Principles of Finance

# 4.2Economic Basis for Accrual Accounting

Principles of Finance4.2 Economic Basis for Accrual Accounting

### Learning Outcomes

By the end of this section, you will be able to:

• Assess the impact of business transactions on cash flow.
• Define double-entry accounting and explain how it supports the accounting equation.

How and when we record our transactions can have a significant impact on financial statements, especially the income statement (net income). In this section you will explore the impact business transactions have on financial statements under each method. In doing so, you’ll be introduced to double-entry accounting and see how it functions to support the accounting equation.

### Timing of Business Activity versus Cash Flow

The first financial statement prepared is the income statement, a statement that shows the organization’s financial performance for a given period of time. We already saw that Chris, who is a sole proprietor, started a summer landscaping business on August 1, 2020. She categorized her business as a service entity and used the cash-basis method of accounting to record the initial operations for her business. Although Chris was using her family’s tractor to get her work done, she was responsible for paying for fuel and any maintenance costs. So, on August 31, Chris realized she had only $250 in her checking account. This balance was lower than expected because she had spent only slightly less ($1,150 for brakes, fuel, and insurance) than she earned ($1,400)—leaving a net income of$250. While she would like the checking balance to grow each month, she realized that most of the August expenses were infrequent (brakes and insurance) and the insurance, in particular, was an unusually large expense. She knew that the checking account balance would likely grow more in September because she would earn money from some new customers; she also anticipated having fewer expenses.

This simple landscaping example can be used to discuss the elements of the income statement, which are revenues, expenses, gains, and losses for a particular period of time (see Figure 4.2). Together, these determine whether the organization has net income (where revenues and gains are greater than expenses and losses) or net loss (where expenses and losses are greater than revenues and gains). Revenues, expenses, gains, and losses are further defined in the Income Statement provided.

Figure 4.2 Income Statement for Chris’s Landscaping

The income statement can also be visualized by the formula:

$Revenue-Expenses=NetIncomeorNetLossRevenue-Expenses=NetIncomeorNetLoss$
4.1

4.3

### Double-Entry Accounting

Accounting is based on a double-entry accounting system, which requires the following:

• Each time we record a transaction, we must record a change in at least two different accounts. Having two or more accounts change will allow us to keep the accounting equation in balance.
• Not only will at least two accounts change, but there must also be at least one debit and one credit side impacted.
• The sum of the debits must equal the sum of the credits for each transaction.

In order for companies to record the myriad of transactions they have each year, there is a need for a simple but detailed system. Journals are useful tools to meet this need.

#### Debits and Credits

Each account can be represented visually by splitting the account into left and right sides as shown. The graphic representation of a general ledger account is known as a T-account. It is called this because it looks like a “T,” as you can see with the T-account shown in Figure 4.3.

Figure 4.3 T-Account

A debit records financial information on the left side of each account. A credit records financial information on the right side of an account. One side of each account will increase, and the other side will decrease. The ending account balance is found by calculating the difference between debits and credits for each account. You will often see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr, respectively. Depending on the account type, the sides that increase and decrease may vary. We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded equation (see Figure 4.4).

Figure 4.4 Expanded Accounting Equation

As we can see from this expanded accounting equation, Assets accounts increase on the debit side and decrease on the credit side. This is also true of Dividends and Expenses accounts. Liabilities increase on the credit side and decrease on the debit side. This is also true of Common Stock and Revenues accounts. This becomes easier to understand as you become familiar with the normal balance of an account.

The balance sheet is a reflection of the accounting equation (see Figure 4.5). It has two sections, assets in one section and liabilities and equity in the other section. It’s key to note that both assets and liabilities are broken down on the balance sheet into current and noncurrent classifications in order to provide more detail and transparency. Current assets are those that are consumed within a year. Assets that will be in use longer than a year are considered noncurrent. Current liabilities are those that will be due within a year. Noncurrent liabilities are those that are due more than a year into the future.

Figure 4.5 Graphical Representation of the Accounting Equation Both assets and liabilities are categorized as current and noncurrent. Also highlighted are the various activities that affect the equity (or net worth) of the business.

Notice each account subcategory (Current Assets and Noncurrent Assets, for example) has an “increase” side and a “decrease” side. As you may recall, these are called T-accounts, and they are used to analyze transactions.

The basic components of even the simplest accounting system are accounts and a general ledger. An account is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation. Each of these categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger. A general ledger is a comprehensive listing of all of a company’s accounts with their individual balances.

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