Principle of Accounting
The elements of accounting environment are concerned with the components under which accountants in an office work. Some of them include company laws, taxation rules, communication, control activities, risk assessment, monitoring, communication and information. Different accounting systems will have different elements. For instance, the main element in financial accounting is measurement that is based on standardized analysis of a company’s historical data. The elements affect financial statement by defining what can be included in each, at what time and the way they are communicated. For instance, they determine when proceeds from a sale of assets are recorded (Kimmel, Weygandt & Kieso, 2011).
These elements are very important when it comes to ensuring effective control of the organization’s finances. They provide a framework upon which financial and economic factors, as well as trends are identified in order to have a standard measurement metric for communicating the financial position of a firm. These elements enable companies within the same industry to compare their financial positions. For instance, companies using GAAP standards use the same measures for communicating and analyzing, hence they can compare with each other (Kimmel, Weygandt & Kieso, 2011).
Debits and credits are used in financial reporting, which are the main components of a double entry accounting. When a company enters a transaction, it does two things, which are getting something new and giving up another (Epstein, 2012). Both transactions are recorded in a ledger account with the left side representing the debits while the right represents credits. An example is when an office purchases furniture. In the supplies account, the value increased after acquiring the new furniture while it reduces in the cash account after paying for it. If the furniture cost $1,000, in the ledger account this would be debited in the supplies account and credited in the cash account.
Considering that both accounts are assets, they will be recorded in the balance sheet, where the assets are offset by the liability. In this case, the cash to be paid to the suppliers will be a liability, while the amount of furniture will be assets, to offset the cash spent. Therefore, the debits and credits are used to develop the financial statements. The above ledger develops a balance sheet while others are used to develop revenue statements (Epstein, 2012).
In the double entry accounting, debits and credits are the entries in a ledger account. Debits are abbreviated as Dr and entered on the left side while credits are abbreviated as Cr and entered on the right side. They are used in recording transactions in a business, showing both sides. The rule is crediting the source of the transaction while the destination is debited. For instance, when buying something, the cash account is the source of the transaction. The destination account is the one receiving the item bought such as supplies, which is credited. Debits and credits affect the accounting equation of a transaction equally. The accounting equation forms the basis of a balance sheet, where assets, liabilities and equity are tallied. Any change in assets affects liabilities. Debits do not always go up. In the assets account, debits increase while they decrease in liability accounts. Credits on the other hand increase in the liability accounts while they decrease in the assets accounts (Kimmel, Weygandt & Kieso, 2011).
Accounting equation is the foundation upon which double entry is based. It indicates that all assets within an organization are financed either through debts or through equity from the shareholders. For instance, a company can choose to purchase an equipment costing $2,000 using a loan of the same amount. Alternatively, it can choose to purchase the equipment using the retained earnings, which are part of owners’ equity.
Assets represent how the sources of finance in a company are spent. The equation is denoted as Assets = liabilities + owners equity. This equation can be expressed in another way by rearranging it. It can be denoted as Liabilities = Asset – Equity or Equity = Assets – Liabilities. This means that all the assets in a balance sheet have to be equal to liabilities added to owners’ equity. Therefore, the balance sheet is the main financial statement displaying this equation because it indicates that total assets in a company are equal to the value of equity and liabilities combined (Jones & Hansen, 2011).
When any sale or purchase is conducted, both sides of the equation are affected equally. For instance, when a company takes a loan, the assets increase because there is more cash available. Liabilities increase as well, indicating that the company owes more to its creditors. This is the same case for equity where it increases if the company sells more shares to raise money for expansion (Warren, Reeve & Duchac, 2014). For example, if the company had $1000 worth of assets and wanted to expand its business by purchasing another asset worth $250, it can issue new shares. The equation would be as follows before purchase
$1,000 assets = 0 liabilities + $1,000 equity
After issuing shares to purchase the asset, it would appear as follows
$1,250 assets = 0 liabilities + $1,250 equity.
Another scenario could exist where the company wants to purchase the equipment using retained earnings. Before the purchase, the equation could be as follows
$1,000 assets = 0 liabilities + $750 Equity + $250 retained earnings
After the purchase, the equation would be as follows
$1,000 Assets = $250 Liabilities + $750 Equity + 0 retained earnings
This is because the cash from retained earnings has used after purchasing the asset. It becomes a liability because the company will be owing money to its creditor from whom it bought the asset.
From examples and explanation
provided, it is clear that the accounting equation revolves around the balance
sheet. It is connected with double entry accounting where both sides must
balance. In addition, the double entry ledgers are used to develop the balance
sheet, which means there has to be two sides. Any change on one side means
equal change on the other.
Jones, J. & Hansen, D. (2011). Financial and Managerial Accounting: The Cornerstones of Business Decisions. Mason, Ohio: South-Western.
Epstein, L. (2012). The Business Owner’s Guide to Reading and Understanding Financial Statements: How to Budget, Forecast, and Monitor Cash Flow for better Decision Making. Hoboken, NJ: John Wiley.
Kimmel, P. D., Weygandt, J. J. & Kieso, D. E. (2011). Financial Accounting: Tools for Business Decision Making. Hoboken, NJ: John Wiley.
Warren, C. S., Reeve, J. M. & Duchac, J. E. (2014). Corporate Financial Accounting. New York, N.Y: Cengage Learning.