Financial Accounting Chapter 2 Key Concepts

How do we record transactions? What are the rules of debit and credit?

All transactions could be recorded in columnar fashion as increases or decreases to elements of the accounting equation. However, even for a very small company with few transactions, this would become cumbersome. So, most companies use a process called the double-entry system. The term double-entry refers to the dual effect that each transaction has on the accounting equation. An account includes the account title, an account number to aid the processing task, and columns or fields for increases, decreases, the cumulative balance, and the date. For instructional purposes we use T-accounts instead of formal ledger accounts. A T-account has space at the top for the account title and two sides for recording increases and decreases. For centuries, accountants have effectively used a system of debits and credits to increase and decrease account balances in the ledger. Debits merely represent the left side of the account and credits the right side. Whether a debit or a credit represents an increase or a decrease depends on the type of account. Accounts on the left side of the accounting equation (assets) are increased (+) by debit entries and decreased (−) by credit entries. Accounts on the right side of the accounting equation (liabilities and shareholders' equity) are increased (+) by credit entries and decreased (−) by debit entries. Each general ledger account can be classified as either permanent or temporary. Permanent accounts represent assets, liabilities, and shareholders' equity at a point in time. Temporary accounts represent changes in the retained earnings component of shareholders' equity for a corporation caused by revenue, expense, gain, and loss transactions

What is the basic accounting equation?

Assets = Liabilities + Shareholder's Equity

What are the financial statements?

Income statement, balance sheet, statement of cash flows, and statement of shareholders' equity.

Income Statement

Is a change statement that summarizes the profit-generating transactions that caused shareholders' equity (retained earnings) to change during the period. The components of the income statement usually are classified, that is, grouped according to common characteristics. A common classification scheme is to separate operating items from nonoperating items, as we do in Dress Right's income statement. Operating itemsPage 72 include revenues and expenses directly related to the principal revenue-generating activities of the company. For example, operating items for a manufacturing company include sales revenues from the sale of products and all expenses related to this activity. Companies that sell products like Dress Right often report a subtotal within operating income, sales less cost of goods sold, called gross profit. Nonoperating items include certain gains and losses and revenues and expenses from peripheral activities. For Dress Right Clothing, rent revenue and interest expense are nonoperating items because they do not relate to the principal revenue-generating activity of the company, selling clothes. In Chapter 4 we discuss the format and content of the income statement in more depth. The statement of comprehensive income extends the income statement by reporting all changes in shareholders' equity during the period that were not a result of transactions with owners. A few types of gains and losses, called other comprehensive income (OCI) or loss items, are excluded from the determination of net income and the income statement, but are included in the broader concept of comprehensive income

Balance Sheet

Presents an organized list of assets, liabilities and equity at a particular point in time. Current assets are those assets that are cash, will be converted into cash, or will be used up within one year or the operating cycle, whichever is longer. Current liabilities are those liabilities that will be satisfied within one year or the operating cycle, whichever is longer. For a manufacturing company, the operating cycle refers to the period of time necessary to convert cash to raw materials, raw materials to a finished product, the finished product to receivables, and then finally receivables back to cash. For most companies, this period is less than a year. Shareholders' equity lists the paid-in capital portion of equity—common stock—and retained earnings. Specifically, the revenue, expense, gain, and loss transactions that make up net income in the income statement become the major components of retained earnings.

The Statement of Cash Flows

Similar to the income statement, the statement of cash flows also is a change statement. The purpose of the statement is to report the events that caused cash to change during the period. The statement classifies all transactions affecting cash into one of three categories: (1) operating activities, (2) investing activities, and (3) financing activities. Operating activities are inflows and outflows of cash related to transactions entering into the determination of net income. Investing activities involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets. Financing activities involve cash inflows and outflows from transactions with creditors and owners. There are two generally accepted formats that can be used to report operating activities, the direct method and the indirect method.

How and why we make adjusting journal entries?

Step 6 in the processing cycle is to record in the general journal and post to the ledger accounts the effect of internal events on the accounting equation. These transactions do not involve an exchange transaction with another entity and, therefore, are not initiated by a source document. They are recorded at the end of any period when financial statements are prepared. These transactions are commonly referred to as adjusting entries Adjusting entriesPage 63 are required to implement the accrual accounting model. More specifically, these entries help ensure that all revenues are recognized in the period goods or services are transferred to customers, regardless of when the cash is received. Also, they enable a company to recognize all expenses incurred during a period, regardless of when cash payment is made. As a result, a period's income statement provides a more complete measure of a company's operating performance and a better measure for predicting future operating cash flows. The balance sheet also provides a more complete assessment of assets and liabilities as sources of future cash receipts and disbursements. You might think of adjusting entries as a method of bringing the company's financial information up to date before preparing the financial statements.

The accounting processing cycle and the closing process

The closing process serves a dual purpose: (1) the temporary accounts (revenues, expenses, gains and losses) are reduced to zero balances, ready to measure activity in the upcoming accounting period, and (2) these temporary account balances are closed (transferred) to retained earnings to reflect the changes that have occurred in that account during the period. Often, an intermediate step is to close revenues and expenses to income summary, and then income summary is closed to retained earnings. The use of the income summary account is just a bookkeeping convenience that provides a check that all temporary accounts have been properly closed (that is, the balance equals net income or loss).

The Statement of Shareholders' Equity

The final statement, the statement of shareholders' equity, also is a change statement. Its purpose is to disclose the sources of the changes in the various permanent shareholders' equity accounts that occurred during the period from investments by owners, distributions to owners, net income, and other comprehensive income.