Accounting equations and financial statements

• Financial statements serve as "report cards" for businesses, providing a graphical representation of the company's financial condition over a specific time frame
• Financial statements must be prepared following specified and standardized accounting standards
• Advantages of financial statements:

  • Ability to generate cash and its sources and applications
  • Ability to repay debts
  • Identifying impending problems with profitability
  • Creating financial ratios for insight into the company's state
  • Investigating specific business transactions' details
  • Foundation for an annual report given to investors and stakeholders
• Drawbacks of financial statements:

  • Potential for fraudulent manipulation
  • Risk of lenders issuing debt to a company that cannot realistically repay
  • Historical nature can be misleading for predicting future performance
• Four financial statements:

  1. Income Statement: Shows company's performance for each period, calculating gross profit and net income

  2. Statement of Owner’s Equity (Retained Earnings Statement): Shows equity accounts affecting the final equity balance

  3. Balance Sheet (Statement of Financial Position): Shows assets, liabilities, and owner’s equity at a particular moment

  4. Statement of Cash Flow: Calculates cash inflows and outflows per period
• Accounting Equation:

  Assets = Liabilities + Owner’s equity

  • Assets (debit accounts) are on the left side, liabilities and capital (credit accounts) are on the right side
  • Interpretations for a balanced equation include various scenarios of asset, liability, and capital changes
• Expanded Accounting Equation:

  Assets = Liabilities + Shareholder’s Equity + Revenue – Expenses – Draws

  • Shows the relationship between income statement items and the balance sheet
  • Allows analysts to see the effect of net income and transactions with owners on equity
• Double-Entry Accounting System:

  • Ensures accounting and transaction equations are equal
  • Changes in asset accounts should correspond to changes in related liability and owner’s equity accounts
• Debits and Credits:

  • Debits and credits ensure balance in the double-entry system
  • Entries on the left side are debits, and on the right side are credits
  • Total debits and credits in a transaction must be equal
• Major Accounts (Elements of Financial Statements):

  • Assets: Tangible or intangible items of monetary advantage
  • Two categories of assets: Current Assets and Non-current Asset
• Two categories of assets:

  • Current Assets: can be exchanged for cash within a single operating cycle or fiscal year, used for day-to-day operational expenses and investments
  • Include: Cash, Certificates of deposit, Equity or debt securities, Accounts receivable, Inventory, Prepaid Expenses (expenses paid in advance)
  • Fixed (Non-current) Assets: non-current resources used in production with a life of more than one year, recorded as property, plant, and equipment
• Two categories of liabilities:

  • Current Liabilities: debts to be paid back within the next twelve months
  • Include: Accounts payable, Principal and interest, Salaries and Wages, Notes payable due within one year, Income Taxes payable, Mortgage payable, Payroll taxes
  • Non-current (Long term) Liabilities: debts not due for more than twelve months
  • Include: Principal and interest due for more than one year, Bonds, debentures, and long-term loans, Deferred tax liabilities, Lease payments due for more than one year, Pension obligations
• Equity: sum invested in a company by owners in addition to retained earnings

  • Include: Owner’s Capital, Owner’s Withdrawals, Common Stocks, Preferred Stocks, Retained Earnings, Additional Paid-in Capitals, Other Comprehensive Income
• Two categories of revenue:

  • Operating Revenue: income from primary business exercises like sales
  • Include: Sales, Professional Services, Service Charges, Rental Income, Commission Earned
  • Non-operating Revenue: money earned from side businesses unrelated to day-to-day operations
  • Include: Dividends, Investment Income, Gains or losses from foreign exchange, Sales of assets, Interest income
• Two categories of expenses:

  • Operating Expense: expenses related to the company’s main activities
  • Include: Cost of Sales, Utilities Expense, Purchases, Freight In and Freight Out, Advertising Expense, Depreciation Expense, Interest Expense, Rent Expense, Salaries Expense, Supplies Expense, Licenses Fees and Taxes
  • Discretionary Expense: non-essential spending
  • Include: Company travel, Investments and innovations, Employee perks, Office improvements, Workshop investments, Employee training sessions
• General Journal, also known as the Book of Original Entry, keeps track of all financial transactions by date. It is used to keep track of real-time transactions. It is the first book to document business transactions and follows the general debit and credit principle.
• According to an article by Byjus (n.d.), the accounting equation is the basic element of the balance sheet and the primary principle of accounting.
• According to Gordon (2022), the owner's equity section of the basic equation has been divided into contributed capital, beginning retained earnings, revenue, expenses, and dividends, as seen from the two equations above.
• Liabilities. Law requires these obligations to be paid to another organization or individual. Liabilities are creditors’ claims on a company asset because this is the amount of assets creditors would own if the company liquidated
• Revenue. It is a measurement of a company's total gross activity. Service and product sales are two examples
• Under Cash accounting, the expense is only recorded when the actual money has been paid
• Accrual accounting is based on the matching principle, ensuring that accurate profits are reflected for every accounting period. The revenue for each period is matched to the expenses incurred in earning that revenue during the same accounting period.
• The recorded documents on the financial transactions and business operations of a company or individuals are called Books of Accounts
• The General ledger, also known as the final book of entries, provides a reconciled balance by summarizing an account's journal entries.
• Cash Receipt Journal. This journal keeps track of all cash payments made to cover expenses and collect receivables
• Cash Disbursement Journal. Accountants maintain the internal journal known as cash disbursement to record cash outflows in businesses.
• Sales Journal. A specific kind of journal called a "Sales Journal" is used to keep track of all a company's sales, including those of goods or other products it sells
• Purchase Journal. It is one of the books of accounts that keep track of the company's credit-based purchases and expenditures. Credit purchases are documented in this format. The term "traditional journal" refers to the general journal, while "special journal" refers to the other four types of journals mentioned above.
• Special Journals are journals that are repetitive and recurring
• Subsidiary ledgers contain detailed information about individual items such as customers, suppliers, employees, etc., which can be transferred into the main ledger when necessary.
• Expenses. It is when an asset loses value because it is used to make money.