A business’s ability to sustainably grow hinges largely on the accuracy and strength of its accounting practices. Whether you’re charting a course to the CFO role or preparing to interview for your first finance job, a basic understanding of core accounting concepts is invaluable.
Test your knowledge on basic, essential accounting principles below, then check your work in the answer key.
- b. Income Statement
An income statement is a financial report that documents a company’s earnings over a specific time period — yearly, quarterly or monthly — and records the expenses and costs associated with earning that revenue.
- a. $1,800 debit in accounts receivable; $3,000 credit in retained earnings; $1,200 debit in cash
Cash is classified as a current asset and therefore expected to be consumed, sold or exhausted within a year, so it’s recorded on the balance sheet as a debit when it's received. When a customer makes a payment, cash is debited. Conversely, when a customer buys something on credit, the sale is documented in accounts receivable, where all funds owed to a company are accounted for. Retained earnings are a portion of the profits earned that are not used as dividends and are often reserved for reinvesting into the business.
- b. Investing in equipment worth $90,000
Cash flow is defined as the movement of cash in and out of a business, and cash flow from financing activities (CFF) — or cash flow financing — is a section of the cash flow statement that includes transactions involving debt, equity and dividends. The purchase of plant, property and equipment (PP&E) would fall under cash flow from investing.
- a. Left
Debits are recorded on the left side of the ledger account because they decrease equity, liability and revenue and increase expense or asset accounts.
- b. No
Assets are recorded at their historical cost values, which means that they are documented at their original cost and time acquired.
- b. False
Increasing an asset involves debiting the account, because assets and expenses have natural debit balances.
- d. Liability
Unearned revenues are incurred when businesses or individuals receive payment for a product or service that has yet to be delivered or provided. Until the item is delivered, these types of transactions are marked as liabilities.
- d. Two
All accounting entries must contain at least two accounts: one that is debited and another that is credited.
- a. Chart of accounts
A chart of accounts helps companies break down all financial transactions made during a certain period into subcategories. That enables them to gain deeper insight into the profitability and effectiveness of various products, services or business units.
- e. Property
Considering that current assets are expected to be converted to cash within a year, property, which is a long-term asset often held for multiple years, would not be classified as such.
- c. Gross Income - Operating Expenses = Operating Income
A company’s operating income is, in other words, its income from core operations. Operating income is calculated by subtracting operating costs from gross income.
- c. If the business has provided the goods or services and can reasonably expect to receive cash, it can recognize the revenue in that period.
The accrual concept requires that revenues and costs are recognized when they are earned or incurred, rather than when they are received in cash or paid. This method tends to provide companies with better and more comprehensive insights into their profitability and overall financial health.
- b. Accounts Payable
Accounts payable tracks the money businesses owe to their creditors, so when businesses begin to pay off their purchases, which are recorded as debits, the balance in accounts payable decreases.
- d. The depreciation expense is larger in the first few years and gets smaller as time goes on.
Double-declining balance depreciation is an accelerated depreciation method that is used to offset an asset’s increased maintenance costs with lower depreciation expenses throughout its lifetime. For example, in knowing that assets will have lower repair and maintenance expenses in their early years, companies allocate higher depreciation expenses to newer assets.
- c. Sales + Taxes + Interest
Earnings before interest and taxes (EBIT) is a business’s net income before interest and taxes are deducted, and it’s often used as a measure of operating profit. There are multiple ways to calculate EBIT; no matter which you use, the metric provides a look at a company’s profitability regardless of its capital structure.
How did you do? It’s accrual world, but continue studying to become audit you can be. (Did you catch our accounting jokes there?)