Difficulty: Introductory | Prerequisites: None
This covers the foundational mechanics of financial accounting: how businesses record what they own, what they owe, and what belongs to the owners. It sits right at the start of any introductory accounting course and underpins everything that follows, from adjusting entries to financial statement preparation. If you are coming in cold, this is your starting point. You should be comfortable with basic arithmetic and the idea that businesses keep records of their money.
Every transaction a business makes must keep the accounting equation (Assets = Liabilities + Stockholders' Equity) in balance. Transactions are recorded through journal entries using debits and credits, posted to T-accounts, and checked with a trial balance. The balance sheet classifies what the business owns and owes into current and non-current categories to show liquidity and long-term commitments.
Entity assumption (separate entity concept)
The principle that a business is a separate economic unit from its owner. All transactions are recorded for the business alone, not mixed with the owner's personal finances. Think of it as: the business has its own wallet, and the owner has theirs.
Historical cost principle (cost principle)
Assets are recorded at their original purchase price and stay at that amount on the books unless a formal revaluation is permitted. In simple terms, this means you write down what you paid, not what something is worth today.
Current assets
Assets expected to be converted into cash or used up within one year (or one operating cycle), such as cash, accounts receivable, and inventory. Think of these as the short-term resources the business cycles through regularly.
Non-current assets (long-term assets)
Assets used over multiple years, such as buildings, land, and equipment. These are the things a business holds onto for the long haul.
Current liabilities
Obligations the business must settle within 12 months, such as accounts payable, wages payable, and short-term debt. In simple terms, these are the bills due soon.
Non-current liabilities (long-term liabilities)
Debts or obligations due beyond one year, such as long-term loans or bonds payable. These are the longer commitments the business has taken on.
Liquidity
How quickly and easily an asset can be converted into cash. Cash itself is the most liquid asset; real estate is among the least. Think of it as: how fast can you turn this into money you can spend?
Accounting equation
Assets = Liabilities + Stockholders' Equity. The fundamental identity that every single transaction must satisfy. In simple terms, everything the business owns is financed either by borrowing (liabilities) or by the owners (equity).
Par value
A legal minimum value assigned to each share of common stock by the company's board. It is largely a formality in modern practice, but it determines how stock issuances are split between the common stock account and additional paid-in capital.
Additional paid-in capital (APIC)
The amount received from issuing stock above par value. Think of it as the premium investors paid over the legal minimum.
Retained earnings
Cumulative net income kept in the business rather than distributed to shareholders as dividends. In simple terms, this is the profit the company has earned over its life and chosen to reinvest.
Dividends
Distributions of earnings to shareholders. Dividends reduce retained earnings and follow a three-date process: declaration, record, and payment.
Debit
The left side of a journal entry. Debits increase assets and expenses, and decrease liabilities, equity, and revenues.
Credit
The right side of a journal entry. Credits increase liabilities, equity, and revenues, and decrease assets and expenses.
T-account
A simplified representation of a ledger account shaped like the letter T, with debits on the left and credits on the right. Think of it as a quick visual way to track increases and decreases in a single account.
Normal balance
The side (debit or credit) where increases to an account are recorded. Assets and expenses normally carry debit balances; liabilities, equity, and revenues normally carry credit balances.
Posting
The process of transferring journal entry amounts to the corresponding T-accounts in the ledger.
Ledger (general ledger)
The complete collection of all T-accounts for a business, providing a comprehensive record of every account balance.
Trial balance
A list of all account balances at a specific point in time, used to verify that total debits equal total credits. Think of it as a sanity check before preparing financial statements.
The business is treated as a distinct entity from its owner (the entity assumption).
All transactions are recorded on the business's books, never mixed with personal activity.
If an owner pays a personal bill from the business bank account, that is recorded as a withdrawal or distribution from the business, not as a business expense.
Assets go on the books at what the business paid for them.
The recorded amount does not change to reflect current market value unless a specific revaluation is permitted.
A building purchased for $500,000 stays at $500,000 on the balance sheet, even if the market says it is now worth $800,000.
The logic: original cost is objective and verifiable. Market value involves estimates and judgement.
The balance sheet organises assets, liabilities, and equity into categories to make the company's financial position easier to read.
Current assets: cash, accounts receivable, inventory, prepaid expenses. Expected to be used or converted to cash within one year.
Non-current assets: buildings, equipment, land. Used over multiple years.
Current liabilities: accounts payable, wages payable, short-term debt. Due within 12 months.
Non-current liabilities: long-term loans, bonds payable. Due beyond one year.
Inventory is always classified as current, regardless of how long it sits on the shelf, because of its role in ongoing operations.
Liquidity is about how fast an asset can become cash.
Cash and accounts receivable are highly liquid. Equipment and real estate are not.
Liquidity matters because it determines a company's ability to pay its short-term obligations.
On the balance sheet, current assets are listed in order of liquidity (cash first).
A transaction is any event that affects the business's financial position.
External events: involve an outside party (buying equipment from a supplier, receiving payment from a customer).
Internal events: happen within the business (using up prepaid insurance over time).
Every transaction must keep the equation in balance: Assets = Liabilities + Stockholders' Equity.
Each transaction affects at least two accounts (dual effect).
Total debits must always equal total credits.
Example: purchasing equipment for $10,000 cash increases Equipment (asset, debit) by $10,000 and decreases Cash (asset, credit) by $10,000. Both sides still balance.
Par value is a nominal, legal minimum assigned to each share of stock.
When a company issues stock, the par value portion goes to the Common Stock account.
Any amount received above par goes to Additional Paid-in Capital (APIC).
Example: 1,000 shares issued at $15 each with a $1 par value. Common Stock increases by $1,000. APIC increases by $14,000.
Dividends are profit distributed to shareholders. They reduce retained earnings, not revenue.
Three key dates:
Declaration date: the board declares the dividend. Retained Earnings decreases, Dividends Payable (a liability) is created.
Date of record: determines which shareholders receive the dividend. No journal entry.
Payment date: the company pays. Cash decreases, Dividends Payable decreases.
When investors trade shares among themselves on the open market, the company's own books are unaffected.
These transactions happen outside the company. No journal entry is made by the company.
Every transaction is recorded as a journal entry with at least one debit and one credit.
Debits (left side): increase assets and expenses, decrease liabilities, equity, and revenues.
Credits (right side): increase liabilities, equity, and revenues, decrease assets and expenses.
The total of all debits in an entry must equal the total of all credits.
A T-account is a visual tool for tracking activity in a single account.
Debits go on the left, credits on the right.
The balance is the net difference between total debits and total credits.
Assets and expenses have normal debit balances. Liabilities, equity, and revenues have normal credit balances.
Posting is the step where journal entry amounts are transferred into the appropriate T-accounts.
The ledger is the full set of all T-accounts for the business.
A trial balance lists every account and its balance at a point in time.
Its purpose is to confirm that total debits equal total credits across all accounts.
A trial balance that balances does not guarantee the books are error-free (a transaction could be recorded in the wrong account, for instance), but it does catch arithmetic mistakes.
\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}This is the accounting equation. Every transaction, without exception, must leave this equation in balance. If assets go up, either liabilities or equity (or both) must also go up, or another asset must go down by the same amount.
The entity assumption is why sole traders need a separate business bank account: mixing personal and business funds makes it impossible to produce accurate financial statements and creates problems at tax time.
The historical cost principle is the reason a company's balance sheet can look underwhelming compared to its market capitalisation. A tech firm's headquarters bought in the 1990s might be on the books for a fraction of its current value.
Students often think that if an asset increases in market value, the balance sheet should reflect the new value. Under the historical cost principle, it does not, unless a specific revaluation standard applies.
Students often confuse revenue with cash received. Under accrual accounting (which GAAP requires), revenue is recognised when earned, not when cash arrives.
Students frequently think dividends are an expense on the income statement. They are not. Dividends are a distribution of retained earnings and appear on the statement of retained earnings.
Students sometimes believe that a balanced trial balance means the books are correct. A trial balance only confirms that debits equal credits. Errors such as recording a transaction in the wrong account will not be caught.
The accounting equation is tested constantly. Expect questions asking you to trace a transaction through the equation and confirm it stays in balance.
Know the normal balance for each account type (assets = debit, liabilities = credit, equity = credit, revenues = credit, expenses = debit). Questions that ask whether an account increased or decreased depend on this.
The three dividend dates (declaration, record, payment) and which ones require journal entries come up regularly. Only declaration and payment involve entries.
Secondary stock sales are a common trick question: the company records nothing when investors trade shares among themselves.
Be comfortable identifying whether a transaction is external or internal, and which accounts are affected.
True or False: Under the historical cost principle, a building's balance sheet value is updated whenever the market price changes.
Fill in the blank: The accounting equation is Assets = __________ + Stockholders' Equity.
True or False: A debit always means an increase.
Fill in the blank: The normal balance of a liability account is a __________.
True or False: When investors sell shares to each other on the stock market, the company records a journal entry.
Answers: 1. False. 2. Liabilities. 3. False (debits increase assets and expenses but decrease liabilities, equity, and revenues). 4. Credit. 5. False.
Q: A company purchases office furniture for $8,000 cash. Which accounts are affected, and how?
A: Office Furniture (asset) increases by $8,000 (debit). Cash (asset) decreases by $8,000 (credit). The accounting equation remains in balance because one asset went up and another went down by the same amount.
Q: On the declaration date, a company declares $5,000 in dividends. What is the journal entry?
A: Debit Retained Earnings $5,000, credit Dividends Payable $5,000. This reduces equity and creates a current liability.
Q: A company issues 2,000 shares of $1 par value stock at $12 per share. How is this recorded?
A: Debit Cash $24,000. Credit Common Stock $2,000 (2,000 shares x $1 par). Credit Additional Paid-in Capital $22,000 (the excess over par).
Q: Why does a balanced trial balance not guarantee that the books are error-free?
A: Because certain errors will not cause an imbalance. For example, if a payment for rent is debited to Utilities Expense instead of Rent Expense, debits still equal credits, but the wrong account has been used.
Q: Classify the following as current or non-current: (a) accounts receivable, (b) a 10-year mortgage, (c) inventory, (d) equipment.
A: (a) Current asset. (b) Non-current liability. (c) Current asset. (d) Non-current asset.
The accounting equation and journal entries form the foundation for adjusting entries (covered in Part 2 of these notes), which correct timing differences at period end. The classified balance sheet categories reappear when you study financial ratios such as the current ratio (current assets / current liabilities). Retained earnings connect directly to the income statement: net income flows into retained earnings at the close of each period.
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