Fundamentals of Financial Statements

Fundamentals of Financial Statements

“Accounting is the process of identifying, measuring, and communicating economic information about an entity for the purpose of making decisions and informed judgments.” Marshall, McManus and Viele (2003). This paper identifies and analyzes specific transactions within the simulation which exemplify accounting concepts and principles. Additionally, this paper differentiates and explains information reported on the balance sheet and the income statement as a result of the transactions. Finally, this paper identifies and describes three accounting concepts which were a challenge while running the simulation.

During the simulation preliminary transactions were conducted for business set-up resulting in entries to the balance sheet. Starting in December however, $10,000 in supplies was used in the form of an operating expense to generate $21,000 in revenue. This cash transaction demonstrated the concept of matching revenue and expense by producing a net gain which was reported on the income statement as net income of $11,000. Additionally, this transaction resulted in a balance sheet annotation which included an increase in assets, a decrease in supplies, and an increase of $11,000 in owner’s equity.

According to Marshall et al. (2003),

Matching revenue and expense is necessary if the results of the firm’s operations are

to reflect accurately its economic activities during the period. The matching concept

does not mean that revenues and expenses for a period are equal. (p. 55).

A second accounting principle is revenue recognition at time of sale. The first cookie sale transaction for cash meant that all $21,000 could be recognized at the time of the sale. In comparison, the second cookie sale of $7,000 was a credit transaction setting up an accounts receivable and allowing for revenue recognition at the time of sale. Never-the-less, both sales transactions affected the income statement and the balance sheet.

A third accounting principle, the cost principle according to Marshall et al. (2003), “The cost principle refers to the fact that transactions are recorded at their original cost to the entity as measured in dollars.” (p. 53-54). During the simulation kitchen equipment was purchased for $20,000 cash and was apparently recorded at the original cost. Additionally, $15,000 worth of office equipment was purchased on credit and seemingly recorded at the original cost. Incidentally, both of these purchases were reported on the November balance sheet however, the latter transaction created an accounts payable for the cookie company.

The accounting period, another concept, refers to the period that transactions are reported. According to the IRS,

Each taxpayer, business or individual, must figure taxable income on an annual

accounting period called a tax year. The calendar year is the most common tax year.

Other tax years are a fiscal year and a short tax year. (2004).

As for the simulation, the accounting periods appeared to be monthly starting at the beginning of November and December and ending each month.

Prepayments are amounts paid in advance for goods and services and show up on the balance sheet as a specific asset. In the simulation $6,000 for two months advanced rent reduced