Basic Accounting
| Basic accounting principles require that the financial statements report information that is primarily useful and understandable to financial statement users. |
Accountants follow a common set of rules to create the financial statements. Without these basic rules in place, it would be difficult for lenders, investors, and other financial statement users to compare, analyze, or even trust the information reported on financial statements.
If one company, for example, reports sales or expenses differently from another company, this reporting difference can give the appearance of more profits for one company, when in fact profits are the same for both companies had they both used the same accounting methods. For this reason, rules are set in place to determine what activities to measure, when to measure them, and how to measure them.
Basic Accounting Principles Rule #1: Accounting information must be useful to the user of the information.
Information can only be useful if it is both relevant and reliable.
What is relevant information?
Relevance includes any information that helps the financial statement user determine the value and performance of the company. Reporting the ratio of males to females working in the company is irrelevant. Reporting total salaries and wages of employees is relevant.
Similarly, reporting the type of machinery the company has is not relevant. Reporting the original cost of the machinery is relevant.
What is reliable information?
Basic accounting principles also centers on the reliability of the information reported. Companies report information that is not biased towards an objective, such as getting investors to invest in its stock, or creditors to lend the company money. Instead, financial reports are reliable when users can rely on the information to represent that which it is intended to represent.
Information that is reliable can be verified independently and repeatedly. Reliability is the main reason companies are audited. Auditing tests and verifies that the financial information reported is accurate, reliable, and represents what it claims to represent so that financial statement users can depend on it to make financial decisions.
Basic Accounting Principles Rule #2: Accounting information must be understandable.
Financial statements are only useful to financial statement users if they are understandable. To be understandable, financial statements must be consistent with past reports of the same company and comparable to other companies.
This means that the company must use the same accounting practices that it has been using for previous periods to remain consistent. In addition, it must use the same practices as other companies for the same transaction so the user of the information can make meaningful and useful comparisons.
Basic Accounting Principles Rule #3: The Financial Statements are the primary means of communicating useful financial information.
The primary means of communicating useful financial information are the main business financial statements called the balance sheet, the income statement, and the statement of cash flows.
Online Accounting and Business Accounting Home Page
Hi Rebecca,
Thank you for your question.
Prepaid expenses are recorded as an asset because it represents a future benefit to the company that has not been consumed yet.
So for example if you prepaid rent for the entire year, you would show prepaid rent as an asset on the balance sheet, with a credit to cash.
The income statement is not affected until the rent is due and consumed.
Each month the rent is due and consumed, it is expensed on the income statement:
Thank you for visiting!
Kenneth Meunier
If u pay rent of 6500 for 12 months but u paid one month in advance. How do u calculate it for an income statement?
Hi Jesse and thank you for your question.
There are a few factors that go into what is considered a healthy cash flow statement, including the growth stage of the business and the industry class. But in general you want to see positive cash flow for operations (+CFFO) that is reinvested (outflow) into the business (-CFFI).
For mature companies, paying down debt and paying dividends -CFFF (financing outflows) is also a good sign.
Also see cash flow analysis
Thank you for visiting!
Kenneth Meunier
Great accounting resource!
What is considered a healthy cash flow statement?
great source for refresher info. thanks for your work
need anwer to this question, state the main categories of inventories for which the net realizable value is likely to be less than cost and describe how to indentify inventories that might be less than cost? have the right answer e-mail it to me plssss as soon as possible
Hello UKJob –
The income statement is important to show profit margins, and the cash flow statement is important to see if the profits are sustainable and real. This is because the income statement only reports profits not cash, and it can be more subject to accounting manipulation (like writing off massive charges in one period, and making subsequent periods look better to show profits that do not really exist).
So it is important to look at the balance sheet and the cash flow statement as well. A strong company has strong profit margins (income statement), cash flow to support what it is reporting as profits (cash flow statement), and growing equity as a result (balance sheet). Please see financial statement analysis for more information.
Kenneth
Very useful info. When analyzing companies online, which is the best statement to look at – cash flow or income statement? Which ones gives the most accurate information about the company?
Hi Judy –
Please see perpetual inventory system examples.
Kenneth
in relation with basic accounting am what transaction would be use to record freight in in perpetual inventory system S company sold merchandise on account to B co. P13500,FOB destination term 1/15 . n/eom. the cost of the merchandise sold was P9500.that’s all
NIFTY JOB THX
Debit Cash (or other asset received) and Credit unearned revenue since the legal service was not yet completed. When the services are performed, debit unearned revenue and credit revenue as they are completed.
What is the journal entry to recognize revenue of a legal 3 year contract.
Hi Carolyn –
Thank you very much for the positive feedback! It helps to know content is clear and understandable.
Kenneth
Hi Kenneth,
I am studying accounting in an on-line class. I happened to find your site when I Googled Special Accounting Journals for a paper I am writing. Thank you for explaining accounting in such a way that I can grasp it.
Hi Ana –
Great point – there are a lot of financial gains and losses that escaped the financial statements in the form of derivatives, insurance contracts, and other complex financial instruments, but these are mostly limited to larger corporations. FASB became concerned about the same issue and issued FAS 130 to account for them (see footnote 1 at
http://business-accounting-guides.com/business-equity/ ). Still, attempting to place a value on them is a current challenge to accountants.
Would like to comment on understandability of the accounting information. First, of course readers of the financial statements must have accounting knowledge to be able to understand financial information. However in certain cases when entity has derivatives or similar fancy things, even accounting knowledge can be useless, i.e. when even CPAs spend a lot of time and consideration deciding how to account for such things properly.
Thanks you have been a great help simple and informative and can easily be tranfered to others
really nice work..thank you so much !!
Thanks for all the time you put in this wonderfull web site; I would like to know where I could get some free accounting courses on line. I have the basic accounting knowledge.
HI it’s really a good work. THanxxxxxxxxxxx a lot
It is great to know the site is helping – thank you for the feedback!
I am preparing for a test….and I prefer this webpage…to my $200 book and its website.
nice site Ken. Thanks for the info! good stuff