A company's senior and middle management uses accounting information to run business. Employees utilize accounting information to determine a company's profitability and profit sharing.

Financial accounting provides information that is designed to satisfy the needs of external users.

Such reporting is usually done in the form of financial statements.

Managerial accounting provides information that is useful in running a company by internal users.

See related illustration for the connection between types of accounting and accounting information users.

People and organizations make decisions based on financial information prepared by accountants.

For example, assume a store sells goods.

When should an accountant record the sale, at the moment the goods are shipped ( accrual accounting ) or at the time cash for these goods is received ( cash accounting)

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Whether the store owner applies the accrual or cash accounting is not important as long as a third rule is established requiring the owner to disclose the method selected for the reporting purposes.

Accounting rules in the USA are grouped and called Generally (Accepted Accounting PrinciplesGAAP)

.

Businesses communicate accounting information to the public through a process known as financial reporting .

Financial reporting is a process through which companies communicate information to the public.

The central means of external financial reporting is a set of financial statements.

The four general-purpose financial statements are the following:

An income statement presents revenues and expenses and resulting net income or loss for a period of time.

An income statement is also called Statement of Operations, Earnings Statement, or Profit and Loss Statement (P/L).

A statement of changes in equity shows all changes in owner's equity for a period of time.

This statement is also called Owners' Equity Statement.

A balance sheet presents assets, liabilities and owner's equity at a specific date. A balance sheet is also called Statement of Financial Position.

A cash flow statement summarizes information about cash outflows (payments) and inflows (receipts).

This statement may also include certain information not related to actual cash flows.

All financial statements consist of classes or categories known as elements . There are ten elements: assets, liabilities, equity, contributed capital, revenue, expenses, distributions, net income, gains, and losses (which will be explained later in this or further chapters).

Assets are economic recourses of a business used to accomplish its main goal, ie, increase owners' wealth.

To be formally recognized as an asset, the following two conditions must be met:

For example, if a company has purchased a piece of equipment and uses it in generating profits, it is considered as an asset.

However, if the company just considers buying new equipment, it can't be deemed or recorded as an asset.

We need to provide a definition of claims before we proceed with the basic accounting equation.

In other words, each asset has its own source provided by an owner or creditor.

So, there can't be any claim without an appropriate asset and vice versa.

Based on the previous statement, we can define the basic accounting equation:

Claims are divided into two categories:

Beginning balance

Effect of revenue

Ending balance

4) As noted above, assets acquired in operating activities are called revenues.

Assets used in the

process of generating revenues are called expenses .

Expenses decrease retained earnings.

Assume Friends Company used $1,000 in assets to earn $3,000 in revenues.

This is an example asset use transaction .

Asset use transactions result in a decrease in an asset account and in one of the claim accounts (liability or equity accounts).

The affect of this asset use transaction (assets and claims decrease) on the basic accounting equation is as follows:

Beginning balance

Effect of expenses

Ending balance

Take a note of how decreases or negative amounts are shown in accounting records.

Instead of prefixing a minus sign ("-"), a number is taken into parenthesis.

This is a common way of showing a decrease in the accounting realm.

5) If a business chooses to transfer part of its assets (retained earnings in particular) to the owners, the transfer is called distribution . Assume Friends Company transfers $500 of assets to its owners.

This is an asset use transaction:

Beginning balance

Effect of distribution

Ending balance

Distribution and expenses both result in decreases in retained earnings and thus, in equity.

The table below is a summary of the effects of the three asset source transactions (events 1 through 3) and two asset use transactions (events 4 and 5):

Beginning balance

Effect of contribution

Effect of borrowing

Effect of revenue

Effect of expenses

Effect of distribution

Ending balance

At the end of a period, all accounts are prepared for the next period. It is important to distinguish between permanent and temporary accounts. Balance sheet accounts (ie, assets, liabilities, and equity) have a continuing nature; thus, they are not closed after each period and that's why they are called permanent accounts.

They are not closed each period.

Their balances are carried forward into the next period.

Permanent accounts are also called real accounts .

At the end of a period, amounts in revenue, expense, and distribution accounts are transferred to Retained Earnings.

Accordingly, the revenue, expense, and distribution accounts must have zero balances at the end of one accounting period (after closing the books) and at the beginning of the following period.

These are mostly income statement accounts, except for a distribution account that is equity statement account. Temporary accounts are also called nominal accounts .

closing the accounts or closing the books .

Based on the five transactions described above, we can now prepare the financial statements for the period.

Recall that there are four general-purpose financial statements: