INTRODUCTION TO ACCOUNTING

AGENDA

1. Fundamental concepts2. The Accounting Cycle3. Financial statements4. Comprehensive example

FUNDAMENTAL CONCEPTS

What is accounting? The language of business. A means to communicate financial

information in a systematic manner. A way to convey information about a

business to users. It refers to application of scientific and

systematic knowledge of accounting.

According to American Institute of Certified Public Accountants (AICPA)Accounting is the art of recording,

classifying and summarizing in a significant manner and in terms of money, transactions and events which are of a financial character and interpreting the results thereof.

FUNDAMENTAL CONCEPTS

Who uses accounting information? Owners Managers Investors (including potential)

Analysts on their behalf Creditors (including potential) Government (tax assessment) Regulators Customers

FUNDAMENTAL CONCEPTS

Accounting has two main divisions: Financial accounting

Primarily prepared for users external to the company. Revenues, earnings, assets, etc.

Management accountingPrimarily for internal purposes

Costing, budgeting, net present value, etc.

This lecture will focus only on financial accounting.

There are several ways that cash gets into a company:

Investment by owners Investment by creditors (loans) Payments from customers. Repayment of amounts loaned to other

entities. Return on investments (interest and

dividend) Proceeds from selling assets.

FUNDAMENTAL CONCEPTSThese can be organized into three categories:Operations Payments from customers Refunds from suppliersFinancing Investment by owners Investment by creditors (loans)Investing Return on investments (interest and dividend) Proceeds from selling assets Repayment of amounts loaned to other entities

FUNDAMENTAL CONCEPTSFinancial accounting categorizes all

transactions and events based on their substance. It is very important that the substance of a

transaction be accurately reflected by financial accounting because the users of the information are using it with the assumption that these categorizations are being made accurately. If money invested by owners was reported as

revenue, this would be counter to the fundamental definition of revenue (i.e. that it results from the operations of the company).

The separation of income and capital is a fundamental concept of financial accounting.

FUNDAMENTAL CONCEPTS- ACCOUNTING PRINCIPLES

Accounting Principles

Accounting Conventions

Accounting Concepts

ACCOUNTING CONVENTIONS Conventions are doctrines which state the customs

and values. Conservatism Discloser Consistency Materiality

ACCOUNTING CONCEPTS

These are assumptions on which accounting is based

Period Concept Dual Aspect Money Measurement Principle Realization concept Separate Entity Cost Concept Going Concern Concept Accounting Equivalence Accrual Concept Verifiable Objective Evidence Concept Capital Concept Matching Concept

Entity concept There are three basic structures that a

company can have in Canada:1. Sole proprietorship2. Partnership3. Corporation A sole proprietorship is not a legal entity separate

from its owner A partnership is not a legal entity separate from its

owners These are both sub-components of their

owners/partners for legal purposes A corporation is a separate legal entity

The entity concept for accounting does not simply follow the legal guidelines

A business can be a separate entity for accounting even if it is not one from a legal perspective

Entity concept It is essential that we know for which

entity we are accounting because it will determine if and how events are recorded.

e.g. If Ms. Prop is the sole proprietor of a business called SP, there is one legal entity, Ms. Prop (SP is not a separate legal entity).

If we wish to account for SP, there will be events to account for that are non-events from a legal perspective e.g. When Ms. Prop puts money into a

separate account for the company. This is a non-event legally, but is an event to be accounted for from an accounting perspective.

Going concern It is assumed that an entity will

complete its current plans, use its existing assets, and meet its obligations in the normal course of business.

This is an underlying concept necessary for many of the fundamental recording and reporting decisions that are made in accounting.

THE ACCOUNTING CYCLE

1. Transaction or event occurs Could simply be the passage of time.

2. Recorded in the Journal using a Journal Entry.

event is translated into accounting language.

3. Journal is posted to Ledger the information from all the journal

entries in the period is aggregated.

4. Ledger accounts are totalled.5. Financial statements are prepared.

1. Transaction or event occurs

2. Recorded in the Journal using a Journal Entry.

3. Journal is posted to Ledger

4. Ledger accounts are totalled.

5. Financial statements are prepared.

It is important to note that the decision-making of accounting occurs at step 2 – Journal entry.

Steps 3 – 5 are mechanical exercises.

Therefore, the decisions made when making the journal entry (i.e. translating to accounting language) are very important as they determine what will ultimately be presented on the financial statements.

cont’d on next slide…

Generally Accepted Accounting Principles

(GAAP)

ACCOUNTING EQUATION Fundamental Accounting Equation:

Assets = Liabilities + Owners’ Equity This equation is always in balance

In order for this equation to remain in balance, double-entry bookkeeping is employed. That is, the recording of every transaction or event

must have at least two parts Either an equal impact (increase or decrease) to

both sides of the equation or equal and opposite impact to one side.

The recording of every transaction must keep this equation in balance

JOURNAL ENTRIES

All journal entries have two “sides”: Debit and Credit

For every journal entry, the total debits must equal the total credits This ensures that the fundamental accounting

equation (A = L + OE) is always in balance.

The basic journal entry:Debit Account name1 $amount Credit Account name2 $amountTo record…

“Debit” and “Credit” are just accounting-speak for “increase” and “decrease” “Debit” means “increase” for some elements

and “decrease” for other elements. Likewise for “credit”. For example, a company pays its $500 utility bill:

In English: the company has incurred an expense (the amount of expense has increased) and the amount of cash in the company has decreased. An expense (Utilities) has increased An asset (Cash) has decreased

In Journal entry:Debit Utility expense $500 Credit Cash $500To record the payment of utility bill

How do we know whether to debit or credit?Convention exists based on what element is

being increased or decreased. Each element “lives in” either debit or credit. If

we want to increase something that “lives in” debit, we will debit it.

The convention works such that the fundamental equation (A = L + OE) is always kept in balance.

The Basic Accounting Elements:Asset

– Has future benefit to the entity

Liability– Obligation to transfer assets in the future

Owners’ Equity– Owners’ interest in the company

Revenue– Increase in economic resources resulting

from normal operations of the company

Expense– Decrease in economic resources resulting

from normal operations of the company

Going back to the Fundamental Accounting Equation:

Assets = Liabilities + Owners’ Equity

Debit CreditCredit

ELEMENT STRUCTURESAssetsLiabilitiesOwners’ equity

AssetsCurrent assets

Cash• Cash on hand

Bank accounts• CIBC• BMO

Accounts receivable• Accounts receivable – customer 1• Accounts receivable – customer 2

InventoryRaw materialsWork in processFinished goods• Product 1• Product 2

AssetsCurrent assetsLong-term assets

BuildingsOntario buildingsQuebec buildings• Montreal building• Sherbrooke building

VehiclesCarsTrucks• Truck 1• Truck 2

LiabilitiesCurrent liabilities

Accounts payableAccrued liabilities

Long-term liabilitiesBank loans• Loan from RBC• Loan from ScotiabankNotes payableBonds payable

Owners’ equityCapital stock (direct investment)Retained earnings (indirect investment)

RevenueExpenses(Dividends)

• Although revenue and expenses are not sub-pieces of Retained earnings the way Current assets are a sub-piece of Total assets, for the purposes of understanding how they fit in to the equation, this representation is helpful.

The balance sheet is a permanent statement Its’ accounts accumulate information from the

entity’s beginning. The amounts presented on the balance sheet are

aggregated from the entity’s beginning to the balance sheet date.

The income statement is a temporary statement Its’ accounts are temporary accounts

They accumulate information for a period and then are reset to zero to begin tracking information for the next period. The amounts presented on the income statement are

aggregated from the beginning of the period to the end of the period only.

The Closing Entry Whenever financial statements are to be

prepared, the temporary (income statement) accounts must be “closed” to zero so that they can begin tracking data for the next period.The amounts in the accounts at closing are

transferred to Retained Earnings (so named because it is the earnings (net income) of the company that is retained in the company and not distributed to the owners). We will see an example in the comprehensive

example.

FINANCIAL STATEMENTSThere are 4 statements in a standard set of

financial statements1. Balance Sheet

The “what do we have?” statement Shows what the entity owns and owes (the

difference being the owners’ residual interest)

2. Income Statement The “what did we do?” statement Shows the activity the entity undertook in its

normal course of operations.

3. Statement of Retained Earnings Shows the changes in Retained earnings in the year

Often shown at the bottom of the Income Statement

4. Statement of Cash Flows Shows the sources and uses of cash in the year

Information is derived from the B/S and I/S and other

Company Name Company NameIncome statement Balance SteetFor year ended December 31, 2003 As at December 31, 2003

Revenue 100,000 AssetsCurrent assets 3,000

Expenses Long-term assets 40,000 Salaries 45,000 Utilities 13,000 Rent 30,000 Other 8,000 Total Assets 43,000

96,000- Liabilities

Net Income 4,000 Current liabilities 15,000

Long-term liabilities 20,000 35,000

Company Name Owners' EquityStatement of Retained Earnings Capital stock 1,000 For year ended December 31, 2003 Retained Earnings 7,000

Opening Retained Earnings 3,500 8,000 Net Income (Loss) 4,000 Dividends 500- Total Liabilities and OE 43,000

Closing Retained Earnings 7,000

ACCOUNTING METHODSCash Accounting Revenue is recorded when cash is received. Expense is recorded when cash is disbursed.

Very straightforward. Facts determine the timing of entries. Less room for judgment.

Accrual Accounting Revenue is recorded (recognized) when the

revenue has been earned. When the product or service has been provided to

the customer, regardless of when payment is received.

Expenses are matched to the revenue that they helped to earn, regardless of when payment is made.

JOURNAL ENTRIESJournal Entries Usually one side (the Debit or the

Credit) will be obvious from the transaction (e.g. when cash is received, cash (an asset) increases. The Debit has to be to cash).

It is the determination of the other side of the entry that requires thought and judgment.