What is the logic behind this equation? How is the structure of the balance sheet related to this equation?

Chapter Eight

3. State the “accounting equation” and define each of its terms. What is the logic behind this equation? How is the structure of the balance sheet related to this equation?
The accounting equation indicates that assets = liabilities + owners’ equity. This means that the left side of the balance sheet, where assets, debits, are normally listed must be equal to the right side of the balance sheet, where liabilities and owners’ equity, credits, are normally placed for a financial statement to be accurate and properly balanced. A financial statement’s balance sheet is only balanced when debits are exactly equal to credits. Assets are financial instruments owned by an organization or used to provide financial income or revenues to the organization. Liabilities, in turn, are debts owed by the organization to outside parties that must be repaid. Owners’ equity refers to the financial contributions made by owners to an organization and the revenues earned by the organization that increase owners’ equity throughout time.
The dual column system of accounting is used to ensure proper entry of all debits and credits. This method of accounting helps validate the financial information of a corporation because only when information is accurately entered (barring outright fraud) will the accounting equation be in balance (Yu & Tomas, 2004). Because so many persons rely on the accuracy of financial statements it is imperative that financial statements be accurate. Accounting has developed to ensure such accuracy, as much as possible, through the methods employed to complete financial statements. The accounting equation is part of this system of verification.
References: Yu, L., Tomas, R. (2004). Inventory is not cash. Industrial Management. Retrieved November 4
4. You have a company’s balance sheet, its income statement, and its statement of cash flows. Which would you refer to if you wanted to know if a company made a profit last year? If you wanted to find out whether the firm had any intangible assets? If you wanted to know why its cash balance had changed over the past year? If you wanted to know how much debt the firm had used to finance its assets? If you wanted to know what the firm’s operating expenses were for the past year?
Money). That information, however, does not fully answer whether a company made or lost money last year. Ultimately money is cash. Income statements are prepared on an accrual basis, meaning that they indicate profits and losses not on the basis of what money was actually earned or lost, but on the timing principles in accounting that indicate when revenues must be recognized and expenses expensed (Rujoub et al., 1995). To know whether a company actually made or lost money, therefore, a review of the cash flow statement is required.
Likewise, while increases in debt may be seen on a balance sheet’s short and long term liabilities, a cash flow statement will indicate the precise change in financing a company underwent during a year. Finally, a cash flow statement is also where one can see the sources of change for a company’s cash account during a year.


Rujoub, M. A., Cook, D.M., & Hay, L.E. (1995). Using cash flow ratios to predict business failures. Journal of Managerial Issues. Retrieved November 4

6. Identify and describe the basic elements of an income statement. Explain how the accrual basis of accounting guides the way the information on the income statement is reported.
to obtain the revenues), operating expenses, including things such as the costs of machinery, rents or leases, employees, salaries, benefits, utilities, and other amounts used to operate the business, and shows deductions for depreciation, amortization, and taxes before arriving at a final net income or loss figure.
Income statements are prepared using the accrual basis of accounting, meaning that revenues are recorded when sales are made, not when payments for sales are collected and expenses are recorded when incurred, not when paid. This means that the income statement does not properly track the inflow and outflow of cash into or out of the business. Therefore, while income statements provide an accrual basis report on profits and losses those amounts do not coincide with the real movement of money through the business. It is possible for an income statement to indicate a large net profit yet the business to fail due to a lack of cash flow.

7. What is the purpose of an external audit by an independent CPA firm?
An external auditor typically must be a certified public accountant (CPA) to perform a financial statement audit in accordance with Public Company Accounting Oversight Board (PCAOB) rules. However, an external auditor performing an operational, an information technology or a compliance audit does not need certification.

8. What is the purpose of budgeting? What is the master budget, and what are its major
Components? How does a top down budgeting process differ from a bottom up approach?
And what are the advantages and disadvantages of each?

Purposes of Budgeting
The system of budgets serves as the comprehensive financial plan for the organization as a whole.
Advantages of budgeting include:
1. Budgeting forces management to plan for the future—to develop an overall direction for the organization, foresee problems, and develop future policies.
2. Budgeting helps convey significant information about the resource capabilities of an organization, making better decisions possible. Example: A cash budget points out potential shortfalls.
3. Budgeting helps set standards that can control the use of a company’s resources and control and motivate employees.
4. Budgeting improves the communication of the plans of the organization to each employee. Budgets also encourage coordination because the various areas and ac-tivities of the organization must all work together to achieve the stated objectives.
The master budget is a comprehensive financial plan made up of various indi-vidual departmental and activity budgets for the year. A master budget can be divided into:
(1) Operating budgets, which outline the income-generating activities of a firm (sales, production, and finished goods inventories).
The outcome of the operating budgets is a pro forma (budgeted) income statement.
(2) Financial budgets, which outline the inflows and outflows of cash and the financial position.
The outcome of the financial budgets includes a cash budget and a pro forma (budgeted) balance sheet.
The master budget is usually prepared for a one-year period corresponding to the company’s fiscal year.
The yearly master budget can be broken down into quarterly and monthly budgets to allow managers to compare actual data with budgeted data as the year unfolds and to make timely corrections.
Bottom-Up Process

Appropriately named, the bottom-up budgeting process starts with the smallest components of an organization, usually lower-level individual projects, to collectively create a budget for the organization. To begin the bottom-up budgeting process, you must look at the steps needed to carry out an individual project and associate a cost to each step. You may need to perform market research to determine costs if you haven’t previously completed a similar project within your organization. Next, you will need to add up the cost for each project to come up with the total. You must do this for every level of the organization. You will need the input of managers on each level, so that you are aware of the cost of the projects under their supervision. To come up with an annual budget, you simply add up all of the monthly budgets for the year.

Bottom-Up Advantages and Disadvantages
An advantage of using the bottom-up budgeting technique is that you can accurately plan every phase of a project. Bottom-up budgeting typically involves individuals of multiple levels within an organization, which is an advantage for most companies because it builds employee morale. A disadvantage of bottom-up budgeting is that it is easy to over-budget, which means that lower-level participants may ask management for more money than is actually needed. Another disadvantage of bottom-up budgeting is that it’s easy to miss a step in the process, which can cause you to miscalculate your budget requirements.
Top-Down Process
Although bottom-up budgeting is more common, some companies and governmental agencies are abandoning traditional budgeting methods to implement the top-down process. Top-down budgeting starts the process by estimating the cost of higher-level tasks within an organization. The budgets are prepared by management, and lower-level staff do not have much input in the process. Management sets the guidelines for the budgeting process, and guidelines are potentially based on projected sales or expenditure levels.
Top-Down Advantages and Disadvantages

An advantage of top-down budgeting is that it can establish organizational principles. For example, if management has budgeted for a certain amount of sales, it will encourage the employees to perform in a way that goals are met. A disadvantage of the top-down process is that lower-level employees are usually excluded from the process, which can make them feel like a budget is imposed upon them against their will. This has the potential to weaken employee morale.

9. Describe the key differences between financial accounting and managerial accounting.
Management accounting is presented internally, whereas financial accounting is meant for external stakeholders. Although financial management is of great importance to current and potential investors, management accounting is necessary for managers to make current and future financial decisions. Financial accounting is precise and must adhere to Generally Accepted Accounting Principles (GAAP), but management accounting is often more of a guess or estimate, since most managers do not have time for exact numbers when a decision needs to be made.(Chron)

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