Basic Concepts of Financial Accounting  Owners may make a direct investment in the

business or operate at a profit and leave the

profit in the business.
The Basic Accounting Equation  Yet another name for owners' equity is net
assets.
Financial accounting is based upon the accounting
equation. – Indicates that owners' equity results
when liabilities are subtracted from
Assets = Liabilities + Owners' Equity
assets.
– This is a mathematical equation which
Owners’ Equity = Assets – Liabilities
must balance.

– If assets total $300 and liabilities total

$200, then owners' equity must be The Basic Accounting Equation
$100.
 Both liabilities and owners' equity represent
The Basic Accounting Equation claims on the assets of a business.
 Liabilities are claims by people external to the
 The balance sheet is an expanded expression
business.
of the accounting equation.
 Owners' equity is a claim by the owners.

A transaction may do one of several things:

 It may increase both the asset side and the

liabilities and owners' equity side.
 It may decrease both the asset side and the
liabilities and owners' equity side.
 It may cause both an increase and a decrease
on the asset side.
 It may cause both an increase and a decrease
on the liabilities and owners' equity side.
 Regardless of what transaction occurs, the
accounting equation must be in balance after
Assets the transaction is analyzed.
 Assets are valuable resources that are owned Transaction Analysis
by a firm.

– They represent probable future

economic benefits and arise as the
result of past transactions or events.

Liabilities

 Liabilities are present obligations of the firm.

– They are probable future sacrifices of

economic benefits which arise as the
result of past transactions or events.

Owners' Equity

 Owners' equity represents the owners'

residual interest in the assets of the business.

– Residual interest is another name for

owners' equity.
  It owes magazines to the subscriber and thus
has a liability (called Unearned Revenue), not
revenue.
 As magazines are sent, revenues may be
recorded.
 Unearned revenues are usually settled by the
performance of a service, unlike other
liabilities which are usually settled by the
payment of cash.

Revenues and Expenses

 Revenues increase owners' equity.

 Expenses decrease owners' equity.

Revenues

 Revenues are inflows of assets (or reductions

in liabilities) 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
preparation or auditing.

 Critically important point:

– Cash need not be received in order for

revenue to be recorded.

– Revenues are earned when a Expenses

company does what it is supposed to
do according to a contract.  Expenses occur when resources are consumed
in order to generate revenue.
 Accounts receivable are promises by a  They are the cost of doing business.
customer or client to pay cash in the future.
 A related concept concerns cash received – Examples include rent, salaries and
before a service is performed or goods are wages, insurance, electricity, utilities,
delivered. and the like.

Consider the following example:

 A magazine company receives $24, which

represents a year's subscription.
 The subscriber, of course, pays in advance.
 The magazine company may not record
revenue because it has not earned revenue
yet.
 To earn revenue, it must send the subscriber
one magazine a month for twelve months.
  A revenue transaction exists because an asset
has been obtained and goods have been
provided to customers.
 An expense transaction exists because an
asset has been consumed to generate the
revenue.
 The resulting expense is called cost of goods
sold.

 A critically 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.

– If a repairman comes to the business

to work on the air conditioning
system, then the business has a repair
expense even though that work may
Adjustments to Accounts
be charged to its account.
 Several adjustments must be made to
– The company will have a liability
accounting records at the end of the
which it will settle later with the
accounting period.
payment of cash.
 A balance in an account may need to be
 The word "payable" is usually used in a adjusted because of the passage of time and
liability title. the occurrence of events in that time period.
 An amount may not have been recorded in an
Examples of Payables
account at all.
 Notes payable—written obligations.
– The amount will have to be recorded
 Accounts payable—unwritten obligations that
before the financial statements are
arise in the normal operations of a business.
prepared so that all the information
 Wages payable.
will be correct.

Revenues and Expenses

 Remember that four transactions affect

owners' equity.

– Owner investments increase owners'

equity.

– Owner withdrawals decrease owners'

equity.

– Revenues increase owners' equity.

– Expenses decrease owners' equity.

Sales of Inventory
Simple Balance Sheets and Income Statements
 Sales of inventory contain both revenue and
expense components.
  The end result of the accounting process is
the preparation of financial statements.

The Balance Sheet

 The balance sheet shows a firm's assets,

liabilities, and owner's equity at one point in
time.

– The date on the balance sheet will be

a single date, such as December 31 or
June 30.

The Statement of Owners' Equity

 The statement of owners' equity summarizes

the changes that took place in owners' equity
during the period under review.
 It will have the same date as does the income
statement.
 It shows results over a period of time, not just
at one point in time.
 The statement starts with the beginning
The Income Statement balance of owners' equity and adds in any
owner investment and net income.
 The income statement summarizes a firm's
 If there are withdrawals, then they are
revenues and expenses for a period of time.
subtracted, as is a net loss.
– The date on the income statement  A business will have either a net income or a
will be a phrase such as, "For the net loss, not both.
month ended July 31," or "For the
year ended December 31."

 If revenues exceed expenses, then the result

is net income.
 If expenses exceed revenues, then the result
is a net loss.
 Only revenues and expenses appear on the
income statement.

– Students sometimes think that cash is

a good thing and should appear on
the income statement.
Relationship Between Balance Sheet and Income
– Cash is an asset and so will appear on Statement
the balance sheet.
 Changes in net income, owner contributions,
and owner withdrawals, all of which affect
owners' equity, explain changes in net assets.

Forms of Business Organization

 Profit-oriented enterprises can be organized

in one of three ways.
– Sole proprietorships

– Partnerships

– Corporations

- End of Accounting Basics -