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Week 1 Transcript (English)

Financial accounting creates standard financial statements for external users by following accounting principles set by the FASB. Financial statements include the balance sheet, income statement, cash flow statement, and statement of owner's equity. The accounting cycle involves analyzing, journalizing, posting, and preparing financial statements from a company's financial transactions.

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0% found this document useful (0 votes)
26 views77 pages

Week 1 Transcript (English)

Financial accounting creates standard financial statements for external users by following accounting principles set by the FASB. Financial statements include the balance sheet, income statement, cash flow statement, and statement of owner's equity. The accounting cycle involves analyzing, journalizing, posting, and preparing financial statements from a company's financial transactions.

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Meidiyantoro
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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What is Financial Accounting?

Financial accounting creates standard financial statements that provide users with
information about a company's financial health. The users of financial statements are
typically external to the company. The data provided is in line with standards established by
the Financial Accounting Standards Board (FASB).

The FASB sets the Generally Accepted Accounting Principles (GAAP) that are used to
produce financial statements. This standard set of principles helps to make financial
statements comparable and reliable across companies. Following the financial accounting
definitions helps a company communicate information about its financial performance.

Financial Accounting versus Managerial


Accounting
While financial accounting generally provides information to users that are external to a
company, managerial accounting typically serves internal users. Managerial accounting
helps internal users such as executives, plant managers, sales managers, or others who are
making business decisions. Because managerial reports are internal, the reports can be
created with user-specific information rather than adhering to financial accounting
standards.

For example, a managerial report can be at a lower level than financial reports, perhaps
looking at the revenue and costs for a specific product versus the company as a whole. That
level of detail is typically not found in financial reports but is very helpful to the manager of
that product line. Or a managerial accounting report might include forecasts for future
revenue and costs while that detail Is not released externally.

Role of Financial Accountants


A financial accountant prepares financial reports. This role requires expert knowledge of the
FASB standards and GAAP in order to provide current information. The financial accountant
must have the training and knowledge to provide useful reports to external users.

Principles of Financial Accounting


In order to produce meaningful financial reports, the Financial Accounting Standards Board
(FASB) sets standards called the Generally Accepted Accounting Principles (GAAP). The 10
key principles that define GAAP are as follows:

 Principle of Regularity - adherence to GAAP


 Principle of Consistency - consistent across periods
 Principle of Sincerity - accounting gives an accurate picture of financial performance
 Principle of Permanence of Methods - standards are constant across different
periods
 Principle of Non-Compensation - all aspects are represented without the promise of
compensation in return
 Principle of Prudence - records are on time and standardized
 Principle of Continuity - assumes the business will continue to operate
 Principle of Periodicity - periods are regular and consistent
 Principle of Materiality - values are based on truthful information
 Principle of Utmost Good Faith - all personnel are honest and reliable

The standards serve to ensure fair and reliable reporting. The FASB is a non-profit
organization whose goal is to raise confidence in published financial reports. The Securities
Exchange Commission (SEC) also promotes the disclosure of market information, but its
principal goal is to promote fair markets and trading, not specific to financial accounting.
Publicly traded companies must follow GAAP while private companies may not unless they
are borrowing publicly. The FASB provides a level of confidence and protection for investors
and creditors in these companies.

Financial Accounting Systems


Three different methods are used for financial accounting systems:

 Accrual financial accounting records transactions when incurred


 Cash basis accounting only records transactions when cash is received or paid
 Modified cash basis combines the two by recording short-term items on a cash basis
and long-term transactions using accrual accounting

Accrual Financial Accounting


Accrual financial accounting calls for including revenue and costs in the period they are
incurred, even if cash is not exchanged. For example, under accrual accounting, the cost
would be incurred when supplies are purchased even if the vendor allows the company to
pay later. Accrual accounting is the prevailing type of accounting used by companies as it is
the approved method under GAAP.

Under accrual accounting, it is standard that two entries are always made, called double-
entry accounting, which maintains the assets equaling liabilities plus credit relationship. One
entry is typically a debit, and one is usually a credit. A debit increases assets accounts and
lowers the balance of liability and equity accounts. In contrast, a credit will lower an asset
account and increase the balance of liability and equity accounts.

In the example where supplies are bought, the supplies account would be debited to show a
higher amount. If the company intends to pay later it will then also credit the accounts
payable account at the time of purchase to reflect the liability. When the invoice is later paid,
cash is credited and accounts payable is debited.
Cash Basis Accounting
An alternative accounting system calls for recording revenues and expenses only when cash
is received or paid. This is called cash basis accounting. In the example above where
supplies are bought on account, the supplies would only be added to the financial
statements when the invoice is paid in cash. This method can be more straightforward, and
easier to understand. It requires only a single-entry, rather than the double-entry
accounting used in the accrual method.

Modified Cash Basis


The modified cash basis of accounting is a mix of accrual and cash basis accounting. Long-
term assets use the accrual method while short-term accounts are recorded on a cash basis.
The overall system uses double-entry accounting. This method can keep costs down by only
recording them when cash is spent while still recording long-term assets earlier due to the
accrual basis. But this method is not approved under GAAP.

Standard Financial Statements


Financial accounting typically produces four common financial statement types:

 A balance sheet shows a company's assets, liabilities, and equity (net worth) at a
point in time
 The income statement presents net income for a specific period after detailing
revenues and costs
 Cash flow statements display cash inflows and outflows typically separated into
operating, investing, and financing activities
 The statement of owner's equity shows how the owner's investment changes during
the period due to dividends, income, or losses, as well as deposits and withdrawals

Lesson Summary
The production of financial statements for an external audience is called financial
accounting. This differs from managerial accounts, which serve internal users and can be
produced in multiple different ways. The financial statements produced include the balance
sheet, income statement, cash flow statement, and statement of owner's equity.

The external standards to create the financial statements are called Generally Accepted
Accounting Principles (GAAP) and are set by the non-profit organization called
the Financial Accounting Standards Board (FASB). This differs from the SEC, who sets
regulates stock trading. All publicly traded companies must follow GAAP.

What is the Accounting Cycle?


There is regularity in most industries. In the accounting field, this regularity is referred to as
the accounting cycle. An accounting cycle is defined as the specific steps that are involved
in completing the process of recording and processing all the financial transactions of a
company. A full accounting cycle has to go through all the steps, and the cycles will be
repeated in accordance with the fiscal year as long as a company is open and in business.
Different companies may have different accounting needs: some may prefer to look at their
performance monthly, while others may put focus on quarterly or annual reports.
Completing accounting cycles is generally a bookkeeper's responsibility. When a cycle ends,
another cycle will begin. It is important to conduct accounting cycles, as they can provide
insight into how the company is performing and facilitate tax reporting and decision-making
in business.

Purpose of the Accounting Cycle


The purpose of the accounting cycle is to ensure the accuracy of financial statements. A
cycle provides a framework for the bookkeeper and the business to monitor the accounting
process and to ensure that every necessary detail is taken care of.

The 10 Steps of the Accounting Cycle in Order


In an accounting cycle, there are ten steps that should be conducted in order. In this
accounting process, the bookkeeper will collect, record, and interpret financial information.
The steps are as follows:

1. Analyze Transactions
In this step, every transaction will be looked at and analyzed to determine how it affects the
financial position or the accounting equation. In this step, documents such as receipts,
invoices, bank statements, etc., will be looked into, as they provide proof of each financial
activity taking place.

2. Journalize Transactions
This is a method to track all the transactions by recording them in chronological order as
they take place. Entries that are recorded are usually separated into credit and debit along
with the date and a summary of the transaction.

3. Post Transactions
Posting transactions refers to the posting of entries from the journal to the general ledger
accounts. General ledger accounts are accounts that have their own unique numbers and
categories. When posting entries, the entries will be transferred to the account that is
affected by the respective entry. For example, if the cash account in the journal is debited,
the entry will be posted to the respective cash ledger account, which will be debited the
same amount as recorded in the journal.

4. Prepare an Unadjusted Trial Balance


The unadjusted trial balance is the first trial balance that must be prepared. This balance
is a listing of all the ledger accounts after all entries are posted. Usually, this listing is
prepared at the end of a financial period. This step is important, as after all entries are
shown, the bookkeeper will check and make sure that the total debit and credit balances are
equal. Performing this step will ensure the record is accurate before moving on to the
following steps.

5. Prepare Adjusting Entries


This step involves updating the ledger account to show an accurate position of balance.
Some transactions may be made earlier in the accounting period and may have had a
different impact when they happened compared to at the end of the accounting period,
which will require an adjustment. For example, office furniture that is bought early in the
accounting period may have been damaged and disposed of at the end of the accounting
period, making the valuation of those assets on the account higher than it actually is.

6. Prepare the Adjusted Trial Balance


In this step, an adjusted trial balance will be produced that contains all of the account titles
and balances of the general ledger after all the entries that require adjustment are adjusted
and the accounts have been updated to reflect the financial situation of the business at the
end of that accounting period.

7. Prepare Financial Statements


After completing the adjusted trial balance, different financial statements will be produced
from it. In this step, an income statement should be prepared first. It shows a positive
number if the company had a net profit and a negative number if the business had a net
loss. After an income statement, a statement of retained earnings will be compiled. This
shows the effect of loss or profit in this accounting period in relation to the retained
earnings of the company. Then, a balance sheet will be prepared. A balance sheet shows the
assets, liabilities, and stockholders' equity in the business. Finally, a cash flow
statement will be produced, which shows the inflow and outflow of the cash of a business
during the accounting period. These statements are considered the output of the
accounting cycle.

8. Prepare Closing Entries


Closing entries are entries that close temporary accounts by transferring data from the
temporary accounts to the permanent accounts or balance sheet. This step takes place after
all the financial statements are prepared and note the beginning of another accounting
period.

9. Post Closing Trial Balance


In this step, a final trial balance will be prepared in order to ensure that debits and credits
are equal. This is a step to ensure the transfer and closing of temporary accounts is
performed well and all of the data needed are recorded.

10. Recording Reversing Entries


This is an optional step in the accounting cycle. At the start of another accounting cycle, a
reversing entry is made to take into account some adjusting entries before recording
transactions in the next accounting period. This can ensure that no entry is double-counted.

Accounting Cycle Vs. Budget Cycle


A budget cycle is a series of steps used to create and prepare a budget for a business. An
accounting cycle is a series of steps used to record and evaluate transactions of a business.
These are different in that a budget cycle takes into account transactions that may happen
in the future while an accounting cycle records transactions that have already happened.

Lesson Summary
There are ten steps in an accounting cycle, which include analyzing transactions,
journalizing transactions, post transactions, preparing an unadjusted trial balance,
preparing adjusting entries, preparing the adjusted trial balance, preparing financial
statements, preparing closing entries, posting a closing trial balance, and recording
reversing entries. In these steps, an unadjusted trial balance is the first trial balance that
must be prepared; it sets a base for the future steps and acts as a guide to make sure all the
transactions recorded are accurate up to that step. When preparing the financial
statements, the income statement is prepared first, followed by the statement of retained
income, balance sheet, and cash flow statement.
A cash flow statement shows how much money came in and went out of a company
during a given time period. Closing entries are the entries that close temporary accounts by
transferring those data to permanent accounts or balance sheet. A budget cycle is a cycle
to plan for transactions that may happen in the future, while an accounting cycle is used to
record transactions that already happened.

Recording Transactions in Accounting


The recording of transactions in accounting is the process of capturing financial data
relating to business activities and operations in a systematic and structured manner. The
main purpose of recording transactions is to provide accurate and up-to-date information
about the financial position of a company as well as maintain accurate and complete
records of financial transactions. Accountants typically first record transactions in an
accounting journal and then a ledger, which forms the basis for financial statements and
other reports.

There are various methods of recording transactions, but the most common and simplest
method is the double-entry bookkeeping system. Under this system, an accountant records
each transaction in at least two different accounts, with a corresponding debit and credit
entry. This system helps to ensure the accuracy of financial records and provides a clear
audit trail in case of any discrepancies.

Accountants use the transactions recorded in journals and ledgers to


create financial statements.
Recording Transactions Process
In the context of accounting, a transaction is an economic event that impacts and changes
the balance of at least two accounts. The reason it affects at least two accounts stems from
double-entry accounting. Double-entry accounting is the most common and standardized
method to record transactions in the practice of modern accounting. Double-entry
accounting results in each transaction having a debit side and a credit side. In other words,
each transaction results in one account being debited while another account is credited. The
total of all debits always equals the total of all credits for any given transaction. The
accountant makes the debits on the left side of the ledger and the credits on the right side.
These credits and debits result in either decreases or increases in accounts depending on
what types of accounts the transaction impacts.

Debits always increase asset and expense accounts, while debits always decrease them. The
converse is true for liability, equity, and revenue accounts; credits increase them, and debits
decrease them. These concepts help to ensure that the accounting equation is always in
balance.

It can be helpful to explore a brief example of the general transaction and recording in the
accounting process. Imagine that furniture company XYZ recently bought a new piece of
machinery. The accountant, Shelby, has entered into the accounting system in the form of a
journal entry. Shelby has considered which accounts this purchase will impact. She has also
determined what account she should debit and which she should credit for this particular
transaction. Shelby will now make the entries in the journal to record the proper debits and
credits.

Recording Transactions in a Journal


A journal is a record of transactions in sequential date-based order. The accountant records
transactions as they occur. This is different from an accounting ledger, which is a record of
transactions that are posted to specific accounts. In other words, the ledger is a summary of
the journal and all accounts. The journal is the starting entry point for all transactions. The
recording of transactions in a journal must occur before they can be posted to the ledger
and, ultimately, the financial statements.

There are different types of journals used in accounting. Some of these include the sales
journal, the purchases journal, the cash receipts journal, the cash disbursements journal,
and a general journal (also known as a proper journal). The type of journal an accountant
uses will depend on the type of business and their accounting software.

Importance of Recording Transactions


Recording transactions is a critical function in accounting as it provides the basis for
preparing financial statements and tax returns. It also helps in the decision-making process
by providing information about the financial performance of a company. Management can
then use this information to make informed decisions about the allocation of resources and
the management of risks.
Recording transactions also helps to ensure the accuracy of financial records which can be
especially useful in case of an audit. An accurate and up-to-date record of transactions also
makes it easier to track trends over time, identify opportunities and potential problems, and
make comparisons with other businesses. A final reason worth noting relates to fraud
prevention. Maintaining accurate records of transactions is especially helpful in deterring
and detecting fraudulent activities such as embezzlement and money laundering.

Recording Transactions Examples


Here are a few examples of transactions and how an accountant would record them:

Example 1
Company ABC is a clothing retailer and recently purchased 1,000 pieces of clothing for its
inventory. The clothing cost $5,000 and was paid for with cash. In this case, the two
accounts that would be impacted are Inventory and Cash. The inventory account would be
debited $5,000 and the cash account would be credited $5,000. This would result in a $5,000
increase in the inventory account and a $5,000 decrease in the cash account because they
are both asset accounts. These entries would be made in the journal and/or ledger with the
date of their occurrence.

Example 2
Company ABC has also recently sold $10,000 worth of clothing to customers. The clothing
was purchased with cash. This entry for this transaction would be the reverse of the
previous one. The cash account would be debited $10,000 and the inventory account would
be credited $10,000. This is because cash is being received and inventory is being sold.

Lesson Summary
The recording of transactions in accounting is an extremely important process because it
provides the basis for financial statements and tax returns, helps in decision-making, can be
used to track trends and identify opportunities, and also aids in fraud prevention. In the
context of accounting, a transaction is an event that results in a change in the financial
position of a company. Transactions are recorded in a journal and then posted to a ledger.
The general flow of the process is as follows:

 Determine which accounts the transaction will affect


 Decide if the accounts are to be debited or credited
 Make the entries in the journal
 Post/transfer the entries to the ledger

According to double-entry accounting, the most common method of modern accounting,


each transaction impacts at least two accounts. One account will be debited and one
account will be credited. The total of all debit entries must, therefore, equal the total of all
credit entries. Expense accounts and asset accounts experience an increase with a debit
entry and a decrease with a credit entry. Revenue, liability, and equity accounts experience
the reverse, an increase with a credit entry and a decrease with a debit entry. Debits are
entered on the left side while credits are entered on the right side. This method of double
entry is important because it is what ensures that accounts remain balanced.

Doube-entry accounting ensures that the total amount of debits equals the total amount of
credits. Learn the basics of how this accounting system is reflected in journals and ledgers
through examples, and understand the concept of normal balances.

The Basis of Double-Entry Accounting


Double-entry accounting is based on the accounting equation that was developed around
1494 by Luca Pacioli. Luca Pacioli was a Franciscan friar who was a friend and collaborator
of Leonardo da Vinci.

Pacioli's equation is profound in its simplicity:

Assets = Liabilities + Equity

Double-entry accounting puts this equation to use by making sure that every financial
transaction is recorded with an entry that utilizes at least two accounts and where the total
amount of money on the left, the debit side, equals the total amount of money on the right,
the credit side.

This is where students taking their first accounting course often get confused. Thanks to the
banking industry's use of the terms, we tend to think of a debit as being like our debit cards
that take money out of our accounts and a credit as being like our credit cards that create a
liability on our part. In accounting, debit and credit are nothing more than directional
indicators meaning left and right. We could use them in well-known situations as nothing
more than directional indicators, and it would make perfect sense to anyone who
understands their use in accounting:

 A drill sergeant could as easily call cadence when marching by shouting


'debit...credit...debit…credit.'
 In the movie Every Which Way But Loose, Clint Eastwood's famous tagline could have
been, 'Credit turn, Clyde.'

The General Journal


So now we know that debit is left and credit is right, but left and right of what? The answer
is, the left and right columns of a standard, two-column journal. The journal and the ledger
are the two basic volumes that control a company's books.

A journal is a record of the various financial transactions that happen in the course of
business. Entries are initially made to the journal and then posted, or copied, to the ledger,
which tracks the effects of those transactions on individual accounts. An individual account
is a group of similar items, such as cash, office equipment, accounts payable, or common
stock. This is a picture of part of a general journal page with a couple of entries to illustrate
the concept.
Notice that each entry has the date that the transaction happened, what accounts were
affected, how much money was involved, and a short description of what happened. Notice,
too, that both the debit and credit columns contain the same total amount of money for
each entry. It is important to remember that they need to contain the same total amount; as
many accounts as are needed may be used on each side, and any appropriate dollar
amounts may be entered. The entry below is just as valid as either entry above:

A journal entry that uses more than two accounts is called a compound entry. Notice in this
example that the entry uses six accounts; four are debited and two are credited. The entry
still meets the requirement that the total dollar amount is the same on each side:

Debits: 4,000 + 1,500 + 8,000 + 2,000 = 15,500

Credits: 10,000 + 5,500 = 15,500

You may have noticed the column labeled post ref, which stands for posting reference. This
column is used to indicate the page in the general ledger to which that line of the
transaction was posted. By keeping the dollar amounts on each side equal, we ensure that
we will also maintain the accounting equation, and assets will indeed equal liabilities plus
equity.

The General Ledger


As noted, each line of a journal entry is posted to the appropriate account of the general
ledger. For example, our first journal page illustration included a $10,000 debit to cash on
April 1 and a $225 credit to cash on April 2. The general ledger page for the cash account is
shown with these items posted:
The '1' in the post ref column tell us that each of these items came from page 1 of the
general journal. Notice that the balance columns don't just copy the amounts transferred
from the journal. Instead, the amounts in the column with the smaller total are subtracted
from the amounts in the column with the larger total and the result is entered into the
larger column:

10,000 debits - 0 credits = 10,000 debit in the first entry

10,000 debit - 225 credit = 9,775 debit in the second entry

Accounts are said to have either debit or credit balances depending on which side has the
most money entered. Different types of accounts also have different normal balances.

Normal Balances
Using the word normal in association with accounting may seem like an oxymoron, but we
do say that certain types of accounts have either a debit or credit normal balance. This
means that they tend to have a balance that is either on the debit or credit side most of the
time.

In studying accounting, we notice that two types of accounts, assets and expenses, tend to
carry debit balances. The other three common types of accounts tend to carry credit
balances, which are liabilities, equity, and revenues. We can think of entries to the normal
balance side of an account as adding to the account and entries to the other side as
subtracting from the account. We saw this with the cash account earlier while looking at the
general ledger.

An easy way to remember the normal balances of the asset, liability, and equity accounts is
to simply remember the accounting equation:

Assets = Liabilities + Equity


Notice that assets are on the left, or the debit side of the equation, and, as we noted earlier,
assets have a normal debit balance. Liabilities and equity are both on the right, or the credit
side of the equation, and both carry a normal credit balance.

This fails to cover revenues and expenses, but we also have a way to remember their
normal balances. The revenues earned and expenses incurred by a business are where the
company's income comes from. The income of the company belongs to the owners.
Therefore, we can think of revenues as adding to equity and expenses as subtracting from
equity. Equity has a normal credit balance, so credits add and debits subtract, and so, we
can remember that revenues (which add to equity) have a normal credit balance--just like
equity. Expenses, which subtract from equity, have a debit normal balance from equity.

Lesson Summary
Double-entry accounting is an accounting system that involves the recording of all
financial transactions in at least two accounts. Within the accounts, the total entries on each
side (the debit side and credit side) must be equal. The debit side is the left side. The credit
side is the right side. Certain accounts tend to carry normal debit balances (like assets and
expenses accounts), while others tend to carry normal credit balances (such as liabilities,
equity, and revenues accounts). This system is based on the equation developed centuries
ago by Luca Pacioli:

Assets = Liabilities + Equity

While this concept has been around for many years, it still finds use in the accounting field.

Periodic reporting and time period principle are common business methods of reporting
financial information. Learn about periodic reporting, time period principle, and the
importance of time periods in reporting financial information.

Periodic Reporting Defined


In accounting, transactions affect account balances on a daily basis. When account balances
change, so does the overall financial status of an organization.

People, like investors, creditors, company executives and employees are all very much
interested in the financial status of a company. Because of that, the concept of periodic
reporting was created. Periodic reporting means that company finances are reported in
distinct time periods.

The Time Period Principle


The time period principle goes hand in hand with periodic reporting. This principle is one of
the major accounting principles that were created by the Financial Accounting Standards
Board, which is also known as the FASB. The FASB is the governing board of accounting
practices in the United States.

The time period principle states that the activities of a business can be broken down into
specific, short and distinct time intervals. These intervals can be monthly, quarterly,
semiannually or annually. It just depends on what the specific company feels is necessary to
accurately show their financial status at specific points in time.

Why Time Periods Are Important


Does it really matter when financial information is reported? It actually does.

Company leadership needs to see the financial reports of a business more than just once a
year, simply because they have to forecast the future sales, expenses, and staffing of their
company. Information that is reported on the financial statements allows them to do that
forecasting as accurately as possible.

For investors, creditors, and those that are potential investors and creditors, it lets them see
how well the company is performing at different times as well as comparing past and
present performance records. This allows them to make informative decisions on whether
they want to enter into or continue business relations with the company.

Employees are interested in the financial status of the company for two very good reasons.
First, employees may take part in profit sharing within a company. In that case, the better
the company performs, the more money that employees are building in retirement
accounts. Second, employees are interested in company finances because it can affect their
job security. They need to know that the company is on track financially, or if it isn't, they
need to prepare themselves for potential lay-offs and shut downs.

Regardless of the reason for periodic reporting and the time period principle, they are both
very important in the world of accounting.

Lesson Summary
Periodic reporting and the time period principle go hand in hand. Periodic
reporting means that company finances are reported in distinct time periods, while
the time period principle means that the activities of a company can be broken down into
specific, short, distinct time periods. These time periods can be weekly, monthly, quarterly,
semiannually or annually, whichever best suits the specific company and accurately portrays
their financial status at specific points in time.

The time period principle is one of the generally accepted accounting principles that have
been established by the Financial Accounting Standards Board (FASB). The FASB is the
governing board of accounting practices in the United States.

There are a number of individuals who use the data that's reported on the financial
statements, such as company leaders, investors, creditors and employees. Employers use
the financial data to aid them in forecasting the future sales, expenses and staffing needs of
their company. Investors and creditors want to see how well a company is performing so
they can decide whether to continue their current relationships or enter into new
relationships with the company. Now, employees may be interested in the financial data
that is reported for a company when they are participants in profit-sharing plans, and the
better the company does financially, the more their nest egg grows. A second reason
employees may find financial data important is that it gives them an insight into how well a
company is performing or not performing, which is important for job security.
Reporting financial data in a timely and orderly fashion is not only a requirement of the
FASB, but it's also a vital part of a company's livelihood.

Learning Outcomes
You'll have the ability to do the following after this lesson:

 Explain what periodic reporting is and why it's important


 Describe the requirement of the time period principle according to the Financial
Accounting Standards Board

What Is a Financial Statement?


A financial statement is a document which summarizes financial data such as income,
expenses, or profit/loss. In business, the financial statements definition refers to a group of
reports used by a company to monitor its financial status. These statements provide
financial details within a specified time period, which is usually one year, but this timeframe
can vary. They can help to provide insight to indicate a company's financial position at a
given point in time or help to forecast upcoming sales. There are four main types of financial
statements that are commonly used in business:

 Income statement
 Statement of retained earnings
 Balance sheet
 Cash flow statement

What is a financial statement?

Income Statement
The income statement is used to determine whether a profit was made. It provides data
about a company's earnings within a specified time period, usually one year. The income
statement must include all revenue (the money made by a business through sales or other
means within a given period) and all expenses (the costs of the business within that same
period). The layout of an income statement typically includes the net sales at the top with
deductions of the cost of these sales, as well as operating expenses and non-operating
expenses right below it. Operating expenses are those incurred due to running the
business, such as employee salaries and conducting market research. Non-operating
expenses are those that are not used in the actual operations of the business, but must still
be recorded. A common example of this type of non-operating expense is taxes paid by the
business.

These figures can be used to calculate the net income, commonly referred to as the bottom
line or net earnings, which is the total amount of profit (or loss) the company experienced
for a given time period. For example, if the net income is equal to $50,000, this means the
company made a profit of $50,000 for that year. The basic formula for calculating net
income is:

Net Income = Total Revenue - Total Expenses

Depending on the needs of the business, an income statement may be simple, or it may be
more detailed, with income and expenses further broken down into additional categories or
lines included on the statement, such as depreciation expenses, amortization, employee
wages, or the cost of goods sold (COGS). The income statement may also be comparable to
the statement of comprehensive income, which includes net income as well as
comprehensive income. Comprehensive income and comprehensive expenses are those
pertaining to sources such as retirement accounts or securities, which aren't included on a
traditional income statement.

Statement of Retained Earnings


The statement of retained earnings is a financial statement that is used to determine
what can be reinvested back into the company. Retained earnings refers to the amount of
profit that is left after dividends are paid out to investors and shareholders. It is also
commonly referred to as the statement of changes in shareholder's equity. Retained
earnings can be calculated using the formula:

Retained Earnings = Beginning Period Balance + Current Net Profit - Cash and Stock
Dividends

For example, if a company's beginning period balance equals $50,000, net profit equals
$10,000, and dividends paid equals $40,000, then the company would have $20,000 in
retained earnings left over to be reinvested.

Balance Sheet
A balance sheet is used by a business to ensure all assets are equal to its liabilities. This
statement essentially shows what a business is worth. It consists of two columns: the left
side for assets and the right side for liabilities and shareholder's equity. Assets are the
things that a business owns, whereas the liabilities are the things a business owes to
others. Liabilities may be owed to other businesses, suppliers, lenders, employees, or
customers. The left and right sides of the balance sheet must be equal, such that:

Assets = Liabilities + Shareholder's Equity

If a business owns $100,000 in total assets, then its shareholder's equity and liabilities
together must also equal $100,000.

Cash Flow Statement


The cash flow statement, or cash flow projection, is used by businesses to determine
where their funds are flowing into the business and how they are flowing out of the
business. It is useful in determining whether a business is on track to afford its expenses.
This statement consists of three parts: operating activities, investing activities, and financing
activities.

Operating activities pertains to the cash flow from the operations of the business and
analyzes the net income of the business. This is the cash flow that is generated from
consumers as products are sold. Investing activities focuses on a company's long-term
assets and how they are sold or purchased. For example, if a company purchases a new
factory or sells some of its equipment, this would be an investing activity. Financing
activities shows the cash flow from activities that pertain to the continued operation of the
business, such as selling company stocks and bonds or paying interest on a bank loan.

Importance of Financial Statements


So why are financial statements important? The purpose of financial statements is to allow
businesses to understand their financial standing. This provides a summary of previous
financial data which can help businesses to make informed decisions. This data can also
inform other individuals or companies which may potentially have a state in the business.
Some examples include:

 Investors (both potential and existing)


 Business owners
 Lenders (both potential and existing)
 Customers
 Market analysts
 Government agencies

Investors refer to financial statements to decide whether to invest their money or to


continue to support the business whose financial status is in question. It's crucial for
business owners to understand the importance of financial statements if they are looking
for investors or seeking bank loans. Many lenders require financial statements such as a
cash flow projection when deciding on an approval. These documents also provide insight
on how the business is running and enable business owners to make more informed
decisions regarding where to make budget cuts or how to allocate funds within the
business.

Customers, market analysts, and government agencies may also use financial statements.
Customers may be impacted by data on financial statements as they may decide on
whether to continue purchasing a company's products or switch to a competitor. Market
analysts can conduct research based on the trends of the financial documents to forecast
sales. Government agencies, like the IRS, may use financial statements with regards to
audits or for other income verification methods.

Understanding the importance of financial statements.

Limitations of Financial Statements


Business owners can use financial statements for a number of reasons; however, they must
ensure they are accurate. Since the data is based on previous amounts, it also may not be
completely accurate in determining forecasted sales. These documents may be interpreted
differently depending on outside factors and changes in costs. Factors, such as book value
and current market value can play a role in these forecasts and may not be accounted for in
the financial statements themselves.

Lesson Summary
Financial statements are important for businesses in order for them to keep track of items
such as revenue, expenses, and overall financial status. There are four main financial
statements which are most commonly used. The income statement indicates whether a
profit was made and includes all revenue and expenses of the business. The statement of
retained earnings shows the amount of money that can be reinvested back into the
business. The balance sheet shows a business's worth and ensures assets are equal
to liabilities. The cash flow statement shows how the money flows in and out and consists
of operating activities, investing activities, and financing activities. Each of these
statements may be used in decision making by business owners, as well as by other
individuals or entities outside of the business, such as customers, investors, lenders, and
government agencies.

What is an Income Statement?


In the financial world, three important statements give the overall health of a business.
These important financial statements are the income statement, the balance sheet, and the
cash flow statement.

What is an income statement? An income statement is a list of all the income entering the
business compared to all the money exiting the business through expenses; it is, essentially,
a profitability report. Investors are interested in how profitable, the ability to make more
than is spent, a business is, and an income statement gives this information clearly and
concisely.

Income entering the business is referred to as revenue. Money being paid out by the
business is called expenses. The income statement allows for a direct comparison between
a business's revenue and expenses with the result of a net income or loss, the profitability
of the business. The formula for calculating the net income (or loss) of a business is:

Revenue −−Expenses = Net Income (Loss)


In layman's terms, this simply means that it is necessary to subtract the financial amount
leaving the company from the amount entering the company to get the total amount the
company keeps (or loses).

Income statements have many names, which all mean the same thing, a financial statement
to compare a business' revenue (income) to its expenses (outgo money) in order to
ascertain its profitability (net income). A few of the commonly used phrases synonymous
with income statements are:

 Statement of Income
 Statement of Earnings
 Statement of Operations
 Statement of Operating Results
 Income Expense Statement

As stated, income statements are used to compare income to expenses, but how to prepare
an income statement depends on the specific needs of that business.

Income Statement Format


What goes on an income statement? An income statement represents a specific period and
shows a snapshot of the profitability of a business. It contains all the ways that a business
brings in money, revenue, and gains and all the reasons why a business might spend
money, expenses, and losses. While revenue is money entering the business through
primary sources (like sales), gains refer to income that comes through secondary sources
(like investments). Similarly, expenses refer to payouts necessary for the direct running of
the business. In contrast, losses relate to secondary forms of lost money (such as money
paid out in a lawsuit or book value loss on equipment).

All companies list items on the income statement in different detail; their income statement
format is suited to the needs of the business. However, it is common to find certain items
on every income statement under the income statement revenue section and under the
income statement expense section.

Income Statement Revenue

 Sales
o This could be broken into sales income for each item on a detailed income
statement.
 Investment Income
 Other Income
o This line might specify each other line of income.

Income Statement Expense

 Operating Expenses (may include costs of materials, rent, licenses required for
operation, salaries).
 utility Expenses
o This may be broken down into specific line items such as water, electricity,
internet, etc.
 Salaries/wages paid (if not included in the operating expenses)
 Tax obligations

It is interesting to note that companies choose whether to list a single line for operating
costs, often called ''Selling, General and Administrative Expenses (SG&A)'', or list individual
lines to document each expense to the company. This fact is a good example of the purpose
of an income statement and what it shows the user. So, what does an income statement
show? It shows the efficiency of a company and details just how profitable the company is. A
company working on a loss would show negative numbers as the net income at the bottom
of the income statement. Companies can review income statements from different periods
to check for consistency, growth, or loss impact over time.

The next logical question to answer is how to prepare an income statement. There are two
main formats:

 Multi-Step: Including calculated net income/loss at four stages throughout the


income statement.
 Single Step: Including no calculations of comparison until the end of the statement.

Each format can include as much or as little detail as desired by the company.

Here is a template for a basic multi-step income statement with an explanation for each
line:
Multi-Step Format Income or Expense Step of Comparison Line

Net Sales Income

Cost of Sales Expense

Gross Income Net Sales -Cost of Sales= Gross sales

SG&A Expenses Expense

Operating Income Gross Income-SG&A

Other Income Income

Other Expenses Expense

Pretax Income Based on above income and expenses

Taxes Expense

Net Income after


Final Net Income
tax
Notice that there are four steps to make comparisons between expenses and revenue in the
above multi-step income statement. Each of these stages can offer important information to
investors about the financial health of a company. This type of income statement is
sometimes called a ''classified income statement.''

Single-step income statements do not have subtotals throughout the statement. In this type
of income statement, revenues are listed first, and expenses come second. They can be
formatted in multiple columns with income and expense amounts listed in separate
columns, or they can be formatted in a single column for income/expense amounts. In the
instance that there is a single column for all monetary amounts, expenses are often listed
within brackets to indicate that they are to be subtracted from the income.

Line Item Revenue Expense

Net Sales 23000

Investment Income 500

Other Income 200

Salaries and wages


12500
paid

Materials and costs 2000

Rent on Premises 1500

Utilities 1000

Tax Obligation 2000


Totals|23700|19000
Net Income= R-E 4700
The above income statement shows a net revenue (the amount of money brought into the
company) or net income of $4700. If the expenses had been more than the revenue, the net
income would be negative. It would show that the company was not profitable during the
represented period.

Income Statement Examples


Real-world income statement examples will help clarify how income statements are built,
what they show, and how they are used by businesses and investors.

Company XYZ had the following income statement for the period January to February (Year
2).

Revenue Expense

Net Sales 23000

Investment Income 500

Salaries and wages


12500
paid

Materials and costs 2000

Rent on Premises 1500

Water 100

Electricity 500

Internet data usage 400


The CEO of the Company XYZ compared the previous income statement to the same period
from the year before (Year 1):

Revenue Expense

Net Sales 20000

Investment Income 500

Salaries and wages


12000
paid

Materials and costs 1800

Rent on Premises 1400

Water 90

Electricity 400

Internet data usage 40


The CEO has a few questions:

1. What was the net income or loss for each period?


2. How did the two time periods compare in sales?
3. Are there any concerns?

Here are the answers to the CEO's questions:

1. The previous period's net income was $4,770, while the current year's net income was
$6,500.

2. Comparing the two income statements shows that the company was more profitable in
the current period than it was a year ago in the same period.

3. All of the expenses have increased over the year, but this is to be expected to some
degree in any working business. However, the internet data usage expense has increased by
a very large margin indicating there may be a concern that the company should investigate.
This increase is a sign that there is inefficiency in internet data usage that might be able to
be resolved.

By comparing these two income expense statements based on the same period in different
years, the CEO of this company can quickly compare profitability, income statement
revenue, and expense changes and identify problem areas within the company's financial
health. In this case, the CEO will likely have the IT department investigate the increase in
data usage and troubleshoot a solution to decrease this expense line item.

Lesson Summary
An income statement is a financial document that compares income to expenses within a
company. Revenue is the amount of money entering a company, while expenses are
payments going out of a company's account. Income statements show whether a company
is profitable, made or lost money in a given period, and indicates the company's general
operating efficiency by allowing owners and investors to compare income to outgoing
money.

There is a simple formula for calculating net income, the amount of profit or loss a
company sees. The formula equates to subtracting the amount paid out from the amount
brought in and can be formally stated: Net Income = Revenue-Expenses.

What is a Balance Sheet?


Balance sheets are one of the core financial statements a company has. What is a balance
sheet? The balance sheet accounts for all of the company's assets and liabilities, in other
words, everything that the company owns, is owed, or owes to others. Assets are what a
company owns or what others owe to that company. Liabilities are what a company owes
to others. The balance sheet is one of the four main financial statements that businesses
utilize. These four statements are:

 Balance sheets
 Income statements
 Cash flow statements
 Statements of shareholders' equity

A balance sheet is used to help a business get loans, convince shareholders to invest with
the company, and demonstrate the financial health of the business. Without knowing how
much money a business owes, the cash flow and income may look a lot better than they
really are. On the other hand, without knowing how much a business holds in assets, lower-
income or cash flow may look less appealing.

Balance Sheet: Equation


The basic equation that balance sheets are based on is that assets are equal to liabilities
plus equity. Equity is the money that shareholders or the owner have put into the business
and what they are currently owed based on that investment. This balance sheet equation
means any assets are either being used towards liabilities or equity for shareholders or
owners. These assets, liabilities, and equity are all listed on the balance sheet. On the
balance sheet liabilities are added to equity to show that the balance sheet assets are equal
to the liabilities plus equity. Assets are listed in their own section and totaled. Liabilities and
equity are in their own sections, totaled separately, and then totaled together. This allows
shareholders to see how much of the assets are tied up in liabilities vs equity for
shareholders.

Balance Sheet: Format


Although the balance sheet can be in any format, as long as it includes all assets, liabilities,
and equity, it is generally written with assets first. The assets then have several sub-
categories. One sub-category can be current assets such as cash, accounts receivable, and
inventory. Other sub-categories may include pre-paid taxes, property, equipment, and
investments. These are then totaled.

The next section is liabilities. This section is also broken into sub-categories. These
subsections may include accounts payable, long-term debt, and unearned revenue.
Sometimes equities are included with liabilities; other times it becomes its own section.
Either way, equity gets added to total liabilities.

The four main financial reports are held to specific standards as outlined by the Generally
Accepted Accounting Principles (GAAP). This helps ensure shareholders or lenders can easily
look at a balance sheet and find what they are looking for. According to GAAP, the balance
sheet needs to list everything based on how easily it can be converted into cash. The items
that are most easily converted are listed first, and items that are least easily converted are
listed last. This means that current assets, such as cash and bank account holdings, are
always listed first since they are already in cash form or can easily be converted into cash to
use. Owner's or shareholders' equity is listed last; this equity can be very difficult to convert
into cash.
Importance of Balance Sheets
Overall the importance of a balance sheet is to help people better understand a company's
financial health. Together with the other financial statements, the balance sheet can help
give a good picture of a company's financial health. Specifically, some of the things that a
balance sheet can help with are:

 Determine how stable a company is


 Determine if a company will be able to pay off debts (and/or acquire new debts)
 See how much cash the business currently has on hand and how much it is expected
to receive (accounts receivable)
 See how much can be gained from asset liquidation

When a merger is under consideration, a balance sheet will show the merging companies
whether they will be taking on extra debt or extra cash. A company can use a balance sheet
to help determine if asset liquidation should be considered or if more debt can be managed.
It can also help a company determine if it is stable enough to expand or if it needs to focus
on paying back debts.

Balance Sheet Example


Balance sheet examples can help demonstrate how to create one for a business. The
general layout of a balance sheet includes the main categories of assets and liabilities. If the
company is privately owned then liabilities will include owner's equity. If the company is
publicly owned then liabilities will include shareholders' equity.

Balance Sheet
Assets
Current Assets
Cash $5,497
Accounts Receivable $19,847
Inventory $26,497
Prepaid Expenses $6,497
Short Term Investments $649
Total Current Assets $58,987
Non-Current Assets
Property, Plant, and Equipment $305,978
(Less Accumulated Depreciation) ($59,847)
Intangible Assets
Total Non-Current Assets $246,131
Other Assets
Deferred Income Tax $5,497
Other $1,647
Total Other Assets $7,144
Total Assets $312,262
Liabilities and Owner's Equity
Current Liabilities
Accounts Payable $4,902
Short Term Loans $6,487
Income Taxes Payable $4,978
Accrued Salaries and Wages $16,497
Lease Obligations
Current Portion of Long Term Debt $52,198
Total Current Liabilities $85,062
Long-Term Liabilities
Deferred Income Tax
Long Term Lease Obligations $12,497
Total Long Term Liabilities $12,497
Equity Capital
Common Stock $64,973
Retained Earnings $110,252
Other Comprehensive Income Loss
Total Owner's Equity $175,225
Non-Controlling Interest $39,478
Total Equity Capital $214,703
Total Liabilities and Owner's
$312,262
Equity
Notice in this balance sheet that the line total for liabilities and owner's equity is the same as
the line total for assets, with both being equal to $312,262. Also, note that line items without
a value assigned to them are still included in the balance sheet. This is to show that these
line items have not simply been forgotten, but instead, have a $0 value.
Lesson Summary
A balance sheet is one of the four main financial statements that are standardized by
GAAP. It includes all assets and liabilities currently held by a company. Assets are the things
that a company owns. While liabilities are things that the company owes to others.
Included in the liabilities sections are owner's equity (for a privately held company) or
shareholders' equity (for a publicly held company), which is money that the shareholders or
owner have put into the business and it is now how much money is owed to them. A
balance sheet is a great tool for businesses or lending groups to use in determining the
financial health of a company. It can also be used to better understand if a company can
afford to grow or if it is time for a company to pay off debts.

A balance sheet is based on the formula Assets = Liabilities + Equity (either owner's equity or
shareholders' equity). On the balance sheet assets are listed first, in order of ease to convert
into cash, and the total is calculated. Liabilities and equities are listed, again in the order of
ease to convert into cash, and the total is calculated. The line that totals assets should equal
the line that totals liabilities and equities.

What is a Cash Flow Statement


A cash flow statement, or statement of cash flows, is one of the most important financial
statements for a business. The statement of cash flows explains any changes in the cash
balance of a company during an accounting period. It's the financial statement that explains
how money entered and left a business. In other words, it shows the inflow and outflow of
cash for the business and can be used to assess the solvency of the business. Solvency is
the ability of the business to pay its debts as they come due. Analyzing the solvency of a
business allows creditors and investors to assess the risk of lending money to or investing in
the business. A cash flow statement can also be used to assess the efficiency of a business.
Efficiency is how well a business uses its resources to generate cash. A business that is not
efficient may have too much inventory, for example, or may be selling its products too
cheaply.

Calculating Cash Flow


A cash flow statement has three sections: operating activities, investing activities,
and financing activities. It is important to discuss these sections in order, as they are listed
in the cash flow statement.

 Operating activities: Operating activities are the day-to-day operations of the


business, such as selling goods or services, manufacturing products, or providing
services. For many businesses, this section will be the largest source of cash flow.
 Investing activities: Investing activities are those activities related to the acquisition
or disposition of long-term assets, such as land, buildings, or equipment. These
activities can either generate cash for the business (if the assets are sold) or use cash
(if the assets are purchased).
 Financing activities: Financing activities are activities that involve the issuance or
repayment of long-term debt or equity. For example, if a business takes out a loan,
the financing activity would be the issuance of debt. If the business repays the loan,
the financing activity would be the repayment of debt. Equity financing, such as the
sale of stock, would also be included in this section.

There are two methods to calculate cash flow: the direct method and the indirect method.
Both of the methods are compliant with both the international accounting standards (IAS)
and the generally accepted accounting principles (GAAP). The direct method provides the
most accurate and transparent view of cash flow. The direct method uses cash receipts and
cash payments to calculate cash flow from operating activities. In other words, all cash
inflows and outflows from operating activities are itemized and listed. From this
information, the net cash flow from operating activities can be calculated. For many
companies, this method is more time-consuming and difficult to calculate. This is because it
requires companies to track all cash receipts and cash payments.

The indirect method of statement of cash flows is the most commonly used method. It is not
as accurate or transparent as the direct method, but it is significantly easier to calculate. The
indirect method starts with net income and then adjusts for items that do not affect cash
flow. For example, depreciation is an expense that does not require the use of cash and
would be added back to net income. The indirect method is a simplified way of calculating
cash flow and does not require companies to track all cash receipts and payments to
calculate cash flow.

Importance of Cash Flow Statements


The cash flow statement is important because it reflects the overall health of the business. A
business with a positive net cash flow is generating more cash than it is using. This means
that the business is able to pay its bills and make a profit. A business with a negative net
cash flow is using more cash than it is generating. This means that the business may have
difficulty paying bills and making a profit. The cash flow statement also shows how well a
business is managing its resources. A business that is not generating enough cash flow may
need to reduce its expenses or raise additional capital. A business that is generating too
much cash flow may be investing its resources inefficiently.

The cash flow statement is also important because it shows the sources and uses of cash.
The operating activities section provides significant insights into the day-to-day operations
of the business. This information can be used to make decisions about how to improve
operations. For example, if a business is not generating enough cash from operations, it
may need to increase prices or reduce expenses. The investing and financing activities
sections provide information about the long-term activities of the business. This type of
information is often used to make decisions related to the allocation of resources. For
example, a business may decide to use its cash flow to pay down debt or repurchase shares.

Statement of Cash Flows Example


It can be useful to explore a few statement of cash flow example scenarios to see how they
are used and to develop a better understanding of their nuances.

Example 1
ABC Ropes is interested in purchasing a retail storefront to sell their ropes, as they have
previously only been selling online. ABC takes a loan from the bank in order to purchase a
retail space outright. A $250,000 loan is received by ABC from the bank in order to make this
purchase. What is this $250,000 categorized as and what type of activity is it?

This $250,000 is categorized as a cash inflow financing activity because it is money that ABC
has received from a loan in order to finance its purchase of retail space. In other words, the
money borrowed from the bank is considered a cash inflow. The money that will later be
paid out to purchase the shop will be a cash outflow, which in this case will be a financing
activity.

Example 2
XYZ Corporation is a manufacturing company. They use cash to purchase raw materials,
which they then use to manufacture their products. They sell their products for cash. What
type of activity is this?

This is an operating activity because it is directly related to XYZ's core business of


manufacturing and selling products. The purchase of raw materials is an operating expense,
and the sale of products is operating revenue.

Example 3
ABC Corporation is a holding company. It owns shares of XYZ Corporation. ABC decides to
sell its shares of XYZ for cash. What type of activity is this?

This is an investing activity because it is directly related to ABC's investment in XYZ


Corporation. The sale of shares is classified as an investing activity because it is a long-term
asset that is being sold for cash.

Lesson Summary
A statement of cash flows, or cash flow statement, is a financial statement that shows the
cash inflows and outflows of a business. This statement explains any changes in the cash
balance of a company during a specific accounting period. The cash flow statement includes
three main sections known as operating activities, investing activities, and financing
activities. The operating section is the section of the cash flow statement that includes
activities that occur during the normal day-to-day operations of the company. The investing
section is the section of the cash flow statement that includes activities that are related to
long-term investments. The financing section of the statement of cash flows includes
activities that involve cash receipts or cash payments from changes on long-term liabilities.
An example of an activity that would be listed as a cash inflow in the financing section would
be if a company took out a $250,000 loan from the bank to purchase a new retail space.

There are several important uses for a cash flow statement. A cash flow statement can be
used to assess the solvency of a company, which is the ability of a company to pay its debts
as they come due. A cash flow statement can also be used to make important decisions
related to resource allocation. For example, a business may decide to use its cash flow to
pay down debt, reinvest in the business, or give back to shareholders in the form of
dividends.

Notes to Financial Statements


Financial statements are documents that publicly traded companies use to communicate
financial data to a governing body called the Securities and Exchange Commission (SEC).
Financial statements contain information about assets owned by a company, debt owed by
a company, revenue, expenses, and information about financing provided by shareholders.
The financial statements contain line items that express a numerical value on each item
listed. Notes to the financial statements contain detailed information on the accounting
decisions made by accountants during the creation of the financial statements as well as
explanations of important factors that impact line items. Financial statement notes are used
to provide shareholders and other interested parties with detailed information about the
accounting decisions and extraneous factors that impact the financial positioning of an
organization.

Elements of Financial Statement Notes


Financial statement notes include elements such as accounting notes that detail how
decisions were made by accountants at an organization, and an explanation of why certain
items were included in different portions of the financial statements. Disclosure notes to the
financial statements of a company are also included and disclose information such as
pending lawsuits, pending patents, or other information that could impact the financial
status of the company in the short-term future. The notes will also contain details about
how inventory was valued for organizations that hold significant stocks of products in
inventory.

The Generally Accepted Accounting Principles (GAAP) are used by accountants when
deciding how to account for different items while preparing financial statements. The GAAP
do not provide strict rules about how different items should be analyzed financially, rather
they provide guidelines that accountants must use to apply to their own organizations when
creating financial report statements. The notes to the financial statements often contain
information about how the accountants applied the GAAP to the financial reports of an
organization.

Different organizations use different accounting methods, and GAAP allows for variability
across organizations to best fit the organization's needs. An organization using cash basis
accounting will recognize revenue when the money for a sale or an expense is received or
dispensed, whereas an organization using an accrual basis of accounting will recognize
revenue when a transaction is completed, but before the money is exchanged. Accounting
for the value of inventory is completed using the lower cost or market method, which states
that inventory should be valued at a lower cost when comparing the historical cost to the
current market value.
The GAAP also provides guidance to accountants for which events must be reported. A
subsequent event is an event that takes place after the closing of the reporting period, but
before the date, the financial statements will release to the public. Subsequent events may
be recognized or unrecognized. Recognized events are events that are recognized in the
notes of a financial statement, whereas unrecognized events are not recognized in the notes
on a financial statement. Intangibles are entities that provide value but are difficult to
quantify because intangibles are not physical objects or tangible services that can receive a
numerical valuation. Intangibles could include assets such as notoriety provided by a
trademarked logo, value added by patents owned by the organization, or trade secrets. The
value of intangibles is heavily dependent on estimation, and valuation methods for
intangible assets will be detailed in the financial statement notes.

Consolidated financial statements report the financial position of an organization that holds
multiple subsidiary groups of businesses. A consolidated financial statement will report the
financial position of the organization as a whole and the consolidated statement will be the
financial report required by the SEC. The organization will often provide financial details for
separate entities in its annual report. A contingent liability is a liability for an event that has
not occurred but is likely to occur in the immediate future. Common contingent liabilities
that receive recognition on financial statements include pending lawsuits and financial
planning for product warranty claims.

Notes to Financial Statements Importance


Notes to financial statements provide investors and other interest parties with important
information that explains how GAAP was applied to the financial statement. The notes will
also include information that explains how estimated valuations were found, and the
expected impact of future liabilities on the financial status of the organization. The Financial
Accounting Standards Board requires notes to financial statements because GAAP leaves
freedom for accounting professionals to apply the principles to individual organizations.

Notes to Financial Statements Examples


Examples of notes to financial statements are discussed below.

 A company that manufactures and sells automobiles will include a value for
contingent liability for warranty claims for the automobiles manufactured. The
company will use data from past warranty claims to calculate the expected future
liability expense, and include that expense on the financial statement. The notes for
the financial statements will detail how accountants at the company estimated the
expense.
 Many companies have outlined the impact of the Covid-19 pandemic in the notes to
their financial statements. These notes provide the company the opportunity to
explain the losses in revenue that many companies experienced, and explain how
those losses were absorbed financially. Providing this information allows investors to
make informed decisions while taking into consideration the special impact of the
pandemic.

Lesson Summary
Financial statements are documents companies use to communicate financial data to
shareholders and the Securities and Exchange Commission (SEC). Notes to financial
statements explain why accounting decisions were made, outline extraneous factors that
impacted a company during an operational cycle, and detail factors that may impact a
company financially in the immediate future. The notes to the financial statements are used
to give additional company information to financial statement users. Generally Accepted
Accounting Principles (GAAP) are the guidelines that accountants use to determine how
things are reported in the financial statements.

The GAAP will also dictate what is reported in the body of the financial statements and what
is disclosed in the notes to the financial statements. The accrual basis of
accounting records income when a sale is made and expenses when a bill is received.
The cash basis of accounting records income when money is exchanged. Subsequent
events are events that happen after the date the financial statements are created but before
the financial statements have been issued to the public. Subsequent events are considered
either recognized or unrecognized. A contingent liability is a liability that has not occurred,
but the conditions are favorable for the event to occur in the immediate future.

What is the Basic Accounting Equation?


The balance sheet is the most important financial statement in a business; it shows all that
the business owns, all debts and obligations, and what owners have invested in the
company. It is categorized into three major sections: assets, liabilities, and owner's equity.
The relationship between these three elements gives the basic principle of accounting:

ASSETS = LIABILITIES + OWNER'S EQUITY

This is the basic accounting equation. It gives meaning to the balance sheet structure and
is the foundation of double-entry accounting. Double-entry accounting is the practice where
one transaction affects both sides of the accounting equation. This is used extensively in
journal entries, where an increase or decrease on one side of the equation may be
explained by an increase or decrease on the other side. Buying raw materials for a
manufacturing business, for example, is an increase in assets but balanced with an increase
in liabilities if the money used for buying was from a credit line or an increase in equity if the
money used was from the owner's capital contribution.

The basic accounting equation balances the following three elements: Assets, Liabilities, and
Owner's Equity.

Assets
Assets are everything that a business owns. They are grouped into two main categories:
current and non-current assets. The current assets are cash and cash equivalents. The non-
current assets are the owned properties that may take time to sell to convert their value to
cash. Examples of assets are cash, accounts receivables, inventory, equipment, and land.
Liabilities
Liabilities are things that the business owes in debt and costs that it needs to pay. Debts
are in the form of lines of credit or loans. The business borrows money or purchases goods
from a lender or supplier and promises to pay after an agreed period with interest.
Examples of liabilities are accounts payable, short-term debt borrowings, and long-term
debts. Costs are obligations that a business needs to pay, including rent, taxes, utilities,
salaries, wages, and dividends payable.

Owner's Equity
Owner's equity is also referred to as shareholder's equity for a corporation. This is the
value of money that the business owners can get after all liabilities are paid off if the
business shuts down. This may be in the form of shared capital or outstanding shares of
stocks. Examples of equity are capital and retained earnings. Retained earnings are the
sums of money that came from the company's profit that was not given back to the
shareholders.

The accounting equation formula helps in ledger balancing using double-entry accounting.
The ledger has debits on the left side and credits on the right side. The total amount of
debits and credits should always balance and equal. In bookkeeping and management of
ledgers, the basic accounting formula is extensive.

Assets Calculation
The basic accounting formula highlights the calculation of the assets and the relationship of
the three elements to each other. Total assets are total liabilities, and shareholder's equity is
added together. The main use of this equation is for the accurate recording of the balance
sheet. The double-entry practice ensures such accuracy by maintaining balance in each
transaction.

Purchase of equipment, for example, will increase assets. The accounting equation creates a
double entry to balance this transaction. If cash were used for the purchase, the increase in
the value of assets would be offset by a decrease in the same value of cash. If the
equipment were purchased using debt, the increase in assets would be balanced by
increasing the same amount in loans or accounts payable. This practice of double-entry
allows verification of transactions and the relationship between each liability and its source.

Expanded Accounting Equation


The basic accounting equation paved the way for developing a new equation called the
expanded accounting equation, which presents the equation in a more detailed fashion. In
this new equation, the owner's equity is broken down further into more detailed
components. The objective of doing this is for the financial analysts to have more insights
into how the company's profits are being used. They check if profits are being used as
dividends, company improvements, or retained as cash.

The formula for the expanded accounting formula is:

Assets = Liabilities + CC + BRE + R - E - D

where:

 CC = Contributed capital (also known as paid-in-capital), which is capital provided by


the original stockholders
 BRE = Beginning retained earnings, which are the earnings that are not distributed to
the stockholders from the previous period
 R = Revenue, which is income generated from the company's operations
 E = Expenses, which mean costs incurred when running the company
 D = Dividends, which are earnings distributed to the stockholders of the company

The contributed capital (CC), beginning of retained earnings (BRE), and dividends (D) show
the company's transactions with the shareholders. It shows how the company shares profit
with its shareholders or keeps money in retained earnings. The revenue (R) less expenses (E)
show the net income on stockholder's equity.

Accounting Equation Examples


Here are the different ways the basic accounting equation is used in real-life situations. The
following examples also show the double entry practice that maintains the balance of the
equation. Assets will always equal the sum of liabilities and owner's equity. Every
transaction demonstrates the relationship of the elements and shows how balance is
maintained.

Example 1:
Paul took $1000 from his savings to contribute to the starting business. He also took a soft
loan of $4000 from a credit union to buy office supplies. He received a $400 insurance bill
for his shop two days later. Calculate the total value of Paul's liabilities.

SOLUTION:

Liabilities are debts and expenses that a company needs to pay after some time. In this
example, Paul's soft loan of $4,000 and the $400 bill for insurance that he needs to pay
(considered expenses) are part of his total liabilities. Therefore, total liabilities = $4,000 +
$400 = $4,400.

Example 2:
On January 1st, 2020, Sherry took out the money from her savings for $100,000 to start her
skincare business. Determine the asset, liability, and equity value of her skin clinic as of
January 1st, 2020.

SOLUTION:

The basic accounting equation is balanced at any time. On January 1, 2020, the business had
$100,000 assets in terms of cash, $0 liabilities, and $100,000 owner's equity.
Example 3:
Company ABC wishes to purchase a $1,500 office machine using only cash. What is the
effect of this transaction on the basic accounting equation?

SOLUTION:

Purchasing the office machine with cash of $1,500 means an additional $1,500 on assets for
the purchased machine and a deduction of $1,500 for the assets in terms of cash going out.
This will cancel the values, and no change has happened on the right side of the equation.

Example 4:
Company ZZK plans to buy office equipment that is $500 but only has $250 cash to use for
the purchase. The remaining amount will be billed at a later time.

What is the net effect on the accounting equation of this transaction?

SOLUTION:

The purchased office equipment will increase Assets by $500 and decrease them by $250
(cash). On the left side of the basic accounting equation, an increase of $250 is balanced by
an increase of $250 on the right side of the equation for liabilities (accounts payable).

Lesson Summary
The basic accounting equation gives meaning to the balance sheet structure and is the
foundation of double-entry accounting. It has the following formula: Assets = Liabilities +
Owner's Equity. For every transaction in a business, there is a balance that is happening
between the three elements of the accounting equation. Assets will always equal the sum of
liabilities and owner's equity. Assets are everything that a company owns. Examples of
assets include cash, land, buildings, equipment, accounts receivable, and
supplies. Liabilities are what a company owes. Things such as utility bills, land payments,
employee salaries, and insurance are examples of liabilities.

Owner's equity is the amount of money that a company owner has personally invested in
the company. The residual value of assets is also what an owner can claim after all the
liabilities are paid off if the company has to shut down. The basic accounting equation is
very useful in analyzing transactions with the global practice of double entry in bookkeeping
and ledger organization. It is enough tool to balance everyday business exchanges. For a
more detailed analysis of the shareholder's equity, an expanded accounting formula may
also be used.

What is a Source Document?


In accounting, the definition of a source document is a piece of paper that proves that a
transaction has occurred. Source documents contain pertinent information about the
transaction, such as the date, the dollar amounts, the involved parties, and the purpose of
the transaction. These documents serve as proof not only that the transaction has occurred
but also of the details of the transaction. With advances in technology, source documents
now also include electronic records, such as an emailed receipt or an electronic bank
statement.

Purpose of Source Documents


Accounting documents and journals are used to maintain records of a company's financial
standing. Not only do they show the current balances for the company's accounts, but they
can also be used to show patterns of income and spending and provide a picture of the
overall health of a company.

An accounting journal entry includes several important details of the transaction, such as
the date and description of the transaction and which accounts will be debited and/or
credited, depending on the nature of the transaction. If the journal entry is incorrect, it can
make the entire accounting record inaccurate and cause tremendous problems for the
business going forward. The examination of source documents, therefore, is a critical first
step to keeping accurate accounting records.

Source documents serve several purposes in accounting. First, original source documents
serve as evidence that a business transaction did occur. They also provide the details of the
transaction, including dollar amounts, the date of the transaction, the parties involved, and
information as to the purpose of the transaction. Accountants use source documents to
complete accounting journal entries about the transaction.

There are eight steps in what is known as the accounting cycleor, the basic steps to
thorough bookkeeping. These steps are:

 Identifying the transaction- this includes examining the source documents to verify
the details of the transaction
 Recording the transaction- once source documents are verified, the details of the
transaction are entered into the accounting journal
 Posting- recording the transaction in the company's general ledger
 Calculating the trial balance- this serves as a mathematical check of the records
 Creating a worksheet- the worksheet is used to check that the records balance and
to look for discrepancies
 Adjusting journal entries- this is as needed, based on the worksheet results
 Creating financial statements- these statements include balance sheets, income
statements, and cash flow statements
 Closing the books- a statement is generated that closes the records for the
accounting cycle

In addition to using source documents to begin the accounting cycle and journal entry
process, source documents can also serve as evidence should there ever be a question or
discrepancy regarding a particular transaction.

Types of Source Documents in Accounting


There are many different types of business source documents. These include bank
statements, deposit slips, purchase orders, sales receipts, and packing slips. Source
documents are classified as internal or external, depending on where they originate.
Internal Source Documents
Internal source documents are generated within the business. These include accounting
reports, invoices, and sales receipts where the company sells products. Internal source
documents can be used to keep records and track business activity over time.

External Source Documents


External source documents are generated outside of the business. Purchase receipts paid
invoices, and banking documents such as statements, deposit receipts, and cancelled checks
are all types of external source documents. External source documents serve as verification
of the company's financial transactions with other entities and are often used to support
income and expense information on the company's tax filings.

Examples of Source Documents


There are countless types of source documents in accounting. Some common examples
include:

 Sales receipts- these demonstrate that a purchase was made and usually include the
item(s) purchased, the name of the vendor, the date, the cost of each item and the
transaction total, and the payment method used
 Banking documents- these documents show the movement of money into and out
of the company's bank accounts and include checks, deposit slips, and account
statements
 Invoices- these can be either internal or external, depending on whether they are
invoices that the company has billed to clients for monies owed to the company or
invoices that have been billed to the company by vendors for payment
 Payroll documents- these include records of hours worked, wages paid to the
employee, and taxes paid on behalf of the employee

Some other types of source documents include payroll records, accounting notes and
reports, leases, financial contracts, and credit memos.

Why are Source Documents Important?


Source documents are a very important part of accurate business accounting. They serve as
proof of the details of a transaction, and they are part of the key first step in the accounting
process, so keeping accurate records of their contents is vital. Source documents may be
required if the business is ever audited or if there is ever a dispute over a transaction or
financial activity, so source documents are often kept and stored for several years in the
event an issue arises in the future. It is important to note that source documents must be
formal. Personal notes and record-keeping are not considered source documents as they
can neither prove that a transaction has occurred nor prove the details of a transaction.
Lesson Summary
Source documents are a key part of business accounting. A source document is a piece of
paper that documents and proves that a transaction has occurred. The examination and
verification of source documents is the first step in the accounting cycle. They provide the
information needed to complete journal entries that are recorded in the accounting journal.

Source documents can either be internal or external, depending on their


origination. Internal source documents originate within the company and include
documents such as accounting reports, payroll data, and billed invoices. External source
documents originate outside of the company. These include documents such as sales
receipts, paid invoices, and bank records. Source documents can be important in the event
of audits or transaction disputes and cannot simply be personal handwritten notes.

Accounting Equation Formula


The basic accounting equation formula shows the relationship between assets, liabilities,
and owner's equity. Assets are things that one owns. For example, if a company does not
pay rent on a building because they own it, the building and the land it is located on are
assets. Liabilities are things that one owes on. For example, accounts payable are a liability
to a business, because the business has an obligation to pay back the purchases they made
on credit. Owner's equity is the amount of money an owner or owners have invested into
the company. The accounting equation is the fundamental basis of the double-entry
bookkeeping system and the balance sheet. Double-entry bookkeeping operates under the
fundamental concept that for every entry made into an account, there must be an equal and
opposite entry made into a different account. The net effect of equal and opposite entries is
one of balance. A balanced accounting entry is when debits equal credits. Double-entry
accounting uses the basic accounting equation, Assets = Liabilities + Owner's Equity, to
ensure that the books are balanced and to evaluate the company's financial health.
Unbalanced accounts do not paint an accurate picture. The accounting equation is
sometimes called the balance sheet equation and the information obtained from the
accounting equation formula allows a balance sheet to be prepared. A balance sheet is a
financial statement showing how much a company earns and how much they owe and is
founded on the principles of the accounting equation. The accounting equation when
present on a balance sheet allows the company's owners to assess their firm's total value.

Accounting Equation Examples


Take, for example, a coffee shop owner who invested $45,000 to open the shop. The owner
owns the building and the land it sits on, with $50,000 in total value. Each month, the owner
purchases supplies like coffee grounds and cups on credit from their supplier and is obliged
to pay a bill of $5,000. Using this information, the accounting equation
is: Assets=Liabilities+Owner
′sEquity������=�����������+�����′������� or 50
,000=5,000+45,00050,000=5,000+45,000 Both sides of the accounting equation balance
as $50,000 on the left side equals $50,000 on the right side. If the coffee shop owner had to
pay a $10,000 bill to their supplier, for instance, the equation would not be balanced. Take
the example from the supplier's side. They earn $5,000 from each coffee shop they supply
with coffee and cups. They have two hundred clients. Their accounting equation would look
like this: Assets=Liabilities+Owner
′sEquity������=�����������+�����′������� or 1,
000,000=25,000+975,0001,000,000=25,000+975,000. The coffee shop supplier is a
much larger business. The business owner invested almost a million dollars to start their
business, and as such, they do not have very many liabilities they owe on. The accounting
equations for both the shop and the supplier balances.

The coffee shop must have their assets balance with their liabilities and
the amount of equity from the owner.

Revenue Formula in Accounting


Revenue is defined as the amount of money a company earns in exchange for goods and
services. It indicates a business's overall income. The revenue formula in accounting is
solved by multiplying how many items were sold times the price at which they were sold.
Revenue is a part of owner's equity, along with expenses and dividends. Owner
′sEquity=(Revenue−(Expenses+Dividends))�����
′�������=(�������−(��������+���������))
Owner's equity can be expanded in the basis accounting equation to include
revenue: Assets=Liabilities+(Revenue−
(Expenses+Dividends))������=�����������+(�������−
(��������+���������))

How to Calculate Revenue in Accounting


The following equation shows how to calculate revenue in
accounting: Revenue=Quantity∗Price�������=��������∗����
�. The revenue a business earns is contingent upon how many items they sell and what the
items are priced at. For example, if the coffee shop sells a cup of coffee for $1.75 and sells
800 cups a day, their revenue
is: Revenue=800∗$1.75=$1,400�������=800∗$1.75=$1,400. The coffee shop
owner earned $1,400 in revenue. If the owner raised their prices to $2.00 but sold 100 fewer
cups of coffee because consumers felt it was too expensive, their revenue could still equal
$1,400: Revenue=700∗$2.00=$1,400�������=700∗$2.00=$1,400. The owner
could also keep the original price of $1.75 and sell 1,000 cups of coffee due to a successful
advertising campaign that drew in more customers. Their revenue would then
be: Revenue=1,000∗$1.75=$1,750�������=1,000∗$1.75=$1,750.

If the coffee shop owner makes the price for a cup of coffee too
expensive, they will not gain any revenue.

Expenses Formula
The expenses formula
is: TotalExpenses=Revenue−OperatingIncome−CostofGoodsandServicesSold�����
��������=�������−���������������−����
����������������������. Within the category of cost of
goods and services sold are labor costs, materials, and permits. Expenses can be fixed, as in
something that is paid on a regular basis regardless of production levels or variables. For
example, the coffee shop owner's rent is a fixed expense, because it doesn't change
depending on how much coffee is sold. Within the extended accounting equation, the
expenses equation is a part of the owner's equity.

Extended Accounting Equation


The extended accounting equation can be written as: Assets=Liabilities+(Revenue−
(Expenses+Dividends))������=�����������+(�������−
(��������+���������)) where Owner′sEquity=(Revenue−
(Expenses+Dividends))�����′�������=(�������−
(��������+���������)). The extended accounting equation is simply
the basic accounting equation but with owner's equity expanded into its parts. The owner's
equity is found by adding up expenses and dividends, then subtracting the total from
revenue. A dividend is the money paid to investors as a return on their investment.

Extended Accounting Equation Problems


The extended accounting equation can be rearranged to find revenue or expenses. For
example, say the coffee shop owner has $70,000 in assets, $15,000 in liabilities, $8,000 in
expenses, and they paid $3,300 in dividends to their investors last year. In order for the
extended accounting equation to balance, their revenue must be: $70,000=$15,000+
(Revenue−($8,000+$3,300))$70,000=$15,000+(�������−($8,000+$3,300)) .
Expenses and dividends equate to $11,300. Rearranging to get revenues isolated on one
side of the equation so it can be solved gives: $55,000=(Revenue−($11,300))
$55,000=(�������−($11,300)). By solving the equation, it can be seen that
revenue must be equal to $66,300 to balance the equation. As another example, expenses
can be found in the same way. Say the coffee shop owner has $65,000 in assets, $30,000 in
liabilities, $60,000 in revenue, and they paid $15,000 in dividends to their investors last year.
Their expenses can be found by: $65,000=$30,000+($60,000−(Expenses+$15,000))
$65,000=$30,000+($60,000−(��������+$15,000)) . Expenses must be
worth $10,000.

Lesson Summary
The basic accounting equation is written as assets = liabilities + owner's equity. The basic
accounting equation forms the foundation for preparing a balance sheet and shows the
relationship that exists between assets, liabilities, and owner's equity. Assets are what
you own. Liabilities are what you owe. Owner's equity is the amount of money that a
business owner or owners have personally invested in the company.

The basic accounting equation can be extended by expanding the owner's equity. Owner's
equity equals the sum of expenses and dividends minus revenue. The expanded
accounting equation is written as assets = liabilities + (revenue - (expenses + dividends)),
where revenue is the amount of money earned in exchange for goods and services,
expenses are money paid to support a company's day-to-day operations, and dividends are
the money investors earn as a return on their investment. The revenue formula in
accounting is defined as price multiplied by quantity. The extended accounting equation can
be rewritten to show how to calculate revenue and expenses.

Account Meaning
There are many ways to define "account," as the term can apply to banking, online user
accounts, and businesses. The account meaning in business refers to a place to record
transactions that occur within the business. It is essentially a statement that consists of
transactions within a certain category. An account in business includes information about
transactions, funds, and available cash. Accounting methods make use of different types of
accounts, which can include transactions with both expenses and income. Businesses must
be sure to account for transactions accurately so that all financial statements are also
represented accurately.

What is a T-Account?
A T-account is a type of account that divides the debits and credit into two columns. It
provides a simplified way to compare money coming in and going out of the account. Debits
to the account are recorded on the left side, and credits are recorded on the right side. T-
accounts can be used for various types of accounts, such as accounts payable, cash, and
accounts receivable. T-accounts are meant to represent the shape of the letter T, with the
name of the account at the top and the debits and credits divided.

Account

Debit Credit

$100 $200

$50 $75

$20 $60

Types of Accounts in Accounting


Accounts can come in various forms, depending on the business. Some of the common
accounting categories used in business include:

 Asset accounts
 Liabilities accounts
 Equity accounts
 Revenue accounts
 Expense accounts

Assets are the things that bring value to a business; therefore, asset accounts include
things of value that are owned, such as equipment, inventory, and cash. Asset accounts
show what a company owns and include both current and noncurrent assets. Current assets
are the items that can be converted into cash in the current period, which is generally one
year. Noncurrent assets are the items that cannot be liquidated within the period, such as
land.

Liabilities are the things owed by the business. Liabilities accounts include the debts and
money owed, such as loan payments, bills, and orders owed to customers. Liabilities are
also classified as current or noncurrent. Current liabilities are those that are owed or due
within the current year, such as rent payments or utilities. Noncurrent liabilities are debts
that are not owed within the current period, such as deferred loan payments.
Equity accounts are the accounts which include owner's capital and shareholders' equity.
Owner's capital includes the investments made directly by the owner, while shareholders'
equity includes other investments and the sales of stocks. These accounts consist of the
money that is invested into the business, as well as the profits received from these
investments. Equity accounts may be referred to as owner's equity or just equity. Equity
accounts go hand-in-hand with assets accounts and liabilities accounts, as all are included
on the balance sheet. Equity is equal to assets minus liabilities.

Two other types of accounts which record the cost and income of a business are expense
accounts and revenue accounts. Expense accounts refer to the accounts which include
costs or expenses incurred by the business. Expense accounts may include costs such as the
bills that need to be paid or other businesses expenses that are accrued. Expense accounts
are similar to liabilities accounts in that they both deal with the debts and costs incurred by
the business. Revenue accounts are the opposite of expense accounts, as they include the
income that flows into the business. Revenue accounts consist of the cash that the business
brings in from things such as customer sales. Revenue accounts are similar to the assets
accounts, as they bring value to the business.

What Type of Account is Equipment?


Equipment that is owned by the business may include machinery used in the manufacturing
of products or computers used at the office. These items are classified as assets within the
business. Equipment is recorded in the asset account, since it is owned by the business and
brings value.

For example, if the business purchases new machinery for production, it would record this
purchase as an asset within the asset account. The equipment is classified as an asset
because it adds value to the business.

Double-entry accounting is a system wherein every transaction affects two or more


accounts. The funds for smaller accounts are recorded again as part of a larger account. For
example, if equipment is first separated in its own account to show all production expenses,
it uses double-entry accounting when it is later included in the assets account. These items
within the smaller account are consolidated with other small accounts to represent a larger
category.

Another account that makes use of double-entry accounting is accounts payable. Items in
this account are owed to other businesses or individuals. These items are then added on to
other debts owed to make up the liabilities account. Essentially, double-entry accounting
shows how one transaction can impact other parts of the business financially.

Lesson Summary
The term "account" can be used for different things, including banking, online accounts, and
in business. In business accounting, an account is a place to record transactions that occur
within the business and typically consists of transactions. A T-account is an account that
divides the debits and credit into two columns, forming the shape of the letter T. Double-
entry accounting is a system where multiple accounts are affected by each transaction.
This means the funds recorded essentially impact other accounts when they are recorded
again in a larger account.

There are five types of accounts that are typically used in a business. These include assets
accounts, liabilities accounts, equity accounts, revenue accounts, and expense
accounts. Asset accounts show what a company owns and include both current and
noncurrent assets. Current assets can be liquidated within a year, while noncurrent cannot
be liquidated within that period. Liabilities accounts include the debts and money owed,
and they are also classified as current or noncurrent. Current liabilities are owed or due
within the current year, while noncurrent liabilities are debts that are not owed within the
current year, such as deferred loan payments. Equity accounts include investment-related
transactions that include owner's capital and shareholders' equity. Shareholders' equity
includes the sales of stocks. Expense accounts are the accounts that include the costs or
expenses incurred by the business, while revenue accounts include the income or revenue
that comes into the business.

Ledger in Accounting: Definition


A ledger is a book or computer printout that contains the accounts of a business. It is
important in accounting because it shows all the financial transactions that have taken place
within a company. A ledger is used in conjunction with the chart of accounts, which is a list
of all the accounts that a company has. Together, these two tools help businesses keep
track of their finances and make sure that everything is accounted for.

Chart of Accounts: Definition


The chart of accounts is a listing of all the accounts in a company. It is used to keep track
of all the financial transactions that take place within a company. The chart of accounts is
organized into three main sections: assets, liabilities, and equity. Each account is given a
unique number so that it can be easily tracked and reported on. The chart of accounts is an
important tool for financial reporting and analysis.

The chart of accounts definition can be divided into two parts. The first part covers the
general ledger accounts. These are the accounts that are used to record all the financial
transactions that take place within a company. The second part covers the special ledger
accounts. These are the accounts that are used to track specific types of transactions, such
as inventory or customer accounts.

The chart of accounts is a vital part of a company's financial reporting system. It provides a
way to track all of the financial transactions that take place within a company and to provide
information for financial analysis. The chart of accounts is also an important tool for
managing a company's finances. By understanding the chart of accounts definition,
businesses can more effectively manage their financial resources.

Chart of Accounts Numbering System


The chart of accounts is the foundation of a company's financial reporting system. It is a
listing of all the account titles that are used in the general ledger to record transactions. The
order in which the account titles are listed in the chart of accounts is called the numbering
system.

There are many different ways to number the accounts in a chart of accounts. The most
common method is to use Arabic numerals (1, 2, 3, etc.). However, some companies prefer
to use Roman numerals (I, II, III, etc.), while others use a combination of both.

The numbering system for the chart of accounts is typically based on the structure of the
company's business. For example, a manufacturing company may have a separate account
for each type of product that it produces. A retail company, on the other hand, may have a
separate account for each type of merchandise that it sells.

A company's chart of accounts numbering system is a vital tool for monitoring financial
transactions. It aids in the preservation of accurate records and reports of all transactions.
Without a numbering system, it would be hard to know where each transaction belongs. As
such, businesses should thoroughly consider their alternatives when selecting a chart of
accounts numbering system.

Types of Ledgers
A chart of accounts and a general ledger are two important components of any accounting
system. The chart of accounts is a list of all the accounts that exist in an organization, while
the general ledger is a record of all transactions involving those accounts.

The chart of accounts contains information on all the different types of accounts that are
used in an organization, including asset, liability, revenue, and expense accounts. These
accounts form the basis for tracking financial data such as income, expenses, assets, and
liabilities over time.

There are two types of ledgers used in accounting: the general ledger and the subsidiary
ledger. The general ledger contains information on all of the accounts, while
the subsidiary ledger contains information for a specific general ledger account.

The subsidiary ledger contains detailed information about a specific account from the
general ledger. For example, the Accounts Receivable Subsidiary Ledger will contain detailed
information about each customer's outstanding balance. The Accounts Payable Subsidiary
Ledger will contain detailed information about each vendor's outstanding balance. It is
important to understand the difference between these two types of ledgers in order to
correctly record transactions and maintain financial records.

While the chart of accounts provides an overview of all the different types of accounts that
are used in an organization, the general ledger provides a more detailed view of the
financial transactions that have taken place within those accounts. This information can be
used to generate financial reports such as balance sheets and income statements.
Ultimately, the chart of accounts and general ledger are essential tools for tracking and
managing an organization's financial data.

Types of Accounts
The chart of accounts is a list of all the individual accounts that are used to keep track of a
company's financial transactions. These accounts are typically divided into five main
categories: assets, liabilities, owner's equity, revenue, and expenses. Each type of account
serves a specific purpose in tracking an organization's finances.

Asset accounts are used to record and track the value of items that a business owns or
controls. Examples include cash on hand, short-term investments, long-term investments,
inventory, and property. Liability accounts represent what the company owes to others -
for example, notes payable or accrued payroll taxes payable. Owner's equity records the
net worth of owners or shareholders in the company. Revenue accounts track income
generated by selling goods or services, while expense accounts record the costs associated
with running the business.

While each type of account provides valuable information about a company's financial
position, they all must be considered in relation to one another to get a complete picture.
For example, a high level of assets may be offset by a high level of liabilities, resulting in low
net worth. Likewise, high revenue can be offset by high expenses, leading to little or no
profit. By understanding how these accounts work together, you can get a clear
understanding of a company's financial health.

How Do the Ledger and Chart of Accounts


Relate?
The general ledger and the chart of accounts are closely related, as they both serve an
important role in tracking financial information for a business. The general ledger is a record
of all transactions that occur within a company, including income, expenses, assets, and
liabilities. In order to create this record, businesses must first create an organized chart of
accounts that lists all the various types of transactions categorized by type and account
number. This allows companies to easily track their finances and make strategic decisions
based on their accounting data.

One way that the general ledger and the chart of accounts relate is through general ledger
entries. When recording transactions in the general ledger, businesses will typically also
need to create corresponding entries in their charts of accounts. For example, if a company
records a sale in their general ledger, they will also need to make a note of this in their chart
of accounts under the category of "sales." This helps businesses keep track of all their
financial information in one place and ensures that nothing is missed or forgotten.

Another way that the general ledger and chart of accounts relate is through financial
reporting. When businesses prepare their financial statements, they will often use data from
both the general ledger and the chart of accounts. The general ledger provides detailed
information about specific transactions, while the chart of accounts can help give a broad
overview of a company's financial picture. Combined, these two tools can give businesses a
complete understanding of their finances and help them make informed decisions about
where to allocate resources.

Lesson Summary
The financial management system of a firm is referred to as accounting. Ledgers are used
to keep track of final accounting entries. The chart of accounts lists all the company's
accounts. The numbering system is the order in which the account titles are presented in
the chart of accounts. The general ledger is used to keep track of all of the accounts, while
the subsidiary ledger is utilized to record transactions for one specific account in the
general ledger. The chart of accounts is a list of all the various accounts used to record a
company's financial transactions. These accounts are generally divided into five major
categories: assets, liabilities, owner's equity, revenue, and expenses. Each sort of
account has its own function in keeping track of a business's finances.

The general ledger and the chart of accounts are related because they both play an
essential function in keeping track of a company's financial information. The general ledger
is a record of all transactions that take place within a company, including income,
expenditures, assets, and liabilities. Businesses must first establish an organized chart of
accounts that lists all of the various accounts that will be used to record financial
information related to the general ledger. Together, these two financial management tools
can provide a comprehensive knowledge of a company's financial status and assist them in
making educated resource allocation decisions.

Two key elements in accounting are debits and credits. Understand these critical pieces of
notation by exploring the definitions and purposes of debits and credits and how they help
form the basics of double-entry accounting.

Newton and Accounting


'For every action there is an equal and opposite reaction.' Have you ever heard that phrase?
A couple of hundred years ago, that phrase was uttered by a man named Sir Isaac Newton,
a world renowned mathematician and physicist. Newton made that statement when he was
discussing the laws of motion in physics. Isn't it amazing that here we are, hundreds of years
later, and that one statement can be used to explain debits and credits in accounting?

The Basics
Before we get too involved in the discussion of debits and credits, let's learn a few basics.
Every business has various transactions that occur each day. Each of these transactions are
examined by accountants and recorded in the accounts that they affect.

In the first steps of accounting, accounts are broken down into T-accounts. T-accounts are
simply visuals to help accounting professionals see the effects of transactions on accounts
individually. The accounting system that is used most often in this day and time is called
double-entry accounting. Double-entry accounting requires that every business
transaction be recorded in at least two accounts. One account will be debited, and one
account will credited.

What Are Debits and Credits?


So, now that you have the basics down, let's talk a little about what debits and credits are.
Debits and credits are both forms of notation that are used in accounting to keep the
balance in accounts. A debit is an entry on the left side of the T-account that increases asset
and prepaid expense balances and decreases liability and equity account balances. A credit,
the opposite of a debit, is an entry on the right side of the T-account. It increases liability,
expense, and owner's equity accounts and decreases asset and prepaid expense accounts.
It can seem a little confusing to understand debits and credits, so let's look at an example.

Peggy owns a dress making shop. It's taken her two months, but she's just finished an
elegant wedding dress for a customer. The customer paid a $200.00 deposit on the dress
before Peggy made it. She comes in and picks up her dress and pays Peggy the $400.00 that
she still owes on the dress. The total cost of the dress is $600.00.

Using this example, you can see that Peggy was given $400.00 today for a balance due on a
dress. That $400.00 is a debit to the cash account. This debit increases the cash balance by
the $400.00. Cash is an asset account. Since a deposit was made on the dress, it was sold on
account, meaning that it is an accounts receivable. Since Peggy uses a double-entry
accounting system, she must have a credit that equals that debit. For this instance, the
credit, which is $400.00, will go to the accounts receivable.

What's the Purpose of Debits and Credits?


Remember Newton's comment from the beginning of this lesson? 'For every action there is
an equal and opposite reaction.' That's exactly what happens with debits and credits. For
every debit, there is a credit, and for every credit there is a debit. One entry increases the
value of an account, while another decreases the value of an account. This keeps accounts
balanced, which is what the main purpose of accounting is - to balance!

Look at Peggy's dress shop. For one transaction, there were two entries made to accounts.
One entry added $400.00 to an account balance, and one entry subtracted $400.00 from an
account balance. In this example, $400.00 - $400.00 = 0. The transaction, once zeroed out, is
considered balanced.

Lesson Summary
Debits and credits are fundamental parts of the double-entry accounting system.
The double-entry accounting system requires that every business transaction be recorded
in at least two accounts. One account will have a debit entry, and one account will have a
credit entry. A debit is an entry that increases the asset and prepaid expense account
balances and decreases a liability, expense, or equity account balance. Just the opposite,
a credit is an entry that increases the balance in a liability, expense, or equity account
balance and decreases the balance in an asset or prepaid expense account.

The easiest way for accounting professionals to see the results of each transaction is to
create T-accounts. T-accounts are visuals that accounting professionals use to see how
accounts are affected by the debits and credits of business transactions. Debits are
recorded on the left side of the T-accounts, while credits are recorded on the right side of
the T-accounts. When the total debits of a transaction is added to the total credits of the
same transaction, the ending result should be zero. This means that the transaction is
balanced.
The best way to remember the purpose of debits and credits is to remember that age-old
saying that is accredited to Newton: 'For every action there is an equal and opposite
reaction.' Remembering that will help you to effectively use debits and credits to achieve the
one thing accounting is famous for: balance!

Learning Outcomes
Following this lesson, you should be able to:

 Summarize what a double-entry accounting system is


 Describe what a T-account is
 Explain how and why credits and debits should balance out to zero in accounting

What is Transaction Analysis?


Transaction analysis is the process of evaluating a business transaction in order to
determine its place in the financial record of a company. Whenever an exchange of goods or
services takes place, a transaction has occurred. This is the lifeblood of business activity. As
soon as a business transaction occurs, the accounting cycle process kicks into effect. Each
transaction that occurs in an accounting period must be analyzed to ensure its proper entry
into the financial record. This is the first step in the accounting cycle, a multi-step process
that begins with transactions and ends with the closing of the books and reporting of
financial information to regulatory agencies and/or interested parties. The steps in the
accounting cycle are:

1. Analyze and journalize transactions


2. Post the journal entries to the general ledger accounts
3. Prepare an unadjusted trial balance
4. Journalize and post the adjusting entries
5. Prepare an adjusted trial balance
6. Prepare financial statements
7. Journalize and post the closing entries
8. Prepare a post-closing trial balance

Transaction analysis, the first step in the process, will be the subject of this lesson.

Role of Accounting Equation in Transaction Analysis


When a company uses a double-entry bookkeeping system, all debit entries must equal all
credit entries in order for the books to stay in balance. This is because in a double-entry
bookkeeping system, each transaction affects at least 2 accounts. A debit is an entry on the
left side of a T-account that increases the balance for asset accounts and decreases it for
liability or owner's equity accounts. A credit is an entry on the right side of a T-account that
decreases asset account balances and increases liability or owner's equity account balances.
The accounting equation is a tool used by accounting professionals to determine whether
or not a transaction is accurate. The accounting equation can be summarized like this:

 Assets = Liabilities + Owners' Equity

An asset is something that a business owns. A liability is something that a business


owes. Owner's equity is the amount of money that a business owner personally invests in
the business. Most transactions fall into income statement (revenue and expense) or
balance sheet (assets, liabilities and owner's equity) accounts. Income statement accounts
are temporary and eventually get rolled up into the owner's equity as a profit or a loss. An
expanded accounting equation is more helpful in determining where to categorize
transactions, particularly expense and revenue transactions that fall under the equity
portion of the accounting equation. The expanded accounting equation is:

 Assets = Liabilities + (Contributed Capital - Dividends + Revenues - Expenses)

When analyzing a transaction, it is very important to make sure the accounting equation
remains in balance. If it is not in balance, there is an input error somewhere and it will not
be possible to close the firm's books at the end of the accounting period.

Transaction Analysis Steps


Proper transaction analysis includes the following steps:

1. Evaluate the situation to determine if a transaction, in the accounting sense of the


word, has in fact taken place.
2. Determine which accounts are affected by the transaction.
3. Determine how the accounts are affected: which account is debited and which
account is credited.
4. Establish the accounts' place in the accounting equation.
5. Ensure that the accounting equation would remain in balance after the entry.
6. Create the journal entry.

Examples of Transaction Analysis


The best way to understand the process is to study an example of transaction analysis.
Below are a few that should clarify the process:

 XYZ, Inc. purchases 10,000 widgets for $50,000 USD from a supplier, for resale to
their customers.

1. A transaction has taken place. Money has exchanged hands for the provision of goods.

2. The inventory asset account and the cash account will be affected by this transaction.

3. Inventory will increase and cash will decrease.

4. Both are asset accounts and will affect only the left side of the equation
Assets = Liabilities + Owner's Equity
+$50,000 = - + -
-$50,000 = - + -
$0.00 = - + -
5. The transaction has a net zero effect on the accounting equation, leaving it in balance.

6. The journal entry for this transaction will be:

Date Account Debit Credit


Inventory -
01/01/21 $50,000
Widgets
01/01/21 Cash $50,000

 ABC, Inc. sells 1000 widgets for $20,000 USD to a client.

1. A transaction has taken place. Money has exchanged hands for the provision of goods.

2. The sales revenue, cash, cost of goods sold and inventory accounts will be affected by the
transaction.

3. Sales revenue, cash and cost of goods sold will increase. Inventory will decrease.

4. Cash and inventory are asset accounts. Cost of goods sold is an expense account and
sales is a revenue account.

Assets = Liabilities + Owner's Equity


+$20,000 = - + +$20,000
-$5000 = - + -$5,000
+$15,000 = - + +$15,000
5. The transaction has a net +$15,000 effect on both sides of the accounting equation,
leaving it in balance.

6. The journal entries for this transaction will be:

Sales transaction:

Date Account Debit Credit


01/05/2
Sales Revenue - Widgets $20,000
1
01/05/2
Cash $20,000
1
Inventory adjustment transaction:

Date Account Debit Credit


01/05/21 Cost of Goods Sold Expense Account $5,000
01/05/21 Inventory - Widgets $5,000

Lesson Summary
Transaction analysis is the act of examining a transaction to decide how it affects the
accounting equation. It is the first step in the accounting cycle. Whenever an exchange of
goods or services takes place, a transaction has occurred. The accounting cycle is a multi-
step process that begins with transactions and ends with the closing of the books and
reporting of financial information to regulatory agencies and/or interested parties.

When analyzing a transaction, it is very important to make sure the accounting equation
remains in balance. If it is not in balance, there is an input error somewhere and it will not
be possible to close the firm's books at the end of the accounting period. The accounting
equation is the tool used by most accountants to make sure the transaction is in balance.
The accounting equation states that Assets = Liabilities + Owner's equity. An asset is
something that a business owns. A liability is something that a business owes. Owner's
equity is the amount of money that a business owner personally invests in the business.
When using a double-entry bookkeeping system, the most important thing to remember
when analyzing business transactions is that all debits and credits must be equal. A debit is
an entry on the left side of a T-account that increases the balance for asset accounts and
decreases it for liability or owner's equity accounts. A credit is an entry on the right side of a
T-account that decreases asset account balances and increases liability or owner's equity
account balances. If, for example, company XYZ, Inc. purchases three workstations on
account for $15,000, this transaction would increase the company's assets by $15,000 with a
debit and increase the liability account by the same with a credit.

What Is a Journal Entry in Accounting?


Journal entry meaning: The journal entry is used to capture information with respect to
transactions that occur within an accounting cycle. Once a transaction occurs, the amounts
are recorded via a journal entry and later transferred to the general journal. The record
created is reflected in a journal that is also called the general journal or book of original
entry. The book of original entry is the first place a business will record its financial
transactions. Two methods exist to record transactions: one being the single-entry method
and the other being the double-entry method. While some businesses use a single-entry
journal entry, most utilize a double-entry method as it reflects both the debit and credit
sides of the transaction. The debit side can be considered the cash or value that flows into
an account, while the credit side represents cash and value outflow from an account. The
double-entry method requires that a debit and credit always be recorded which means that
at least two accounts will always be affected. The double-entry method is the most accurate
way to record journal entries.

Most organizations will record the debit and credit side of the transaction in the general
journal with both sides offsetting each other. A good example that reflects this concept
would be a $60 cash transaction for office supplies. In this instance, one would record a $60
debit to office supplies and a $60 credit to cash. This record is detailed in the table below.

Account Debit Credit

Office
$60
Supplies

Cash $60

Types of Journal Entries


There are a few types of accounting journal examples worth noting: adjusting entries,
compounding entries, and reversing entries.

Adjusting Entries: At the end of each accounting period, the organization completes
adjusting entries. This is to balance the general ledger and ensure that the financial
statements correctly reflect accounting balances. Most adjusting entries are completed for
items such as prepaid expenses, accrued expenses, accrued revenues, and unearned
revenues. However, adjustments may be needed for other accounts or to correct erroneous
entries or accrued expenses. An example of an adjusting entry would be prepaid rent.
Often, companies will pay for a 12-month-period lease agreement. Therefore, it is necessary
to record the full amount at the time payment is made and then reverse part of the expense
monthly.

For example, if rent is $900 per month, then for one period there would be a record of the
rental expense of $900 as a debit and then a credit to prepaid rent for the same amount.

Account Debit Credit

Rent
$900
Expense

Prepaid Rent $900


Compounding Journal Entries: Compounding entries contain more than two lines and are
generally more complex. For example, a company may need to record more than one credit
or debit and instead of making an entry for each, it is simply broken down into one entry. A
good example of when this may be needed is in the instance of recording credit card
transactions, multiple petty cash expenses, or payroll entries that require more than one
line.

This table is an example of a compound entry with expenses recorded against petty cash.

Account Debit Credit

Office
$35
Supplies

Postage $20
Account Debit Credit

Fuel-Travel $25

Petty Cash $80


Reversing Entries: Reversing entries are generally made on the first day of an accounting
period with the intent to reverse a previous accrual completed in the previous month. For
example, credit card fees accrued at the end of the previous month are reversed in the next
month as the actual amounts post to that particular month. Consider a company charged a
customer's credit card on the 31st for $200, the income will not be received until the next
month as it will still need to post. Therefore, the associated fees will not be reflected until
the next month. The example table shows an accrual for one month and then the reversing
entry the next month.

Recording of Credit Card Fees on the 31st of the prior month:

Account Debit Credit

Credit Card Fees


$35
Expense

Credit Card Fees Payable $35


Reversing entry completed on the 1st of the current month:

Account Debit Credit

Credit Card Fees Payable $35

Credit Card Fees


$35
Expense

Importance of Journal Entry


The importance of the journal entry is that this is the first place where transactions are
recorded. Any transaction that occurs will result in a change in financial information and
must be reflected in order to maintain accurate records. The journal entry process is the
initial recording of these transactions to the general journal which are later posted to the
general ledger. The general journal is the book of original entries and recording transactions
accurately is important as this information is passed on to the general ledger which then
affects the overall financial statements. The general journal reflects every financial
transaction that has occurred during an accounting period and therefore contains every
entry ever made for an organization.

The journal entries are posted to the general journal which is the book of original record
that reflects and tracks accounts such as assets, liabilities, owner's capital, revenues, and
expenses. The balances of the journal entries are transferred to the general ledger, the
ledger being the foundation for the creation of financial statements. The general ledger can
also be considered a book of record reflecting the summaries of the journal entries. For
example, the balance of prepaid rent will be reflected in the general ledger. In the example
below, if prepaid rent had a balance of $1,200 in the previous period and $100 was utilized
this period, then the remaining balance of $1,100 will be reflected in the general ledger once
all adjusting entries are completed. The asset of prepaid rent will show a decrease, while the
rental expense will be increased.

Dat
Account Debit Credit
e

6/30 Rent Expense $100

Prepaid Rent $100

Example of a Journal Entry


How do journal entries work? Journal entries are how the financial transactions that take
place during the accounting cycle are recorded. Journal entries are part of the accounting
journal and are one of the most important parts of the accounting process. If they are
recorded incorrectly, this can affect the general journal and everything that occurs after the
amounts are posted. These journal entries are transferred to the general journal, the book
of the original record, reflecting the transactions that have taken place for that given period.
While some organizations use a single-entry method for recording entries, this is not the
most common method. Double-entry bookkeeping is the most standard type of entry
method which reflects both the inflows and outflows of a particular transaction. The left side
of the journal entry reflects the debits, while the right side reflects the credits of the
transaction being recorded.

Debits record all of the money flowing into an account, while credits record the outflows
from the account. Whatever is done on one side should equal what is done on the other.
Here are some examples of journal entries.

Example 1: June 5th — The company sells $1200 worth of product to a customer on account.
No cash is received as the customer has Net 30 terms. In this instance: the Accounts
Receivable will increase, meaning this account will be debited. Sales will then be credited.

Date Account Debit Credit

6/5 Accounts Receivable $1200

Sales $1200
Example 2: July 15th — The company receives cash on the customer's account to pay the
previous transaction in full. The company will decrease the Accounts Receivable, meaning
they will need to credit this account. Note that this account was previously debited.

Date Account Debit Credit

7/15 Cash $1200

Accounts Receivable $1200


What Is a Trial Balance in Accounting?
The next step in the accounting cycle is to run a trial balance. A trial balance is simply a list
of all the general ledger accounts that an organization utilizes and the corresponding
balance. These accounts are part of the Chart of Accounts and each account is usually
classified with an assigned number. Creating a trial balance is an important step as it will
allow us to verify that all journal entries have been entered correctly. The trial balance
consists of three major account types:

 Assets — Assets refer to the tangible or intangible items an organization owns that
add value to the company such as land, equipment, buildings, computers, prepaid
insurance policies, prepaid rent, and one of the most important would be accounts
receivable for companies that offer credit terms. Assets are generally recorded on
the left side of the balance sheet.
 Liabilities — Liabilities are comprised of financial obligations of an organization
which may include loans, accounts payable, salaries payable, unearned revenue,
warranties, and accrued expenses. Basically, anything a company owes would be
considered a liability. Liabilities are generally recorded on the right side of the
balance sheet.
 Owner's Equity or Shareholders' Equity — Shareholders' equity is the amount of
investment the stockholders have in a business and the amount of claim the owners
or stockholders have once the liabilities are subtracted from the assets.
The accounting equation for owner's or shareholders' equity is: Assets - Liabilities =
Owners Equity

One of the most important factors to why a trial balance is run is that it offers a sort of
check and balance system in that the debit side on the left should equal the credit side on
the right. If for any reason these amounts do not match, it shows that there is an issue
related to one of the journal entries for that accounting period. The accountant or
accounting team member will then have to trace the error back to the entry that caused the
issue. One should also note that even if the trial balance does actually balance, this is no
guarantee that the journal entries are error-free. The work should still be double-checked
for completeness and accuracy. The image below provides a good example of how a
balanced trial balance should look.
An example of how a trial balance should look

How Does a Trial Balance Differ From a Journal?


The general journal is a book of the original record and reflects all transactions as they
occurred during the accounting period. The final balances are not recorded in the general
journal; the journal records transactions as they occur. The final balances are then
generated from the posting of the general journal to the general ledger accounts. In trial
balance accounting, the trial balance reflects the final balances for each account and if
completed correctly, the debits and credits will be equal. If the trial balance is out of balance
then the error will need to be traced back to the entry causing the issue.

Types of Errors in a Trial Balance


In trial balance accounting, using the double-entry method allows for the detection of errors
since entries that are not recorded correctly, the debits and credits will not balance.
Although, the credits and debits balancing does not ensure that the amounts were recorded
correctly and the trial balance will still have equal debits and credits. For example, if an entry
is completed twice, the debits and credits will still be equal. If the debits and credits in a trial
balance do not match, then the source of the error should be discovered. Errors can result
from any number of things. However, there are several common types of errors:

 Entries to the wrong accounts


 Incorrect amounts recorded or transposed numbers
 Entries entered in reverse (the debit account should be credited and the credit
account should be debited)
 Entries not made that should have been

General Ledger vs Trial Balance


The difference between the general ledger and trial balance — the general ledger contains
all the details related to all the journal entries completed during an accounting period. In
contrast, the trial balance is only comprised of the ending balances for each account. When
considering the full accounting cycle, journal entries are made as each transaction occurs
then those entries are posted to the general ledger. At the end of the accounting cycle,
adjusting entries are made for prepaid expenses, accruals, and any unrecognized revenue
which is also posted to the general ledger. These postings of debits and credits will either
deduct or add to the general ledger account balances. These balances are then reflected in
the trial balance.

Example of Journal Entry and Trial Balance


Below are examples of how to do a trial balance as well as how to do journal entries can be
found. Using the example trial balance from an earlier section will assist in recording
accounts receivables via a journal entry. Consider that on December 31st the accounts
receivable balance was $5,000 and the company received a payment of $1,800 from a
customer towards this account on January 15th of the current month. Then the journal entry
would be journalized for this transaction as follows.

Dat
Account Debit Credit
e

1/15 Cash $1,800

Accounts Receivable $1,800


The balance was $5,000 on December 31st. If $1,800 was received towards the account in
January and the journal entry is then posted to the general ledger, then the ending balance
in the account should be $3,200. This transaction resulted in an increase in cash or debit to
cash and a decrease in accounts receivable or credit to accounts receivable. Looking at the
image below, it can be seen that the accounts receivable has the proper balance of $3,200
which indicates that all journal entries related to the accounts receivable account were
entered correctly.
Lesson Summary
The journal entry is used to capture information with respect to transactions that occur
within an accounting cycle. The amounts recorded via a journal entry are later transferred to
the general journal which is the book of original entry. The general journal reflects every
transaction recorded during an accounting cycle and therefore contains every entry a
business has ever made. Two methods exist to record financial transactions: one is the
single-entry method and the other is the double-entry method. The double-entry method
must include both a debit and credit, which means that at least two accounts will be
affected. The debit reflects the left side of the entry, while the credit reflects the right side.
This means that a journal entry will always have both a debit and a credit. For example, if a
company receives a utility bill, this would be a liability as it has not been paid yet. In this
instance, the accountant would record a debit to the utilities expense and credit accounts
payable which is a liability account. There are a few types of accounting journal examples
worth noting: adjusting entries, compounding entries, and reversing entries.

 Adjusting Entries: At the end of each accounting period, the organization completes
adjusting entries. This is to balance the general ledger and ensure that the financial
statements correctly reflect accounting balances.
 Compounding Journal Entries: Compounding entries contain more than two lines
and are generally more complex.
 Reversing Entries: Reversing entries are generally made on the first day of an
accounting period with the intent to reverse a previous accrual completed in the
previous month.
A trial balance is simply a list of all the general ledger accounts that an organization utilizes
and the corresponding balance. Creating a trial balance is an important step as it will allow a
company to verify that all journal entries have been entered correctly. The trial balance
consists of the three major account types: assets, liabilities, and shareholders' equity. One of
the most important factors related to why we run a trial balance is that it offers a sort of
check and balance system in that the debit side on the left should equal the credit side on
the right. If for any reason these amounts do not match, then there is an issue related to
one of the journal entries for that accounting period. The general ledger contains all the
details related to all the journal entries completed during an accounting period. In contrast,
the trial balance is only comprised of the ending balances for each account.

There are some problems with financial information, which is the information found on a
company's financial statements. Learn more about financial statements and typical
problems with financial information, including reporting errors, disagreements in judgment,
and fraudulent financial reporting.

Financial Information Defined


Have you ever heard the term 'financial information'? I'm sure that most of us have. The
term financial information, in the accounting industry, refers to information found on the
financial statements of a company that tells how well or badly a company is performing.

Now that you know what it means, do you have any idea why financial information is
important? Financial information, as seen on the financial statements, gives users of this
information, which is usually creditors, investors, and potential creditors and investors, the
tools they need to make informed decisions about their interactions with the company.

Financial Statements
The financial statements provide all of a company's financial information. They are the
income statement, the statement of retained earnings, the balance sheet and the statement
of cash flows. Together, these reports tell the story of how well a company is operating and
how much of a risk investing in that company would be.

Problems with Financial Information


Reporting Errors
Sometimes, there are problems that occur when creating the reports that provide the
financial information. Some of the most common problems that occur in the reporting
process are reporting errors. Reporting errors are errors that are a result of such things as
miscalculations or transposing numbers. For example, let's say that Henry is the bookkeeper
for Wasabi International. While calculating the net income for the company, Henry added
$5,000 that really should have been subtracted from the company's income. This
miscalculation means that the net income for the quarter is overstated.

Disagreements in Judgment
Another problem that may occur when deciding what to include on the financial reports
involves disagreements in judgment. Now, this term should be pretty self-explanatory. In
simple terms, it means that what I believe and what you believe may not be the same. I bet
you're wondering how this can possibly have anything to do with financial information. Well,
let's look back at Henry and another situation he has run into when preparing the financial
statements.

Wasabi International has a decision to make on its inventory. There are three GAAP
approved methods they can choose from, FIFO or First In First Out, LIFO or Last In First Out,
or Weighted Average. The issue is that the methods each give a different valuation for the
remaining inventory and for Cost of Goods Sold. This leads to a different number for assets
and income, as well as taxes! While LIFO reduces income and Henry's tax bill, he chooses
FIFO because it is more realistic, and the increased income will look good at the bank when
he applies for a loan.

Most of the time, disagreements in judgment are related to the timing that the expenses are
reported.

Fraudulent Financial Reporting


The third problem that we're going to discuss is fraudulent financial reporting. Fraudulent
financial reporting means to deliberately omit or misstate financial information with the
intent of deceiving investors and creditors. This is the one action that is anything but an
honest mistake. Fraudulent reporting practices are such things as changing the amount paid
to a vendor, changing the amount of income that's received by a company, failure to report
expenses, and that's just to name a few. These types of activities usually occur because of
the desire to pad the financial statements or make them look better.

Let's go back to Henry again. What would happen if Henry decided that he didn't want to
report the expense of purchasing the new machine at all? He knows that if he does report it,
then the company is going to have a lower net income in this accounting period compared
to the prior accounting period, and that's not what creditors and investors want to see.
However, not reporting the expense is definitely a fraudulent reporting practice.

Lesson Summary
Financial information refers to information found on the financial statements of a
company that tells how well or badly a company is performing. There are four reports,
called the financial statements that provide all of a company's financial information. They
are the income statement, the statement of retained earnings, the balance sheet, and the
statement of cash flows.

Three typical problems that occur when creating the financial statements are reporting
errors, disagreements in judgment, and fraudulent financial reporting. Reporting
errors are errors that are a result of such things as miscalculations or transposing numbers.
Disagreements in judgment simply means that what I believe and what you believe may not
be the same. Fraudulent financial reporting means to deliberately omit or misstate financial
information with the intent of deceiving investors and creditors. Each of these problems has
a major impact on the financial statements, which in turn has an effect on the financial
information that is used by potential and current creditors and investors that a company
may have.
Learning Outcomes
You should have the ability to do the following after watching this video lesson:

 Describe what financial information refers to and identify the four reports of the
financial statements
 Explain three common problems when creating the financial statements and their
effect on the financial information

What are Internal Controls in Accounting?


Internal controls in accounting are policies and procedures in accounting that a company
or organization implements to guarantee that financial and accounting information is
accurate and reliable. Internal controls promote accountability and prevent fraud within the
organization. Internal errors in accounting avoid errors and irregularities in accounting
information, allow the organizations to find problems and ensure that the right actions are
taken, reduce the risk of loss and guarantee that assets are kept secure.

What is internal control? Internal control definition can simply be stated as procedures put
in place within an organization to ensure a business is carried out in an orderly, effective
and accurate manner. Internal controls ensure that financial documents are accurate
because the financial documents will be used by the managers as well as investors and
bankers to get a picture of how well the company is doing. If they are not accurate, incorrect
decisions could be made.

What is the Purpose of Internal Controls?


Internal controls in accounting have several purposes. They include:

 Understanding and mitigation of risks to safeguard the company or organization's


assets from loss — Internal controls focus on high-risk areas in organizational
accounting, and understanding the risk allows the officers to understand which
areas need more controls and in which areas there exist sufficient controls. When
the controls included are in the right place, losses are hard to create, and they can
be easily and quickly detected and dealt with. Internal controls allow the company to
deal with both intentional and accidental losses and provide information and know-
how to separate accidental losses from intentional losses. Intentional losses may be
a case of fraud, and this makes it paramount for the separation to occur.
When intentional errors occur, the responsible individual should be investigated
and disciplined. Sometimes, the errors are accidental; that is, they are honest
mistakes by an individual.
 Verification of assets and finances listed in financial documents — Financial
assertions in financial statements such as rights, wholesomeness, accuracy, and
existence allow organizations to track assets, finances, and claims to guarantee that
what is listed on the inventory is what is available on the financial sheets. The
Securities and Exchange Commission founded the Financial Accounting Standards
Board (FASB) to develop the guidelines that all accounting professionals ought to
follow. The FASB guidelines allow companies to provide financial information in a
transparent and useful manner, and this information can be of use when auditing
and to investors who want to lay a stake in the company. Internal controls ensure
that financial documents are accurate because managers, investors, and bankers will
use them to get a picture of how well the company is doing.
 Detect and prevent fraud through Segregation of Duties — Internal controls
distribute responsibilities so that no single individual gets to perform two of the
three most important functions of Segregation of Duties. Thus, a different individual
or section performs each custody, recording, and authorization. In this way, it
becomes harder for fraud to occur or occur without being detected and stopped.
 Allow organizations to prove that they possess company practices — One of the core
functions of internal controls in accounting is to prove to auditors and other external
parties that the company runs reliably and legally. Internal controls provide
documented evidence of internal practice to external parties and make it easier to
train new employees.

Components of Internal Controls


Internal controls are important to a company's financial and legal health, specifically
because internal control in auditing checks for and evaluates a company's internal controls.
In internal control, there exist five crucial components. They can be explained as follows:

 Control environment — The control environment is an intangible factor that serves


as the foundation for the rest of the elements or components of internal control. The
control environment provides discipline and structure to the organization's
accounting and serves to ensure that competence and commitment are of the
required standard.
 Risk assessment — Risk assessment is basically the examination of possible risks
with regard to objectives. It involves evaluating potential events and evaluating their
likelihood of occurrence and finding a suitable way to respond to these risks.
 Control activities — Control activities ensure that responses to risk are undertaken
in a structured and reliable manner and guarantee that key concepts are included.
 Information and communication — The control structure of a chapter must allow
information to be captured, identified, and transferred internally and externally. The
information ought to be communicated accurately and at the right time.
 Monitoring — Monitoring involves the evaluation or consideration of the success of
the internal controls of a chapter as well as evaluating that they continue to operate
effectively. It is considered successful when it allows control weaknesses to be found
and corrected before they wreck the objective acquisition of the chapter.

Internal control procedures can be categorized into:

 Separation of duties — This involves dividing bookkeeping, deposits, reporting, and


auditing roles.
 Access controls — This involves limiting access to an accounting system using
passwords, locks, and other authentication-specific mechanisms.
 Physical audits — This involves physically tracking assets to verify their existence.
 Standardized documentation — This involves using standard documents such as
invoices for consistent bookkeeping.
 Trial balances — This involves the use of double-entry to ensure the reliability of
accounting information.
 Periodic reconciliations — This involves comparing similar accounting data such as
finances that different individuals maintain in the accounts department.
 Approval authority — This involves the addition of an extra layer of security by
having superior accounting officers add their authentication and approval to certain
documents.

Types of Internal Controls


Internal controls can easily be categorized into three fundamental types, each serving its
purpose. They include detective controls, preventative controls, and corrective controls.
They can be explained as:

 Preventative control — Preventative controls mitigate the chances of a negative


event in accounting from taking place. These controls typically prevent an action
from happening to negate a loss or mistake completely.
 Detective controls — Detective controls detect inevitable errors which are not
prevented by preventative measures in preventative controls. These controls come
into play after a security event has already transpired.
 Corrective controls — Corrective controls are reactive controls employed or activated
after detective controls have flagged down a negative event. These controls allow for
improving existing controls by reacting effectively to the negative event.

Internal Control Examples


There are several examples of internal controls. Four of them include:

 Segregation of Duties — Segregation of Duties (SoD) is an example of preventative


control that divides the duties of custody, recording, and authorization. In this
division, no party has control over more than one duty, and it is important because it
makes it hard for an intentional loss or negative event to occur.
 Physical controls — Physical controls such as safes, locks, and environmental
controls are examples of preventative and detective controls in accounting. Assets
such as cash are important to safeguard, and these controls can be relied upon in
that regard. They are important because the access restrictions ensure that guilty
parties can be identified easily.
 Reconciliations — Reconciliations can be defined as the practice of having different
individuals or sections maintain the same transactions so that they can be compared
later for discrepancies. Reconciliations are important because they easily alert to the
presence of errors, whether intentional or accidental, and make it easy for the
source of error to be diagnosed.
 Policies and procedures — Policies and procedures are preventative and corrective
controls that provide a standard of operation and ensure that all parties in
accounting are aware of what is required and what is wrong. They are important
because they eliminate liability and allow fraud to be prosecuted and handled
internally.

Lesson Summary
Internal controls in accounting are policies and procedures in accounting that a company
or organization implements to guarantee that financial and accounting information is
accurate and reliable. Internal controls can be simply stated as procedures put in place
within an organization to ensure a business is carried out in an orderly, effective and
accurate manner. Internal controls ensure that financial documents are accurate because
the financial documents will be used by the managers as well as investors and bankers to
get a picture of how well the company is doing. If they are not accurate, incorrect decisions
could be made. In internal control, there exist five crucial components. They include Control
environment, Risk assessment, Control activities, Information and communication,
and Monitoring.

When the internal controls are in the right place, losses are hard to create, and they can be
easily and quickly detected and dealt with. Intentional losses may be a case of fraud, making
it paramount for the separation to occur. When intentional errors occur, the responsible
individual should be investigated and disciplined. Sometimes, the errors are accidental; that
is, they are honest mistakes by an individual. The Securities and Exchange Commission
founded the Financial Accounting Standards Board (FASB) to develop the guidelines that
all accounting professionals ought to follow. The FASB guidelines allow companies to
provide financial information in a transparent and useful manner, and this information can
be of use when auditing and to investors. Internal controls can easily be categorized into
three fundamental types, each serving its purpose. They include detective controls,
preventative controls, and corrective controls.

As institutions trusted with our money, banks must have strong safeguards and internal
controls in place to protect it. With this lesson, explore what safeguards and controls are,
the goals of safeguards, and how banks achieve these goals.

Safeguards and Controls Defined


Have you ever wondered just how safe your money is when you deposit it in the bank? I
used to, but then I did a little research on the safeguards and controls of banking activities,
and I don't worry so much anymore. You see, my research showed that the banking industry
is one of the most highly regulated industries in the world. And because of this, they have
stringent safeguards and internal controls in place.

Safeguards are measures that are taken to prevent someone or something from an
undesirable outcome. Internal controls are rules and regulations that are put into place to
guard assets owned by a person or a company. These two terms seem to mean the same
thing, but in reality, they don't. You see, the rules and regulations that are put into place
(which are internal controls) are the measures that are taken to prevent someone or
something from an undesirable outcome (which are safeguards).
Goals of Safeguards
There are five goals for having effective safeguards in place in the banking industry. To
begin with, effective safeguards and internal controls provide reasonable assurance that
banks operate efficiently and effectively. They also ensure that each transaction that occurs
in the bank is recorded correctly. The third goal of effective safeguards is to make sure that
the information provided by banks is true and reliable information. Yet another goal of
banking safeguards is to make sure that the risk management system in place in the bank is
effective. And the final goal is to make sure that all the banking laws and regulations are
being complied to.

How Do They Do It?


Now that you know what a bank's goals are for having safeguards and internal controls, how
do they manage to achieve those goals? Well, the key to this is having written policies and
procedures in place that must be followed by all employees. A specific component that must
be a part of the policies and procedures is the separation of duties. What do I mean when I
say separation of duties? Separation of duties means to separate one big job into smaller
jobs, with a different individual performing each.

Example
Let's look at a banking scenario and see how the process flows. Jenny, Christie, Chelsea,
Faith, Jared and Blake all work at the First Bank of TyTy.

Jenny's a teller. At the beginning of her work day her bank protocol says that she needs to
count her drawer to ensure that it contains the correct amount of currency. The rest of her
day she spends taking customer deposits, customer loan payments, cashing checks and
making change. At the end of the day, again per bank protocol, she totals up the deposits
and loan payments that she's taken in and the checks she's cashed, and then balances her
drawer again. She turns all the cash and checks that she has received, along with all
associated paperwork, in to the head teller, Christie, at the end of the day.

Christie is the head teller. She's responsible for all the customer service duties of a regular
teller, as well as the direct supervision of the other tellers. She's also responsible for
retrieving money from the vault as needed to make change for the teller drawers, and
collecting all daily paperwork and reports that each teller generates. Christie turns all the
daily paperwork over to Chelsea.

Chelsea works in the bookkeeping department. It's her job to process all the documents
that Christie gives her at the end of the day, and check them against reports that are pulled
from the computer. Checks are then scanned and electronically dispersed to the Federal
Reserve. Once everything is verified, and copies are all scanned, the checks are then sent to
the document shredding department and shredded.

Faith works in the loan department of the bank. Faith does not take deposits or payments,
and she does not cash checks. Instead, she meets with bank customers who are seeking a
bank loan. She takes the application and submits it to the credit department at the bank.
Jared works in the credit department. He doesn't take deposits or payments. He doesn't
cash checks. He doesn't take loan applications. Jared runs the credit reports and does all the
legwork that needs to be done to verify whether a loan package can be offered to a
customer. He also writes the loan paperwork. The loan paperwork is then sent back to Faith
so that she can meet with the customer and have him sign the papers. She then gives him
something to take to Jenny so that she can deposit the loan proceeds to the customer's
account.

Blake is a compliance officer. He spends his day reviewing the work of Jenny, Christie,
Chelsea, Faith and Jared. He has to make sure that they're following the protocol that is
defined in the bank's procedures manual. If not, then he's responsible for letting the bank's
president know.

Do you see the separation of duties here? None of the six people that we talked about do
the same job. However, each of their jobs collectively fulfill the purpose of the bank, which is
to provide quality customer service. Having each of the employees do a different job is an
important safeguard. It allows for the internal control system to not only be followed, but to
be monitored closely.

Lesson Summary
Safeguards and internal controls are important concepts in the banking
industry. Safeguards are measures that are taken to prevent someone or something from
an undesirable outcome. Internal controls are rules and regulations that are put into place
to guard assets owned by a person or a company. The tie that binds the two concepts is
rather simple: internal controls are the safeguards that banks put into place to protect
customer assets.

There are five goals of having safeguards in the banking industry. They are to provide
assurance that banks are operating efficiently; to ensure that transactions are recorded
correctly; to make sure that information provided by the bank is true and reliable; to ensure
that risk management systems are effective; and to make sure that banking laws and
regulations are being complied to.

The best way to ensure that these goals are achieved is to have written policies and
procedures in place that consist of distinct separation of duties. Separation of
duties means to separate one big job into several smaller jobs, with a different individual
performing each. Having this system of safeguards and controls allows for customers in the
banking world to feel confident that their money is being protected.

Learning Outcomes
Following this lesson, you'll have the ability to:

 Define safeguards and internal controls and describe how the two are interrelated
 Identify the five goals of safeguards in the banking industry
 Explain the importance of separation of duties in the banking industry
Cash Control
The term cash control has many facets. By definition, cash control is a way to monitor a
company's credit, collections, cash allocation, and disbursement policies, as well as its
invoicing function. In simple terms, cash control is the internal regulation of cash and cash-
related policies in a business. There are multiple components to cash. Cash includes
currency notes, coins, and bills. Cash can be defined as any money that takes the form of
currency. Cash equivalents can be defined as investment securities that mature within 90
days. Simply stated, cash equivalents are liquid assets that can be turned into cash within a
short period of time and are not affected by changing interest rates. An example of a highly-
liquid item would be a 90-day CD (Short-time Certificate of Deposit). Cash equivalents also
include bank certificates of deposit, money orders, banker's acceptances, treasury bills, and
commercial paper.

The relationship between value and its applicability lies in the concept of liquidity. Liquidity
can be defined as how quickly something can be turned into cash. This is important because
a business with few liquid assets can quickly encounter trouble that could derail business
activities. To understand liquidity, consider that a business might have $10,000 in the bank,
$25,000 in 90-day CDs, $15,000 in 1-year bonds, $5,000 in money orders, and $30,000 in real
estate. To understand how much cash and cash equivalents a business possesses,
remember that CDs and money orders are cash equivalents. Adding those $25,000 + 5,000
with the $10,000 in the bank equals $40,000 cash and cash equivalents.

Cash Control in Business


Cash is an extremely important part of a company's business for several reasons. Cash can
provide businesses with:

 independent control over activities


 effective coverage of expenses
 investor satisfaction

First, cash allows a business to have more control over its activities. Having cash on hand is
important because it relieves a business of the pressures of being in debt. When a business
takes on a debt, specifically a sizable one, and is unable to repay in the short term, the
debtors tend to stake a claim as to how the business ought to be run. Debtors want their
debt repaid, so they may issue guidelines on how the business can recoup cash, or may
even offer ultimatums. This can derail the business, as what is necessary to do to cover a
debt may actually be unhealthy for the business in the long term. Having cash, then, allows
a business to run on its own terms and have a much wider scope of activities.

Second, cash allows a business to cover expenses effectively. The availability of cash makes
it possible for a business to pay employees, pay for utilities such as rent, power, and taxes,
and allows them to do so in a timely manner. Paying for expenses when they are due is
important because it avoids conflict with external parties and allows the business to focus
on itself, instead of worrying about factors such as reputation or litigation. One of the signs
that a business is not healthy is unpaid utilities, which rob the business of its reputation in
the eyes of the public and its investors. Having cash negates these possibilities.

Finally, cash allows businesses to pay investors and provide them with dividends. Cash in a
business can be used to acquire share buybacks within the context of investors, which is
beneficial to both the business and the investors. Paying out dividends keeps investors
happy and ensures that there is less internal friction to worry about. When investors are
happy, more investment is likely to be poured into the business, which allows it to grow and
thrive. Having cash provides the possibility for growth in this manner and negates internal
conflict.

Cash Management Control System


A cash management control system can be defined as a system, usually online in
contemporary economies, that is created or implemented to enter and preserve daily
transactions that affect the finances and budgets of a business, and allow for investing
operations and other core financial activities in a business. An effective cash management
control system is important for the long-term success of a business.

 It reduces the amount of idle cash in a business and ensures that the cash is being
put to productive use.
 It ensures that transactions are recorded and balanced out to reduce the probability
of or to eliminate fraud in the business.
 It keeps track of assets in such a way that going bankrupt or landing in debt becomes
very difficult. It is easy for a business to disintegrate without a cash management
control system.

Internal controls in cash management refer to the guidelines for managing a cash account.
Two necessary important components of an effective internal control system for cash
management are first, the separation of duties and second, a written protocol for cash
handling and disbursements. Internal controls can also include employee background
checks, training of staff, use of lockboxes for customer cash, reconciliation of statements,
and securing assets and cash in secure locations. They can be explained as follows:

Internal Control
Explanation
Measure

This ensures that no individual can exploit or operate the whole


Separation of duties system on their own. When duties are divided, it becomes harder
for fraud to occur.

Written protocol for A written protocol provides a foundation for integrity, allows for
cash handling and later access to transactions, and serves as a deterrent for
disbursements deliberate illegal transactions.

Employee background These are important in verifying that an individual can be trusted
checks to partake in cash transactions.
For a cash management control system to be effective,
personnel must be trained on the time value of money, how to
Training of staff
detect transactions' inconsistencies, how to ensure integrity
during transactions, and the overall importance of cash.

Lockboxes are a common internal control for cash because they


provide a safe and reliable mechanism for the short-term
Use of lockboxes
storage of customer cash. They also provide the security feature
of authentication.

An effective cash management control system must be bolstered


Reconciliation of by double entries and periodic reconciliation to ensure that
statements records are consistent. In this manner, it is relatively difficult for
fraud to occur.

Placing assets in well-defended locations prevents physical theft


Securing assets in safe
of cash and serves as a proper foundation for financial activities
locations
such as disbursement.

Lesson Summary
Cash control is a way to monitor a company's credit, collections, cash allocation,
disbursement policies, and invoicing function. Cash is money that takes the form of
currency. Cash equivalents are liquid assets that can be turned into cash within a short
period and that are not affected by changing interest rates. An example of a cash equivalent
would be a 90-day CD (Short-term Certificate of Deposit), or a money order. Liquidity refers
to how quickly something can be turned into cash. It is important because a business with
few liquid assets can quickly encounter trouble that may derail its business activities. Cash
(whether currency or cash equivalents) is highly important to the ongoing function of
business.

A cash management control system is a system, usually online, created or implemented


to record daily transactions that affect the budgetary accounts of the business. Internal
controls in cash management are the guidelines for managing a cash account. Two
important internal controls are the separation of duties and a written protocol for cash
handling and disbursement. Other internal control measures include employee background
checks, training of staff, use of lockboxes for customer cash, reconciliation of statements,
and securing assets in secure locations.

What is Cash Disbursement?


The management of cash transactions is arguably the most important part of accounting.
Cash is a highly valued asset because it's easy to carry and exchange for other goods and
services. This makes it highly desirable. To prevent theft and misuse of funds, cash controls
are necessary. Proper cash management requires the control of cash receipts and cash
disbursements, which are the inflows and outflows of cash to a firm.
Cash disbursements pay for the company's expenses and asset purchases. These are
necessary to keep the firm in operation. Failure to manage cash disbursements properly can
cause severe business problems, from poor vendor relations to unprofitability and
eventually bankruptcy. A cash disbursements journal can help a company keep accurate
and organized records, allowing for proper cash management.

How Does Cash Disbursement Work?


A cash disbursement can be recorded in several ways. One way is to debit the account's
payable account related to the purchase and credit the cash account. Accounts payable is a
liability account on the balance sheet, which is decreased with a debit and increased with a
credit. The cash account is an asset account on the balance sheet. It is increased with a debit
and decreased with a credit.

Example:

# Account Debit Credit

1 Accounts Payable $500

2 Cash $500
An entry can also be made directly to the expense account. Expense accounts are income
statement accounts that are increased with a debit and decreased with a credit. For
example, a one-time purchase of door stoppers for the office might be placed in office
supplies. In this situation, expense went up, so it gets debited, and cash went down, so it
gets credited.

Debi
# Account Credit
t

1 Sundry Supplies $125

2 Cash $125

Types of Cash Disbursements


Any cash outflow from the firm is a cash disbursement. There are many types of cash
disbursements.

 Office supplies expenses like pens, pencils, and erasers for the accounting
department.
 Employee payroll expenses like salaries and wages for management and laborers.
 Rental cost for office or warehouse space.
 Leasehold improvements expenses for any changes made to the building structure
being leased.
 Utilities expenses like electricity and water.
 Customer refunds for returned and refunded goods.

Part of the cash management process may include managing the timing of payments made
to vendors and other payees. Two ways a company can manage cash outflows are through
the use of controlled and delayed disbursements.

 Controlled disbursements allow a firm to review and schedule payments in a way


that maximizes the interest they receive on the account. This is done by delaying
payments.
 Delayed disbursements keep funds in the checking account for as long as possible.

Banks offer these services to businesses with large account balances, where keeping the
funds in the account for a day might make a meaningful difference. An example would be a
Fortune 500 company with millions flowing through its bank accounts daily. The interest for
just one day is substantial enough to justify managing the outflows with delayed, controlled
disbursements.

To illustrate, in a company where the cash balance is $500,000 USD a day and the bank pays
3% interest on the balance, by maintaining this amount in the bank as much as possible, the
company would only earn $41.10 USD a day. Over the course of the year, that amounts to
about $15,000. It is not completely insignificant and is probably not worth actively
managing. Keeping the highest balance possible could have meaningful ramifications for a
company whose daily running balance ranges from $25,000,000 to $75,000,000, If the bank
pays this company 5% on its daily balance and the company strives to keep it at
$50,000,000, the daily earnings would amount to $6,849.31 USD. Over the course of the
year, this would turn into roughly $2.5 million dollars, certainly not insignificant. Part of that
could become a bonus for the accounting team that exercised such expert skill at managing
cash flows.

Cash Disbursement vs Drawdown


A cash disbursement is a payment made from a cash account. A drawdown is money taken
out that decreases the balance in an account. For example, a payment made from a
retirement account disburses funds to the account owner through a drawdown from the
retirement funds. When all disbursements are made, the fund will have a zero balance.

Example
Positive and negative disbursements are other examples of payments a firm might make.
Receiving a refund for a previous purchase can be recorded as a negative disbursement. It is
negative because the firm is receiving money back that had been disbursed for the
purchase of the returned product. Unlike most disbursements, this actually increases the
cash balance. Most items that increase the cash balance are cash receipts, not
disbursements.
A positive disbursement is any purchase made using cash. For example, buying office
supplies to replenish the diminishing stock is a positive disbursement. Normal
disbursements are positive, meaning they decrease the cash balance.

What Is A Cash Receipt?


Cash receipts are records of cash transactions that confirm the sale or purchase of a
product or service. Two copies of the receipt are usually made. For a sale transaction, one
copy goes to the customer and another to the accounting department records.

If the transaction is for the purchase of a good or service by the firm, then it keeps the
customer's receipt and places it in its accounting record files as proof of payment.

For transactions where there is no invoice, the cash receipt may be the only proof of its
occurrence.

Characteristics Of A Cash Receipt


A cash receipt serves as back-up documentation for cash transactions recorded in the cash
receipts and cash payments journals. It has the following attributes:

 It can be presented as proof of payment or sale


 It is a legally enforceable document that can be used in a court of law as evidence
 It is issued for the maintenance of accurate, substantiated records
 It can help detect misappropriation of funds by confirming an inappropriate
purchase

Contents Of A Cash Receipt


A cash receipt may contain the following information about the transaction:

 Date
 A unique receipt number
 The name of the customer
 The quantity of and list of items purchased
 The cash value for each item
 The total value for entire purchase
 The payment method and amount
 The change due back (for cash payments)
 Customer signature (for credit transactions)

Not all receipts are the same, and some have more information than others. The above is an
example of a comprehensive receipt. A very basic receipt must include at least a unique
receipt number, the quantity of and list of items purchased, the cash value for each item,
and the total value of the purchase.
How To Account For Cash Receipts?
Cash receipts are accounted for by:

1. Making a sale and issuing a cash receipt for the transaction.


2. Making an entry into the cash receipts journal and an equal and opposite entry into
the sales journal. (or make a journal entry debiting Cash and crediting Sales
revenue).
3. Depositing the funds into the bank account associated with the cash account where
the transaction was posted.

Cash Receipt Example


If a retail establishment, like a restaurant, takes in a cash payment for a client that
purchased dinner for $156.00, it will issue a receipt with the details of the transaction and a
total balance paid with cash.

Gotham Restaurant #14087

January 20, 2021

J. Jones

1 Greek Salad 6.35

1 Quinoa Chickpea
8.00
Salad

2 Pumpkin Soup 12.00

1 Penne a la Vodka 22.00

1 Eggplant Parmesan 32.00

2 Martinis 24.00

2 Artisanal Beers 16.00

1 Chocolate Cake 8.00

1 Red Velvet Cake 8.00

2 Expresso Coffees 10.00

Sub-Total $146.35

Tax 6.625% $9.65

Total $156.00

Received $200.00
Change $44.00

Internal Controls For Cash


Internal controls are created to make sure the financial information being reported is
reliable, business operations are run effectively and efficiently, and the business complies
with applicable laws and regulations. They are a necessary part of running a well-functioning
operation that can sustain itself into perpetuity. Internal controls for cash are an especially
important part of a business' overall internal control structure because cash is a highly
desirable commodity that is easily exchanged for other goods and easy to carry. The proper
control environment must be created in order to prevent theft and misuse of funds.
Management typically accomplishes this through the use of control activities. Some
examples of control activities are:

 Segregation of duties - different people should be in charge of different parts of


certain activities, particularly those requiring authorization, custody of an asset or
recordkeeping.
 Proper authorization - having someone familiar with the company rules responsible
for authorizing transactions and activities ensures the rules are complied with and
proper control over the process is maintained.
 Adequate documents and records - documents and records proving the accuracy of
financial statement information are an important part of maintaining control. The
documents should contain all the details necessary to prove the transaction
happened. They should be created efficiently, using mechanisms like prenumbered,
consecutive documents that ensure a unique identifier for each transaction and are
easier to find based on the transaction date.
 Physical control - Some assets, like cash, need physical monitoring to be protected
from theft and misuse. Control activities may include the use of safes, locks, cash
registers, biometric identification tools, or simple ID cards. Some assets are virtual,
like online bank accounts and the entire bookkeeping system. These can be
protected by creating a hierarchy of access privileges and back-up files.
 Independent checks - periodic random checks on the work of employees handling
sensitive company information or assets can discourage malfeasance.

Separation of duties, as a mechanism of cash control, would mean having different people
responsible for different parts of the cash flow process. A good example of separation of
duties is to have one person responsible for cash withdrawals, another taking care of cash
deposits, another person writing checks, and yet another person filing receipts. Each person
takes on a minor job in order to complete a big one.

Good Internal Control System


A good system of internal control for cash follows the guidelines for good internal control
stated above, as applied specifically to cash. So, for cash:
 Different people receive, record, and deposit cash.
 A limited number of people are authorized to handle cash and/or make cash
transactions. All cash expenditures must be authorized by a manager.
 Cash transactions are recorded efficiently using prenumbered checks and invoices,
which diminish the possibility of errors like transactions being recorded twice or not
at all.
 To keep physical cash safe, use cash registers, maintain just enough cash in the
register to handle transactions, make frequent bank deposits, and keep blank checks
locked.
 Conduct random, periodic checks on employees that handle cash to discourage
theft.

Internal Control Example


When a company requires certain employees to travel for work-related purposes, it will
often provide access to an expense account and some guidelines on limits for the different
expenses the employee may incur as part of the work-related trip. When the employee
returns, it will require that they submit travel and expense reports, with documentation
verifying each of the expenses. This ensures that the charges to the expense account used
to make the purchases are backed up with receipts and invoices providing the details and
ensuring that they were within the limits allotted. Once the expense report is submitted,
someone in accounting will verify and reconcile the back-up documents with the expense
report and the charges in the company expense account. If something is missing, a request
for the backup or justification will be issued. Travel and expense reports are approved by
various people to make sure they are in line with company rules.

If back-up data was not required of employees and they were given free rein with the
expense account, it might encourage overspending and the charging of inappropriate items
to the company expense account. If no internal controls were in place to monitor the
expenses, no one would track them and no one would know what they were. The employee
could charge anything without repercussions. The policy outlined above is an example of
good internal controls because it applies segregation of duties, proper authorization,
adequate documents and records, and independent checks on activity.

Lesson Summary
Cash is the business asset most vulnerable to fraudulent activity. Whether cash is being
taken in or paid out, having several people play individual roles in the handling process will
allow for a system of checks and balances where mistakes or fraudulent activity have a
higher chance of being noticed. Internal Controls are rules and regulations that are put
into place to guard the assets owned by a person or a company.

Separation of duties, as a mechanism of cash control, would mean having different people
responsible for different parts of the cash flow process. A good example of separation of
duties is to have one person responsible for cash withdrawals, another taking care of cash
deposits, another person writing checks, and yet another person filing receipts. Each person
takes on a minor job in order to complete one big one. Part of cash management requires
the proper internal controls for cash disbursements and cash receipts. Cash
disbursements are monies paid out to individuals for the purchase of items that are needed
and used by a company. This can be anything from purchasing inventory, raw materials, or
even utilities. Cash receipts are money received from consumers for the sale of goods or
services.

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