ACCOUNTING

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ACCOUNTING FINANCE BASICS

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WHO USES ACCOUNTING?

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

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FINANCIAL REPORTING

• 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
• Statement of Cash Flows

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FINANCIAL STATEMENTS

• 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.

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ELEMENTS OF FINANCIAL STATEMENTS 1.

• 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
• 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.

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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
• Assets   Claims (Liabilities Equity)

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NET ASSESTS RESIDUAL 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.
• 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 Example of basic accounting
  equation
• Assets Claims (Liabilities Equity)
• 800 ( 300 500
  ).

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BOOKKEEPING DOUBLE ENTRY

• 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 2 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.

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EFFECT OF BORROWING

• 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 3 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

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EQUITY CONTRIBUTED CAPITAL RETAINED EARNINGS

• 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
• Assets Liabilities
  Equity
• (Contributed Capital Retained
  Earnings)

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EFFECT OF REVENUE

• 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 4 Effect of revenue recognition
• Equity
• Assets Liabilities Contributed
  CapitalRetained 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

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ASSET USE

• As noted, 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

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EXPENSE REDUCES ASSETS CLAIMS
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.
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DISTRIBUTION

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

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SUMMARY TRANSACTION EFFECTS
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PERMANENT 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.

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TEMPORARY ACCOUNTS CLOSING

• 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.
• Based on the five transactions described, 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

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INCOME STATEMENT ORIENTATION

• 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.

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BASIC INCOME STATEMENT
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STATEMENT OF CHANGES IN EQUITY ORIENTATION

• 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.

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BALANCE SHEET ORIENTATION

• 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).

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STATEMENT OF CASH FLOWS ORIENTATION

• 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.

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BASIC STATEMENT OF CASH FLOWS
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HORIZONTAL ACCOUNTING MODEL

• 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.
• Obtained capital acquisition 5,000
• Borrowed cash 2,000
• Received cash revenue 3,000
• Paid expenses with cash 1,000
• Distributed cash to owners 500
• 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.

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BASIC HORIZONTAL STATEMENT
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ACCOUNTING EVENTS EFFECTS

• 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.