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Accounting for the Nonfinancial Manager Chapter 2: The Accounting Equation. Chapter 2: The accounting equation. The basic accounting framework:. The accounting equation. The basic accounting framework: Total assets = Total claims - PowerPoint PPT Presentation
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Accounting for the Nonfinancial Manager
Chapter 2: The Accounting Equation
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Chapter 2: The accounting equation
The basic accounting framework:
2
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting equation
The basic accounting framework:
Total assets = Total claims
= Total debt claims + total owners’ (“equity”) claims
3
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting equation
The basic accounting framework:
Total assets = Total claims
= Total debt claims + total owners’ (“equity”) claims
Or most commonly,
Total assets = Total liabilities + total shareholders’ equity
4
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Framework: the basic accounting equation
The basic accounting framework:
Total assets = Total claims
= Total debt claims + total owners’ (“equity”) claims
Or most commonly,
Total assets = Total liabilities + total shareholders’ equity
The last form of the equation uses the terminology of the balance sheet of an incorporated company. In fact, the balance sheet is a direct expression of the accounting equation.
5
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting equation as a framework for financial reporting
The basic accounting equation is a powerful framework for collecting, organizing and reporting financial information. With this one conceptual tool we can simultaneously:
6
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting equation as a framework for financial reporting
The basic accounting equation is a powerful framework for collecting, organizing and reporting financial information. With this one conceptual tool we can simultaneously:
Measure how the company has been doing (income statement)
7
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting equation as a framework for financial reporting
The basic accounting equation is a powerful framework for collecting, organizing and reporting financial information. With this one conceptual tool we can simultaneously:
Measure how the company has been doing (income statement)
Show where it stands financially at the end of the period (balance sheet)
8
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting equation as a framework for financial reporting
The basic accounting equation is a powerful framework for collecting, organizing and reporting financial information. With this one conceptual tool we can simultaneously:
Measure how the company has been doing (income statement)
Show where it stands financially at the end of the period (balance sheet)
Summarize transactions with its owners (statement of retained earnings or statement of owners’ equity).
9
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting equation as a framework for financial reporting
The basic accounting equation is a powerful framework for collecting, organizing and reporting financial information. With this one conceptual tool we can simultaneously:
Measure how the company has been doing (income statement)
Show where it stands financially at the end of the period (balance sheet)
Summarize transactions with its owners (statement of retained earnings or statement of owners’ equity).
One further extension allows us to summarize balance sheet changes (statement of cash flows).
10
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting cycle
The steps involved in using the accounting equation from the initial recording of transactions to the production of the financial statements comprise the accounting cycle.
11
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting cycle
events
Id en tify tran sa c tio n s & rec o rd in jo u rn a l
P re p a re fin a n c ia l s ta tem en ts
users
P o st to g e n e ra l le d g er
Correct, adjust & close books
Begin cycle againfor next period
12
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
A simple example
Consider the following situation:
You know a bit about computers and have decided to go into business selling specialized computer accessories to other small businesses.
You will operate out of your home as a sole proprietor.
You have savings from part-time and summer jobs and you are prepared to commit that money to your new business.
13
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Example: details
1. On 1 September you deposit $6,000 in a bank account in name ofyour company, Handywares & Co.
2. You order $7,000 of your product line from a supplier. You make apartial payment of $4,000 and the supplier ships all the goods. Theterms are that you pay the balance by 15 October.
3. In September, you pay $2,000 cash (including tax) for an officecomputer with programs. This should be useful for 2 years.
4. September sales are $4,500. Of this, $3,000 is collected in cash, thebalance is expected to be received in first two weeks of October.
5. At end of September, you still have one half the goods that youpurchased in the month.
Write answers to the following questions.
" How well did you do in September?" Where do you stand financially at the end of September? " Other than you, who else has an interest in these results and why?
14
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Procedure
This involves:a. Identifying transactionsb. Recording them in an accounting frameworkc. Balancing the accountsd. Drawing up financial statements
Drawing up the financial statements will allow us to answer questions 1 & 2 and suggest the answers to question 3.
15
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Recording transactions
The accounting cycle starts by recording transactions. Each transaction must be recorded in a way that maintains the basic accounting equation.
Writing ΔX to represent a change in X, this means that each transaction must satisfy the following equation:
Δ Assets = Δ Liabilities + Δ Shareholders’ Equity
For each transaction, the algebraic sum of value changes on one side of the balance sheet must equal the algebraic sum of value changes on the other side.
If each transaction is balanced, the accounting equation will remain in balance.
16
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Examples of transactions
Issue of shares for $600 cash: increase the asset cash by $600and increase shareholders’ equity, share capital, by $600
Purchase of $75 inventory on account: increase the asset inventory by $75,
and increase the liability, accounts payable, by $75
Purchase of land for $200 cash and $300 bonds payable: increase the asset, land, by $500)and decrease the asset, cash, by $200)and decrease the liability, bonds payable, by $300
17
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Handywares & Co.Analysis of transactions, Sep 2006
LINES are TRANSACTIONS, COLUMNS are ACCOUNTS
LIABILITIES +# ITEM CASH ACCO'S INV'TORY OFFICE CHECK TOTALS* ACCO'S J DOE REVENUE EXPENSES
REC'BLE EQUIP TOT. ASSETS TOT. L & O/ E PAYABLE CAPITAL
1 Initial deposit 0 0
2 Purchases 0 0
3 Office computer 0 0
4 Sales 0 0
5 Inventory 0 0
0 0
0 0 0 0 0 0 0 0 0 0
TRANSACTIONS (journal) are recorded line by line, and at the same time sorted by column into ACCOUNTS (general ledger)
=ASSETS OWNERS' EQUITY
18
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Handywares & Co.
Analysis of transactions, Sep 2003LINES are TRANSACTIONS, COLUMNS are ACCOUNTS
LIABILITIES +
# ITEM CASH ACCO'S INV'TORY OFFICE CHECK TOTALS* ACCOS J DOE REVENUEEXPENSES
REC'BLE EQUIP T OT . A T OT . L & O/ EPAYABLE CAPITAL
1 Initial deposit 6,000 6,000 6,000 6,0002 Purchases -4,000 7,000 3,000 3,000 3,0003 Office computer -2,000 2,000 0 0
4 Sales 3,000 1,500 4,500 4,500 4,5005 Inventory -3,500 -3,500 -3,500 -3,500
Amortization -83 -83 -83 -833,000 1,500 3,500 1,917 9,917 9,917 3,000 6,000 4,500 -3,583
=ASSETS OWNERS' EQUITY
THE LAST LINE IS THE TRIAL BALANCE
From here you can preparea set of financial statements
in good form
19
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Now prepare the statements
The following order will be the easiest1. Income Statement2. Statement of Capital
– This is because this is an unincorporated company
– for an incorporated company we would prepare a Statement of Retained Earnings
3. Balance Sheet4. Cash Flow Statement
20
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Handywares & Co.Income Statement
For the month of September 2006
RevenueSales …………………………………………….. $
4,500Expenses
Cost of goods sold ………….. $ 3,500Amortization ………………….. 83
Total expenses ………………………………..… 3,583Net income ………………………………………………… $ 917
21
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Handywares & Co.Statement of CapitalAs at 30 September 2006
Initial investment …………………………………….. $ 6,000Net income for the month …………………….…… 917
6,917
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Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Handywares & Co.Balance Sheet
As at 30 September 2006
Assets
Cash ……………………… $ 3,000Accounts receivable …….
1,500Inventory ………………….. 3,500Total current assets …… $
8,000 Equipment, net ………….. 1,917
$ 9,917
Liabilities and Owner’s Equity
LiabilitiesAccounts payable .…. $ 3,000
Owner’s equityJ. Doe, Capital ……….. 6,917
$ 9,917
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Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Handywares & Co.Cash Flow Statement
For the month of September 2006
Cash received from (used in) operating activitiesNet income …………………………………………….. $ 917Add back amortization ……………………………. 83
1,000Increase in non-cash working capital …….… (2,000)
$ (1,000) Cash received from (used in) investing activities
Purchase of equipment …………………..……… (2,000)Cash received from (used in) financing activities
Investment by owner ………..…………………… 6,000
Cash at end of the year ….…………………………………… $ 3,000
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Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Dimensions of the financial statements
• With respect to Time– Stock – Flow
• Scope– Comprehensive – Specific focus on evolution of the
shareholders’ claim
25
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The financial statements
• Statement– Balance sheet
– Income statement
– Statement of retained earnings
– Statement of cash flows
• Dimensions & purpose– Stock/Comprehensive
• where does the company stand financially at end of period
– Flow/Shareholders’ claim• Details of operations for benefit
of shareholders over the period– Flow/Shareholders’ claim
• Summary of operations• How much of shareholders’
claim was distributed to them in the period
– Flow/Comprehensive• In what ways and why did the
balance sheet change over the period
26
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Purpose of principal financial statements
Balance sheet• Business valuation:
– What it has; what it owes; owners’ equity
• To assess ability to pay debts as they come due – Liquidity (short-term)– Solvency/risk (long-
term)
Income statement• Size of market• Structure of
expenses• to predict long-term
profits• ability to pay future
dividends
Both Scale of operations To predict long-term profitability
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Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Double entry transactions
If every accounting transaction must satisfy the following equation
Assets = Liabilities + Shareholders’ Equity
then we have these possiblilities:
+ Assets with + Liabilities or + Shareholders’ Equity
- Assets with - Liabilities or - Shareholders’ Equity
+ Assets with + Liabilities or + Shareholders’ Equity - Assets with - Liabilities or - Shareholders’ Equity
Note revenue is an increase in shareholders’ equity expense and dividends are decreases in S/E
28
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Double entry transaction, continued
Increase inan asset
Increase in aliability or equity,includingrevenue
Decrease inan asset
Decrease in aliability or equity,includingexpense ordividend
And we can generalizes as follows--for simple doubleentry transactions, only those combinations linked bybars maintain the basic accounting equation:
29
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Double entry transactions, concluded
And even more consisely
Left side entry
Right sideentry
Debit Credit
Dr CrThus the terms debit (Dr) and credit (Cr) are simply shorthand ways of describing transactions. If the (dollar value of) the debits in a transaction equal the credits, the basic accounting equation is respected.
30
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Handywares & Co.Analysis of transactions, Sep 2003
ASSETS = LIABILITIES AND OWNERS' EQUITY
INCREASES ON LEFT SIDE--DECREASES ON RIGHT SIDE DECREASES ON LEFT SIDE--INCREASES ON RIGHT SIDE
# ITEM CASH ACCO REC 'BLE INVENTORY OFFICE EQUIP ACCO PAYABLE J . DOE, CAP ITAL REVENUE EXPENSES
LS RS LS RS LS RS LS RS LS RS LS RS LS RS LS1 Initial deposit 6,000 6,0002 Purchases 4,000 7,000 3,0003 Office computer 2,000 2,0004 Sales 3,000 1,500 4,5005 Inventory 3,500 3,500
TOTAL 9,000 6,000 1,500 7,000 3,500 2,000 3,000 6,000 4,500 3,500
ACCOUNTS, NET 3,000 1,500 3,500 2,000 3,000 6,000 4,500 3,500
Total RS/LS LS RS
Assets 10,000 0 LS RS
Liabilities & O/E 3,500 13,500
Overall LS RS
13,500 13,500
31
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Handywares & Co.Analysis of transactions, Sep 2003
ASSETS = LIABILITIES AND OWNERS' EQUITY
INCREASES ON LEFT SIDE--DECREASES ON RIGHT SIDE DECREASES ON LEFT SIDE--INCREASES ON RIGHT SIDE
therefore, DEBITS ON LEFT SIDE -- CREDITS ON RIGHT SIDE
# ITEM CASH ACCO REC 'BLE INVENTORY OFFICE EQUIP ACCO PAYABLE J . DOE, CAPITAL REVENUE EXPENSES
Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr1 Initial deposit 6,000 6,0002 Purchases 4,000 7,000 3,0003 Office computer 2,000 2,0004 Sales 3,000 1,500 4,5005 Inventory 3,500 3,500
TOTAL 9,000 6,000 1,500 7,000 3,500 2,000 3,000 6,000 4,500 3,500
ACCOUNTS, NET 3,000 1,500 3,500 2,000 3,000 6,000 4,500 3,500
Total Dr/Cr Dr Cr
Assets 10,000 0 Dr Cr
Liabilities & O/E 3,500 13,500
Overall Dr Cr
13,500 13,500
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Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Form of a transaction
A transaction is normally recorded first as a journal entry in the journal. For example, if a company borrows $5,000 from the bank on 1 Sep 06, the transaction is recorded in its books as follows:
Dr Cr1 Sep 06 Dr Cash [A] 5,000
Cr Bank loan [L] 5,000
Demand loan taken from Bank of XYZ, secured on inventory
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Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Form of a transaction--Notes
Notes1. Form is important. Debits, both account titles and dollar amounts,
are aligned to the left in their columns and the credits accounts titles and amounts are aligned to the right.
2. Statement signifiers [Asset, Liability, Shareholders’ Equity, REVenue, EXPense, DIVidend] are used only for teaching purposes.
Dr Cr1 Sep 06 Dr Cash [Asset] 5,000
Cr Bank loan [Liab’y] 5,000
Demand loan taken from Bank of XYZ, secured on inventory
34
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
The accounting cycle in practice
events
rec o rd tran s ac tio n s in jo u rn a l
P re p a re fin a n c ia l s ta tem en ts
users
P o st to g e n era l le d g er
JournalSalary exp….500
cash…………..…500
Acc rec…….2000
Sales……………2,000
etc
cashxxxxx
xx
xx
xx
xx xx
A/Rec
Inv Equip
A/Pay
C/S Rev
Sal Rent
xxx
GL
xx
Add adjusting journal entries
35
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
What are adjustments?
Adjustments are journal entries (AJEs) made at period-end to ensure that the books are on a full accrual basis.
The accrual basis of accounting is the principle that revenues and expenses are recognized in the period that the underlying event takes place (rather than when the associated cash transactions occur).
36
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Why adjustments?
• Day-to-day accounting normally just picks up transactions involving cash, receivables, payables
• This gives cash flow information• Income measurement needs value flow
information, in particular:– Revenue, not receipts– Expense, not expenditure
• Also, day-to-day accounting misses time-based transactions
37
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Types of adjustments
• Accruals – From cash flow to value flow
• Adjust expenditure to expense, receipt to revenue• Examples: accrued salaries payable, prepaids, COGS, income
taxes • Also allowances such as warranties & bad debts
– Accrue pure time-based revenue and expenses such as interest & depreciation
• Other– Correction of errors– Exceptional events such as major write downs
38
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Adjustments: procedure
• Review accounts in light of all available information
• Compare actual balance of relevant account (income statement, balance sheet or both) to what it should be
• Make entry to income statement, balance sheet accounts pairs to bring them to what they should be, e.g., so income statement measures resource flows, not cash flows
39
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
Relationship between convention set of books
and the spreadsheet
• A conventional set of books comprises the A conventional set of books comprises the journal and the general ledgerjournal and the general ledger
• The spreadsheet combines the twoThe spreadsheet combines the two– The lines are the journal entries The lines are the journal entries – The columns are the general ledger The columns are the general ledger – Analytically very neat, but practically very Analytically very neat, but practically very
cumbersome for traditional paper systems cumbersome for traditional paper systems • As time passes it gets very longAs time passes it gets very long• After more than a few accounts, it gets very wideAfter more than a few accounts, it gets very wide
– The spreadsheet, however, is well suited to The spreadsheet, however, is well suited to computerized accounting systems.computerized accounting systems.
40
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
From journal to general ledger
• Journal: chronological• Ledger: analytical• Journal entries are ournal entries are
posted (copied), line by posted (copied), line by line, to corresponding line, to corresponding accountaccount in the general in the general ledgerledger
• Use a Use a T-accountT-account to to represent an accountrepresent an account
Account name
Debit
Credit
xxxxx
41
Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011
1. Identify amount of discrepancya. look for that number in source document & missing from TB; if notb. look for half that number in a column; if notc. divisible by 9? look for transposition*
2. If these don’t work (& they only work for a single error)a. add again in opposite directionb. check postings....
3. Just start again
For example, consider 5this trial balance: 7
1448
*a transposition is any 60 rearrangement of all digits 67 67
Errors in a Trial Balance or other self-balancing columns
42