Unit
- Accounting equation: Assets equal liabilities plus equity. This fundamental relationship underpins every transaction recording and ensures the balance sheet remains balanced after each entry.
- Double-entry mechanism: Every transaction affects at least two accounts, with debits on the left and credits on the right. A debit increases asset or expense accounts and decreases liability, equity, or revenue accounts.
- Transaction analysis: To record an event, identify which accounts change and whether each increases or decreases. For example, purchasing inventory on credit increases both an asset account and a liability account.
- Ledger posting: After journalizing transactions, post them to individual ledger accounts to maintain a running balance. This process forms the basis for preparing trial balances and financial statements.
- Trial balance: A list of all general ledger accounts with their ending debit or credit balances. Total debits must equal total credits, providing a preliminary check on recording accuracy.
- Accrual basis: Revenues are recognized when earned, expenses when incurred, regardless of cash movement. This principle distinguishes accrual accounting from cash-based accounting.
- Adjusting entries: At period-end, adjust entries for prepayments, accruals, and estimates to bring accounts to their correct balances before financial statement preparation.
- Closing entries: Temporary accounts such as revenues, expenses, and dividends are closed to retained earnings at year-end, resetting them for the next period.
Strategic Framework
Framework: The Accounting Equation and Double-Entry Model
Purpose: To provide a structured method for recording all financial transactions with built-in error detection through the balancing requirement.
- Component - Assets: Resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow. Examples: cash, inventory, receivables, equipment.
- Component - Liabilities: Present obligations arising from past events, the settlement of which is expected to result in an outflow of resources. Examples: accounts payable, loans, accrued expenses.
- Component - Equity: The residual interest in the assets after deducting liabilities. Comprises contributed capital, retained earnings, and accumulated other comprehensive income.
- Application context: Every business transaction is tested against this framework. If a transaction fails to maintain the equation, an error exists. This makes the framework both a recording tool and a verification mechanism.
Quick Revision
- The accounting equation (Assets = Liabilities + Equity) is the foundation of all financial recording.
- Double-entry accounting requires debits equal credits for every transaction.
- The trial balance identifies unbalanced entries before financial statement preparation.
- Accrual accounting recognizes revenues and expenses when earned or incurred, not when cash changes hands.