Recording of Transactions

Krishnamurthy Surysekar
School of Accounting
Florida International University
Summer 2011
 Overview of the Presentation
• The Financial Statements
• GAAP
• What is accrual ?
• Conceptual Framework
• Elements of financial statements
• Example: Accounting for transactions
 The Financial Statements
– Income Statement
– Balance Sheet
– Statement of Cashflows
– Statement of Owners Equity
 GAAP
• Generally Accepted Accounting Principles
• Guidelines, but very powerful
• In the USA, what FASB (Financial
Accounting Standards Board) says is GAAP
• FASB follows due process
 Cash v. Accrual – Important
Distinction- An Example
• Year 2010: Buys Inventory for $500, none
paid for in cash. Sells $ 400 worth of this
inventory for $600, none received in cash.
• Year 2011: Collected the $600 from
customers and paid the $500 for the
inventory bought in 2000.
• Year 2012: Sold the remaining $100
inventory at cost for $100 cash
 Cash v. Accrual Example: Cash
Profits
• On a cash basis, your surplus for 2010 was
zero-no cash paid for purchases and no cash
collected on sales.
• Your surplus for 2011 is $100 ($600 sales
collected -$500 paid for purchases)
• Your surplus is 2012 is $100 (cash collected
on the sale of remaining inventory)
 Cash v. Accrual Example:
Accrual Profits-2010
• Under accrual accounting (GAAP), your 2010
profits are as follows:
Credit Sales $ 600
*Cost of goods sold $(400)
Profits $ 200
At the end of 2010, you have two assets: customer
receivables $600, and Inventory $100. You have one
liability: Accounts Payable $500 and your Owner’s
Equity is $200 (profits on the transaction).
 Inventory Comment
• Note that cost of goods sold can be
computed as:

Beg. Inventory + Inventory Purchases –

Ending Inventory
= 0 + $500 - $100 = $400
 Accrual Accounting-2011
• Assuming no other transactions is 2001, your
profits for 2011 is zero – no sales, no cost of goods
sold.
• Your assets at the end of 2011 are Cash $100 ($600
collected from customers less $500 paid for
purchases) and Inventory $100 (continues from the
previous year).
• There are no liabilities
• Your owner’s equity remains at $200 (continues
from the previous year)
 Accrual Accounting – 2012
• Now Revenues are $100 and cost of goods
sold are also $100.
• Zero profits
• Assets are now Cash (only) at $200 and
Owner’s Equity stays at $200
• Again, no liabilities
 Profit comparison over three
periods
Year
Basis 2010 2011 2012

• Cash: $0, $100, $100

• Accrual: $200, $0*, $0**
• * No Revenues and Expenses
• ** Revenues equal Expenses
 Key Message of Accrual
Accounting
• Profits are not determined when cash changes
hands, but by the “economic” nature of the
transaction.
• Since GAAP rests on accrual accounting
(implying that profits do not necessarily represent
cash flows), we need an important financial
statement other than the balance sheet and the
income statement – the statement of cash flows.
 Financial Statement Elements
• Balance Sheet Equation:
• Assets ≡ Liabilities + Owner’s Equity
• Income Statement has Revenues, Expenses,
Gains and Losses, and computes Net
Income
• Net income increases Owner’s equity and
Net loss reduces Owner’s Equity
 Typical Owner’s Equity
Transactions
• Infusion of cash by owners/shareholders (+)
• Taking out business cash by owners(-)
• Declaring dividends(-)
• Revenues (+)
• Expenses(-)
• Revenues increase and expenses decrease
owner’s equity, but they are routed through
the income statement
 What is double entry ?
• Every transaction has two aspects – debit and a
credit
• Assets = Liabilities + Owners Equity
• Owners Equity = Revenues – Expenses +/- direct
changes
• For example if an asset is increased by a
transaction, it is accompanied by a decrease in
another asset, an increase in a liability or an
increase in owners’ equity or a combination
 Simple example of double entry
• Buy a machine for $15,000, paying cash.
• Asset account called “Machine A/C” increases by $15,000
• Asset account called “Cash A/C” decreases by $15,000
• We “debit” Machine A/C and “credit” Cash A/C (more on
this later)
• Buy inventory on account $5,000
• “Inventory A/C”, an asset, increases by $5,000 and a
liability called “Accounts Payable A/C” also increases by
$5,000
 Debit-Credit
Category Increase Decrease

Asset Debit Credit

Liability Credit Debit

Owners Equity* Credit Debit

 Debit-Credit Owners Equity
Category Increase Decrease

Capital Credit Debit*

Revenues Credit Debit
Expenses Debit Credit

* Example: Withdrawals or Dividends

 Important Principle – Accrual
• Issue of Timing
• Recognize Revenues and Expenses irrespective of
when cash is received
• Profits as distinct from cash flow
• Profitable companies need not be cash-rich and
vice versa
• J3 records profits and affects owner’s equity even
though no cash changed hands
• J5 has no effect on profits/owner’s equity
 Debits, Credits and Normal
Balances
• Debits and credits
• Journals and Ledgers
• Normal balance (net effect of debit and
credit entries in the account)
• Trial Balance
• Adjustment process
• Financial statements
 Accounting Cycle
• Journalize regular transactions
• Post in ledgers
• Journalize and post adjusting transactions
• Prepare the adjusted trial balance
• Prepare the financial statements
– Income Statement
– Balance Sheet
– Statement of Owner’s Equity
– Statement of cashflows
• Prepare the closing entries