Introduction to

Financial Accounting
 Types of Businesses
Manufacturing Business

Product
General Motors Cars, trucks, vans
Intel Computer chips
Boeing Jet aircraft
Nike Athletic shoes and apparel
Coca-Cola Beverages
Sony Stereos and television
 Types of Businesses
Merchandising Business

Product
Wal-Mart General merchandise
Toys “R” Us Toys
Circuit City Consumer electronics
Lands’ End Apparel
Amazon.com Internet books, music, video
retailer
 Types of Businesses
Service Business

Product
Disney Entertainment
Delta Air Lines Transportation
Marriott Hotels Hospitality and lodging
Merrill Lynch Financial advice
Sprint Telecommunication
There are three types of
business organizations

 Proprietorship
 Partnership
 Corporation
A proprietorship Advantages
is owned by one • Ease in organizing
individual. • Low cost of
organizing
Disadvantage
Joe’s • Limited source of
financial resources
• Unlimited liability
 Advantages
A partnership is • More financial
owned by two or resources than a
more individuals. proprietorship.
• Additional
management skills.
Joe and Marty’s Disadvantage
• Unlimited liability.
 A corporation is
organized under state Advantage
or federal statutes as a • The ability to obtain
separate legal entity. large amounts of
resources by issuing
stocks.
J & M, Inc. Disadvantage
• Double taxation.
 What is Accounting?

Identifying

Economic to
Measuring
Information various
users

Communicating
 Internal and External
Users of Accounting Information
Bankers
Current Creditors
and
Potential Internal
Owners Users –
Management Financial
Analysts

Suppliers
Trade
Government
Associations
Agencies
LO1
 Decisions Made with Financial
Information

Add new
Invest?? product line??

Borrow $$?? Build new plant??

Loan $$??
Extend credit $$??
Start new business?? Sell stocks or bonds??
 What is a business
transaction?

A business transaction is an economic event or

condition that directly changes an entity’s financial
condition or directly affects its results of operations.
 The Accounting Equation

Assets = Liabilities + Owner’s Equity

The resources
owned by a
business
 The Accounting Equation

Assets = Liabilities + Owner’s Equity

The rights of the

creditors, which
represent debts
of the business
 The Accounting Equation

Assets = Liabilities + Owner’s Equity

The rights of the

owners
 – snapshot of
Balance Sheet financial position

Assets Liabilities
12
THE
FEDERALRESERVENOTE

THEUNITED
UNITED STATES
STATES OF
THI S NOTE I S LEGAL TENDER
OF AMERICA

FOR ALL DEBTS, PUBLI C AND PRI VATE

AMERICA

L70744629F

WASHINGTON, D.C. 12
=
+
A
H 293

L70744629F
12 SERI ES 12
1985

ONE
ONE DOLLAR
DOLLAR

Owners’ Equity
(or Stockholders’ Equity)

Stock
Certificate
On November 1,
2005, Chris
Clark begins a
business that will
be known as
NetSolutions.
a. Chris Clark deposits $25,000 in a bank
account in the name of NetSolutions.

Assets = Owner’s Equity

Cash Chris Clark, Capital
= 25,000 Investment
a. 25,000
by Chris
Clark
 b. NetSolutions exchanged $20,000 for land.

Assets = Owner’s Equity

Cash + Land Chris Clark, Capital
Bal. 25,000 = 25,000
b. –20,000 +20,000
Bal. 5,000 20,000 25,000
 c. During the month, NetSolutions purchased
supplies for $1,350 and agreed to pay the
supplier in the near future (on account).
Owner’s
Assets = Liabilities + Equity
Accounts Chris Clark,
Cash + Supplies + Land Payable Capital
=
Bal. 5,000 20,000 25,000
c. + 1,350 + 1,350
Bal. 5,000 1,350 20,000 1,350 25,000
 d. NetSolutions provided services to
customers, earning fees of $7,500 and
received the amount in cash.
Owner’s
Assets = Liabilities + Equity
Accounts Chris Clark,
Cash + Supplies + Land Payable Capital
Bal. 5,000 1,350 20,000 = 1,350 25,000
d. + 7,500 + 7,500 Fees
earned
Bal. 12,500 1,350 20,000 1,350 32,500
 e. NetSolutions paid the following
expenses: wages, $2,125; rent, $800;
utilities, $450; and miscellaneous, $275.
Owner’s
Assets = Liabilities + Equity
Accounts Chris Clark,
Cash + Supplies + Land Payable Capital
Bal. 12,500 1,350 20,000 1,350 32,500
e. – 3,650 –2,125 Wages
=
– 800 Rent
– 450 Util.
– 275 Misc.
Bal.8,850 1,350 20,000 1,350 28,850
 f. NetSolutions paid $950 to
creditors during the month.

Owner’s
Assets = Liabilities + Equity
Accounts Chris Clark,
Cash + Supplies + Land Payable Capital
Bal. 8,850 1,350 20,000 = 1,350 28,850
f. – 950 – 950
Bal. 7,900 1,350 20,000 400 28,850
 g. At the end of the month, the cost
of supplies on hand is $550, so
$800 of supplies were used.
Owner’s
Assets = Liabilities + Equity
Accounts Chris Clark,
Cash + Supplies + Land Payable Capital
Bal. 7,900 1,350 20,000 = 400 28,850
g. – 800 – 800 Supplies
expense
Bal. 7,900 550 20,000 400 28,050
 h. At the end of the month, Chris
withdrew $2,000 in cash from the
business for personal use.
Owner’s
Assets = Liabilities + Equity
Accounts Chris Clark,
Cash + Supplies + Land Payable Capital
Bal. 7,900 550 20,000 = 400 28,050
h. –2,000 –2,000 With-
drawal
Bal. 5,900 550 20,000 400 26,050
Accounting reports, called
financial statements,
provide summarized
information to the owner.
 Financial Statements
• Income statement—A summary of the revenue
and expenses for a specific period of time.
• Statement of owner’s equity—A summary of
the changes in the owner’s equity that have
occurred during a specific period of time.
• Balance sheet—A list of the assets, liabilities,
and owner’s equity as of a specific date.
• Statement of cash flows—A summary of the
cash receipts and disbursements for a specific
period of time.
 Top of the World A = L + SE
Balance Sheet
June 30, 2007
Assets
Current assets: A
Cash $ 200
Accounts receivable 600 800
Non current assets:
Land 4,000
Lodge, lifts and equipment 2,500 6,500

Total assets $7,300

 Top of the World A = L + SE
Balance Sheet
June 30, 2007
Liabilities and Stockholders’ Equity
=L
Liabilities:
Accounts payable $ 700
Salaries and wages payable 400
Notes payable 3,000
Total liabilities $4,100
+ SE
Stockholders’ equity:
Capital stock $2,000
Retained earnings 1,200
Total stockholders’ equity $3,200

Total Liabilities and Stockholders’ Equity $ 7,300

 Income Statement

Revenues $$
Less: Expenses ($$)
Net income $$
 Top of the World
Income Statement
For the Year Ended June 30, 2007
Revenues – Expenses = Net Income
Revenues:
Lift tickets Revenues $5,800
Equipment rentals 2,200
Total revenues $8,000
Expenses:
Salaries and wages $2,000
Depreciation 100
Water, gas, and electricity Expenses 1,500
Insurance 1,100
Interest 300
Income taxes 1,000
Total expenses 6,000

Net income Net Income $2,000

 Relationships among Financial
Statements – Top of the World Example
Income Statement for 2007
Revenues $ 8,000
Less: Expenses ( 6,000)
Net income $ 2,000

Statement of Retained Earnings for 2007

Beginning balance, retained earnings $ 0
Add: Net income 2,000
Deduct: Cash dividends (800)
Ending balance, retained earnings $1,200

Balance Sheets 2007 2006

Total assets $7,300 $ 0
Liabilities 4,100 0
Capital stock 2,000 0
Retained earnings 1,200 0
Total liabilities and stockholders’ equity $7,300 $ 0
Financial Statement Assumptions

Economic
Entity Cost
Concept Principle
Time
Period
Assumption
Going Monetary
Concern Unit

LO3
 Economic Entity Concept
 Each entity has its own books, records,
and financial statements that are
separate from owners
 No intermingling of personal and
business assets and liabilities or
income and expenses
Business
Books and
Records
 Cost Principle

 Record assets at cost paid

to acquire them
 Continue to value assets at
historical cost until sold
 More objective than market
value
 Going Concern

 Assume business
will continue
indefinitely into the
future
 Justifies use of
historical cost
 Monetary Unit
 How we measure amounts in
the financial statements (e.g.,
U.S. dollar, Japanese yen,
Mexican peso, etc.)
 Assumes economic measure
is relatively stable; no
adjustment for inflation made
in financial statements
 Time Period Assumption
 Assumes it is possible to break up an
entity’s earnings in discrete time
periods (a month, quarter, year)
 Necessary to provide users with
financial results on a timely basis
 Requires use of estimates 4 5 6 7
1

8
2

9
3

10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 27 28 29 30 31
Relationship between the income statement and the
balance sheet

Assets + Profit
= Capital + Liabilities
(–) (Loss)

The above equation can be extended to:

Sales – Expenses
Assets = Capital + + Liabilities
revenue
 Better-Price Stores
Income statement for the year ended 31 October 2007
£
Sales revenue 232,000
Cost of sales 154,000
Gross profit 78,000
Salaries and wages (24,500)
Rent and rates (14,200)
Heat and light (7,500)
Telephone and postage (1,200)
Insurance (1,000)
Motor vehicle running expenses (3,400)
Depreciation – fixtures and fittings (1,000)
Depreciation – motor van (600)
Operating profit 24,600
Interest received from investments 2,000
Loan interest (1,100)
Profit for the year 25,500
 Elements of the income
statement
 Gross profit
 The difference between revenue and cost of sales
 Operating profit
 Gross profit less expenses (overheads) incurred in
operating the business
 Represents the wealth generated from operating
(trading) activities
 Profit for the year
Operating profit
+ any non-trading income
- Costs of financing the business
 Cost of sales
 This represents the cost of goods SOLD by
the business (not cost of goods BOUGHT)
during the accounting period
 Part of goods bought during the accounting
period may remain in the business as
inventories
 To calculate the cost of goods sold, we need
to know the amount of any opening and
closing inventories, as well as purchases
made
 Cost of sales example
1 Jan 2008 Inventory £ 20,000
Purchases during 2008 £140,000
31 Dec 2008 Inventory £ 45,000

Cost of sales £
Opening inventory 20,000
Purchases 140,000
160,000
Less: Closing inventory (45,000)
115,000
 Classification of expenses
 These are often a matter of judgement
by the company, depending on how
useful the information may be to users
 Large items will be shown separately
(concept of materiality)
 Finance costs are shown below
operating profit
 Limited companies have to follow
Company Law for their classification
 Activity: Prepare an Income
Statement
£’000
 The adjacent Sales 210
information relates Purchases 109
to Sankey Ltd Inventory: 1.10.07 9
Salaries & Wages 42
 Prepare an income Motor expenses 2
Rent 7
statement for the General expenses 3
year ended 30.9.08 Motor vehicles 14
Cash at bank 5
 N.B. Not all the Loan interest payable 2
information is Loan 20
Inventory: 30.9.08 11
relevant
Profit measurement and the recognition of revenue

Basic criteria that must be met before

revenue is recognised:

The amount of revenue can be

measured reliably.

It is probable that the economic

benefits will be received.

An additional criterion to be applied where the

revenue comes from the sale of goods:

Ownership and control of the item

should pass to the buyer.
The effect of trading operations on the balance sheet

The balance sheet equation can be extended as follows:

plus plus
equals
(minus)

Assets Capital Profit Liabilities.

(Loss)
The classification of assets

The classification of assets

may vary according to the
nature of the business:

Current assets

Non-current assets.
 Current Assets
 Assets that are held for the
short term
 Have ANY of the following
characteristics:
 Held for sale or
consumption in the normal
course of business
 Expected to be sold within
the next year
 Held primarily for trading
 Cash or near cash
 Common examples
 Inventories (stock)
 Trade receivables (debtors)
 Cash
The circulating nature of current assets

Inventories

Cash Receivables
Profit measurement and inventory costing methods

Common assumptions used are:

First in, first out (FIFO)

Last in, first out (LIFO)

Weighted average cost (AVCO)

 Valuation of inventories
 Each method is theoretical, and doesn’t
reflect the physical movement of
inventory
 In times of rising prices:
 FIFO will give the highest profit and
inventory value
 LIFO will give the lowest profit and
inventory value
 AVCO will be in between
 Example
Nelson Ltd has the following inventory records for
October 2008:
Number Price/unit
Oct 1 Purchase 1,000 £3.00
Oct 3 Purchase 500 £3.20
Oct 4 Sale 700
Oct 6 Purchase 300 £3.50
Oct 8 Sale 900

Required:
Calculate the amounts for cost of sales and for
closing inventory for each of FIFO, LIFO and
AVCO
 FIFO
Purchase Cost of Balance
cost sales Inventory
1 Oct 1,000@£3.00 £3,000 £3,000

3 Oct 500@£3.20 £1,600 £4,600

4 Oct (700)@£3.00 £2,100 £2,500

6 Oct 300@£3.50 £1,050 £3,550

8 Oct (300)@£3.00
(500)@£3.20
(100)@£3.50 £2,850 £ 750
Clg 200 £5,650 £4,950 £ 700
 LIFO
Purchase Cost of Balance
cost sales Inventory
1 Oct 1,000@£3.00 £3,000 £3,000

3 Oct 500@£3.20 £1,600 £4,600

4 Oct (500)@£3.20
(200)@£3.00 £2,200 £2,400
6 Oct 300@£3.50 £1,050 £3,450

8 Oct (300)@£3.50
(600)@£3.00 £2,850 £ 600
Clg 200 £5,650 £5,050 £ 600
 AVCO
Purchase Cost of Balance
cost sales Inventory
1 Oct 1,000@£3.00 £3,000 £3,000
@£3.00
3 Oct 500@£3.20 £1,600 £4,600
@£3.07
4 Oct (700)@£3.07 £2,149 £2,451

6 Oct 300@£3.50 £1,050 £3,501

@£3.18
8 Oct (900)@£3.18 £2,862 £ 639
@£3.18
Clg 200 £5,650 £5,011 £ 639
Valuation of inventories
 Usually valued at cost
 In some circumstances,
may need to be valued
at NET REALISABLE
VALUE:
 The estimated selling
price less any further
costs
 Examples:
 Goods have deteriorated
or become obsolete
 Fall in market price
 ‘loss leadership’
promotions
 Allowances for trade receivables
 We recognise revenue at the point when the
sale is made
 Even if the customer won’t pay the money owing for
another 30 days
 Trade receivables shown as an asset on the balance
sheet
 There is always a risk that the customer won’t
pay
 Assets will then be overstated on the balance sheet
 Profits will have been overstated on the income
statement
Allowances for trade receivables
– specific bad debts
 If there is news about a specific customer
 Eg they have gone bankrupt

 Then:
 Decrease trade receivables by the amount owing
 Increase expenses (bad debts) by that amount
 Note: we don’t just cancel out the sale
 This way more information is given on
Allowances for trade receivables
– general provision
 Usually there won’t be specific information
available at the end of the accounting period
 However, past experience tells us that a
proportion of trade receivables are never
going to be paid
 We therefore make a provision for ‘doubtful
debts’ as follows:
 Decrease trade receivables by the required
provision
 Increase expenses (allowances for trade
receivables) by that same amount
 Example
In the year ended 30.9.07 Callands Ltd has
trade receivables of £90,000.
It recently heard that one of its customers,
Bewsey, has gone bankrupt, owing Callands
£3,000.
After careful checking of its other customers,
Callands considers other trade receivables
totalling £1,800 to be doubtful.
Required: Show the extracts from the
income statement and balance sheet for
y/e 30.9.07
 Callands Ltd
Income statement extract £
Bad debts written off
3,000
Allowances for trade receivables
1,800

Balance sheet extract

Trade receivables [90000-3000]
87,000
Allowances for trade receivables
Non-current Assets
 Assets that are held
for the long term
 Examples
 Land
 Buildings
 Plant &equipment
 Vehicles
 Computers
The classification of claims

Current liabilities

Non-current liabilities
 Current Liabilities
 Amounts due to be paid in the short
term
 Have ANY of the following
characteristics:
 Expected to be settled in the normal
course of business
 Expected to be settled within the next year
 Held primarily for trading
 Examples
 Trade payables (creditors)
 Bank overdraft
 Non-current Liabilities
 Amounts due to be paid after more than
1 year
 Examples
 Long term loans
 Debentures
 Activity
 Delivery van
 Label each item as one  Bank loan to be repaid in
of: 2 year’s time
 Current asset
 Non-current asset  Money owed by
 Current liability
customers
 Non-current liability  Cash in the office safe
 Capital  Electronic parts to be
used in production
process
 Bank overdraft
 Money the owner put into
the business
 Office computer
 Unpaid electricity bill
Brie Manufacturing: balance sheet as at 31 December 2006
£000
Non-current assets
Property 45
Plant and equipment 30
Motor vans 19
94
Current assets
Inventories 23
Trade receivables 18
Cash at bank 12
53
Total assets 147
Capital (owner’s equity)
Opening balance 50
Add Profit 14
64
Less Drawings 4
60
Non-current liabilities
Long-term borrowings 50
Current liabilities
Trade payables 37
Total equity and liabilities 147
Purpose of the Statement of Cash
Flows
 Explains changes in
cash over a period of
time
 Summarizes cash
inflows and outflows
from:
Operating
Activities Investing Financing
Activities Activities

LO1
 FEDERALRESERVENOTE

THE
THE UNITED
UNITED STATES
STATES OF
OF AMERICA
AMERICA
THI S NOTE I S LEGAL TENDER

FOR ALL DEBTS, PUBLI C AND PRI VATE

L70744629F

12 WASHINGTON, D.C. 12
A

Cash Equivalents
H 293

L70744629F
12 SERI ES 12
1985

ONE
ONE DOLLAR
DOLLAR

 Readily convertible
to cash
4 5 6 7
1

8
2

9
3

10
1 2 3
 Little risk of price
11

18
12

19
13

20
14
4
15
5
16

2111 2212 23 13 2414

6
17
7 8

15
4
9

16
5
10

17
6 7
1

8
2

9
3

10
change
 Original maturity
25 26 27 2818 2919 30 20 3121 22 23 24
11 12 13 14 15 16 17

25 26 27 28 29
18 30
19 31
20 21 22 23 24

25 26 27 28 29 30 31

to investor of three
months or less
Examples:
 Commercial paper
 U.S. Treasury bills
 Certain money market funds

LO2
Statement of Cash Flows Format

inflows Cash outflows

Classified by:
Operating activities
Investing activities =
+Beginning Financing activities
Cash and = Ending
Increase or decrease in Cash and
Cash cash and cash
Equivalents Cash
equivalents Equivalents
LO3
Statement of Cash Flows Format
Cash flows from operating activities:
Inflows $ xxx
Outflows (xxx)
Net cash provided (used) by operating activities $xxx
Cash flows from investing activities:
Inflows $ xxx
Outflows (xxx)
Net cash provided (used) by investing activities xxx
Cash flows from financing activities:
Inflows $ xxx
Outflows (xxx)
Net cash provided (used) by financing activities xxx
Net increase (decrease) in cash and cash equivalents $xxx
Cash and cash equivalents at beginning of year xxx
Cash and cash equivalents at end of year $xxx
from balance sheets
 Operating Activities
Payment to suppliers
for inventory
Collection of Cash
customer accounts transactions
concerned with
acquiring and
selling products
and services

Payment of taxes Payment of wages

 Investing Activities
Capital
Cash transactions expenditures
concerned with
acquiring and
disposing of long-
Sale of
term assets
property, plant,
and equipment
Purchase/sale of
another company
 Financing Activities
Issuance/repurchase Cash Issuance/repayment
of stock transactions of bank note
concerned with
12
the raising and
THE
FEDERALRESERVENOTE

THE UNITED
UNITED STATES
STATES OF
THI S NOTE I S LEGAL TENDER
OF AMERICA

FOR ALL DEBTS, PUBLI C AND PRI VATE

AMERICA

L70744629F

12

repayment of
WASHINGTON, D.C.

A
H 293

L70744629F
12 SERI ES 12
1985

ONE
ONE DOLLAR
DOLLAR

funds in the
form of debt
Issuance/retirement and equity
Payment of
of bonds
dividends
 Categorizing Cash Flow Activities
Operating Activities Current
assets
and
current
Investing Activities liabilities

Long-term
liabilities
Long-term Financing or
assets Activities stockholders’
equity
 £ £
Non Current Assets
Car: Cost 8000
Less Depreciation (2000)
6000
Equipment: 3000
Less Depreciation (500) 2500
8500
Current Assets
Inventories 300
Receivables 275
Prepayments 585
Cash 190 1350

Total Assets 9850

Less Current Liabilities

Payables 325
Accruals 180
505
Less Long Term Liabilities
Bank loan 3500

Total Liabilities 4005

5845

Share Capital and Reserves

Share Capital 3500
Retained profit 2345 5845
 Balance Sheet Adjustments
a.Merlin bought the car and the equipment
on his first day of trading.

b. All depreciation is calculated on a straight

line basis.

c. Merlin rents a room in a local nursery at

a cost of £225 per month, which is paid
monthly in advance on the last day of each
month.
d. The prepayments are made up of (i) prepaid
rent and (ii) prepaid council tax (local taxes)
of £360.

e. The accrued expenses relate to (i) an unpaid

telephone bill for £50 and (ii) wages for
Guinevere, Merlin’s bookkeeper, who
prepares the accounts and maintains the
records for Archimedes Ltd at a salary of
£130 per month which she is paid in arrears
on the 1st of each month.

f. Interest on the bank loan is charged at a rate

of 7% per annum and is paid on 31
December each year.
 Income Statement Adjustment

On 31st July, Merlin’s rent was increased by

£25 per month.

On 1st January, Guinevere’s wages were

increased to £135 per month.

Wages paid to Guinevere during the year

totalled £1,585.
Tutoring sessions where the customer paid cash
totalled £13,500.

Tutoring sessions provided to customers on credit

totalled £12,000.

Inventories of books and stationery costing £1,200

were bought on credit during the year.

The year-end inventory count identified that Merlin

had inventory to the value of £425.
Cash received in respect of receivables totalled
£11,800.
Payments to suppliers of inventory
totalled £1,100.

Electricity was paid in cash during the

month the electricity was used. A total of
£420 was paid for electricity during the
year.

Council tax (local taxes) of £600 for 1

April 2009 to 31 March 2010 was paid.
Cash paid in relation to telephone bills during the
year totalled £375. At the end of the year, £45 was
owed to the telephone company in relation to the
year to 30 June 2009.

Running expenses for the car were £950 and were

paid for as they were incurred.

Other expenses averaged £50 per month and were

paid for as they arose.

Merlin withdrew £1,450 every month for his personal

expenses.
 Market Value vs. Book Value
In general, the market value of either equity or assets is not the same
as book value. Book value is based on the cost principle and reflects
the cost of a transaction which has occurred or is reasonably certain to
occur. Book value is an accounting number. Market value, on the
other hand, represents the market’s estimate of the value of assets or
equity. Market value is forward looking; that is, market value reflects
expectations about the future of the company. Market value and book
value may differ because:

• book value does not reflect reputation, brand names, customer

loyalty
• book value does not reflect expected future growth
• book value does not reflect management talent
• book value does not reflect the fact the whole is greater than the sum
of the parts.