The fundamental principle that states Assets = Liabilities + Owner's Equity, representing the financial position of a company at a specific point in time.
This equation must always balance, providing a foundational check for all accounting transactions.
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Asset
Answer
A probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events.
Assets are resources the company owns and expects to provide value, like cash, inventory, or equipment.
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Liability
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A probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
Liabilities represent what the company owes to external parties, such as accounts payable or loans.
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Owner's Equity
Answer
The residual interest in the assets of an entity after deducting liabilities, representing the owners' claims on the company's net assets.
Equity is what's left for the owners if all assets were sold and all liabilities paid off.
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Retained Earnings
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The cumulative amount of net income earned by the company since its inception, less the cumulative amount of dividends paid to shareholders.
This equity account links the Income Statement (via Net Income) to the Balance Sheet, showing profits kept for reinvestment.
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Debit
Answer
An entry on the left side of a T-account, used to increase asset and expense accounts and decrease liability, equity, and revenue accounts.
Remember the mnemonic 'DEAD C LR': Debits increase Expenses, Assets, Dividends; Credits increase Liabilities, Revenues, Owner's Equity.
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Credit
Answer
An entry on the right side of a T-account, used to increase liability, equity, and revenue accounts and decrease asset and expense accounts.
Debits and credits are not inherently 'good' or 'bad,' but merely represent the left and right sides of an account.
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Normal Balance
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The side of an account (debit or credit) where increases to that account are recorded, reflecting the account's typical balance.
Knowing the normal balance helps determine if a debit or credit will increase or decrease a specific account.
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Normal Balance for Assets
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Assets have a normal debit balance, meaning a debit increases the asset account and a credit decreases it.
Think of cash: receiving cash (an asset) is a debit, while paying cash is a credit.
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Normal Balance for Liabilities
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Liabilities have a normal credit balance, meaning a credit increases the liability account and a debit decreases it.
When you incur a loan (a liability), the liability account is credited, increasing what you owe.
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Normal Balance for Revenues
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Revenues have a normal credit balance, meaning a credit increases the revenue account and a debit decreases it.
Earning revenue typically increases equity, and equity accounts normally have a credit balance.
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Normal Balance for Expenses
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Expenses have a normal debit balance, meaning a debit increases the expense account and a credit decreases it.
Expenses reduce equity, and to reduce an equity account (which has a normal credit balance), you debit it.
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Journal Entry
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The initial chronological record of a business transaction, showing the accounts affected, whether they are debited or credited, and the amount.
A journal entry ensures that for every transaction, total debits always equal total credits, maintaining the accounting equation.
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Posting
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The process of transferring debit and credit amounts from the journal to the individual general ledger accounts.
Journal entries are chronological; posting organizes the data by account, showing the running balance for each.
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Trial Balance
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A list of all general ledger accounts and their balances at a specific point in time, used to verify that total debits equal total credits before preparing financial statements.
While a trial balance ensures debits equal credits, it does not guarantee that all transactions were recorded correctly or that the correct accounts were used.
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Income Statement
Answer
A financial statement that reports a company's revenues, expenses, and net income or loss over a period of time, such as a quarter or a year.
It shows the profitability of the company's operations over a specific duration, often summarized as 'Revenue - Expenses = Net Income'.
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Balance Sheet
Answer
A financial statement that presents a company's financial position at a specific point in time, showing its assets, liabilities, and owner's equity.
Unlike the income statement, the balance sheet is a 'snapshot' on a particular date, always adhering to the accounting equation.
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Statement of Cash Flows
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A financial statement that reports the cash generated and used by a company during a period, categorized into operating, investing, and financing activities.
This statement helps assess a company's liquidity and solvency by showing where cash came from and where it went, distinct from net income.
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Statement of Retained Earnings
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A financial statement that reports the changes in retained earnings for a period, reconciling the beginning and ending balances by adding net income and subtracting dividends.
This statement explains how much profit was kept in the business and how much was distributed to owners.
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Net Income
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The amount by which revenues exceed expenses for a given period, representing the company's profit.
Net income is a key measure of profitability and is calculated on the income statement.
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Current Assets
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Assets that are expected to be converted into cash, sold, or consumed within one year or the company's operating cycle, whichever is longer.
Examples include cash, accounts receivable, and inventory, indicating resources readily available for operations.
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Current Liabilities
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Obligations that are expected to be settled or paid within one year or the company's operating cycle, whichever is longer, typically requiring the use of current assets.
Examples include accounts payable, salaries payable, and short-term loans, representing short-term financial obligations.
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Accrual Basis Accounting
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An accounting method where revenues are recognized when earned and expenses are recognized when incurred, regardless of when cash is exchanged.
This method adheres to GAAP and provides a more accurate picture of a company's financial performance over time, matching efforts (expenses) with accomplishments (revenues).
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Cash Basis Accounting
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An accounting method where revenues are recognized only when cash is received and expenses are recognized only when cash is paid.
This simpler method is not permitted under GAAP for most businesses because it may not accurately reflect a company's economic performance in the period.
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Revenue Recognition Principle
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The principle stating that revenue should be recognized when it is earned, meaning when the company has substantially completed the service or delivered the goods, regardless of cash receipt.
This principle is a cornerstone of accrual accounting, ensuring revenues are reported in the period they are generated, not necessarily when cash changes hands.
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Expense Recognition Principle
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The principle stating that expenses should be recognized in the same period as the revenues they helped generate, or over the period of their benefit, regardless of when cash is paid.
Also known as the Matching Principle, this ensures that the costs associated with generating revenue are reported in the same period as that revenue, providing a true measure of profitability.
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Accrued Revenue
Answer
Revenue that has been earned but not yet received in cash or recorded, requiring an adjusting entry to recognize the revenue and an asset (e.g., Accounts Receivable).
This represents money owed to the company for services already provided or goods delivered, even if the invoice hasn't been sent yet.
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Prepaid Expense
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An expense that has been paid in cash but not yet incurred or used, initially recorded as an asset and later expensed through an adjusting entry as it is consumed.
Think of paying for a year of insurance upfront; it's an asset (future benefit) until each month passes, at which point it becomes an expense.
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Accrued Expense
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An expense that has been incurred but not yet paid in cash or recorded, requiring an adjusting entry to recognize the expense and a liability (e.g., Salaries Payable).
This represents costs incurred, such as employee salaries for work performed, even if payday is still in the future.
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Unearned Revenue
Answer
Cash received from a customer for goods or services that have not yet been delivered or performed, recorded as a liability until the revenue is earned.
This is money received in advance; the company owes the customer a service or product, hence it's a liability until the work is done.