the Balance Sheet can be further divided into subgroups of accounts,
such as Current Assets, Inventory Assets, etc. Consider how much more you learn about a
company from this detailed Balance Sheet compared with the single summary amounts for each
section in the accounting equation above the statement. These divisions aid in analyzing the
financial performance of a business.
Income Statement
The Income Statement contains two sections that can be subdivided. Again, the detailed account
names provide a fuller portrait of the business activity.
Revenues and Expenses: Revenues are sources of income, such as revenue from the sale of
merchandise, revenue from providing services or consulting, revenue from interest on bank
deposits or investments, and so on. Expenses are the costs incurred in generating revenue or in
doing business. These may include interest charges on loans or mortgages, the costs of supplies or
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 4 of 13
Purbhoo & Purbhoo

merchandise that is sold, maintenance of equipment and property, rent, utilities, depreciation of
equipment, losses from theft or from customers failing to pay, labour costs, payroll benefits,
advertising, and so on.
Net Income (Loss): Expenses are subtracted from revenue to determine the net income. If
revenue exceeds expenses, the company has earned a profit. If expenses exceed revenue, the
business will show a net loss. Thus, the income statement shows the economic performance of the
company. The following statement is a typical example:
Overview Company
Income Statement 01-04-01 to 04-30-01

Revenue from Sales
15 800.00
Revenue from Contracting
47 500.00
Sales Returns & Allowances
-1 100.00
Other Revenue
62 468.00
Advertising & Promotion
Bank Charges
Construction Materials Used
2 200.00
Cost of Goods Sold
17 070.00
Delivery Expense
Freight Expense
Hydro Expense
Interest Expense
2 140.00
Legal Expenses
Repairs & Maintenance
Telephone Expense
20 812.24
EI Expense

CPP Expense
WCB Expense
1 416.85
EHT Expense
47 071.10
15 396.90
Debits and Credits
In a manual accounting approach, assets are generally displayed on the left side of the balance
sheet. Liabilities and Equity are traditionally presented on the right side of a balance sheet. This
presentation is important because it relates to the use of debits and credits. Debit means left and
credit means right. Thus, a debit entry is a left-side entry and a credit entry is a right-side entry.
The sides refer to the balance sheet placement of accounts. Assets, on the left side of the Balance
Sheet, normally have a debit or left-side balance. Furthermore, an increase in assets is represented
by a debit entry. Liability and equity accounts on the right side of the Balance Sheet normally
have a credit balance and increases to these accounts are recorded with credit entries. The Income
Statement accounts, expenses and revenues, are really subsections of the Equity section of the
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 5 of 13
Purbhoo & Purbhoo

Balance Sheet. Revenues increase equity and are credit balance accounts just like the equity
accounts. Expenses decrease equity; therefore, they are debit balance accounts – the opposite of
equity accounts.
Journal Entries
The daily operation of a business includes many kinds of transactions — sales, purchases,
payment for expenses, receipt of cash, etc. These transactions that affect the financial profile of
the business are recorded in journal entries. The recording of each transaction includes what
accounts (items) are affected, by how much, and in what direction. Each transaction affects at
least two accounts — one account is debited (left-side entry) and another account is credited
(right-side entry). The debit and credit parts of a journal entry must be equal, to keep the
accounting equation in balance. This system of recording is therefore named double entry
accounting. (The earliest known written description of double entry accounting dates back to
Pacioli in the early 1100s and had been in use for at least 150 years before that.) Thus, journal
entries record the changes to accounts that result from economic transactions. The account
changes are then posted to ledgers that reflect the summary of these transactions and the balances
in each account.
Account balances are recorded in Ledgers. Each account has its own ledger page that records only
the increases and decreases to that account. The current balance is also part of the ledger record.
Ledgers are updated as a separate step from recording the transaction in the journal. There are
separate ledgers for:
• accounts — General Ledger for accounts in the Balance Sheet and Income Statement
• customers — each customer ledger page records individual sale and receipt amounts for that
customer along with the current balance owing
• vendors or suppliers — each vendor ledger page records the individual purchases and
payments for that vendor together with the amount owing
• inventory ledger — each page records the increases and decreases for a single inventory asset
resulting from sales, purchases, losses, etc.
• payroll — each employee is on a separate ledger page
The General (accounts) Ledger is the main ledger and the others are subsidiary ledgers that link to
the General Ledger through one or more control accounts. For example, the Accounts Receivable
account in the General Ledger shows the total owed by all customers while the individual
customer ledger pages show how much each customer owes. The total of all customer ledger
balances must equal the Accounts Receivable balance in the General Ledger.
As an example, consider the changes that result when a business collects $5 350 for selling
merchandise. Clearly this is a revenue-producing transaction and cash is received. Since cash is
an asset and it increases, this part is a debit entry. The balancing part is an increase in revenue – a
credit account that, therefore, has a credit entry.
The business also collected GST at 7 percent on the sale transaction. Thus, although the amount
of cash received was $5 350, revenue was only $5 000. Since the tax must be passed on to the
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 6 of 13
Purbhoo & Purbhoo

Receiver General, it is not counted as part of revenue. The remaining amount, $350, is the tax
collected. Until the tax is remitted, it is owing to the Receiver General — a liability increase — so
it must have a credit entry to keep the debits and credits in balance. The journal entry now looks
like this:
Cash in Bank (Debit)
$5 350
Revenue from Sales (Credit)
$5 000
GST Collected on Sales (Credit)
Because the sale involved inventory merchandise, there is another component to the transaction.
Inventory assets that cost $3 000 were sold or reduced. This credit entry must be matched by a
debit entry, the expense or cost associated with the goods. Since they are no longer held as assets
by the business, the cost of purchasing the inventory can now be recorded as an expense as
shown. Again, debits equal credits.
Cost of Goods Sold (Debit)
$3 000
Stone Slabs (Inventory) (Credit)
$3 000
The final component of the journal entry is the explanation of the transaction; that is, when it took
place and what happened. This makes it possible to trace the journal entry back to its original
source document.
05/31/98 Invoice #4522, Sold stone slabs to Marchbanks
Cash in Bank (Debit)
$5 350
Cost of Goods Sold (Debit)
$3 000
Revenue from Sales (Credit)
$5 000
GST Collected on Sales (Credit)
Stone Slabs (Inventory) (Credit)
$3 000
$8 350
$8 350
The Ledger updates would include the following entries (DR and CR are commonly-used
abbreviations for Debits and Credits, respectively):
General (Accounts) Ledger: Cash in Bank Account

Balance forward
10 000 (DR)
Sale of stone slabs
5 350
15 350 (DR)
Similar entries would appear on the ledger pages for the other four accounts: Cost of Goods Sold,
Revenue from Sales, GST Collected on Sales, and Stone Slabs (Inventory Assets).
Customers (Receivables) Ledger: Marchbanks Account

Balance forward
0 (DR)
Sale of stone slabs
5 350
5 350 (DR)
Cash receipt with sale
5 350
0 (DR)
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 7 of 13
Purbhoo & Purbhoo

Inventory Ledger: Stone Slabs

Balance forward
11 920 (DR)
Sale to Marchbanks
3 000
8 920 (DR)
The chart that follows summarizes how accounts change in transactions:
Normal Balance (Side)
debit balance
requires debit entry
requires credit entry
(left side of Balance Sheet)
credit balance
requires credit entry
requires debit entry
(right side of Balance Sheet)
credit balance
requires credit entry
requires debit entry
(right side of Balance Sheet)
credit balance
requires credit entry
requires debit entry
(increases in revenue increase equity)
debit balance
requires debit entry
requires credit entry
(increases in expenses decrease equity)
Trial Balance
After all the journal transactions have been entered for a work session and the ledgers are
updated, a Trial Balance should be prepared to check that the debit and credit entries are equal.
The Trial Balance shows the balances in all General Ledger accounts as either debit or credit
amounts. The totals for the debits and credits columns should be equal if the transactions have
been entered correctly. (Of course the Trial Balance may be in balance but incorrect if
transactions were posted to the wrong accounts, or if incorrect amounts were entered.)
Contra Accounts
In the description of account balances, debits and credits, left and right referred to normal
accounts of each type. There is, however, a group of accounts that are opposite to the normal
accounts. These are the contra accounts. Contra means opposite or against. Thus, these accounts
have their balance on the opposite side and they reduce the total of a section. On the Balance
Sheet and Income Statement, they appear as negative amounts. In the Trial Balance, they appear
in the opposite column.
For example, contra asset accounts have a credit balance instead of a debit balance. They are
grouped with the assets because of a logical association. Accumulated Depreciation, for example,
is an amount that shows how much an asset has declined in value as a result of time and use. The
original value of the asset is recorded separately on the Balance Sheet. Allowance for
Uncollectable Accounts is logically associated with Accounts Receivable, but it shows what part
of the Receivables amount may never be collected. Unearned Revenue reflects money that has
been collected from a customer as an advance or deposit for work that is not yet completed. If the
work is never completed, the amount would be returned to the customer so it represents a
reduction in the amount owed by customers.
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 8 of 13
Purbhoo & Purbhoo

Contra liability accounts have a debit balance instead of a credit balance. GST Paid on Purchases
is a contra liability because it reduces the GST liability and remittance (GST Collected on Sales).
Refer to Appendix C in the text.
Contra equity accounts have a debit balance. The Drawings account, for example, shows how
much the owner has withdrawn from the business. Thus it reduces the total capital or equity in the
Contra revenue accounts also have a debit balance. For example, Sales Discounts show how
much the revenue from sales is reduced by discounts allowed to customers.
And finally, contra expense accounts have a credit balance. Purchase Discounts are logically
grouped with other expense accounts because they reduce the costs of doing business.
In journal entries, contra assets are increased by crediting, and decreased by debiting the
accounts. Contra liabilities are increased with debit entries, etc.
Entries in Simply Accounting journals are somewhat different for contra accounts. In the General
Journal, contra accounts have debit and credit entries reversed from the normal accounts. In Sales
and Purchases Journal entries, contra account transactions are entered as negative amounts by
adding a minus sign to the amount.
Audit Trail
Accuracy is very important in accounting. Accountants are not permitted to change any entries
already recorded. There is a specific procedure that must be followed for correcting mistakes —
making a reversing entry. As the name suggests, reversing entries reverse or undo a previous
journal entry. The original entry is repeated, using the same accounts and amounts but with all
debit and credit entries reversed. Thus, the reversing entry cancels the previous one and restores
the account balances to their pre-transaction amounts. An appropriate descriptive comment such
as “Reversing sales invoice #4522” should accompany the reversing entry. The correct journal
entry can then be completed again with an appropriate comment.
The reason for this approach is simple. Periodically, the books for a business are examined by
independent inspectors or auditors to ensure that all cash and assets can be properly accounted
for. The auditors must be able to retrace all the steps taken by the accountant. If an accountant has
erased or changed entries, the inspector cannot determine if the changes were made honestly, or if
there was an attempt to defraud the business. Audits for small businesses may be conducted by
Revenue Canada for income tax purposes or by independent auditing firms for corporations that
report to shareholders and other investors. This is why it is so important to include source
document numbers in journal entries — they establish a paper trail that the auditor or accountant
can follow to find and correct mistakes.
Generally Accepted Accounting Principles (GAAP)
The requirements for accurate financial records are outlined in federal and provincial tax laws. In
addition, the basic rules for good accounting practice are summarized in a set of guidelines
known as the Generally Accepted Accounting Principles.
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 9 of 13
Purbhoo & Purbhoo

1. Business Entity Concept (Accounting Entity)
A business is separate from its owner. It has certain rights and responsibilities that are separate
from the owner. For example, the business must file its own income tax return and pay its debts.
The owner must file his or her own income tax return that is separate from the business return.
The property or assets that a business owns must be recorded separately from the property that the
owner of the business has.
2. Going-Concern Assumption
When a business is started, it is expected to last or continue operations for some time. It does not
plan to go bankrupt or to dissolve immediately. It expects to be able to carry out its commitments
to its customers or clients, either to provide goods or services. The business often continues, even
when the ownership changes.
When you buy a radio from a store and find that it doesn’t work, you expect to be able to return it
or exchange it (unless you bought it in a bankruptcy or liquidation sale). You expect the store to
still be there when you return the next day, or even the next month.
3. Time Period Principle
Even though a business is expected to continue operations for a long time (Going-Concern
Assumption), it must report frequently and at regular time periods on its status and changes for
various reasons such as annual statements to shareholders, income statements for income tax
purposes and for normal business decisions, etc. This need for reporting changes regularly creates
the need to measure various parts of the business at different periods of time (monthly, quarterly
or yearly). For assets, therefore, it is necessary to know how long they can be expected to last so
that their value can be stated at these different times.
4. Monetary Principle
In order for a business to report on its status and progress, we need to be able to measure the
things that it owns and the things that it does. It has been decided that money will be used to
provide this information — dollars in Canada, yen in Japan, etc. Thus, all assets are recorded on
the balance sheet in dollar values, whileincome and expenses are reported in dollars on the
income statement. This principle also assumes that the dollar is stable — it is worth as much now
as it was 20 years ago, and will be 20 years from now. Of course, with inflation, this is not true;
but for now, we have not found a better way to provide information about the business. We could
measure everything in chickens, but that might create some other problems!
5. Objectivity Principle
All estimates and measurements in the business must be fair and reasonable. Whenever possible,
they should be based on fact so that they are not biased. This is why historical costs are preferred
for determining the value of assets. Fair market value is often used as the criterion or guideline.
How much something is worth should not be determined by how much your best friend will give
you for it, but by how much a group of strangers would be willing to pay for it. Your best friend
is less likely to be unbiased or objective. You might be willing to give her a really low price
because she’s your best friend. Or she might be willing to pay extra to help you out because she’s
your best friend. The deal with your friend would be a non-arms-length deal, because of this
potential for bias.
Basic Accounting Supplement for Using Simply Accounting Version 8
Page 10 of 13
Purbhoo & Purbhoo