Accounting follows rules known as Generally Accepted Accounting Principles (GAAP). The Securities & Exchange Commission (SEC), and the Financial Accounting Standards Board (FASB) sets accounting policy in the United States and developed this set of rules called (GAAP). The rules are made to establish uniformity in accounting systems and financial statements. The following is an example of accounting rules dealing with the basic accounting formula: Assets = Liabilities + Owner’s Equity. In a double entry system of accounting, every debit must have an offset entry of a credit; therefore, I feel you should have a better understanding of how the debits and credits apply to this accounting formula.
Assets = Liabilities + Owners equity
Left Right
Debit Credit
Normal debit balance Normal credit balance
Debits increase asset accounts. Credits increase liabilities and equity.
Credits decrease asset accounts. Debits decrease liabilities and equity.
GAAP utilizes prefix numbers that assist in the orderly placement of the individual items in a financial statement. Some accounting software systems do not require numbers, but without a numerical system the individual items would be listed alphabetically. If the accounts were listed alphabetically in the chart of accounts shown below, you would have accounts receivable first and then buildings with cash showing up third. The numbering system allows the manager to place the individual accounts (items) in the order that he wants them to appear on the financial statement. The numbering system is the key that opens the door for developing managerial financial statements.
Keys behind the numbers
The lower numbers in the Balance Sheet 100-140 are all of the Current Asset accounts that either are already Cash or will turn into Cash in a short period of time. The Current Asset accounts are classified as liquid relative to the time frame necessary to turn them into cash.
The accounts 150-160 in this particular Chart are the longer term or other assets. This group of accounts includes both the fixed assets as well as the other assets owned by the company.
The accounts 201-232 represent the current liabilities that must be paid the soonest, starting with the lowest number group.
The 240’s in this case represent the long term debt, and as you can see, we have established accounts to take out the current portion of debt that is due to be paid within a one year time frame.
The 300 accounts represent owner’s equity and include the stock accounts and the retained earnings accounts.
The numbering system for the Income Statement has a specific plan: the 400 accounts represent Income, the 500 accounts represent Cost of Goods Sold, the 600 accounts represent Operating Overhead, the 700 accounts represent Selling Expenses, and the 800 accounts represent Administrative Expenses.
Within each grouping the Chart of Accounts has been expanded to give the manager a more complete insight to where the Income or Expenses are coming from.
When a manager becomes familiar with the grouping of the Income Statement accounts he has a management tool that will give him trends for his business. It will also allow him to plan much better for the future operation of his company when preparing his Budgets. See an example of the Income Statement later in this section.The magic in the Financial Statements is really not magic but common sense. A manager that develops his skills at reading the statements will become a much stronger manager, and will be more aware of what is happening with his company. When he talks to investors, creditors, or must go to the bank to establish his line of credit, his skills at reading his own statements will go a long way in proving his knowledge of what is happening economically with his company. The results will be a better response from whichever group of people he is meeting with.
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