Accounting is a practice that allows someone (or something, in the case of an organisation), the accounting entity, to keep track of their economic and financial details. It involves accounting for their economic resources, as well as the sources from which they are obtained.In early accounting practice, businesses would keep separate lists of their resources and sources. It was soon discovered that both can be linked. Thus came double-entry accounting, where every transaction that is recorded would recognise both and implicitly relate the two together.
All accounting entities strive to accumulate resources, while being careful of how they finance them. Those resources help to satisfy the accounting entity’s economic wants by providing economic benefits.
Costs consist of assets and expenses
An accounting entity incurs costs in order to obtain resources and achieve economic benefits, either now or in the future. Where that cost remains existent and promises economic benefits in the future, it is considered an asset. Assets include:
- Cash
- Investments (where they are promised cash in the future)
- Consumable goods (e.g. food, stationery)
- Durable goods (e.g. clothing, car, computer)
Unfortunately, most assets do not last forever. They will eventually expire, in which case they no longer can be expected to provide economic benefits. This component of cost is considered an expense.
Sources of resources: liabilities, equity and revenue
An accounting entity cannot obtain an asset or subsequently incur an expense without first extracting it from a source. There are two ways to finance costs.
A liability can be incurred, where an obligation forms which the accounting entity must settle by sacrificing future economic benefits. Liabilities include:
- Loans taken out
- Bills for utilities
- Court orders to pay damages
- Tax bills
Most often, a liability is settled by paying cash, but can also be paid for with other assets (e.g. returning a rented refrigerator) or cause an expense to occur, which then eventually requires sacrificing an asset (e.g. accumulating income tax to be paid later).
Once all liabilities have been settled, the accounting entity has free claim over their remaining assets. This component of their sources is their equity (or net worth), and signifies sourcing from personal value. For individuals, their equity consists of their retained income. Revenue (or income) involves free inflows of economic benefits or preventions of free outflows of economic benefits, which may include:
- Wages and salaries
- Interest, dividends and rent from their investments
- Forgivings of loans taken out
- Discounts received on goods
- Windfall gains
Retained income is total revenues minus total expenses.
The accounting equation connecting assets and liabilities
This way of treating the accounting entity’s resources and sources leads to the following accounting equation:
Resources = Sourceswhere:
or
Assets = Liabilities + Equity
Equity (for an individual) = Retained income , and
Retained income = Total revenues – Total expenses
From this, the accounting entity’s net worth is:
Net worth = Equity = Assets – Liabilities
Accounts: Types of assets, liabilities, revenues and expenses
The total values of sources and resources are divided into two or more accounts. This classification should be meaningful to the accounting entity, and is normally according to specific assets, liabilities, revenues and expenses, in the way that they are identified beforehand. Each account will then have a balance, or value in currency terms. The collection of all these accounts is called the general ledger. However, special accounts can be moved out of the general ledger into specific subsidiary ledgers at the accounting entity’s discretion.
Journal entries: Debits and credits
To avoid needing to deal with the accounting equation directly, each account balance is treated as either a debit balance or credit balance. According to long-standing convention, all positive balances in the resource side are in debit and all positive balances in the source side are in credit:
- Asset: In debit (hence “debtors”!)
- Liability: In credit (hence “creditors”!)
- Equity: In credit where Total assets > Total liabilities , in debit when Total assets < Total liabilities
- Revenue: In credit
- Expense: In debit
As the accounting entity conducts transactions (which affect the balances of the accounts), it records them in a journal as journal entries. Like the way subsidiary ledgers are to the general ledger, special journals can be established to capture special transactions. Each journal entry will consist of at least one debit (Dr) entry and one credit (Cr) entry (hence “double-entry” accounting), where debit entries increase a debit balance or decrease a credit balance, and credit entries increase a credit balance or decrease a debit balance. Since the accounting equation must hold, the debits must always equal the credits. The debit entry may be interpreted as representing “a resource-gaining or source-reducing transaction”, while the credit entry may be interpreted as “a source-gaining or resource-reducing transaction”. The entry as a whole can be interpreted as “the debit transaction was funded by the credit transaction”.
Transactions: Obtaining an asset
When the accounting entity obtains an asset, it must record the values of both the asset and the combination of funding methods for it. There are many ways to fund an asset acquisition.
The asset may be obtained by sacrificing another asset. If a car worth $10 000 was paid for in cash, then the journal entry would be:
Dr Car (Asset) 10,000
Cr Cash (Asset) 10,000
The asset may be obtained by incurring a liability. If that same car was financed under a personal loan, then the journal entry would be:
Dr Car (Asset) 10,000
Cr Personal loan (Liability) 10,000
The asset may have been obtained as revenue. If that same car was a prize from a competition, then the journal entry would be:
Dr Car (Asset) 10,000
Cr Windfall gain (Revenue) 10,000
Of course, that car may be financed in any combination of those ways:
Dr Car (Asset) 10,000
Cr Car parts (Asset) 2,000
Cr In-store financing (Liability) 7,500
Cr Discount received (Revenue) 500
Transactions: Settling a liability
When the accounting entity settles a liability, it must record the values of both the portion of the liability setand the combination of funding methods for it.
The liability may be settled by sacrificing an asset. If a $500 principal repayment was made to a mortgage, the journal entry would be:
Dr Long-term loan (Liability) 500
Cr Cash (Asset) 500
The liability may be settled by incurring another liability. That other liability will then eventually need to be settled by either incurring yet another liability or sacrificing an asset. If the same mortgage repayment was made by credit card, the journal entry would be:
Dr Long-term loan (Liability) 500
Cr Credit card (Liability) 500 (hence "credit card"!)
If the liability was settled in neither of the above ways, an outflow of economic benefits was prevented (both now and in the future) and revenue was generated. If the bank forgave that particular repayment (which would be unlikely in real life unless a default occurred), the journal entry would be:
Dr Long-term loan (Liability) 500
Cr Forgiven debt (Revenue) 500
Transactions: Incurring expenses
Examples of revenue-generating transactions were given beforehand. When the accounting entity incurs an expense, it must record the values of both the expense and the sacrifice of future economic benefits that “funded” it.
The expense may have been a result of using up an asset’s promise of economic benefits. If $100 of income tax was paid in cash, the journal entry would be:
Dr Income tax expense (Expense) 100
Cr Cash (Asset) 100
A liability may have been incurred to cause the expense. In this case, the expense occurs before the asset expires. If the government allows paying for the same tax bill later, the journal entry would be:
Dr Income tax expense (Expense) 100
Cr Income tax payable (Liability) 100
The expense may have been immediately deducted from revenue. If the employer automatically deducts the same tax payment from $400 in cash wages, the journal entry would be:
Dr Income tax expense (Expense) 100
Dr Cash (Asset) 300
Cr Wages (Revenue) 400
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