Financial Accounting Review

# Financial Accounting Review - In-Class Exercise Financial...

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In-Class Exercise Financial Accounting Recording Transactions and Preparing Financial Statements Where do revenues, expenses, assets, liabilities and equity come from? How do you go from financial events to financial statements? This exercise will use a hypothetical example to illustrate the double-entry accounting system. Before we begin, let’s review a little about the double-entry accounting system. Since you’ve all just seen debits and credits, let’s start there. Remember that debit simply means “left” and credit simply means “right”. The double-entry accounting system is based on the accounting identity: ASSETS = LIABILITIES + EQUITY In financial accounting, every transaction has two sides, and the accounting equation must always be true. For example, if you increase assets, you must also increase liabilities or equity to keep the equation in balance. Notice that the balance sheet is a reflection of the accounting equation, so we’ll start there. To begin, free your mind and think about the world as layers of T-accounts. The balance sheet is the king of the T-accounts. It is much like a summary T-account, with assets on the left side of the T and liabilities and equity on the right side. Since assets are on the LEFT side (the debit side) of the balance sheet, they must be “positive on the left”. In other words, assets INCREASE with a left side (debit) entry. Similarly, since liabilities and equity are on the right side of the balance sheet (the credit side), they have to be “positive on the right”. In other words, liabilities and equity INCREASE with a right side (credit) entry. Contained within this giant balance sheet T-account are a bunch of smaller T-accounts that reflect individual asset, liability and equity accounts. For example, cash, an asset, will have its own T-account. Like all assets, you increase cash with an entry to the left side of the T-account (a debit) and you decrease cash with an entry to the right side of the T-account (a credit). Remember, assets are on the LEFT side of the balance sheet so all asset accounts are going to increase on the left side of the T-account (the debit side). Liabilities and equity are on the RIGHT side of the balance sheet so liability and equity accounts are going to increase on the right side of the T-account (the credit side). For an illustration with examples of asset and liability accounts, see EXHIBIT A in the EXCEL workbook. The balance sheet reflects all of the account balances at a point in time. It is a snapshot of what you have on the day it is prepared.

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