35 Basic Accounting Test Questions

1. Which of the following is not a core financial statement?

a. The Income Statement

b. Statement of Cash Flows
c. The Trial Balance
d. The Balance Sheet
2. The income statement, which presents the results of operations, can
be prepared in many forms including:

a. Single Step Income Statement

b. Condensed Income Statement
c. Common Sized Income Statement
d. All of the above
3. Which of the following account types increase by debits in double-
entry accounting?

a. Assets, Expenses, Losses

b. Assets, Revenue, Gains
c. Expenses, Liabilities, Losses
d. Gains, Expenses, Liabilities
4. Which of the following is true?

a. Accounts receivable are found in the current asset section of a

balance sheet.
b. Accounts receivable increase by credits.
c. Accounts receivable are generated when a customer makes
payments.
d. Accounts receivable become more valuable over time.
5. A company that uses the cash basis of accounting will:

a. Record revenue when it is collected.

b. Record revenue when it is earned.
c. Record revenue at the same time as accounts receivable.
 d. Record bad debt expense on the income statement.
6. What are the main sections on a balance sheet?

a. Assets, liabilities, income

b. Assets, liabilities, equity
c. Assets, liabilities, expenses
d. Assets, gains, revenue
7. How are a company’s financial statements used?

a. For internal analysis

b. For external negotiation
c. For compliance
d. All of the above
8. Which of the following scenarios increases accounts payable?

a. A customer fails to pay an invoice.

b. A supplier delivers raw materials on credit.
c. Office supplies are purchased with cash.
d. None of the above
9. Which of the following must a certified public accountant (CPA) have
in-depth knowledge of to pass the CPA licensing exam? (Check all
that apply.)

a. Accounting software packages

b. Auditing
c. Derivatives
d. International banking laws
10. What is the result of the following transaction for Company A?
Company A’s customer is unable to pay for a previous credit sale in
accordance with Company A’s 90-day payment terms. The customer
makes a promissory note to Company A that extends payment over a
24-month term including 5% interest.

a. No result because the customer didn’t pay.

b. Accounts receivable increases because of the interest.
c. A note receivable is recorded in non-current assets.
d. Company A records the loan as a liability.
11. When are liabilities recorded under the accrual basis of
accounting?

a. When incurred
b. When paid
c. At the end of the fiscal year
d. When bank accounts are reconciled
12. Which is true about time in accounting?

a. Current liabilities are debts payable within 2 years.

b. Balance sheets reflect a company’s financial position at a
certain point in time.
c. The time value of money is a finance concept, not relevant in
accounting.
d. Accounts receivable are more easily collected as time passes.
13. When a company purchases property, plant, and equipment,
how is it reflected on the statement of cash flows?

a. As a source of cash in the "cash from investing activities"

section
b. As a source of cash in the "cash from financing activities"
section.
c. As a use of cash in the "cash from investing activities" section.
d. As a use of cash in the "cash from operating activities" section.
14. What would the journal entry be for a company that takes out a
five-year, $100,000 business loan?

a. Debit $100,000 non-current asset, Credit $100,000 non-current

liabilities
b. Debit $100,000 current asset, Credit $100,000 non-current
liabilities
c. Debit $100,000 non-current liabilities, Credit $100,000 non-
current assets
d. Debit $100,000 current liabilities, Credit $100,000 current
assets
15. Which accounts are associated with cost of goods sold?

a. Accrued interest
b. Depreciation
 c. Dividends
d. Inventory
16. Which organizations are involved in development of US
Generally Accepted Accounting Principles (GAAP)? (Check all that
apply.)

a. Financial Accounting Standards Board (FASB)

b. Government Accounting Standards Board (GASB)
c. Securities and Exchange Commission (SEC)
d. Federal Accounting Standards Advisory Board (FASAB)
17. Which inventory valuation method reflects the most current
market value for inventory on hand?

a. Last-in-First-Out (LIFO)
b. Average Costs
c. First-in-First-Out (FIFO)
d. Specific Identification
18. Which of the following statements is not true about
intercompany accounting?

a. Intercompany transactions are between two units within the

same legal entity.
b. Intercompany transactions are eliminated in consolidated
parent financial statements.
c. They can significantly impact taxes.
d. Intercompany transactions are between different legal entities
under the same parent control.
19. Which is the method of depreciation used for US tax returns
that is not GAAP-compliant?

a. Straight-line method
b. Modified accelerated cost recovery systems
c. Double-declining balance method
d. Units of production method
20. What is the most-used method to amortize intangible assets on
a company’s financial statements?

a. Straight-line method
 b. Sum of the years’ digits method
c. Double-declining balance method
d. Units of production method
21. Which financial statement is a report of a company’s revenues
and expenses during a certain time period?

a. Statement of Changes in Equity

b. Income Statement
c. Statement Of Cash Flows
22. After making a sale of $3,000, where $1,200 is paid in cash
and $1,800 is sold on credit, how would a company go about
updating its balance sheet?

a. $1,800 debit in accounts receivable; $3,000 credit in retained

earnings; $1,200 debit in cash
b. $3,000 debit in retained earnings; $1,200 credit in cash; $1,800
credit in accounts receivable
c. $1,800 debit in accounts payable; $1,200 debit in cash; $3,000
credit in retained earnings
d. $1,200 credit in cash; $1,800 credit in accounts payable;
$3,000 debit in retained earnings
23. Which is not an example of financing cash flow?

a. Paying off a debt of $25,000

b. Investing in equipment worth $90,000
c. Paying $12,000 worth of dividends to shareholders
d. Issuing $42,000 worth of shares
24. Which side of the ledger account are debits recorded on?

a. Left
b. Right
c. Depends on the debit
25. Are assets on the balance sheet recorded at their estimated
fair market value?

a. Yes
b. No
c. Sometimes; it’s situational
26. Increasing an asset involves crediting the account.

a. True
b. False
27. Unearned revenues are recorded on a company’s balance
sheet under which kind of account?

a. Current asset
b. Owners’ or stockholders’ equity
c. Non-current asset
d. Liability
28. What is the minimum number of accounts that accounting
entries can have?

a. One
b. Four
c. Five
d. Two
29. The listing of all the financial accounts within a company’s
general ledger is called the _____.

a. Chart of accounts
b. Journal entry
c. Balance sheet
d. P&L statement
30. Which is not classified as a current asset?

a. Cash
b. Product inventory
c. Liquid assets
d. Prepaid liabilities
e. Property
31. Which formula is used to calculate operating income?

a. Revenue + Direct Operating Cost = Operating Income

b. Indirect Operating Cost - Revenue = Operating Income
c. Gross Income - Operating Expenses = Operating Income
d. Gross Profit - Indirect Operating Cost = Operating Income
32. Which of these statements about accrual accounting is true?

a. Revenue is recorded only when payments are received, while

expenses are recognized when they're incurred.
b. All revenue from prepayments should be recognized when the
payment is received, while expenses accrue over the life of the
obligation.
c. If the business has provided the goods or services and can
reasonably expect to receive cash, it can recognize the
revenue in that period.
d. The matching principle dictates that expenses should be
recognized when they are incurred, regardless of when
revenue is recognized.
33. In a journal entry, a debit decreases which of the following
accounts?

a. Cash
b. Accounts Payable
c. Supplies Expense
d. Both a and c
34. Which describes the double-declining balance depreciation
method?

a. Estimated salvage value is greater at the end of the assets’

useful life than with straight-line depreciation.
b. It yields reports of higher income in the early years and lower
income later on.
c. This method decreases the useful life of the asset and disposal
costs by half.
d. The depreciation expense is larger in the first few years and
gets smaller as time goes on.
35. Which one of these WILL NOT yield earnings before interest
and taxes (EBIT)?

a. Revenue - Cost of goods sold - Operating expenses

b. Net income + Tax expense + Interest expense
c. Sales + Taxes + Interest
d. Gross profit - Operating expenses
Answer Key With Explanations
1. C — Running a trial balance is an intermediary step in the financial
close, not a core financial statement. Core financial statements are:
the income statement, the balance sheet, statement of cash flows,
statement of retained earnings and the notes to the financial
statements.

2. D — All are correct. A single step income statement has a section for
revenue and expenses and only requires one subtraction to arrive at
net income/loss. A condensed income statement only includes
summary totals. Common sized income statements add a column to
show the calculation of each line item as a percentage of revenue.

3. A — Assets, expenses and losses increase with debits. Revenue,

liabilities and gains increase with credits.

4. A — Accounts receivable is a short-term asset included in the current

asset section of a balance sheet and increases by debits. They come
about when customer sales are made on credit, not cash. Accounts
receivable become harder to collect, and therefore less valuable, as
they age.

5. A — Cash basis accounting records revenue when paid. Accrual

accounting reflects revenue when it is earned. Accounts receivable
and its related bad debt are part of accrual accounting only.

6. B — Assets, liabilities and equity are found on the balance sheet.

Revenue (or sales), expenses, gains, losses and net income (or
earnings) are income statement accounts.

7. D — All are correct. Financial statements are used for internal

analysis, like trending and calculating key performance indicators.
External negotiations, such as applying for loans and credit cards,
require financials statements. Compliance agencies, such as the
Securities & Exchange Commission (SEC), require financial
statements from public companies.
8. B — When a supplier delivers raw material a liability is incurred.
Customer payments relate to accounts receivable, not accounts
payable. Expenses paid with cash do not generate accounts payable
because the payment is made concurrent with incurring the liability.

9. B — The four sections of the CPA exam are Auditing and Attestation,
Business Environment and Concepts, Financial Accounting and
Reporting, and Regulation. While knowledge of accounting software,
derivative financial instruments and international banking law are
helpful, they are not mandatory for licensure.

10. C — Company A records a note receivable from its customer. It

is a non-current asset because the term is greater than 12 months. A
non-paying customer would cause accounts receivable to be written
off. Interest payments are not recorded in accounts receivable.
Company A is the payee of the promissory note, not the debtor, and
has no liability.

11. A — Under the accrual basis of accounting, liabilities are

recorded in the fiscal period that they are incurred or committed,
regardless of when paid.

12. B — Balance sheets are prepared "as of" a specified date.

Current liabilities are due within the next 12 months. Time value of
money, or net present value, is often used by accountants such as
for lease accounting. Accounts receivable become less likely to be
paid as they age.

13. C — Acquisitions of property, plant and equipment are uses of

cash/cash equivalents and categorized as an investing activity. The
operating activities section of the statement of cash flows captures
the inflow/outflows from business operations, such as sales or labor
expenses, rather than investments.

14. B — The transaction increases cash, a current asset, via a

debit. It also increases loans payable, which is a non-current liability
because it is due in five years, via a credit.
15. D — Cost of goods sold is an interim step on the income
statement and is calculated as: Beginning Inventory + Purchases -
Ending Inventory = Cost of Goods Sold.

16. A, B, C & D — All of the organizations listed are involved in

development of financial accounting standards.

17. C — The FIFO method assumes that the oldest inventory is

sold first, and inventory on hand at the end of a period is the newest.
The newest purchases reflect the most current market values.

18. C — The FIFO method assumes that the oldest inventory is

sold first, and inventory on hand at the end of a period is the newest.
The newest purchases reflect the most current market values.

19. B — The IRS requires the MACRS method for most fixed
assets. MACRS is not GAAP-compliant because salvage values are
ignored and because it relies on an IRS-determined table of useful
lives that is inconsistent with GAAP principles.

20. A — The straight-line method is the only GAAP-compliant

method for amortizing intangible assets.

21. B — An income statement is a financial report that documents

a company’s earnings over a specific time period — yearly, quarterly
or monthly — and records the expenses and costs associated with
earning that revenue.

22. A — $1,800 debit in accounts receivable; $3,000 credit in

retained earnings; $1,200 debit in cash. Cash is classified as a
current asset and therefore expected to be consumed, sold or
exhausted within a year, so it’s recorded on the balance sheet as a
debit when it's received. When a customer makes a payment, cash is
debited. Conversely, when a customer buys something on credit, the
sale is documented in accounts receivable, where all funds owed to a
company are accounted for. Retained earnings are a portion of the
profits earned that are not used as dividends and are often reserved
for reinvesting into the business.
23. B — Cash flow is defined as the movement of cash in and out
of a business, and cash flow from financing activities (CFF) — or
cash flow financing — is a section of the cash flow statement that
includes transactions involving debt, equity and dividends. The
purchase of plant, property and equipment (PP&E) would fall under
cash flow from investing.

24. A — Debits are recorded on the left side of the ledger account
because they decrease equity, liability and revenue and increase
expense or asset accounts.

25. B — Assets are recorded at their historical cost values, which

means that they are documented at their original cost and time
acquired.

26. B — Increasing an asset involves debiting the account,

because assets and expenses have natural debit balances.

27. D — Unearned revenues are incurred when businesses or

individuals receive payment for a product or service that has yet to be
delivered or provided. Until the item is delivered, these types of
transactions are marked as liabilities.

28. D — All accounting entries must contain at least two accounts:

one that is debited and another that is credited.

29. A — A chart of accounts helps companies break down all

financial transactions made during a certain period into
subcategories. That enables them to gain deeper insight into the
profitability and effectiveness of various products, services or
business units.

30. E — Considering that current assets are expected to be

converted to cash within a year, property, which is a long-term asset
often held for multiple years, would not be classified as such.

31. C — Gross Income - Operating Expenses = Operating Income.

A company’s operating income is, in other words, its income from
core operations. Operating income is calculated by subtracting
operating costs from gross income.
 32. C — If the business has provided the goods or services and
can reasonably expect to receive cash, it can recognize the revenue
in that period. The accrual concept requires that revenues and costs
are recognized when they are earned or incurred, rather than when
they are received in cash or paid. This method tends to provide
companies with better and more comprehensive insights into their
profitability and overall financial health.

33. B — Accounts payable tracks the money businesses owe to

their creditors, so when businesses begin to pay off their purchases,
which are recorded as debits, the balance in accounts payable
decreases.

34. D — The depreciation expense is larger in the first few years

and gets smaller as time goes on. Double-declining balance
depreciation is an accelerated depreciation method that is used to
offset an asset’s increased maintenance costs with lower
depreciation expenses throughout its lifetime. For example, in
knowing that assets will have lower repair and maintenance
expenses in their early years, companies allocate higher depreciation
expenses to newer assets.

35. C — Sales + Taxes + Interest.

Earnings before interest and taxes (EBIT) is a business’s net income
before interest and taxes are deducted, and it’s often used as a
measure of operating profit. There are multiple ways to calculate
EBIT; no matter which you use, the metric provides a look at a
company’s profitability regardless of its capital structure.

How did you do? It’s accrual world, but continue studying to
become audit you can be. (Did you catch our accounting
jokes there?). Accounting is a challenging field that requires years of initial
education, experience and continuing professional education. Specialties
within the field include managerial accounting, cost accounting, project
accounting, forensic accounting, nonprofit accounting, tax accounting and
financial accounting — which is the type of accounting covered by this test.
Accounting Basics FAQ
What are the five basic accounting principles?
There are many principles of accounting that guide the way accountants
record transactions. Four accounting principles are considered basic:
historical cost, revenue recognition, matching and full disclosure. When
referring to "5 basic accounting principles," the fifth is objectivity.

What are basic accounting questions?

Basic accounting questions focus on topics concerning the financial
statements and how transactions are recorded.

What are the basics of accounting?

Accounting basics include how to value business transactions, how to
record activity in a company’s books and how to report business results
using financial statements.

What is an accounting assessment test?

An accounting assessment test gauges an individual’s knowledge of basic
accounting information, often used to screen potential candidates for
bookkeeping and lower-level accounting jobs.

1.Financial accounting is focused on the __________ financial statements of

a company.
External Internal
2.Financial statements report the fair market value of a company.

True
False
3.Large corporations must follow the __________ basis of accounting.
4.Corporations whose stock is publicly traded must have their financial
statements __________ by independent certified public accountants.
5.The U.S. government agency with authority over the financial reporting
requirements of publicly traded corporations is the __________.
AICPA
FASB
IRS
SEC
6.The non-government organization that researches and develops new
accounting standards is the __________.
AICPA
FASB
IRS
SEC
7.The acronym for the common rules and standards that companies must
follow when preparing its external financial statements is __________.
8.SEC is the acronym for __________.
9.FASB is the acronym for __________.
10.GAAP is the acronym for __________.
11.__________-entry bookkeeping will result in at least two accounts being
involved in every transaction.
12.Every transaction will have one account being credited and one
account being __________.
13.The accounting equation is Assets = __________ + Stockholders' (or
Owner's) Equity.
14.Matching, cost, and full disclosure are examples of the fundamental or
basic accounting __________.
15.The profitability of a company for a specified period of time is reported
on the __________ statement.
16.The main components or elements of the income statement
are __________, expenses, gains, and losses.
17.Prepaid insurance is reported as an __________ on a company's balance
sheet.
18.The word "__________" is often in the title of liability accounts.
19.The statement of cash flows explains the changes in cash and
cash __________ during the specified time interval.
20.The first section of the statement of cash flows pertains
to __________ activities.

Answers
1. External
2. False
3. Accrual
4. Audited
5. SEC
6. FASB
7. GAAP
8. Securities and Exchange Commission
 9. Financial Accounting Standard Board
10. Generally Accepted Accounting Principles
11. Double
12. Debited
13. Liabilities
14. Principles
15. Income
16. Revenue
17. Asset
18. Payable
19. Equivalents
20. Operating

Introduction
Financial accounting is a specialized branch of accounting that keeps track of a
company’s financial transactions. Using standardized guidelines, the transactions
are recorded, summarized, and presented in a financial report or financial statement
such as an income statement or a balance sheet.

Companies issue financial statements on a routine schedule. The statements are

considered external because they are given to people outside of the company, with
the primary recipients being owners/stockholders, as well as certain lenders. If a
corporation’s stock is publicly traded, however, its financial statements (and other
financial reporting) tend to be widely circulated, and information will likely reach
secondary recipients such as competitors, customers, employees, labor
organizations, and investment analysts.

It’s important to point out that the purpose of financial accounting is not to report the
value of a company. Rather, its purpose is to provide enough information for others
to assess the value of a company for themselves.

Because external financial statements are used by a variety of people in a variety of

ways, financial accounting has common rules known as accounting
standards and as generally accepted accounting principles (GAAP). In the
U.S., the Financial Accounting Standards Board (FASB) is the organization that
develops the accounting standards and principles. Corporations whose stock is
publicly traded must also comply with the reporting requirements of the Securities
and Exchange Commission (SEC), an agency of the U.S. government.

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Double Entry and Accrual Accounting

At the heart of financial accounting is the system known as double-entry
bookkeeping (or “double entry accounting”). Each financial transaction that a
company makes is recorded by using this system.

The term “double entry” means that every transaction affects at least two accounts.
For example, if a company borrows $50,000 from its bank, the
company’s Cash account increases, and the company’s Notes Payable account
increases. Double entry also means that one of the accounts must have an amount
entered as a debit, and one of the accounts must have an amount entered as
a credit. For any given transaction, the debit amount must equal the credit amount.
(To learn more about debits and credits, visit our Debits and Credits
Explanation.)

The advantage of double-entry accounting is this: at any given time, the balance of a
company’s asset accounts will equal the balance of its liability and stockholders’ (or
owner’s) equity accounts. (To learn more on how this equality is maintained, visit
our Accounting Equation Explanation.)

Financial accounting is required to follow the accrual basis of accounting (as

opposed to the “cash basis” of accounting). Under the accrual basis, revenues are
reported when they are earned, not when the money is received.
Similarly, expenses are reported when they are incurred, not when they are paid.
For example, although a magazine publisher receives a $24 check from a customer
for an annual subscription, the publisher reports as revenue a monthly amount of $2
(one-twelfth of the annual subscription amount). In the same way, it reports its
property tax expense each month as one-twelfth of the annual property tax bill.

By following the accrual basis of accounting, a company’s profitability, assets,

liabilities and other financial information is more in line with economic reality. (To
learn more about the accrual basis of accounting, visit our Adjusting Entries
Explanation.)

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Accounting Principles
If financial accounting is going to be useful, a company’s reports need to be credible,
easy to understand, and comparable to those of other companies. To this end,
financial accounting follows a set of common rules known as accounting
standards or generally accepted accounting principles (GAAP, pronounced
“gap”).

GAAP is based on some basic underlying principles and concepts such as the cost
principle, matching principle, full disclosure, going concern, economic entity,
conservatism, relevance, and reliability. (To learn more about the basic principles,
visit our Accounting Principles Explanation.)

GAAP, however, is not static. It includes some very complex standards that were
issued in response to some very complicated business transactions. GAAP also
addresses accounting practices that may be unique to particular industries, such as
utility, banking, and insurance. Often these practices are a response to changes in
government regulations of the industry.

GAAP includes many specific pronouncements as issued by the Financial

Accounting Standards Board (FASB, pronounced “fas-bee”). The FASB is a non-
government group that researches current needs and develops accounting rules to
meet those needs. (To learn more about FASB and its accounting pronouncements,
visit www.FASB.org.)

In addition to following the provisions of GAAP, any corporation whose stock is

publicly traded is also subject to the reporting requirements of the Securities and
Exchange Commission (SEC), an agency of the U.S. government. These
requirements mandate an annual report to stockholders as well as an annual report
to the SEC. The annual report to the SEC requires that independent certified public
accountants audit a company’s financial statements, thus giving assurance that the
company has followed GAAP.

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Financial Statements
Financial accounting generates the following general-purpose, external, financial
statements:

1. Income statement (sometimes referred to as “results of operations”

or “earnings statement” or “profit and loss [P&L] statement”)
2. Statement of comprehensive income
3. Balance sheet (sometimes referred to as “statement of financial
position“)
4. Statement of cash flows (sometimes referred to as “cash flow
statement“)
5. Statement of stockholders’ equity

Income Statement

The income statement reports a company’s profitability during a specified period of

time. The period of time could be one year, one month, three months, 13 weeks, or
any other time interval chosen by the company.

The main components of the income statement are revenues, expenses, gains, and
losses. Revenues include such things as sales, service revenues, and interest
revenue. Expenses include the cost of goods sold, operating expenses (such as
salaries, rent, utilities, advertising), and nonoperating expenses (such as interest
expense). If a corporation’s stock is publicly traded, the earnings per share of
its common stock are reported on the income statement. (To learn more about the
income statement, visit our Income Statement Explanation.)

Statement of Comprehensive Income

The statement of comprehensive income covers the same period of time as the
income statement, and consists of two major sections:

 Net income (taken from the income statement)

 Other comprehensive income (adjustments involving foreign
currency translation, hedging, and postretirement benefits)

The sum of these two amounts is known as comprehensive income.

The amount of other comprehensive income is added/subtracted from the

balance in the stockholders’ equity account Accumulated Other Comprehensive
Income.

Balance Sheet

The balance sheet is organized into three parts: (1) assets, (2) liabilities, and (3)
stockholders’ equity at a specified date (typically, this date is the last day of an
accounting period).

The first section of the balance sheet reports the company’s assets and includes
such things as cash, accounts receivable, inventory, prepaid insurance,
buildings, and equipment. The next section reports the company’s liabilities; these
are obligations that are due at the date of the balance sheet and often include the
word “payable” in their title (Notes Payable, Accounts Payable, Wages Payable,
and Interest Payable). The final section is stockholders’ equity, defined as the
difference between the amount of assets and the amount of liabilities. (To learn more
about the balance sheet, visit our Balance Sheet Explanation.)

Statement of Cash Flows

The statement of cash flows explains the change in a company’s cash (and cash
equivalents) during the time interval indicated in the heading of the statement. The
change is divided into three parts: (1) operating activities, (2) investing activities, and
(3) financing activities.

The operating activities section explains how a company’s cash (and cash
equivalents) have changed due to operations. Investing activities refer to amounts
spent or received in transactions involving long-term assets. The financing
activities section reports such things as cash received through the issuance of
long-term debt, the issuance of stock, or money spent to retire long-term liabilities.
(To learn more about the statement of cash flows, visit our Cash Flow
Statement Explanation.)

Statement of Stockholders’ Equity

The statement of stockholders’ (or shareholders’) equity lists the changes in

stockholders’ equity for the same period as the income statement and the cash flow
statement. The changes will include items such as net income, other comprehensive
income, dividends, the repurchase of common stock, and the exercise of stock
options.

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Financial Reporting
Financial reporting is a broader concept than financial statements. In addition to
the financial statements, financial reporting includes the company’s annual report to
stockholders, its annual report to the Securities and Exchange Commission (Form
10-K), its proxy statement, and other financial information reported by the company.

Introduction
Financial accounting is a specialized branch of accounting that keeps track of a
company’s financial transactions. Using standardized guidelines, the transactions
are recorded, summarized, and presented in a financial report or financial statement
such as an income statement or a balance sheet.

Companies issue financial statements on a routine schedule. The statements are

considered external because they are given to people outside of the company, with
the primary recipients being owners/stockholders, as well as certain lenders. If a
corporation’s stock is publicly traded, however, its financial statements (and other
financial reporting) tend to be widely circulated, and information will likely reach
secondary recipients such as competitors, customers, employees, labor
organizations, and investment analysts.

It’s important to point out that the purpose of financial accounting is not to report the
value of a company. Rather, its purpose is to provide enough information for others
to assess the value of a company for themselves.

Because external financial statements are used by a variety of people in a variety of

ways, financial accounting has common rules known as accounting
standards and as generally accepted accounting principles (GAAP). In the
U.S., the Financial Accounting Standards Board (FASB) is the organization that
develops the accounting standards and principles. Corporations whose stock is
publicly traded must also comply with the reporting requirements of the Securities
and Exchange Commission (SEC), an agency of the U.S. government.
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Double Entry and Accrual Accounting

At the heart of financial accounting is the system known as double-entry
bookkeeping (or “double entry accounting”). Each financial transaction that a
company makes is recorded by using this system.

The term “double entry” means that every transaction affects at least two accounts.
For example, if a company borrows $50,000 from its bank, the
company’s Cash account increases, and the company’s Notes Payable account
increases. Double entry also means that one of the accounts must have an amount
entered as a debit, and one of the accounts must have an amount entered as
a credit. For any given transaction, the debit amount must equal the credit amount.
(To learn more about debits and credits, visit our Debits and Credits
Explanation.)
The advantage of double-entry accounting is this: at any given time, the balance of a
company’s asset accounts will equal the balance of its liability and stockholders’ (or
owner’s) equity accounts. (To learn more on how this equality is maintained, visit
our Accounting Equation Explanation.)

Financial accounting is required to follow the accrual basis of accounting (as

opposed to the “cash basis” of accounting). Under the accrual basis, revenues are
reported when they are earned, not when the money is received.
Similarly, expenses are reported when they are incurred, not when they are paid.
For example, although a magazine publisher receives a $24 check from a customer
for an annual subscription, the publisher reports as revenue a monthly amount of $2
(one-twelfth of the annual subscription amount). In the same way, it reports its
property tax expense each month as one-twelfth of the annual property tax bill.

By following the accrual basis of accounting, a company’s profitability, assets,

liabilities and other financial information is more in line with economic reality. (To
learn more about the accrual basis of accounting, visit our Adjusting Entries
Explanation.)

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Accounting Principles
If financial accounting is going to be useful, a company’s reports need to be credible,
easy to understand, and comparable to those of other companies. To this end,
financial accounting follows a set of common rules known as accounting
standards or generally accepted accounting principles (GAAP, pronounced
“gap”).

GAAP is based on some basic underlying principles and concepts such as the cost
principle, matching principle, full disclosure, going concern, economic entity,
conservatism, relevance, and reliability. (To learn more about the basic principles,
visit our Accounting Principles Explanation.)

GAAP, however, is not static. It includes some very complex standards that were
issued in response to some very complicated business transactions. GAAP also
addresses accounting practices that may be unique to particular industries, such as
utility, banking, and insurance. Often these practices are a response to changes in
government regulations of the industry.
GAAP includes many specific pronouncements as issued by the Financial
Accounting Standards Board (FASB, pronounced “fas-bee”). The FASB is a non-
government group that researches current needs and develops accounting rules to
meet those needs. (To learn more about FASB and its accounting pronouncements,
visit www.FASB.org.)

In addition to following the provisions of GAAP, any corporation whose stock is

publicly traded is also subject to the reporting requirements of the Securities and
Exchange Commission (SEC), an agency of the U.S. government. These
requirements mandate an annual report to stockholders as well as an annual report
to the SEC. The annual report to the SEC requires that independent certified public
accountants audit a company’s financial statements, thus giving assurance that the
company has followed GAAP.

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Financial Statements
Financial accounting generates the following general-purpose, external, financial
statements:

1. Income statement (sometimes referred to as “results of operations”

or “earnings statement” or “profit and loss [P&L] statement”)
2. Statement of comprehensive income
3. Balance sheet (sometimes referred to as “statement of financial
position“)
4. Statement of cash flows (sometimes referred to as “cash flow
statement“)
5. Statement of stockholders’ equity

Income Statement

The income statement reports a company’s profitability during a specified period of

time. The period of time could be one year, one month, three months, 13 weeks, or
any other time interval chosen by the company.

The main components of the income statement are revenues, expenses, gains, and
losses. Revenues include such things as sales, service revenues, and interest
revenue. Expenses include the cost of goods sold, operating expenses (such as
salaries, rent, utilities, advertising), and nonoperating expenses (such as interest
expense). If a corporation’s stock is publicly traded, the earnings per share of
its common stock are reported on the income statement. (To learn more about the
income statement, visit our Income Statement Explanation.)

Statement of Comprehensive Income

The statement of comprehensive income covers the same period of time as the
income statement, and consists of two major sections:

 Net income (taken from the income statement)

 Other comprehensive income (adjustments involving foreign
currency translation, hedging, and postretirement benefits)

The sum of these two amounts is known as comprehensive income.

The amount of other comprehensive income is added/subtracted from the

balance in the stockholders’ equity account Accumulated Other Comprehensive
Income.

Balance Sheet

The balance sheet is organized into three parts: (1) assets, (2) liabilities, and (3)
stockholders’ equity at a specified date (typically, this date is the last day of an
accounting period).

The first section of the balance sheet reports the company’s assets and includes
such things as cash, accounts receivable, inventory, prepaid insurance,
buildings, and equipment. The next section reports the company’s liabilities; these
are obligations that are due at the date of the balance sheet and often include the
word “payable” in their title (Notes Payable, Accounts Payable, Wages Payable,
and Interest Payable). The final section is stockholders’ equity, defined as the
difference between the amount of assets and the amount of liabilities. (To learn more
about the balance sheet, visit our Balance Sheet Explanation.)

Statement of Cash Flows

The statement of cash flows explains the change in a company’s cash (and cash
equivalents) during the time interval indicated in the heading of the statement. The
change is divided into three parts: (1) operating activities, (2) investing activities, and
(3) financing activities.

The operating activities section explains how a company’s cash (and cash
equivalents) have changed due to operations. Investing activities refer to amounts
spent or received in transactions involving long-term assets. The financing
activities section reports such things as cash received through the issuance of
long-term debt, the issuance of stock, or money spent to retire long-term liabilities.
(To learn more about the statement of cash flows, visit our Cash Flow
Statement Explanation.)
Statement of Stockholders’ Equity

The statement of stockholders’ (or shareholders’) equity lists the changes in

stockholders’ equity for the same period as the income statement and the cash flow
statement. The changes will include items such as net income, other comprehensive
income, dividends, the repurchase of common stock, and the exercise of stock
options.

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Financial Reporting
Financial reporting is a broader concept than financial statements. In addition to
the financial statements, financial reporting includes the company’s annual report to
stockholders, its annual report to the Securities and Exchange Commission (Form
10-K), its proxy statement, and other financial information reported by the company.

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Financial Accounting vs. “Other” Accounting

Financial accounting represents just one sector in the field of business
accounting. Another sector, managerial accounting, is so named because it
provides financial information to a company’s management. This information is
generally internal (not distributed outside of the company) and is primarily used by
management to make decisions. Other sectors of the accounting field include cost
accounting, tax accounting, and auditing.
Visit our Accounting Careers page to learn more about the scope and variety of
accounting opportunities.

Where to Go From Here

We recommend taking our Practice Quiz next, and then continuing with the rest
of our Financial Accounting materials (see the full outline below).

We also recommend joining PRO to unlock our premium materials (certificates of

achievement, video training, flashcards, visual tutorials, quick tests, quick tests with
coaching, cheat sheets, guides, puzzles, business forms, printable PDF files,
progress tracking, badges, points, medal rankings, activity streaks, public profile
pages, and more).

Disclaimer

You should consider our materials to be an introduction to selected accounting and

bookkeeping topics (with complexities likely omitted). We focus on financial
statement reporting and do not discuss how that differs from income tax reporting.
Therefore, you should always consult with accounting and tax professionals for
assistance with your specific

1. Introduction to the main financial statements and accounting rules, balance

sheet heading and sections, reporting of cash

2. Balance sheet: accounts receivable, estimated allowance for doubtful

accounts, inventory cost flows (FIFO & LIFO)

3. Balance sheet: prepaid expenses; current assets; investments; property, plant

and equipment

4. Balance sheet: property, plant and equipment (accumulated depreciation,

book value)

5. Balance sheet: asset classifications (intangible assets, other assets)

6. Balance sheet: current liabilities (notes payable, accounts payable, accrued

expenses, customer deposits)

7. Balance sheet: long-term liabilities, stockholders' equity

8. Balance sheet: working capital, current ratio, financial leverage, notes to

financial statements, comparative balance sheets
 9. Income statement: revenues, cost of goods sold, expenses, nonoperating
items

10. Income statement: formats (multiple-step, single-step, comparative, amounts

as % of net sales)

11. Connection between the income statement and balance sheet

12. Statement of cash flows: introduction, cash flows from operating activities

13. Statement of cash flows: cash flows from operating activities, cash flows from
investing activities, cash flows from financing activities, quality of earnings

14. Statement of cash flows: free cash flow; statement of owner's equit

Definition of General Ledger Account

A general ledger account is an account or record used to sort, store and
summarize a company’s transactions. These accounts are arranged in the general
ledger (and in the chart of accounts) with the balance sheet accounts appearing
first followed by the income statement accounts.

Examples of General Ledger Accounts

Some of the more common balance sheet accounts and how they are further
arranged in the general ledger include:

 asset accounts such as Cash, Accounts Receivable, Inventory,

Investments, Land, and Equipment
 liability accounts including Notes Payable, Accounts Payable,
Accrued Expenses Payable, and Customer Deposits
 stockholders’ equity accounts such as Common Stock, Retained
Earnings, Treasury Stock, and Accumulated Other Comprehensive
Income

Some of the general ledger income statement accounts and how they are arranged
include:

 operating revenue accounts such as Sales and Service Fee

Revenues
 operating expense accounts including Salaries Expense, Rent
Expense, and Advertising Expense
 nonoperating or other income accounts such as Gain on Sale of
Assets, Interest Expense, and Loss on Disposal of Assets

Definition of Adjunct Account

An adjunct account is a general ledger account that is related to another general
ledger account. The combination of the balance in the adjunct account and the other
general ledger account is the carrying amount or book value of the main account.
An adjunct account might be referred to as a valuation account.

Example of Adjunct Account

Assume that a corporation issued bonds with a maturity value of $2,000,000 but
investors paid the corporation $2,100,000 because of the bonds’ favorable interest
rate. The corporation will record the transaction with a credit to the liability account
Bonds Payable for $2,000,000, a credit to the related adjunct liability
account Premium on Bonds Payable for $100,000, and a debit to Cash for
$2,100,000. At the time the bonds are issued, they have a carrying amount or book
value of $2,100,000. (The corporation will then amortize the Premium on Bonds
Payable to Interest Expense over the life of the bonds.)

Definition of Contra Account

A contra account is a general ledger account with an account balance that is the
opposite of the normal balance for that account classification. For
example, Accumulated Depreciation is a contra asset account that is associated
with asset accounts for buildings, equipment, vehicles, etc. The asset accounts have
debit balances, but the related account Accumulated Depreciation will have a credit
balance.

Examples of a Contra Account

Assume that a company’s Equipment has a debit balance of $450,000. The related
account Accumulated Depreciation of Equipment has a credit balance of $190,000.
Therefore, the carrying amount or book value of the equipment is $260,000.

Assume a company has sold goods on credit for $900,000. As a result, its Sales
account was credited for $900,000 and Accounts Receivable was debited for
$900,000. Several customers were disappointed in the goods they received and the
company gave them a sales allowance of $10,000. In order to account for such
allowances, the company will debit the contra sales account Sales Allowances for
$10,000 (instead of debiting Sales) and credits Accounts Receivable. The company
will likely combine the credit balance of $900,000 in the Sales account with the debit
balance of $10,000 in the Sales Allowances account and report net sales of
$890,000.

Definition of Sales Tax

In the U.S., a sales tax is a state tax (and possibly an additional city and/or county
tax) that is paid by the buyer at the time of purchase. The sales tax is based on
certain products’ (or services’) selling prices and the sales tax rate. For instance, in
some states unprepared grocery items are not subject to a sales tax. Items
purchased for resale are not subject to the sales tax when purchased by the retailer,
but will be subject to the sales tax when the items are sold to the end customer. In
some cities, there could be a state sales tax of 6% plus a county tax of 1% and a
tourist district sales tax of 3%. In another state there could be only a sales tax rate of
8%.

The sales taxes collected by a merchant are not part of the merchant’s sales and
are not part of the merchant’s expenses. Instead, the merchant is merely an agent
of the state and will record the sales taxes collected in a current liability account
such as Sales Taxes Payable. When the merchant remits the sales taxes to the
state, the current liability account is reduced.

If a company purchases a new delivery van, the sales taxes paid on the van are
recorded as part of the cost of the van. The total cost of the van will then be charged
to depreciation expense over the van’s useful life.

Examples of Sales Tax

If a company sells $100,000 of merchandise that is subject to a state sales tax of
7%, the company will collect $107,000. The journal entry to record this information is:

 Debit: Cash for $107,000

 Credit: Sales (or Sales Revenues) for $100,000
 Credit: Sales Taxes Payable for $7,000

When the company remits the $7,000 to the state, the company will credit Cash and
debit Sales Taxes Payable. Note that in this example that the sales tax is not
an expense and it is not part of the company’s sales revenues.

If a company purchases a new delivery van for $50,000 plus $3,500 of sales tax, the
company will record the truck as an asset at its total cost of $53,500. In this situation,
the sales tax of $3,500 is considered to be a necessary cost of the truck and will be
part of the depreciation expense recorded during the useful life of the truck.