SAINT BERNARD COLLEGE

ACCOUNTING FUNDAMENTAL

Introduction to Accounting (Lecture 1)

In this accounting lesson we define accounting, accounting information and

double-entry bookkeeping. We also provide information about the differences
between financial and managerial accounting. We then get familiar with four
basic financial statements (income statement, statement of cash flows, statement
of changes in owners' equity and balance sheet). After that, we define major
financial statement components like assets, liabilities, contributed capital,
retained earnings, distributions, equity, revenues, expenses, net income, net
loss, cash inflows and cash outflows. We then move on to definitions of
permanent (real) and temporary (nominal) accounts and learn about the four
types of accounting transactions. Accounting examples are provided for most
learning objectives.

1.1 Definition of accounting

What is accounting? People around the world consider it quite important. Whether you are going
to invest in McDonalds's stock, buy new equipment, forecast future sales or expenditures, you
almost always use accounting information. Why? The answer is because accounting provides
information for decision-making in the business world.

Accounting is a service-based profession that provides reliable and relevant financial information
useful in making decisions.

Financial information may include sales, expenses, taxes and other figures.

So, how exactly is this information prepared? There are several steps involved. These steps are
identification, recording and communication.

First, economic events are identified. A sale at a gas station, payment of taxes by a commercial
enterprise, or purchase of insurance are all examples of economic events.

Second, all economic events are recorded. Recording is done to provide a history of a company's
financial activities. In this step economic events are also classified and summarized.

Third, information about classified and summarized economic events is communicated to

interested parties. Such communication may take several forms. One of them is financial
statements about which we will talk later in this chapter.

1.2 Users of accounting information

Interested parties are also called accounting information users. There are two broad categories of
accounting information users:

 external users
 internal users.

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.

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Managerial accounting provides information that is useful in running a company by internal
users. Such reporting is usually accomplished through custom designed reports.

See related illustration for the connection between types of accounting and accounting
information users.

Illustration 1-1: Types of accounting and accounting information users

Introduction to Accounting
1.3 Generally Accepted Accounting Principles (GAAP)

People and organizations make decisions based on financial information prepared by

accountants. That is why it is important for these people and organizations to understand how
accounting information is measured. To facilitate communication, rules are established that
business people can use to ensure they compare oranges to oranges. For example, assume a
store sells goods. When should an accountant record the sale, at the moment the goods are
shipped (accrual accounting) or at the time cash for these goods is received (cash accounting)?
Whether the store owner applies the accrual or cash accounting is not important as long as a
third rule is established requiring the owner to disclose the method selected for the reporting
purposes. Accounting rules in the USA are grouped and called Generally Accepted Accounting
Principles (GAAP).

Generally Accepted Accounting Principles (GAAP) are common standards that

indicate how to report economic events.

Financial Accounting Standards Board (FASB) issues Statements of Financial Accounting

Standards (SFAS) that comprise a large portion of GAAP. You can find more information about
SFAS, their issuance process and current projects on FASB's website. Other organizations
playing a significant role in regulating the accounting profession are Securities and Exchange
Commission and Public Company Accounting Oversight Board. The last two mostly regulate
public companies, while the first one establishes standards for private companies.

1.4 Financial reporting and financial statements

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

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  Statement of Cash Flows

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.

1.4.1 Elements of financial statements

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 (which will be explained later in this or further chapters).

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:

 potential economic benefit must be assignable to a particular entity, and

 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.

Introduction to Accounting
1.5 Basic accounting equation

We need to provide a definition of claims before we proceed with the basic accounting equation.

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

Claims
Assets = 
Liabilities + Equity

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.

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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 1-2: Example of basic accounting equation

Claims
Assets =
Liabilities + Equity
$800 = $300 + $500

1.6 Effects of transactions on the basic accounting equation

Apart from the example above, let us see how different transactions will affect the basic
accounting equation. We will take a look at several transactions separately.

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 1-3: 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.

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 1-4: 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 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:
Equity
Assets = Liabilities + Contributed Retained
+
Capital Earnings

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Introduction to Accounting
3) 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 1-5: Effect of revenue recognition

        Equity
Contributed Retained
  Assets = Liabilities + +
Capital Earnings
Beginning balance $7,000 = $2,000 + $5,000 + $0
Effect of revenue +3,000 =   +   + +3,000
Ending balance $10,000 = $2,000 + $5,000 + $3,000

4) As noted above, 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:

Illustration 1-6: Effect of expense recognition

          Equity
Contributed Retained
  Assets = Liabilities + +
Capital Earnings
Beginning
$10,000 = $2,000 + $5,000 + $3,000
balance
Effect of
(1,000) =   +   + (1,000)
expenses
Ending balance $9,000 = $2,000 + $5,000 + $2,000

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.

5) 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:

Illustration 1-7: Effect of cash distribution

          Equity
Contributed Retained
  Assets = Liabilities + +
Capital Earnings
Beginning balance $9,000 = $2,000 + $5,000 + $2,000
Effect of
(500) =   +   + (500)
distribution
Ending balance $8,500 = $2,000 + $5,000 + $1,500

Distribution and expenses both result in decreases in retained earnings and thus, in equity.

The table below is a summary of the effects of the three asset source transactions (events 1
through 3) and two asset use transactions (events 4 and 5):

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Illustration 1-8: Summary of transaction effects

          Equity
Contributed Retained
  Assets = Liabilities + +
Capital Earnings
Beginning balance $0 = $0 + $0 + $0
Effect of contribution +5,000 =   + +5,000 +  
Effect of borrowing +2,000 = +2,000 +   +  
Effect of revenue +3,000 =   +   + +3,000
Effect of expenses (1,000) =   +   + (1,000)
Effect of distribution (500) =   +   + (500)
Ending balance $8,500 = $2,000 + $5,000 + $1,500

Introduction to Accounting
1.7 Closing the books. Permanent and temporary accounts

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 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.

1.8 Financial statements description

Based on the five transactions described above, we can now prepare the financial statements for
the period. Recall that there are four general-purpose financial statements:

 Income Statement
 Statement of Changes in Equity
 Balance Sheet
 Statement of Cash Flows

1.8.1 Presentation of the income statement

The income statement is presented below. We do not intend to go through the preparation of
financial statements process at this point. That will be covered in other chapters. The purpose of
showing the financial statements below is just to understand how they are look like.

Illustration 1-9: Income statement for Friends Company

Friends Company
Income Statement
For the Period Ended 20X6
   
Revenue (i.e., assets increase) 3,000
Expenses (i.e., assets decrease) (1,000)
Net Income (i.e., change in net assets)  $  2,000

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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.

1.8.2 Presentation of the statement of changes in equity

The statement of changes in equity has the following format:

Illustration 1-10: Statement of changes in equity for Friends Company

Friends Company
Statement of Changes in Equity
Period Ended 20X6
   
Beginning Contributed Capital $0
Plus: Capital Acquisition 5,000
Ending Contributed Capital 5,000
   
Beginning Retained Earnings $0
Plus: Net Income 2,000
Less: Distribution (500)
Ending Retained Earnings 1,500
   
Total Equity $ 6,500

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.

Introduction to Accounting
1.8.3 Presentation of the balance sheet

The balance sheet is presented as follows:

Illustration 1-11: Balance sheet for Friends Company

Friends Company
Balance Sheet
Period Ended 20X6
Assets $8,500
Total Assets 8,500
   
Liabilities 2,000
Equity  
      Contributed Capital 5,000
      Retained Earnings 1,500
Total Equity 6,500
   
Total Liability and Equity (Claims) 8,500

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).

1.8.4 Presentation of the statement of cash flows

The statement of cash flows has the following format:

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Illustration 1-12: Statement of cash flows for Friends Company

Friends Company
Statement of Cash Flows
For the Period Ended 20X6
Cash Flows from Operating Activities  
      Cash Receipts from Revenue $3,000
      Cash Payments for Expenses (1,000)
Net Cash Flow from Operating Activities 2,000
   
Cash Flows from Investing Activities 0
   
Cash Flows from Financing Activities  
     Cash Receipts from Borrowing 2,000
     Cash Receipts from Capital Acquisitions 5,000
     Cash Payments for Distributions (500)
Net Cash Flow from Financing Activities 6,500
   
Net Increase in Cash 8,500
Plus: Beginning Cash Balance 0
   
Ending Cash Balance $8,500

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.

Introduction to Accounting
The statement classifies cash inflows and outflows into three categories:

 Operating activities section explains cash generated through revenue and cash
spent for expenses.
 Investing activities include cash received or spent on productive assets and
investments in the debt or equity of other companies.
 Financing activities describe cash transactions associated with resource providers
(i.e., owners and lenders).

Illustration 1-13: Cash flow categories

1.9 Financial statements model

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To better understand effects of transactions on financial statements and see connections
between financial statement elements, a statements model was created. The two forms of such a
model are vertical and horizontal. As its name implies, the vertical model arranges financial
statements elements from top to bottom on a page. Horizontal, on the other hand, is so named
because it arranges financial statements elements horizontally across a page. In the horizontal
model, the balance sheet is presented to the left, followed by the income statement, and the
statement of cash flows.

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.

1. Obtained capital acquisition: $5,000

2. Borrowed cash: $2,000
3. Received cash revenue: $3,000
4. Paid expenses with cash: $1,000
5. Distributed cash to owners: $500

Illustration 1-14: Horizontal statements model for Friends Company

Balance Sheet Income Statement

Event
Net Cash Flow
No Cash = Liabilities + Equity Rev. - Exp. =
Income
1 5,000 = n/a + 5,000 n/a - n/a = n/a 5,000 FA
2 2,000 = 2,000 + n/a n/a - n/a = n/a 2,000 FA
3 3,000 = n/a + 3,000 3,000 - n/a = 3,000 3,000 OA
4 (1,000) = n/a + (1,000) n/a - (1,000) = (1,000) (1,000) OA
5 (500) = n/a + (500) n/a - n/a = n/a (500) FA
Totals 8,500 = 2,000 + 6,500 3,000 - (1,000) = 2,000 8,500  

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.

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.

Accounting Exercise 1.1 (Introduction to Accounting)

Manny Services had the following transactions during periods 20X6 and 20X7. Assume all
transactions involve cash receipt or payment.

Transactions for 20X6:

1. Acquired $4,000 from the owners to begin operations;

2. Provided services to customers and received $2,000 cash payment;
3. Borrowed $1,000 from creditors;
4. Paid operating expenses of $500;
5. Purchased land for $1,500.

Transactions for 20X7:

1. Acquired additional $1,000 from the owners;

2. Performed services and was paid $3,000 in cash;
3. Paid $500 cash to creditors;

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 4. Paid operating expenses of $600;
5. Made $1,500 cash distribution to the owners.

Required:

Prepare the accounting equation and record effects of each event under the appropriate
headings. Use the accounting equation format provided below:

Balance Sheet Income Statement

Statement of Cash
No L. Cont. Ret. Net
Cash + Land = + + Rev. - Exp. = Flows
Pay Cap. Earn. Inc.
                                

Accounting Solution 1.1 (Introduction to Accounting)

The table below provides the solution:

Balance Sheet Income Statement

Statement
No Cont. Ret. Net of Cash Flows
Cash + Land = L. Pay + + Rev. - Exp. =
Cap. Earn. Inc.
Transactions for 20X6
BB 0 + 0 = 0 + 0 + 0 0 - 0 = 0    
1 4,000 + n/a = n/a + 4,000 + n/a n/a - n/a = n/a 4,000 FA
2 2,000 + n/a = n/a + n/a + 2,000 2,000 - n/a = 2,000 2,000 OA
3 1,000 + n/a = 1,000 + n/a + n/a n/a - n/a = n/a 1,000 FA
4 (500) + n/a = n/a + n/a + (500) n/a - 500 = (500) (500) OA
5  (1,500)  +  1,500  = n/a + n/a + n/a n/a - n/a = n/a (1,500) IA
EB 5,000 + 1,500 =  1,000  + 4,000 + 1,500  2,000  - 500 = 1,500 5,000  
Transactions for 20X7
BB 5,000 + 1,500 = 1,000 + 4,000 + 1,500 0 - 0 = 0 5,000  
1 1,000 + n/a = n/a + 1,000 + n/a n/a - n/a = n/a 1,000 FA
2 3,000 + n/a = n/a + n/a + 3,000 3,000 - n/a = 3,000 3,000 OA
3 (500) + n/a = (500) + n/a + n/a n/a - n/a = n/a (500) FA
4 (600) + n/a = n/a + n/a + (600) n/a - 600 = (600) (600) OA
5 (1,500) + n/a = n/a + n/a + (1,500) n/a - n/a = n/a (1,500) FA
EB 6,400 + 1,500 = 500 + 5,000 + 2,400 3,000 - 600 = 2,400 6,400  

Accounting Exercise 1.2 (Introduction to Accounting)

Required:

Identify each of the following unrelated events as asset source, asset use, or asset
exchange transaction. Some events may not be recordable under current accounting rules.
In this case, classify the event as Not Applicable (n/a). Also for each event, indicate
whether total assets will increase, decrease, or remain unchanged. Use the table format
below for your answer:

Event Type of Effect on Total

Explanations
No Event Assets
Increase in assets (Cash) and
a Asset Source Increase
equity (Contributed Capital)
... ... ... ...

The list of events is presented below:

a) Started an accounting consulting firm when the business acquired a cash

contribution from owners;
b) Borrowed cash from a local bank;
c) Purchased supplies with cash;
d) Planned a purchase of new office equipment;
e) Traded a used car for a computer. Both assets had identical value;

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 f) Used supplies in the process of rendering services to customers;
g) Agreed to represent a client in a Tax Administration audit. The owner will be
paid when the audit is complete;
h) Received cash for the service provided to customers;
i) Paid employees salaries in cash;
j) Repaid a bank loan with cash;
k) Paid interest to the bank with cash;
l) Transferred cash from its checking account to a money market account;
m) Sold land for $15,000 cash. The land originally cost $15,000;
n) Distributed cash to the owners;
o) Learnt that a financial analyst determined the company's debt-to-equity ratio to
be 40%.

Accounting Solution 1.2 (Introduction to Accounting)

Look at the table below for the answers:

Event Type of Effect on Total

Explanations
No Event Assets
Increase in assets (Cash) and
a Asset Source Increase
equity (Contributed Capital)
Increase in assets (Cash) and
b Asset Source Increase
liabilities (Accounts Payable)
Asset Increase in one asset (Supplies)
c Unchanged
Exchange and decrease (Cash) in another
Making plans does not affect any
d n/a n/a
asset
Simultaneous increase in one
Asset
e Unchanged asset (Computer) and decrease
Exchange
(Car) in another
Decrease in assets (Supplies)
f Asset Use Decrease
and equity (Retained Earnings)
Making plans does not change
g n/a n/a
assets
Increase in assets (Cash) and
h Asset Source Increase
equity (Retained Earnings)
Decrease in assets (Cash) and
i Asset Use Decrease
equity (Retained Earnings)
Decrease in assets (Cash) and
j Asset Use  Decrease
liabilities (Accounts Payable)
Decrease in assets (Cash) and
k Asset Use Decrease
equity (Retained Earnings)
Simultaneous increase in one
Asset asset (Money Market Account)
l Unchanged
Exchange and decrease in another
(Checking Account)
Asset Increase (Cash) and decrease
m Unchanged
Exchange (Land) in assets
Decrease in assets (Cash) and
n Asset Use Decrease
equity (Retained Earnings)
Receiving such information does
o n/a n/a
not change assets

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