I.

Communicating through Financial Statements

A. The four financial statements and their purposes are:

1. Income Statement

1. - describes a company’s revenues and expenses along with the resulting net income or loss over
a period of time. (Net income occurs when revenues exceed expenses. Net loss occurs when
expenses exceed revenues.)
2. Statement of Changes in Equity - explains changes in equity from net income (or loss) and from
owner investment and withdrawals over a period of time.
3. Balance Sheet - describes a company’s financial position (types and amounts of assets, liabilities,
and equity) at a point in time.
4. Statement of Cash Flows - identifies cash inflows (receipts) and cash outflows (payments) over a
period of time.

B. Statement Preparation from Transaction Analysis - prepared in the following order using the procedure
indicated below.

1. Income Statement – information about revenues and expenses is conveniently taken from the
owner's equity column. Total revenues minus total expenses equals net income or loss. Notice
that owner’s withdrawals and investments are not part of measuring income or loss.
2. Statement of Changes in Equity – the beginning equity is taken from the equity column and any
investments of owner are added. The net income, from the income statement is added (or the net
loss is subtracted) and finally the owner’s withdrawals are subtracted to arrive at the ending
capital. Ending capital is carried to the Balance Sheet.
3. Balance Sheet – the ending balance of each asset is listed and the total of this listing equals total
assets. The ending balance of each liability is listed and the total of this listing equals total
liabilities. The ending capital (note that this is taken from the statement of changes in owner’s
equity), is listed and added to total liabilities to get total liabilities and equity. This total must agree
with total assets to prove the accounting equation. Either the account form or the report form may
be used to prepare the balance sheet.
4. Statement of Cash Flows – the cash column must be carefully analyzed to organize and report
cash flows in categories of operating, financing, and investing. The net change in cash is
determined by combining the net cash flow in each of the three categories. This change is
combined with the beginning cash. The resulting figure should be the ending cash that was
shown on the balance sheet.

II. Generally Accepted Accounting Principles

The rules that make up acceptable accounting practices are referred to as generally accepted accounting
principles.
A. Setting Accounting Principles The responsibility for setting accounting principles is determined by
many individuals and groups, and is discussed in Extend Your Knowledge 2-3. A primary purpose of
GAAP is to make information in financial statements relevant, reliable, consistent, and comparable.

B. Principles of Accounting - two types are general (concepts and guidelines for preparing financial
statements) and specific (detailed rules used in reporting transactions). The principles discussed in this
chapter are:
 1. Cost principle

1. - financial statements are based on actual costs incurred in business transactions. Cost is
measured on a cash or equal-to-cash basis.
2. Going-concern principle - financial statements are to reflect the assumption that the business will
continue operating instead of being closed or sold.
3. Monetary Unit - transactions and events are expressed in monetary, or money, units. Generally
this is the currency of the country in which it operates but today some companies express reports
in more than one monetary unit.
4. Revenue Recognition - revenue is recognized (recorded) when earned.

III. The Accounting Equation

The accounting equation describes the relationship between a company’s assets, liabilities, and equity. It
is expressed as:
Assets = Liabilities + Equity
Assets = Non-Owner Financing + Owner Financing
Net Assets = Assets – Liabilities

IV. Transactions and the Accounting Equation

Transaction Analysis - each transaction and event always leaves the equation in balance. (Assets =
Liabilities + Equity)

1. Investment by owner = +Asset (Cash) = + Equity (Owner’s Name, Capital) reason: investment
Increase on both sides of equation keeps equation in balance.
2. Purchased supplies for cash = +Asset (Supplies) = – Asset (Cash) Increase and decrease on one
side of the equation keeps the equation in balance.
3. Purchase equipment for cash = + Asset (Equipment) = – Asset (Cash) Increase and decrease on
one side of the equation keeps the equation in balance.
4. Purchase supplies on credit = + Asset (Supplies) = + Liability (Account Payable) Increase on both
sides of equation keeps equation in balance.
5. Provided services for cash = + Asset (Cash) = + Equity (reason: revenue earned) Increase on
both sides of equation keeps equation in balance.
6. Payment of expense in cash (salaries, rent etc.) = – Asset (Cash) = –Equity (reason: expense
incurred) Decrease on both sides of equation keeps equation in balance.
7. Provided services for credit = + Asset (Accts Receivable) = + E (reason: revenue earned)
Increase on both sides of equation keeps equation in balance.
8. Receipt of cash from account receivable = + Asset (Cash) = – Asset (Accounts Receivable)
Increase and decrease on one side of the equation keeps the equation in balance.
9. Payment of accounts payable = –Asset (Cash) = – Liability (Accounts Payable) Decrease on both
sides of equation keeps equation in balance.
10. Withdrawal of cash by owner =–Asset (Cash) = – Equity (reason: owner’s withdrawal) Decrease
on both sides of equation keeps equation in balance.

V. Financial Statements
Financial statements are prepared from business transactions. A. Income Statement - revenue and
expense amounts are taken from the owner’s equity column of the summary analysis of transactions.
Revenues are reported first on the income statement. Expenses are listed after the revenues and can be
listed in different ways. For convenience they are listed from largest amounts to smallest in this chapter.
Net income (net loss) is reported at the bottom on the income statement.

B. Statement of Changes in Equity - the beginning balance of equity is measured as of the start of the
business. It is equal to the ending balance of the previous reporting period. Investments of the owner
during the period are added. The net income from the income statement is also added. If there was a net
loss, it would be subtracted. The owner’s withdrawals for the period are subtracted to arrive at the ending
capital.

C. Balance Sheet - the amounts appearing on the balance sheet are the ending balance of each asset,
liability, and equity. The left side of the balance sheet lists the assets. The right side of the balance sheet
lists the liabilities and equity. The equity balance is taken from the statement of changes in equity. The
total of liabilities plus equity must equal total assets.

I. The Accounting Cycle

The accounting cycle refers to the steps in preparing financial statements for users. These steps include:
A. Analyzing each transaction and event from source documents. Source documents are business papers
that identify and describe economic events and transactions. Examples: sales tickets, cheques, purchase
orders, bills, and bank statements. Source documents provide objective and reliable evidence about
transactions and events.

B. Record (journalize) relevant transactions and events in a journal.

C. Post journal information to ledger accounts.

D. Prepare and analyze the trial balance.

E. Record any adjusting entries.

F. Prepare an adjusted trial balance.

G. Prepare the financial statements.

H. Close the temporary accounts.

I. Prepare a post-closing trial balance.

II. Accounts
A. An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or
expense item.

B. The general ledger or ledger is a record containing all the accounts a company uses.

C. Accounts are arranged into three basic categories based on the accounting equation. Categories are:
 1. Assets - resources owned or controlled by a company that have future economic benefit.
Examples include Cash, Accounts Receivable, Note Receivable, Prepaid Expenses, Prepaid
Insurance, Office Supplies, Store Supplies, Equipment, Buildings, and Land.
2. Liabilities - claims (by creditors) against assets, which means they are obligations to transfer
assets or provide products or services to other entities. Examples include Accounts Payable,
Note Payable, Unearned Revenues, and Accrued Liabilities.
a. Unearned revenue - revenue collected before it is earned; before services or goods are
provided.
b. Accrued liabilities - amounts owed that are not yet paid.

3. Equity - owner’s claim on company’s assets is called equity. Examples include Owner’s Capital,
Owner’s Withdrawals (decreases in equity), and different kinds of revenue (increases in equity)
and expense (decreases in equity) accounts reflecting their own important activities.

D. A T-account represents a ledger account and is a tool used to understand the effects of one or more
transactions. Has shape like the letter T with account title on top.

E. Account Balance – is the difference between increases and decreases recorded in an account. To
determine the balance, we:

1. Compute the total increases shown on one side (including the beginning balance).
2. Compute the total decrease shown on the other side.
3. Subtract the sum of the decreases from the sum of the increases, and
4. Calculate the account balance.

F. Debits and Credits

1. The left side of an account is called the debit side. A debit is an entry on the left side of an
account.
2. The right side of an account is called the credit side. A credit is an entry on the right side of an
account.
3. Accounts are assigned balance sides based on their classification or type.
4. To increase an account, an amount is placed on the balance side, and to decrease an account,
the amount is placed on the side opposite its assigned balance side.
5. The account balance is the difference between the total debits and the total credits recorded in
that account. When total debits exceed total credits the account has a debit balance. When total
credits exceed total debits the account has a credit balance. When two sides are equal the
account has a zero balance.

G. Chart of Accounts

1. Ledger: the collection of all accounts for an information system.

2. Chart of accounts: a list of all accounts used in the ledger by a company.

III. Analyzing Transactions - requires that each transaction affect, and be recorded in, at least two
accounts. The total debits must equal total credits for each transaction.
A. The assignment of balance sides (debit or credit) follows the accounting equation.
 1. Assets are on the left side of the equation; therefore, the left, or debit, side is the normal balance
for assets.
2. Liabilities and equities are on the right side; therefore, the right, or credit, side is the normal
balance for liabilities and equity.
3. Withdrawals, revenues, and expenses really are changes in equity, but it is necessary to set up
temporary accounts for each of these items to accumulate data for statements. Withdrawals and
expense accounts really represent decreases in equity; therefore, they are assigned debit
balances. Revenue accounts really represent increases in equity; therefore, they are assigned
credit balances.

B. Three important rules for recording transactions in a double-entry accounting system are:

1. Increases to assets are debits to the asset accounts. Decreases to assets are credits to the asset
accounts.
2. Increases to liabilities are credits to the liability accounts. Decreases to liabilities are debits to the
liability accounts.
3. Increases to equity are credits to the equity accounts. Decreases to equity are debits to the equity
accounts.

IV. Accounting Equation Analysis

A. Assets = Liabilities + Equity

1. The totals for the three columns show that the accounting equation is in balance.
2. The owner’s investment is recorded in the capital account and the withdrawals, revenue, and
expense accounts reflect the events that change owner’s equity. Their ending balances make up
the statement of owner’s equity.
3. The revenue and expense account balances are summarized and reported in the income
statement.

V. Recording and Posting Transactions

A. Four steps in processing transactions are as follows:

1. Journalizing - The process of recording each transaction in a journal.

2. Analyze transaction and source documents.
3. Apply double-entry accounting. (Determine account to be debited and credited.)
4. Journalize - record each transaction in a journal. (A journal gives us a complete record of each
transaction in one place.)
a. A General Journal is the most flexible type of journal because it can be used to record
any type of transaction.
b. When a transaction is recorded in the General Journal, it is called a journal entry. A
journal entry that affects more than two accounts is called a compound journal entry.
c. Each journal entry must contain equal debits and credits.