Class 1 L1: Understanding Financial Statements

The accounting system is based upon the basic accounting equation: Assets = Liabilities + Stockholders' Equity (A = L + E).

Definitions:
Assets - Everything the company owns.
Liabilities - The claims on assets by creditors.
Stockholders' Equity - The claim on assets by the owners of the company.

To start the accounting process you have analyze each individual transaction, whether it effects an asset, liability, or equity account.

     Say you wanted to buy a house for $200,000, you went to the bank and asked for a loan. The loan officer tells you he wants a 20% down payment on the loan. If you go through with the decision, you would now have an asset (the house) of $200,000, you would owe $160,000 (liability) and you would have $40,000 in equity from the down payment (stockholders' equity). assets ($200,000) = liabilities ($160,000) + equity ($40,000), thus the equation is equal.

*Nota Bene - The accounting equation must always balance.

     A common misunderstanding is that a debit always means subtract and a credit always means add. This is not the case, unfortunately there is a bit more to it. Each account has a normal balance of either a debit or credit. When I say a normal balance I mean if the normal balance is a debit, then when you debit that account it increases it and when you credit the account it decreases it and vice versa for a normal credit balance account.
     So let's go back to our equation, Assets = Liabilities + Stockholders' Equity. The asset account has a normal debit balance, liabilities have a credit balance, and stockholders' equity has a credit balance.

*Nota Bene - Credits and debits MUST always be equal.

     The next part in the accounting process is journalizing. Each transaction after being analyzed is then journalized in the appropriate journal. There are many different journals that we will get to later, but the journal that we will be using is the General Journal. A journal entry applies both techniques of analyzing and the debit and credit rules.
     With our previous example of the house loan, all I said was the accounts increased, but journalizing involves debits and credits. Thus when we have obtained the house as an asset we debit (increase) the asset account, credit (increase) the liability account and credit (increase) the stockholders' equity account. Also debit entries always go first, then followed by indented credit entries.
     To make an journal entry, your journal must have a four columns. From left to right an appropriate journal would have a date column, a column for the accounts names, a column for debits, and a column for credits. An appropriate journal setup is in the picture to the right. This is also the correct journalization for our houseing loan.
     At the top of each new column there must be a dollar sign as well as at the end when you have a grand total it must be underlined and have a dollar sign.

The accounting equation can be extended into several more accounts. Stockholders' equity can be broken into two separate accounts common stock and retained earnings. Both common stock and retained earnings have normal credit balances.

Definitions
Common Stock - What the owners have paid into the company through the purchase of stocks.
Retained Earnings - The amount of earnings not distributed to owners.

Retained earnings can then be broken down further into three accounts. Revenues (normal credit balance), expenses (normal debit balance), and dividends (normal credit balance). This can said as revenue less expenses occurred less dividends paid to stockholders is equal to retained earnings.

After you have journalized your entries you then post them to the proper accounts using T-Charts. Each account has it's own T-Chart, and of course all debits and credits must equal. An example, if I was to incur an expense of $200 and I paid it out of existing assets, I would credit (decrease) assets and debit (increase) expenses which would in-turn debit (decrease) retained earnings and thus debit (decrease) stockholders' equity by $200. We have now analyzed the transaction we would then journalize it and then post to the two T-Accounts, assets and stockholders' equity. The T-Charts would look like the picture to the right. Remember: Debits are in the left column and credits are in the right column.

Quiz (T or F)
1. The basic accounting equation is: Stockholders' Equity = Assets - Liabilities.
2. If I were to buy equipment on account, I would debit liabilities and credit assets.
3. Retained earnings is equal to revenues plus expenses less dividends.
4. If I wanted to increase the asset account, I would debit it.
5. If I credit liabilities and credit stockholders' equity, assets must necessarily be credited.
6. Ceteris paribus if I credit the revenue account, stockholders' equity will increase.
7. You usually post to T-charts before you journalize a transaction.
8. Credits and debits MUST balance.
9. If I credited stockholders' equity for $100 and debited liabilities for $100, then assets MUST be debited for $200 dollars.
10. The accounting equation MUST balance.

Study Problem
In the beginning of the year ABC Company had $120,000 in assets, $70,000 in liabilities, and $50,000 in Stockholders' Equity. They purchased $40,000 of equipment by borrowing from a bank. They spent $25,000 of existing assets to pay creditors. By the year end ABC Co. had cash sales revenue of $135,000 and borrowed $85,000 to pay yearly expenses. What are the ending balances of ABC's asset, liability and Equity accounts?

*For answers please left click and drag pointer over the white area below. For more in a more in-depth solution to the study problem go to the answers page.


Quiz Answers

1. T
2. F When you buy equipment on account, liabilities increase (credit) and assets would increase (debit).
3. F Retained earnings is equal to revenues - expenses - dividends.
4. T
5. F If both s/e and liabilities were credited (increased) assets would have to be debited (increased).
6. T
7. F You journalize the entry before you post it to T-Charts.
8. T
9. F If s/e was to increase (credited) by $100 and liabilities decreased (debited) then assets would not need to be changed.
10. T

Study Question:
Asset account = Debit balance of $270,000
Liability account = Credit balance of $170,000
Stockholders' equity = Credit balance of $100,000