© 1991 John Petroff 

Chapter 1:



The purpose of accounting is to provide a means of recording, reporting, summarizing, and interpreting economic data. In order to do this, an accounting system must be designed. A system design serves the needs of users of accounting information. Once a system has been designed, reports can be issued and decisions based upon these reports are made for various departments. Since accounting is used by everyone in one form or another, a good understanding of accounting principles is beneficial to all.

The accounting profession is generally divided into two categories: 1) private accounting and 2) public accounting. Private accountants are employed by a business, while public accountants practice as individuals or as members of an accounting firm. Public accountants are subject to strict government regulations and requirements which are determined by each individual state where a license is granted. Private accountants on the other hand require no licenses. They perform tasks which have been determined by their employer. Accounting fields exist that specialize in very specific areas of a business. Examples are auditing, budgetary, tax, social, cost, managerial, financial and international.

Bookkeeping is concerned with the recording of business data, while accounting is concerned with the design, interpretation of data, and the preparation of financial reports. Three forms of business entities exist: 1) sole proprietorship, 2) partnership, and 3) corporations. Corporations have the unique status of being a separate legal entity in which ownership is divided into shares of stock. A shareholder's liability is limited to his/her contribution to capital. Whenever a business transaction is recorded, it must be recorded to accounting records at cost. All business transactions must be recorded. All properties owned by businesses are assets. All debts are liabilities. The rights of owners is equity.

Assets, liabilities and owner's equity are the basic elements of the accounting equation. The excess of assets over liabilities is owner's equity. Thus, assets are equal to liabilities plus owner's equity at all times. Any business transaction has to affect at least one of these elements.

There are two basic accounting statements used by most businesses. The balance sheet presents the assets, liabilities and owner's equity. Each account balance in the balance sheet is reported as of the last day of the financial period. The income statement determines whether a net profit or loss was realized by matching total revenue and expenses for a specific time period. A third statement is used by some businesses. It is the statement of owner's equity which presents the changes which have taken place in owner's equity over the period.

The financial statements of corporations are different from those of other forms of business in several aspects. Instead of having an owner's equity section in the balance sheet statement, a corporation has a stockholders' equity. Shareholders' equity is composed of capital stock and retained earnings. Capital stock represents the initial investment of the shareholders. Retained earnings represents accumulated profits. The owner's equity statement is usually called retained earnings statement. The retained earnings statement will at times have deductions called dividends which represent payments of earnings to shareholders. Whenever shareholders buy shares of stock from the corporation, assets and stockholders' equity increase. The reverse occurs when dividends are distributed.


The income statement reports the amount of net income or loss determined by subtracting expenses from revenues during a specific time period. Only expenses which are attributable to items of income are recognized as period expenses. The net income or loss from the income statement is recorded in the statement of owner's equity.

The statement of owner's equity records the changes in the value of owner's equity. Additional investments and net profits increase owner's equity. Dividend payments, owner withdrawals, and net losses decrease owner's equity. Net profits or losses are derived from the income statement. The statement of owner's equity (or retained earnings statement for corporations) is the connecting link between the income statement and the balance sheet.

The balance sheet lists all assets, liabilities, and owner's equity balances as of the last day of the financial period. The balance sheet always begins with assets, then liabilities and owner's equity. Assets which are listed first are the most liquid, such as cash, accounts receivable and prepaid expenses. Liabilities are grouped by due date, with short-term liabilities listed first.

The following is a summary of business transactions and how they affect the items of the balance sheet.
1)- Initial and additional investments increase both assets and owner's equity.
2)- Assets purchased on credit increase both assets and liabilities.
3)- When assets are used to purchase other assets, there is no net change in the amount of total assets.


4)- Assets used to pay debts decrease assets and liabilities.
5)- Net income increases assets and owner's equity.
6)- Net losses decrease assets and owner's equity.
7)- Assets that are used up for the purpose of the generating revenue decrease assets and owner's equity.
8)- Withdrawals owners and dividends decrease assets and owner's equity.
9)- Expenses reduce assets and owner's equity.

Review Quiz


[Your opinion is important to us. If have a comment, correction or question pertaining to this chapter please send it to comments@peoi.org .]


 Next: Accounting_cycle