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FUNDAMENTALS OF ACCOUNTING Accounting refers to the process of data entry, recording, summarizing, analyzing, and reporting financial data. It provides a clear picture of a company's financial health and performance.
1. Five Accounting Principles 1. Revenue Recognition Principle: Revenue is recorded at the time of the transaction, not when the payment is received.
Example: - A cable factory ships a large order of cables in December but receives payment in January.
- Revenue is recorded in December when the cables are delivered, not when the payment is received.
2. Matching Principle: Expenses are recorded in the same period as the revenue they generate.
Example: - A cable factory records the cost of raw materials in the same period when the finished cables are sold.
3. Historical Cost Principle: Assets are recorded at their original purchase cost, not market value.
Example: - A cable factory buys a machine for $100,000.
- Even if the market value of the machine increases to $120,000, the machine is recorded at $100,000 in the books.
4. Full Disclosure Principle: All relevant financial information must be disclosed in financial reports.
Example: - A cable factory's financial statement includes a note about ongoing litigation that could affect future profitability.
5. Objectivity Principle: Financial data must be based on objective evidence and free from bias.
Example: - A cable factory records its revenue based on invoices and sales receipts, not estimates or projections.
2. Categories of Accounting Assets: All tangible and intangible items owned by the company.
Example: - Machinery, factory building, inventory, patents.
Liability: Amount the company owes to others.
Example: - Bank loans, unpaid supplier invoices.
Equity: Net worth of the company, calculated as Assets – Liabilities.
Example: - If a cable factory has $500,000 in assets and $300,000 in liabilities, equity = $500,000 - $300,000 = $200,000.
Expense: Cost incurred in operating the business.
Example: - Electricity bill, raw material cost, salaries.
Income: Revenue earned from the sale of goods or services.
Example: - Selling 10,000 cables at $5 each = $50,000 income.
3. Journal vs Ledger Journal: - Initial recording of transactions as debits and credits.
- Transactions are listed in chronological order.
Example (Journal Entry): - Raw materials purchased on credit for $5,000:
Dr. Raw Material Inventory $5,000
Cr. Accounts Payable $5,000
Ledger: - Transactions are posted from the journal to appropriate accounts (e.g., asset, liability).
Example (Ledger Entry): - Raw Material Inventory (Asset) → +$5,000
- Accounts Payable (Liability) → +$5,000
4. Double Entry System Each accounting entry has two sides — a debit and a credit.
- Debit increases assets and expenses.
- Credit increases liabilities and income.
Example: - A cable factory receives $10,000 for a completed order:
Dr. Cash $10,000
Cr. Sales Revenue $10,000
5. Financial Statements Income Statement: Shows profit or loss during a period.
Example: - Revenue = $50,000
- Expenses = $30,000
- Net Profit = $50,000 - $30,000 = $20,000
Balance Sheet: Lists assets, liabilities, and equity at a particular point in time.
Example: - Assets = $500,000
- Liabilities = $300,000
- Equity = $200,000
Statement of Cash Flow: Shows cash inflows and outflows.
Example: - Operating cash flow = $15,000
- Investing cash flow = -$5,000
- Financing cash flow = $10,000
- Net cash flow = $20,000
6. Three Fields of Accounting Financial Accounting: Preparing reports for external use.
Example: - Preparing a quarterly income statement for shareholders.
Managerial Accounting: Preparing reports for internal use.
Example: - Creating a report on production costs for the factory manager.
Cost Accounting: Measuring the cost of production.
Example: - Analyzing the cost of raw materials and labor for each cable produced.
7. Types of Accounts Real Accounts: Tangible and intangible assets.
Example: - Machinery, building, patents.
Personal Accounts: Accounts related to individuals, entities, and groups.
Example: - Accounts payable, customer accounts, supplier accounts.
Nominal Accounts: Accounts related to income, expenses, gains, and losses.
Example: - Sales revenue, rent expense, loss on asset sale.
✅ Summary Example (Cable Factory): | Accounting Principle | Example |
| Revenue Recognition | Record sale when product is delivered |
| Matching Principle | Record raw material cost with cable sale |
| Historical Cost | Machine recorded at original cost |
| Full Disclosure | Litigation disclosed in financial reports |
| Objectivity | Revenue recorded based on invoices |
| Type of Account | Example |
| Real | Factory machinery |
| Personal | Customer account |
| Nominal | Sales revenue |
🔎 Practical Insights: - The double-entry system ensures financial accuracy and prevents fraud.
- Financial statements provide insight into business health.
- Proper classification of accounts improves reporting and decision-making.
- Objectivity and full disclosure build trust with stakeholders.