Financial Accounting

Accounting is the system a business uses to identify, record, summarize, and report its economic activity in money terms. It is often called the language of business because it turns the messy reality of a company - sales, purchases, loans, wages - into a small set of standardized reports that anyone can read. The central purpose is simple to state: to give useful information to people who make decisions about the business.

Two branches

Accounting splits into two branches aimed at different audiences. Financial accounting, the subject of this course, produces general-purpose reports for people outside the company - investors, lenders, suppliers, and regulators. Because outsiders cannot see inside the business, these reports follow shared rules (in the United States, Generally Accepted Accounting Principles, or GAAP) so that one company's numbers can be trusted and compared with another's. Managerial accounting, by contrast, produces detailed internal reports for managers and follows no fixed external rulebook.

Who uses the statements, and why

• Investors and owners want to know whether the business is profitable and worth investing in.
• Lenders and suppliers want to know whether the business can pay what it owes.
• Managers use the numbers to run the business and plan ahead.
• Governments and regulators use them to assess taxes and enforce rules.

To keep the information reliable, accountants follow a few bedrock ideas. The business entity assumption says the business is a separate "person" from its owner, so the owner's personal groceries never appear in the company's books. The monetary unit assumption says we record only things we can measure in money. The going concern assumption says we assume the business will keep operating, which is why we can spread the cost of a machine over the years it will be used. And the cost principle says assets are first recorded at what we actually paid, not at a hopeful market value.

Finally, most businesses use accrual accounting: revenue is recorded when it is earned and expenses when they are incurred, regardless of when cash changes hands. That is different from cash-basis accounting, which records only when cash moves. Accrual accounting gives a truer picture of performance, and it is the approach this whole course uses.

Everything in financial accounting rests on one short formula, the accounting equation:

Assets = Liabilities + Equity

Assets are the economic resources a business owns or controls that are expected to bring future benefit: cash, equipment, inventory, and amounts customers owe it. Liabilities are what the business owes to others: loans, unpaid bills, wages owed. Equity (also called owners' equity or stockholders' equity) is the owners' claim on what is left after the debts are covered. Rearranged, equity is simply Assets minus Liabilities - the "net worth" of the business.

Why it always balances

The equation is not a lucky coincidence; it is true by design. Everything a business owns had to be financed by someone. Every dollar of assets was supplied either by a lender (a liability) or by the owners (equity). So the left side, which lists the resources, must always equal the right side, which lists the claims on those resources. This balance is the reason the system is called double-entry bookkeeping: every transaction touches at least two accounts so the equation stays level.

A worked example

Watch the equation stay balanced through the first few events of a lawn-care company, Maple Lawn Care, Inc.

Event	Assets	=	Liabilities	+	Equity
Owner invests $20,000 cash	+20,000 cash	=	0	+	+20,000 stock
Buy equipment for $9,000 cash	-9,000 cash, +9,000 equip	=	0	+	0
Buy $1,200 supplies on account	+1,200 supplies	=	+1,200 payable	+	0
Borrow $5,000 from the bank	+5,000 cash	=	+5,000 note	+	0

After these four events, total assets are 20,000 - 9,000 + 9,000 + 1,200 + 5,000 = 26,200. Total liabilities are 1,200 + 5,000 = 6,200 and equity is 20,000. Check the equation: 26,200 = 6,200 + 20,000. It balances, and it will balance after every transaction for the rest of the course.

Two things quietly grow equity and two things shrink it. Equity rises when owners invest and when the business earns revenue (income from doing business). Equity falls when the business pays expenses (the costs of earning that revenue) and when it pays dividends (cash returned to owners). Hold on to that idea; it is the bridge from the equation to the income statement in Module 4.

We cannot lump every transaction into one giant pile of "money," so accountants use accounts. An account is a running record of all the increases and decreases to one specific item, such as Cash, or Wages Expense, or Accounts Payable. Think of each account as its own labeled folder. Every account belongs to one of five types, and those five map directly onto the accounting equation.

Type	What it is	Examples
Assets	Resources owned	Cash, Accounts Receivable, Supplies, Equipment
Liabilities	Amounts owed	Accounts Payable, Notes Payable, Wages Payable
Equity	Owners' claims	Common Stock, Retained Earnings, Dividends
Revenue	Earnings from operations	Service Revenue, Sales Revenue
Expenses	Costs of earning revenue	Wages Expense, Rent Expense, Supplies Expense

The first three types (assets, liabilities, equity) are permanent accounts: their balances carry from one year to the next, and they appear on the balance sheet. Revenue and expense accounts are temporary accounts: they collect activity for one period, feed the income statement, and then are reset to zero to start the next period. Revenues and expenses are really sub-categories of equity, because earning revenue grows equity and paying expenses shrinks it.

The chart of accounts

A chart of accounts is simply the organized master list of every account the business uses, usually with a number assigned to each. A common convention groups accounts by their first digit: 1 for assets, 2 for liabilities, 3 for equity, 4 for revenue, and 5 (and up) for expenses. A small company's chart might read:

• 101 Cash, 105 Accounts Receivable, 110 Supplies, 150 Equipment
• 201 Accounts Payable, 210 Notes Payable
• 301 Common Stock, 320 Retained Earnings, 330 Dividends
• 401 Service Revenue
• 501 Wages Expense, 505 Rent Expense, 510 Supplies Expense, 515 Depreciation Expense

The numbering is not accounting theory - it is just a filing system that keeps related accounts together and leaves gaps so new accounts can be slotted in later. Every entry you record for the rest of the course will name accounts drawn from a chart like this one.

Now we meet the two words that scare newcomers and shouldn't: debit and credit. Forget their everyday meanings. In accounting they are just directions: debit means the left side of an account, and credit means the right side. That is the whole definition. Whether a debit is "good" or "bad" depends only on the account type. Accountants often write debit as Dr and credit as Cr.

Picture each account as a T-account: a big letter T with the account name on top, debits on the left, credits on the right.

Cash
Debit (left)	Credit (right)
increases go here	decreases go here

The rules of increase and decrease

Each type of account has a normal balance - the side on which increases are recorded. Here is the entire rulebook, and it follows straight from the accounting equation. Accounts on the left of the equation (assets) increase with debits; accounts on the right (liabilities and equity) increase with credits.

Account type	Increase with a...	Decrease with a...	Normal balance
Asset	Debit	Credit	Debit
Expense	Debit	Credit	Debit
Dividends	Debit	Credit	Debit
Liability	Credit	Debit	Credit
Equity (stock, retained earnings)	Credit	Debit	Credit
Revenue	Credit	Debit	Credit

A memory aid many students use is DEA-LER: Dividends, Expenses, and Assets have normal debit balances; Liabilities, Equity, and Revenue have normal credit balances. Notice the pattern: expenses and dividends behave like assets (debit to increase) because both ultimately reduce what the owners keep, while revenue behaves like equity (credit to increase) because it builds the owners' claim.

The golden rule

In every transaction, total debits must equal total credits. That is what keeps the accounting equation balanced. If you record a $500 debit somewhere, you must record $500 of credits somewhere else - to one account or split across several. When your debits and credits do not match, you know at once that something is wrong. Suppose the business receives $7,500 cash for services: you debit Cash $7,500 (an asset increasing) and credit Service Revenue $7,500 (revenue increasing). Debits equal credits, and the books stay in balance.

A journal entry is the formal, dated record of a single transaction, written the moment it happens. The book of original entry where these are first written is called the journal, and recording an entry is called journalizing. Every entry follows the same tidy format: the account debited is written first and flush left, the account credited is written second and indented, and the debit column total equals the credit column total.

A three-step method

1. Identify the accounts the transaction touches, and their type.
2. Decide the direction - is each account increasing or decreasing?
3. Apply the debit/credit rules and confirm debits equal credits.

Let us journalize the first several transactions of Maple Lawn Care, Inc. These are the same events we will carry through the ledger, trial balance, and statements in the modules ahead, so it is worth reading each one slowly.

#	Transaction	Entry (Dr / Cr)	Amount
1	Owner invests cash for stock	Dr Cash Cr Common Stock	20,000 20,000
2	Buy equipment for cash	Dr Equipment Cr Cash	9,000 9,000
3	Buy supplies on account	Dr Supplies Cr Accounts Payable	1,200 1,200
4	Borrow cash on a note	Dr Cash Cr Notes Payable	5,000 5,000
5	Perform services for cash	Dr Cash Cr Service Revenue	7,500 7,500
6	Perform services on account	Dr Accounts Receivable Cr Service Revenue	2,500 2,500
7	Pay wages in cash	Dr Wages Expense Cr Cash	3,000 3,000
8	Pay rent in cash	Dr Rent Expense Cr Cash	1,000 1,000
9	Pay part of accounts payable	Dr Accounts Payable Cr Cash	800 800
10	Collect part of receivable	Dr Cash Cr Accounts Receivable	1,500 1,500
11	Pay a cash dividend	Dr Dividends Cr Cash	500 500

Walk through entry 5 to see the method: the business earned money, so Cash (asset) goes up - a debit - and Service Revenue (revenue) goes up - a credit. Both are 7,500, so the entry balances. Entry 7 is the mirror image on the cost side: Wages Expense goes up (debit) and Cash goes down (credit).

Compound entries

An entry with more than one debit or more than one credit is called a compound entry; it still must balance overall. Suppose instead of entry 3 the company had bought $1,000 of supplies by paying $200 cash now and putting $800 on account. The compound entry would be: Dr Supplies 1,000; Cr Cash 200; Cr Accounts Payable 800. The single debit of 1,000 equals the two credits of 200 plus 800. As long as total debits equal total credits, an entry can touch as many accounts as the transaction requires.

The journal records transactions in the order they happen, but to know how much cash you have you need all the cash activity gathered in one place. That gathering happens in the general ledger: the complete set of every account, each holding all the debits and credits that have been posted to it from the journal. Journalizing captures a transaction; posting copies each debit and credit into the right ledger account.

Finding an account balance

An account's balance is the difference between its total debits and total credits, sitting on whichever side is larger. Take Maple Lawn Care's Cash account after all eleven transactions from the last lesson. Cash was debited by transactions 1, 4, 5, and 10 and credited by 2, 7, 8, 9, and 11.

Cash (ledger)
Debits	Credits
20,000 · 5,000 · 7,500 · 1,500	9,000 · 3,000 · 1,000 · 800 · 500
Total 34,000	Total 14,300
Balance = 34,000 - 14,300 = 19,700 debit

The trial balance

Once every account has a balance, we prove the books with a trial balance: a two-column list of every account and its balance, with debit balances in one column and credit balances in the other. If the bookkeeping obeyed the rule that debits equal credits, the two columns must total to the same number. Here is Maple Lawn Care's trial balance before month-end adjustments (an unadjusted trial balance):

Account	Debit	Credit
Cash	19,700
Accounts Receivable	1,000
Supplies	1,200
Equipment	9,000
Accounts Payable		400
Notes Payable		5,000
Common Stock		20,000
Dividends	500
Service Revenue		10,000
Wages Expense	3,000
Rent Expense	1,000
Totals	35,400	35,400

Both columns total 35,400, so the trial balance balances. Be careful, though: a balanced trial balance proves only that debits equal credits. It does not prove the books are correct. If you posted a transaction to the wrong account, or forgot an entry entirely, or recorded the right amount twice, the columns can still match. The trial balance is a useful checkpoint, not a certificate of accuracy.

Under accrual accounting, some economic activity does not arrive with a tidy transaction to record. Supplies get used up a little each day. Equipment wears out slowly. Wages build up before payday. To make the accounts tell the truth at period-end, accountants record adjusting entries: entries made on the last day of the period to bring each account to its correct balance and to match revenues with the expenses that helped earn them (the matching principle). Every adjusting entry changes at least one income-statement account and one balance-sheet account, and none of them involves cash.

Adjustment 1: supplies used

Maple Lawn Care bought $1,200 of supplies (entry 3). A count at month-end shows $400 of supplies still on hand, so 1,200 - 400 = 800 worth were used up and have become an expense. The adjusting entry moves that 800 out of the asset and into an expense:

Account	Debit	Credit
Supplies Expense	800
Supplies		800

After this entry the Supplies asset is 400 (what remains) and Supplies Expense is 800 (what was consumed).

Adjustment 2: depreciation

The $9,000 of equipment will serve for years, so its cost is spread over its useful life through depreciation. Say the monthly depreciation is $150. We do not credit the Equipment account directly; instead we credit a special account called Accumulated Depreciation, a contra-asset that is subtracted from the equipment's cost on the balance sheet:

Account	Debit	Credit
Depreciation Expense	150
Accumulated Depreciation		150

The equipment still shows its original $9,000 cost, but its book value (or carrying value) is now 9,000 - 150 = 8,850.

Two more common adjustments

• Accrued expenses are costs incurred but not yet paid or recorded, such as wages earned by employees in the last days of the month. The adjustment debits an expense and credits a payable (for example, Dr Wages Expense, Cr Wages Payable).
• Unearned revenue is cash collected before the work is done, which starts life as a liability because you owe the customer service. As you deliver, you move it into revenue (Dr Unearned Revenue, Cr Service Revenue).

After all adjustments are posted, a new adjusted trial balance is prepared, and its balances are the ones used to build the financial statements. For Maple Lawn Care, the two adjustments above raise total expenses by 800 + 150 = 950, which we will see flow straight into the income statement next.

The income statement (also called the profit-and-loss statement) reports a company's financial performance over a period of time - a month, quarter, or year. Its logic is one subtraction: Revenues minus Expenses equals Net Income. When revenues exceed expenses the result is net income (a profit); when expenses exceed revenues it is a net loss. Because it covers a span of time, its heading always names a period, such as "For the Month Ended June 30."

Maple Lawn Care's income statement

Using the adjusted balances - Service Revenue of $10,000 and the four expenses, including the $800 supplies and $150 depreciation adjustments from the last lesson - here is the finished statement:

Maple Lawn Care, Inc. - Income Statement For the Month Ended June 30
Service revenue	$10,000
Expenses:
Wages expense	3,000
Rent expense	1,000
Supplies expense	800
Depreciation expense	150
Total expenses	4,950
Net income	$5,050

The arithmetic: total expenses are 3,000 + 1,000 + 800 + 150 = 4,950, and net income is 10,000 - 4,950 = 5,050. That $5,050 is the single most-watched number in the statements, and it will reappear on the balance sheet through retained earnings.

Single-step and multi-step

The statement above is single-step: one revenue total, one expense total, one subtraction. A company that sells goods (a merchandiser) usually uses a multi-step format that first subtracts the cost of goods sold from sales to show gross profit, then subtracts operating expenses. Consider a bike shop, Bright Bikes:

Bright Bikes - Income Statement (multi-step)
Sales revenue	$250,000
Cost of goods sold	(150,000)
Gross profit	100,000
Operating expenses	(68,000)
Operating income	32,000
Interest expense	(2,000)
Income before tax	30,000
Income tax expense (20%)	(6,000)
Net income	$24,000

Every subtotal is a story: gross profit (100,000) shows how much the products themselves earn, operating income (32,000) shows how the core business performs before financing and tax, and net income (24,000) is the bottom line the owners keep. Note that the income statement contains no cash balances and no debts - performance, not position, is its job.

The balance sheet (or statement of financial position) is a snapshot of what a business owns and owes on a single date. It is the accounting equation dressed up as a report: assets on one side, liabilities and equity on the other, always equal. Because it captures one instant, its heading names a date, such as "June 30," not a period.

First, the bridge: retained earnings

Before we can finish the equity section we need one link. Net income from the income statement does not vanish; it accumulates in an equity account called Retained Earnings - the total profit a company has kept rather than paid out as dividends. The statement of retained earnings shows the roll-forward:

Beginning retained earnings	$0
Add: net income	5,050
Less: dividends	(500)
Ending retained earnings	$4,550

Maple Lawn Care is new, so it began with $0 retained earnings. It earned $5,050 and paid a $500 dividend, leaving 0 + 5,050 - 500 = 4,550.

Maple Lawn Care's balance sheet

Now assemble the snapshot. A classified balance sheet groups assets into current (cash and items expected to become cash within a year) and long-term. Equipment appears at its cost less accumulated depreciation.

Maple Lawn Care, Inc. - Balance Sheet June 30
Assets
Cash	$19,700
Accounts receivable	1,000
Supplies	400
Equipment	9,000
Less: accumulated depreciation	(150)
Total assets	$29,950
Liabilities
Accounts payable	$400
Notes payable	5,000
Total liabilities	5,400
Equity
Common stock	20,000
Retained earnings	4,550
Total equity	24,550
Total liabilities and equity	$29,950

Check the equation. Assets: 19,700 + 1,000 + 400 + (9,000 - 150) = 29,950. Liabilities plus equity: 5,400 + (20,000 + 4,550) = 29,950. The two sides match at $29,950, so the balance sheet balances - the proof that the whole cycle, from journal entry to statement, was done correctly.

A company can be profitable on the income statement yet still run out of cash, because accrual accounting records revenue before the cash arrives and expenses before they are paid. The statement of cash flows closes that gap by reporting only actual cash coming in and going out over the period, sorted into three activities. It answers the blunt question the other statements skip: where did the cash come from, and where did it go?

The three sections

• Operating activities - cash from the day-to-day business: cash from customers, cash paid to employees and suppliers, cash for rent.
• Investing activities - cash from buying or selling long-term assets, such as equipment.
• Financing activities - cash from owners and lenders: issuing stock, borrowing, repaying loans, and paying dividends.

Maple Lawn Care's cash flows

We can build the statement directly from the eleven transactions, listing each that moved cash. (This is the direct method, which shows cash receipts and payments plainly.)

Maple Lawn Care, Inc. - Statement of Cash Flows For the Month Ended June 30
Operating activities
Cash received from customers (7,500 + 1,500)	$9,000
Cash paid to employees	(3,000)
Cash paid for rent	(1,000)
Cash paid to suppliers	(800)
Net cash from operating activities	4,200
Investing activities
Purchase of equipment	(9,000)
Net cash from investing activities	(9,000)
Financing activities
Issued common stock	20,000
Borrowed on note payable	5,000
Paid dividends	(500)
Net cash from financing activities	24,500
Net increase in cash	19,700
Cash at beginning of month	0
Cash at end of month	$19,700

Add the three section totals: 4,200 - 9,000 + 24,500 = 19,700. Starting from $0 cash, the month ends with $19,700 - and that is exactly the Cash balance on the balance sheet. That match is the built-in check on the whole statement: the net change in cash must reconcile to the cash on the balance sheet. Notice too that the two adjusting entries (supplies used, depreciation) never appear here, because no cash moved; they are on the income statement, not this one.

Finished statements are full of numbers, but numbers alone can be hard to judge: is $5,050 of profit good? Ratio analysis answers such questions by dividing one statement figure by another to reveal a relationship that raw dollars hide. Ratios let you compare a company with its own past, with rivals of different sizes, or with an industry norm. They fall into three families: liquidity (can it pay bills soon?), solvency (can it survive its long-term debt?), and profitability (is it making good money?). We will compute each from Maple Lawn Care's finished statements.

Liquidity: the current ratio

The current ratio compares current assets to current liabilities: Current assets / Current liabilities. For Maple Lawn Care, current assets are cash 19,700 + receivable 1,000 + supplies 400 = 21,100, and current liabilities are 5,400. The ratio is 21,100 / 5,400 = 3.91. A current ratio of 3.91 means the company has $3.91 of short-term assets for every $1 of short-term debt - very comfortable. As a rough guide, a current ratio above 1.0 means current assets cover current debts, and many analysts like to see roughly 1.5 to 2.0.

Solvency: debt-to-assets

The debt-to-assets ratio shows how much of the company is financed by debt: Total liabilities / Total assets. Here that is 5,400 / 29,950 = 0.18, or 18%. Only 18 cents of every dollar of assets is funded by creditors; the other 82 cents comes from the owners. A lower ratio generally signals less financial risk.

Profitability: margin and return on equity

The net profit margin is net income divided by revenue: 5,050 / 10,000 = 0.505, or 50.5%. The company keeps about 50.5 cents of profit from every sales dollar - strong for a service business with few costs. Return on equity (ROE) measures profit against the owners' investment: Net income / Total equity = 5,050 / 24,550 = 0.206, or 20.6%. Each dollar of equity generated about 20.6 cents of profit this period.

Ratio	Formula	Maple Lawn Care	Reads as
Current ratio	Current assets / current liabilities	21,100 / 5,400 = 3.91	Liquidity
Debt-to-assets	Total liabilities / total assets	5,400 / 29,950 = 18%	Solvency
Net profit margin	Net income / revenue	5,050 / 10,000 = 50.5%	Profitability
Return on equity	Net income / total equity	5,050 / 24,550 = 20.6%	Profitability

One caution: a ratio is only meaningful in context. A current ratio of 3.91 is healthy for most firms but might mean idle cash for another; a margin of 50.5% is great for services but unheard of in grocery retail. Always compare a ratio to something - the company's trend, a competitor, or the industry - before you judge it. That habit, turning statements into questions, is the payoff of the whole accounting cycle you have now completed.