01 - Basics of Accounting

Financial Accounting
Winter 2016/17
Prof. Dr. Kerstin Lopatta

Johann Trenkle, M.A.
Module 1: Basics
Content
1.1 The Nature and Objectives of Financial Accounting
1.2 Balance Sheet Equation and its Components
1.3 Balance Sheet Transactions
1.4 Measuring Income to Assess Performance
1.5 The Income Statement
1.6 Double Entry Accounting
Learning objectives
You should be able to
(1) record an entitys transactions in the double-entry bookkeeping
manner and
(2) prepare the balance sheet and the income statement at any
point in time.
Accounting
The process of identifying, recording, summarizing, and

reporting economic information to decision makers.
Accounting System
The series of steps involved in initially recording information

and converting it into financial statements.
3
Accounting
Financial
The field of accounting that serves external

decision makers, such as stockholders,
suppliers, banks, and government agencies.
Management
Accounting
The field of accounting that serves internal

decision makers, such as top executives,
department heads, hospital administrators,
and people at other management levels
within an organization.
4
Financial Statements
Income Statement of
Balance Sheet
Statement Cash Flows
5
Annual Report
A combination of financial
statements, management
discussion and analysis, and
graphs and charts that is provided
annually to investors.
6
Balance Sheet Biwheels Company
Assets Balance Sheet Liabilities and

as at December 31, 2003 Owners Equity
I. Cash $500,000 I. Liabilities $100,000

II. Smith, capital $400,000
Total assets $500,000 Total liabilities and

owners equity $500,000
7
Assets = Liabilities + Owners Equity
8
Assets
Economic resources that are expected to help

generate future cash inflows or help reduce future
cash outflows.
Liabilities
Economic obligations of the organization to

outsiders, or claims against its assets by
outsiders.
9
Owners Equity
The residual interest in the organizations assets

after deducting liabilities.
Owners Equity = Assets - Liabilities
10
Entity
An organization or a section of an organization

that stands apart from other organizations and
individuals as a separate economic unit.
Transaction
Any event that both affects the financial position
of an entity and can be reliably recorded in
money terms.
11
Transaction 1, Initial Investment

on December 31, 2003
Owners
Assets = Liabilities +
Equity
Cash Smith, Capital
+ $400,000
(1) + $400,000 = (Owner
investment)
12
Transaction 2, Loan from Bank

on December 31, 2003
Owners
Equity
Cash Note Payable Smith, Capital
(1) + $400,000 = + $400,000
(2) + $100,000 = + $100,000
Bal. $500,000 = $100,000 $400,000
$500,000 $500,000
13
Transaction 3, Acquire Inventory for Cash

on January 2, 2004
Owners
Equity
Merchandise Note
Cash Smith, Capital
Inventory Payable
(1) + $400,000 = + $400,000
(2) + $100,000 = + $100,000
(3) - $150,000 + $150,000
Bal. $350,000 $150,000 = $100,000 $400,000
$500,000 $500,000

as at January 2, 2004 Owners Equity
I. Cash $350,000 I. Liabilities

II. Merchandise (note payable) $100,000
Inventory $150,000 II. Smith, capital $400,000
Total assets $500,000 Total liabilities and

owners equity $500,000
15
Account
A summary record of the changes in a particular asset,
liability, or owners equity.
Fiscal Year
Year established for accounting purpose.
Account Balance
Total of all entries to the account to date.
16
Analysis of Transactions
? Which specific accounts are affected?
Whether the account balances are

? increased or decreased.
? The amount or the change in each account

balance.
17
Transaction 4, Acquire Inventory on Credit

on January 3, 2004
Owners
Equity
Merchandise Note Accounts Smith,
Cash
Inventory Payable Payable Capital
Bal. $350,000 $150,000 = $100,000 $400,000
(4) + $10,000 = + $10,000
Bal. $350,000 $160,000 = $100,000 $10,000 $400,000
$510,000 $510,000 18
compound entry
Transaction 5, Acquire Store Equipment for Cash Plus Credit

on January 4, 2004
Owners
Equity
Merchan-
Store Note Accounts Smith,
Cash dise
Equipment Payable Payable Capital
Inventory
Bal. $350,000 $160,000 = $100,000 $10,000 $400,000
(5) - $4,000 + $15,000 = + $11,000
Bal. $346,000 $160,000 $15,000 = $100,000 $21,000 $400,000
$521,000 $ 521,000 19
Open Account
Buying or selling on credit, usually by just an authorized
signature of the buyer.
Account Payable
A liability that results from a purchase of goods or
services on open account.
20
Exercise:
Analyse transactions No. 6 to 10 using the balance sheet
equation. Determine:
? Which specific accounts are affected?
Whether the account balances are

? increased or decreased.
? The amount of the change in each account

balance.
21
Creditor
A person or entity to whom

money is owed by us/our business.
Debtor
A person or entity that owes money

to us/our business.
22

as at January 12, 2004 Owners Equity
I. Cash $342,700 I. Note payable $100,000

II. Accounts receivable $300 II. Accounts payable $16,200
III.Merchandise Total liabilities $116,200
inventory $159,200
IV.Store equipment $14,000 III. Smith, capital $400,000
Total $516,200 Total $516,200

23
Operating Cycle
Buy Merchandise Sell Accounts

Cash
Inventory Receivable
$100,000
$100,000 $160,000
Collect
24
Fiscal Year
The year established for accounting purposes.
Interim Periods
The time spans established for accounting

purposes that are less than a year.
25
Revenues/Sales
Increases in owners equity arising from increases

in assets received in exchange for the delivery of
goods or services to customers.
Expenses
Decreases in owners equity that arise because

goods or services are delivered to customers.
26
Net Income
The remainder after all expenses have been
deducted from revenues.
Income/Profit/
Net Loss
Earnings
The difference between
The excess of revenues revenues and expenses
over expenses. when expenses exceed
revenues.
27
Retained Income/Retained Earnings/

Reinvested Earnings
Additional owners equity generated by

income or profits.
28
Transaction 10a and 10b, Sales on Open Account

for the entire month of January, 2004
Stockholders
Equity
Accounts Merchandise
Retained Income
Receivable Inventory
+$160,000
(10a) +$160,000 =
(sales revenues)
(10b) - $100,000 = -$100,000
(cost of goods
sold expenses)
29

Stockholders
Equity
Retained Income
+$160,000
(10a) +$160,000 =
(sales revenues)
(10b) - $100,000 = -$100,000
(cost of goods
sold expenses)
30
Assets = Liabilities + Stockholders equity
Paid-in
Assets = Liabilities + + Retained income
Liabilities capital
receivable
Accounts
Inventory
Paid-in
+ = + + Revenues - Expenses
capital
+160,000 + -100,000 = 0 + 0 + +160,000 - +100,000

31
Accrual Basis
Accounting method that recognizes the impact of

transactions on the financial statements in the time periods
when revenues and expenses occur.
Cash Basis
Accounting method that recognizes the impact of

transactions on the financial statements only then cash is
received or disbursed.
32

Stockholders
Equity
Retained Income
+$160,000
(10a) +$160,000 =
(sales revenues)
(10b) - $100,000 = -$100,000
(cost of goods
sold expenses)
33
Recognition of Revenues
A test for determining whether revenues

should be recorded in the financial statements
of a given period. To be recognized, revenues
must be earned and realized.
34
Examples of Revenue Recognition:
Newsweek (a company which produces daily

newpapers) received prepaid subscriptions. When are
revenues realized and when are they earned?
A dealer in oriental rugs lets a potential customer take

a rug home on a trial basis. When are revenues
realized and when are they earned?
35
Exercise:
Recognition of Revenues
A new theatre company sells a subscription series
that allows patrons to attend all nine of its
productions that occur monthly from September
through May. During August and September, the
company sells 1,000 subscriptions for the 2001-2002
season at $180 each and collects the cash. How
much revenue would the theatre recognize in its
income statement for the year ended December 31,
2001 from these subscriptions?
36
Expenses
Product Costs Period Costs
Costs that are linked with revenues

and are charged as expenses when Items identified
the related revenue is recognized. directly as
expenses of the
Cost of Goods Sold/ Cost of Sales time period in
which they are
The original aquisition cost of the incurred.
inventory that was sold to customers
during the reporting period.
37
Matching
The recording of expenses in the same time period as the
related revenues are recognized.
Cost Recovery
The concept by which some purchases of goods or

services are recorded as assets because their costs are
expected to be recovered in the form of cash inflows (or
reduced cash outflows) in future periods.
38
Exercise:
Applying Matching and Cost Recovery by analysing

transactions No. 11 to 13.
39
Transaction 13, Depreciation

on January 31, 2004
Depreciation expense for the Biwheels Equipment:
Original cost: $14,000

Useful life: 140 months
Depreciation expense per month:
$14,000 / 140 months = $100 per month
40
Transaction 13, Depreciation

on January 31, 2004
Stockholders
Equity
Store Equipment Retained Income
(13) - $100 = - $100
41
Advertising
Assets = Liabilities + Owners Equity
Other Prepaid Paid-in Retained

Cash =
Assets Advertising Capital Income
Alternative 1:
Two Phases
Phase (a)
Prepay for -1,000 +1,000
advertising
Phase (b) Use
up advertising
-1,000 = -1,000
Alternative 2:
One Phase
Phases (a)
and (b) -1,000 = -1,000
together 42
Exercise:
Matching and Cost Recovery
A company starts its business on

January 1, 2003 and rents an office for
$4,000 per month and pays 4 months of
rent in advance. During January, no
revenue is earned. How much rent
expense should the company report on its
income statement for January?
43
Income Statement Biwheels Company

for the Month Ended January 31, 2004
Sales (revenues) $160,000

Deduct expenses
Cost of goods sold $100,000
Rent $2,000
Depreciation $100
Total expenses $102,100
Net income $57,90044
44
Relationship between
Income Statement and Balance Sheet
Balance Sheet Balance Sheet Balance Sheet Balance Sheet

December 31 January 31 February 28 March 31
2003 R. Income 2004 2004 2004
+$57,900
S. Equity: Income S. Equity: Income Income
$400,000 Statement $457,900 Statement Statement
for January for February for March
Time
Income Statement for Quarter Ended Mach 31, 2004

45

as at January 31, 2004 Sholders Equity
I. Cash $336,700 I. Liabilities:

II. Accounts receivable $160,300 Note payable $100,000
III.Merchandise Accounts payable $16,200
inventory $59,200 Total liabilities $116,200
IV.Prepaid rent $4,000 II. Stockholders equity:
Paid-in capital $400,000
V. Store equipment $13,900 Retained income $57,900
Total sholders equity $457,900
Total liabilities and
Total assets $574,100 owners equity $574,100
46
Exercise: Transactions 14-20, February 2004
(14) Collection of accounts receivable, $130,000.

(15) Payments of accounts payable, $15,000.
(16) Acquisitions of inventory on open account, $80,000, and for
cash, $10,000.
(17) Merchandise carried in inventory at a cost of $110,000 was
sold for $176,000, of which $125,000 was on open account
and $51,000 was for cash.
(18) Recognition of rent expense for February.
(19) Recognition of depreciation expense for February.
(20) Borrowing of $10,000 from the bank was used to buy $10,000
of store equipment on February 28.
47

as at February 28, 2004 Sholders Equity
I. Cash I. Liabilities:
II. Accounts receivable Note payable
III.Merchandise Accounts payable
inventory Total liabilities
IV.Prepaid rent II. Stockholders equity:
Paid-in capital
V. Store equipment Retained income
Total sholders equity
Total assets owners equity
48
Income Statement Biwheels Company

for the Month Ended February 28, 2004
Sales (revenues)
Deduct expenses
Cost of goods sold
Rent
Depreciation
Total expenses
Net income
49
1.6 Double-entry Accounting
Double-entry Accounting System
The method usually followed for recording

transactions, whereby at least two
accounts are always affected by each
transaction.
50
Recall the first three transactions of the

Biwheels Company
Stockholders
Equity
Merchandise Note
Cash Paid-in Capital
Inventory Payable
(1) + $400,000 = + $400,000
(2) + $100,000 = + $100,000
(3) - $150,000 + $150,000
Bal. $350,000 $150,000 = $100,000 $400,000
$500,000 $500,000 51
Ledger
The records for a group of related accounts kept current in

a systematic manner.
General Ledger
The collection of accounts that accumulates the amounts

reported in the major financial statements.
52
T-account
Simplified version of ledger accounts

that takes the form of the capital letter T.
Debit (Dr) Cash Credit (Cr)

Left side Right side
Increases in cash Decreases in cash
53
Biwheels Company
Assets = Liabilities + Stockholders Equity
Dr Cash Cr Dr Note Payable Cr
Increases Decreases Decreases Increases
(1) 400,000 (3) 150,000

(2) 100,000 (2) 100,000
Dr Mer. Inventory Cr Dr Paid-in Capital Cr

(1) 400,000
(3) 150,000
54
Book of original entry
The chronological list of all transactions.
Balance
The difference between the total left-side

and right-side amounts in an account at
any particular time.
55
Biwheels Company
Dr Cash Cr Dr Note Payable Cr

Balance 100,000
(1) 400,000 (3) 150,000 (2) 100,000
(2) 100,000 Balance 350,000
500,000 500,000 100,000 100,000
Dr Mer. Inventory Cr Dr Paid-in Capital Cr
(3) 150,000 Balance 150,000 Balance 400,000 (1) 400,000
150,000 150,000 400,000 400,000
56
Biwheels Company

Stockholders Equity
I. Cash $350,000 I. Liabilities:

II. Merchandise Note payable $100,000
Inventory $150,000 II. Stockholders equity:
Paid-in capial $400,000

Total assets $500,000 Stockholders equity $500,000
57
Debit (Dr.) / Charge
An entry or balance on the left side of an account.
Credit (Cr.)
An entry or balance on the right side of an

account.
58
Assets = Liabilities + Stockholders Equity
Dr Accounts Receivable Cr
(a) 1,000 (c) 1,000
Dr Cash Cr Dr Sales Revenues Cr
(c) 1,000 (a) 1,000
Dr Mer. Inventory Cr Dr Cost of Goods Sold Cr
(b) 800 (b) 800
59
Assets = Liabilities + Stockholders equity
Paid-in
Assets = Liabilities + + Retained income
capital
Merchandise
Liabilities
receivable
Accounts
Inventory
Paid-in
Cash
= + + Revenues - Expenses
+
capital
Dr Sales Revenues Cr Dr Cost of Goods Sold Cr

Increase Increase
(a) 1,000 (b) 800
60
Trial Balance
List of all the accounts in the general ledger

together with their balances.
61
Trail Balance as at January 31, 2004
Assets Dr Cr
Cash 336,700
Accounts receivables 160,300
Merchandise inventory 59,200
Prepaid rent 4,000
Store equipment 13,900
Liabilities
Note payable 100,000
Accounts payable 16,200
Stockholders equity
Paid-in capital 400,000
Retained income
Revenues
Sales 160,000
Expenses
Cost of goods sold 100,000
Rent 2,000
Depreciation 100
Sum 676,200 676,200 62

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01 - Basics of Accounting

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Financial Accounting

Prof. Dr. Kerstin Lopatta

The process of identifying, recording, summarizing, and

The series of steps involved in initially recording information

The field of accounting that serves external

The field of accounting that serves internal

Balance Sheet Biwheels Company

Assets Balance Sheet Liabilities and

I. Cash $500,000 I. Liabilities $100,000

Total assets $500,000 Total liabilities and

Assets = Liabilities + Owners Equity

Economic resources that are expected to help

Economic obligations of the organization to

The residual interest in the organizations assets

Owners Equity = Assets - Liabilities

An organization or a section of an organization

Transaction 1, Initial Investment

Cash Smith, Capital

Transaction 2, Loan from Bank

Cash Note Payable Smith, Capital

(1) + $400,000 = + $400,000

(2) + $100,000 = + $100,000

Bal. $500,000 = $100,000 $400,000

Transaction 3, Acquire Inventory for Cash

Balance Sheet Biwheels Company

Assets Balance Sheet Liabilities and

I. Cash $350,000 I. Liabilities

Total assets $500,000 Total liabilities and

? Which specific accounts are affected?

Whether the account balances are

? The amount or the change in each account

Transaction 4, Acquire Inventory on Credit

(4) + $10,000 = + $10,000

Bal. $350,000 $160,000 = $100,000 $10,000 $400,000

Transaction 5, Acquire Store Equipment for Cash Plus Credit

(5) - $4,000 + $15,000 = + $11,000

Bal. $346,000 $160,000 $15,000 = $100,000 $21,000 $400,000

? Which specific accounts are affected?

Whether the account balances are

? The amount of the change in each account

A person or entity to whom

A person or entity that owes money

Balance Sheet Biwheels Company

Assets Balance Sheet Liabilities and

I. Cash $342,700 I. Note payable $100,000

Total $516,200 Total $516,200

Buy Merchandise Sell Accounts

The year established for accounting purposes.

The time spans established for accounting

Increases in owners equity arising from increases

Decreases in owners equity that arise because

Retained Income/Retained Earnings/

Additional owners equity generated by

Transaction 10a and 10b, Sales on Open Account

Transaction 10a and 10b, Sales on Open Account

Assets = Liabilities + Stockholders equity

+160,000 + -100,000 = 0 + 0 + +160,000 - +100,000

Accounting method that recognizes the impact of

Accounting method that recognizes the impact of

Transaction 10a and 10b, Sales on Open Account

A test for determining whether revenues

Examples of Revenue Recognition:

Newsweek (a company which produces daily