Double-entry bookkeeping is the standard method used by accountants to record financial transactions. First used as early as in the 13th century, this system recognizes that every transaction contains two sides: a receiving side and a giving side. For example, when someone makes a purchase he receives merchandise and gives cash. This concept is recorded in a general ledger by the use of accounts. Separate accounts are maintained for assets, liabilities, and owner’s equity. Increases in assets are recorded in the debit (left) column, and increases in liabilities and owners’ equity are recorded in the credit (right) column. In order for the ledger to be balanced, the assets must equal the sum of the liabilities and owners’ equity. If they do not, the ledger is not balanced and an error has occurred.
The “cost of goods sold” line on an income statement contains combined costs of raw materials, labor, overhead, and any other applicable expenses attributable to inventory that has been sold. It is calculated by summing the expenses associated with production and subtracting the expenses associated with current inventory.
The balance sheet is so named because it contains the assets, liabilities, and owners’ equity as of a certain date. The accounting equation states that assets must equal liabilities plus owners’ equity. The balance sheet is presented in the same way. The total of the assets at the top of the balance sheet must equal the total of the liabilities and owners’ equity at the bottom; or, assets are balanced against liabilities and owners’ equity.
There are four financial statements: the income statement, the balance sheet, the statement of cash flows, and the statement of owners’ equity. Managers and owners use financial statements to review an entity’s past performance (amounts of revenue and expenses, changes in assets, liabilities, and equity, etc.) and to predict what future actions should be taken to maintain or improve the financial health of the entity.
Ratio analysis is used by analysts to show where a company’s strengths and weaknesses lie.Ratios put detailed financial data into a percentage form which is easier to understand and use for comparisons.For those analyzing stocks, financial statement ratios give the necessary information for assessing a stock’s price and how likely it is to increase or decrease.