ENGLISH LANGUAGE IN ACCOUNTING
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Unit One
Accounting Profession
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INTRODUCTION OF ACCOUNTING. Accounting is a process of recorded, classifying,
summarizing, and interpreting of those business activities that can be in expressed in monetary
terms. A person who specializes in this field is known as an accountant.
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Accounting frequently offers the qualified person an opportunity to move ahead quickly in
today’s business world. Indeed, many of the heads of large corporations throughout the world have
advanced to their position from the accounting department. Accounting is a basic and vital element
in every modern business. It records the past growth or decline of the business. Careful analysis of
these results and trends may suggest the ways in which the business may grow in future. Expansion
or reorganization should not be planned without proper analysis of the accounting information;
and new products and the campaign to advertise and sell them should not be launched without
the help of accounting expertise.
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Accounting is one of the fastest growing professions in the modern business world. Every
new store, school, restaurant, or filling station;indeed, any new enterprise of any kind;increases
the demand for accountants. Consequently, the demand for competent accountants is generally
much greater than the supply. Government officials often have a legal background; similarly, the
men or women in management often have a background on accounting. They are usually familiar
with the methodology of finance and the fundamentals of fiscal and business administration.
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DISTINCTION BETWEEN BOOKKEEPING AND ACCOUNTING Earlier accounting
procedures were simple in comparison with modern methods. The simple bookkeeping procedures
of a hundred years ago have placed in many cases by the data-processing computer. The control of
the fiscal affairs of an organization must be as scientific as possible in order to be effective.
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In the past, a bookkeeper kept the books of accounts for an organization; the present-day accountants’
job developed from the bookkeepers’ job. Today, a sharp distinction is made between
the relatively unchanged works performed by a bookkeeper and the more sophisticated duties of
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the accountants. The bookkeeper simply enters data in financial records books; the accountant
must understand entire system of records so that he or she can analyze and interpret business
transaction. To explain the difference briefly, the accountant sets up a bookkeeping system and
interprets the data in it, whereas the bookkeeper performs the routine work of recording figures in
books. Because interpretation of the figures is such an important part of the accountant’s function,
accounting has often been described as an art.
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DIVISIONS OF ACCOUNTING The field of accounting is divided into three broad divisions:
public, private, and governmental. A certified accountant or a CPA, as the term is usually abbreviated,
must pass a series of examinations, after which he or she receives a certificate. In the United
States, the certification examinations are prepared and administered by the American Institute of
Certified Public Accountants. The various states or other major governmental jurisdictions set additional
qualifications for residence, experience, and so on. The British equivalent for a CPA is
called a charted accountant.
CPAs can offer their services to the public on an individual consultant basis for which they
receive a fee. In this respect or many others, they are similar to doctors or lawyers. Like them,
CPAs may be self-employed or partners in a firm; or they may be employed by an accounting
firm.
Many accountants worked in government offices or for nonprofit organizations. These two
areas are often joined under the term government and institutional accounting. The two are similar
because of legal restrictions in the way in which they receive and spend funds. Therefore, a legal
background is sometimes necessary for this type of accounting practice.
All branches of governments employ accountants. In addition, government-owned corporation
have accountants on their staffs. All of these accountants, like those in private industry, work
on a salary basis. They tend to become specialists in limited fields like transportation or public
utilities.
Nonprofit organizations are, of course, in business for some purpose other than making
money. They include cultural organizations like symphony orchestras or opera societies, charitable
organizations, religious groups, or corporate-owned research organizations. Although they are limited
in the manner in which they can raise and spend their funds, they usually benefit from special
provisions in the tax laws.
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Private accountants, also called executive or administrative accountants, handle the financial
records of a business. Like those who work for government or nonprofit organizations, they are
salaried rather than paid a fee. Those who work for manufacturing concerns are sometimes called
industrial accountants. Some large corporations employ hundreds of employees in their accounting
offices.
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The chief accounting officer of a company is the controller, or comptroller, as he or she is
sometimes called. Controllers are responsible for maintaining the records of the company’s operations.
On the basis of the data that have been recorded, they measure the company’s performance;
they interpret the results of the operations; and they plan and recommend future actions. This position
is very close to the top of management. Indeed, a controller is often just a step away from being
the executive officer of a corporation.
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Many people have chosen accounting as a professional because of its many advantages.
Many jobs are available, primarily because the education and training for accounting careers have
not kept pact with the demand for accounting services. Once on the job, private or governmental
accountants have security, and they are usually given the chance to move upward in the company
;sometimes, as we have noted, to the top. Salaries for people with accounting training are usually
good, even on the lower levels, and for those who rise to the top of the profession, they are correspondingly
high. Certified public accountants now enjoy professional status similar to that of doctors
or lawyers.
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The Conventions of Contemporary Accounting (1)
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Accounting conventions are concepts and rules which have been accepted in performing
bookkeeping and accounting. It came from a careful observation of accounting practice which revealed
patterns of consistent behavior.
The existence of conventions was not generally recognized by accountants until the 20th century.
They were developed to aid accountants in exercising judgment and estimation in order to
limit likely differences in recording similar events by different accountants. The principal convention
of contemporary accounting will be discussed.
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THE ENTITY CONVENTION Contemporary accounting divides the community into separate
units called “accounting entities”. For each accounting entity a self-contained, double-entry
accounting system is employed. Transactions between accounting entities are recorded in the accounts
of both entities. Each accounting entity interprets transactions from its own viewpoint. For
example, the same transaction may be recorded as a sale by one accounting entity and as a purchase
by another. Similarly, one accounting entity may record a transaction as an investment,
while the other accounting entity may record it as a capital contribution.
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In any particular case the identification of the accounting entity may be difficult. Consider,
for example, the case of a large chain of retail stores. Is the accounting entity the whole business, a
regional operation, a single store or a single department in that store? The answer can be found
only by looking at the organization of the business. If a department has its own accounting system
and records transactions with other departments, then it is an entity for accounting purpose. If it
has no records, then it is not an accounting entity. The accounting entity is, therefore, identified as
the smallest unit of activity with a self-contained accounting system.
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THE “GOING CONCERN” CONVENTION Contemporary accounting assumes the entity
will remain in operation for the foreseeable future. This assumption is known as the “going concern”
or the “continuity” convention. This assumption does not refer simply to its continued existence.
It also assumes that it will continue in the same line of business as those in which it is currently involved.
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The assumption of continuity is made in the absence of evidence to the contrary. In other
words, when it is clear that an assumption of continued existence would result in misleading financial
reports, then the assumption is not made. A major problem facing the accounting profession
is in identifying the circumstances under which the continuity assumption should be abandoned.
Sometimes company failures occur with the accounting reports continuing to be based
upon the going concern convention. These accounting reports are subsequently as misleading. And
premature abandonment of the continuity assumption by accountants may cause liquidation if it
results in demands by creditors for repayment of accounts outstanding. Authoritative guidelines
are needed in this area if continuity is to remain a basic assumption of contemporary accounting.
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THE MONETARY CONVENTION In contemporary accounting, an entity’s transactions are
recorded in the accounts in the monetary unit of the country in which it is operating. However, in
general, financial statements are presented in the currency of the country where the reports are
published.
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The use of money as the unit of account is accepted today without question, but that has not
always been the case. For example, such commodities as cattle, salt, shells, and tobacco are said to
be employed as a unit of account.
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The use of money as a unit of account does create some difficulties. In the first place, transactions
must be expressed in money before they can be recorded in the accounts. In some cases
transactions or events may not have an obvious money amount. Transactions and events of this
type are either ignored or assigned a subjective or arbitrary money amount.
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The second difficulty associated with the monetary convention is that the value of money is
not constant over time. Its purchasing power changes as a result of either inflation or deflation.
Accountants conventionally choose to ignore the changes in the purchasing power of money in the
accounts. And this will cause some deficiencies in accounting reports.
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THE CONSISTENCY CONVENTION Contemporary accounting assumes that accountants
consistently apply accounting procedures from one period to the next. As a corollary, if accounting
procedures are changed, the fact of the change and its effect on reported results are supposed to be
disclosed in the financial statements. The purpose of this convention is to allow meaningful inter-
period comparisons of results of an entity. Without consistency in accounting procedures,
management could manipulate a firm’s reported results merely by changes in accounting procedures.
Under these circumstances inter-period comparisons would have to be treated with skepticism.
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This convention differs from the others in an important respect. The others describe conventional
practices actually used by accountants. The consistency convention, however, involves prescription.
This convention is one that accountants ought to follow rather than that is necessary followed.
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The consistency convention does not mean that accounting methods cannot be changed. A
change should be made if a new procedure would result in financial statements with improved
“truth and fairness”. If a justifiable change is made, the fact and the effect of the changes should
be disclosed. The convention only requires that capricious changes in procedure which can be justified
by reference to a “true and fair” view should not be made.
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The convention does not require an inter-firm consistency in accounting procedures. Two
similar firms in the same industry may record a similar transaction in different ways and still comply
with the consistency convention. The convention applies only to the accounting practices of a
particular entity from period to period. The lack of inter-firm consistency means that analyst needs
to exercise a great deal of care in making inter-firm comparisons.
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Even, the convention does not mean that there must be an internal consistency in the use of
accounting procedures. For example, the convention does not imply that a business depreciates all
its assets on same basis or that all discounts allowed are treated as expense. Consistency would
allow, for example, that plant and equipment be depreciated on a straight-line basis and that motor
vehicles be depreciated on an accelerated basis. All that consistency implies is that the accounting
procedures for a particular type of transactions are the same from period to the next.
The Conventions of Contemporary Accounting (2)
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THE CONVENTION OF CONSERVATISM It is a characteristic of contemporary accounting
that accountants act conservatism or prudently in the measurement of profit. In general, this means
that accountants use “reasonable pessimism” in measuring revenues and expenses. Revenues are
not recorded until they are reasonably certain, but expenses are recorded as soon as they are become
probable. Similarly, when accountants have a choice of measurements of cost for assets and
liabilities, they will, other things being equal, choose the lowest for assets and the highest for liabilities.
The effect of this convention is that reported profits and net assets will be lower than under
most alternative assumptions.
There are several possible explanations for the convention of conservatism. One is that it is
the traditional role of accountants to curb the optimism of management. Accountants are seen as a
sobering influence, forcing management to assess proposals and expectations in a realistic way to
minimize errors arising from over-optimism.
A second explanation is that all conservatism is a natural reaction to uncertainly. As students
will behave conservatively and publicly choose a modest expectation of an exam result even
through they may think that they have a good chance for a high grade, accountants faced with uncertainty about futures events also behave conservatively.
A third explanation is that statements users may prefer conservatism to any alternative policy.
Given that profit measurement depends upon estimates, conservatism ensures that the actual profit
must be at least as high as the reported profit. Conservatism allows confidence in published reports.
Whatever profits and net assets may be, they will not be less than those disclosed in the
published accounts.
THE OBJECTIVITY CONVENTION Where an accountant has a choice of measurements
the most objective will be preferred, other things equal. As far as possible, an accountant will
avoid incorporating guesses or estimates in the accounting records and reports. In practical terms,
objectivity means that an accountant requires evidence of the existence and the amount of a transaction before recording in the books. For many transactions the evidence is documentary, for example, invoices, receipts, cash register type and credit notes. The documentary evidence is the
stimulus for recording transactions.
Accountants prefer objectivity for two reasons. First, it makes the accountant’s job easier.
Routine rule-following is easier than a careful examination of each transaction to determine a reasonable
amount for recording purpose. Second, reliance upon documentary evidence and generally
accepted accounting procedures provides accountants with some support if their professional
competence is questioned. It is a more convincing defense to produce evidence to support accounting
records or to argue that generally accepted procedures were used than to assert that the
entries seemed reasonable at the time.
THE MATERIALITY CONVENTION It is contemporary accounting practice to record and
report separately only those transactions which are material. An item is judged to be material if it
is important enough to influence the decisions of statement users. Some items are material because
they are large. For example, a large bad-debt write-off would usually be regarded as a material
event. Some items are material because they are small. For example, a very low inventory figure
may be judged to be material if it reflects unfavorably on a firm’s liquidity. Some items may be
material if they differ significantly in amount from the same item in earlier periods. For example, a
small bad-debt write-off may be judged material if it is twice as large as normal. Some items may
be judged to be material solely because of their nature and regardless of their relative size. For
example, the sales figure would probably be material no matter how large, how small or how
variable it was.
Materiality has two principal applications. One is in the processing and the other is in disclosure.
In recording process, accountant must decide how much detail is necessary. Are separate
ledger accounts needed for every asset or could some assets be grouped under a general heading,
for example, “plant and equipment”? In general, ledger accounts would be maintained only if they
contained material data. All not-material items would be aggregated in “sundry accounts”. In other
words, the decision of accounting system should be strongly influenced by considerations of materiality.
The second aspect of materiality relates to disclosure. Accountants use the notion of materiality
as a criterion to decide how much detail to include in financial reports. If a piece of information
is not material, then it should not be disclosed separately. For example, nowadays nearly all published
financial statements omit cents and most show dollar amounts rounded to the nearest thousand.
Any greater detail is judged to be not material.
THE ACCOUNTING PERIOD CONVENTION It is contemporary accounting practice to
measure the result of an entity’s operation over a relatively short period and to present a balance
sheet at frequent intervals.
The economic activity of a business is continuous. All transaction are recorded in the accounts
and change the picture of the firm, as revealed in financial statements. The firm changes
continuously as it carries out its operations. Changes cease only when the firm cease operations. In
this world of continuity of operations and change, accountants are required by law to report on
financial position and results at least annually. This requirement for annual reporting is a relatively
modern development. Even as late as the 19th century major businesses presented financial statements
at irregular and lengthy intervals. Annual reporting probably arose from the demands of
investors, owners, creditors and taxation authorities who were not prepared to wait until the end of
a firm’s life before the success of its operation was measured.
The accounting period convention does, however, lead to difficulties. First, it should be realized
that the shorter the reporting period the greater the need for estimates and judgment. Over a
short period, few transactions will be completed and there will be more accruals and deferrals than
for longer period. Incorporating accruals and deferrals into the accounts increase the subjectivity
of financial statements. In addition, financial reports for short periods may provide misleading
impressions of the long-run prospects for the firm. A balance sheet represents a “snapshot” of the
entity’s financial position at an instant of time. Immediately before and after the date of the balance
sheet, the financial position is different. Bye the time the balance sheet is published the financial
position of the firm may have changed dramatically. As a result, the balance sheet is out of
date the day after the end of the accounting period, and by the time it is published; it is of historical interest only.
Accounting Equation and Double Entry
The financial condition or position of a business enterprise is represented by the relationship
of assets to liabilities and capital.
Assets are properties that are owned and have monetary value; for instance, cash, inventory,
buildings, equipments.
Liabilities are amounts owned to outsiders, such as notes payable, accounts payable, bonds
payable. Liabilities may also include certain deferred items, such as income taxes to be allocated.
Capital is the interest of the owner in an enterprise. Also known as owner’s equity.
These three basic elements are connected by fundamental relationship called balance-sheet
equation, sometimes called simply the accounting equation.
This equation expresses the equality of the assets on one side with the claims of the creditors
and owners on the other side:
Assets = Liability + Capital.
According to the accounting equation, a firm is assumed to possess its assets subject to the
rights of the creditors and owners.
The equilibrium which the bookkeeping record achieves through the accounting equation is
an essential feature of double entry. The creation of assets within an enterprise is always accompanied
by the incurring of identical financial obligations, either to the properties of the enterprise
(owner’s equity) or to outside creditors (liabilities). The derivation of profit is always accompanied
by an identical increase in the net assets (i.e. assets minus liabilities) of the enterprise. It is
now possible to see how double-entry bookkeeping produces this equilibrium of results by ensuring
that the equation holds well at all times.
Examplev1:
Assume that a business owned assets $100 000, owed the creditors $80 000, and owed the
owner $20 000. The accounting equation would be:
Assets = Liabilities + Capital
$100 000 $80 000 $20 000
100 000 = 80 000 + 20 000
If over a certain period of time, the firm had a net income of $10 000, representing an increase
of net assets; the change may be reflected as increased cash, increased inventory or other
assets, or decreased liabilities. Suppose that $6 000 was used to reduce liabilities and the balance
remained in assets. The equation would then be:
Assets = Liabilities + Capital
$104 000 $74 000 $30 000
104 000 = 74 000 + 30 000
Example 2:
The selected events of January of Water Dentists’ are as following:
(1) Invest $4 000 to practice.
(2) Bought supplies for cash $300.
(3) Bought office furniture from Brown Furniture company on account $2 000.
The accounting equation after each transaction will appear as follows:
(1) Assets = Liabilities + Capital
Cash Water Capital
+ $4 000 +$4 000
(2) Assets = Liabilities + Capital
Cash Supplies Water Capital
$4 000 $4 000
- $300 + $300
$3 700 $300 $4 000
(3) Assets = Liabilities + Capital
Cash Supplies Furniture Accounts Payable Water Capital
$3 700 $300 $4 000
+$2 000 +$2 000
$3 700 $300 $2000 $2000 $4000
We shall call any business event which alters the amount of assets, liabilities, or capital a
transaction. In example 1, the net changes in asset groups were discussed; in example 2, we show
how the accountant makes a meaningful record of a series of transactions, reconciling them step
by step with the accounting equation.
However, preparing a new equation A=L+C after each transaction would be cumbersome and
costly; especially there are a great many transactions in an accounting period. Also, information
for a specific item such as cash would be lost as successive transactions were recorded. This information could be obtained by going back and summarizing the transactions, but that would be
very time-consuming.
A much more efficient way is to classify the transaction according to items on the balances
sheet and income statement. The increases and decreases are then recorded according to type of
item by means of a summary called account.
An account may be defined as a record of the increases, decreases, and balances in an individual
item of asset, liability, capital, revenue, or expense.
The simplest form of the account is known as the “T” account because it resembles the letter
“T”. The account has three parts: (1) the name of the account and the account number, (2) the
debit side (left side), and (3) the credit side (right side). The increases are entered on one side, and
the decreases on the other. The balance (the excess of the total of one side over the total of the
other) is inserted near the last figure on the side with the larger amount.
Account title
Left side or debit side Right side or credit side
When an amount is entered on the left side of an account, it is a debit, and the account is said
to be debited. When an amount is entered on the right side, it is a credit, and the account is said to
be credited. The abbreviations for debit and credit are Dr. and Cr., respectively.
Whether an increase in a given item is credited or debited depends on the category of the item.
By convention, asset and expense increases are recorded as debits while liability, capital and income
increases are recorded as credits. Assets and expense decreases are recorded as credits, while
liability, capital, income decreases are recorded as debits. The following tables summarize the
rule.
Liabilities, Capital and Income
Dr.
-
(Decreases)
Cr.
+
(Increases)
Example 3:
T&T Co. LTD bought furniture from ABC Co. on account, $2 000. In this event, the company
is receiving an asset (furniture) and therefore, debits Furniture to show the increases. They are not
paying cash but creating a new liability, thereby increasing the liability account (Accounts Payable).
An account has a debit balance when the sum of its debits exceeds the sum of its credits; it
Assets and Expenses
Dr.
+
(Increases)
Cr.
-
(Decreases)
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Furniture
Dr.
$2 000
Cr.
Accounts Payable
Dr.
Cr.
$2 000
has a credit balance when the sum of creditors is the greater. In double-entry accounting, which is
in almost universal use, there are equal debit and credit entries for every transaction. Where there
are only two accounts affected, the debit and credit amounts are equal. If more than two accounts
are affected, the total of the debit entries must equal the total of the credit entries.
Ledgers
As was mentioned earlier, an account is a record of the changes and balances in the value of
an individual item of an organization. It is understandable that an enterprise may use a member of
accounts. The complete set of accounts for a business entity is called a ledger. It is the “reference
book” of the accounting system and is used to classify and summarize transactions and to prepare
data for financial statements. It is also a valuable source of information for managerial purposes,
giving, for example, amount of sales for the period or the cash balance at the end of the period.
GENERAL LEDGER The general ledger is the book used to list all the accounts established
by an organization. It is desirable to establish a systematic method of identifying and locating each
account in the ledger. The chart of accounts, sometimes called the code of accounts, is a listing of
the accounts by title and numerical designation. In some companies, the chart of accounts may run
to hundreds of items. It serves both as an index to the ledger and a description of the accounting
system and also a link between financial statements and the ledger.
Generally, blocks of numbers are assigned to various groups of accounts. A simple chart
structure is to have the first digit represent the major group in which the account is located. Thus,
account which have numbers beginning with 1 are assets; 2, liabilities; 3, capital; 4, income; and 5,
expenses. The second or the third digit designates the position of the account in the group.
In the two-digit system, assets are assigned the block of numbers 10-19, and the liabilities
20-29. In larger firms, a three digit (or higher) system may be used, with assets assigned 100-199,
and liabilities 200-299.
Example 1:
Numerical designations for the account groups under two-digit and three-digit methods:
Account Group Two-digit Three-digit
1. Assets 10-19 100-199
2. Liabilities 20-29 200-299
3. Capital 30-39 300-399
4. Income 40-49 400-499
5. Expenses 50-59 500-599
Thus, cash may be account 11 under the first system and 101 under the second system. The
cash may be further broken down as 101, Cash-First National Bank; 102, Cash-Second National
Bank; and so on.
In designing a numbering structure for the accounts, it is important to provide adequate flexibility
to permit expansion without having to revise the basic system. There are various systems of
coding, depending on the needs and desires of the company.
SUBSIDARY LEDGER Further simplification of the general ledger is brought about by the
use of subsidiary ledger. In particular, for those businesses which sell goods on credit and which
find it necessary to maintain a separate account with each customer and eliminates the need to
make multiple entries in the general ledger.
The advantages of subsidiary ledgers are as following:
(1) Reduces ledger detail. Most of information will be in the subsidiary ledger, and the general
ledger will be reserved chiefly for summary or total figures. Therefore, it will be easier to prepare
the financial statements.
(2) Permits better division of labor. Here, each special or subsidiary will be handed by a different
person. Therefore, one person may work on the general ledger accounts while another person
may work simultaneously on the subsidiary ledger.
(3) Permits a different sequence of accounts. In the general ledger, it is desirable to have the
accounts in the same sequence as in the balance sheet and income statement. As a further said, it is
desirable to use numbers to locate and refer to the accounts. However, in connection with accounts
receivable, which involves names of customers or companies, it is preferable to have the accounts
alphabetical sequence.
(4) Permits better internal control. Better control is maintained if a person other than the person
responsible for the general ledger is responsible for the subsidiary ledger. For example, the
subsidiary accounts receivable ledger trial balance should agree with the balance of the accounts
receivable accounts in the general ledger. The general ledger account acts as a controlling account,
and the subsidiary ledger must agree with the control.
The idea of control accounts introduced above is an important one in accounting. Any group
of similar accounts may be removed from the general ledger and a controlling account substituted
for it. Not only is another level of error-protection thereby provided, but the time needed to prepare
the general ledger trial balance and the financial statements becomes further reduced.
In order to be capable of supplying information concerning the businesses’ accounts receivable,
a firm needs a separate account for each customer. These customer’s accounts are grouped
together in a subsidiary ledger known as the accounts receivable ledger. Each time the accounts
receivable (control account) is increased or decreased, a customer’s account in the accounts receivable
ledger must also be increased or decreased by the same amount.
The subsidiary ledger and control account technique may be applied similarly to transactions
with creditors and other groups of related accounts, detailed information which in not required in
the general ledger. It is particularly useful, for example, in accounting for inventories, fixed assets
or expenses and it has general application to the accounts of manufacturing enterprises and organizations
consisting of a head office and one or more branches. It enables the general ledger to
be confined to the basic information necessary for a broad understanding of operating results and
financial position of a business.
Journals
In a western accounting system, the information about each business transaction is initially
recorded in an accounting recorded called a Journal. Afterward, the data is transferred or posted to
the ledger, the book of subsequent or secondary entry. The various transactions are evidenced by
sales tickets, purchase invoices, check stubs, and so on. Since the journal is the accounting recorded
which transactions are first recorded, it is sometimes called the book of original entry. It is
also called the day book because the journal is a chronological (day-by-day) record of all business
transactions.
The information about each transaction that should be recorded includes the date of transaction,
the debit and credit figures in specific ledger accounts, and a brief explanation of the transaction.
At convenient intervals, the debit and credit amounts recorded in the journals are transferred
to the accounts in the ledger. The process of recording a transaction in a journal is called journalizing
the transaction and the one of transferring information from the journal to the ledger is called
posting and usually done monthly. The updated ledger accounts, in turn, serve as the basis for
preparing the balance sheet and other financial statements.
ADVANTAGES OF USING JOURNALS. Technically speaking, it is possible to record
transactions indirectly in the ledgers, then why bother to maintain a journal? The answer is that the
unit of organization for the journal is the transaction, whereas the unit of organization for ledger is
the account. By having both a journal and a ledger, we achieve several advantages which would
not be possible if transactions were recorded indirectly in ledger accounts.
(1) The journal shows all information about a transaction in one place and also provides an
explanation of the transaction. In a journal entry, the debits and credits for a given transaction are
recorded together, but when the transaction is recorded in the ledger, the debits and credits are entered
in different accounts. Since a ledger may contain hundreds of accounts, it would be very difficult
to locate all the facts about a particular transaction by looking in the ledger. The journal is
the record which shows the complete story of a transaction in one entry.
(2) The journal provides a chronological record of all the events in the life of a business. If
we want to look up the facts about a transaction of some months or years back, all we need is in
the date of the transaction in order to locate it in the journal.
(3) The use of a journal helps to prevent errors. If the transactions were recorded directly in
the ledger, it would be very easy to make errors such as omitting the debit or the credit, or entering
the debit twice or the credit twice. Such errors are not likely to be made in the journal, since the
offsetting debits and credits appear together for each transaction.
TYPES OF JOURNALS. Many businesses maintain several types of journal. The nature of
operation and the volume of transactions in the particular business determine the number and
types of journals needed. Journals are designed to recorded information about different transactions,
including sales, purchases, cash receipts and cash disbursements, and many others. Journal
have two or more columns to record increases or decreases in the accounts affected by the transaction,
and they often have space for the a date and an explanation of the transaction. They may be
grouped into (1) general journals and (2) specialized journals.
The simplest type of journal is called a general journal. It has only two money columns, one
for debits and the other for credits; it may be used for all the types of transaction. To illustrate
journalizing, we present the standard form of general journal as below:
General Journal
Date
(1)
Account titles and Description
(2)
P.R
(3)
Debit
(4)
Credit
(5)
19;;
Sept.
1 Cash
Accounts Receivable
Collected receivable from ABC CO.
11
13
5 500
5 500
3
Land
Cash
Purchased land for office site
17
11
150 000
150 000
We describe the entries in the general journal according to the numbering in the table above.
(1) Date. The year, month, and day of the first entry are written in the date column. The year
and month do not have to be repeated for the additional entries until a new month occurs or a new
page is needed.
(2) Description. The account title to be debited is entered on the first line, next to the date
column. The name of the account to be credited is entered on the line below and indented.
A brief explanation of the transaction is usually made on the ling below the credit. Generally,
a blank line is left between the explanation and the next entry.
(3) P.R. (Posting Reference). Nothing is entered in the column until the particular entry is
posted; that is, until the amounts are transferred to the related ledger accounts.
(4) Debit. The debit amount for each account is entered in this column. Generally, there is
only one item, but there could be two or more separate item.
(5) Credit. The amount of each account is entered in this column. Here again, there is generally
only one account, but there could be two or more accounts involved with different amounts.
SPECIAL JOURNALS. In the modern world, a business of any size enters into so many
transactions that the use of a single journal would impose intolerable restrictions on its ability to
maintain adequate records. It is, therefore, usual to break down or subdivide the journal into a
number of specialized journals, each being used to record transactions of certain kind. It is much
simpler and more efficient to group together those transactions which are repetitive such as sales,
purchases, cash receipts and cash payments and place each of them in a special journal. In particular, it is likely that all the transactions involving credit sales will be recorded in a separate
journal known as the sales journal; all transactions involving credit purchases of goods in a purchase
journal; receipts of cash in a cash receipts journal; and cash payments in a cash payments
journal. Special journal may also be maintained for other groups of transactions which occur frequently,
such as returns or allowances in respect of goods bought or sold, bills of exchange receivable
or payable journal, leaving the general journal to record only those transactions not included
elsewhere.
Example 1:
Sales on account are made during the months as follows:
On February 1 to A. Anderson for $200, on February 2 to B. Butler for $350, on February 12
to C. Chase for $125. These can be journalized in the sales journal.
Sales Journal
Date Account Debited P.R Amount
19;;
Feb.
1
2
12
A. Anderson
B. Butler
C. Chase
$ 200
350
125
Special journal have several advantages:
(1) Reduce detail recording. Each sales transaction is recorded on a single line with all details
included on that line: date, customer’s name, and amount.
(2) Reduce posting. There is only one posting made to Accounts Receivable and one posting
to Sales, regardless of the number of transactions.
(3) Permit better division of labor. If there are several journals, it makes it possible for more
than one bookkeeper to work on the books at the same time.
The Trial Balance
Since equal dollar amounts of debits and credits are entered in the accounts for every transaction
recorded, the sum of all the debits in the ledger must be equal to the sum of all the credits. If
the computation of account balances has been accurate, it follows that the total of the accounts
with debit balances must be equal to the total of the accounts with credit balances.
PREPAIRING A TRIAL BALANCE. Before using the account balances to prepare financial
statements, it is desirable to prove that the total of accounts with debit balances is in fact equal to
the total of accounts with credit balances. This proof of equality of debit and credit balances is
called a trial balance. A trial balance is a two-column schedule listing the name and balances of all
the accounts in the order in which they appear in the ledger. The debit balances are listed in the
left-hand column and the credit balances in the right-hand column. The totals of the columns
should agree. The procedure is as follows:
(1) List account titles in numerical order.
(2) Record balances of each account, entering the debit balances in the left column and the
credit balances in the right column.
(3) Add the columns and record the totals.
(4) Compare the totals.
Asset and expenses accounts are debited for increases and would normally have debit balances.
Liabilities, capital, and income accounts are credited for increases and would normally have
credit balances.
If the totals of debits and credits agree, the trial balance is in balance, indicating that debits
and credits are equal for the hundreds or thousands of transactions entered in the ledger.
Example 1:
The summary of the transactions for ABC Co. LTD and their effect on the accounts is shown
below. The trial balance is then taken.
(Omitted)
ABC Co. LTD.
Trial Balance
September 30, 19—
Dr. Cr.
Cash $ 5 800
Furniture 2 000
Accounts Payable $ 2 000
Capital 4 000
Income 2 500
Rent Expense 500
Salaries Expense 200
$ 8500 $ 8 500
USES AND LITMITATIONS OF THE TRIAL BALANCE. The trial balance provide proof
that the ledger is in balance. The agreement of the debit and credit totals of the trial balance gives
assurance that:
(1) Equal debits and credits have been recorded for all transaction.
(2) The debit and credit of each account has been correctly computed.
(3) The additional of the account balances in the trial balance has been correctly performed.
Suppose that the debit and credit totals of the trial balance do not agree. This situation indicates that one or more errors have been made. Typical of such errors are:
(1) The entering of a debit as a credit or vice versa;
(2) Arithmetical mistakes in balancing account;
(3) Clerical errors in copying account balances into the trial balance;
(4) Listing a debit balance in the credit column of the trial balance, or vice versa; and
(5) Errors in addition of the trial balance.
The preparation of a trial balance does not prove that transactions have been correctly analyzed
and recorded in the proper accounts. If, for example, the purchase of a machine was incorrectly
charged to expense, the trial balance would still balance, but theoretically the accounts
would be wrong, as Expense would overstated and Machinery understated. Also, if a transaction
were complete omitted from the ledger, the error would not be disclosed by the trial balance. In
brief, the trial balance proves only one aspect of the ledger, and that is the equality of debits and
credits.
Despite the limitations, the trial balance is a useful device. It not only provides assurance that
the ledger is in balance, but it also serves as a convenient stepping-stone for the preparation of
financial statements showing the financial position of the business, intended for distribution to
managers, owners, banker, and various outsiders. The trial balance, on the other hand, is merely a
working paper, useful to the accountant but not intended for distribution to others. The balance
sheet and other financial statements can be prepared more conveniently from the trial balance than
directly from the ledger, especially if there are a great many ledger accounts
Cash Basis and Accrual Basis of Accounting
Because an income statement pertains to a definite period of time, it becomes necessary to
determine just when an item of revenue or expenses is to be accounted for. Two systems can be
used in dealing with this problem: cash basis and accrual basis.
DISTINCTIONS BETWEEN CASH BASIS AND ACCRUAL BASIS. Under the cash basis,
revenue is recorded when received in cash and expenses are recorded in the period in which cash
payment is made. The cash basis of accounting does not give a good picture of profitability because
it fails to match revenue and related expenses and therefore does not lead to a logical measurement
of income. For example, it ignores uncollected revenue which has been earned and expenses
which have been incurred but not paid. The use of it is limited mostly to individual income
tax returns and to accounting records of physicians and other professional people.
Most business firms use the accrual basis of accounting and it will be discussed in more details.
The accrual basis differs significantly from cash basis of accounting. Under the accrual basis
it needs to record revenue in the period in which it is earned and to record expenses in the period
in which they are incurred. The effect of events on the business is recognized as service are rendered
or consumed rather than when cash is received or paid.
Essential to the accrual basis is the matching of expenses with the revenue that they helped
produce. Most revenue is earned when goods or services are delivered. At this time, title to goods
or services is transferred, and there is legal obligation created to pay for such goods and services.
Some revenue is recognized on a time basis, such as rental income, and is earned when the specified
period of time has passed. The accrual concept demands that expenses be kept in step with
revenue, so that each month sees only that month’s expense applied against the revenue for that
month. Therefore, under the accrual system, the accounts are adjusted at the end of the accounting
period to properly reflect the revenue earned and the cost and expenses applicable to period. The
entries to be made on the balance day are called adjusting entries.
ADJUSTMENTS UNDER ACCRUAL BASIS. Balance-day adjustments are of four main
kinds:
(1) Transactions which have been recorded in the books of account during the current period,
but which relate wholly or partly to subsequent accounting periods;
(2) Transactions which have occurred during the current period, but which for some reason
have not been recorded in the books of account prior to balance day;
(3) Allocations to the current period of its share of the original cost of fixed capital assets—
depreciation;
(4) Provision for anticipated revenue, costs or losses arising out of the current period’s operations,
the exact amounts of which can not be determined at balance-day.
The following examples will show how the adjusting entries are made for the four types of
adjustments.
Example 1: Prepaid Expenses
Assume that a business paid a $1 200 premium on April 1 for one year’s assurance in advance.
This represents an increase in one asset (prepaid expense) and a decrease in another asset
(cash). Thus, the entry would be:
Dr. Prepaid Insurance $ 1 200
Cr. Cash $ 1 200
At the end of April, 1/12 of the $1 200 or $100 had expired or been used up. Therefore, an
adjustment has to be made, decreasing or crediting Prepaid Insurance and Increasing or debiting
Insurance Expense. The entry would be:
Dr. Insurance Expense $ 100
Cr. Prepaid Insurance $100
Example 2: Accrued Salaries
Assume that April 30 falls on the Tuesday for the last weekly payroll period. Then, two days
of that week will apply to April, three days to May. The payroll for the week amounted to $2 500,
of which $1 000 applied to April and $1 500 to May. The entries would be as follows:
April 30 Dr. Salaries Expense $ 1 000
Cr. Salaries Payable $ 1 000
When the payment of the payroll is made, say, on May 3, the entry would be as follows:
May 3. Dr. Salaries Expense $ 1 500
Salaries Payable $ 1 000
Cr. Cash $ 2 500
As can be seen above, $1 000 was charged to expense in April and $1 500 in May. The debit
to Salaries Payable of $1 000 in May is merely canceled the credit entry made in April, when the
liability was set up for the April salaries expense.
Example 3: Accumulated Depreciation
This is a valuation of offset account, which means that the balance is offset against the related
asset account. In the case of property, plant and equipment, it is desirable to know the original cost
as well as the value after depreciation. Assume the machinery costing $15 000 was purchased on
February 1 of the current year and was expected to 10 years. With the straight-line method of accounting,
the depreciation would be $1 500 a year, or $125 a month. The adjusting entry would be
as follows:
ENGLISH LANGUAGE IN ACCOUNTING
Page 31 of 122
Dr. Depreciation Expense $ 125
Cr. Accumulated Depreciation $ 125
At the end of April, Accumulated Depreciation would have a balance of $375, representing
three months’ accumulated depreciation. The account would be shown in the balance sheet as follows:
Machinery $ 15 000
Less: Accumulated Depreciation 375 $ 14 625
Example 4: Allowance for Uncollected Accounts
A business with many accounts receivables will reasonably expect to have losses from uncollectible
accounts. It will be not known which specific accounts will not be collect, but past experience
furnishes an estimate of the total uncollectible amount.
Assume that a business estimates that 1 percent of sales on account will be uncollectible.
Then, if such sales $10 000 for April, it is estimated that $100 will be uncollectible. The actual
loss may not definitely be determined for a year or more, but the loss attributed to April sales
would call for an adjusting entry.
Dr. Uncollectible Accounts expense $ 100
Cr. Allowance for Uncollectible Accounts $ 100
If the balance in Accounts Receivable at April 30 was $9 500 and the previous month’s balance
in Allowance for Uncollectible Accounts was $300, the balance sheet at April 30 would show
the following:
Accounts Receivable $ 9 500
Less: Allowance for Uncollectible Accounts 400 $ 9 100
Balance Sheet
NATURE AND PURPOSE OF BALANCE SHEET. The balance sheet is one of the basic financial
statements. Financial statements are the main source of financial information for persons
outside the business organization and also useful to management. These statements are very concise,
summarizing in three or four pages the activities of a business for a specified period of time,
such as a month or a year. They show the financial position of the business at the end of the time
period and also the operating result by which the business arrived at this financial position.
The basic purpose of financial statements is to assist decision maker in evaluating the financial
strength, profitability, and future prospects of a business. Thus, managers, investors, major
customers, and labor all have a direct interest in these reports. Every large corporation prepares
annual financial statements which are distributed to all owners of the business. In addition, these
statements are filed with various government agencies and become a matter public record.
The balance sheet is a financial statement which shows the financial position of a business
entity by summarizing the assets, liabilities, and owners’ equity at a specific date. This statement is
also called a Statement of Financial Position or Statement of Financial Condition.
Every business prepares a balance sheet at the end of year, and most companies prepare one
at the end of each month. A balance sheet consists of a listing of the assets and liabilities of a
business and of the owners’ equity. In preparing the balance sheet, it is not necessary to make any
further analyze of the data. The needed data—that is, the balances of the assets, liabilities, and
capital accounts—are already available.
formAT OF BALANCE SHEET. The balance sheet may be arranged in either account form
or report form.
In the account form, the assets are listed on the left side of the page and liabilities and owners’
equity on the right side. And in the report form, the liabilities and owners’ equity sections are
listed below rather than to the right of the assets section. Both the account form and the report
form are widely used. The following balance sheets illustrate the difference.
ABC Co. LTD.
Balance Sheet
December 31, 19—
Assets
Cash••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$20 500
Accounts Receivable•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••65 000
Supplies ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••1 500
Land •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••68 000
Buildings ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••133 500
Cleaning Equipment •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••39 000
Delivery Equipment••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••22 500
Total assets $350 000
Liabilities $ Owners’ Equity
Liabilities:
Notes Payable ••••••••••••••••••••••••••••••••••••••••••••• $26 000
Accounts Payable•••••••••••••••••••••••••••••••••••••••••• 36 000
Income Taxes Payable••••••••••••••••••••••••••••••••••• 18 000 $80 000
Owners’ Equity:
Capital Stock••••••••••••••••••••••••••••••••••••••••••••• $225 000
Retained Earnings••••••••••••••••••••••••••••••••••••••••• 45 000 270 000
Total Liabilities & Owners’ Equity $350 000
ABC Co. LTD.
Balance Sheet
December 31, 19—
Assets Liabilities & Owners’ Equity
Cash $20 500 Liabilities:
Accounts Receivable 65 000 Notes Payable $26 000
Supplies 1 500 Accounts Payable 36 000
Land 68 000 Income Taxes Payable 18 000 $80 000
Buildings 133 500 Owners’ Equity
Cleaning Equipment 39 000 Capital Stock $225 000
Delivery Equipment 22 500 Retained Earnings 45 000 270 000
Total $350 000 Total $350 000
Note that the balance sheet sets forth in its heading three items: (1) the name of the business,
(2) the name of the financial statement “Balance Sheet”, and (3) the date of the balance sheet. Below
the heading is the body of the balance sheet, which consists of three distinct sections: assets,
liabilities, and owners’ equity.
Another point to note about the form of a balance sheet is that cash is always the first asset
listed; it is followed by receivables, supplies and any other assets that will soon be converted into
cash or consumed in operations. Following these items are the more permanent assets, such as
land, buildings, and equipment. The liabilities of a business are always listed before the owners’
equity.
CLASSIFIED BALANCE SHEET. The balance sheet becomes a more useful statement for
comparison and financial analysis if the assets and liabilities groups are classified. For example,
an important index of the financial state of business, derivable from the classified balance sheet, is
the ratio of current assets to current liabilities. This current ratio ought, generally, to be at least 2 to
1; that is, current assets should be twice current liabilities. For our purpose, we will designate the
following classifications:
ASSETS LIABILITIES
Current Current
Fixed Long-term
Other
Current Assets. Assets reasonably expected to be converted into cash or used in the current
operation of the business. (The current period is generally as one year.) Example are cash, notes
receivable, accounts receivable, inventory, and prepaid expenses (prepaid insurance, prepaid rent,
and so on).
Fixed Assets. Long-lived assets used in the production of goods or services. These assets,
sometimes called non-current assets or plant assets, are used in the operation of the business rather
than being held for sale.
Other Assets. Various assets other than current assets, fixed assets, or assets to which specific
captions are given. For instance, the caption “Investments” would be used if significant sums were
invested. Often, companies show a caption for intangible assets such as patents or goodwill. In
other cases, there may be a caption for deferred charges. If, however, the amounts are not large in
relation to total assets, the various items may be grouped under one caption, “Other Assets”.
Current Liabilities. Debts which must be satisfied from current assets within next operation
period, usually one year. Examples are accounts payable, notes payable, the current portion of
long-term debt, and various accrued items as salaries payable and taxes payable.
Long-term Liabilities. Liabilities which are payable beyond the next year. The most common
examples are bonds payable and mortgages payable. The example on next page shows a classified
balance sheet of typical form.
ABC Co. LTD.
Classified Balance Sheet
December 31, 19—
Assets
Current Assets
Cash $20 500
Accounts Receivable 65 000
Supplies 1 500
Total Current Assets $87 000
Fixed Assets
Land $68 000
Buildings 133 500
Cleaning Equipment 39 000
Delivery Equipment 22 500
Total Fixed Assets 263 000
Total assets $350 000
Liabilities $ Owners’ Equity
Current Liabilities
Notes Payable $26 000
Accounts Payable 36 000
Income Taxes Payable 18 000
Total Current Liabilities $80 000
Long-term Liabilities 0
Total Liabilities $80 000
Owner’s Equity
Capital Stock $225 000
Retained Earnings 45 000
Total Owners’ Equity 270 000
Total Liabilities & Owners’ Equity $350 000
Income Statement
NATURE AND PURPOSE OF INCOME STATEMENT. An income statement is a financial
statement showing the results of operations for a business by matching revenue and related expenses
for a particular accounting period. It shows the net income or net loss.
When we measure the net income earned by a business we are measuring its economic performance—
its success or failure as a business enterprise. Stockholders, prospective investors,
managers, bankers, and other creditors are anxious to see the latest available income statement and
thereby to judge how well the company is doing.
Alternative titles for the Income Statement include Earnings Statement, Statement of Operations,
and Profit and Loss Statement. However, income statement is by far the most popular term
for this important financial statement. In brief, we can say that an income statement is used to
summarize the operating results of a business by matching the revenue earned during a given time
period with the expenses incurred in obtaining that revenue.
Every business prepares an annual income statement, and most businesses prepare quarterly
and monthly income statements as well. The period of time covered by an income statement is
termed the company’s accounting period. This period may be a month, a quarter of a year, a year,
or any other specified period of time. A 12-month accounting period used by an entity is called its
fiscal year.
The fiscal year used by most companies coincides with the calendar year and ends on December
31. However, some businesses select to use a fiscal year which ends on some other date. It
may be convenient for the business to end its fiscal year during a slack season rather than during a
time of peak business activity. The fiscal year of some governments, for example, begins on October
1 and ends 12 months later on September 30.
There are town common forms of income statement: the multiple-step income statement and
the single-step income statement.
MULTIPLE-STEP INCOME STATEMENT. The multiple-step income statement is so named
because of the series of steps in which costs and expenses are deducted from revenue. As a first
step, the cost of goods sold is subtracted from net sales to produce an amount for gross profit on
sales. As a second step, operating expenses are deducted to obtain a subtotal term income from
operations (or operating income). As a final step, income tax expenses are subtracted to determine
net income. The multiple-step income statement is noted for its numerous sections and significant
subtotals. It is widely used by small businesses, and the official format of income statement in
china is a multiple-step one. The following is a multiple-step income statement. It is also a classified
income statement because the various items of expense are classified into significant groups.
XYZ TRADERS
Income Statement
For the year ended December 31, 19—
Revenue:
Sales ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• $ 506 000
Less: Sales returns and allowances ••••••••••••••••••••••••••••••••••••••••••••••••••••••• $ 4 000
Sales discounts••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••2 000 6 000
Net sales ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• $ 500 000
Cost of goods sold:
Inventory, Jan. 1•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• $ 60 000
Purchases••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$ 300 000
Less: Purchases returns & allowances•••••••••••••••••• $2 000
Purchases discounts ••••••••••••••••••••••••••••••••••••••• 1 000 3 000
Net purchases••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$ 297 000
Add: Transportation-in••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••13 000
Cost of goods purchased ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 310 000
Cost of goods available for sale •••••••••••••••••••••••••••••••••••••••••••••••••••••••• $370 000
Less: Inventory, Dec. 31 ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 70 000
Cost of goods sold•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••300 000
Gross profit on sales: ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$200 000
Operating expenses:
Selling expense:
Sales salaries•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$76 000
Delivery service ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••4 000
Adverting••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••16 000
Depreciation••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••9 000
Total selling expense••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• $105 000
General & administrative expenses:
Office salaries •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$60 000
Telephone••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••2 000
Depreciation••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••8 000
Total general & administrative expenses ••••••••••••••••••••••••••••••••••••••• 70 000
Total operating expenses•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••175 000
Income from operations••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$25 000
Income tax expenses•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••5 000
Net income •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$20 000
The classified income statement enables management, stockholders, analysts, ant others to
study the changes in the expenses over successive periods. The items of an income statement may
be classified as the following four groups.
(1) Revenue. This includes gross income from the sales of products or services. It may be
designated a Sales, Incomes from Fees, and so on, to indicate gross income. The gross amount is
reduced by sales returns and allowances and sales discounts to arrive at net sales.
(2) Cost of goods sold. This includes the costs related to the products or services sold. It
would be relatively simple to compute for a firm that retails goods; it would be more complex for
a manufacturing firm that changes raw materials into finished products.
(3) Operating expenses. This includes all expenses or resources consumed in obtaining revenue.
Operating expenses are further divided into two groups. Selling expenses are those related to
the promotion and sales of the company’s product or service. General and administrative expenses
are those related to overall activities of the business, such as the salaries of the president and other
officers.
(4) Other expenses. This includes non-operating and incidental expenses. Income taxes is
shown an non-operating expense because they don’t help to produce operating revenue (sales).
Those expenses appear in the final section of the income statement after the figure of showing income
from operations.
SINGLE-STEP INCOME STATEMENT. The income statements prepared by large corporations
for distribution to thousands of stockholders often are greatly condensed because public presumably
is more interested in a concise report than in the details of operations. The single-step
form of income statement takes its name from the fact that the total of all expenses (including the
cost of goods sold) is deducted from total revenue in a single step. All types of revenue, such as
sales, interest earned, and rent revenue, are added together to show the total revenue. Then all expenses
are grouped together and deducted in one step without the use of subtotals. A condensed
income statement in single-step from is shown below.
B&B CORPORATION
Income Statement
For the year ended December 31, 19—
Revenue:
Net sales ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• $90 000 000
Interest earned ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••1 800 000
Total revenue ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$91 800 000
Expenses:
Cost of goods sold •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• $60 000 000
Selling expenses ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 14 400 000
General administrative expenses••••••••••••••••••••••••••••••••••••••••••••••••••••• 9 750 000
Income taxes expense ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 3 150 000
Total expenses•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••87 300 000
Net income •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$4 500 000
Use of the single-step income statement has increased in recent years, perhaps because it is
relatively simple and easy to read. A disadvantage of this format is that useful concepts such as the
gross profit on sales are not readily apparent.
Statement of Changes in Financial Position and Cash Flow Statement
STATEMENT OF CHANGES IN FINANCIAL POSITION. Statement of changes in financial
position is a financial statement showing the sources and uses of working capital during the
accounting period. In addition, this statement shows financing and investing activities, such as
exchange transactions, which do not directly affect working capital.
A statement of changes in financial position helps us to understand how and why the financial
position of a business has changed during the period. This statement summarizes the long-term
financing and investing activities of the business; it shows where the financial resources (funds)
have come from and where they have gone. With the understanding of how the funds have flowed
into the business and how these funds have been used, we can begin to answer such important
questions as: Do the normal operations of the business generate sufficient funds to enable the
company to pay regular dividends? Has the company been forced to borrow to pay for new plant
assets, or has it been able to generate the funds from the current operation? Is the business becoming
more solvent or less solvent? Perhaps the most puzzling question is: How can a profitable
business be running low on cash and working capital? Even though a business operates profitably,
its working capital may be decline and the business may even become insolvent.
The statement of changes in financial position gives us answer to these questions, because it
shows in detail the amount of funds received from each source and the amount of funds used for
each purpose throughout the year. In fact, this financial statement used to be called a statement of
sources and applications of funds. Many people still call it simply a funds statement.
“Funds” here are defined as working capital—the excess of current assets over current liabilities.
If the amount of working capital increased during a given fiscal period, this means that more
working capital was generated than was used for various business purposes; if a decrease in
working capital occurred, the reverse is true. One of the key purposes of the statement of changes
in financial position is to explain fully the increase or decrease in working capital during a fiscal
period. This is done by showing where working capital originated and how it is used.
Any transaction that increases the amount of working capital is a source of working capital.
The principal sources of working capital include:
(1) Net sources of funds provided by current operations—the inflow of funds from sales exceeds
the outflow of funds to cover the cost of merchandise purchases and expenses of doing
business.
(2) Sales of noncurrent assets. A business may obtain working capital by selling noncurrent
assets, such as plant and equipment or long-term investments, in exchange for current assets.
(3) Long-term borrowing. Long-term borrowing such as issuing bonds payable, results in an
increase in current assets, thereby increasing working capital.
(4) Sales of additional shares of stock. The sale of capital stock results in an inflow of current
assets, thereby increasing working capital.
The uses of working capital mainly include:
(1) Declaration of cash dividends. The declaration of a cash dividend results in a current liability
(dividend payable) and is therefore a use of funds.
(2) Purchase of noncurrent assets. Purchases of noncurrent assets, such as plant and equipment,
reduce the current assets or increase current liabilities, in either case, working capital is reduced.
(3) Repayment of long-term debt. Working capital is decreased when current assets are used
to repay long-term debts.
(4) Repurchase of outstanding stock. When cash is paid out to repurchase outstanding shares
of stock, working capital is reduced.
The example below shows a simple statement of changes in financial position, saving the
process of preparation.
AAA COMPANY
Statement of Changes in Financial Position
For Month of May
Sources of working capital:
Operations (net income)••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$7 500
Additional investment by owner •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••20 000
Total sources of working capital •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$27 500
Uses of working capital:
Purchase of land•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• $47 000
Withdrawal by owner•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 2 000
Total uses of working capital ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••49 000
Decrease in working capital••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$21 500
CASH FLOW STATEMENT. A statement of changes in financial position is designed to provide
stockholders and other outsiders with an overview of the company’s liquid resources. Managers,
however, are often more concerned with have enough cash available to meet the company’s
maturing liabilities. To help managers plan and control cash balances, most companies prepare
cash flow statements. These statements explain the changes in the company’s cash balance by
summarizing the cash receipts and cash disbursements occurring over the accounting period.
Cash flow statements often are prepared monthly as well as annually. In addition, many
companies prepare projected cash flow statements (called cash budgets or cash forecasts) which
forecast the cash receipts and cash disbursements of future accounting periods. These forecasts
enable managers to plan the company’s borrowing and investment activities so as to avoid cash
shortages or excessively high cash balances.
Cash flow statements did not appear in the annual report to stockholders and other outsiders
until recently; they are prepared only for internal use by management. However, banks often insist
that a company applying for a loan include both a cash flow statement and a cash forecast with the
loan application.
We will get a general idea of the forecast of the cash flow statement by looking at the following
example.
AAA COMPANY
Cash Flow Statement
For the year ended December 31, 19—
Cash receipts:
Cash generated from operations••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$50 000
Sales of land •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••70 000
Sales of capital stock•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••65 000
Total cash receipts•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$185 000
Cash payments:
Purchase of equipment•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• $90 000
Retirement of bonds payable••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 75 000
Withdrawal by owner•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• 40 000
Total cash payments••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••205 000
Decrease in cash during the year•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••$20 000