INTRODUCTION TO FINANCIAL ACCOUNTING

Financial Accounting ........................................................................................................................... 2

Introduction ...................................................................................................................................... 2
Accounting Standards ...................................................................................................................... 2
Financial Statements ............................................................................................................................ 2
Transactions ......................................................................................................................................... 3
The Accounting Process................................................................................................................... 3
Accounting Concepts ........................................................................................................................... 4
Underlying Assumptions and Principles .......................................................................................... 4
Assumptions ..................................................................................................................................... 4
Principles.......................................................................................................................................... 4
Single Entry Bookkeeping ................................................................................................................... 4
Single Column System ..................................................................................................................... 5
Separating Revenues and Expenses ................................................................................................. 5
Double Entry Bookkeeping .................................................................................................................. 6
The Accounting Equation .................................................................................................................... 7
Debits and Credits ................................................................................................................................ 9
The Accounting Cycle ......................................................................................................................... 9
The Source Document........................................................................................................................ 11
Journal Entries.................................................................................................................................... 12
Format of a General Journal Entry ................................................................................................. 12
Compound Journal Entries ............................................................................................................. 12
Format of a Compound General Journal Entry .............................................................................. 12
Special Journals.............................................................................................................................. 13
From Journal Entry to Ledger Posting ........................................................................................... 13
The General Ledger ........................................................................................................................... 13
General Journal Entry .................................................................................................................... 13
Ledger Accounts ............................................................................................................................ 14
Debits and Credits .......................................................................................................................... 14
Trial Balance ...................................................................................................................................... 28
Adjusting Entries................................................................................................................................ 29
• Accruals ................................................................................................................................. 30
• Deferrals ................................................................................................................................. 30
How to Make Adjusting Entries......................................................................................................... 30
Accrued Items ................................................................................................................................ 30
Adjusting Entry for Interest Accrual .......................................................................................... 30
Journal Entry for Interest Received ........................................................................................... 30
Deferred Items................................................................................................................................ 30
Journal Entry for Prepaid Insurance........................................................................................... 31
Adjusting Entry for Prepaid Insurance....................................................................................... 31
Closing Entries ............................................................................................................................... 31
1. Close Revenue to Income Summary ..................................................................................... 32
2. Close Expenses to Income Summary .................................................................................... 32
3. Close Income Summary to Retained Earnings ..................................................................... 32
4. Close Dividends to Retained Earnings.................................................................................. 33
Posting of the Closing Entries ........................................................................................................ 33
Post-Closing Trial Balance ............................................................................................................ 33
The Four Financial Statements .......................................................................................................... 33
Balance Sheet ................................................................................................................................. 34
Income Statement........................................................................................................................... 34
Statement of Owners' Equity ......................................................................................................... 35
Cash Flow Statement ..................................................................................................................... 35

PREPARED BY INFORMATION MANAGEMENT SYSTEMS

INTRODUCTION TO FINANCIAL ACCOUNTING

Financial Accounting
Introduction

The purpose of accounting is to provide the information that is needed for sound economic
decision making. The main purpose of financial accounting is to prepare financial reports
that provide information about a Organization’s performance to external parties such as
investors, creditors, and tax authorities. Managerial accounting contrasts with financial
accounting in that managerial accounting is for internal decision making and does not have
to follow any rules issued by standard-setting bodies. Financial accounting, the other hand,
is performed according to Generally Accepted Accounting Principles (GAAP) guidelines.

Accounting Standards

In order that financial statements report financial performance fairly and consistently, they
are prepared according to widely accepted accounting standards. These standards are
referred to as Generally Accepted Accounting Principles, or simply GAAP. Generally
Accepted Accounting Principles are those that have "substantial authoritative support".

Accrual vs. Cash Method

Many public and private agencies utilize an accounting system that recognizes revenue
and expenses on a cash basis, meaning that neither revenue nor expenses are
recognized until the cash associated with them actually is received or paid.

However large businesses and public institutions use the accrual method.

Under the accrual method, revenues and expenses are recorded according to when they
are earned and incurred, not necessarily when the cash is received or paid. For example,
under the accrual method revenue is recognized when customers are invoiced, regardless
of when payment is received. Similarly, an expense is recognized when the bill is received,
not when payment is made.

Under accrual accounting, even though employees may be paid in the next accounting
period for work performed near the end of the present accounting period, the expense still
is recorded in the current period since the current period is when the expense was
incurred.

Financial Statements
Businesses and public institutions have two primary objectives:

• Provide services
• Being accountable
• Earn a profit
• Remain solvent

Solvency represents the ability of the business to pay its bills and service its debt.

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INTRODUCTION TO FINANCIAL ACCOUNTING

The four financial statements are reports that allow interested parties to evaluate the
profitability, accountability and solvency of a public/private agency. These reports include
the following financial statements:

• Balance Sheet
• Income Statement
• Statement of Owner's Equity (only for business)
• Statement of Cash Flows

These four financial statements are the final product of the accountant's analysis of the
transactions of an agency. A large amount of effort goes into the preparation of the
financial statements. The process begins with book-keeping, which is just one step in the
accounting process. Book-keeping is the actual recording of the agency's transactions,
without any analysis of the information. Accountants evaluate and analyze the information,
making sense out of the numbers.

For the reports to be useful, they must be:

• Understandable
• Timely
• Relevant
• Fair and Objective (free from bias)

Transactions
To record transactions, one must:

1. Identify an event that affects the entity financially.

2. Measure the event in monetary terms.
3. Determine which accounts the transaction affects.
4. Determine whether the transaction increases or decreases the balances in those
accounts.
5. Record the transaction in the ledgers.

Under double entry, instead of recording a transaction in only a single account, the
transaction is recorded in two accounts.

The Accounting Process

Once a financial transaction occurs, a sequence of activities begins to identify and analyze
the transaction, make the journal entries, etc. Because this process repeats over
transactions and accounting periods, it is referred to as the accounting cycle.

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INTRODUCTION TO FINANCIAL ACCOUNTING

Accounting Concepts

Underlying Assumptions and Principles

Financial accounting relies on several underlying concepts that have a significant impact
on the practice of accounting.

Assumptions

The following are basic financial accounting assumptions:

• Separate entity assumption - the business/agency is an entity that is separate and

distinct from its owners, so that the finances of the firm are not co-mingled with the
finances of the owners.
• Going concern assumption - the business/agency is going to be operating for the
foreseeable future.
• Stable monetary unit assumption - e.g. the U.S. dollar
• Fixed time period assumption - info prepared and reported periodically (quarterly,
annually, etc.)

Principles

The basic assumptions of accounting result in the following accounting principles:

• Historical cost principle - assets are reported and presented at their original cost
and no adjustment is made for changes in market value. One never writes up the
cost of an asset. Accountants are very conservative in this sense. Sometimes costs
are written down, for example, for some short-term investments and marketable
securities, but costs never are written up.
• Matching principle - matching of revenues and expenses in the period earned and
incurred.
• Revenue recognition principle - revenue is realized (reported on the books as
earned) when everything that is necessary to earn the revenue has been
completed.
• Full disclosure principle - all of the information about the business entity that is
needed by users is disclosed in understandable form.

Single Entry Book-keeping

Most of financial accounting is based on double-entry book-keeping. To understand and
appreciate the advantages of double entry, it is worthwhile to examine the simpler single-
entry book-keeping system. In its most basic form, a single-entry system is similar to a
checkbook register and is characterized by the fact that there is only a single line entered
in the journal for each transaction. In a simple checkbook, each transaction is recorded in
one column of an account as either a positive or a negative amount in order to represent
the receipt or disbursement of cash. This system is demonstrated in the following example
for a repair shop business.

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INTRODUCTION TO FINANCIAL ACCOUNTING

Single Column System

Date Description Amount
Jan 1 Beginning Balance 1,000.00
Jan 2 Purchased shop supplies (150.00)
Jan 4 Performed repair service 275.00
Jan 7 Performed repair service 125.00
Jan 15 Paid phone bill (50.00)
Jan 30 Ending balance 1,200.00

While extremely simple, because the above system uses a single column, only the
difference between revenues and expenses is totaled - not the individual values of each.
Knowing the individual total amounts of revenues and expenses is important to a business,
for example, when formulating a budget. The revenues and expenses also are reported in
the income statement. In the above example, the individual revenue and expense amounts
can be determined only by sorting through the transactions and tabulating the revenue and
expense totals. This process can be designed into the system by using a separate column
for revenues and expenses:

Separating Revenues and Expenses

Date Description Revenues Expenses
Jan 2 Purchased shop supplies 150.00
Jan 4 Performed repair service 275.00
Jan 7 Performed repair service 125.00
Jan 15 Paid phone bill 50.00
January Totals 400.00 200.00

While the above example now uses two columns, it still is considered to be a single-entry
system since only one line is used to record each transaction in the cash account. This
single-entry system often is expanded to provide more useful information. For example,
additional columns can be added to classify the revenues as sales and sales tax collected,
and the expenses as rent, utilities, supplies, etc. Some single-entry systems may add
dozens of columns for different types of revenues and expenses. Many small businesses
utilize such a system. However, even with columns to classify the revenues and expenses,
single-entry bookkeeping is limited in its ability to provide detailed financial information.
Some disadvantages of a single-entry system include:

• Does not track asset and liability accounts such as inventory, accounts receivable
and accounts payable. These must be tracked separately.
• Facilitates the calculation of income but not of financial position. There is no direct
linkage between income and the balance sheet.
• Errors may go undetected and often are identified only through bank statement
reconciliation.

Because of these drawbacks, a single-entry system is not practical for many organizations
such as those having many thousands of transactions in a reporting period, significant
assets, and external suppliers of capital. The more sophisticated double-entry
bookkeeping system addresses the more demanding needs of such businesses.

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INTRODUCTION TO FINANCIAL ACCOUNTING

Double Entry Bookkeeping

A business transaction involves an exchange between two accounts. For example, for
every asset there exists a claim on that asset, either by those who own the business or
those who loan money to the business. Similarly, the sale of a product affects both the
amount of cash (or cash receivable) held by the business and the inventory held.

Two notable characteristics of double-entry systems are that 1) each transaction is

recorded in two accounts, and 2) each account has two columns.

In a double-entry system, two entries are made for each transaction - one entry as a debit
in one account and the other entry as a credit in another account. The two entries keep the
accounting equation in balance so that:

Assets = Liabilities + Owners' Equity

To illustrate, consider a repair same as above shop with a transaction involving repair
service performed on Jan 4 for a cash payment of $275.00. In a single-entry bookkeeping
system, the transaction would be recorded as follows:

Single Entry Example

Date Description Revenues Expenses
Jan 4 Performed repair service 275.00

In a double-entry system, the transaction would be recorded as follows:

Double Entry Example

Date Accounts Debit Credit
Jan 4 Cash 275.00
Revenue 275.00

A notation may be added to this journal entry to indicate that the revenue was from repair
services.

Note that two accounts (revenue and cash) are affected by the transaction. If the customer
did not pay cash but instead was extended credit, then "accounts receivable" would have
been used instead of "cash."

In this system, the double entries take the form of debits and credits, with debits in the left
column and credits in the right. For each debit there is an equal and opposite credit and
the sum of all debits therefore must equal the sum of all credits. This principle is useful for
identifying errors in the transaction recording process.

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INTRODUCTION TO FINANCIAL ACCOUNTING

Double-entry accounting has the following advantages over single-entry:

• Accurate calculation of profit and loss in complex organizations

• Inclusion of assets and liabilities in the bookkeeping accounts.
• Preparation of financial statements directly from the accounts
• Easier detection of errors and fraud

The Accounting Equation

The resources controlled by a business/agency are referred to as its assets. For a new
business, those assets originate from two possible sources:

• Investors who buy ownership in the business or public agency

• Creditors who extend loans to the business or public agency

Those who contribute assets to the agency have legal claims on those assets. Since the
total assets of the business are equal to the sum of the assets contributed by investors
and the assets contributed by creditors, the following relationship holds and is referred to
as the accounting equation

Assets = Liabilities + Owners' Equity

Resources Claims on the Resources

Initially, owner equity is affected by capital contributions such as the issuance of stock.
Once business operations commence, there will be income (revenues minus expenses,
and gains minus losses) and perhaps additional capital contributions and withdrawals such
as dividends. At the end of a reporting period, these items will impact the owners' equity as
follows:

Assets = Liabilities + Owners' Equity

+ Revenues
- Expenses
+ Gains
- Losses
+ Contributions
- Withdrawals

These additional items under owners' equity are tracked in temporary accounts until the
end of the accounting period, at which time they are closed to owners' equity.

The accounting equation holds at all times over the life of the business. When a
transaction occurs, the total assets of the business may change, but the equation will
remain in balance. The accounting equation serves as the basis for the balance sheet, as
illustrated in the following example.

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INTRODUCTION TO FINANCIAL ACCOUNTING

The Accounting Equation

To better understand the accounting equation, consider the following example. Hassan Ali
decides to open a bicycle repair shop To get started he rents some shop space, purchases
an initial inventory of bike parts, and opens the shop for business. Here is a listing of the
transactions that occurred during the first month:

Date Transaction
Sep 1 Owner contributes $7500 in cash to capitalize the business.
Sep 8 Purchased $2500 in bike parts on account, payable in 30 days.
Sep 15 Paid first month's shop rent of $1000.
Sep 17 Repaired bikes for $1100; collected $400 cash; billed customers for the $700 balance.
Sep 18 $275 in bike parts were used.
Sep 25 Collected $425 from customer accounts.
Sep 28 Paid $500 to suppliers for parts purchased earlier in the month.

These transactions affect the accounting equation as shown below.

Assets = Liabilities + Owner's Equity

Bike Accounts Accounts Peddler, Revenue
Cash + Parts + Receivable = Payable + Capital + (Expenses)

Sep 1 7500 = 7500

Sep 8 2500 = 2500

Sep 15 (1000) = (1000)

Sep 17 400 700 = 1100

Sep 18 (275) = (275)

Sep 25 425 (425) =

Sep 28 (500) = (500)
Totals: 6825 + 2225 + 275 = 2000 + 7500 + (175)

$9325 = $9325

Note that for each date in the above example, the sum of entries under the "Assets"
heading is equal to the sum of entries under the "Liabilities + Owner's Equity" heading. In
most of these cases, the transaction affected both sides of the accounting equation.
However, note that the Sep 25 transaction affected only the asset side with an increase in
cash and an equal but opposite decrease in accounts receivable.

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INTRODUCTION TO FINANCIAL ACCOUNTING

At the end of the month of September, the net income (revenues minus expenses) is
closed to capital and the balance sheet for the business would appear as follows:

Peddler's Bikes
Balance Sheet
September 30, 20xx
Liabilities &
Assets
Owner's Equity
Cash 6825 Accounts Payable2000
Accounts Receivable275 Peddler, Capital 7325
Bike Parts 2225

Total Assets $9325 Total Liabilities $9325

The bike parts are considered to be inventory, which appears as an asset on the balance
sheet. The owner's equity is modified according to the difference between revenues and
expenses. In this case, the difference is a loss of $175, so the owner's equity has
decreased from $7500 at the beginning of the month to $7325 at the end of the month.

Debits and Credits

The above example illustrates how the accounting equation remains in balance for each
transaction. Note that negative amounts were portrayed as negative numbers. In practice,
negative numbers are not used; in a double-entry bookkeeping system the recording of
each transaction is made via debits and credits in the appropriate accounts.

The Accounting Cycle

The sequence of activities beginning with the occurrence of a transaction is known as the
accounting cycle. This process is shown in the following diagram:

Steps in the Accounting Cycle it is possible to number the stages and refer to the
next pages with the example.

Identify the Transaction

Identify the event as a transaction
and generate the source document.

Analyze the Transaction

Determine the transaction amount,
which accounts are affected,
and in which direction.

Journal Entries

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INTRODUCTION TO FINANCIAL ACCOUNTING

The transaction is recorded in

the journal as a debit and a credit.

Post to Ledger
The journal entries are transferred
to the appropriate T-accounts
in the ledger.

Trial Balance
A trial balance is calculated
to verify that the sum of the debits
is equal to the sum of the credits.

Adjusting Entries
Adjusting entries are made for
accrued and deferred items.
The entries are journalized and
posted to the T-accounts
in the ledger.

Adjusted
Trial Balance
A new trial balance is calculated
after making the adjusting entries.

Financial Statements
The financial statements
are prepared.

Closing Entries
Transfer the balances of the
temporary accounts
(e.g. revenues and expenses)
to owner's equity.

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INTRODUCTION TO FINANCIAL ACCOUNTING

After-Closing
Trial Balance
A final trial balance is
calculated after the closing
entries are made.

The above diagram shows the financial statements as being prepared after the adjusting
entries and adjusted trial balance. The financial statements also can be prepared before
the adjusting entries with the help of a worksheet that calculates the impact of the
adjusting entries

The Source Document

When a financial transaction occurs, a document known as the source document
captures the key data of the transaction. The source document describes the basic facts of
the transaction such as its date, purpose, and amount.

Some examples of source documents:

• cash receipt
• cancelled check
• invoice sent or received
• credit memo for a customer refund
• employee time sheet

The source document is the initial input to the accounting process and serves as objective
evidence of the transaction, serving as part of the audit trail should the firm/agency need to
prove that a transaction occurred.

To facilitate referencing, each source document should have a unique identifier, usually a
number or alphanumeric code. Prenumbering of commonly-used forms helps to enforce
numbering, to classify transactions, and to identify and locate missing source documents.
A well-designed source document form can minimize errors and improve the efficiency of
transaction recording.

The source document may be created in either paper or electronic format. For example,
automated accounting systems may generate the source document electronically or allow
paper source documents to be scanned and converted into electronic images. Accounting
software often provides on-screen entry forms for different types of transactions to capture
the data and generate the source document.

The source document is an early document in the accounting cycle. It provides the
information required to analyze and classify the transaction and to create the journal
entries.

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INTRODUCTION TO FINANCIAL ACCOUNTING

Journal Entries
After a transaction occurs and a source document is generated, the transaction is
analyzed and entries are made in the general journal. A journal is a chronological listing
of the firm's/agencies transactions, including the amounts, accounts that are affected, and
in which direction the accounts are affected. A journal entry takes the following format:

Format of a General Journal Entry

Date Accounts Debit Credit
mm/dd account to be debited xxxx.xx
account to be credited xxxx.xx
Single journal entry

In addition to this information, a journal entry may include a short notation that describes
the transaction. There also may be a column for a reference number so that the
transaction can be tracked through the accounting system.

The above format shows the journal entry for a single transaction. Additional transactions
would be recorded in the same format directly below the first one, resulting in a time-
ordered record. The journal format provides the benefit that all of the transactions are
listed in chronological order, and all parts (debits and credits) of each transaction are listed
together.

Because the journal is where the information from the source document first enters the
accounting system, it is known as the book of original entry.

Compound Journal Entries

The format shown above has a single entry for the debit and a single entry for the credit.
This type of entry is known as a simple journal entry. Sometimes, more than two
accounts are affected by a transaction so more than two lines are required. Such a journal
entry is know as a compound journal entry and takes the following format:

Format of a Compound General Journal Entry

Date Accounts Debit Credit
mm/dd account to be debited xxxx.xx
account to be credited xxxx.xx
account to be credited xxxx.xx

For example, if an expense is incurred in which part of the expense is paid with cash and
the remainder placed in accounts payable, then two lines would be used for the credit -
one for the cash portion and one for the accounts payable portion. The total of the two
credits must be equal to the debit amount.

As many accounts as are necessary can be used in this manner, and multiple accounts
also can be used for the debit side if needed.

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INTRODUCTION TO FINANCIAL ACCOUNTING

Special Journals

The general journal is the main journal for a wide range of transactions. Of these, a
business/agency usually finds itself performing some types much more frequently than
others. By grouping specific types of transactions into their own special journal, the
efficiency and organization of the accounting system can be improved.

Some commonly-used special journals:

• sales journal
• purchases journal
• cash receipts journal
• cash disbursements journal

While a special journal may be organized differently from the general journal, it still
provides the core transaction information such as date, debits and credits, and the relevant
accounts.

From Journal Entry to Ledger Posting

Once the source document is generated and the appropriate journal entry is made, the
next step in the accounting cycle is to post the entry to the general ledger.

The General Ledger

While the journal lists transactions in chronological order, its format does not faciliate the
tracking of individual account balances. The general ledger is used for this purpose.

The general ledger is a collection of T-accounts to which debits and credits are
transferred. The action of recording a debit or credit in the general ledger is referred to as
posting. The posting of a journal entry to the general ledger accounts is a purely
mechanical process using information already in the journal entry and requiring no
additional analysis.

To understand the posting process, consider a journal entry in the following format:

General Journal Entry

Date Accounts Debit Credit
mm/dd Account 1 xxxx.xx
Account 2 xxxx.xx

There are two ledger accounts affected by the above journal entry (Account 1 and Account
2). Each of these accounts is represented by a T-account in the general ledger. To post
the entry to the ledger, simply transfer the information to the T-accounts:

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INTRODUCTION TO FINANCIAL ACCOUNTING

Ledger Accounts

Account 1 Account 2
Mm/dd xxxx.xx mm/dd xxxx.xx

Bal. xxxx.xx Bal. xxxx.xx

Note that the debit portion of the journal entry is posted to the left side of its associated T-
account, and the credit portion is posted to the right side of its T-account. The date helps
to identify the transactions with the journal entries. Additionally, a reference number may
be added to further facilitate cross-referencing.

Because the general ledger is organized by account, it allows one to view the activity and
balance of any account at a glance.

Debits and Credits

In double entry accounting, rather than using a single column for each account and
entering some numbers as positive and others as negative, we use two columns for each
account and enter only positive numbers. Whether the entry increases or decreases the
account is determined by choice of the column in which it is entered. Entries in the left
column are referred to as debits, and entries in the right column are referred to as credits.

Two accounts always are affected by each transaction, and one of those entries must be a
debit and the other must be a credit of equal amount. Actually, more than two accounts
can be used if the transaction is spread among them, just as long as the sum of debits for
the transaction equals the sum of credits for it.

The double entry accounting system provides a system of checks and balances. By
summing up all of the debits and summing up all of the credits and comparing the two
totals, one can detect and have the opportunity to correct many common types of
bookkeeping errors.

To avoid confusion over debits and credits, avoid thinking of them in the way that they are
used in everyday language, which often refers to a credit as increasing an account and a
debit as decreasing an account. For example, if our bank credits our checking account,
money is added to it and the balance increases. In accounting terms, however, if a
transaction causes a company's checking account to be credited, its balance decreases.
Moreover, crediting another company account such as accounts payable will increase its
balance. Without further explanation, it is no wonder that there often is confusion between
debits and credits.

The confusion can be eliminated by remembering one thing. In accounting, the verbs
"debit" and "credit" have the following meanings:

Debit

Page 14 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING

"Enter
in the
left
colum
n
of"
 Cre
dit

"Enter
in the
right
colum
n
of" 
 Cr
edit

"Enter
in the
right
colum
n
of" 
Credit

"Enter
in the
right
colum
n
of" 


Thats
all.
Debit
refers
to the
left
colum
n;
credit
refers
to the
right
colum
n. To
debit

Page 15 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING

the
cash
accou
nt
simpl
y
mean
s to
enter
the
value
in the
left
colum
n of
the
cash
accou
nt.
There
are
no
deepe
r
meani
ngs
with
which
to be
conce
rned.

The
reaso
n for
the
appar
ent
incon
sisten
cy
when
comp
aring
every
day
langu
age to
accou
nting
langu

Page 16 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING

age is
that
from
the
bank
custo
mer's
persp
ective
, a
check
ing
accou
nt is
an
asset
accou
nt.
From
the
bank'
s
persp
ective
, the
custo
mer's
accou
nt
appea
rs on
the
balan
ce
sheet
as a
liabilit
y
accou
nt,
and a
liabilit
y
accou
nt's
balan
ce is
increa
sed
by
crediti

Page 17 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING

ng it.
In
comm
on
use,
we
use
the
termin
ology
from
the
persp
ective
of the
bank'
s
books
,
hence
the
appar
ent
incon
sisten
cy.

Whet
her a
debit
or a
credit
increa
ses or
decre
ases
an
accou
nt
balan
ce
depen
ds on
the
type
of
accou
nt.
Asset
and
expen

Page 18 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING

se
accou
nts
are
increa
sed
on the
debit
side,
and
liabilit
y,
equity
, and
reven
ue
accou
nts
are
increa
sed
on the
credit
side.
The
followi
ng
chart
serve
s as a
graphi
cal
refere
nce
for
increa
sing
and
decre
asing
accou
nt
balan
ces:

Assets
 = L
iabiliti
es +
 Own

Page 19 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING

er's
Equity 
= Liabilities + Owner's
Equity 
Liabilities + Owner's
Equity 
+ Owner's
Equity 
Owner's
Equity 




Cas
h





 De
bit

+
 Cr
edit

-
Debi
t

+
 Cr
edit

-

 Cr
edit

Page 20 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING

-
Cred
it

-






A/P




Page 21 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING




 De
bit

-
 Cr
edit

+
Debi
t

-
 Cr
edit

+

 Cr
edit

+
Cred
it

+






Ret
aine
d
Ear
nin
gs



Page 22 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING




 De
bit

-
 Cr
edit

+
Debi
t

-
 Cr
edit

+

 Cr
edit

+
Cred
it

+


Exp
ens
e





 De
bit

Page 23 of 36
INTRODUCTION TO FINANCIAL ACCOUNTING

+
 Cr
edit

-
Debi
t

+
 Cr
edit

-

 Cr
edit

-
Cred
it

-

R
eve
nue

Rev
enu
e





 De
bit

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-
 Cr
edit

+
Debi
t

-
 Cr
edit

+

 Cr
edit

+
Cred
it

+




Type of Account Accounting Effect

Cash/Bank Account : Debit will Increase and Credit will Decrease the cash balance.
Accounts Payable : Debit will Reduce and Credit will Increase the Debt.
Expenses : Debit will Increase and Credit will Decrease the Expenses.
Revenue : Debit will Decrease and Credit will Increase the Revenue
Retained Earnings : Debit will Decrease and Credit will increase the R. Earnings

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Trial Balance
A basic rule of double-entry accounting is that for every credit there must be an equal debit
amount. From this concept, one can say that the sum of all debits must equal the sum of
all credits in the accounting system. If debits do not equal credits, then an error has been
made. The trial balance is a tool for detecting such errors.

The trial balance is calculated by summing the balances of all the ledger accounts. The
account balances are used because the balance summarizes the net effect of all of the
debits and credits in an account. To calculate the trial balance, construct a table in the
following format:

Trial Balance Calculation

Account Debits Credits

Account 1 xxxx.xx
Account 2 xxxx.xx
Account 3 xxxx.xx
.
.
.
Account 4 xxxx.xx
Account 5 xxxx.xx
Account 6 xxxx.xx
.
.
.
________ ________
Totals: xxxx.xx xxxx.xx

In the above trial balance, the balances of Accounts 1, 2, and 3 are net debits, and the
balances of Accounts 4, 5, and 6 are net credits. The totals of the debits and credits
should be equal; if they are not, then an error was made somewhere in the accounting
process. Some common errors include the following:

1. Error in totaling the columns - make sure that the trial balance columns were
summed properly.
2. Error in transferring account balances to proper trial balance columns - make
sure that debit and credit account balances are in the appropriate debit and credit
columns of the trial balance calculation. Check for reversed digits and misplaced
decimal points.

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3. Omission of an account - an account may be missing in the trial balance

calculation.
4. Error in account balance - an error may have been made in the calculation of a
ledger account balance.
5. Error in posting a journal entry - a journal entry may not have been posted
properly to the general ledger.
6. Error in recording a transaction in the journal - for example, making an error in a
debit or credit, or failing to enter a debit or credit.

In general, the most effective way to isolate an error is to work backward from the trial
balance itself to the initial journal entry, as outlined in the above list.

Note that a balanced trial balance does not guarantee that there are no errors. An error of
omission could have been made in which a transaction was not recorded, a journal entry
could have been posted to the wrong ledger account, or a debit and credit could have
been transposed. Such errors are not caught by the trial balance.

Adjusting Entries
In the accounting process, there may be economic events that do not immediately trigger
the recording of the transaction. These are addressed via adjusting entries, which serve
to match expenses to revenues in the accounting period in which they occur. There are
two general classes of adjustments:

• Accruals - revenues or expenses that have accrued but have not yet been
recorded. An example of an accrual is interest revenue that has been earned in one
period even though the actual cash payment will not be received until early in the
next period. An adjusting entry is made to recognize the revenue in the period in
which it was earned.
• Deferrals - revenues or expenses that have been recorded but need to be
deferred to a later date. An example of a deferral is an insurance premium that was
paid at the end of one accounting period for insurance coverage in the next period.
A deferred entry is made to show the insurance expense in the period in which the
insurance coverage is in effect.

How to Make Adjusting Entries

Like regular transactions, adjusting entries are recorded as journal entries. The following
illustrates adjustments for accrued and deferred items.

Accrued Items

As an example of an accrued item, consider the accrual of interest revenue. The journal
entry would be similar to the following:

Adjusting Entry for Interest Accrual

Date Accounts Debit Credit
mm/dd Interest Receivable xxxx.xx
Interest Revenue xxxx.xx

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The date of the above entry would be at the end of the period in which the interest was
earned. The adjusting entry is needed because the interest was accrued during that period
but is not payable until sometime in the next period. The adjusting entry is posted to the
general ledger in the same manner as other journal entries.

In the next period when the cash is actually received, one makes the following journal
entry:

Journal Entry for Interest Received

Date Accounts Debit Credit
mm/dd Cash xxxx.xx
Interest Receivable xxxx.xx

Deferred Items

For deferrals, a journal entry already has been made in asset or liability accounts and an
adjusting entry is needed to move the balances to expense or revenue accounts in the
next accounting period. Consider the case in which the firm prepays insurance premiums
in one period for insurance coverage in the next period. The journal entry made at the time
of payment would be similar to the following:

Journal Entry for Prepaid Insurance

Date Accounts Debit Credit
mm/dd Prepaid Insurance xxxx.xx
Cash xxxx.xx

In the next period when the insurance coverage is in effect, one makes the following
adjusting entry:

Adjusting Entry for Prepaid Insurance

Date Accounts Debit Credit
mm/dd Insurance Expense xxxx.xx
Prepaid Insurance xxxx.xx

For a single deferred item, there may be several adjusting entries over subsequent
accounting periods as the expense or revenue for the item is recognized over time.

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Closing Entries

Revenue, expense, and capital withdrawal (dividend) accounts are temporary accounts
that are reset at the end of the accounting period so that they will have zero balances at
the start of the next period. Closing entries are the journal entries used to transfer the
balances of these temporary accounts to permanent accounts.

After the closing entries have been made, the temporary account balances will be reflected
in the Retained Earnings (a capital account). However, an intermediate account called
Income Summary usually is created. Revenues and expenses are transferred to the
Income Summary account, the balance of which clearly shows the firm's income for the
period. Then, Income Summary is closed to Retained Earnings.

The sequence of the closing process is as follows:

1. Close the revenue accounts to Income Summary.

2. Close the expense accounts to Income Summary.
3. Close Income Summary to Retained Earnings.
4. Close Dividends to Retained Earnings.

The closing journal entries associated with these steps are demonstrated below. The
closing entries may be in the form of a compound journal entry if there are several
accounts to close. For example, there may be dozens or more of expense accounts to
close to Income Summary.

1. Close Revenue to Income Summary

The balance of the revenue account is the total revenue for the accounting period. Since
revenue is one of the components of the income calculation (the other component being
expenses), in the last day of the accounting period it is closed to the Income Summary
account as follows:

Closing Entry : Revenue to Income Summary

Date Accounts Debit Credit

mm/dd Revenue xxxx.xx
Income Summary xxxx.xx

Once this closing entry is made, the revenue account balance will be zero and the account
will be ready to accumulate revenue at the beginning of the next accounting period.

2. Close Expenses to Income Summary

Expenses are the other component of the income calculation and like revenue, are closed
to the Income Summary account:

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Closing Entry : Expenses to Income Summary

Date Accounts Debit Credit

mm/dd Income Summary xxxx.xx
Expenses xxxx.xx

After closing, the balance of Expenses will be zero and the account will be ready for the
expenses of the next accounting period. At this point, the credit column of the Income
Summary represents the firm's revenue, the debit column represents the expenses, and
balance represents the firm's income for the period.

3. Close Income Summary to Retained Earnings

The income or loss for the period ultimately adds to or subtracts from the firm's capital.
The Retained Earnings account is a capital account that accumulates the income from
each accounting period. The Income Summary account is closed to Retained Earnings as
follows:

Closing Entry : Income Summary to Retained Earnings

Date Accounts Debit Credit

mm/dd Income Summary xxxx.xx
Retained Earnings xxxx.xx

4. Close Dividends to Retained Earnings

Any capital withdrawals (e.g. dividends paid) during the period will reduce the capital
account balance, so the withdrawal is closed to Retained Earnings:

Closing Entry : Dividends to Retained Earnings

Date Accounts Debit Credit

mm/dd Retained Earnings xxxx.xx
Dividends xxxx.xx

After closing, the dividend account will have a zero balance and be ready for the next
period's dividend payments.

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Posting of the Closing Entries

As with other journal entries, the closing entries are posted to the appropriate general
ledger accounts. After the closing entries have been posted, only the permanent accounts
in the ledger will have non-zero balances.

Post-Closing Trial Balance

Once the closing entries have been posted, the trial balance calculation is performed to
help detect any errors that may have occurred in the closing process.

The Four Financial Statements

Businesses report information in the form of financial statements issued on a periodic
basis. GAAP requires the following four financial statements:

• Balance Sheet - statement of financial position at a given point in time.

• Income Statement - revenues minus expenses for a given time period ending at a
specified date.
• Statement of Owner's Equity - also known as Statement of Retained Earnings or
Equity Statement.
• Statement of Cash Flows - summarizes sources and uses of cash; indicates
whether enough cash is available to carry on routine operations.

Balance Sheet

The balance sheet is based on the following fundamental accounting model:

Assets = Liabilities + Equity

Assets can be classed as either current assets or fixed assets. Current assets are assets
that quickly and easily can be converted into cash, sometimes at a discount to the
purchase price. Current assets include cash, accounts receivable, marketable securities,
notes receivable, inventory, and prepaid assets such as prepaid insurance. Fixed assets
include land, buildings, and equipment. Such assets are recorded at historical cost, which
often is much lower than the market value.

Liabilities represent the portion of a firm's assets that are owed to creditors. Liabilities can
be classed as short-term liabilities (current) and long-term (non-current) liabilities. Current
liabilities include accounts payable, notes payable, interest payable, wages payable, and
taxes payable. Long-term liabilities include mortgages payable and bonds payable. The
portion of a mortgage long-term bond that is due within the next 12 months is classed as a
current liability, and usually is referred to as the current portion of long-term debt. The
creditors of a business are the primary claimants, getting paid before the owners should
the business cease to exist.

Equity is referred to as owner's equity in a sole proprietorship or a partnership, and

stockholders' equity or shareholders' equity in a corporation. The equity owners of a
business are residual claimants, having a right to what remains only after the creditors

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have been paid. For a sole proprietorship or a partnership, the equity would be listed as
the owner or owners' names followed by the word "capital". For example:

Sole Proprietorship: Mohamud Ahmed, Capital

Partnership: Mohamud Ahmed, Capital

Hassan Ali, Capital

In the case of a corporation, equity would be listed as common stock, preferred stock, and
retained earnings.

The balance sheet reports the resources of the entity. It is useful when evaluating the
ability of the company to meet its long-term obligations. Comparative balance sheets are
the most useful; for example, for the years ending December 31, 2005 and December 31,
2006.

Income Statement

The income statement presents the results of the entity's operations during a period of
time, such as one year. The simplest equation to describe income is:

Net Income = Revenue - Expenses

Revenue refers to inflows from the delivery or manufacture of a product or from the
rendering of a service. Expenses are outflows incurred to produce revenue.

Income from operations can be separated from other forms of income. In this case, the
income can be described by:

Net Income = Revenue - Expenses + Gains - Losses

where gains refer to items such as capital gains, and losses refer to capital losses, losses
from natural disasters, etc.

Statement of Owners' Equity (Statement of Retained Earnings)

The equity statement explains the changes in retained earnings. Retained earnings appear
on the balance sheet and most commonly are influenced by income and dividends. The
Statement of Retained Earnings therefore uses information from the Income Statement
and provides information to the Balance Sheet.

The following equation describes the equity statement for a sole proprietorship:

Ending Equity = Beginning Equity + Investments - Withdrawals + Income

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For a corporation, substitute "Dividends Paid" for "Withdrawals". The stockholders' equity
in a corporation is calculated as follows:

Common Stock (recorded at par value)

+ Premium on Common Stock (issue price minus par value)
+ Preferred Stock (recorded at par value)
+ Premium on Preferred Stock (issue price minus par value)
+ Retained Earnings
----------------------------------------------------------------
= Stockholders' Equity

Note that the premium on the issuance of stock is based on the price at which the
corporation actually sold the stock on the market. Afterwards, market trading does not
affect this part of the equity calculation. Stockholders' equity does not change when the
stock price changes!

Cash Flow Statement

The nature of accrual accounting is such that a company may be profitable but
nonetheless experience a shortfall in cash. The statement of cash flows is useful in
evaluating a company's ability to pay its bills. For a given period, the cash flow statement
provides the following information:

• Sources of cash
• Uses of cash
• Change in cash balance

The cash flow statement represents an analysis of all of the transactions of the business,
reporting where the firm obtained its cash and what it did with it. It breaks the sources and
uses of cash into the following categories:

• Operating activities
• Investing activities
• Financing activities

The information used to construct the cash flow statement comes from the beginning and
ending balance sheets for the period and from the income statement for the period.

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