Summary

The accounting process is a key component of financial reporting. The mechanics of this process convert business transactions into records necessary to create periodic reports on a company. An understanding of these mechanics is useful in evaluating financial statements for credit and equity analysis purposes and in forecasting future financial statements. Key concepts are as follows:

• Business activities can be classified into three groups: operating activities, investing activities, and financing activities.

• Companies classify transactions into common accounts that are components of the five financial statement elements: assets, liabilities, equity, revenue, and expense.

• The core of the accounting process is the basic accounting equation: Assets = Liabilities + Owners’ equity.

• The expanded accounting equation is Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends.

• Business transactions are recorded in an accounting system that is based on the basic and expanded accounting equations.

• The accounting system tracks and summarizes data used to create financial statements: the balance sheet, income statement, statement of cash flows, and statement of owners’ equity. The statement of retained earnings is a component of the statement of owners’ equity.

• Accruals are a necessary part of the accounting process and are designed to allocate activity to the proper period for financial reporting purposes.

• The results of the accounting process are financial reports that are used by managers, investors, creditors, analysts, and others in making business decisions.

• An analyst uses the financial statements to make judgments on the financial health of a company.

• Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.