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straight line depreciation

The organization of this book is intended to present the material in the order in which it needs to be understood. Therefore, we start with the end product of financial accounting, the financial statements, then jump back to the first step in the accounting process, making journal entries. This may seem out of order, but it follows the way accounting is best understood and learned rather than following the chronology of how accounting is done.

You cannot be a good accountant if you are not a good bookkeeper. Bookkeeping is considered a lower-level profession than accounting, and this perception is accurate because accountants possess skills that bookkeepers do not. However, the first step in learning accounting is to learn bookkeeping. What makes it accounting and not simply bookkeeping is going beyond just recording the entries into such areas as preparing the financial statements, analyzing the statements, and making necessary adjusting entries at the end of the accounting period.

A last thing to keep in mind when reading this book and looking at the examples and descriptions is that how things are presented and how they are arranged are highly variable in practice. Companies and managers adapt forms, schedules,

and statements to meet their own needs (within the existing rules). Except as specifically prescribed by accounting guidance, there is an abundance of flexibility. A nimble mind will come in handy in trying to reconcile what is described in this book with what you may see in the real world. Sometimes these will be the same and sometimes there will be minor differences in presentation, but even given that variability, it should not be hard to take what you learn from this book and relate it directly to real-world situations.


Financial Statements

The end product of the financial accounting process is the financial statements. There are four basic financial statements: the Balance Sheet, the Income Statement, the Statement of Retained Earnings, and the Statement of Cash Flows. In addition to the four financial statements there will also be a section called notes to the financial statements or footnotes. This section provides additional information that helps the reader understand certain details without making the basic statements overly long.

Sometimes the basic financial statements will have slightly different names, such as the Statement of Income instead of the Income Statement or the Statement of Changes in Owners Equity instead of the Statement of Retained Earnings. Accountants have flexibility when it comes to account titles and statement names; the important thing is that anyone can recognize what the account or statement is. The names and titles used in this book are both typical and descriptive.

Income Statement

The Income Statement lists the companys revenues and expenses and gives the difference between them. This difference is called net income. For the most part, revenues arise from selling goods or services. Expenses are the costs involved in operating the business.

Some examples of accounts that are classified as revenues and expenses are:

Revenues Expenses

Sales Cost of goods sold

Interest income Salary expense

Rent expense

Tax expense

Interest expense

This is a very short list of the accounts that may be found on the Income Statement. Salary expense is also known as Wage expense or Payroll expense. The names are synonymous and are used interchangeably. It is also common not to use the full title Rent expense, but to call it simply Rent. This is done for most items where there is not a revenue and an expense with similar names. For instance, in the list given here, we cannot call Interest income simply Interest, since if we did, we would not be able to distinguish between the income and expense accounts. We have to use the full name Interest income in order not to confuse this account with Interest expense. When an account comes in two flavors (income and expense), we cannot shorten its name.

The Income Statement is concerned with how much

money the company brought in and how much it spent in order to bring that money in. The Income Statement covers a period of time. This period may be a month, a quarter, six months, a year, or any other period of time that the company feels is appropriate. Many companies prepare their financial statements on a monthly, quarterly, and annual basis. A proper heading for the Income Statement will have three lines: the name of the company, the name of the statement, and the period of time the statement covers. An example is:

Jeffry Haber Company Income Statement For the Year Ended December 31, 2002

If the statement is for the quarter ended December 31, 2002, there are two acceptable ways to state the period of time:

For the Quarter Ended December 31, 2002

For the Three Months Ended December 31, 2002

The revenues are listed in one section and the expenses in another. The order of the accounts within each section is usually determined by the size of the account balances, with the largest balances listed first. Each section is then totaled.

Financial statements have some weird rules. For one thing, it is typical to capitalize only the first letter of each account name (for example, Interest income). There are also some other peculiarities related to the appearance of the financial statements. The first number in each section gets a dollar sign ($), as does the last number in each section. The last number before a subtotal is underlined, and the final total is double-underlined. Each number in a section is indented after the

subheading. Figure 2-1 is an example of a typical Income Statement.

Even though such rules seem silly, and for the most part are not very important as long as it is obvious to the reader how to interpret the information, they do serve a purpose. The double underline tells the reader what the final total of the statement is. The single underline alerts the reader that a subtotal is coming on the next line. Indenting is an efficient way of depicting a grouping of like items.

Statement of Retained Earnings

The Statement of Retained Earnings takes the beginning balance of Retained earnings (which is the same as the ending


Jeffry Haber Company

Income Statement

For the Year Ended December 31, 2002




Interest income

Total revenue





Payroll taxes






Office supplies


Total expenses


Net income

$ 85,500

balance from the previous period), then adds net income and subtracts dividends paid to stockholders to arrive at the ending balance of Retained earnings. Dividends are distributions of money to shareholders. The Statement of Retained Earnings is for a period of time, and the period should be the same as that of the Income Statement. A dollar sign ($) is used for the first and last numbers, and the last number is double-underlined. Some people like to use a subtotal after net income, but this is not required.

A sample Statement of Retained Earnings is given in Figure


Note that the net income amount is the same as the net income shown on the Income Statement. The financial statements are related to one another, and at times, a figure from one statement is carried over to another statement.

Balance Sheet

The Balance Sheet lists the assets, liabilities, and equity accounts of the company. The Balance Sheet is prepared as on a particular day, and the accounts reflect the balances that existed at the close of business on that day. The Balance Sheet is

Jeffry Haber Company Statement of Retained Earnings For the Year Ended December 31, 2002

Beginning balance, January 1, 2002 $100,000

Add: Net income 85,500

Less: Dividends 35,500

Ending balance, December 31, 2002 $150,000

prepared on the last day that the Income Statement covers, so if the Income Statement is for the period ending December 31, 2002, the Balance Sheet would be as on December 31, 2002. You can state the date in a variety of formats. All of the following are acceptable:

As on December 31, 2002

December 31, 2002

On December 31, 2002

The following are typical accounts that are classified as assets, liabilities, and equity accounts. (These accounts are defined later on in the book. There is no reason why you need to know the definitions at this point, but if you are curious, you can turn to the glossary.)

Assets Liabilities Equity

Cash Accounts payable Common stock Accounts receivable Salaries payable Paid-in capital

Prepaid expenses Taxes payable Retained earnings

Inventory Unearned revenue

Land Notes payable

Building Bonds payable

Equipment Mortgage payable Vehicles

A good general rule of thumb is that any account that has the word receivable in its title will be an asset, and any account that has the word payable in its title will be a liability. Any account that has the word expense in its title is likely to be classified as an expense on the Income Statement, except for

the account Prepaid expenses, which is an asset. Any account with the word income or revenue in its title is classified as revenue on the Income Statement, except for the account Unearned revenue, which is a liability.

A sample Balance Sheet is shown in Figure 2-3.

On the Balance Sheet, the largest numbers in each section are not necessarily listed first. On the asset side of the Balance Sheet, the accounts are listed in order of their liquidity. Liquidity means nearness to cash. Cash is listed first, since cash is already cash. Each current asset is then listed in the order in which it is expected to become cash. Accounts receivable


Jeffry Haber Company

Balance Sheet

December 31, 2002



$ 75,000

Accounts receivable




Prepaid expenses


Total Assets



Accounts payable


Salaries payable


Notes payable


Total Liabilities


Stockholders Equity:

Common stock

$ 10,000

Retained earnings


Total Stockholders Equity


Total Liabilities and Stockholders Equity


comes second, since this company believes that its accounts receivable will be collected prior to the other assets being turned into cash.

On the liability side, the accounts are listed in the order in which they are expected to be satisfied (a fancy way of saying paid). The order of the equity accounts is defined by custom and tradition.

There is a special type of Balance Sheet called a classified Balance Sheet. In a classified Balance Sheet, the assets are separated into current and noncurrent (or long-term; the names noncurrent and long-term are synonymous in accounting) assets, and the liabilities are similarly classified as current and noncurrent. Included in the current section of the assets are those assets that are expected to be turned into cash or used up within the next year. Assets that are not expected to be turned into cash or used up within the next year are classified as noncurrent. Current liabilities are those liabilities that are expected to be paid during the next year. Noncurrent liabilities are those liabilities that are expected to be paid sometime after next year.

We have talked about three of the statements (the Income Statement, the Statement of Retained Earnings, and the Balance Sheet). Which statement do you prepare first? This is strictly a matter of preference; however, as a general rule, it makes the most sense to prepare the Income Statement first, then the Statement ofRetained Earnings, and then the Balance Sheet. (The Statement of Cash Flows will be dealt with in a later chapter and is not discussed here.)

Why does that order make sense? To complete the Balance Sheet, the ending amount of Retained earnings is needed. This number comes from the Statement of Retained Earnings, so it makes sense to prepare the Statement of Retained Earnings

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