Chapter 2: Fundamental Accounting Principles

1. The Accounting Equation (Assets = Liabilities + Equity)

Definition
The accounting equation is the foundation of all accounting systems. It states:

Assets = Liabilities + Equity

This equation illustrates how a business’s resources (assets) are financed—either by borrowing money (liabilities) or through the owner’s or shareholders’ investments (equity).

Key Components

1. Assets
   • What the business owns (cash, inventory, equipment, etc.).
   • Assets provide future economic benefits or can be converted to cash.
2. Liabilities
   • What the business owes to outsiders (loans, credit card balances, accounts payable).
   • Represents a legal or financial obligation to pay back a debt.
3. Equity
   • Also known as owner’s equity or shareholders’ equity.
   • The residual interest in the assets of a business after deducting liabilities.
   • Reflects the owner’s (or shareholders’) net investment in the company.

Example

• Suppose a company has:
  • $10,000 in assets (bank account, office equipment)
  • $4,000 in liabilities (bank loan)
  • Equity would then be $6,000
• Equation check:

10,000 (Assets) = 4,000 (Liabilities) + 6,000 (Equity)

By ensuring the equation balances, you confirm that every transaction is recorded correctly in the books.

2. Accrual vs. Cash Basis

Overview
Accrual and cash basis are two different methods of recognizing revenue and expenses in accounting. Choosing the right method impacts how a company measures performance and when it reports income.

Accrual Basis

1. Definition:
   • Revenue is recorded when earned (not necessarily when cash is received).
   • Expenses are recorded when incurred (not necessarily when cash is paid).
2. Example:
   • You invoice a client in December for services delivered that month, but don’t receive payment until January. Under accrual accounting, you record the revenue in December.
3. Why Use It?
   • Provides a more accurate picture of a company’s financial health.
   • Matches revenues and expenses to the periods in which they are incurred, aiding in better decision-making.

Cash Basis

1. Definition:
   • Revenue is recorded only when cash is received.
   • Expenses are recorded only when cash is paid out.
2. Example:
   • You invoice a client in December but don’t receive payment until January. Under cash basis accounting, you record that revenue in January (when the cash actually arrives).
3. Why Use It?
   • Simpler to track, especially for small businesses or freelancers.
   • Doesn’t require monitoring accounts receivable or payable in the same way as accrual accounting.

Pros and Cons

Key Consideration

• Many businesses start with cash basis due to simplicity. However, accrual basis is the standard under most accounting regulations for larger entities because it offers a more accurate view of financial performance over time.

Key Takeaway

The Accounting Equation forms the backbone of all financial tracking, ensuring every transaction remains balanced. Choosing between the accrual and cash basis impacts how and when revenue and expenses are recognized. Understanding these concepts helps maintain accurate books and supports sound decision-making.