FINANCIAL ACCOUNTING IN BRIEF The purpose of accounting is to be able to collect, organize, and report financial transactions in financial statements

s so that people both inside and outside a business can evaluate how well the company has done and make decisions in respect to the organization. ACCOUNTS Accounting information is organized by accounts. Accounts are simply groups of like things, such as cash, buildings, or accounts payable. Accounts are grouped into five categories: Assets, Liabilities, Owners Equity, Revenues, and Expenses. 1. Assets are things the company owns or is entitled to receive. Examples include cash, buildings, equipment, inventory, and accounts receivable. Accounts receivable represents money owed to the company from customers who charged their purchases. They are said to have purchased on account. Prepaid Rent represents rent that has been paid by the company ahead of timeand will be reduced over time as we use the space weve rented. We can divide assets into short term (or current) and long term. Current assets will be used up or converted to cash within a year. Long term assets will last more than a year. 2. Liabilities are claims on assets by people or businesses outside the company. Examples include notes payable (money borrowed from a bank which must be repaid, usually with interest), interest payable (what has not yet been paid), accounts payable (owed to suppliers because the company bought inventory or other items and charged their purchase), and salaries payable. If the company receives payment for a product or service before it has provided the product or servicesuch as a magazine subscriptionit would have a liability called Unearned Revenue. Another word for liabilities is debt. Liabilities can also be divided into current and long-term. Debt to be paid within a year is a current liability; if it is to be paid in more than a year, its long-term. 3. Owners Equity represents the residual claims on the assets by the owners of the company. If the assets were converted to cash and the liabilities paid off, everything left would go to the owners. There are two main types of equity: contributed capital and retained earnings. Contributed capital is what owners put into the company to become owners. Usually what the owners put into the company is cash, but it could be another asset, such as some equipment. If you buy some stock in Google, you become a part-owner of Googlealthough a very small one. The primary contributed capital account is Common Stock. The owners receive shares of stock as evidence of their partial ownership of the company. Retained Earnings represents all the income a company has generated from the day it started minus anything given back to the owners as dividends. 4. Revenues represent an increase in assets or a decrease in liabilities AND an increase in equity resulting from the sale of goods or services. Revenue is the price you charge your customers for the goods or services you provide. Typical examples are Sales Revenues, Cleaning Service Revenue, Subscription Revenue, Rent Revenue, and Interest Revenue (if you loan money to someone else).

5. Expenses represent the costs of running your business. Expenses represent either a decrease in assets or an increase in liabilities AND a decrease in equity. Typical examples are Cost of Goods Sold (what your business had to pay for the inventory items sold to your customers), Supplies Expense (the cost of paper, computer diskettes, etc., used in running the business), Utilities Expense, Salaries Expense, Interest Expense, and Insurance Expense. FINANCIAL STATEMENTS Four basic financial statements are prepared primarily for external users. The Income Statement shows the results of operating the company for a period of time. Revenues Expenses = Net Income. (Hint: that word Net means something has been subtracted.) If the Expenses are greater than the Revenues, the result is a Net Loss. You may have heard the term the bottom line. Net Income is the bottom line. The Statement of Retained Earnings shows changes in the Retained Earnings account from one period to another. Net Income makes Retained Earnings increase; Net Loss makes it decrease. If a company pays dividends to its stockholders, the dividends decrease the Retained Earnings. Note: Dividends paid to a companys own stockholders are not expenses. Dividends paid to the companys stockholders are not found on the income statement. They are reductions of equity. Beginning Retained Earnings + Net Income Dividends = Ending Retained Earnings. The Balance Sheet shows the equality of the accounting equation on one particular day. The accounting equation is Assets = Liabilities + Owners Equity. It shows the financial position of the company at a point in time. Assets are usually divided into current and longterm. Liabilities are also usually divided into current and long-term. Owners Equity shows the contributed capital accounts (Common Stock) and Retained earnings. The total assets must be equal to the total of the liabilities plus the owners equity. The Statement of Cash Flows shows where cash came from and where cash was paid to over a period of time. The difference between the inflows and outflows equals the change in the cash account from the beginning of the period until the end. Cash flows are shown as deriving from three types of activities: operating, investing, and financing. On financial statements, you can use one or two columns for numbers. Use the far right column for totals. If you show details, those items may be shown in a column to the left of the total column. Put a dollar sign with the first number in a column and with the bottom number. The Net Income, Ending Retained Earnings, and Ending Cash balance should have double underlines. The Balance sheet will show two numbers with double underlines: the total assets and the total (combined) liabilities and owners equity. See page 19 for examples of these statements. One of the best things I can suggest is that you keep lists so that if you see an account name, youll be able to recognize the accounts category, which statement it can be found on, and whether it increases with a debit or credit (see next section). Assets, Liabilities, and Owners Equity are called permanent or real accounts and are found only on the Balance Sheet. Revenues and Expenses are called temporary or nominal accounts and are found only on the Income Statement. Dividends is also a temporary or nominal account, but they are found only on the Statement of Retained Earnings not on the Income Statement.

THE ACCOUNTING CYCLE Transactions that occur during operating the business are recorded in financial records in a series of steps called the accounting cycle. Step 1: Record Transactions in a journal. The journal, also called the book of original entry, is where accounting information is first recorded. Transaction information is organized chronologically and shows the date, which accounts are affected, the amount, and a brief description. When transactions are recorded, we use debits (which in accounting only means left) or credits (which only means right). Sometimes we use a debit to make an account increase, and sometimes we use a credit. It depends on the type of account. Think of that accounting equation: Assets = Liabilities + Owners Equity. It has a left side (the assets) and a right side (Liabilities & Owners Equity). Assets, which are on the left side of the equation, increase with a debit (which means left) and decrease with a credit (which means right). Liabilities & Owners Equity, which are on the right side of the equation, increase with a credit (which means right) and decrease with a debit (which means left). Assets Debit to increase = Liabilities Credit to increase + Owners Equity Credit to increase

Every transaction is recorded with at least account being debited and one account being credited. Since every transaction requires at least two accountsone debit and one credit, the accounting equation will always balance. In a journal entry, you may have more than one debit account and more than one credit account. However, the total debits must equal the total credits. Lets take a closer look at Owners Equity. It has two parts: Contributed Capital (stock) and Retained Earnings. These accounts will increase with a credit and decrease with a debit. Furthermore, Retained Earnings is made up of two items: Net Income and Dividends. Net Income increases Retained Earnings. Net Income = Revenues minus Expenses. Revenues increase Net Income, which in turn increases Retained Earnings. Since Retained Earnings increases with a credit, Revenues also increase with a credit. Expenses, however, decrease Net Income, which in turn decreases Retained Earnings. Since Retained Earnings decrease with debits, the Expenses must be increased with a debit. As the expenses get bigger, the Net Incomeand Retained Earningsget smaller. Dividends decrease Retained Earnings. Dividends work like Expenses. As they increase with debits, they are actually decreasing Retained Earnings. We often use whats called a T account to keep track of the balance of each account (how much is in the account). It actually looks like a Twith a left side and a right side.
Name of the account Debit side Credit side

If we put the accounts on their increase side, which we call the normal balance, they look like this:
Normal Balance (the increase side) A L Liabilities OE Owners equity R Revenue Expenses E Dividends D Assets

Here are the steps to help you write journal entries: Decide which accounts are affected by the transaction Determine whether the account balance increases or decreases Determine what type of account it is (asset, liability, owners equity, revenue, expense) Remember whether that type of account increases with a debit or a credit Write the journal entry with the debits first and the credits last A journal entry is used to record the transactions. For example, if the company buys inventory from a supplier on account (they promise to pay later), it would look like this: 2010 May 3 Inventory Accounts Payable Purchased inventory on account Debits 10,000 Credits 10,000

Notice how the numbers are in left (debit) and right (credit) columns and do not have dollar signs? Notice how the names of the accounts show the debit account before the credit account and the credit account indented. If you have more than one debit account (or credit account), list all the debit accounts to the left before listing any of the credit accounts. The year of the transaction would go above the first column. The name of the month goes in the first transaction on the page and would not need to be repeated unless the month changed before you got to the end of the paper. The day is entered for every transaction. Step 2: Post the transactions to the ledger. The ledger is the entire collection of accounts used by the company. Records for each account are kept separatelyon a different piece of paper, in a separate column of a spreadsheet, or as a separate file in a computerized accounting system. They are organized in the same order as they are presented on the balance sheet followed by the income statement. There are several types of ledger format. The easiest is the T account that we looked at above. We could also use a running balance format, which is shown in Exhibit 2.11 on page 16 of your textbook. To post a transaction from the journal to the ledger, copy the informationline by linefrom the journal to the appropriate account by entering the amount on the debit or credit side used in the

journal entry. If an account was debited in the journal entry, debit that amount in the account in the ledger. Your accounting system will also have some way to identify which journal entry the amount came from for easy back-tracking should you need additional information in the future. We can use dates in the T-accounts to help with tracking entries.
Inventory 10,00 0 Accounts Payable 10,000 May 3

May 3

At the end of the period, if youre using a T-account, draw a line below the numbers listed in each account. Add up all the debits, add up all the credits, find the difference and put that difference on the larger side. If the total debits were 1,200 and the total credits were 800, you would put 400 on the debit side below the line. Dont put your subtotals in the accounts. If you must write them down, use scrap paper.
Cash 3,50 6,000 1,800 680 140 2,880 0 74 0 1,50 0

Step 3: Prepare a trial balance. A trial balance is a list of all the accounts that have dollar balances. The trial balance has three columns. In the first column, on the left, are the account names. To the right, in the second column, you will find the debit amounts. And to the far right, in the third column, you will find the credit amounts. List the accounts and their appropriate balances. Total them and put the total debits and total credits at the bottom of the columns. If youve been careful, the debit total will equal the credit total. Put a dollar sign with the top number in each column and with the two totals at the bottom. Double underline the two totals. Note: This is not a financial statement. Its a worksheet. Step 4: Make adjusting entries At the end of a period (month, quarter, year), review the balance sheet accounts to make sure that all assets and liabilities are properly stated. Review the income statement accounts to make sure that all revenue earned during the period and all expenses related to that period have been properly recorded. If they havent, make any necessary journal entries. Then post those entries to the ledger. Hint: Every adjusting entry will have at least one balance sheet account and one income statement account. Please see the Adjusting Entries link for information on making journal entries. Step 5: Prepare an adjusted trial balance. Prepare another trial balance using the account balances in your ledger after youve posted the adjusting entries. Again, total debits should equal total credits.

Step 6: Prepare the financial statements. Prepare the income statement first. Prepare the statement of retained earnings next using the net income(loss) from the income statement and the dividends account. Prepare the balance sheet third using the ending retained earnings balance you just calculated. Prepare the statement of cash flows last. Step 7: Closing entries. At the end of the year, the books are closed with closing entries. Only temporary accounts are closed. Balance sheet accounts are called real or permanent accounts because their balances carry forward as long as the business continues. Income statement accounts and dividends are called temporary or nominal accounts because they are closedhave their balances reduced to zeroat the end of every year. This allows us to more easily keep track of the results of operations for each year individually. To close, we transfer the balances in each temporary account to the Retained Earnings. First close the income statement accounts. The first journal entry closes the Revenue accounts. Revenue accounts, which normally have credit balances, are debited and an account called Income Summary is credited. The Income Summary account is a temporary account that exists only to handle the closing entries. The second journal entry closes the Expense accounts. The Income Summary will be debited for the total of all the expenses and the Expense accounts, which normally have debit balances, are credited. Post these two journal entries to the ledger. The third journal entry closes the Income Summary account. If there was Net Income, the Income Summary will have a credit balance at this point. Debit the Income Summary to close it and credit Retained Earnings for the amount of net income. If there was Net Loss, the Income Summary will have a debit balance. Debit Retained Earnings for the net loss and credit the Income Summary to close it. Post this entry to the ledger. The fourth (and last) journal entry closes the Dividends account. Since it normally has a debit balance, youll want to credit it to make its balance go down to zero. Debit Retained Earnings and credit Dividends. Post this entry to the ledger. At this point, all revenue and expense accounts, the Dividends account, and the Income Summary account, should have zero balances. Retained Earnings should have the same balance as the ending balance in the Statement of Retained Earnings. Step 8: Post closing trial balance. Prepare one more trial balance using the balances in the ledger after you posted the closing entries. This is just a check to make sure that you dont have any temporary accounts still open and that the debits still equal the credits. And youre ready to start the next year.