We are now going to shift gears and start building financial statements from scratch. We will be confronted with hypothetical (and carefully chosen) transactions and events, decide whether they should be recognized in the formal accounting records and, if so, make balancing Journal Entries to record them. We will adjust the accounts as needed before compiling our work into a set of financial statements. We will start with simple transactions to hone our skills at classification and valuation, then progress to ever more complex ones.
We will begin with examples in which an entity is just starting up. This allows us to start with a clean slate. We will see that accounting starts off well, meaning that valuations start on solid footing, classifications are straightforward, and the numbers in our financial statements have mostly intuitive meanings. We will see however that as an entity operates, the numbers we push around have less and less direct meaning. They become best viewed as products of accounting rules applied to an ever-increasing series of facts and circumstances instead of as inherently meaningful measures.
Accountants are aware of this drift, and GAAP have many requirements for evaluating when to hit the “reset” button - i.e., when we have to make adjustments to bring things back to being better aligned with underlying economics.
There is no better way to learn all this than by digging into a specific problem. Here is an example: