Basic Accounting:
Concepts, Techniques,
and Conventions
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Learning Objectives
1. Read and interpret basic financial statements.
2. Analyze typical business transactions using the
balance sheet equation.
3. Distinguish between the accrual basis of accounting
and the cash basis of accounting.
4. Make adjustments to the accounts under accrual
accounting.
5. Explain the nature of dividends and retained earnings.
6. Select relevant items from a set of data and assemble
them into a balance sheet and an income statement.
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Learning Objectives
7. Distinguish between the reporting of corporate owners’
equity and the reporting of owners’ equity for partnerships
and sole proprietorships.
8. Explain the role of auditors in financial reporting and
how accounting standards are set.
9. Identify how the measurement principles of recognition,
matching and cost recovery, and stable monetary unit
affect financial reporting.
10. Define continuity, relevance, faithful representation,
materiality, conservatism, and cost benefit (Appendix 15A).
11. Use T-accounts, debits, and credits to record
transactions (Appendix 15B).
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The Need for Accounting
Accounting information can be used to assess past
financial performance of a company and help predict
its future performance.
All kinds of organizations—
government agencies, nonprofit organizations, and
others —rely on accounting to gauge their progress.
The accounting process begins with a transaction.
A transaction is any event that affects the financial
position of an organization and requires recording.
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The Need for Accounting
Many concepts, conventions, and rules
determine what events a company
records as accounting transactions and
how accountants measure the financial
impact of each transaction.
Financial statements are used to
summarize the recorded accounting
transactions.
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The Need for Accounting
Managers, investors, and other internal groups
want the answers to two important questions:
How well did
the organization
perform? Where does
the organization
stand?
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Learning
Objective 1 The Need for Accounting
Accountants answer these questions
with three major financial statements:
Balance Income
sheet statement
Statement of
cash flows
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Balance Sheet
The balance sheet (also called statement
of financial position or statement of financial
condition) is a snapshot of the financial status
of an organization at a point in time.
The balance sheet has two sections
(1) assets and
(2) liabilities plus owners’ (stockholders’) equity.
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Balance Sheet
Assets are economic resources that
are expected to benefit future
activities of the organization.
Liabilities are the entity’s economic
obligations to nonowners.
Owners’ equity is the excess
of the assets over the liabilities.
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Balance Sheet
The owners’ equity of a corporation
is called stockholders’ equity.
Stockholders’ equity
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Balance Sheet
The balance sheet for King Hardware
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Revenues and Expenses
Revenues are increases in ownership
claims arising from the delivery
of goods or services.
Recognize revenue by formally recording it in the
accounting records during the current period only after
it meets two tests:
[Link] company must earn the revenues. That is, it must
deliver the goods or render the services to customers.
[Link] revenue must be realized or realizable.
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Revenues and Expenses
Expenses are decreases in ownership
claims (stockholders’ equity) arising from
delivering goods or services or using up assets.
Income (also called net income, profits, or
earnings), is the excess of revenues over
expenses. It increases stockholders’ equity.
An income statement summarizes revenues and
expenses. It measures an organization’s
performance by matching its revenue and its
expenses for a span of time, often a month, a
quarter, or a year.
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Income Statement
The income statement shows that General Mills’
stockholders’ equity (retained earnings) increased by
$1,804 million because of profitable operations in the
year ended May 29, 2011. This $1,804 million is
included in the $6,612 million of stockholders’ equity
on the May 29, 2011, balance sheet.
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The Analytical Power of the
Balance Sheet Equation
The balance sheet equation can highlight the link
between the income statement and balance sheet.
Assets (A) = Liabilities (L) + Stockholders’ equity (SE)
A = L + Paid-in capital + Retained income
A = L + Paid-in capital + Revenue – Expenses
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Learning
Objective 3 Accrual Basis and Cash Basis
The accrual basis of accounting
recognizes revenues and expenses
when they occur regardless of when
cash is received or disbursed.
The cash basis of accounting recognizes
revenue and expense when cash is
received and disbursed.
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Accrual Basis and Cash Basis
The major deficiency of the cash basis
of accounting is that it is incomplete.
It fails to match efforts and accomplishments
in a manner that properly measures economic
performance and financial position.
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Nonprofit Organizations
Nonprofit organizations, such as
government agencies and charitable
organizations, also use balance sheets
and income statements.
For years, most nonprofit organizations
used cash-basis rather than accrual accounting.
As these organizations face more pressure to
develop accurate measures of performance,
they are increasingly using accrual accounting.
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Nonprofit Organizations
The basic concepts of assets, liabilities, revenues,
and expenses apply to all organizations, whatever
their goals and wherever they are located. However,
organizations that do not seek profits do not measure
income. Further, because they have no owners, there
is no owners’ equity.
Balance sheets of nonprofit organizations show a
category of “net assets” instead of “owners’ equity”
To measure the difference between assets and
liabilities. Instead of an income statement, nonprofit
organizations have a “statement of activities”
that reports changes in net assets.
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Learning
Objective 5 Dividends and Retained Earnings
Dividends are distributions of assets to
stockholders that reduce retained earnings.
Cash dividends are distributions of
cash rather than some other asset.
The distribution reduces both assets
and owners’ equity and is made
possible by profitable operations.
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Dividends and Retained Earnings
Dividends reduce retained earnings,
But they are not expenses.
Companies do not deduct dividends from
revenues when measuring income because they
do not help generate sales or conduct operations.
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Retained Earnings
Stockholders’ equity represents the claims of
owners arising out of their initial investment
(paid-in capital) and subsequent profitable
operations (retained earnings).
Retained earnings and paid-in capital represent
a general claim against, or undivided interest in,
total assets, not a specific claim against any asset.
Retained earnings and paid-in capital result from
profitable operations. Equity is not a pot of cash
awaiting distribution to stockholders.
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Retained Earnings
Retained earnings and paid-in capital result from
profitable operations. Equity is not a pot of cash
awaiting distribution to stockholders.
Do not confuse retained earnings and cash. Cash
can increase while retained earnings decreases,
and vice versa. There is no direct relationship
between retained earnings and available cash.
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Learning
Objective 6 King Hardware Company
Select relevant items from a set of data and
assemble them into a balance sheet and an
income statement.
The balance sheet uses totals from the asset,
liability, and stockholders’ equity columns.
The income statement uses the revenue and
expense entries in the retained earnings column.
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Balance Sheet
King Hardware Company
Balance Sheet as of April 30, 20X1
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Income Statement
King Hardware Company Income Statement
for the Month Ended April 30, 20X1
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Changes in Retained Earnings
King Hardware Company Changes in Retained
Earnings for the Month Ended April 30, 20X1
This statement shows the linkage between the balance
sheet and income statement. It starts with the
beginning balance, adds net income for April, and
deducts cash dividends, to arrive at an ending balance.
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Learning Sole Proprietorships and
Objective 7
Partnerships
A sole proprietorship is a business
entity with a single owner.
A partnership is an organization
that joins two or more individuals
together as co-owners.
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Comparison of Owners’ Equity Reporting
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Comparison of Owners’ Equity Reporting
Unlike corporations, sole proprietorships
and partnerships do not distinguish
between paid-in capital (i.e., amounts
invested by owners) and retained earnings.
Instead, they typically accumulate a single
amount for each owner’s original
investment, subsequent investments, share
of net income, and withdrawals.
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Learning Generally Accepted
Objective 8 Accounting Principles (GAAP)
Accounting is more an art than a science. It is
commonly misunderstood as being a precise
discipline that produces exact measurements
of a company’s financial position and performance.
Accounting is based on a set of principles
on which there is general agreement,
not on rules that can be “proved.”
The principles and procedures that together make
up accepted accounting practice at any given time
are known as generally accepted accounting
principles (GAAP).
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Audit
An audit is an “examination” or in-depth
inspection of financial statements and companies’
records that is made in accordance with
generally accepted auditing standards.
Auditing standards are approved by the Public
Company Accounting Oversight Board (PCAOB)
which is a part of the Securities and Exchange
Commission (SEC), a government agency that
regulates the financial markets in the U.S.
including financial reporting.
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Ethics
The public sector–private sector relationship:
Confidence in financial information is important to the
smooth functioning of the world’s capital markets, and
confidence in financial statements depends on the
competence and integrity of accountants and auditors.
A hallmark of the accounting profession has been its
ethics and integrity. Most accountants and auditors
are highly ethical and truthfully report their financial
results in accordance with GAAP.
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Learning
Objective 9 Three Measurement Conventions
Recognition
U. S. GAAP is based on a
conceptual framework
that contains three broad
measurement or valuation Matching and
conventions (principles) that cost recovery
underlie accrual accounting:
Stable
monetary unit
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Recognition Principle
The recognition principle specifies when a
company should record revenue in the
accounting records.
Generally, companies recognize revenue when
it is both earned and realized or realizable.
In some industries revenue recognition is not so
straightforward. These judgment issues require
company accountants together with its auditor to
decide when earning and realization are
sufficiently complete to recognize the revenue.
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Matching and Cost Recovery
The timing of revenue recognition is important
because it leads to the recording of expenses
through the concept of matching—the linking of
revenues with expenses incurred to generate them.
Accountants apply matching as follows:
1. Identify the revenue recognized during the period.
2. Record expenses that relate directly to the
recognized revenue.
3. Record expenses that are costs of operations during
a specific time period that have no measurable benefit
for a future period and must be linked to the current
period’s revenues.
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Matching and Cost Recovery
The heart of recognizing expense is the cost
recovery concept. Companies carry forward
as assets such items as inventories, prepayments,
and equipment because they expect to recover
the costs of these assets in the form of cash
inflows (or reduced cash outflows) in future periods.
At the end of each period, accountants examine
evidence to assure themselves that they should not
write off these assets—the unexpired costs—as an
expense of the current period.
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Stable Monetary Unit
The monetary unit (for example, the dollar in the
United States, the yen in Japan, or the euro in the
European Union) is the principal means for measuring
assets, liabilities, and stockholders’ equity.
This measurement assumes that the monetary unit—
the dollar, for example—is an unchanging yardstick.
Yet, a 2010 dollar does not have the same purchasing
power as a 2000 or 1990 dollar. Therefore, users of
accounting statements that include dollars from
different years must recognize the limitations of the
basic measurement unit.
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