Principles of Accounting

ACC1001

Professor Wendy Cuijpers, MSc.

Financial Statements and Accounting Concepts / Principles

Chapter 2
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 Learning Objectives

After studying this chapter, you should understand and be able to:
• LO 2-1: Explain what transactions are.
• LO 2-2: Identify and explain the kind of information reported in each
financial statement and describe how financial statements are related to
each other.
• LO 2-3: Explain the meaning and usefulness of the accounting equation.
• LO 2-4: Explain the meaning of each of the captions on the financial
statements illustrated in this chapter.

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 Learning Objectives (cont.)

After studying this chapter, you should understand and be able to:
• LO 2-5: Identify and explain the broad, generally accepted concepts and
principles that apply to the accounting process.
• LO 2-6: Discuss why investors must carefully consider cash flow
information in conjunction with accrual accounting results.
• LO 2-7: Identify and explain several limitations of financial statements.
• LO 2-8: Describe what a corporation’s annual report is and why it is issued.

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 Financial Statements

• Transactions are economic interchanges between

entities that are accounted for and reflected in
financial statements.
 External transactions

– External transactions: are transactions the firm conducts with a

separate economic entity.
• Examples: selling products to a customer, purchasing supplies from
a vendor, paying salaries to an employee and borrowing money
from a bank.

– Internal transactions: are events that affect the financial

position of the company but do not include an exchange with a
separate company or individual.
• Examples: using supplies already purchased and earning revenues
after having received cash in advance from a customer.
• (we’ll address internal transactions later in this course)

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 Accounts

Transactions are summarized in accounts.

An account is a record in which transactions

affecting individual assets, liabilities, stockholders’
equity, revenues, and expenses are recorded.

Accounts are further summarized in the financial

statements.
 Financial Statements

Required Disclosure Financial Statements That Satisfy Requirement

Financial position at the end of the period Balance Sheet

Earnings for the period Income Statement

Cash flows during the period Statement of Cash Flows

Investments by and distributions to owners during the Statement of Changes in Stockholders’ Equity
period

• In addition to the financial statements, the annual report will probably

include several accompanying notes that include explanations of the
accounting policies used and detailed information about many of the
amounts and captions shown on the financial statements.
CHANGE OF BACK GROUND…..
 BALANCE SHEET

• The accounting equation:

EAGLE GOLF ACADEMY
BALANCE SHEET
 EFFECT ON THE BASIC ACCOUNTING EQUATION

• Measuring external transactions:

• Analyse the impact of the transaction on the basic accounting
equation:

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 UNDERSTANDING EFFECTS OF TRANSACTION

For each transaction, ask these three questions:

1. What is one account affected by the transaction?
• Does this account increase or decrease?

2. What is a second account affected by the transaction?

• Does this account increase or decrease?

3. Do assets equal liabilities plus stockholders’ equity?

• THEY MUST!!! EVERY TIME!!
 EFFECT ON THE BASIC ACCOUNTING EQUATION

• Exercise Eagle Golf Academy, transaction 1-5:

• Effects of transactions on the basic accounting equation
 PRACTICE

Transactions of Eagle Golf Academy

 TRANSACTION 1:
ISSUE COMMON STOCK (1 OF 3)

Sell shares of common stock for $25,000 to obtain the

funds necessary to start the business.

What is one account affected by the transaction?

• Cash
Does that account increase or decrease?
• Increase by $25,000
 TRANSACTION 1:
ISSUE COMMON STOCK (2 OF 3)

Sell shares of common stock for $25,000 to obtain the

funds necessary to start the business.

What is a second account affected by the transaction?

• Common Stock
Does that account increase or decrease?
• Increase by $25,000
 TRANSACTION 1:
ISSUE COMMON STOCK (3 OF 3)

Sell shares of common stock for $25,000 to obtain the

funds necessary to start the business.

Do assets equal liabilities plus stockholders’ equity?

• Yes, assets increase by $25,000 and stockholders’ equity
increases by $25,000
 COMMON MISTAKE

It’s sometimes tempting to decrease cash as a way of

recording an investor’s initial investment.

However, remember we account for the transactions

from the company’s perspective, and the company
received cash from the stockholder – an increase in
cash.
 TRANSACTION 2:
BORROW FROM THE BANK

Borrow $10,000 from the local bank and sign a note

promising to repay the full amount of the debt in three
years.
 TRANSACTION 3:
PURCHASE EQUIPMENT

Purchase equipment necessary for giving golf training,

$24,000 cash.
 CONCEPT CHECK 2–1 (1 OF 2)

What would be the effect on total assets if a

company purchased land for $200,000 cash?
a.Total assets would go up by $200,000.
b.Total assets would go down by $200,000.
c.There would be zero effect on total assets.
d.None of the above
 CONCEPT CHECK 2–1 (2 OF 2)

What would be the effect on total assets if a

company purchased land for $200,000 cash?
a.Total assets would go up by $200,000.
b.Total assets would go down by $200,000.
c.There would be zero effect on total assets.
d.None of the above
One asset (land) would go up and another asset
(cash) would go down. Therefore there would be
zero effect on total assets.
 KEY POINT OF ASSETS AND LIABILITIES

After EACH transaction, the accounting equation

must ALWAYS remain in balance.

In other words, assets must always equal liabilities plus

stockholders’ equity.

Get into the habit of checking this equality often!

 TRANSACTION 4:
PAY FOR RENT IN ADVANCE

Pay one year of rent in advance, $6,000 ($500 per

month).
 TRANSACTION 5:
PURCHASE SUPPLIES ON ACCOUNT

Purchase supplies on account, $2,300.

EAGLE GOLF ACADEMY – PART 2
EXPANDED ACCOUNTING EQUATION
 KEY POINT OF EXPANDED ACCOUNTING EQUATION

The expanded accounting equation demonstrates

that:
1. Revenues increase retained earnings
2. Expenses decrease retained earnings
3. Dividends decrease retained earnings

Retained earnings is a component of stockholders’

equity.
 TRANSACTION 6:
PROVIDE SERVICES FOR CASH

Provide golf training to customers for cash, $4,300.

 TRANSACTION 7:
PROVIDE SERVICES ON ACCOUNT

Provide golf training to customers on account, $2,000.

 TRANSACTION 8:
RECEIVE CASH IN ADVANCE FROM CUSTOMERS

Receive cash in advance for 12 golf training sessions to be given

in the future, $600.
 COMMON MISTAKE – DEFERRED REVENUES

Don’t let the account name fool you. Even though

the term revenue appears in the account title for
deferred revenue, this is NOT a revenue account.

Deferred indicates that the company has yet to

provide services even though it has collected the
customer’s cash.

The company owes the customer a service, which

creates a liability.
 TRANSACTION 9:
PAY SALARIES TO EMPLOYEES

Pay salaries to employees, $2,800.

 TRANSACTION 10:
PAY CASH DIVIDENDS

Pay cash dividends of $200 to shareholders.

 CONCEPT CHECK 2-2 (1 OF 2)

What effect does the payment of

dividends have on the accounting
equation?
a.Assets decrease and equity increases
b.Assets decrease and equity decreases
c. Assets decrease and liabilities increase
d.Assets increase and equity increases
 CONCEPT CHECK 2-2 (2 OF 2)

What effect does the payment of dividends have on

the accounting equation?
a. Assets decrease and equity increases
b. Assets decrease and equity decreases
c. Assets decrease and liabilities increase
d. Assets increase and equity increases

Payment of dividends causes the cash account (which is

an asset) to decrease and also causes retained earnings
(which is an equity account) to decrease. So the correct
answer is the payment of dividends decreases both assets
and equity.
 Balance Sheet

Caption Explanation
Accounts receivable Amounts due from customers
Merchandise inventory Cost of merchandise acquired but not yet sold
Equipment Cost of equipment purchased and used in business
Accumulated depreciation Portion of the cost of equipment that is estimated to have been used up in the
process of operating the business
Depreciation Process of spreading the cost of an asset over its useful life to the entity

Short-term debt Amounts borrowed that will be repaid within one year of the balance sheet date

Accounts payable Amounts due to suppliers

Other accrued liabilities Amounts owed to various creditors
Long-term debt Amounts borrowed from banks or other creditors that will not be repaid within
one year from the balance sheet date
Stockholders’ equity Residual claim of owners, computed as “assets minus liabilities”
Balance Sheet
Balance Sheet

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44

Income Statement

Captions Explanation
Net sales Amount of sales of merchandise to customers, less the amount of customer
returns of merchandise
Cost of goods sold Represents the total cost of merchandise removed from inventory and
delivered to customers as a result of sales
Gross profit Difference between net sales and cost of goods sold and represents the
seller’s maximum amount of “cushion” from which all other expenses of the
business must be deducted before it is possible to have net income
Selling, general, and Represents the operating expenses of the entity
administrative expenses
Income from operations Represents one of the most important measures of the firm’s activities
Interest expense Represents the cost of using borrowed funds
Income taxes Shown after all of the other income statement items have been reported,
because income taxes are a function of the firm’s income before taxes
Earnings per share of common A significant item in evaluating the market value of a share of common stock;
stock outstanding often referred to as EPS
Income Statement
 Statement of Changes in Stockholders' Equity

Captions Explanation
Paid-in capital Represents the total amount invested in the entity by the
owners
Common stock Reflects the number of shares authorized by the
corporation's charter, the number of shares issued to
stockholders, and the number of shares still held by the
stockholders
Additional paid-in Difference between the total amount invested by the
capital stockholders and the par value or stated value of the stock
Retained Represents the cumulative net income of the entity that has
earnings been retained for use in the business
Dividends Distributions of earnings to the stockholders
 Statement of Changes in Stockholders' Equity

• This financial statement shows the details of stockholders'

equity and explains the changes that occurred in the
components of stockholders' equity during the year.
 Statement of Cash Flows

• The purpose of this financial statement is to identify the

sources and uses of cash during the year.
 Statement of Cash Flows

Captions Explanation
Cash flows from operating Shown first; net income is the starting point for this measure of cash flow
activities
Depreciation expense Added back to net income because it is subtracted to arrive at net income,
but does not require the use of cash
Increase in accounts receivable Deducted because it reflects sales revenues included in net income, but not
yet received in cash

Increase in merchandise Deducted because cash was spent to acquire the increase in inventory
inventory
Increase in current liabilities Added because cash has not yet been paid for the products and services that
have been received during the current fiscal period
Cash flows from investing Show the cash sources and uses related to long-lived assets
activities
Cash flows from financing Show the cash sources and uses related to transactions with creditors and
activities stockholders
Cash flows from operating Shown first; net income is the starting point for this measure of cash flow
activities
Financial Statement Relationships 2
Concepts/Principles Related to Bookkeeping Procedures and the Accounting Process

• Accounting Period.
• The period of time selected for reporting
results of operations and changes in financial
position.
Concepts/Principles Related to Bookkeeping Procedures and the Accounting Process

• Matching revenue and expense.

• All expenses incurred to generate that period’s
revenues are to be deducted from the revenues earned
– matching principle

• Revenue is recognized at the time of sale.

• When the title to the product being sold passes from
the seller to the buyer or when the services involved in
the transaction have been performed.
– Revenue recognition principle
Concepts/Principles Related to Bookkeeping Procedures and the Accounting Process

• Accrual Accounting.
• Recognize revenue at the point of sale and
recognize expenses when incurred, even
though the cash receipt or payment may occur
at another time.
 Accrual Accounting Versus Cash Flows

Revenue Recognition
Accrual accounting Cash flow recognizes:
recognizes: • Revenue: when
• Revenue: when revenue payment is received for
is earned, at the point of services rendered or
sale of services or
products. products sold.
• Expenses: when they are • Expenses: when they
incurred. are paid.

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 Limitations of Financial Statements 2

• Cost Concept • Matching Concept

• Assets are usually • Estimates are
valued at the cost of acceptable, provided
the asset when there is a basis for
acquired (historical them.
purchase price)
• Many estimates are
• The balance sheet does used, such as
not report market warranty costs,
values or replacement depreciation, and
costs of the assets. pension expense.
 The Corporation’s Annual Report

• The annual report is distributed to

shareholders (and others).

• It contains the financial statements, together

with the report of the external auditor’s
examination of the financial statements.
You got this!