Accounting for the Nonfinancial Manager Chapter 2: The Accounting Equation

1. Accounting for the Nonfinancial ManagerChapter 2: The Accounting Equation

2. Chapter 2: The accounting equation The basic accounting framework:

3. The accounting equation The basic accounting framework: Total assets = Total claims = Total debt claims + total owners’ (“equity”) claims

4. 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

5. 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.

6. 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:

7. 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)

8. 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)

9. 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).

10. 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).

11. 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.

12. The accounting cycle

13. 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.

14. Example: details

15. Procedure This involves: • Identifying transactions • Recording them in an accounting framework • Balancing the accounts • Drawing up financial statements Drawing up the financial statements will allow us to answer questions 1 & 2 and suggest the answers to question 3.

16. 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 = ΔLiabilities + ΔShareholders’ 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.

17. Examples of transactions Issue of shares for $600 cash: increase the asset cash by $600 and 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

19. THE LAST LINE IS THE TRIAL BALANCE From here you can prepare a set of financial statements in good form

20. The following order will be the easiest Income Statement Statement of Capital This is because this is an unincorporated company for an incorporated company we would prepare a Statement of Retained Earnings Balance Sheet Cash Flow Statement Now prepare the statements

21. Handywares & Co. Income Statement For the month of September 2006 Revenue Sales …………………………………………….. $ 4,500 Expenses Cost of goods sold ………….. $ 3,500 Amortization ………………….. 83 Total expenses ………………………………..… 3,583 Net income ………………………………………………… $ 917

22. Handywares & Co. Statement of Capital As at 30 September 2006 Initial investment …………………………………….. $ 6,000 Net income for the month …………………….…… 917 6,917

23. Assets Cash ……………………… $ 3,000 Accounts receivable ……. 1,500 Inventory ………………….. 3,500 Total current assets …… $ 8,000 Equipment, net ………….. 1,917 $ 9,917 Liabilities and Owner’s Equity Liabilities Accounts payable .…. $ 3,000 Owner’s equity J. Doe, Capital ……….. 6,917 $ 9,917 Handywares & Co.Balance SheetAs at 30 September 2006

24. Handywares & Co. Cash Flow Statement For the month of September 2006 Cash received from (used in) operating activities Net income …………………………………………….. $ 917 Add back amortization ……………………………. 83 1,000 Increase 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

25. Dimensions of the financial statements • With respect to Time • Stock • Flow • Scope • Comprehensive • Specific focus on evolution of the shareholders’ claim

26. 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 The financial statements

27. 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 Purpose of principal financial statements • Both • Scale of operations • To predict long-term profitability

28. Double entry transactions

29. Double entry transaction, continued

30. Double entry transactions, concluded Thus 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.

33. 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 Cr 1 Sep 06 Dr Cash [A] 5,000 Cr Bank loan [L] 5,000 Demand loan taken from Bank of XYZ, secured on inventory

34. Form of a transaction--Notes Dr Cr 1 Sep 06 Dr Cash [Asset] 5,000 Cr Bank loan [Liab’y] 5,000 Demand loan taken from Bank of XYZ, secured on inventory • Notes • 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. • Statement signifiers [Asset, Liability, Shareholders’ Equity, REVenue, EXPense, DIVidend] are used only for teaching purposes.

35. The accounting cycle in practice Journal Salary exp….500 cash…………..…500 Acc rec…….2000 Sales……………2,000 etc Add adjusting journal entries GL A/Rec Inv Equip cash xx xx xx xx xxx A/Pay C/S Rev xx xx xxx Sal Rent xx

36. 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).

37. 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

38. 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

39. 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

40. Relationship between convention set of books and the spreadsheet • A conventional set of books comprises the journal and the general ledger • The spreadsheet combines the two • The lines are the journal entries • The columns are the general ledger • Analytically very neat, but practically very cumbersome for traditional paper systems • As time passes it gets very long • After more than a few accounts, it gets very wide • The spreadsheet, however, is well suited to computerized accounting systems.

41. From journal to general ledger • Journal: chronological • Ledger: analytical • Journal entries are posted (copied), line by line, to corresponding account in the general ledger • Use a T-account to represent an account Account name Debit Credit xxx xx

42. Errors in a Trial Balance or other self-balancing columns • Identify amount of discrepancy • look for that number in source document & missing from TB; if not • look for half that number in a column; if not • divisible by 9? look for transposition* • If these don’t work (& they only work for a single error) • add again in opposite direction • check postings.... • Just start again • For example, consider 5 • this trial balance: 7 • 14 • 48 • *a transposition is any 60 • rearrangement of all digits67 67