Financial Accounting: An Integrated Statements Approach, 2nd Edition

54 Chapter 2 Basic Accounting Concepts

ELEMENTS OF AN ACCOUNTING SYSTEM

A financial accounting system is designed to produce financial statements. You should

recall from Chapter 1 that the basic financial statements are the income statement,

retained earnings statement, balance sheet, and statement of cash flows. So what are

the basic elements of an accounting system that will enable the preparation of these

statements?

The basic elements of a financial accounting systeminclude (1) a set of rules for

determining what, when, and the amount that should be recorded for economic

events, (2) a framework for preparing financial statements, and (3) one or more con-

trols to determine whether errors may have arisen in the recording process. These basic

elements are found in all financial accounting systems—from a local retailer or

hardware store to Microsoft,Sony,Boeing, and Wrigley.

Rules

A set of rules for determining what, when, and the amount that should be recorded

for an entity’s economic events are derived from the eight concepts we discussed in

Chapter 1. These concepts form the foundation for generally accepted accounting prin-

ciples. Throughout this text, we describe and illustrate generally accepted accounting

principles based upon these eight concepts.

Atransactionis an economic event that under generally accepted accounting

principles affects an element of the financial statements and, therefore, must be

recorded. A transaction may affect one, two, or more elements of the financial state-

ments. For example, equipment purchased for cash affects only assets. That is, one as-

set (equipment) increases while another asset (cash) decreases. If, on the other hand,

the equipment is purchased on credit, both assets (equipment) and liabilities (accounts

or notes payable) increase.

Framework

In order to prepare financial statements, transactions must be analyzed, recorded, and

summarized using a framework. The accounting equation provides a starting point for

designing such a framework. You should recall from Chapter 1 that the accounting

equation is expressed as follows:

AssetsLiabilitiesStockholders’ Equity

We use an integrated financial statement approachfor analyzing, recording, and summa-

rizing transactions by expanding the accounting equation as shown in Exhibit 1. We

do this by including columns for the statement of cash flows, balance sheet, and in-

come statement.

The left-hand column in Exhibit 1 shows the effects of transactions on the state-

ment of cash flows. Each cash transaction is recorded and classified into operating, in-

vesting, and financing activities as a basis for preparing the statement of cash flows.

The cash amount at the beginning of the period plus or minus the cash flows from op-

erating, investing, and financing activities equals the end of the period cash. This end

of the period cash amount is reported as an asset on the balance sheet. Thus, the state-

ment of cash flows is integrated with the balance sheet.

The far right-hand column in Exhibit 1 records and summarizes revenue and ex-

pense transactions as a basis for preparing the income statement. Recall, net income,

which is revenue less expenses, affects retained earnings. Thus, revenue and expense

Q.The receipt of cash for

capital stock affects what

elements of the accounting

equation?

A.Total assets (cash)

increases, and stockhold-

ers’ equity (capital stock)

increases.

Describe the basic

elements of a financial

accounting system.

1