This chapter surveys the underlying assumptions, major principles, and modifying conventions that govern accounting practice, and describes the conceptual framework project of the Financial Accounting Standards Board. It also discusses what a company’s own summary of significant accounting policies typically covers in its published annual report.
Assumptions and principles in accounting theory
Accounting rests on underlying assumptions, such as treating the business as a separate entity and assuming it will continue operating, and on major principles that guide how transactions are measured and recorded, including matching revenues with the expenses that produced them. Together these form the conceptual basis for the more detailed accounting rules applied to individual transactions day to day.
Modifying conventions
Alongside the formal principles, a set of modifying conventions, or practical constraints, shape how strictly those principles are actually applied, including considerations of materiality and conservatism in everyday practice. These conventions exist because rigid application of every principle to every transaction, however small, would not always produce useful or cost-effective financial reporting for a business.
The conceptual framework and disclosure
The Financial Accounting Standards Board’s conceptual framework project sets out the objectives and qualitative characteristics that financial reporting should meet. In practice, a company communicates the specific choices it has made, among the acceptable alternatives that theory and principle allow, through a summary of significant accounting policies included in its annual report, so readers can judge one company against another.
This chapter summarizes the full accounting cycle for a service company, from preparing a work sheet through adjusting and closing entries to a post-closing trial balance. It also covers preparing a classified balance sheet and analyzing results using the current ratio, tying the cycle’s mechanical steps to the statements they ultimately produce.
The work sheet
A work sheet brings together the unadjusted trial balance, the period’s adjustments, and the resulting adjusted figures in one place, making it easier to prepare the income statement, statement of retained earnings, and balance sheet without error. It is a working tool rather than a formal financial statement, but it organizes the numbers that those statements are ultimately built from, step by step.
Adjusting, closing, and completing the accounting cycle
Adjusting entries update the accounts before statements are prepared, while closing entries transfer the balances of temporary accounts, revenues, expenses, and dividends, into retained earnings so the books are ready for the next period. A post-closing trial balance is then prepared to confirm that only permanent balance sheet accounts remain open and that total debits still equal total credits before the cycle begins again.
The classified balance sheet and the current ratio
A classified balance sheet groups assets and liabilities into current and long-term categories, making the statement considerably easier to analyze. The current ratio, current assets divided by current liabilities, is introduced as a way to assess a company’s short-term ability to meet its obligations, drawing directly on the figures organized in this classified presentation of the balance sheet.
This chapter distinguishes the cash basis from the accrual basis of accounting and explains why adjusting entries are necessary at the end of a period. It identifies the classes and types of adjusting entries, shows how to prepare them, and examines the effect on financial statements if they are omitted.
Cash basis versus accrual basis
Under the cash basis, revenue and expenses are recorded only when cash actually changes hands. Under the accrual basis, revenue is recorded when it is earned and expenses when they are incurred, regardless of when cash moves. Accrual accounting gives a more complete picture of a period’s financial performance, which is exactly why adjustments for financial reporting are needed to bring the accounts up to date before statements are finally prepared.
Why and when adjusting entries are made
Adjusting entries are needed because some transactions span more than one accounting period, or because certain events, such as the earning of interest or the gradual using up of supplies, occur continuously without triggering a matching daily journal entry on their own. Without these entries, revenues and expenses would be misstated and would not reflect the period in which they genuinely occurred, distorting the resulting financial statements.
Classes of adjusting entries
Adjusting entries generally fall into a small number of recurring types: apportioning previously recorded assets and liabilities between periods, and recording previously unrecorded revenues and expenses that have already accrued. The chapter works through preparing each type in turn and shows, with a worked example, exactly how omitting them would distort a company’s reported income and its year-end account balances.
This chapter covers the account as the basic unit for storing accounting information, expressing transaction effects as debits and credits, and the full accounting cycle from journal entry to trial balance. It also introduces horizontal and vertical analysis for interpreting the financial results a company’s recorded transactions eventually produce.
Accounts, debits, and credits
Every asset, liability, equity, revenue, and expense is tracked in its own account, and each transaction is expressed as debits to some accounts and equal credits to others, keeping the accounting equation permanently in balance. Understanding which account type increases with a debit and which increases with a credit, and why the two sides must always be equal, is the foundation for everything the rest of the accounting cycle depends on.
The accounting cycle in outline
The chapter lists the steps of the accounting cycle: identifying and analyzing each transaction, recording it in a journal, posting the journal entries to individual ledger accounts, and periodically summarizing those accounts into a trial balance. This sequence is what turns a stream of individual, everyday business events into organized, reliable financial records that later chapters build statements from.
Recording business transactions: journal, ledger, and trial balance
Recording a transaction in the general journal captures its date, the accounts affected, and the debit and credit amounts involved. Posting then transfers those amounts to the relevant ledger accounts, and a trial balance lists every account and its balance to confirm that total debits equal total credits. The chapter closes by introducing horizontal and vertical analysis as ways to interpret the results these recorded transactions eventually produce.
This chapter introduces the three basic forms of business organization and the three types of business activity. It explains the purpose of the income statement, statement of retained earnings, balance sheet, and statement of cash flows, states the basic accounting equation, and shows how everyday transactions are analyzed and translated into these four financial statements.
Forms and activities of business organizations
A business is normally organized as a sole proprietorship, a partnership, or a corporation, and each form carries different implications for ownership, liability, and how the entity is taxed. Every business, regardless of form, engages in financing activities to raise funds, investing activities to acquire the resources it needs, and operating activities to run its day-to-day operations, and accounting exists to record and communicate the financial results of all three.
The four financial statements
The income statement reports revenues and expenses to show whether a period was profitable. The statement of retained earnings shows how those profits are retained in the business or distributed to owners as dividends. The balance sheet lists assets, liabilities, and owners’ equity at a point in time, tied together by the basic accounting equation, assets equal liabilities plus owners’ equity. The statement of cash flows then explains how cash actually moved during the period.
Analyzing transactions with accounting and its use in business decisions
Underlying assumptions and concepts, such as the business entity and the monetary unit, govern how a transaction is recognized and measured for financial reporting. Each transaction changes at least two elements of the accounting equation, and the chapter works step by step through preparing an income statement, a statement of retained earnings, and a balance sheet directly from a company’s own recorded business transactions.
