ACCOUNTING & FINANCE BASICS
WHO USES ACCOUNTING?
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External users are parties outside the reporting entity (company) who are
interested in the accounting information.
Investors (owners) use accounting information to make buy, sell or keep
decisions related to shares, bonds, etc. Creditors (suppliers, banks) utilize
accounting information to make lending decisions. Taxing authorities (Internal
Revenue Service) need accounting information to determine a company's tax
liabilities. Customers may need accounting information to decide which products
and from which company to buy.
Internal users are parties inside the reporting entity (company) who are
interested in the accounting information.
A company's senior and middle management uses accounting information to run
business. Employees utilize accounting information to determine a company's
profitability and profit sharing.
Financial accounting provides information that is designed to satisfy the
needs of external users. Such reporting is usually done in the form of financial
statements.
Managerial accounting provides information that is useful in running a
company by internal users. Such reporting is usually accomplished through
custom designed reports.
FINANCIAL REPORTING
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Businesses communicate accounting information to the public
through a process known as financial reporting.
Financial reporting is a process through which companies
communicate information to the public.
The central means of external financial reporting is a set of
financial statements. The four general-purpose financial
statements are the following:
Income Statement
Statement of Changes in Equity
Balance Sheet
Statement of Cash Flows
FINANCIAL STATEMENTS
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An income statement presents revenues and expenses and
resulting net income or loss for a period of time. An income
statement is also called Statement of Operations, Earnings
Statement, or Profit and Loss Statement (P/L).
A statement of changes in equity shows all changes in
owner's equity for a period of time. This statement is also called
Owners' Equity Statement.
A balance sheet presents assets, liabilities and owner's equity
at a specific date. A balance sheet is also called Statement of
Financial Position.
A cash flow statement summarizes information about cash
outflows (payments) and inflows (receipts). This statement may
also include certain information not related to actual cash flows.
ELEMENTS OF FINANCIAL
STATEMENTS 1.
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All financial statements consist of classes or categories known as elements.
There are ten elements: assets, liabilities, equity, contributed capital,
revenue, expenses, distributions, net income, gains, and losses
Assets are economic recourses of a business used to accomplish its main
goal, i.e., increase owners' wealth.
To be formally recognized as an asset, the following two conditions must
be met:
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potential economic benefit must be assignable to a particular entity, and
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event giving rise to the assignment must have already occurred.
For example, if a company has purchased a piece of equipment and uses it
in generating profits, it is considered as an asset. However, if the company
just considers buying new equipment, it can't be deemed or recorded as
an asset.
BASIC ACCOUNTING EQUATION
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A company's assets belong to the resource providers who are
said to have claims on the assets.
In other words, each asset has its own source provided by an
owner or creditor. So, there can't be any claim without an
appropriate asset and vice versa. Based on the previous
statement, we can define the basic accounting equation:
Assets = Claims
Claims are divided into two categories:
Creditors' claims that are called liabilities
Owners' claims that are called equity
Assets =
Claims (Liabilities + Equity)
NET ASSESTS = RESIDUAL EQUITY
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Liabilities are debts and obligations of a company.
Equity is what the company "owes" to owners.
The amount of total assets minus total liabilities equals equity. Because
equity equals the difference between assets and liabilities, it is also
called net assets.
If a company goes bankrupt, liabilities are paid off first to creditors,
while equity is the last to be distributed. Therefore, owners' equity is
also called residual equity.
Let us look at an example of the basic accounting equation. Suppose Our Company
has assets of $800, liabilities of $300, and equity of $500. These amounts will
be shown in the basic accounting equation as follows:
Illustration 1: Example of basic accounting equation:
Assets = Claims (Liabilities + Equity)
$800 =
( $300
+ $500 ).
BOOKKEEPING: DOUBLE ENTRY
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1) Friends Company is created when the owners pool $5,000 into the
business. The effect of the contributions on the accounting equation is
as follows:
Illustration 2: Effect of cash contribution:
Claims
Assets
=
Liabilities
+
Equity
+$5,000
=
+
+$5,000
Note that the amount of this single transaction is recorded twice. The
first time it is recorded as an asset and the second time it is recorded
as the asset source (equity). Here is a rule: Any transaction is recorded
at least twice. This rule is known as double-entry bookkeeping.
EFFECT OF BORROWING
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Double-entry bookkeeping rule states that any transaction is recorded at
least twice.
Because this transaction provided assets to the enterprise, it is called an asset
source transaction. An asset source transaction is one of the four types of
accounting transactions.
Asset source transactions result in an increase in an asset account and in
one of the claim accounts (liability or equity accounts).
2) Next, assume that Friends Company acquires additional $2,000 of assets by
borrowing cash from creditors. This is also an asset source transaction. In the
table below the beginning balances are derived from the ending balances of the
previous transaction:
Illustration 3: Effect of borrowing
Claims
Assets =
Liabilities
+
Equity
Beginning balance
$5,000 =
+
$5,000
Effect of borrowing
+$2,000 =
+$2,000
Ending balance
$7,000 =
$2,000
+
$5,000
EQUITY: CONTRIBUTED CAPITAL &
RETAINED EARNINGS
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Equity is usually viewed as a source of assets, and that's why it becomes
necessary to subdivide the owner's' interest into two components. First, owner's
claims are established when a business acquires assets from owners. These
claims result from the contributions of capital resources by the owners, and
therefore they are frequently called contributed capital.
Contributed capital is a component of equity resulting from contributions of
capital resources from owners.
The second source of assets associated with equity occurs when a business
obtains assets through its earnings activities and is called retained earnings.
Retained earnings form a component of equity resulting from earnings
activities.
Taking into account above definitions, the basic accounting equation can be
presented like this:
Assets = Liabilities
+
Equity
(Contributed Capital +Retained Earnings)
EFFECT OF REVENUE
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An increase in assets resulting from rendition of goods or services to
customers is called revenue.
Earning revenue can also be an asset source transaction. To illustrate
the effect of a revenue transaction, assume that Friends Company
received $3,000 cash for services it provided to customers (note that
both assets and retained earnings increase - asset source transaction):
Illustration 4: Effect of revenue recognition
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Earnings
Beginning balance
Effect of revenue
Ending balance
Equity
Assets = Liabilities + Contributed Capital+Retained
$7,000 = $2,000 + $5,000
+3,000 =
+
$10,000 = $2,000 + $5,000
+ $0
+ +3,000
+ $3,000
ASSET USE
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As noted, assets acquired in operating activities are called revenues.
Assets used in the process of generating revenues are called expenses.
Expenses decrease retained earnings. Assume Friends Company used
$1,000 in assets to earn $3,000 in revenues. This is an example asset
use transaction.
Asset use transactions result in a decrease in an asset account and
in one of the claim accounts (liability or equity accounts).
The affect of this asset use transaction (assets and claims decrease) on
the basic accounting equation is as follows:
EXPENSE: REDUCES ASSETS & CLAIMS
Take a note of how decreases or negative amounts are shown in accounting
records. Instead of prefixing a minus sign ("-"), a number is taken into parenthesis.
This is a common way of showing a decrease in the accounting realm.
DISTRIBUTION
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If a business chooses to transfer part of its assets (retained earnings in
particular) to the owners, the transfer is called distribution. Assume
Friends Company transfers $500 of assets to its owners. This is an
asset use transaction:
Distribution and expenses both result in decreases in retained earnings
and thus, in equity.
SUMMARY: TRANSACTION EFFECTS
PERMANENT ACCOUNTS
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At the end of a period, all accounts are prepared for the next period. It
is important to distinguish between permanent and temporary
accounts. Balance sheet accounts (i.e., assets, liabilities, and equity)
have a continuing nature; thus, they are not closed after each period
and that's why they are called permanent accounts.
Permanent accounts are balance sheet accounts. They are not
closed each period. Their balances are carried forward into the next
period. Permanent accounts are also called real accounts.
In contrast, revenue, expense, and distribution accounts are used to
collect information about a single accounting period. At the end of a
period, amounts in revenue, expense, and distribution accounts are
transferred to Retained Earnings. Accordingly, the revenue, expense,
and distribution accounts must have zero balances at the end of one
accounting period (after closing the books) and at the beginning of the
following period.
TEMPORARY ACCOUNTS & CLOSING
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Temporary accounts are closed at the end of each period. These are
mostly income statement accounts, except for a distribution account
that is equity statement account. Temporary accounts are also called
nominal accounts.
The process of transferring the balances from the temporary accounts
to the permanent account, Retained Earnings, is referred to as closing
the accounts or closing the books.
Based on the five transactions described, we can now prepare the
financial statements for the period. Recall that there are four generalpurpose financial statements:
Income Statement
Statement of Changes in Equity
Balance Sheet
Statement of Cash Flows
INCOME STATEMENT ORIENTATION
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The income statement measures the change in net assets or the
difference between assets increases and assets decreases. The asset
increases from the operating activities were labeled revenues. The
asset decreases were called expenses. The difference between
revenues and expenses is called net income (if revenue is greater than
expenses) or a net loss (if vice versa).
Net income is the excess of asset increases (revenues) and asset
decreases (expenses) for a period. Note that distributions do not fall
under expenses caption and thus are not used in calculating the net
income.
Net loss is the opposite of net income. Net loss results from the
excess of asset decreases (expenses) over asset increases (revenues)
for a period.
BASIC INCOME STATEMENT
STATEMENT OF CHANGES IN EQUITY
ORIENTATION
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The statement of changes in equity explains the effects of transactions on owner's equity
during an accounting period. The statement includes the beginning and ending balances of
contributed capital and reflects any new capital acquisitions made during the accounting
period. The statement also shows the portion of net earnings retained in the business.
BALANCE SHEET ORIENTATION
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The balance sheet lists assets and corresponding claims (liabilities and equity). Any asset has
a source, so assets balance with claims. That is why total assets equal total claims (liabilities
and equity).
STATEMENT OF CASH FLOWS
ORIENTATION
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The statement of cash flows explains how the company obtained and used cash during a period.
Sources of cash are called cash inflows, and uses of cash are known as cash outflows.
Cash inflows are sources of cash; for example, payments from customers, capital acquisitions, etc.
Cash outflows are uses of cash; for example, payments to vendors, paying off bank loans, etc.
BASIC STATEMENT OF CASH FLOWS
HORIZONTAL ACCOUNTING MODEL
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1.
2.
3.
4.
5.
Let us demonstrate the usefulness of the horizontal model and apply it
to the five transactions we covered before. Note that if a transaction
does not affect the model, a related cell will show "n/a" in it. In the
statement of cash flows, FA means cash flows from financing, IA
means cash flows from investing, and OA means case flows from
operating activities.
Obtained capital acquisition: $5,000
Borrowed cash: $2,000
Received cash revenue: $3,000
Paid expenses with cash: $1,000
Distributed cash to owners: $500
Using horizontal model helps a lot in understanding the effects
produced by each event, so it is advisable to use it as often as possible
while learning principles of financial accounting.
BASIC HORIZONTAL STATEMENT
ACCOUNTING EVENTS & EFFECTS
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With respect to Events No. 1 and 2, it is clear that only the balance sheet and
statement of cash flows are affected. There is no effect on the income
statement. Furthermore, you can see that Event No. 1 increases assets and
equity and that the cash inflow is defined as a financing activity. Event No. 2 has
a similar effect, except that liabilities increase instead of equity. Event No. 3
affects three financial statements. Assets and equity increase on the balance
sheet. The recognition of revenue causes net income to increase, and the cash
inflow is shown as an operating activity on the statement of cash flows. Event
No. 4 is the opposite of Event No. 3. Assets, equity and net income decrease.
Cash flow statement shows this decrease as an operating activity. Finally, Even
No. 5 acts to decrease cash and equity. The cash distribution is not shown
anywhere in the income statement. That's because distribution is not an
expense and thus, is not included in the determination of net earnings. Cash
distribution is categorized as a financing activity in the cash flow statement.