One of the primary ways investors and the cash received from revenues and other

creditors assess the probability that an transactions as well as the cash paid for
enterprise will be able to make future cash certain expenses and other acquisitions
payments is to study, analyze, and during the period. While the primary focus
understand the enterprise’s financial of investors and creditors is on cash flows
statements. to themselves rather than to the enterprise,
information about cash activity of the
Financial statement is simply a declaration enterprise is an important signal to investors
of what is believed to be true about an and creditors about the prospects of future
enterprise, communicated in terms of a cash flows to them.
monetary unit, such as the dollar. When
accountants prepare financial statements, A logical starting point for understanding
they are describing in financial terms certain financial statements is the statement of
attributes of the enterprise that they believe financial position, also called the
fairly represent its financial activities. balance sheet. The purpose of this
financial statement is to demonstrate where
The corporation is a unique form of the company stands, in financial terms, at a
organization that allows many owners to specific point in time. The date is important,
combine their resources into a business as the financial position of a business may
enterprise that is larger than would be change quickly.
possible based on the financial resources of
a single or a small number of owners. ~ Notice that cash is listed first among the
assets, followed by notes receivable,
The statement of financial position, or accounts receivable, supplies, and any
balance sheet, (point in time) is a financial other assets that will soon be converted into
statement that describes where the cash or used up in business operations.
enterprise stands at a specific date. It is
sometimes described as a snapshot of the Capital stock represents the amount that
business in financial or dollar terms (that is, owners originally paid into the company to
what the enterprise “looks like” at a specific become owners. It consists of individual
date). shares and each owner has a set number of
shares. This means that the assigned value
An income statement (period of time) is an of the shares held by owners, multiplied by
activity statement that shows the revenues the number of shares.
and expenses for a designated period of
time. The retained earnings part of owners’
equity is simply the accumulated earnings
Revenues result in positive cash flows — of previous years that remain within the
either past, present, or future—while enterprise. Retained earnings is considered
expenses result in negative cash flows — part of the equity of the owners and serves
either past, present, or future. to enhance their investment in the business.
The term net income (or net loss) is Generally accepted accounting principles
simply the difference between all of an require that financial statements describe
enterprise’s revenues and expenses for a the affairs of a specific economic entity. This
designated period of time. concept is called the entity principle.
The statement of cash flows is particularly A business entity is an economic unit that
important in understanding an enterprise for engages in identifiable business activities.
purposes of investment and credit
decisions. As its name implies, the Assets are economic resources that are
statement of cash flows shows the ways owned by a business and are expected to
cash changed during a designated period— benefit future operations. In most cases, the
benefit to future operations comes in the historical cost as the basis of the asset in
form of positive future cash flows. The the balance sheet.
positive future cash flows may come directly
as the asset is converted into cash The Stable-Dollar Assumption- A
(collection of a receivable) or indirectly as limitation of measuring assets at historical
the asset is used in operating the business cost is that the value of the monetary unit or
to create other assets that result in positive dollar is not always stable. Inflation is a
future cash flows (buildings and land used term used to describe the situation where
to manufacture a product for sale). the value of the monetary unit decreases,
meaning that it will purchase less than it did
At present, generally accepted accounting previously. Deflation, on the other hand, is
principles call for the valuation of some the opposite situation in which the value of
assets in a balance sheet at cost, rather the monetary unit increases, meaning that it
than at their current value. will purchase more than it did previously.

Cost Principle- When we say that an asset Liabilities are financial obligations or debts.
is shown in the balance sheet at its They represent negative future cash flows
historical cost, we mean the original amount for the enterprise. The person or
the business entity paid to acquire the organization to whom the debt is owed is
asset. This amount may be different from called a creditor. All businesses have
what it would cost to purchase the same liabilities; even the largest and most
asset today. Exceptions to the cost principle successful companies often purchase
are found in some of the most liquid assets merchandise, supplies, and services “on
(that is, assets that are expected to soon account.” Accounts payable, in contrast to
become cash). Amounts receivable from notes payable, involve no written promises
customers are generally included in the and generally do not call for interest
balance sheet at their net realizable value, payments. In essence, a note payable is a
which is an amount that approximates the more formal arrangement than an account
cash that is expected to be received when payable, but they are similar in that they
the receivable is collected. require the company to make payment in
the future.
Net realizable value = the gross
receivables-the allowance for bad debts Liabilities are usually listed in the order in
(doubtful accounts) which they are expected to be repaid. 1
Liabilities that are similar may be combined
The Objectivity Principle- Another reason to avoid unnecessary detail in the financial
for using cost rather than current market statement. For example, if a company had
values in accounting for many assets is the several expenses payable at the end of the
need for a definite, factual basis for year (for example, wages, interest, taxes), it
valuation. Accountants use the term might combine these into a single line called
objective to describe asset valuations that accrued expenses. The word accrued is an
are factual and can be verified by accounting term communicating that the
independent experts. On the other hand, payment of certain expenses has been
estimated market values for assets such as delayed or deferred. Creditors’ claims take
buildings and specialized machinery are not priority over those of the owners.
factual and objective. Market values are
constantly changing, and estimates of the Owners’ equity represents the owners’
prices at which assets could be sold are claims on the assets of the business.
largely a matter of judgment. Because liabilities or creditors’ claims have
legal priority over those of the owners,
As you will learn, for some assets we adjust owners’ equity is a residual amount. If you
the amount in the balance sheet as the are the owner of a business, you are
value changes. For other assets, we retain
entitled to assets that are left after the financial position changed between the
claims of creditors have been satisfied in beginning and ending of that period.
full.
A second set of information that is
Increases in Owners’ Equity The owners’ particularly important concerning how a
equity in a business comes from two company’s financial position changed
primary sources: between two points in time is cash flow
information.
1. Investments of cash or other assets by
owners. Cash flows from operating activities are
the cash effects of revenue and expense
2. Earnings from profitable operation of the transactions that are included in the income
business. statement. Cash flows from investing
Decreases in Owners’ Equity Decreases in activities are the cash effects of
owners’ equity also are caused in two ways: purchasing and selling assets. Cash flows
from financing activities are the cash
1. Payments of cash or transfers of other effects of the owners investing in the
assets to owners. company and creditors loaning money to
the company and the repayment of either or
2. Losses from unprofitable operation of the
both.
business.
Notice that the operating, investing, and
A fundamental characteristic of every
financing categories include both positive
statement of financial position is that the
and negative cash flows.
total for assets always equals the total of
liabilities plus owners’ equity. Transactions that did not affect cash are
called noncash investing and financing
Specifically, the income statement is a
transactions. In a formal statement of cash
separate financial statement that shows
flows, these transactions are required to be
how the statement of financial position
noted even though they do not affect the
changed as a result of its revenue and
actual flow of cash into and out of the
expense transactions. The statement of
company.
cash flows shows how the company’s cash
increased and decreased during the period. The statement of financial position (balance
sheet), the income statement, and the
The income statement is a summarization
statement of cash flows are all based on the
of the company’s revenue and expense
same transactions, but they present
transactions for a period of time. It is
different “views” of the company. They
particularly important for the company’s
should not be thought of as alternatives to
owners, creditors, and other interested
each other; rather, all are important in terms
parties to understand the income statement.
of presenting key financial information
Ultimately the company will succeed or fail
about the company.
based on its ability to earn revenues in
excess of its expenses. The income statement and the statement of
cash flows—cover the intervening period of
Notice that the heading for the income
time between the two balance sheets and
statement refers to a period of time rather
help explain important changes that
than a point in time, as was the case with
occurred during the period.
the balance sheet. The income statement
reports on the financial performance of the Because the balance sheet, income
company in terms of earning revenue and statement, and statement of cash flows are
incurring expenses over a period of time derived from the same underlying financial
and explains, in part, how the company’s information, they are said to “articulate,”
meaning that they relate closely to each standpoint, a partnership is viewed as a
other. business entity separate from the personal
affairs of its owners. A benefit of the
Financial reporting, and financial partnership form over the sole
statements in particular, can be thought of proprietorship form is the ability to bring
as a lens through which you can view a together larger amounts of capital
business. Financial reporting encompasses investment from multiple owners.
financial statements, but it is not limited to
financial statements. - A partnership has two or more
owners. Accountants use the term
Financial Statement Analysis, in which we partners’ equity instead of owners’
provide a comprehensive treatment of how equity and usually list separately
financial statements are used to inform the amount of each partner’s equity
investors and creditors. in the business.
Generally accepted accounting principles A corporation is a type of business
can be applied to the financial statements of organization that is recognized under the
all three forms of organization. law as an entity separate from its owners.
An unincorporated business owned by one Therefore, the owners of a corporation are
person is called a sole proprietorship. not personally liable for the debts of the
Often the owner also acts as the manager. business. These owners can lose no more
From an accounting viewpoint, a sole than the amounts they have invested in the
proprietorship is regarded as a business business—a concept known as limited
entity separate from the other financial liability. This concept is one of the principal
activities of its owner. From a legal reasons that corporations are an attractive
viewpoint, however, the business and its form of business organization to many
owner are not regarded as separate investors.
entities. Thus, the owner is personally liable Ownership of a corporation is
for the debts of the business. If the business divided into transferable shares of capital
encounters financial difficulties, creditors stock, and the owners are called
can force the owner to sell his or her stockholders or shareholders. Stock
personal assets to pay the business debts. certificates are issued by the corporation to
While an advantage of the sole each stockholder showing the number of
proprietorship form of organization is its shares that he or she owns. The
simplicity, this unlimited liability feature is a stockholders are generally free to sell some
disadvantage to the owner. or all of these shares to other investors at
- A sole proprietorship is owned by any time. This transferability of ownership
only one person. Therefore, the adds to the attractiveness of the corporate
owner’s equity section of the form of organization, because investors can
balance sheet includes only one more easily get their money out of the
item—the equity of the owner. business. Corporations offer an even
greater opportunity than partnerships to
An unincorporated business owned by two bring together large amounts of capital from
or more persons voluntarily acting as multiple owners. Ownership of a corporation
partners (co-owners) is called a is divided into transferable shares of capital
partnership. Partnerships, like sole stock, and the owners are called
proprietorships, are widely used for small stockholders or shareholders. Stock
businesses. As in the case of the sole certificates are issued by the corporation to
proprietorship, the owners of a partnership each stockholder showing the number of
are personally responsible for all debts of shares that he or she owns. The
the business. From an accounting stockholders are generally free to sell some
or all of these shares to other investors at the owners’ equity in the business. A
any time. This transferability of ownership company that continually operates
adds to the attractiveness of the corporate unprofitably will eventually exhaust its
form of organization, because investors can resources and be forced out of existence.
more easily get their money out of the Therefore, most users of financial
business. Corporations offer an even statements study these statements carefully
greater opportunity than partnerships to for clues to the company’s liquidity and
bring together large amounts of capital from future profitability.
multiple owners.
The Short Run versus the Long Run In
- In a business organized as a the short run, liquidity and profitability may
corporation, it is not customary to be independent of each other. A business
show separately the equity of each may be operating profitably but
stockholder. In the case of large nevertheless run out of cash needed to
corporations, this clearly would be meet its obligations. On the other hand, a
impractical because these company may operate unprofitably during a
businesses may have several given year yet still have enough cash from
million individual stockholders previous periods to pay its bills and remain
(owners). Owners’ equity (also liquid.
referred to as stockholders’ equity
or shareholders’ equity) is Over a longer term, however, liquidity and
presented in two amounts—capital profitability go hand in hand. If a business is
stock and retained earnings. to survive, it must remain liquid and, in the
long run, must operate profitably.
Capital stock represents the amount that
the stockholders originally invested in the Evaluating Short-Term Liquidity One key
business in exchange for shares of the indicator of short-term liquidity is the
company’s stock. Retained earnings, in relationship between an entity’s liquid
contrast, represents the increase in owners’ assets and the liabilities requiring payment
equity that has accumulated over the years in the near future. By studying the nature of
as a result of profitable operations. a company’s assets, and the amounts and
due dates of its liabilities, users of financial
Financial statements are designed statements often may anticipate whether
primarily to meet the needs of creditors and the company is likely to have difficulty in
investors. Two factors of particular concern meeting its upcoming obligations.
to creditors and investors are the liquidity
and profitability of a business organization. This simple type of analysis meets the
needs of many short-term creditors.
Creditors are interested in liquidity —the Evaluating long-term debt-paying ability is a
ability of the business to pay its debts as more difficult matter. In studying financial
they come due. Liquidity is critical to the statements, users should always read the
very survival of a business organization—a accompanying notes and the auditors’
business that is not liquid may be forced report.
into bankruptcy by its creditors. Once
bankrupt, a business may be forced by the The concept of adequate disclosure is an
courts to stop its operations, sell its assets important generally accepted accounting
(for the purpose of paying its creditors), and principle. Adequate disclosure means that
eventually go out of existence. users of financial statements are informed
of all information necessary for the proper
Investors also are interested in the liquidity interpretation of the statements. Adequate
of a business organization, but often they disclosure is made in the body of the
are even more interested in its profitability. financial statements and in notes
Profitable operations increase the value of accompanying these statements. It is not
unusual to find a series of notes to financial improve the company’s financial position
statements that are longer than the and financial performance.
statements themselves.
These actions are sometimes called
As a general rule, a company should window dressing —measures taken by
disclose all financial information that a management to make the company appear
reasonably informed person would consider as strong as possible in its financial
necessary for the proper interpretation of statements. Users of financial statements
the financial statements. Events that clearly should realize that, while the financial
are unimportant do not require disclosure. statements are fair representations of the
Determining information that should be financial position at the end of the period
disclosed in financial statements is another and financial performance during the period,
situation that requires significant judgment they may not necessarily describe the
on the part of the accountant. typical financial situation of the business
throughout the entire financial reporting
Most large organizations provide managers period. In its annual financial statements, in
with financial statements on at least a particular, management tries to make the
monthly basis. With modern technology, company appear as strong as is reasonably
financial statements prepared on a weekly, possible. The more frequently financial
daily, or even hourly basis are possible. statements are presented, the less able
Managers have a special interest in the management is to window-dress and make
annual financial statements, because these a company look financially stronger than it
statements are used by decision makers actually is.
outside of the organization. Management is For practical purposes, businesses do not
concerned with its ability to obtain the funds prepare new financial statements after
it needs to meet its objectives, so it is every transaction. Rather, they accumulate
particularly interested in how investors and the effects of individual transactions in their
creditors react to the company’s financial accounting records. Then, at regular
statements. intervals, the data in these records are used
A strong statement of financial position to prepare financial statements, income tax
(at a particular date/point in time) is one returns, and other types of reports.
that shows relatively little debt and large The sequence of accounting procedures
amounts of liquid assets relative to the used to record, classify, and summarize
liabilities due in the near future. A strong accounting information in financial reports at
income statement (period of time) is one regular intervals is often termed the
that shows large revenues relative to the accounting cycle. The accounting cycle
expenses required to earn the revenues. A begins with the initial recording of business
strong statement of cash flows is one transactions and concludes with the
that not only shows a strong cash balance preparation of a complete set of formal
but also indicates that cash is being financial statements. The term cycle
generated by operations. Demonstrating indicates that these procedures must be
that these positive characteristics of the repeated continuously to enable the
company are ongoing and can be seen in a business to prepare new, up-to-date
series of financial statements is particularly financial statements at reasonable intervals.
helpful in creating confidence in the
company on the part of investors and The accounting cycle generally consists of
creditors. Because of the importance of the eight specific steps. In this chapter, we
financial statements, management may take illustrate how businesses (1) journalize
steps that are specifically intended to (record) transactions, (2) post each journal
entry to the appropriate ledger accounts,
and (3) prepare a trial balance. The as a particular asset or liability. In its
remaining steps of the cycle will be simplest form, an account has only three
addressed in Chapters 4 and 5. They elements: (1) a title; (2) a left side, which
include (4) making end-of-period is called the debit side; and (3) a right
adjustments, (5) preparing an adjusted trial side, which is called the credit side. This
balance, (6) preparing financial statements, form of an account, page, is called a T
(7) journalizing and posting closing entries, account because of its resemblance to the
and (8) preparing an after-closing trial letter “T.”
balance.
In simple terms, debits refer to the left side
The cyclical process of collecting financial of an account, and credits refer to the right
information and maintaining accounting side of an account.
records does far more than facilitate the
preparation of financial statements. Each debit and credit entry in the Cash
Managers and employees of a business account represents a cash receipt or a cash
frequently use the information stored in the payment. The amount of cash owned by the
accounting records for such purposes as: business at a given date is equal to the
balance of the account on that date.
1. Establishing accountability for the
assets and/or transactions under an The balance of an account is the
individual’s control. difference between the debit and credit
entries in the account. If the debit total
2. Keeping track of routine business exceeds the credit total, the account has
activities—such as the amounts of money a debit balance; if the credit total
in company bank accounts, amounts due exceeds the debit total, the account has
from credit customers, or amounts owed to a credit balance.
suppliers.
This debit balance is entered in the debit
3. Obtaining detailed information about a side of the account just below the line. In
particular transaction. effect, the line creates a “fresh start” in the
account, with the month-end balance
4. Evaluating the efficiency and representing the net result of all the
performance of various departments within previous debit and credit entries.
the organization.
All asset accounts normally have debit
5. Maintaining documentary evidence of balances. It is hard to imagine an account
the company’s business activities. (For for an asset such as land having a credit
example, tax laws require companies to balance, as this would indicate that the
maintain accounting records supporting the business had disposed of more land than it
amounts reported in tax returns.) had ever acquired. (For some assets, such
An accounting system includes a separate as cash, it is possible to acquire a credit
record for each item that appears in the balance—but such balances are only
financial statements. The record used to temporary.)
keep track of the increases and decreases The fact that assets are located on the left
in financial statement items is termed a side of the balance sheet is a convenient
“ledger account” or, simply, an account. means of remembering the rule that an
The entire group of accounts is kept increase in an asset is recorded on the left
together in an accounting record called a (debit) side of the account and an asset
ledger. account normally has a debit (left-hand)
An account is a means of accumulating in balance.
one place all the information about changes
in specific financial statement items, such
Increases in liability and owners’ equity It is important to realize, however, that
accounts are recorded by credit entries and transactions are rarely recorded directly in
decreases in these accounts are recorded general ledger accounts. In an actual
by debits. The relationship between entries accounting system, the information about
in these accounts and their position on the each business transaction is initially
balance sheet may be summed up as recorded in an accounting record called the
follows: (1) liabilities and owners’ equity journal. This information is later transferred
to the appropriate accounts in the general
belong on the right side of the balance ledger.
sheet, (2) an increase in a liability or an
owners’ equity account is recorded on the The journal is a chronological (day-by-day)
right (credit) side of the account, and (3) record of business transactions. At
liability and owners’ equity accounts convenient intervals, the debit and credit
normally have credit (right-hand) balances. amounts recorded in the journal are
transferred (posted) to the accounts in the
The use of debits and credits to record ledger. The updated ledger accounts, in
changes in assets, liabilities, and turn, serve as the basis for preparing the
owners’ equity company’s financial statements.
The rules for debits and credits are The most basic type of journal is called a
designed so that every transaction is general journal.
recorded by equal dollar amounts of debits
and credits. Note the basic characteristics of this
general journal entry:
Assets=Liabilities+Equity
1. The name of the account debited (Cash)
Debit Balances=Credit Balances is written first, and the dollar amount to be
If this equation is to remain in balance, any debited appears in the left-hand money
change in the left side of the equation column.
(assets) must be accompanied by an 2. The name of the account credited
equal change in the right side (either (Capital Stock) appears below the account
liabilities or owners’ equity). According to debited and is indented to the right. The
the debit and credit rules that we have just dollar amount appears in the right-hand
described, increases in the left side of the money column.
equation (assets) are recorded by debits,
while increases in the right side (liabilities 3. A brief description of the transaction
and owners’ equity) are recorded by credits, appears immediately below the journal
entry.
Assets= increase debit, decrease credit
Accounting software packages automate
Liabilities and Equity= increase credit, and streamline the way in which
decrease debit transactions are recorded. However,
This system is often called double-entry recording transactions manually—without a
accounting. The phrase double-entry computer—is an effective way to
refers to the need for both debit entries and conceptualize the manner in which
credit entries, equal in dollar amount, to economic events are captured by
record every transaction. Virtually every accounting systems and subsequently
business organization uses the double- reported in a company’s financial
entry system regardless of whether the statements.
company’s accounting records are A familiarity with the general journal form of
maintained manually or by computer. describing transactions is just as essential
to the study of accounting as a familiarity
with plus and minus signs is to the study of Revenues-Expenses= Net Income
mathematics. The journal entry is a tool for
analyzing and describing the impact of As income is earned, either an asset is
various transactions on a business entity. always results in increased or the liability is
The ability to describe a transaction in decreased. Net income always results in the
journal entry form requires an increase of Owners’ Equity.
understanding of the nature of the Our point is that net income represents an
transaction and its effect on the financial increase in owners’ equity and has no direct
position of the business. relationship to the types or amounts of
We have made the point that transactions assets on hand. Even a business operating
are recorded first in the journal. Ledger at a profit may run short of cash. In the
accounts are updated later, through a balance sheet, the changes in owners’
process called posting. equity resulting from profitable or
unprofitable operations are reflected in the
Posting simply means updating the ledger balance of the stockholders’ equity account,
accounts for the effects of the transactions Retained Earnings. The assets and
recorded in the journal. Viewed as a liabilities of the business that change as a
mechanical task, posting basically amounts result of income-related activities appear in
to performing the steps you describe when their respective sections of the balance
you “read” a journal entry aloud. Posting sheet.
involves copying into the ledger accounts
information that already has been recorded The Retained Earnings account appears in
in the journal. the stockholders’ equity section of the
balance sheet. Earning net income causes
The accounts are arranged in the same the balance in the Retained Earnings
order as in the balance sheet—that is, account to increase. However, many
assets first, followed by liabilities and corporations follow a policy of distributing to
owners’ equity accounts. Each ledger their stockholders some of the resources
account is presented in what is referred to generated by profitable operations.
as a running balance format (as opposed Distributions of this nature are termed
to simple T accounts). You will notice that dividends, and they reduce both total
the running balance format does not assets and stockholders’ equity. The
indicate specifically whether a particular reduction in stockholders’ equity is reflected
account has a debit or credit balance. This by decreasing the balance of the Retained
causes no difficulty, however, because we Earnings account. The balance in the
know that asset accounts normally have Retained Earnings account represents the
debit balances, and liability and owners’ total net income of the corporation over the
equity accounts normally have credit entire lifetime of the business, less all of the
balances. dividends to its stockholders. In short,
retained earnings represent the earnings
When the sum of debits equals the sum that have been retained by the corporation
of credits, the account has a zero to finance growth.
balance.
An income statement (covers a period of
Net income is an increase in owners’ equity time) is a financial statement that
resulting from the profitable operation of the summarizes the profitability of a business
business. Net income does not consist of entity for a specified period of time. In this
any cash or any other specific assets. statement, net income is determined by
Rather, net income is a computation of the comparing sales prices of goods or services
overall effects of many business sold during the period with the costs
transactions on owners’ equity. incurred by the business in delivering these
goods or services. The technical accounting on the other side of the accounting
terms for these components of net income equation, owners’ equity increases to match
are revenue and expenses. Therefore, the increase in total assets. Thus, revenue
accountants say that net income is equal is the gross increase in owners’ equity
to revenue minus expenses. Should resulting from operation of the business.
expenses exceed revenue, a net loss
Various account titles are used to describe
result.
different types of revenue. For example, a
Net income cannot be evaluated unless business that sells merchandise rather than
services, such as Walmart or General Motors,
it is associated with a specific time
uses the term Sales to describe its revenue.
period.
In the professional practices of physicians,
The period of time covered by an income CPAs, and attorneys, revenue usually is
called Fees Earned. A real estate office,
statement is termed the company’s
however, might call its revenue Commissions
accounting period. To provide the users of Earned. Overnight Auto Service’s income
financial statements with timely information, statement reveals that the company records its
net income is measured for relatively short revenue in two separate accounts: (1) Repair
accounting periods of equal length. This Service Revenue and (2) Rent Revenue
concept, called the time period principle, Earned. Another type of revenue common to
is one of the underlying accounting many businesses is Interest Revenue (or
principles that guide the interpretation of Interest Earned), stemming from the interest
financial events and the preparation of earned on bank deposits, notes receivable, and
interest-bearing investments.
financial statements. The length of a
company’s accounting period depends on In most cases, the realization principle
how frequently managers, investors, and indicates that revenue should be
other interested people require information recognized at the time goods are sold or
about the company’s performance. services are rendered. At this point, the
business has essentially completed the
Every business prepares annual income
earnings process, and the sales value of the
statements, and most businesses prepare
goods or services can be measured
quarterly and monthly income statements
objectively. At any time prior to the sale, the
as well. (Quarterly statements cover a
ultimate value of the goods or services sold
three-month period and are prepared by all
can only be estimated. After the sale, the
large corporations for distribution to their
only step that remains is to collect from the
stockholders.) The 12-month accounting
customer, usually a relatively certain event.
period used by an entity is called its fiscal
In other words, revenue is recognized
year. The fiscal year used by most
when it is earned, without regard to
companies coincides with the calendar year
when a contract is signed or when cash
and ends on December 31. Some
payment for providing goods or services
businesses, however, elect to use a fiscal
is received.
year that ends on some other date.
Expenses are the costs of the goods and
Revenue is the price of goods sold and
services used up in the process of earning
services rendered during a given
revenue. Expenses are often called the
accounting period. Earning revenue causes
“costs of doing business,” that is, the
owners’ equity to increase. When a
cost of the various activities necessary to
business renders services or sells
carry on a business. An expense always
merchandise to its customers, it usually
causes a decrease in owners’ equity. The
receives cash or acquires an account
related changes in the accounting equation
receivable from the customer. The inflow of
can be either (1) a decrease in assets or (2)
cash and receivables from customers
an increase in liabilities. An expense
increases the total assets of the company;
reduces assets if payment occurs at the
time that the expense is incurred. If the treatment that results in the lowest (most
expense will not be paid until later, as, for conservative) estimate of net income for the
example, the purchase of advertising current period.
services on account, the recording of the The policy of recognizing revenue in the
expense will be accompanied by an accounting records when it is earned and
increase in liabilities. recognizing expenses when the related goods or
services are used is called the accrual basis of
A significant relationship exists between accounting. The purpose of accrual accounting
revenue and expenses. Expenses are is to measure the profitability of the economic
incurred for the purpose of producing activities conducted during the accounting
revenue. In the measurement of net income period. The most important concept involved in
for a period, revenue should be offset by all accrual accounting is the matching principle.
the expenses incurred in producing that Revenue is offset with all of the expenses
incurred in generating that revenue, thus
revenue. This concept of offsetting
providing a measure of the overall profitability of
expenses against revenue on a basis of
the economic activity.
cause and effect is called the matching
principle. Timing is an important factor An alternative to the accrual basis is called cash
in matching (offsetting) revenue with the basis accounting. Under cash basis
related expenses. accounting, revenue is recognized when cash is
collected from the customer, rather than when
Not all transactions can be divided so precisely the company sells goods or renders services.
by accounting periods. The purchase of a Expenses are recognized when payment is
building, furniture and fixtures, machinery, a made, rather than when the related goods or
computer, or an automobile provides benefits to services are used in business operations. The
the business over all the years in which such an cash basis of accounting measures the amounts
asset is used. No one can determine in advance of cash received and paid out during the period,
exactly how many years of service will be but it does not provide a good measure of the
received from such long-lived assets. profitability of activities undertaken during the
Nevertheless, in measuring the net income of a period.
business for a period of one year or less,
accountants must estimate what portion of the We have stressed that revenue increases
cost of the building and other long-lived assets is owners’ equity and that expenses decrease
applicable to the current year. Since the owners’ equity. The debit and credit rules for
allocations of these costs are estimates rather recording revenue and expenses in the
than precise measurements, it follows that ledger accounts are a natural extension of
income statements should be regarded as useful the rules for recording changes in owners’
approximations of net income rather than as
equity. The rules previously stated for
absolutely correct measurements. For some
expenditures, such as those for employee
recording increases and decreases in
training programs, it is not possible to estimate owners’ equity are as follows:
objectively the number of accounting periods
• Increases in owners’ equity are recorded
over which revenue is likely to be produced. In
such cases, generally accepted accounting by credits.
principles require that the expenditure be
• Decreases in owners’ equity are recorded
charged immediately to expense. This
treatment is based upon the accounting
by debits.
principle of objectivity and the concept of This rule is now extended to cover revenue
conservatism. Accountants require objective
and expense accounts:
evidence that an expenditure will produce
revenue in future periods before they will view • Revenue increases owners’ equity;
the expenditure as creating an asset. When this
therefore, revenue is recorded by credits.
objective evidence does not exist, they follow the
conservative practice of recording the • Expenses decrease owners’ equity;
expenditure as an expense. Conservatism, in therefore, expenses are recorded by debits.
this context, means applying the accounting
A dividend is a distribution of assets The preparation of a trial balance does not prove
(usually cash) by a corporation to its that transactions have been correctly analyzed
stockholders. In some respects, dividends and recorded in the proper accounts. If, for
example, a receipt of cash was erroneously
are similar to expenses—they reduce
recorded by debiting the Land account instead of
both the assets and the owners’ equity in
the Cash account, the trial balance would still
the business. However, dividends are not balance. Also, if a transaction were completely
an expense, and they are not deducted omitted from the ledger, the error would not be
from disclosed by the trial balance. In brief, the trial
balance proves only one aspect of the ledger,
revenue in the income statement. The and that is the equality of debits and credits.
reason why dividends are not viewed as an
expense is that these payments do not
serve to generate revenue. Rather, they are
a distribution of profits to the owners of the
business.

This proof of the equality of debit and credit

balances is called a trial balance. A trial
balance is a two-column schedule listing
the names and balances of all the accounts
in the order in which they appear in the
ledger; the debit balances are listed in the
left-hand column and the credit balances in
the right-hand column.

This trial balance proves the equality of the

debit and credit entries in the company’s
accounting system. Notice that the trial
balance contains both balance sheet and
income statement accounts. Overnight, like
most companies, updates its Retained
Earnings balance only once each year.
The trial balance provides proof that the ledger
is in balance. The agreement of the debit and
credit totals of the trial balance gives assurance
that:

1. Equal debits and credits have been recorded

for all transactions.

2. The addition of the account balances in the

trial balance has been performed correctly.

Suppose that the debit and credit totals of the

trial balance do not agree. This situation
indicates that one or more errors have been
made. Typical of such errors are (1) the posting
of a debit as a credit, or vice versa; (2) arithmetic
mistakes in determining account balances; (3)
clerical errors in copying account balances into
the trial balance; (4) listing a debit balance in the
credit column of the trial balance, or vice versa;
and (5) errors in addition of the trial balance.