Chapter 1

The assets of an entity are the things of value that it owns.

The sources of funds used to acquire assets are (1) liabilities and (2) equity.
Liabilities are sources from creditors.
quity consists of (1) funds obtained from equity investors! who are owners!
and (2) retained earnings! which result from the entity"s pro#table operation.
Creditors have a strong claim on the assets. They can sue if the amounts due
them are not paid quity investors have only a residual claim.
Total assets equal the total of liabilities plus equity. This is the dual$aspect
concept.
The amounts of assets! liabilities! and equity as of one point in time are
reported on the entity"s balance sheet.
%ccounting reports only those facts that can be stated in monetary amounts.
This is the money$measurement concept.
&usiness accounts are 'ept for entities! rather than for the persons who own!
operate! or otherwise are associated with those entities. This is the entity
concept.
%ccounting assumes that an entity will continue to operate inde#nitely. This is
the going$concern concept.
(onetary assets are reported at their fair value) other assets are reported at
a number based on cost. This is the asset$measurement concept.
%ssets are valuable items that are owned or controlled by the entity and that
were acquired at a measureable cost. *oodwill is not an asset unless it was
purchased.
Current assets are cash and other assets that are e+pected to be converted
into cash or used up in the near future usually within one year.
Current liabilities are obligations due in the near future! usually within one
year.
The current ratio is the ratio of assets to current liabilities.
quity consists of paid$in capital (which in a corporation is represented by
shares of stoc') plus earnings retained since the entity began. ,t does not
report the mar'et value of the stoc'. -etained arnings is not cash) it is part
of the owners" claim on the assets.
.art 2/ &alance 0heet Changes) ,ncome (easurement
Current assets are cash and assets that are e+pected to be converted into
cash or used up in the near future! usually within one year.
Current liabilities are obligations due in the near future! usually within one
year.
(ar'etable securities are current assets) investments are noncurrent assets.
% single liability may have both a current portion and a noncurrent portion.
quity consists of capital (which in a corporation is represented by shares of
stoc' plus paid$in capital) plus earnings retained since the entity began. ,t
does not report the mar'et value of the stoc'. -etained arnings is not cash)
it is part of the owners" claim on the assets.
very accounting transaction a1ects at least two items and preserves the
basic equation %ssets 2 Liabilities 3 quity. %ccounting is a double$entry
system.
0ome events are not transactions) they do not a1ect the accounting
amounts. +amples in this part were a change in the value of land! 4goodwill5
that was not purchased! and a change in the entity from a proprietorship to a
corporation.
6ther events a1ect assets and7or liabilities but have no e1ect on equity.
+amples in this part were borrowing money! purchasing inventory!
purchasing insurance protection! acquiring an asset! giving a mortgage!
buying land! selling land at its cost! and repaying a ban' loan.
0till other events a1ect equity as well as assets and7or liabilities. -evenues
are increases in equity resulting from operations during a period. +penses
are decreases. Their net e1ect is shown in the equity item called -etained
arnings. quity also increases when owners pay in capital! and equity
decreases when owners withdraw capital! but these transactions do not a1ect
income.
% sale has two aspects/ a revenue aspect and an e+pense aspect. -evenue
results when the sale is made! whether or not cash is received at that time.
The related e+pense is the cost of the merchandise that was sold. The income
of a period is the di1erence between the revenues and e+penses of that
period.
.art 8/ %ccounting -ecords and 0ystems
9ebit refers to the left side of an account and credit to the right side.
,ncreases in asset and e+pense accounts are debits.
,ncreases in liability! equity! and revenue accounts are credits. 9ecreases are
the opposite.
:or any transaction! debits must equal credits. :or the whole set of accounts!
debit balances must equal credit balances.
Transactions are #rst recorded in a ;ournal. %mounts are then posted to the
accounts in a ledger.
-evenues and e+pense accounts are temporary accounts. %t the end of each
accounting period! they are closed to -etained arnings. They start over at
the beginning of the ne+t accounting period. The di1erence between the
revenues of a period and the e+penses of the period is the net income of the
period. These revenues and e+penses are reported on the income statement.
<et income is the increase in retained earnings from operating performance
during the period.
%sset! liability! and equity accounts are permanent accounts. Their balances
are carried forward to the ne+t accounting period.
0ome revenues do not result in immediate cash in=ows. 0ome e+penses do
not result in immediate cash out=ows. Therefore! retained earnings are not
the same cash>
.art ?/ -evenues and (onetary %ssets
The o@cial accounting period is called the #scal year! but #nancial
statements can be prepared for shorter periods they are called interim
statements.
%ccrual accounting measures revenues and e+penses during an accounting
period and the di1erence between them! which is the net income. %ccrual
accounting is more complicated! but more useful! than accounting only for
cash receipts and cash payments.
The conservatism concept/ -ecogniAe increases in equity when they are
reasonably certain! but recogniAe decreases as soon as they are reasonably
possible.
The materiality concept/ 9isregard trivial matters! but disclose all important
matters.
The realiAation concept/ -evenue is usually recogniAed when goods and
services are delivered.
,f revenue is recogniAed before the cash receipt! an asset! %ccounts
-eceivable! is debited (increased). ,f cash is received before revenue is
recogniAed! a liability! %dvances from Customers! is credited (increased). The
liability is debited (decreased) in the period(s) in which revenue is recogniAed.
The equity and accounts receivable balances in a period are reduced by
estimated bad debt losses. % &ad 9ebt +pense account is used to record the
decrease in equity. Bhen speci#c bad debts are later discovered! %ccounts
-eceivable is reduced! but revenue is una1ected.
The days" sales uncontrolled ratio is/ 9ays" 0ales Cncollected 2 %ccounts
-eceivable7(Credit 0ales78DE). ,t indicates whether customers are paying their
bills on time.
.art E/ +pense (easurement) The ,ncome 0tatement
+penditures are made when goods or services are acquired. ,f these goods
or services are used up during the current period! they are e+penses of the
period. ,f not used up! they are assets at the end of that period. These assets
will become e+penses in future periods as they are used up.
0ome e+penditure result in liabilities that will be paid in future periods. %n
e+ample is accrued salaries.
+penses are e+pired costs. %ssets are une+pired costs.
(atching concept/ Costs associated with the revenues or activities of a period
are e+penses of the period.
+penses of a period are (1) cost of the products (i.e.! goods and services)
that were delivered to customers during the period) (2) other e+penditures
that bene#t operations of the period) and (8) losses! that is! decreases in
assets from #re! theft! and other unusual reasons! and increases in liabilities
from unusual events! such as lawsuits.
The income statement summariAes revenues and e+penses of the period. ,ts
4bottom line!5 or net income! shows the increase in equity resulting from
activities during the period.
9ividends are a distribution of earnings to shareholders. 9ividends are not
e+penses.
-etained arnings at the beginning of the period 3 <et ,ncome F 9ividends 2
-etained arnings at the end of the period.
.ercentages are calculated for various income statement items! especially
gross margin and net income! ta'ing sales revenue as 1GG percent.
.art D/ ,nventories and Cost of 0ales
,f an entity has no record of the cost of the speci#c items that were sold
during a time period! it deduces Cost of 0ales by (1) adding purchases to the
beginning inventory! which gives the goods available for sale! and (2)
subtracting the cost of the ending inventory. ,n doing this! the entity must
ma'e an assumption as to which items were sold.
The #rst$in! #rst$out (:,:6) method assumes that the oldest items are the #rst
to be sold.
The last$in! #rst$out (L,:6) method assumes that the most recently purchased
items are the #rst to be sold. ,n periods of rising prices! it results in a higher
Cost of 0ales and hence a lower ta+able income than the :,:6 method.
The average$cost method charges both Cost of 0ales and the ending
,nventory at the average cost of the goods available for sale.
The inventory method that a company selects does not necessarily re=ect the
physical =ow of its goods.
,f the fair value (i.e.! mar'et value) of items in inventory decreases below
their cost! the inventory is written down to fair value.
The cost of goods produced in a manufacturing company is the sum of their
direct materials cost! direct labor cost! and production overhead cost.
.eriod costs are costs that are charged as e+penses in the period in which the
costs were incurred. .roduct costs become Cost of 0ales in the period in
which the products are sold! which may be later than the period in which the
products were manufactured.
6verhead is charged to products by means of an overhead rate! such as a
rate per direct labor dollar.
The inventory turnover ratio shows how many times the inventory is turned
over during a year.
.art H/ <oncurrent %ssets and 9epreciation
Bhen acquired! a property! plant and equipment (..) asset is recorded at its
cost! including installation and other costs of ma'ing the asset ready for its
intended use.
Land has an unlimited life and is rarely depreciated.
.. assets are depreciated over their service life. ach year! a fraction of
their cost is debited to 9epreciation +pense and credited to %ccumulated
9epreciation.
9epreciation +pense is an estimate. Be do not 'now how long the service
life will be! nor the asset"s residual value.
The boo' value of .. asset is the di1erence between its cost and its
accumulated depreciation. Bhen boo' value reaches Aero or the residual
value! no more depreciation e+pense is recorded.
&oo' value does not report what the asset is worth.
Bhen an asset is sold! the di1erence between the sale price and boo' value
is a gain or loss and is so reported on the income statement.
,n #nancial accounting! depreciation is calculated either by an accelerated
method or by the straight$line method.
,n the units$of$production method! the annual depreciation e+pense is
calculated by multiplying the number of service units produced in that year
by a unit cost. This unit cost is found by dividing the asset"s depreciable cost
by the number of service units estimated to be produced over the asset"s
total life.
,n the straight$line method! the annual depreciation e+pense is calculated by
multiplying the asset"s depreciable cost by a constant percentage. This
percentage is found by dividing 1 by the number of years in the asset"s
estimated service life.
%ccelerated depreciation is often used for income ta+ purposes because it
decreases the amount of ta+able income in the early years.
Ta+able income may di1er from preta+ income reported on the income
statement. ,f so! the di1erence between the ta+ e+pense and the amount of
ta+ actually paid is a balance sheet item! 9eferred ,ncome Ta+es.
9epletion is the process of writing o1 wasting assets! and amortiAation is the
process of writing o1 intangible assets. The accounting for both processes is
similar to depreciation! e+cept that the credit is made directly to the asset
account.
.art I/ Liabilities and quity
% company obtains its permanent capital from two sources/ (1) debt (i.e.!
noncurrent liabilities) and (2) equity. ,t uses this capital to #nance (1) wor'ing
capital (i.e.! current assets F current liabilities) and (2) noncurrent assets.
(ost debt capital is obtained by issuing bonds. &onds obligate the company
to pay interest and to repay the principal when it is due.
quity capital is obtained by (1) issuing shares of stoc' and (2) retaining
earnings.
The amount of capital obtained from preferred and common shareholders is
the amount they paid in. The par! or stated! value of common stoc' is not an
important number today! but it is still reported on the balance sheet.
Cash dividends decrease the amount of equity capital. 0toc' dividends and
stoc' splits do not a1ect the total equity.
-etained earnings are total earnings (i.e.! net income) since the entity began
operations! less total dividends. (% net loss! of course! results in a decrease in
retained earnings.)
%lthough sometimes called 4net worth5 the amount of owners" equity does
not show what the owner"s interest is worth.
,n deciding on its permanent capital structure! a company attempts to stri'e
the right balance between (1) ris'y but lowerJcost debt capital and (2) less
ris'y but higher$cost equity capital. :or a given company this balance is
indicated by its debt ratio.
(any companies have subsidiaries. The economic entity is a family consisting
of a parent and its subsidiaries (in which! by de#nition! it owns more than EG
percent of the stoc'). Consolidated #nancial statements are prepared for such
an economic entity by combining their separate #nancial statements and
eliminating transactions among members of the family.
The consolidated balance sheet reports all the assets owned by the
consolidated entity and all the claims of parties outside the family.
The consolidated income statement reports only revenues from sales to
outside parties and e+penses resulting from costs incurred with outside
parties. ,ntrafamily revenues and e+penses are eliminated.
.art K/ 0tatement of Cash :lows
% required #nancial statement! the statement of cash =ows! reports the
changes in balance sheet accounts as positive or negative impacts on cash
during the accounting period.
The statement has three sections/ cash =ow from operating activities! cash
=ow from investing activities! and cash =ow from #nancing activities.
The statement of cash =ows shows the net increase or decrease in cash that
must equal the di1erence between beginning and ending cash on the
corresponding balance sheet for two consecutive periods.
The cash =ow from operating activities is found by ad;usting net income for
(1) depreciation e+pense and (2) changes in noncash current assets and
current liabilities.
9epreciation e+pense is not a cash =ow. &ecause it decreases net income on
the income statement! it is added bac' to the net income in order to arrive at
the cash =ow from operating activities.
,n general! investing activities include the acquisition of new #+ed assets and
the proceeds of selling #+ed assets.
,n general! #nancing activities include obtaining funds from long$term
borrowing! repaying these borrowings! and obtaining funds from issuance of
additional stoc'.
*%%. has speci#c requirements for determining which cash =ows are
classi#ed as investing activities and which are classi#ed as #nancing
activities! but statement users need not memoriAe these rules because they
are evident from the statement itself.
Bhen a company is growing or when it is e+periencing #nancial crisis! it may
pay more attention to the statement of cash =ows than to the income
statement. Cash =ows from sustainable operating activities are often a focus
for analysis.
.art 1G/ %nalysis of :inancial 0tatements
The #nancial statements do not tell the whole story about an entity because
they report only past events! do not report mar'et values! and are based on
;udgments and estimates. <evertheless! they provide important information.
:inancial statements are analyAed by using ratios! rather than absolute dollar
amounts. These ratios are compared with those for the same entity in the
past! with those for similar entities! and with standard based on ;udgment.
%n overall measure of performance is return on equity (-6). ,t ta'es into
account both pro#tability and the capital used in generating pro#ts. %nother
overall measure is return on permanent capital! or return on investment!
which is the ratio of pro#ts (ad;usted for interest and ta+es) to total
permanent capital.
%n entity with a low pro#t margin can provide a good return on equity
investment if it has a su@ciently high capital turnover.
,n addition to information about pro#tability! #nancial statements provide
information about the entity"s liquidity and solvency.
-6 can be bro'en down into three distinct components for purpose of
#nancial analysis. This is the 9u.ont system of ratios.
Luality of earnings analysis helps investors and analysts to identify 4red
=ags5 or warnings. This type of analysis is often used to determine the
ris'iness of stoc's. ,t goes beyond a simpler and more usual customary
#nancial performance analysis.
The 0arbanes$6+ley %ct of 2GG2 (06M) is comple+ and detailed. ,n essence it
is a law designed to increase disclosure of all material events that could
a1ect #nancial reporting. :urthermore! it de#nes unethical and unlawful
behavior that could give rise to criminal and civil penalties.
.art 11/ <onpro#t :inancial 0tatements
0ome entities have no ownership) such organiAations are nonpro#t or non$for$
pro#t organiAations.
<onpro#t organiAations have three #nancial statements! ;ust as for$pro#t
businesses have/ the statement of #nancial position! the statement of
activities! and the statement of cash =ows.
<et assets is the portion of the statement of #nancial position occupied by
equity on a balance sheet. The three categories of net assets are
unrestricted! temporarily restricted! and permanently restricted.
-evenues from contributions must be classi#ed as unrestricted! temporarily
restricted! or permanently restricted. -evenues from services provided are
unrestricted revenues.
&oth realiAed and unrealiAed gains on investments are reported as
unrestricted revenues.
Transfers from temporarily restricted funds occur when the funds are used for
their speci#ed purpose.
The interpretation of ratios is di1erent in nonpro#t organiAations than in for$
pro#t organiAations. -atios have meaning only to the e+tent that both their
numerator and denominator are appropriate measurements.
<onpro#t organiAations have many goals that are non#nancial. %ppropriate
performance measures must be chosen to complement the information
provided in their #nancial statements.
.art 12/ ,nternational :inancial -eporting 0tandards (,:-0)
,nternational :inancial -eporting 0tandards (,:-0) are principles$based! as
opposed to the C.0. *enerally %ccepted %ccounting .rinciples (*%%.)! which
are rules$based.
,:-0 intends to create a global accounting reporting standard for users to
ma'e economic decisions and understand the #nancial aspects of an entity.
The four qualitative characteristics of ,:-0 are understandability! reliability!
ability! relevance! and comparability.
,:-0 uses a fair value measurement basis! unless reliable information is not
available) then assets will be measured at cost.
%lthough the names of the three #nancial statements di1er between ,:-0 and
C.0. *%%.! they represent the same information.
,:-0 and the C.0. *%%. have converged on several levels! but there are still
many di1erences between the two sets of reporting standards.
0ome of the di1erences between the standards are/
,:-0 and C.0. *%%. recogniAe revenue when the ris's and rewards are
transferred! but ,:-0 prohibits the use of the completed contract method
to recogniAe revenue.
L,:6 is not permitted by ,:-0.
,:-0 measures inventory at the lower of cost or net realiAable value (<-N))
C.0. *%%. measures inventory at the lower of cost or mar'et.
The classi#cation of e+traordinary items is not allowed when preparing an
income statement (or 0tatement of Comprehensive ,ncome) in accordance
with ,:-0.
-egarding consolidation! ,:-0 is more lenient with the EG percent control
rule than C.0. *%%.! and considers factors such as voting rights! and the
parent company"s ability to in=uence the subsidiary.
C.0. *%%. and ,:-0 have converged to some degree! with further
convergence planned for the future. 0ome similarities include when to
recogniAe revenue! amortiAation guidelines for intangible assets! and
elimination of all intercompany transaction upon consolidation.