Accounting Basics Foundations of Accounting Syllabus

Define a partnership.

A business owned by two or more persons (partners) who share management, profits, and losses under a partnership agreement; it is a separate accounting entity but generally not a separate legal/taxable entity from its partners.

What is the key liability difference between a general partnership and a corporation?

In a general partnership, partners have unlimited personal liability for business debts (and are jointly/severally liable). In a corporation, shareholders have limited liability restricted to their investment.

Define a corporation.

A business organized as a separate legal entity, owned by shareholders (stockholders), created under state law, with the ability to issue stock, and whose owners enjoy limited liability.

List two advantages and two disadvantages of a corporation.

Advantages: limited liability for owners; ability to raise large amounts of capital and unlimited (continuous) life. Disadvantages: double taxation of corporate income and dividends; more costly and complex to form and regulate.

What is meant by "double taxation" of a corporation?

Corporate profits are taxed at the corporate level, and then dividends distributed to shareholders are taxed again as personal income to the shareholders.

What are the three main types of business by activity?

Service businesses, merchandising businesses, and manufacturing businesses.

What does a service business do, and give an example?

A service business provides intangible services rather than physical products (e.g., a law firm, accounting firm, salon, or consulting company). It has no inventory of goods for sale.

What does a merchandising business do, and how does it earn profit?

A merchandising business buys finished goods and resells them to customers without changing their form. It earns profit from the difference between sales revenue and the cost of goods sold (gross profit).

What distinguishes a manufacturing business?

A manufacturing business buys raw materials and converts them into finished products for sale, maintaining three inventory types: raw materials, work in process, and finished goods.

What are the three inventory accounts of a manufacturing business?

Raw materials inventory, work in process (WIP) inventory, and finished goods inventory.

What does GAAP stand for, and what is it?

GAAP stands for Generally Accepted Accounting Principles—the common set of accounting standards, rules, and procedures that companies follow when preparing financial statements to ensure consistency and comparability.

Which body sets GAAP in the United States?

The Financial Accounting Standards Board (FASB), an independent private-sector body; the SEC oversees and has legal authority for public companies.

What are the four basic underlying assumptions of accounting?

Economic (business) entity assumption, going concern assumption, monetary unit assumption, and time period (periodicity) assumption.

What is the economic entity assumption?

The assumption that the activities of a business are kept separate and distinct from the activities of its owner(s) and of all other economic entities.

What is the going concern assumption?

The assumption that a business will continue operating into the foreseeable future—long enough to fulfill its objectives and commitments—rather than being liquidated.

What is the monetary unit assumption?

The assumption that only transactions expressible in money are recorded, and that the monetary unit is stable (ignoring inflation) so amounts can be added and compared.

What is the time period (periodicity) assumption?

The assumption that the economic life of a business can be divided into artificial, standardized time periods (months, quarters, years) for reporting purposes.

State the revenue recognition principle.

Revenue should be recognized (recorded) in the accounting period in which the performance obligation is satisfied—i.e., when it is earned—regardless of when cash is received.

State the matching (expense recognition) principle.

Expenses should be recognized in the same period as the revenues they helped to generate, matching efforts (expenses) with accomplishments (revenues).

What is the historical cost principle?

Assets should be recorded and reported at their original acquisition (historical) cost, not at current market value.

What is the full disclosure principle?

All information that would make a difference to the decisions of financial statement users must be disclosed in the statements or accompanying notes.

What are the two fundamental qualitative characteristics of useful accounting information?

Relevance and faithful representation.

What are the enhancing qualitative characteristics of accounting information?

Comparability, verifiability, timeliness, and understandability.

What is the materiality constraint?

An item is material if omitting or misstating it could influence a user's decision. Immaterial items may be handled in the most cost-effective or expedient way without strictly following GAAP.

What is the cost constraint (cost-benefit)?

The benefits of providing accounting information should exceed the costs of providing it; information need not be reported if the cost of producing it outweighs its usefulness.

What does IFRS stand for, and who issues it?

IFRS stands for International Financial Reporting Standards, issued by the International Accounting Standards Board (IASB) and used in many countries around the world.

Give two key differences between U.S. GAAP and IFRS.

GAAP is more rules-based while IFRS is more principles-based; GAAP prohibits LIFO's counterpart differently and IFRS bans LIFO inventory costing; IFRS permits revaluation of certain assets to fair value while GAAP generally requires historical cost.

Define an asset.

An asset is a resource controlled by the entity as a result of past events, from which future economic benefits are expected to flow to the entity (e.g., cash, inventory, equipment, accounts receivable).

Define a liability.

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of economic resources (e.g., accounts payable, loans, wages payable).

Define owner's equity.

Owner's equity is the owner's residual claim on the assets of the business after deducting liabilities; it represents the net worth of the business (assets minus liabilities).

State the basic accounting equation.

$$\text{Assets} = \text{Liabilities} + \text{Owner's Equity}$$

Rearrange the accounting equation to solve for owner's equity.

$$\text{Owner's Equity} = \text{Assets} - \text{Liabilities}$$

If a company has assets of $500{,}000 and liabilities of $180{,}000, what is owner's equity?

$$\text{Owner's Equity} = \$500{,}000 - \$180{,}000 = \$320{,}000$$

State the expanded accounting equation for a sole proprietorship.

$$\text{Assets} = \text{Liabilities} + \text{Owner's Capital} - \text{Owner's Drawings} + \text{Revenues} - \text{Expenses}$$

In the expanded accounting equation, which items increase owner's equity and which decrease it?

Owner's capital (investments) and revenues increase owner's equity; owner's drawings (withdrawals) and expenses decrease owner's equity.

Why must the accounting equation always remain in balance?

Because of double-entry accounting: every transaction affects at least two accounts, and total assets must always equal the total claims (liabilities plus owner's equity) against those assets.

A owner invests $10{,}000 cash into the business. What is the effect on the accounting equation?

Assets (Cash) increase by $10{,}000 and Owner's Equity (Capital) increases by $10{,}000; the equation stays in balance.

The business buys equipment for $3{,}000 cash. What is the effect on the accounting equation?

One asset (Equipment) increases by $3{,}000 and another asset (Cash) decreases by $3{,}000; total assets are unchanged and the equation stays in balance.

The business purchases $2{,}000 of supplies on account (credit). What is the effect on the equation?

Assets (Supplies) increase by $2{,}000 and Liabilities (Accounts Payable) increase by $2{,}000; the equation stays in balance.

The business earns $5{,}000 of service revenue in cash. What is the effect on the equation?

Assets (Cash) increase by $5{,}000 and Owner's Equity increases by $5{,}000 through revenue; the equation stays in balance.

The business pays $800 for this month's rent expense in cash. What is the effect on the equation?

Assets (Cash) decrease by $800 and Owner's Equity decreases by $800 through an expense; the equation stays in balance.

The owner withdraws $1{,}000 cash for personal use. What is the effect on the equation?

Assets (Cash) decrease by $1{,}000 and Owner's Equity decreases by $1{,}000 through drawings; the equation stays in balance.

The business pays $500 to a creditor on account. What is the effect on the equation?

Assets (Cash) decrease by $500 and Liabilities (Accounts Payable) decrease by $500; the equation stays in balance.

What is the difference between owner's drawings and an expense?

Both reduce owner's equity, but drawings are withdrawals of assets by the owner for personal use, whereas expenses are costs incurred in the process of earning revenue for the business.

Why is the corporate equivalent of owner's equity called stockholders' equity, and what are its two main parts?

In a corporation, owners are shareholders, so equity is called stockholders' (shareholders') equity. Its two main parts are paid-in (contributed) capital from issuing stock and retained earnings (accumulated profits not distributed as dividends).