Reading: Lesson 4 - The financial accounting process

In this section, we explain the accounting equation—the framework for the entire accounting process. Then, we show you how to recognize a business transaction and describe underlying assumptions that accountants use to record business transactions. Next you learn how to analyze and record business transactions. In the balance sheet presented in Exhibit 2 (Part C), the total assets of Metro Courier, Inc., were equal to its total liabilities and stockholders’ equity. This equality shows that the assets of a business are equal to its equities; that is, Assets = Equities

Assets were defined earlier as the things of value owned by the business, or the economic resources of the business. Equities are all claims to, or interests in, assets. For example, assume that you purchased a new company automobile for USD 15,000 by investing USD 10,000 in your own corporation and borrowing USD 5,000 in the name of the corporation from a bank. Your equity in the automobile is USD 10,000, and the bank’s equity is USD 5,000. You can further describe the USD 5,000 as a liability because you owe the bank USD 5,000. If you are a corporation, you can describe your USD 10,000 equity as stockholders’ equity or interest in the asset. Since the owners in a corporation are stockholders, the basic accounting equation becomes: Assets A = Liabilities L + Stockholders’ Equity SE From Metro’s balance sheet in Exhibit 2 (Part C), we can enter in the amount of its assets, liabilities, and stockholders’ equity:

A = L + SE

USD 38,700 = USD 6,600 + USD 32,100 Remember that someone must provide assets or resources—either a creditor or a stockholder. Therefore, this equation must always be in balance. You can also look at the right side of this equation in another manner. The liabilities and stockholders’ equity show the sources of an existing group of assets. Thus, liabilities are not only claims against assets but also sources of assets. Together, creditors and owners provide all the assets in a corporation. The higher the proportion of assets provided by owners, the more solvent the company. However, companies can sometimes improve their profitability by borrowing from creditors and using the funds effectively. As a business engages in economic activity, the dollar amounts and composition of its assets, liabilities, and stockholders’ equity change. However, the equality of the basic accounting equation always holds.

An accounting transaction is a business activity or event that causes a measurable change in the accounting equation, Assets = Liabilities + Stockholders’ equity. An exchange of cash for merchandise is a transaction. The exchange takes place at an agreed price that provides an objective measure of economic activity. For example, the objective measure of the exchange may be USD 5,000. These two factors—evidence and measurement—make possible the recording of a transaction. Merely placing an order for goods is not a recordable transaction because no exchange has taken place. A source document usually supports the evidence of the transaction. A source document is any written or printed evidence of a business transaction that describes the essential facts of that transaction. Examples of source documents are receipts for cash paid or received, checks written or received, bills sent to customers for services performed or bills received from suppliers for items purchased, cash register tapes, sales tickets, and notes given or received. We handle source documents constantly in our everyday life. Each source document initiates the process of recording a transaction.

Underlying assumptions or concepts

In recording business transactions, accountants rely on certain underlying assumptions or concepts. Both preparers and users of financial statements must understand these assumptions: 

• Business entity concept (or accounting entity concept). Data gathered in an accounting system relates to a specific business unit or entity. The business entity concept assumes that each business has an existence separate from its owners, creditors, employees, customers, other interested parties, and other businesses.
  
• Money measurement concept. Economic activity is initially recorded and reported in a common monetary unit of measure—the dollar in the United States. This form of measurement is known as money measurement.
  
• Exchange-price (or cost) concept (principle). Most of the amounts in an accounting system are the objective money prices determined in the exchange process. As a result, we record most assets at their acquisition cost. Cost is the sacrifice made or the resources given up, measured in money terms, to acquire some desired thing, such as a new truck (asset).
  
• Going-concern (continuity) concept. Unless strong evidence exists to the contrary, accountants assume that the business entity will continue operations into the indefinite future. Accountants call this assumption the going-concern or continuity concept. Assuming that the entity will continue indefinitely allows accountants to value long-term assets, such as land, at cost on the balance sheet since they are to be used rather than sold. Market values of these assets would be relevant only if they were for sale. For instance, accountants would still record land purchased in 1988 at its cost of USD 100,000 on the 2010 December 31, balance sheet even though its market value has risen to USD 300,000.
  
• Periodicity (time periods) concept. According to the periodicity (time periods) concept or assumption, an entity’s life can be meaningfully subdivided into time periods (such as months or years) to report the results of its economic activities.
  

Now that you understand business transactions and the five basic accounting assumptions, you are ready to follow some business transactions step by step. To begin, we divide Metro’s transactions into two groups: (1) transactions affecting only the balance sheet in June, and (2) transactions affecting the income statement and/or the balance sheet in July. Note that we could also classify these transactions as operating, investing, or financing activities, as shown in the statement of cash flows.