Basic Concepts of

Financial
Accounting
Analysis of Financial statements Lesson 2

The Basic Accounting

Equation

Financial accounting is based upon the accounting

equation.
Assets = Liabilities + Owners' Equity

This is a mathematical equation which must balance.

If assets total $300 and liabilities total $200, then owners'

equity must be $100.

The Basic Accounting

Equation

The balance sheet is an expanded expression of the

accounting equation.

The Basic Accounting

Equation

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Assets

Assets are valuable resources that are owned by a firm.

They represent probable future economic benefits and

arise as the result of past transactions or events.

Liabilities

Liabilities are present obligations of the firm.

They are probable future sacrifices of economic benefits

which arise as the result of past transactions or events.

Owners' Equity

Owners' equity represents the owners' residual interest

in the assets of the business.

Residual interest is another name for owners' equity.

Owners' Equity

Owners may make a direct investment in the business or

operate at a profit and leave the profit in the business.

Owners' Equity

Yet another name for owners' equity is net assets.

Indicates that owners' equity results when liabilities are

subtracted from assets.

Owners Equity = Assets Liabilities

The Basic Accounting

Equation

Both liabilities and owners' equity represent claims on

the assets of a business.

The Basic Accounting

Equation

Liabilities are claims by people external to the business.

The Basic Accounting

Equation

Owners' equity is a claim by the owners.

Analyzing Transactions

Transaction analysis is the central component of the

financial accounting process.

Remember that every transaction must keep the

accounting equation in balance.

The Entity Assumption

The entity assumption dictates that business records

must be kept separate and distinct from the personal
records of the owners.

If a person owns more than one business, then each

business must have its own set of records.

A transaction may do one of

several things:

It may increase both the asset side and the liabilities

and owners' equity side.

It may decrease both the asset side and the liabilities

and owners' equity side.

A transaction may do one of

several things:

It may cause both an increase and a decrease on the

asset side.

It may cause both an increase and a decrease on the

liabilities and owners' equity side.

A transaction may do one of

several things:

Regardless of what transaction occurs, the accounting

equation must be in balance after the transaction is
analyzed.

Transaction Analysis

Transaction Analysis

Transaction Analysis

Transaction Analysis

Transaction Analysis

Transaction Analysis

Transaction Analysis

Transaction Analysis

Historical Cost

Historical cost is used for the recording of an asset.

It is the exchange price on the date of the acquisition of

the asset.

Historical Cost

Even though over time an asset's value may increase

above the historical cost, that cost is still kept on the
books because the number is considered to be reliable.

Revenues and Expenses

Revenues increase owners' equity.

Expenses decrease owners' equity.

Revenues

Revenues are inflows of assets (or reductions in

liabilities) in exchange for providing goods and services
to customers.

A retail store such as Wal-Mart earns revenues by selling

goods to customers.

A CPA firm earns revenues by providing services such as tax

return preparation or auditing.

Revenues

Critically important point:

Cash need not be received in order for revenue to be

recorded.

Revenues are earned when a company does what it is

supposed to do according to a contract.

Revenues

Accounts receivable are promises by a customer or

client to pay cash in the future.

Revenues

A related concept concerns cash received before a

service is performed or goods are delivered.

Consider the following

example:

A magazine company receives $24, which represents a

year's subscription.

The subscriber, of course, pays in advance.

Consider the following

example:

The magazine company may not record revenue

because it has not earned revenue yet.

Consider the following

example:

To earn revenue, it must send the subscriber one

magazine a month for twelve months.

Consider the following

example:

It owes magazines to the subscriber and thus has a

liability (called Unearned Revenue), not revenue.

Consider the following

example:

As magazines are sent, revenues may be recorded.

Consider the following

example:

Unearned revenues are usually settled by the

performance of a service, unlike other liabilities which
are usually settled by the payment of cash.

Revenues

Revenues

Expenses

Expenses occur when resources are consumed in order

to generate revenue.

They are the cost of doing business.

Examples include rent, salaries and wages, insurance,

electricity, utilities, and the like.

Expenses

Expenses

A critically important point similar to that for revenues

holds true for expenses.

A business need not pay out cash in order to have to record

that an expense has occurred.

Expenses

A critically important point similar to that for revenues

holds true for expenses.

If a repairman comes to the business to work on the air

conditioning system, then the business has a repair
expense even though that work may be charged to its
account.

Expenses

A critically important point similar to that for revenues

holds true for expenses.

The company will have a liability which it will settle later

with the payment of cash.

Expenses

The word "payable" is usually used in a liability title.

Examples of Payables

Notes payablewritten obligations.

Accounts payableunwritten obligations that arise in

the normal operations of a business.

Wages payable.

Examples of Payables

Sales of Inventory

Sales of inventory contain both revenue and expense

components.

Sales of Inventory

A revenue transaction exists because an asset has been

obtained and goods have been provided to customers.

Sales of Inventory

An expense transaction exists because an asset has been

consumed to generate the revenue.

Sales of Inventory

The resulting expense is called cost of goods sold.

Sales of Inventory

Adjustments to Accounts

Several adjustments must be made to accounting

records at the end of the accounting period.

Adjustments to Accounts

A balance in an account may need to be adjusted

because of the passage of time and the occurrence of
events in that time period.

Adjustments to Accounts

An amount may not have been recorded in an account

at all.

The amount will have to be recorded before the financial

statements are prepared so that all the information will be
correct.

Interest

Interest is a rental charge for the use of money.

It is computed by multiplying the principal (or borrowed

amount) by the interest rate and by the period of time
involved.

Interest

Since the interest rate is an annual rate, the time

period must also be an annual period.

If the time is given in months, then the time fraction will

have 12 in the denominator.

Interest

Since the interest rate is an annual rate, the time

period must also be an annual period.

If a company borrowed $12,000 at 10% for three months,

and one month has elapsed, then accumulated interest is
computed as follows:

$12,000 X .10 X 1/12 = $100

Interest

Since the interest rate is an annual rate, the time

period must also be an annual period.

If the time is given in days, then the time fraction will

have 360 (bobtail or banker's year) or 365 in the
denominator.

Interest

Since the interest rate is an annual rate, the time

period must also be an annual period.

The number 360 is used in the denominator because it

eases computations.

Interest

Since the interest rate is an annual rate, the time

period must also be an annual period.

The number 360 is also used by some financial institutions

because it results in more interest for them.

Which results in more

interest?

Try multiplying $12,000 X 10% X 90/360.

Now multiply $12,000 X 10% X 90/365.

Interest Payable

Rent

If rent is prepaid, then as time elapses, the asset is

used up, or consumed, and an expense is incurred.

Rent

If a business prepays $6,000 for five months' worth of

rent, and if two months have gone by, then the business
has incurred $2,400 of expense$1,200 per month for
two months.

The same is true for other items paid in advance, such as

insurance.

Rent

Depreciation

Depreciation shows that an asset such as equipment or

a building is wearing out and being used up.

Depreciation

Depreciation expense is computed by dividing the

estimated useful life of the asset into the asset's
historical cost less any salvage value estimated by the
business.

Depreciation

If a machine cost $5,000 and has a salvage value of

$500, with a useful life of five years, then the
depreciation expense per year will be $900.

Depreciation

Unearned Revenue

If a company has unearned revenue, then it may have

earned revenue as time has elapsed because it has
provided the service to the customer.

The liability "Unearned Revenue" will have to be

decreased, and revenue will have to be recorded.

Unearned Revenue

Using the magazine example, if three months' worth of

magazines have been sent to the subscriber, then the
company will reduce its liability and increase its
revenues by $6.

3 months X $2/month = $6

Unearned Revenue

Withdrawal by Owner

A withdrawal by owner is treated exactly the opposite

of a contribution by the owner.

Withdrawal by Owner

Revenues and Expenses

Remember that four transactions affect owners' equity.

Owner investments increase owners' equity.

Owner withdrawals decrease owners' equity.

Revenues increase owners' equity.

Expenses decrease owners' equity.

Simple Balance Sheets and

Income Statements

The end result of the accounting process is the

preparation of financial statements.

The Balance Sheet

The balance sheet shows a firm's assets, liabilities, and owner's

equity at one point in time.

The date on the balance sheet will be a single date, such as

December 31 or June 30.

The Income Statement

The income statement summarizes a firm's revenues and expenses

for a period of time.

The date on the income statement will be a phrase such as, "For the
month ended July 31," or "For the year ended December 31."

The Income Statement

If revenues exceed expenses, then the result is net

income.

If expenses exceed revenues, then the result is a net

loss.

The Income Statement

Only revenues and expenses appear on the income

statement.

Students sometimes think that cash is a good thing and

should appear on the income statement.

Cash is an asset and so will appear on the balance sheet.

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The Statement of Owners'

Equity

The statement of owners' equity summarizes the

changes that took place in owners' equity during the
period under review.

The Statement of Owners'

Equity

It will have the same date as does the income

statement.

It shows results over a period of time, not just at one

point in time.

The Statement of Owners'

Equity

The statement starts with the beginning balance of

owners' equity and adds in any owner investment and
net income.

If there are withdrawals, then they are subtracted, as is

a net loss.

The Statement of Owners'

Equity

A business will have either a net income or a net loss,

not both.

The Statement of Owners' Equity

Relationship Between Balance

Sheet and Income Statement

Changes in net income, owner contributions, and owner

withdrawals, all of which affect owners' equity, explain
changes in net assets.

The Accrual Basis of

Accounting

The accrual basis of accounting records revenues when

goods have been delivered or services have been
performed, regardless of when cash is received.

The Accrual Basis of

Accounting

This basis also records expenses when resources are

consumed, regardless of when payment is made.

The Cash Basis of Accounting

The cash basis of accounting records revenue when cash

is received.

This basis also records expenses when cash is paid.

The Accrual Basis Is

Preferable

The accrual basis is preferable for providing the most

useful information to financial statement users.

GAAP requires use of the accrual basis.

The Accrual Basis Is

Preferable

The accrual basis keeps in place the matching principle.

All resources consumed in generating revenue should be

shown on the same income statement (that is, during the
same time period) as that revenue.

Forms of Business
Organization

Profit-oriented enterprises can be organized in one of

three ways.

Sole proprietorships

Partnerships

Corporations

Sole Proprietorships

Sole proprietorships are businesses that are owned by

one individual and usually operated by that individual.

Sole Proprietorships

Their primary advantage is ease of formation.

Their major disadvantage is unlimited liability.

Sole Proprietorships

Because of the entity assumption, records of the

business and its owner must be kept separate.

Partnerships

Partnerships consist of two or more persons in business

to make a profit.

They are very similar to sole proprietorships.

Corporations

Corporations, unlike proprietorships or partnerships,

are separate legal entities.

They are more difficult to form, and they must pay

income taxes.

Corporations

If shareholders receive dividends, then those dividends

are taxable, leading to double taxation of income.

Corporations

A major advantage of a corporation is the limited

liability of its shareholders.

Only a shareholder's investment in the corporation is at

risk.

Balance Sheet Differences

Differences in balance sheets lie mainly in the equity

section.

Balance Sheet Differences

A sole proprietorship has one capital account.

In a partnership, each partner has his or her own capital

account.

Balance Sheet Differences

Shareholders' equity of a corporation consists of two

components:

Invested capitalresults from direct contributions by the

shareholders.

Retained earningsreflects the increases and decreases in

the shareholders' interest in the company that arose from
operations since the company's inception.

End