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 firm'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, on the other hand, is performed according to Generally Accepted Accounting Principles (GAAP) guidelines.
CPA's
The primary accounting professional association in the
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 small businesses 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. Most larger businesses, however, 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.
Underlying Assumptions, Principles, and Conventions
Financial accounting relies on the following underlying concepts:
· Assumptions: Separate entity assumption, going-concern assumption, stable monetary unit assumption, fixed time period assumption.
· Principles: Historical cost principle, matching principle, revenue recognition principle, full disclosure principle.
· Modifying conventions: Materiality, cost-benefit, conservatism convention, industry practices convention.
Financial Statements
Businesses have two primary objectives:
- Earn a profit
- Remain solvent
Solvency represents the ability of the business to pay its bills and service its debt.
The four financial statements are reports that allow interested parties to evaluate the profitability and solvency of a business. These reports include the following financial statements:
- Balance Sheet
- Income Statement
- Statement of Owner's Equity
- Statement of Cash Flows
These four financial statements are the final product of the accountant's analysis of the transactions of a business. A large amount of effort goes into the preparation of the financial statements. The process begins with bookkeeping, which is just one step in the accounting process. Bookkeeping is the actual recording of the company'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)
Double Entry Accounting
Financial accounting is based on double-entry bookkeeping procedures in which each transaction is recorded in opposite columns of the accounts affected by the exchange. Double entry accounting is a significant improvement over simple and more error-prone single-entry bookkeeping systems.
Fundamental Accounting Model
The balance sheet is based on the following fundamental accounting equation :
Assets = Liabilities + Equity
This model has been used since the 18th century. It essentially states that a business owes all of its assets to either creditors or owners, where the assets of a business are its resources, and the creditors and owners are the sources of those resources.
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.
Most larger business accounting systems utilize the double entry method. 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 business 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.
Accounting Concepts
Underlying Assumptions, Principles, and Conventions
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 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 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.
Modifying Conventions
Due to practical constraints and industry practice, GAAP principles are not always applied strictly but are modified as necessary. The following are some commonly observed modifying conventions:
· Materiality convention - a modifying convention that relaxes certain GAAP requirements if the impact is not large enough to influence decisions. Users of the information should not be overburdened with information overload.
· Cost-benefit convention - a modifying convention that relaxes GAAP requirements if the expected cost of reporting something exceeds the benefits of reporting it.
· Conservatism convention - when there is a choice of equally acceptable accounting methods, the firm should use the one that is least likely to overstate income or assets.
· Industry practices convention - accepted industry practices should be followed even if they differ from GAAP.
Single Entry Bookkeeping
Most of financial accounting is based on double-entry bookkeeping. To understand and appreciate the advantages of double entry, it is worthwhile to examine the simpler single-entry bookkeeping 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:
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 |
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| Jan 7 | Performed repair service | 125.00 |
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| Jan 15 | Paid phone bill |
| 50.00 |
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| 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.
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.
Recognizing this fundamental dual nature of transactions, merchants in medieval
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 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 |
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In a double-entry system, the transaction would be recorded as follows:
Double Entry Example
| Date | Accounts | Debit | Credit |
| Jan 4 | Cash | 275.00 |
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| 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.
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
To appreciate the importance of double-entry bookkeeping, it is interesting to note that the industrial revolution might not have been possible without it. At that time, businesses increased in size and complexity. Accurate bookkeeping was required for managers to understand the financial status of their businesses in order to keep them solvent and offer a degree of transparency to investors. While a single-entry system can be adapted by a skilled bookkeeper to meet some of these needs, only a double-entry system provides the required detail systematically and by design.
The Accounting Equation
The resources controlled by a business are referred to as its assets. For a new business, those assets originate from two possible sources:
- Investors who buy ownership in the business
- Creditors who extend loans to the business
Those who contribute assets to a business 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 |
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| + | Revenues |
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| - | Expenses |
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| + | Gains |
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| - | Losses |
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| + | Contributions |
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| - | 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.
The Accounting Equation - A Practical Example
To better understand the accounting equation, consider the following example. Mike Peddler 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.
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| = | + | Peddler, | + | Revenue | |
| Sep 1 | = |
| 7500 |
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| Sep 8 | = |
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| Sep 15 | = |
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| (1000) | |
| Sep 17 | = |
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| 1100 | |
| Sep 18 | = |
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| (275) | |
| Sep 25 | = |
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| Sep 28 | = |
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| Totals: | = | + | 7500 | + | (175) | |
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| = | |||||
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.
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 | ||||
| Assets |
| Liabilities & | ||
| Cash | 6825 |
| Accounts Payable | 2000 |
| Accounts Receivable | 275 |
| Peddler, Capital | 7325 |
| Bike Parts | 2225 |
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| 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
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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 before they actually are posted.
The Source Document
When a business 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 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.
ournal 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 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 |
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| account to be credited |
| xxxx.xx |
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 |
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| account to be credited |
| xxxx.xx |
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| 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.
Special Journals
The general journal is the main journal for a wide range of transactions. Of these, a business 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 |
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| 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:
Ledger Accounts
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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 |
| Credit |
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
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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.
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 |
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| Interest Revenue |
| xxxx.xx |
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 |
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| 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 |
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| 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 |
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| 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.
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 |
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| 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:
Closing Entry : Expenses to Income Summary
| Date | Accounts | Debit | Credit |
| mm/dd | Income Summary | xxxx.xx |
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| 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 |
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| 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 |
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| Dividends |
| xxxx.xx |
After closing, the dividend account will have a zero balance and be ready for the next period's dividend payments.
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 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: | John Doe, Capital |
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| Partnership: | John Doe, Capital |
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| Josephine Smith, 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, 2000 and December 31, 2001.
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
For a corporation, substitute "Dividends Paid" for "Withdrawals". The stockholders' equity in a corporation is calculated as follows:
| Common Stock (recorded at par value) |
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.
Financial Accounting Standards
Accounting standards are needed so that financial statements will fairly and consistently describe financial performance. Without standards, users of financial statements would need to learn the accounting rules of each company, and comparisons between companies would be difficult.
Accounting standards used today are referred to as Generally Accepted Accounting Principles (GAAP). These principles are "generally accepted" because an authoritative body has set them or the accounting profession widely accepts them as appropriate.
Securities and Exchange Commission (SEC)
The Securities and Exchange Commission is a
When the SEC was formed there was no standards-issuing body. However, rather than set standards, the SEC encouraged the private sector to set them. The SEC has stated that FASB standards are considered to have authoritative support.
Committee on Accounting Procedure (CAP)
In 1939, encouraged by the SEC, the American Institute of Certified Public Accountants (AICPA) formed the Committee on Accounting Procedure (CAP). From 1939 to 1959, CAP issued 51 Accounting Research Bulletins that dealt with issues as they arose. CAP had only limited success because it did not develop an overall accounting framework, but rather, acted upon specific problems as they arose.
Accounting Principles Board (APB)
In 1959, the AICPA replaced CAP with the Accounting Principles Board (APB), which issued 31 opinions and 4 statements until it was dissolved in 1973. GAAP essentially arose from the opinions of the APB.
The APB was criticized for its structure and for several of its positions on controversial topics. In 1971 the Wheat Committee (chaired by Francis Wheat) was formed to evaluate the APB and propose changes.
Financial Accounting Standards Board (FASB)
The Wheat Committee recommended the replacement of the Accounting Principles Board with a new standards-setting structure. This new structure was implemented in 1973 and was made up of three organizations:
- Financial Accounting Foundation (FAF)
- Financial Accounting Standards Board (FASB)
- Financial Accounting Standards Advisory Council (FASAC).
Of these organizations, FASB (pronounced "FAS-B") is the primary operating organization.
Unlike the APB, FASB was designed to be an independent board comprised of members who have severed their ties with their employers and private firms. FASB issues statements of financial accounting standards, which define GAAP. The AICPA issues audit guides. When a conflict occurs, FASB rules.
International Accounting Standards Committee (IASC)
The International Accounting Standards Committee (IASC) was formed in 1973 to encourage international cooperation in developing consistent worldwide accounting principles. In 2001, the IASC was succeeded by the International Accounting Standards Board (IASB), an independent private sector body that is structured similar to FASB.
Governmental Accounting Standards Board (GASB)
The financial reports of state and local goverment entities are not directly comparable to those of businesses. In 1984, the Governmental Accounting Standards Board (GASB) was formed to set standards for the financial reports of state and local government. GASB was modeled after FASB.
The Balanced Scorecard
Traditional financial reporting systems provide an indication of how a firm has performed in the past, but offer little information about how it might perform in the future. For example, a firm might reduce its level of customer service in order to boost current earnings, but then future earnings might be negatively impacted due to reduced customer satisfaction.
To deal with this problem, Robert Kaplan and David Norton developed the Balanced Scorecard, a performance measurement system that considers not only financial measures, but also customer, business process, and learning measures. The Balanced Scorecard framework is depicted in the following diagram:
Diagram of the Balanced Scorecard
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The balanced scorecard translates the organization's strategy into four perspectives, with a balance between the following:
- between internal and external measures
- between objective measures and subjective measures
- between performance results and the drivers of future results
Beyond the Financial Perspective
In the industrial age, most of the assets of a firm were in property, plant, and equipment, and the financial accounting system performed an adequate job of valuing those assets. In the information age, much of the value of the firm is embedded in innovative processes, customer relationships, and human resources. The financial accounting system is not so good at valuing such assets.
The Balanced Scorecard goes beyond standard financial measures to include the following additional perspectives: the customer perspective, the internal process perspective, and the learning and growth perspective.
· Financial perspective - includes measures such as operating income, return on capital employed, and economic value added.
· Customer perspective - includes measures such as customer satisfaction, customer retention, and market share in target segments.
· Business process perspective - includes measures such as cost, throughput, and quality. These are for business processes such as procurement, production, and order fulfillment.
· Learning & growth perspective - includes measures such as employee satisfaction, employee retention, skill sets, etc.
These four realms are not simply a collection of independent perspectives. Rather, there is a logical connection between them - learning and growth lead to better business processes, which in turn lead to increased value to the customer, which finally leads to improved financial performance.
Objectives, Measures, Targets, and Initiatives
Each perspective of the Balanced Scorecard includes objectives, measures of those objectives, target values of those measures, and initiatives, defined as follows:
· Objectives - major objectives to be achieved, for example, profitable growth.
· Measures - the observable parameters that will be used to measure progress toward reaching the objective. For example, the objective of profitable growth might be measured by growth in net margin.
· Targets - the specific target values for the measures, for example, +2% growth in net margin.
· Initiatives - action programs to be initiated in order to meet the objective.
These can be organized for each perspective in a table as shown below.
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| Objectives | Measures | Targets | Initiatives |
| Financial |
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| Customer |
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| Process |
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| Learning |
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Balanced Scorecard as a Strategic Management System
The Balanced Scorecard originally was conceived as an improved performance measurement system. However, it soon became evident that it could be used as a management system to implement strategy at all levels of the organization by facilitating the following functions:
1. Clarifying strategy - the translation of strategic objectives into quantifiable measures clarifies the management team's understanding of the strategy and helps to develop a coherent consensus.
2. Communicating strategic objectives - the Balanced Scorecard can serve to translate high level objectives into operational objectives and communicate the strategy effectively throughout the organization.
3. Planning, setting targets, and aligning strategic initiatives - ambitious but achievable targets are set for each perspective and initiatives are developed to align efforts to reach the targets.
4. Strategic feedback and learning - executives receive feedback on whether the strategy implementation is proceeding according to plan and on whether the strategy itself is successful ("double-loop learning").
These functions have made the Balanced Scorecard an effective management system for the implementation of strategy. The Balanced Scorecard has been applied successfully to private sector companies, non-profit organizations, and government agencies.
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