Chapter 1: Introduction to accounting

Information Needs

Accounting — The basis of decision making

Accounting is the ‘language of business’, the information system that
- Measures business activities
- Processes that information into reports
- Communicates the results to decision makers
Working definition: A system providing information to managers and owners in order to
make business decisions.
Formal definition: “The process of identifying, measuring and communicating economic
information to permit informed judgements and decisions by users of the information”.
(American Accounting Association (1966), Statement of Basic Accounting Theory, p. 1).

Nature of Accounting
Accounting is about recording, preparing and interpreting business transactions.
Enables key questions to be answered, such as how much profit we have made.
Difference between large and small businesses:
- In small businesses, managers and owners are the same people
- In large businesses, managers and owners will be different

The Flow of Information of the Accounting System

People make decisions → Business transactions occur → Businesses prepare reports to
show the results of their operations id
The Notion of Accounting

Accounting as Communication of Financial Information

gaaministracion

Importance of Accounting Information

Money makes the world go round, as businesses depend on cash and profit. In order to
understand business, we need to understand accounting and know basic terminology:
- Income: the money that an entity receives from business transactions/operations.
- Assets: the resources that a company owns (cash, human resources, operational
resources, real estate).
- Expenses: the payments that the business is liable to pay in a given term. The
amount of liabilities that is divided off the income.
- Liabilities: everything the company owns or has to pay to parties outside the
enterprise.
- Profit: Aand
financial gain, especially the difference between the amount earned
the amount spent in buying, operating, or producing something
- Capital: the money invested by the owner so that the business could start
operating. Investment by individuals who have the right to profit after the period
has ended.
- Cash flow: the only asset that can be accessed immediately.

After the accounting information is available to the public, the public reacts to it (is
affected by it) and makes transactions depending on the information announced.
Internal vs. External Users
Accounting measures all business transactions and records them to users.
Internal users are managers and employees
External users are shareholders or investors, inter alia.
Within internal and external users there are different approaches to accounting:
- Internal: management accounting (focused and detailed information, feedback)
- External: financial accounting (global information with no influence on the
reporting process).

Financial and Management accounting

Financial accounting
Provision of financial information on a business’s recent financial performance targeted at
external users such as shareholders.
- Backwards-looking
- Double-entry bookkeeping
- Main products: profit and loss account (income statement) and balance sheet
Management accounting
Not an official system, but decisions of managers where they have freedom to organize
business transactions to have impact in the financial accounting. They are able to produce
good financial prospects in the enterprise.
It is not required by law (unlike financial accounting) and it is related to the internal
needs of business. It can be split into cost accounting and decision-making.

accounting
making
Decision

- Financial accounting serves outsiders while management accounting serves insiders

- The main work of financial accounting is to prepare the financial statements, and it
is the only one based upon double entry bookkeeping
- Financial accounting looks backwards while management accounting looks forwards
- The product of each accounting is different

Users of Accounting Information

In a firm, there are insiders (internal users) and outsiders (external users):
- Insiders: management, employees
- Outsiders: suppliers, consumers, regulators, tax officials, lenders, financial
markets
User Information Requirements:

Internal Users

Management Information for costing, decision-making,

planning and control

Employees Information about job security and for

collective bargaining

External Users

Shareholders and analysts advisers Information for buying and selling shares

Lenders Information about assets and the

company’s cash position

Suppliers and other trade creditors Information about assets and the
company’s cash position

Customers Information about long-term prospects and

survival of the business

Government and tax authorities Information on profits to use as a basis for

calculating tax

Public Information about the social and

environmental impact of corporate
activities

Financial Statements
The financial statements help managers make decisions about the company (although they
may have different incentives).
The income statement reports net income or net loss for the period. It reflects the wealth
generated by the company in a given period.
The balance sheet reflects the financial position of the company at the end of a period
(assets and liabilities).

The demand and supply of nancial information

The Demand for financial information will depend upon:
- Tastes and preferences (risk attitudes)
- Beliefs about the future
- Access to financial information
The supply of financial information will depend upon:
- Incentives companies have to voluntarily disclose financial information
- Regulatory framework

Need for regulation

Financial Information and Financial Markets

The relationship between financial information and security prices can influence investors’
direct demand for financial information.
Evidence shows:
- Annual earnings are not timely information and are preempted by alternative,
more timely sources
- However, significant price reaction was found in the week of the announcement of
annual earnings
- Prices act as if earnings announcements alter investors’ belief in such a way as to
alter the price or security
Overview of Information Characteristics

- Content
Relevance: whether financial statements provide all information related to users needs,
and if they alter their decisions.
Reliability: the information is representationally faithful, neutral, free from any material
error, prudent and completeIt is measured and recorded correctly.
- Content must be presentative
Comparability: the information given must be able to be subjected to inter— and
intra—company comparisons, comparable to that of e.g. previous years. For this, the
accounting system needs to satisfy the following conditions: consistency in the same
process.
Understandability: information must be presented as understandably as possible
- Information must also be
Material: the change in the information impacts actions of users.
Timely: the information of the accounting system is provided in the true time when it
should be provided.

Accounting Principles and Concepts

The Generally Accepted Accounting Principles (GAAP) are the rules that govern how
accountants operate, and they are based upon a conceptual framework.
The Key Spanish Accounting Organizations are: ICAC, the Treasury Ministry, the Bank of
Spain, AECA, the EU Commission and CNMV.
Both the ICAC and AECA are the Regulatory Bodies Issuing Accounting Rules in Spain:
ICAC (Instituto de Contabilidad y Auditoría de Cuentas) is a public organization linked to
the Ministry of Economy. It issues regulation (compulsory for companies).
AECA (Asociación Española de Contabilidad y Administración de Empresas) is a private
body composed by professionals and academics. Although influential, it cannot regulate
accounting issues.
Regarding accounting regulation in Spain, there are two different regulatory regimes in
place in Spain:
- International regulation: for Group Accounts of listed companies (enterprises in
the stock market). For comparability, these enterprises must follow international
 regulation to make international accounting regulation useful. It is based on the
rules issued by the IASB approved by the European Commission.
- National regulation: it is the one followed by the rest of the companies.

International Accounting Standards

Since 2005, all quoted companies within the EU have to prepare their accounts following
the International Accounting Standards issued by the IASB. (CE 1606/2002)
The IASB (International Accounting Standards Board) is the regulatory body of the IASC
(International Accounting Standards Committee).
- Until 2001, the standards issued by the IASB were denominated IAS (or NIC in
Spanish). Eg. IAS 2: Inventory.
- From 2001 the new standards are denominated IFRS (NIIF in Spanish). E.g. IFRS
Insurance Contracts
Benefits of IAS-General common standards
- Need to improve comparability of accounting information
- The objective is to have a common standard capital market
- Expand investment possibilities of European citizens
- Macroeconomic benefits: employment, economic growth, prosperity
Chapter 2: The accounting equation
The value of the company: Owners’ Equity
𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 𝑂𝑤𝑛𝑒𝑟'𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
Owner’s equity is the amount of an entity’s assets that remain after its liabilities are
subtracted. The purpose of a business is to increase the owner's equity.

The Accounting Equation

The accounting equation presents the resources of the business and the claims to those.
- 𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 = 𝐶𝑙𝑎𝑖𝑚𝑠 𝑡𝑜 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠
- 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑜𝑤𝑛𝑒𝑟'𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
Assets are the economic resources of a business that are expected to be of benefit in the
future. Claims to assets come from:
- Liabilities: economic obligations, debts payable to outsiders (creditors)
- Owner’s equity (capital): assets held by the owners of the business

Accounting Equation Elements (PGC)

Assets: goods, rights and other resources controlled by the company as a result of past
events and from which future economic benefits are expected to flow to the company.
Liabilities: present obligations of the company arising from past events, the settlement
of which is expected to result in an outflow of resources from the company embodying
future economic benefits. Liabilities shall include provisions.
Equity: the residual interest in the assets of the company after deducting all its
liabilities. Equity includes contributions made by equity holders or owners upon
incorporation of the company or subsequently that are not considered as liabilities, as
well as retained earnings and cumulative losses or other related variations.

For a corporation, stockholders’ (owners’) equity consists of two main categories:

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟'𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + (𝑝𝑎𝑖𝑑 − 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠)
Paid-in (contributed) capital is the amount invested in the corporation by its owners, and
it is comprised basically of common stock.
Retained earnings is the amount earned by income-producing activities and kept for use
in the business. It is affected by
- Revenues — increases in retained earnings from delivering goods or services
- Expenses — decreases in retained earnings that result from operations
Transactions that affect owner’s equity:
- Increase due to owner investments in the business, revenues
- Decrease due to owner withdrawals from the business, expenses
Net income
- Net earnings: total revenues exceed total expenses (R>E)
- Net loss: total expenses exceed total revenues (R<E)
- Dividends: distributions to stockholders (usually cash) generated by net income
The accounting equation
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
=, UWt *

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑝𝑟𝑜𝑓𝑖𝑡 (𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠)

𝐴𝑠𝑠𝑒𝑡𝑠 + 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠

Assets
Current assets are those assets which the company expects to convert to cash, sell, or
consume during the next 12 months or within the business's normal operating cycle if
longer than a year. Current assets include:
- Cash
- Accounts receivable
- Merchandise inventory
- Prepaid expenses asset *

- Short-term investment
Long-term assets are those assets which the company expects to hold longer than the
next 12 months or the business’s normal operating cycle if longer than one year. Long-term
assets include:
- Property, Plant and Equipment
- Long-term investment
Intangible assets, those with no physical form (trademarks, patents, R&D…).
Other assets have small values which don’t fall within any other standard asset category.

Liabilities
Current liabilities are debts payable within one year or within the business’s normal
operating cycle if longer than a year. Current liabilities include:
- Notes payable, short term
- Accounts payable
 - Accrued expenses payable viability *

- Income taxes payable

Long-term liabilities are debts not payable within one year or within the business’s
normal operating cycle if longer than a year. Long-term liabilities include:
- Notes payable, long term investment
- Bonds payable

Owners’ Equity
The owners’ equity represents the shareholders’ ownership of the assets of the business. A
corporation’s owners’ equity consists of:
- Common stock (or capital)
- Retained earnings (or reserves)
- Profits

Transactions
A transaction is any event that affects the financial position of the business entity and
that can be measured reliably.
Transactions involve give-get exchanges (e.g. give merchandise, get cash).
Transactions must be stated in monetary terms to be entered in books.

Accounting for Business Transactions

Consider the following transactions for Air & Sea Travel, Inc., and their effect on the
accounting equation:
Analysis of Transactions
Information reported on the nancial statements
- Profit and loss account (Income statement)
- Statement of Retained Earnings
- Balance Sheet
- Cash flow statement

Income Statement
The income statement (statement of earnings) reports the company’s revenues, expenses,
and net income or net loss for the period.
It shows revenue earned less expenses incurred, gives profit over a period of time.
untraes

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 (𝑙𝑜𝑠𝑠) = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

Revenues
Increases in retained earnings from delivering goods or services to clients.
Increases in the company’s equity during the reporting period in the form of inflows or
enhancements of assets or decreases in liabilities, other than those relating to monetary
or non-monetary contributions from equity holders or owners.
Expenses
Decreases in retained earnings that result from operations
Decreases in equity during the reporting period in the form of outflows or depletions of
assets or incurrences of liabilities, other than those relating to monetary or non-monetary
distributions to equity holders or owners.
- Cost of goods sold (cost of sales that a company sold to its customers)
- Operating expenses, the costs of operating business
- Advertising (the cost to promote the company’s products)
- Depreciation (the expense of using company-owned buildings, equipment
and furniture)
- Other operating expenses (costs of salaries, utilities, rent, supplies)
- Interest expense (the cost of borrowed money)
Statement of Retained Earnings
The statement of retained earnings (or statement of stockholders’ equity) reports that
portion of net income the company has retained, or kept for use in the business.
𝐸𝑛𝑑𝑖𝑛𝑔 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑅𝐸 + 𝑁𝐼 (𝑅 − 𝐸) − 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
- Net income increases retained earnings
- Dividends paid to stockholders decrease retained earnings

Balance Sheet
The balance sheet (statement of financial position) reports the company’s assets,
liabilities, and owners’ equity. It shows assets, liabilities and capital at point in time.
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑂𝑤𝑛𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦

Statement of Cash Flows

The statement of cash flows reports the company’s cash inflows and outflows from
operating, investing and financing activities.
Shows cash received and paid over a period of time.
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 (𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒) 𝑖𝑛 𝑐𝑎𝑠ℎ 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔, 𝑖𝑛𝑣𝑒𝑠𝑡𝑖𝑛𝑔, 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 (+ / −)
- Operating activities: companies operate by buying goods and services, which are
sold to customers
- Investing activities: companies invest in long-term assets used to run the business
- Financing activities: companies finance themselves by issuing stock and borrowing
money
Relationship among the nancial statements
Income statement is completed first
Statement of retained earnings requires net income to calculate an ending balance
Balance sheet requires the ending balance of retained earnings to balance
Statement of cash flows reports increases and decreases in cash and must agree with the
cash balance on the balance sheet

3
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* Merchandising company

service
expenses

Saves R
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cost of goods Gold
op. expenses
inventury