Chapter 2: Elements and Components of the Financial Statement

Accounting Cycle

1. Analyzing and Classify Data about an Economic Event.

Events are analyzed to find the impact on the financial position or to be more specific the impacts on the
accounting equation. Documents such as; a receipt, an invoice, a depreciation schedule, and a bank
statement, etc. provide evidence that an economic event has actually occurred.
2. Journalizing the transaction
Transactions having an impact on the financial position of a business are recorded in the general journal.
In the general journal, the transactions are recorded as a debit and a credit in monetary terms with the
date and short description of the cause of the particular economic event.
3. Posting from the Journals to the General Ledger
Transactions recorded in the general journal are then posted to the general ledger accounts.
4. Preparing the Unadjusted Trial Balance
To determine the equality of debits and credits as recorded in the general ledger, an unadjusted is
prepared. It is a way to investigate and find the fault or prove the correctness of the previous steps
before proceeding to the next step.
5. Recording Adjusting Entries
Adjusting entries ensure that the revenue recognition and matching principles are followed. To find the
revenues and expenses of an accounting period adjustments are required. Adjusting entries are required
because a transaction may have influence revenues or expenses beyond the current accounting period
and to journalize the events that not yet recorded.
6. Preparing the Adjusted Trial Balance
An adjusted trial balance contains all the account titles and balances of the general ledger which is
created after the adjusting entries for an accounting period have been posted to the accounts. It is an
internal document and is not a financial statement. It helps to create the income statement and balance
sheet and provide enough information for preparing the cash flow statement.
7. Preparing Financial Statements
Financial statements are prepared from the balances from the adjusted trial balance. The financial
statements are made at the very last of the accounting period. Financial Statements is the output of the
accounting process, which is used by the interested parties both within and out of the organization.
8. Recording Closing Entries
At the end of an accounting period, Closing entries are made to transfer data in the temporary accounts
to the permanent balance sheet or income statement accounts. Transferring the balances of the
temporary accounts or nominal accounts (e.g. revenue, expense, and drawing accounts) to the owner’s
equity or retained earnings account is used because these types of accounts only affect one accounting
period.
9. Preparing a Closing Trial Balance
To make sure that debits equal credits, the final trial balance is prepared. As the temporary ones have
been closed only the permanent accounts appear on the closing trial balance to make sure that debits
equal credits.
 10. Recording Reversing Entries
A reversing journal entry is recorded on the first day of the new period for avoiding double counting the
amount when the transaction occurs in the next period.

* The primary objective of the accounting cycle in an organization is to process financial information and to
prepare financial statements at the end of the accounting period. An accounting cycle is a continuous and fixed
process that needs to be followed accordingly. Maintenance of the continuity accounting cycle is important.

Element of Financial Statements

• Assets

Resources owned by a company.

Cash – used to make purchases

Inventory – used to make product sales to customers

Supplies – used to perform basic business functions

Building – used by employees as a location from which to operate a company

“A present economic resource controlled by the entity as a result of past events. An economic resource
is a right that has the potential to produce economic benefits.”

Two parties claim the resources of the company:

• Creditors = Liability

Amounts owed to suppliers (accounts payable), workers (salaries payable), utility companies and
government (in the form of taxes)

Must be paid on a specified date.

“A present obligation of the entity to transfer an economic resource as a result of past

events. An obligation is a duty or responsibility that the entity has no practical ability to avoid.”

• Investors = Equity

Owners Claim any resources not owed to creditors

Residual.

Corporation – Stockholders’ Equity

Partnership/Sole – Capital

*Asset, liability and equity are called REAL accounts because their balances are carried from one accounting
period to the next.
Accounting Equation

Asset (resources) = Liability (creditor’s claim) + Equity (owners claim) [claim to resources]

Asset (company owns) = Liability (company owes) + Equity (difference)

Modified accounting equation

Asset (company owns) - Liability (company owes) = Equity (difference)

• Revenue/income

Amount earned from selling products or services to customers

“Income refers to increases in assets, or decreases in liabilities, that result in increases in equity, other
than those relating to contributions from holders of equity claims.”

*own more than what they owe

*profits are solely claimed by the owners of the company, the stockholders

Profit (net income) = Revenue less expenses

Revenue > Expenses, positive, net income

Revenue < Expenses, negative, net loss

*net = difference of two amounts

• Expenses

Costs of providing products and services

“Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than
those relating to distributions to holders of equity claims.

*it takes money to make money.

Dividends

Redistribution of wealth. Cash payments signifying distribution of profit

Unlike creditors, investors are not assured with regular cash payments.
The Basic Financial Statements of Business Organizations

* first important role of financial accounting is to record the relevant transactions of a company.

* Its second vital role is to communicate these business activities to those outside the company, primarily
through financial statements

Financial Statements

Periodic reports published by the company for the purpose of providing information to external users.

Provides key information for making informed decisions

Complete set (5 components)

1. Statement of Financial Position, also known as Balance sheet

2. Statement of Comprehensive Income or Income statement

3. Statement of Changes in Owner’s Equity

4. Statement of Cash Flows

5. Notes to Financial Statements

1. Statement of Financial Position, also known as Balance sheet

Presents the financial position of the company on a particular date

Summarized by accounting equation: Assets = Liabilities +Equity

Example:

*note of the time period used.

*not an interval, but a point in time

2. Statement of Comprehensive Income or Income statement

Reports the company’s revenues and expenses over an interval of time

Enough revenue to cover expenses

Revenue > Expenses, positive, net income

Revenue < Expenses, negative, net loss

Example:

*heading

Company name

Title of financial statement

Time period covered

*three major captions

Revenue

Expenses

Net income

*Income statement compares the revenues and expenses for the CURRENT period to assess the company’s
ability to earn profit from running its operations.
3. Statement of Changes in Owner’s Equity

Summarizes the changes in owner’s equity over an interval of time.

Period is same with income statement

*owner’s equity is mount invested by the owners of the business

Example:

*represents value of the company to its owners. Value creation – inside → profit, outside → investors

4. Statement of Cash Flows

Measures activities involving cash receipts and cash payments over an interval of time

Cash transactions → three categories → business activities

Operating

Revenue and expenses

Investing

Investments and productive long term assets. More than a year

Financing

Lenders → borrowing and payment money

Owners → issuing stock and paying dividends

*assess profitability →net income and operating cash flows

*information about mix of external financing. Debt and equity ratio

Example:

*inflows (positive) and outflows (negative) of cash during the period

*inflows less outflows → net activity, net cash flow for type of activity

*net cash flow of three activities = change in cash for the period.

*net cash flow of three activities plus beginning cash = should be cash balance

*explains why cash changed

5. Notes to Financial Statements

No longer discussed. For higher accounting subjects.

Relationships among the financial statements