Chapter 3 The accounting information system

Normal debit account = they increase with debits and decrease with credits: dividends, expenses, assets.

Normal credit account = they increase with credits and decreases with debits: liabilities, equity, revenue

Basic accounting information system

  • Assets = Liabilities + Equity

  • Equity = Share capital + Retained earnings - Dividends + Revenues - Expenses

  • Net income or Net loss (Income Statement) = Revenues - Expenses

  • Ending retained earnings (Retained earnings statement) = Beginning retained earnings + Net income/loss - Dividends

Three fundamental financial statements

  1. Income statement = summarizes a company's revenues and expenses over a specific period. Shows the company's profitability by calculating the net income/loss. Describes the success or failure of the company's operations over a period of time. Only contains tqo types of accounts: revenues and expenses.

  2. Statement of owners' equity = shows the changes in a company's retained earnings over a specific period (year). Statement begins with the capital balance at the start of the year and ends with the capital balance at the end of the year. Capital increases by contributions from the owners and a positive net income. Capital decrease by owners' withdrawals and a negative net income (loss). The ending capital = starting capital + (owners' contributions + net income) - (owner's withdrawals + net loss).

  3. Statement of financial position (Balance sheet) = provides a snapshot of a company's financial position at a specific point in time. Reports all assets and liabilities from a company and the owners' equity. Owners' equity is taken from the statement of owners' equity.

Statement of cashflow = a financial statement that provides information about the cash inflows and outflows from operating, investing, and financing activities of a company during a specific period.

Three main sections of the Statement of cashflow

  1. Operating activities = represent the cash flows generated from the primary business operations of the company, such as sales of goods and services, payment of operating expenses, and receipt of interest and dividends.

  2. Investing activities = involve the cash flows related to the acquisition and disposal of long-term assets, such as property, plant, equipment, and investment in securities. Cash inflows from investing activities include proceeds from the sale of assets or investments, while cash flows include purchase of assets/investments.

  3. Financing activities = represent the cash flows resulting from the company's financing activities, including borrowing and repaying debt, issuing and repurchasing equity shares, and paying dividends to shareholders. Cash inflows from financing activities typically include proceeds from loans or issuance of stocks, while cash outflows include repayment of loans, repurchase of shares, and payment of dividends.

Adjusting entries = correct a previously made mistake or adjust accounts because of time-period-principle or usage of resource

  • Two rules:

    1. Never involves cash

    2. Either increase revenue or an expense

  • Two types:

    1. Prepaids = expenses that are paid in advance but have not yet been consumed or used

      • Recognise what portion of the prepaid good/service has already been used

      • Is an asset account

    2. Accruals = expenses that have been incurred, but have not yet been paid or revenue that has not yet been received

Steps to close accounts

  1. Move revenues and expenses to one T-account called Income summary. It is an equity account meaning it has a normal credit balance: If revenues > expenses the T-account has a credit balance.

  2. The income summary balance is now added to the capital account (also an equity account), meaning that a net profit is added to the credit side of the T-account. The income summary account is now closed.

  3. The withdrawals account, or retained earnings (also an equity account), is closed. Remember that withdrawals are recorded on the debit side since they decrease. The withdrawals debit balance is added to the capital account.

  4. Capital/retained earning: Ending balance = Beginning balance + Net income