Understanding Accounting
Financial Statements

The financial statements of the business are prepared using the balances in the General Ledger. Provided the books are updated daily, financial statements can be prepared at any time. They are generally prepared, however, at regular reporting intervals. Many businesses prefer monthly financial statements.
     The two main financial statements required are the Balance Sheet and Income Statement.

Balance Sheet

     The above example is a very simple balance sheet. Note that Assets = Liabilities + Capital. If all transactions have been recorded properly, the books will be in balance.

Income Statement

     Notice that the net income on the Income Statement matches the net income on the Balance sheet.

     Traditional Financial Statements are prepared on the basis of the
stable-dollar concept.9 Price-level adjusted statements and statements adjusted to show the current market value of a business may be created as supplementary information.
Double-Entry Accounting
Double-entry accounting means you enter the amount of a transaction twice. Why would we do that? Consider this: you purchase a computer for $5,000. While you now have $5,000 less cash, you have $5,000 more tangible assets. You simply exchanged one kind of asset for another. When you record this transaction, you will make an entry to decrease the cash account, an asset, and an entry to increase the office equipment account, another asset. This is how we keep the accounting equation in balance. The value of total assets has not changed, so this transaction has not affected the financial position of the business.
     Now consider if you take out a loan from the bank in the amount of $10,000. You will make an entry to increase the cash account, an asset, by $10,000 and an entry to increase the notes payable account, a liability, by $10,000. You have made equal increases to each side of the accounting equation, so now have greater assets and greater liabilities. This has not affected the capital account, so the financial position of the business hasn't changed yet. Let's change it.
     You use the $10,000 to pay bills for regular expenses like heat, water, electricity, salaries, and supplies. Each transaction will be a decrease in cash and a decrease in capital. You now have equal decreases to each side of the accounting equation, but more importantly, you no longer have the assets to cover the liabilities and this is reflected in the decreased capital. The net affect is to reduce the book value of the business by $10,000.
Debits and Credits

Each account in the general ledger has a debit side (left) and a credit side (right). This is not to be confused with add and subtract. When we say "to debit" an account, we don't mean add an amount to it. We mean enter the amount on the left side of the account. Debits and credits are part of keeping the Accounting Equation in balance:
Assets = Liabilities + Capital
Debits = Credits

     Hence, all asset accounts normally have a debit balance and all liability and capital accounts normally have a credit balance.

Do not confuse debits and credits with our understanding of debits and credits in relation to banking statements. On banking statements, a debit to our account is a subtraction and a credit to our account is a deposit. This is opposite of what happens in the Cash account in a Ledger.

     A transaction increasing assets, such as the purchase of a computer, is debited to an asset account, meaning it is entered on the left side of the account. Any adjustment to reduce the value of that asset—like depreciation—is made on the right side of the account, the credit side.
     A transaction increasing liabilities, such as the taking out of a loan, is credited to a liability account, meaning it is entered on the right side of the account. Any adjustment to reduce that liability—like a payment on principal—is made on the left side of the account, the debit side.
     Transactions increasing capital, such as sales, are normally credited to a capital account, meaning they are entered on the right side of the account. Transactions decreasing capital, such as expenses, are made on the left side of the account, the debit side. For these reasons, all income accounts normally have a credit balance and all expense accounts normally have a debit balance.

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9. Stable-Dollar Concept
The transactions of a business in the U.S. are recorded and reported as though the dollar were a stable unit of measure. Inflation and purchasing power are not considered in traditional accounting. If a company purchases a piece of land for $20,000 and sells it for $40,000, a $20,000 gain is recorded even though the $40,000 has the same purchasing power today as the $20,000 had when the property was purchased. return

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Copyright © 1997-2007 Kathleen A. O'Connell, ALL RIGHTS RESERVED. Last updated Dec. 27, 2007
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