Basic Concepts of Financial Accoun2ng
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1 Basic Concepts of Financial Accoun2ng
2 The Basic Accoun2ng Equa2on Financial accoun2ng is based upon the accoun2ng equa2on. Assets = Liabilities + Owners' Equity This is a mathema2cal equa2on which must balance. If assets total $300 and liabili2es total $200, then owners' equity must be $100.
3 The Basic Accoun2ng Equa2on The balance sheet is an expanded expression of the accoun2ng equa2on.
4 The Basic Accoun2ng Equa2on Assets Balance Sheet Liabilities and Owners Equity Cash 5,000 Liabilities Accounts receivable 7,000 Accounts payable 8,000 Inventory 10,000 Notes payable 2,000 Equipment 7,000 Total liabilities 10,000 Owners equity 19,000 Total assets 29,000 Total liabilities and owners equity 29,000
5 Assets Assets are valuable resources that are owned by a firm. They represent probable future economic benefits and arise as the result of past transac2ons or events.
6 Liabili2es Liabili*es are present obliga2ons of the firm. They are probable future sacrifices of economic benefits which arise as the result of past transac2ons or events.
7 Owners' Equity Owners' equity represents the owners' residual interest in the assets of the business. Residual interest is another name for owners' equity.
8 Owners' Equity Owners may make a direct investment in the business or operate at a profit and leave the profit in the business.
9 Owners' Equity Yet another name for owners' equity is net assets. Indicates that owners' equity results when liabili2es are subtracted from assets. Owners Equity = Assets Liabilities
10 The Basic Accoun2ng Equa2on Both liabili2es and owners' equity represent claims on the assets of a business.
11 The Basic Accoun2ng Equa2on Liabili2es are claims by people external to the business.
12 The Basic Accoun2ng Equa2on Owners' equity is a claim by the owners.
13 Analyzing Transac2ons Transac*on analysis is the central component of the financial accoun2ng process. Remember that every transac2on must keep the accoun2ng equa2on in balance.
14 The En2ty Assump2on The en2ty assump2on dictates that business records must be kept separate and dis2nct 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.
15 A transac2on may do one of several things: It may increase both the asset side and the liabili2es and owners' equity side. It may decrease both the asset side and the liabili2es and owners' equity side.
16 A transac2on 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 liabili2es and owners' equity side.
17 A transac2on may do one of several things: Regardless of what transac2on occurs, the accoun2ng equa2on must be in balance aqer the transac2on is analyzed.
18 Transac2on Analysis ASSETS Cash +$50,000 Owners Original Investment = LIABILITIES + OWNERS EQUITY H.Jacobs, capital +$50,000
19 Transac2on Analysis ASSETS Cash +$20,000 Bank Loan = LIABILITIES + OWNERS EQUITY Notes Payable +$20,000
20 Transac2on Analysis ASSETS Cash $12,000 Prepaid rent +$12,000 Rent = LIABILITIES + OWNERS EQUITY
21 Transac2on Analysis ASSETS Inventory +$30,000 Inventory = LIABILITIES + OWNERS EQUITY Accounts Payable +$30,000
22 Transac2on Analysis ASSETS Cash $25,000 Equipment +$25,000 Equipment = LIABILITIES + OWNERS EQUITY
23 Transac2on Analysis ASSETS Cash Prepaid Rent Inventory Equipment +50, ,000 12, , ,000 25, ,000 33,000 12,000 30,000 25,000
24 Transac2on Analysis LIABILITIES OWNER S EQUITY Accounts Payable Notes Payable H.Jacobs, Capital +20, , ,000 30,000 20,000 50,000
25 Transac2on Analysis Assets Balance Sheet Liabilities and Owners Equity Cash 33,000 Liabilities Accounts receivable 12,000 Accounts payable 30,000 Inventory 30,000 Notes payable 20,000 Equipment 25,000 Total liabilities 50,000 H.Jacobs, capital 50,000 Total assets 100,000 Total liabilities and owners equity 100,000
26 Historical Cost Historical cost is used for the recording of an asset. It is the exchange price on the date of the acquisi2on of the asset.
27 Historical Cost Even though over 2me an asset's value may increase above the historical cost, that cost is s2ll kept on the books because the number is considered to be reliable.
28 Revenues and Expenses Revenues increase owners' equity. Expenses decrease owners' equity.
29 Revenues Revenues are inflows of assets (or reduc2ons in liabili2es) 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 prepara2on or audi2ng.
30 Revenues Cri2cally 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.
31 Revenues Accounts receivable are promises by a customer or client to pay cash in the future.
32 Revenues A related concept concerns cash received before a service is performed or goods are delivered.
33 Consider the following example: A magazine company receives $24, which represents a year's subscrip2on. The subscriber, of course, pays in advance.
34 Consider the following example: The magazine company may not record revenue because it has not earned revenue yet.
35 Consider the following example: To earn revenue, it must send the subscriber one magazine a month for twelve months.
36 Consider the following example: It owes magazines to the subscriber and thus has a liability (called Unearned Revenue), not revenue.
37 Consider the following example: As magazines are sent, revenues may be recorded.
38 Consider the following example: Unearned revenues are usually se\led by the performance of a service, unlike other liabili2es which are usually se\led by the payment of cash.
39 Revenues ASSETS Cash +$200 Accounts receivable +$400 Accounts Receivable = LIABILITIES + OWNERS EQUITY H.Jacobs, capital Service revenue +$600
40 Revenues ASSETS Cash +$100 Unearned Revenue = LIABILITIES + OWNERS EQUITY Unearned revenue +$100
41 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, u2li2es, and the like.
42 Expenses ASSETS Cash $700 Expenses = LIABILITIES + OWNERS EQUITY H.Jacobs, capital Salary expense $700
43 Expenses A cri2cally 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.
44 Expenses A cri2cally important point similar to that for revenues holds true for expenses. If a repairman comes to the business to work on the air condi2oning system, then the business has a repair expense even though that work may be charged to its account.
45 Expenses A cri2cally important point similar to that for revenues holds true for expenses. The company will have a liability which it will se\le later with the payment of cash.
46 Expenses The word "payable" is usually used in a liability 2tle.
47 Examples of Payables Notes payable wri\en obliga2ons. Accounts payable unwri\en obliga2ons that arise in the normal opera2ons of a business. Wages payable.
48 Examples of Payables ASSETS Payable Accounts = LIABILITIES + OWNERS EQUITY Utilities payable +120 H.Jacobs, capital Utility expense $120
49 Sales of Inventory Sales of inventory contain both revenue and expense components.
50 Sales of Inventory A revenue transac2on exists because an asset has been obtained and goods have been provided to customers.
51 Sales of Inventory An expense transac2on exists because an asset has been consumed to generate the revenue.
52 Sales of Inventory The resul2ng expense is called cost of goods sold.
53 Sales of Inventory ASSETS Accounts receivable +$4,000 Inventory 2,200 Sales of Inventory = LIABILITIES + OWNERS EQUITY H.Jacobs, capital Sales revenue +$4,000 Cost of goods sold $2,200
54 Adjustments to Accounts Several adjustments must be made to accoun2ng records at the end of the accoun2ng period.
55 Adjustments to Accounts A balance in an account may need to be adjusted because of the passage of 2me and the occurrence of events in that 2me period.
56 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 informa2on will be correct.
57 Interest Interest is a rental charge for the use of money. It is computed by mul2plying the principal (or borrowed amount) by the interest rate and by the period of 2me involved.
58 Interest Since the interest rate is an annual rate, the 2me period must also be an annual period. If the 2me is given in months, then the 2me frac2on will have 12 in the denominator.
59 Interest Since the interest rate is an annual rate, the 2me 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
60 Interest Since the interest rate is an annual rate, the 2me period must also be an annual period. If the 2me is given in days, then the 2me frac2on will have 360 (bobtail or banker's year) or 365 in the denominator.
61 Interest Since the interest rate is an annual rate, the 2me period must also be an annual period. The number 360 is used in the denominator because it eases computa2ons.
62 Interest Since the interest rate is an annual rate, the 2me period must also be an annual period. The number 360 is also used by some financial ins2tu2ons because it results in more interest for them.
63 Which results in more interest? Try mul2plying $12,000 X 10% X 90/360. Now mul2ply $12,000 X 10% X 90/365.
64 Interest Payable ASSETS Interest Payable = LIABILITIES + OWNERS EQUITY Interest H.Jacobs, capital payable Interest expense +$133 $133
65 Rent If rent is prepaid, then as 2me elapses, the asset is used up, or consumed, and an expense is incurred.
66 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.
67 Rent ASSETS Prepaid rent $1,000 Prepaid Rent = LIABILITIES + OWNERS EQUITY H.Jacobs, capital Rent expense $1,000
68 Deprecia2on Deprecia2on shows that an asset such as equipment or a building is wearing out and being used up.
69 Deprecia2on Deprecia2on expense is computed by dividing the es2mated useful life of the asset into the asset's historical cost less any salvage value es2mated by the business.
70 Deprecia2on If a machine cost $5,000 and has a salvage value of $500, with a useful life of five years, then the deprecia2on expense per year will be $900. ($5,000 $500) = $900 5years
71 Deprecia2on ASSETS Equipment $208 Depreciation = LIABILITIES + OWNERS EQUITY H.Jacobs, capital Depreciation expense $208
72 Unearned Revenue If a company has unearned revenue, then it may have earned revenue as 2me 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.
73 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
74 Unearned Revenue ASSETS Unearned Revenue = LIABILITIES + OWNERS EQUITY Unearned H.Jacobs, capital revenue Service revenue $50 +$50
75 Withdrawal by Owner A withdrawal by owner is treated exactly the opposite of a contribu2on by the owner.
76 Withdrawal by Owner ASSETS Cash $100 Withdrawal by Owner = LIABILITIES + OWNERS EQUITY H.Jacobs, capital Withdrawal $100
77 Revenues and Expenses Remember that four transac2ons affect owners' equity. Owner investments increase owners' equity. Owner withdrawals decrease owners' equity. Revenues increase owners' equity. Expenses decrease owners' equity.
78 Simple Balance Sheets and Income Statements The end result of the accoun2ng process is the prepara2on of financial statements.
79 The Balance Sheet The balance sheet shows a firm's assets, liabili2es, and owner's equity at one point in 2me. The date on the balance sheet will be a single date, such as December 31 or June 30.
80 Assets Balance Sheet January 31, 2000 Liabilities and Owners Equity Cash $ 32,500 Liabilities Accounts receivable 4,400 Accounts payable $ 30,000 Prepaid rent 11,000 Unearned revenue 50 Inventory 27,800 Utilities payable 120 Equipment 27,792 Interest payable 133 Total assets $100,492 Notes payable 20,000 Total liabilities 50,303 H.Jacobs, capital 50,189 Total liabilities and owners equity $100,492
81 The Income Statement The income statement summarizes a firm's revenues and expenses for a period of 2me. 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."
82 The Income Statement If revenues exceed expenses, then the result is net income. If expenses exceed revenues, then the result is a net loss.
83 The Income Statement Only revenues and expenses appear on the income statement. Students some2mes 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.
84 Income Statement For the Month Ended January 31, 2000 Revenues Sales $ 4,000 Service 650 Total revenue 4,650 Expenses Cost of goods sold 2,200 Rent 1,000 Salary 700 Depreciation 208 Interest 133 Utilities 120 Total expenses 4,361 Net income $ 289
85 The Statement of Owners' Equity The statement of owners' equity summarizes the changes that took place in owners' equity during the period under review.
86 The Statement of Owners' Equity It will have the same date as does the income statement. It shows results over a period of 2me, not just at one point in 2me.
87 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.
88 The Statement of Owners' Equity A business will have either a net income or a net loss, not both.
89 The Statement of Owners' Equity Statement of Owners Equity For the Month Ended January 31, 2000 Balance, January 1 $ 0 Investment by owner $ 50,000 Net income 289 Withdrawal by owner (100) Balance, January 31 $ 50,189
90 Rela2onship Between Balance Sheet and Income Statement Changes in net income, owner contribu2ons, and owner withdrawals, all of which affect owners' equity, explain changes in net assets.
91 The Accrual Basis of Accoun2ng The accrual basis of accoun2ng records revenues when goods have been delivered or services have been performed, regardless of when cash is received.
92 The Accrual Basis of Accoun2ng This basis also records expenses when resources are consumed, regardless of when payment is made.
93 The Cash Basis of Accoun2ng The cash basis of accoun2ng records revenue when cash is received. This basis also records expenses when cash is paid.
94 The Accrual Basis Is Preferable The accrual basis is preferable for providing the most useful informa2on to financial statement users. GAAP requires use of the accrual basis.
95 The Accrual Basis Is Preferable The accrual basis keeps in place the matching principle. All resources consumed in genera2ng revenue should be shown on the same income statement (that is, during the same 2me period) as that revenue.
96 Forms of Business Organiza2on Profit- oriented enterprises can be organized in one of three ways. Sole proprietorships Partnerships Corpora2ons
97 Sole Proprietorships Sole proprietorships are businesses that are owned by one individual and usually operated by that individual.
98 Sole Proprietorships Their primary advantage is ease of forma2on. Their major disadvantage is unlimited liability.
99 Sole Proprietorships Because of the en2ty assump2on, records of the business and its owner must be kept separate.
100 Partnerships Partnerships consist of two or more persons in business to make a profit. They are very similar to sole proprietorships.
101 Corpora2ons Corpora*ons, unlike proprietorships or partnerships, are separate legal en22es. They are more difficult to form, and they must pay income taxes.
102 Corpora2ons If shareholders receive dividends, then those dividends are taxable, leading to double taxa2on of income.
103 Corpora2ons A major advantage of a corpora2on is the limited liability of its shareholders. Only a shareholder's investment in the corpora2on is at risk.
104 Balance Sheet Differences Differences in balance sheets lie mainly in the equity sec2on.
105 Balance Sheet Differences A sole proprietorship has one capital account. In a partnership, each partner has his or her own capital account.
106 Balance Sheet Differences Shareholders' equity of a corpora2on consists of two components: Invested capital results from direct contribu2ons by the shareholders. Retained earnings reflects the increases and decreases in the shareholders' interest in the company that arose from opera2ons since the company's incep2on.
107 Basic Concepts of Financial Accoun2ng End of Chapter 2
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