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Accounting Concepts - Section AM-001

Effective Date 2/16/04

The following discussion includes an explanation of the accounting equation.  In addition, the concept of debit and credit accounting is discussed, and the effects of debit and credit entries on each of the major account groups.

Asset accounts are used to account for any physical thing (tangible) or right (intangible) that is owned and has monetary value.

  • Cash accounts reflect currency, coins, checks, petty cash and bank deposits.  Cash accounts are assets because they account for physical things that are owned and have monetary value.
  • Receivable accounts such as Due from Fund or Due from Government are used to reflect amounts owed by a fund or government to another fund (receiving fund).  Receivable accounts are assets because they reflect the right that is owned by the receiving fund based on an existing monetary claim against another entity or person.

Equity accounts are used to reflect the rights to the assets.  Equities can be divided into two types - the rights of creditors and the rights of owners.

  • The rights of creditors represent debts of the entity and are called liabilities.
  • The rights of the owners are those rights to the assets that remain after the creditors' and are called owner's equity.

The relationship of assets to equities can be shown in the "accounting equation"

ASSETS = LIABILITIES + OWNER'S EQUITY

All transactions can be stated in terms of their effect on the three basic elements of the accounting equation.

EXAMPLE

1.   Mr. A. starts a business and opens a bank account with $1000 in the name of the business.  The transaction is recorded as follows:

 

 

ASSETS

 

 

 

EQUITY

 

 

 

 

 

 

 

 

 

CASH

 

 

=

Mr. A, CAPITAL

 

 

 

 

 

 

 

 

(1)

$1000.00

 

 

=

$1000.00

 

2.   Mr. A decides he needs a small amount of cash at the office to make change.  He withdraws $50.00 from the bank.  The transaction is recorded as follows:

 

 

 

ASSETS

 

 

EQUITY

 

 

 

 

 

 

 

 

 

CASH

+

PETTY CASH

=

Mr. A, CAPITAL

 

 

 

 

 

 

 

 

(1)

$1000.00

 

 

 

$1000.00

 

(2)

-     50.00

+

$50.00

=

 

 

BAL

$  950.00

 

$50.00

=

$1000.00

 

3.   Mr. A. decides he needs to borrow $3,000.00 to buy some equipment.  The bank approves the loan request and deposits the money in Mr. A's bank account.  The transaction is recorded as follows:

 

 

 

ASSETS

 

 

LIABILITIES

 

EQUITY

 

 

 

 

 

 

 

 

 

 

 

CASH

+

PETTY CASH

=

ACCOUNTS PAYABLE

+

Mr. A, CAPITAL

 

 

 

 

 

 

 

 

 

 

(1)

$1000.00

 

 

 

 

 

$1000.00

 

(2)

-     50.00

+

$50.00

=

 

 

 

 

(3)

3000.00

 

 

=

$3000.00

+

 

 

BAL

$3950.00

 

$50.00

=

$3000.00

+

$1000.00


The above transactions show that the equality of the two sides of the equation is always maintained.  The effect of every transaction can be shown as an increase or decrease to one or more of the elements of the accounting equation.

The accounts (assets, liabilities, and equity) are used to prepare a Balance Sheet.  The Balance Sheet is an accounting statement listing all asset, liability and equity accounts with their appropriate balances as of a specific date.  A Balance Sheet is always prepared after the close of a fiscal year and may be prepared during the year (interim statements).  This is the reason asset, liability and equity accounts are referred to as Balance Sheet accounts.

Expense and revenue accounts are used to record transactions resulting from the operation of the business.  Revenues are increases in owner's equity attributable to the business activities.  For example the sale of merchandise, the performance of services for a customer and other activities entered into for the purpose of earning income are recorded as revenues.  Expenses are costs directly related to the process of producing revenue.

Expense and revenue accounts have a direct relationship to the equity accounts.  The concept of debits and credits is applied to expense and revenue accounts based on this relationship to the equity accounts.  Revenues increase equity; therefore, increases to revenues are recorded as a credit, just as increases to equity are recorded as credits. Expenses decrease equity; therefore, increases to expenses are recorded as debits, just as decreases to equity are recorded as debits.

At the end of each fiscal year another accounting statement is prepared called the Income Statement.  The Income Statement summarizes the expense and revenue accounts for a specific time period.  At the end of the fiscal year the balances in the expense and revenue accounts are transferred to the equity account.  The excess of the revenue account balances over the expense account balances result in net income.  The excess of expenses over revenues is called net loss.  Because the expense and revenue account balances are transferred to equity (closed out) at the end of the fiscal year, these accounts are referred to as "nominal" accounts.  The balance sheet account balances are carried forward each year and are referred to as "real" accounts.

Every accounting transaction affects at least two accounts.  The sum of the debits must always be equal to the sum of the credits.  This is referred to as double-entry accounting.

The following table summarizes the effects of debits and credits on accounts and the normal balance of the accounts.

 

TYPE OF

 

 

 

 

 

NORMAL

 

ACCOUNT

 

INCREASES

 

DECREASES

 

BALANCE

 

Asset

 

Debit

 

Credit

 

Debit

 

Liability

 

Credit

 

Debit

 

Credit

 

Equity

 

Credit

 

Debit

 

Credit

 

Revenue

 

Credit

 

Debit

 

Credit

 

Expense

 

Debit

 

Credit

 

Debit

The sum of increases in an account will normally exceed the sum of decreases in an account.  However, account balances can have a balance other than their normal balance.  For instance if a business writes checks for more than what is in their bank account their cash account would show a credit balance.  Usually an account with a credit balance which normally has a debit balance or vice versa indicates an unusual transaction or an accounting error.  For example, if the petty cash account has a credit balance that would result only from an accounting error.  But, if a State agency's accounts receivable account had a credit balance that could be the result from a customer overpaying on his account.