Last annotated on October 22, 2014
Assets = Liabilities + Owners’ Equitya liability for one person is, in fact, an asset for somebody else.
A company’s balance sheet shows its financial situation at a given point in time.
Cash and Cash Equivalents: Balances in checking and savings accounts, as well as any investments that will mature within 3 months or less.
Accounts Receivable: Amounts due from customers for goods or services that have already been delivered.Accounts Payable: Amounts due to suppliers for goods or services that have already been received.
Notes Payable: Contractual obligations due to lenders (e.g., bank loans).
Current assets are those that are expected to be converted into cash within 12 months or less. Typical current assets include Accounts Receivable, Cash, and Inventory.
Everything that isn’t a current asset is, by default, a long-term asset (a.k.a. non-current asset). For example, Property, Plant, and Equipment is a long-term asset account.
Current liabilities are those that will need to be paid off within 12 months or less. The most common example of a current liability is Accounts Payable.
Notes Payable that are paid off over a period of time are split up on the balance sheet so that the next 12 months’ payments are shown as a current liability, while the remainder of the note is shown as a long-term liability.
A company’s income statement shows the company’s financial performance over a period of time (usually one year). This is in contrast to the balance sheet, which shows financial position at a point in time. A frequently used analogy is that the balance sheet is like a photograph, while the income statement is more akin to a video.
Gross profit refers to the sum of a company’s revenues, minus Cost of Goods Sold.
Cost of Goods Sold (CoGS) is the amount that the company paid for the goods that it sold over the course of the period.
Operating revenues are those coming from the sale of the business’s primary products or services. Similarly, operating expenses are the expenses related to the core operation of the business. Things such as rent, insurance premiums, and employees’ wages are typical operating expenses.
Non-operating revenues and expenses are those that are unrelated to the core operations of the business and would include things such as interest income, interest expense, and gains or losses on investments.
For some purposes, operating income is a more meaningful number than net income, because it provides a measure of how well the company is doing at its core business, without including the effects of financing and investment decisions.
retained earnings is the sum of all of a company’s undistributed profits over the entire existence of the company. We say “undistributed” in order to distinguish from profits that have been distributed to company shareholders in the form of dividend payments.
The statement of retained earnings functions much like a bridge between the income statement and the balance sheet. It takes information from the income statement, and it provides information to the balance sheet.
The final step of preparing an income statement is calculating the company’s net income:
Net income is then used in the statement of retained earnings to calculate the end-of-year balance in Retained Earnings:
The ending Retained Earnings balance is then used to prepare the company’s end-of-year balance sheet:
Unlike many other cash payments, however, dividends are a distribution of profits (as opposed to expenses, which reduce profits). Because they are not a part of the calculation of net income, dividend payments do not show up on the income statement. Instead, they appear on the statement of retained earnings.
Retained earnings is not the same as cash. Often, a significant portion of a company’s retained earnings is spent on attempts to grow the company.
The cash flow statement does exactly what it sounds like: It reports a company’s cash inflows and outflows over an accounting period.
First, there are often differences in timing between when an income or expense item is recorded and when the cash actually comes in or goes out the door.
The second major difference between the income statement and the cash flow statement is that the cash flow statement includes several types of transactions that are not included in the income statement.
all cash inflows or outflows are separated into one of three categories:
Cash flow from operating activities,
Cash flow from investing activities, and
Cash flow from financing activities.
Cash flow from operating activities includes most cash transactions that would factor into the calculation of net income.
Cash flow from investing activities includes cash transactions relating to a company’s investments in financial securities and cash transactions relating to long-term assets such as property, plant, and equipment.
Cash flow from financing activities includes cash transactions between the company and its owners or creditors.
Liquidity ratios are used to determine how easily a company will be able to meet its short-term financial obligations. Generally speaking, with liquidity ratios, higher is better. The most frequently used liquidity ratio is known as the current ratio: current asset / current liability
A company’s quick ratio serves the same purpose as its current ratio: It seeks to assess the company’s ability to pay off its current liabilities by excluding inventories.
A company’s return on assets shows us the company’s profitability in comparison to the company’s size (as measured by total assets). In other words, return on assets seeks to answer the question, “How efficiently is this company using its assets to generate profits?”
Return on equity is similar except that shareholders’ equity is used in place of total assets. Return on equity asks, “How efficiently is this company using its investors’ money to generate profits?”
A company’s gross profit margin shows what percentage of sales remains after covering the cost of the sold inventory. This gross profit is then used to cover overhead costs, with the remainder being the company’s net income.
Gross profit margin is often used to make comparisons between companies within an industry. For example, comparing the gross profit margin of two different grocery stores can give you an idea of which one does a better job of keeping inventory costs down.
A company’s debt ratio shows what portion of a company’s assets has been financed with debt.
A company’s debt-to-equity ratio shows the ratio of financing via debt to financing via capital from investors.
The more highly leveraged a company is, the greater its return on equity will be for a given amount of net income.
when the company’s debt-to-equity ratio increased (from 1 in the first example to 3 in the second example), the company’s return on equity increased as well, even though net income remained the same.
Asset turnover ratios seek to show how efficiently a company uses its assets. The two most commonly used turnover ratios are inventory turnover and accounts receivables turnover.
The calculation of inventory turnover shows how many times a company’s inventory is sold and replaced over the course of a period. The “average inventory” part of the equation is the average Inventory balance over the period, calculated as follows:
Inventory period shows how long, on average, inventory is on hand before it is sold.
A higher inventory turnover (and thus, a lower inventory period) shows that the company’s inventory is selling quickly and is indicative that management is doing a good job of stocking products that are in demand.
A company’s receivables turnover (calculated as credit sales over a period divided by average Accounts Receivable over the period) shows how quickly the company is collecting upon its Accounts Receivable.
Average collection period is exactly what it sounds like: the average length of time that a receivable from a customer is outstanding prior to collection.
higher receivables turnover and lower average collection period is generally the goal.
The goal of GAAP is to make it so that potential investors can compare financial statements of various companies in order to determine which one(s) they want to invest in, without having to worry that one company appears more profitable on paper simply because it is using a different set of accounting rules.
All publicly traded companies are required by the Securities and Exchange Commission to follow GAAP procedures when preparing their financial statements.
In addition, because of GAAP’s prevalence in the field of accounting, many companies follow GAAP even when they are not required to do so.
Governmental entities are required to follow GAAP as well. That said, there is a different set of GAAP guidelines (created by a different regulatory body) for government organizations.
GAAP is the use of double-entry accounting, and the accompanying system of debits and credits. With double-entry accounting, each transaction results in two entries being made. (These two entries collectively make up what is known as a “journal entry.”)
If each transaction resulted in only one entry, the equation would no longer balance. That’s why, with each transaction, entries will be recorded to two accounts.
Debits and credits are simply the terms used for the two halves of each transaction. That is, each of these two-entry transactions involves a debit and a credit.
A debit entry will increase an asset account, and it will decrease a liability or owners’ equity account
A credit entry will decrease an asset account, and it will increase a liability or owners’ equity account.
As you can see, when recording a journal entry, the account that is debited is listed first, and the account that is credited is listed second, with an indentation to the right. Also,
debit is conventionally abbreviated as “DR” and credit is abbreviated as “CR.” (Often, these abbreviations are omitted, and credits are signified entirely by the fact that they are indented to the right.)
An easy way to keep everything straight is to think of “debit” as meaning “left,” and “credit” as meaning “right.”
entry to a revenue account, we use a credit, and when making an entry to an expense account, we use a debit.
The purpose of the trial balance is to check that debits—in total—are equal to the total amount of credits.
Debits increase asset accounts and decrease equity and liability accounts.
Credits decrease asset accounts and increase equity and liability accounts. Formun Üstü
Debits increase expense accounts, while credits increase revenue accounts.
Under the cash method of accounting, sales are recorded when cash is received, and expenses are recorded when cash is sent out.
The problem with the cash method, however, is that it doesn’t always reflect the economic reality of a situation.
Under the accrual method of accounting, revenue is recorded as soon as services are provided or goods are delivered, regardless of when cash is received. ( This is why we use an Accounts Receivable account.)
Similarly, under the accrual method of accounting, expenses are recognized as soon as the company receives goods or services, regardless of when it actually pays for them. (Accounts Payable is used to record these as-yet-unpaid obligations.)
First, because Mario uses the accrual method, the expense is recorded when the services are performed, regardless of when they are paid for.
Second, after both entries have been made, the net effect is a debit to the relevant expense account and a credit to Cash. (Note how this is exactly what you’d expect for an entry recording an expense.)
Last point of Commissions Payable will have no net change after both entries have been made.
In order to be in accordance with GAAP, businesses must use the accrual method of accounting (as opposed to the cash method).
The goal of the accrual method is to recognize revenue (or expense) in the period in which the service is provided, regardless of when it is paid for.
At the end of each accounting period, closing journal entries are made to zero out the balance in revenue, expense, gain, and loss accounts—with an Income Summary account being used for the other half of each closing journal entry.
After all the income statement accounts have been zeroed out, the Income Summary account will have a balance equal to the firm’s net income or loss for the period. A journal entry is then made to transfer this balance into the Retained Earnings account.
GAAP makes the assumption that the dollar is a stable measure of value. It’s no secret that this is a faulty assumption due to inflation constantly changing the real value of the dollar.
According to GAAP, the matching principle dictates that expenses must be matched to the revenues that they help generate, and they must be recorded in the same period in which the revenues are recorded. This concept goes hand-in-hand with the concept of accrual accounting.
An asset’s historical cost is often quite different from its current market value. However, due to its objective nature, historical cost is generally used when reporting the value of assets under GAAP.
A transaction is said to be immaterial if an omission of the transaction would not result in a significant misstatement of the company’s financial statements.
Under GAAP, in order to simplify accounting, currency is generally assumed to have a stable value. This is known as the monetary unit assumption.
For GAAP accounting, a business is considered to be an entirely separate entity from its owners. This is known as the entity concept or entity assumption.
According to GAAP’s matching principle, expenses must be reported in the same period as the revenues which they help produce.Formun Üstü
GAAP-approved. For example, the double declining balance method consists of multiplying the remaining net book value by a given percentage every year. The percentage used is equal to double the percentage that would be used in the first year of straight-line depreciation.
Another GAAP-accepted method of depreciation is the units of production method. Under the units of production method, the rate at which an asset is depreciated is not a function of time, but rather a function of how much the asset is used.
Straight-line depreciation is the simplest depreciation method. Using straight-line, an asset’s cost is depreciated over its expected useful life, with an equal amount of depreciation being recorded each month.
Accumulated depreciation—a contra-asset account—is used to keep track of how much depreciation has been recorded against an asset so far.
An asset’s net book value is equal to its original cost, less the amount of accumulated depreciation that has been recorded against the asset.
If an asset is sold for more than its net book value, a gain must be recorded. If it’s sold for less than net book value, a loss is recorded.
Immaterial asset purchases tend to be expensed immediately rather than being depreciated.
Amortization is the process in which an intangible asset’s cost is spread out over the asset’s life.
The time period used for amortizing an intangible asset is generally the shorter of the asset’s legal life or expected useful life.
Any business that keeps real-time information on inventory levels and that tracks inventory on an item-by-item basis is using the perpetual method.
(CoGS will simply be calculated as the sum of the costs of all of the particular items sold over the period.)
The primary disadvantage to using the perpetual method is the cost of implementation.
Any stolen items will accidentally get bundled up into CoGS,
inventory-valuation method is used. The three most-used methods are known as FIFO, LIFO, and Average Cost. Under GAAP, a business can use any of the three.
It’s important to note that the two methods result not only in different Cost of Goods Sold for the period, but in different ending inventory balances as well.
Avg. Cost per Unit x Units Sold = Cost of Goods Sold Avg. Cost/Unit x Units in End. Inv. = End. Inv. Balance
The perpetual method of inventory involves tracking each individual item of inventory on a minute-to-minute basis. It can be expensive to implement, but it improves and simplifies accounting.
The periodic method of inventory involves doing an inventory count at the end of each period, then mathematically calculating Cost of Goods Sold.
FIFO (first-in, first-out) is the assumption that the oldest units of inventory are sold before the newer units.
LIFO (last-in, first-out) is the opposite assumption: The newest units of inventory are sold before older units are sold.
The average cost method is a formula for calculating CoGS and ending inventory based upon the average cost per unit of inventory available for sale over a given period.