TOOLS OF THE ACCOUNTING TRADE:Double-Entry Accounting, Assets

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Introduction to Business MGT 211

Lesson 44

TOOLS OF THE ACCOUNTING TRADE

For thousands of years, businesses and governments have kept records of their transactions.

Accountants are guided by three fundamental principles: the accounting equation, double-

entry accounting, and the matching principle.

The Accounting Equation --- Accountants use the following equation to balance the data in

journals and ledgers: Assets = Liabilities + Owners' Equity

Assets and Liabilities

1. Asset--any economic resource expected to benefit a firm or an

individual who owns it.

2. Liability--debt owned by a firm to an outside organization or

individual.

ii.

Owners' Equity--amount of money that owners would receive if they

sold all of a firm's assets and paid all of its liabilities. It consists of two

sources of capital: the amount the owners originally invested, and profits

earned by and reinvested in the company.

Double-Entry Accounting ----To keep the accounting equation in balance, companies use a

system developed by Fra Luca Pacioli, an Italian monk, in 1494.

Double-entry accounting is a way of recording financial transactions

that requires two entries for every transaction, so that the accounting

equation is always kept in balance.

ii.

Every transaction--a sale, a payment, a collection--has two offsetting

sides. Any excess plowed back into the business becomes retained

earnings. The accounting equation remains in balance if the

transactions are properly recorded.

iii.

Once the individual transactions are recorded and then summarized,

accountants review the summaries and adjust or correct errors, so they

can close the books, the act of transferring net revenue and expense

account balances to retained earnings for the period.

iv.

Although computers do much of the tedious recording today, mastering

the fundamental principles such as double-entry bookkeeping is

important because accountants must decide which accounts to increase

or decrease, and they must understand what to do if transactions are

recorded improperly.

Financial Statements --- Any of several types of reports summarizing a company's financial

status to aid in managerial decision making.

Balance Sheets -- also known as a statement of financial position, is a kind of "snapshot" of

where a company is, financially speaking, at one moment in time. The balance sheet includes

all the elements in the accounting equation, showing the balance between assets on one side

and liabilities and owners' equity on the other.

Every company prepares a balance sheet at least once a year, most often at the end of the

calendar year, January 1 to December 31. The fiscal year, any 12 consecutive months, is used

by many business and government bodies.

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Assets

There are three types:

1. Current Asset--asset that can or will be converted into cash

within the following year.

a. Liquidity--ease with which an asset can be converted

into cash.

b. Non-liquid Assets--Includes marketable securities

which vary in liquidity and three other forms:

accounts receivable--amount due from a

customer who has purchased goods on credit

ii.

merchandise inventory--cost of merchandise

that has been acquired for sale to customers and

is still on hand

iii.

prepaid expense--expense that is paid before

the upcoming period in which it is due

2. Fixed Asset--asset with long-term use or value

a. depreciation--process of distributing the cost of an

asset over its life

3. Intangible Asset--nonphysical asset that has economic value in

the form of expected benefits.

a. goodwill--amount paid for an existing business above

the value of its other assets

ii.

Liabilities are the debts that a business has incurred and appear after

assets because they are claims against the assets as shown in the

accounting equation: Assets = Liabilities + Owners' Equity

1. Current Liability--debt that must be paid within the year.

2. Account Payable--current liabilities consisting of bills owed to

suppliers, plus wages and taxes due within the upcoming year.

3. Long-Term Liability--debt that is not due for more than one

year.

iii.

Owners' Equity is the owners' investment in a business. This is also

the section that shows a corporation's retained earnings, the portion of

shareholders' equity earned by the company, but not distributed to its

owners in the form of dividends.

1. Common Stock

2. Paid-In Capital--additional money, above proceeds from stock

sale, paid directly to a firm by its owners.

3. Retained Earnings--earnings retained by a firm for its use

rather than paid as dividends.

Income Statements -- financial statement listing a firm's annual revenues and expenses so

that a bottom line shows annual profit or loss. If the balance sheet is a "snapshot," the income

statement is a "movie."

Revenues--funds that flow into a business from the sale of goods or

services.

ii.

Cost of Goods Sold--total cost of obtaining materials for making the

products sold by a firm during the year.

iii.

Gross Profit (or Gross Margin)--revenues obtained from goods sold

minus cost of goods sold.

iv.

Operating Expenses--costs, other than the cost of goods sold,

incurred in producing a good or service.

Operating Income--gross profit minus operating expenses.

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Introduction to Business MGT 211

1. net income (or net profit or net earnings)--gross profit minus

operating expenses and income taxes

Statement of Cash Flows -- financial statement describing a firm's yearly cash receipts and

cash payments.

cash flows from operations

ii.

cash flows from investing

iii.

cash flows from financing

The Budget: An Internal Financial Statement

A detailed statement of estimated receipts and expenditures for a period of time in the future.

The budget is probably the most crucial internal financial report. Most companies use their

budgets for internal planning, controlling, and decision-making. Although the accounting staff

coordinates the budget process, many different employees contribute to creating and updating

the budget.

Reporting Standards and Practices

The common language dictated by standard practices is designed to give external users

confidence in the accuracy and meaning of the information in any financial statement.

Revenue Recognition--formal recording and reporting revenues in the

financial statements. This principle states that revenue is not formally

recorded and reported until 1) The sale is complete and the product has

been delivered, and 2) The sale price is collected or is collectable (part

of accounts receivable).

ii.

Matching principle requires that expenses incurred in producing

revenues be deducted from the revenue they generated during the

same accounting period in order to accurately present the profitability of

a business.

1. Accountants match revenue to expenses by adopting the accrual

basis of accounting, which states that revenue is recognized

when you make a sale and expense is recorded when it is

incurred.

2. If a business runs on a cash basis, the company records

revenue only when money from the sale is actually received and

expense is recorded when cash is paid.

3. Depreciation is the accounting procedure for systematically

spreading the cost of a tangible asset over its estimated useful

life.

iii.

Full Disclosure means that financial statements should include not just

numbers, but also interpretations and explanations by management so

that external users can better understand information contained in the

statements.

Analyzing Financial Statements

Organizations and individuals use financial statements to spot problems and opportunities.

Managers and outsiders use them to evaluate a company's performance in relation to the

economy, the competition, and past performance. To perform this analysis, most users look at

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historical trends and key ratios. Three major classifications of ratios: solvency,

profitability, activity.

Short-Term Solvency Ratios

Liquidity Ratio -- solvency ratio measuring a firm's ability to pay its immediate debts.

current ratio--solvency ratio that determines a firm's credit worthiness

by measuring its ability to pay current liabilities, calculated by dividing

current assets by current liabilities.

ii.

working capital--the difference between the firm's current assets and

current liabilities, which indicates the firm's ability to pay off short-term

debts to outsiders.

Long-Term Solvency Ratios

Debt Ratio -- solvency ratio measuring a firm's ability to meet its long-term debts.

debt-to-owners' equity ratio (or debt-to-equity ratio)--solvency ratio

describing the extent to which a firm is financed through borrowing,

calculated by dividing debt by owners' equity.

ii.

leverage--ability to finance an investment through borrowed funds

Profitability Ratios

Return on Equity--profitability ratio measuring income earned for each

dollar invested, calculated by dividing net income by total owners'

equity.

ii.

Earnings per Share--profitability ratio measuring the size of the

dividend that a firm can pay shareholders, calculated by dividing net

income by the number of shares of common stock outstanding.

Activity Ratios --- may be used to analyze how well a company is managing its assets.

Inventory Turnover Ratio--activity ratio measuring the average

number of times that inventory is sold and restocked during the year,

calculated as cost of goods sold divided by average inventory.

International Accounting

a. Foreign Currency Exchange Rate--value of a nation's currency as

determined by market forces.

International Transactions --- International purchases, sales on credit, and accounting for

foreign subsidiaries all involve accounting transactions that include currency exchange rates.

International Accounting Standards --- Bankers, investors, and managers would like to see

financial reporting that is comparable from country-to-country and across all firms regardless

of home nation.

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