There are a number of conceptual issues that one must understand in order to develop a firm foundation of how accounting works. These basic accounting concepts are as follows:
- Accruals concept. Revenues are recognized when earned, and expenses are recognized when assets are consumed. This concept means that a business may recognize sales, profits and losses in amounts that vary from what would be recognized based on the cash received from customers or when cash is paid to suppliers and employees. Auditors will only certify the financial statements of a business that have been prepared under the accruals concept.
- Conservatism concept. Revenues are only recognized when there is a reasonable certainty that they will be realized, whereas expenses are recognized sooner, when there is a reasonable possibility that they will be incurred. This concept tends to result in more conservative financial statements.
- Consistency concept. Once a business chooses to use a specific accounting method, it should continue using it on a go-forward basis. By doing so, the financial statements prepared in multiple periods can be reliably compared.
- Economic entity concept. The transactions of a business are to be kept separate from those of its owners. By doing so, there is no intermingling of personal and business transactions in a company’s financial statements.
- Going concern concept. Financial statements are prepared on the assumption that the business will remain in operation in future periods. Under this assumption, revenue and expense recognition may be deferred to a future period, when the company is still operating. Otherwise, all expense recognition in particular would be accelerated into the current period.
- Matching concept. The expenses related to revenue should be recognized in the same period in which the revenue was recognized. By doing this, there is no deferral of expense recognition into later reporting periods, so that someone viewing a company’s financial statements can be assured that all aspects of a transaction have been recorded at the same time.
- Materiality concept. Transactions should be recorded when not doing so might alter the decisions made by a reader of a company’s financial statements. This tends to result in relatively small-size transactions being recorded, so that the financial statements comprehensively represent the financial results, financial position, and cash flows of a business.
A number of basic accounting principles have been developed through common usage. They form the basis upon which modern accounting is based. The best-known of these principles are as follows:
- Accrual principle. This is the concept that accounting transactions should be recorded in the accounting periods when they actually occur, rather than in the periods when there are cash flows associated with them. This is the foundation of the accrual basis of accounting. It is important for the construction of financial statements that show what actually happened in an accounting period, rather than being artificially delayed or accelerated by the associated cash flows. For example, if you ignored the accrual principle, you would record an expense only when you paid for it, which might incorporate a lengthy delay caused by the payment terms for the associated supplier invoice.
- Conservatism principle. This is the concept that you should record expenses and liabilities as soon as possible, but to record revenues and assets only when you are sure that they will occur. This introduces a conservative slant to the financial statements that may yield lower reported profits, since revenue and asset recognition may be delayed for some time. Conversely, this principle tends to encourage the recordation of losses earlier, rather than later. This concept can be taken too far, where a business persistently misstates its results to be worse than is realistically the case.
- Consistency principle. This is the concept that, once you adopt an accounting principle or method, you should continue to use it until a demonstrably better principle or method comes along. Not following the consistency principle means that a business could continually jump between different accounting treatments of its transactions that makes its long-term financial results extremely difficult to discern.
- Cost principle. This is the concept that a business should only record its assets, liabilities, and equity investments at their original purchase costs. This principle is becoming less valid, as a host of accounting standards are heading in the direction of adjusting assets and liabilities to their fair values.
- Economic entity principle. This is the concept that the transactions of a business should be kept separate from those of its owners and other businesses. This prevents intermingling of assets and liabilities among multiple entities, which can cause considerable difficulties when the financial statements of a fledgling business are first audited.
- Full disclosure principle. This is the concept that you should include in or alongside the financial statements of a business all of the information that may impact a reader’s understanding of those financial statements. The accounting standards have greatly amplified upon this concept in specifying an enormous number of informational disclosures.
- Going concern principle. This is the concept that a business will remain in operation for the foreseeable future. This means that you would be justified in deferring the recognition of some expenses, such as depreciation, until later periods. Otherwise, you would have to recognize all expenses at once and not defer any of them.
- Matching principle. This is the concept that, when you record revenue, you should record all related expenses at the same time. Thus, you charge inventory to the cost of goods sold at the same time that you record revenue from the sale of those inventory items. This is a cornerstone of the accrual basis of accounting. The cash basis of accounting does not use the matching the principle.
- Materiality principle. This is the concept that you should record a transaction in the accounting records if not doing so might have altered the decision making process of someone reading the company’s financial statements. This is quite a vague concept that is difficult to quantify, which has led some of the more picayune controllers to record even the smallest transactions.
- Monetary unit principle. This is the concept that a business should only record transactions that can be stated in terms of a unit of currency. Thus, it is easy enough to record the purchase of a fixed asset, since it was bought for a specific price, whereas the value of the quality control system of a business is not recorded. This concept keeps a business from engaging in an excessive level of estimation in deriving the value of its assets and liabilities.
- Reliability principle. This is the concept that only those transactions that can be proven should be recorded. For example, a supplier invoice is solid evidence that an expense has been recorded. This concept is of prime interest to auditors, who are constantly in search of the evidence supporting transactions.
- Revenue recognition principle. This is the concept that you should only recognize revenue when the business has substantially completed the earnings process. So many people have skirted around the fringes of this concept to commit reporting fraud that a variety of standard-setting bodies have developed a massive amount of information about what constitutes proper revenue recognition.
- Time period principle. This is the concept that a business should report the results of its operations over a standard period of time. This may qualify as the most glaringly obvious of all accounting principles, but is intended to create a standard set of comparable periods, which is useful for trend analysis.
Balance sheet: The financial statement that presents a snapshot of the company’s financial position as of a particular date in time. It’s called a balance sheet because the things owned by the company (assets) must equal the claims against those assets (liabilities and equity).
Assets: All the things a company owns in order to successfully run its business, such as cash, buildings, land, tools, equipment, vehicles, and furniture.
Liabilities: All the debts the company owes, such as bonds, loans, and unpaid bills.
Equity: All the money invested in the company by its owners. In a small business owned by one person or a group of people, the owner’s equity is shown in a Capital account. In a larger business that’s incorporated, owner’s equity is shown in shares of stock.
Another key Equity account is Retained Earnings, which tracks all company profits that have been reinvested in the company rather than paid out to the company’s owners. Small businesses track money paid out to owners in a Drawing account, whereas incorporated businesses dole out money to owners by paying dividends.
INCOME STATEMENT TERMINOLOGY
Here are a few terms related to the income statement that you’ll want to know:
Income statement: The financial statement that presents a summary of the company’s financial activity over a certain period of time, such as a month, quarter, or year. The statement starts with Revenue earned, subtracts the Costs of Goods Sold and the Expenses, and ends with the bottom line — Net Profit or Loss.
Revenue: All money collected in the process of selling the company’s goods and services. Some companies also collect revenue through other means, such as selling assets the business no longer needs or earning interest by offering short-term loans to employees or other businesses.
Costs of goods sold: All money spent to purchase or make the products or services a company plans to sell to its customers.
Expenses: All money spent to operate the company that’s not directly related to the sale of individual goods or services.
Reach your life’s goals. First figure out what your priorities and goals in life are, then work out a realistic saving and spending plan that helps you achieve those goals.
Calculate how much your regular expenses are. Allocating money for every expense puts you in control of your money, deciding how your money’s used and helping you pay your bills on time. You have the power to make better decisions on how you spend your income.
Know just how much your regular income is. The amount you actually earn after tax may be less than you think. So, unless you change jobs or take a second job, you need to live within your means. By bringing spending in line with income, you ensure you don’t accumulate unmanageable debt and risk your good credit standing.
Prepare for unexpected events. An expected cost, such as a large dental bill, can blow your budget. To lessen the pain, it’s wise to budget for emergencies.
Get and stay out of debt. Because budgeting brings expenses in line with income, your debt level falls. Making regular payments can get you right out of debt.
Build your credit. Pay off the balances on your credit cards, for example, and both your available credit and financial standing go up.
Reduce stress. Gaining control over your finances relieves the constant worry over money, which can cause sleepless nights, reduced productivity at work and, at worst, family breakdown.
Academic Appointment: An appointment for the nine-month period corresponding to the appropriate academic calendar. This is a special kind of cyclic appointment. This type of appointment is not used for classified staff.
Account: Budget-project combination which defines a specific economic activity. The account is used as the key for the Master Account Table and may be used to derive the remaining elements of the coding (e.g., fund, appropriation, program).
Account Entity: A primary entity which provides financial resources for a position.
Accrual: When there is a difference between what is allocated per pay cycle versus what is expensed, an accrual occurs. This term of accrual is somewhat misnamed and would be better understood if it were termed ‘allocation adjustment’. An accrual is a flow of dollars from an operating account, typically to a reserve account. An accrual occurs when there is a difference between what is planned and what has actually happened.
ACH: Automated Clearing House. An agency which acts as an electronic transfer center. Used by payroll for direct deposit of employee payments. (Commonly used as a reference term for the direct deposit system.)
ACS: Administrative Computing Services. That portion of Systems and Computing which works with on campus units on their system development and production needs.
Adjustment Worksheet: Form used for one-time deductions (DS transactions), refunds (RF transactions), hour balance adjustments (HA transactions) and dollar balance adjustments (DA transactions).
Advice: Report to employees whose pay is direct deposited showing gross pay, reductions, deductions, contributions, net pay, selected year-to-date totals and bank account number.
AIS: Administrative Information Systems. Terminal control for accessing on-line systems at Washington State University.
ALC: Annual Leave Cashout. Earnings type used when paying terminal annual leave hours above 240 for classified staff on separation. These earnings are not subject to PERS deductions.
Allocation: The process by which Washington State University specifies where the state allocated dollars are to be expended.
ALP: Annual Leave Payoff. Earnings type used when paying the first 240 hours of terminal annual leave for classified staff. These earnings are subject to PERS deductions.
Annual Appointment: An appointment for twelve months (with provisions for annual leave in the case of non-classified staff).
Acquisition indebtedness – This is the technical term that Congress uses for what most of us call home mortgage debt, on which the interest is deductible. To qualify, the debt must be used to buy, build or improve your principal residence or second home and must be secured by the property. The interest paid on up to $1 million of acquisition indebtedness is deductible if you itemize deductions. The interest on an additional $100,000 of debt can be deductible if certain requirements are met.
Active participation – The level of involvement that real estate owners must meet to qualify to deduct up to $25,000 of passive losses from rental real estate. Failure to pass this test could make such losses nondeductible under passive-loss rules. (see passive loss rules below.)
Additional child tax credit – You may qualify for this credit if the regular child credit more than wipes out your tax liability. This additional credit can trigger a refund check from the IRS even if you don’t owe any tax.
Adjusted basis – Your basis in property is the starting point for determining whether you have a gain or loss when you sell it. (This is sometimes referred to as cost basis, tax basis or simply, basis.) The basis generally starts out as what you pay for the property, although special rules apply to assets you inherit or receive as a gift. The basis can be adjusted while you own property. When you buy rental property, for example, the basis begins at what you pay for the place, including certain buying expenses, and it is adjusted upward by the cost of permanent improvements. The basis is reduced by the amount of any depreciation you are allowed to deduct while you own the property. You use your adjusted basis to figure the gain or loss on the sale.
Adjusted Gross Income (AGI) – This is your income from all taxable sources, minus certain adjustments, and is the key to determining your eligibility for certain tax benefits and the phase-out of your eligibility for others. Adjusted Gross Income is also the amount from which deductions (the standard deduction or itemized deductions) and personal and dependent exemptions are deducted to arrive at the amount of taxable income that will actually be taxed. The adjustments—sometimes called above-the-line deductions because you can claim them whether or not you itemize deductions—include (among other things) deductible contributions to Individual Retirement Accounts (IRAs), SIMPLE and Keogh plans, contributions to Health Savings Accounts (HSAs), job-related moving expenses, any penalty paid on early withdrawal of savings, the deduction for 50 percent of the self-employment tax paid by self-employed taxpayers, alimony payments, up to $2,500 of interest on higher education loans and certain qualifying college costs.
Adoption credit – This credit effectively refunds to you part of what you pay to adopt a qualifying child. An eligible child is generally one under age 18 or one who is physically or mentally incapable of caring for him or herself. If you adopt a special-needs child, you may be eligible for a credit that exceeds your actual costs. The right to the credit phases out as AGI rises.
Alimony – Qualifying payments to an ex-spouse that can be deducted as adjustments to income whether or not you itemize. The recipient must include the payments in his or her taxable income.
Alternative Minimum Tax (AMT) – A special tax designed primarily to prevent the wealthy from using so many legal tax breaks that their regular tax bill is reduced to little or nothing. In recent years, it has hit more and more taxpayers who live in high-tax states, have many children or exercise incentive stock options and will increasingly hit taxpayers who do not consider themselves rich. The AMT ignores certain tax benefits allowed by the regular rules and applies special rates—26 percent and 28 percent—to a larger amount of income than is hit by the regular tax.
Amended return – A revised tax return, filed on Form 1040X, to correct an error on a return filed during the previous three years. An amended return can result in owing extra tax or getting a refund, depending on the mistake you correct.
Audit – As if you didn’t know, this is a review of your tax return by the IRS, during which you are asked to prove that you have correctly reported your income and deductions. Most audits are done by mail and involve specific issues, not the entire return.
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