From David H. Marshal and Wayne W. McManus. Accounting. What numbers mean.
From Transactions to Financial Statements
An entity's financial statements are the end product of a process that starts with transactions between the entity and other organizations and individuals. Transactions are economic interchanges between entities; for example, a sale/purchase, or a receipt of cash by a borrower and the payment of cash by a lender. The flow from transactions to financial statements can be illustrated as follows:
Current generally accepted accounting principles and auditing standards require that the financial statements of an entity show the following for the reporting period:
Financial position at the end of the period.
Earnings for the period.
Cash flows during the period.
Investments by and distributions to owners during the period.
The financial statements that satisfy these requirements are, respectively, the:
Balance sheet (or statement of financial position).
Income statement (or statement of earnings, or profit and loss statement or statement of operations).
Statement of cash flows.
Statement of changes in owners' equity (or statement of changes in capital stock and/or statement of changes in retained earnings).
In addition to the financial statements themselves, the annual report will probably include several accompanying footnotes or explanations of the accounting policies and information about many of the amounts and captions shown on the financial statements.
An alternative solution to determine net income for the year involves focusing on just the changes in owners' equity during the year, as follows:
Increase in paid-in capital from additional
investment by owners......................................................... 8
Net income.......................................................................... ?
Dividends........................................................................ —6
Change in owners' equity for the year.......................... $13
Again, solving for the unknown, net income is equal to $11. The important points to remember here are:
1. The balance sheet shows the amount of assets, liabilities, and owners' equity at a point in time.
2. The balance sheet equation must always be in balance.
3. The income statement shows net income for a period of time.
4. The retained earnings component of owners' equity changes over a period of time as a result of the firm's net income (or loss) and dividends for that period of time.
ACCOUNTING CONCEPTS AND PRINCIPLES
In order to understand the kinds of decisions and informed judgments that can be made from the financial statements, it is appropriate to have an understanding of some of the broad concepts and principles of accounting that have become generally accepted for financial accounting and reporting purposes. The termsconcepts and principles are used interchangeably here. Some of these ideas relate directly to the financial accounting concepts introduced in Chapter 1, and others relate to the broader notion of generally accepted accounting principles. Again, it is important to recognize that these concepts and principles are more like practices that have been generally agreed upon over a period of time than hard and fast rules or basic laws such as those encountered in the physical sciences.
These concepts and principles can be related to the basic model of the flow of data from transactions to financial statements illustrated earlier, as shown on page 46.
CONSEPTS/Principles Related to the Entire Model
The basic accounting equation described earlier in this chapter is the mechanical key to the entire financial accounting process because the equation must be in balance after every transaction has been recorded in the accounting records. The method for recording transactions and maintaining this balance will be illustrated in Chapter 4.
Accounting entity refers to the entity for which the financial statements are being prepared. The entity can be a proprietorship, partnership, corporation, or even a group of corporations (see Business Procedure Capsule 4—Parent and Subsidiary Corporations). The entity for which the accounting is being done is defined by the accountant, and even though the entities may be related (e.g., an individual and the business she owns), the accounting is done for the defined entity.
The going concern concept refers to the presumption that the entity will continue to operate in the future—that it is not being liquidated. This continuity assumption is necessary because the amounts shown on the balance sheet for various assets do not reflect the liquidation value of those assets.
Concepts/Principles Related to Transactions
In the United States, the dollar is the unit of measurement for all transactions. No adjustment is made for changes in the purchasing power of the dollar. No attempt is made to reflect qualitative economic factors in the measurement of transactions.
The cost principle refers to the fact that transactions are recorded at their original cost to the entity as measured in dollars. For example,