Question

Discuss in your own words the following topics:

The four financial statements to include the time frame they are each for, how they are connected to each other and the preferred order of preparation.

The accounting equation, broken down to its finest accounts and its importance.

What are debits and credits and what are the normal balance of each of the major accounts (eg assets)

Answer 1

Financial Statements comprises of four major reports/statements which are arranged in the order of preparation below:

1.      Income Statement

2.      Statement of Retained earnings

3.      Balance Sheet

4.      Statement of Cash flows

Each financial statement is made for a particular time frame. These are

a.       Reporting Date - Balance Sheet is made as on a particular reporting date. E.g. 31^st March in most cases.

b.      Reporting Period – Income Statement, Cash Flow and retained earnings statements are made for a particular reporting period. E.g. For the year/period ending 31^st March.

The accounting equation is:

Assets= Liabilities + Shareholder Equity

Broken Down Accounting Equation: Basically the Shareholders Equity is broken down to the finest accounts.

Assets = Liabilities + Capital/Equity + Reserves – Expenses – Dividends – Treasury Stock

Importance of breaking down accounting equation is

·         The user can notice the effect of change in revenues and expenses on the net income.

·         Also the user can notice the effect of owners/shareholders transactions such as earnings payout in form of dividends or sale/purchase of ownership interests.

In the above broken down accounting equation, there are 5 major accounts which have the following normal balances.

·         Assets - Debit Balance

·         Liabilities – Credit Balance

·         Capital/Equity - Credit Balance

·         Revenues – Credit Balance

·         Expenses - Debit Balance

The debits and credits have different effect on each of the above major accounts.

·         The accounts having debit balance will increase if there is a debit in that particular account and decrease if there is a credit in that particular account. E.g. Assets balance increase if asset purchased i.e. Asset A/c debited.

·         The accounts having credit balance will increase if there is a credit in that particular account and decrease if there is a debit in that particular account. E.g. Liabilities balance increase if the raw material is purchased on credit i.e. Liabilities A/c is credited.