Principles of Financial Accounting: The Accounting Cycle - Preparing Financial Statements, Income Statement Statement of OwnersStockholders' Equity Balance Sheet Statement of Cash Flows

What It Is

Preparing financial statements is a crucial step in financial accounting, as it provides stakeholders with a clear picture of a company's financial performance and position. The four main financial statements are the Income Statement, Statement of Owner's/Stockholders' Equity, Balance Sheet, and Statement of Cash Flows. These statements are used to report a company's revenues, expenses, assets, liabilities, and equity over a specific period. For example, if a company generates $100,000 in sales and incurs $60,000 in cost of goods sold, its gross profit would be $40,000 ($100,000 - $60,000).

Key Concepts & Formulas

• Gross Profit: Gross profit is the difference between sales and cost of goods sold (COGS). Gross Profit = Sales – COGS. Example: If a company generates $100,000 in sales and incurs $60,000 in COGS, its gross profit would be $40,000.
• Operating Expenses: Operating expenses are expenses incurred to generate revenue. They are typically recorded on the income statement. Example: Rent expense of $5,000 is recorded on the income statement.
• Net Income: Net income is the profit earned by a company after deducting all expenses from revenue. Net Income = Revenue – Total Expenses. Example: If a company generates $100,000 in revenue and incurs $60,000 in COGS and $10,000 in operating expenses, its net income would be $30,000 ($100,000 - $60,000 - $10,000).
• Retained Earnings: Retained earnings represent the portion of net income that is retained by the company and not distributed to shareholders. Retained Earnings = Beginning Retained Earnings + Net Income - Dividends. Example: If a company has beginning retained earnings of $50,000, net income of $30,000, and dividends of $10,000, its ending retained earnings would be $70,000 ($50,000 + $30,000 - $10,000).
• Current Ratio: The current ratio is a liquidity ratio that measures a company's ability to pay its short-term debts. Current Ratio = Current Assets / Current Liabilities. Example: If a company has current assets of $100,000 and current liabilities of $50,000, its current ratio would be 2 ($100,000 / $50,000).
• Debit/Credit Rules: Debits increase asset, expense, and drawing accounts, while credits increase liability, equity, and revenue accounts. Example: If a company purchases $10,000 of inventory, it would debit Inventory and credit Cash.
• GAAP Principles: GAAP (Generally Accepted Accounting Principles) is a set of accounting standards that provide guidelines for financial reporting. GAAP requires companies to match revenues and expenses, and to provide a fair presentation of financial information. Example: GAAP requires companies to recognize revenue when earned, regardless of when cash is received.
• Matching Principle: The matching principle requires companies to match revenues and expenses in the same period. Example: If a company generates revenue in December, but incurs expenses in January, it would recognize the expenses in the same period as the revenue.
• Materiality Principle: The materiality principle requires companies to disclose information that is material to financial statement users. Example: If a company has a transaction that is significant enough to affect the financial statements, it would be disclosed in the notes to the financial statements.

Journal Entry Examples

1. Dr. Cash $10,000 Cr. Inventory $10,000

Explanation: This journal entry records the purchase of $10,000 of inventory. The cash account is debited to decrease its balance, and the inventory account is credited to increase its balance.

1. Dr. Rent Expense $5,000 Cr. Prepaid Rent $5,000

Explanation: This journal entry records the payment of $5,000 of rent. The rent expense account is debited to increase its balance, and the prepaid rent account is credited to increase its balance.

1. Dr. Dividends $10,000 Cr. Retained Earnings $10,000

Explanation: This journal entry records the declaration of $10,000 of dividends. The dividends account is debited to increase its balance, and the retained earnings account is credited to decrease its balance.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Expense accounts are debited, while revenue accounts are credited. Remember the mnemonic "ADE" (Assets, Drawings, Expenses).
2. Mistake: Failing to match revenues and expenses. Correction: The matching principle requires companies to match revenues and expenses in the same period. This ensures that financial statements provide a fair presentation of financial information.
3. Mistake: Ignoring materiality principles. Correction: Materiality principles require companies to disclose information that is significant enough to affect the financial statements. This ensures that financial statement users have access to relevant information.

Exam Tips

1. Tip: Remember that a debit increases assets AND expenses – remember "ADE" (Assets, Drawings, Expenses).
2. Tip: Be careful with reversing normal balances. For example, if a company has a normal balance of $10,000 in cash, a debit of $5,000 would decrease the balance to $5,000.
3. Tip: Make sure to match revenues and expenses in the same period. This ensures that financial statements provide a fair presentation of financial information.

Quick Practice

1. What is the adjusting entry for accrued salaries of $5,000? Answer: Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000 Explanation: This journal entry records the accrual of $5,000 of salaries. The salaries expense account is debited to increase its balance, and the salaries payable account is credited to increase its balance.

2. If a company generates $100,000 in revenue and incurs $60,000 in COGS, what is its gross profit? Answer: $40,000 Explanation: Gross profit is the difference between sales and COGS. Gross Profit = Sales – COGS.

3. If a company has beginning retained earnings of $50,000, net income of $30,000, and dividends of $10,000, what is its ending retained earnings? Answer: $70,000 Explanation: Retained earnings represent the portion of net income that is retained by the company and not distributed to shareholders. Retained Earnings = Beginning Retained Earnings + Net Income - Dividends.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. Debits increase asset, expense, and drawing accounts.
3. Credits increase liability, equity, and revenue accounts.
4. GAAP requires companies to match revenues and expenses.
5. The matching principle requires companies to match revenues and expenses in the same period.
6. The materiality principle requires companies to disclose information that is significant enough to affect the financial statements.
7. Current Ratio = Current Assets / Current Liabilities.
8. Retained Earnings = Beginning Retained Earnings + Net Income - Dividends.
9. Gross Profit = Sales – COGS.
10. Reversing normal balances can affect financial statement balances.