introduction to accounting مقدمه ای بر حسابداری به انگلیسی

Introduction to Accounting

Accounting and double-entry bookkeeping; financial and managerial accounting; basic financial statements (income statement, statement of cash flows, statement of changes in owners' equity and balance sheet); permanent (real) and temporary (nominal) accounts; four types of accounting transactions.

1. Definition of accounting

What is accounting? People in the business world consider it to be quite important. When you plan to invest in McDonald's stock, buy new equipment, or forecast future sales and expenditures, you almost certainly use accounting information. Why? Because, accounting provides information for decision-making in the business world.

Accounting is a service-based profession that provides reliable and relevant financial information useful in making decisions.

Financial information may include sales, expenses, taxes and other figures.

There are three steps to preparing financial information: identification, recording and communication.

First, economic events are identified. A sale at a gas station, payment of taxes by a commercial enterprise, or purchase of insurance are all examples of economic events.

Next, all economic events are recorded. Recording provides a history of a company's financial activities. In this step, economic events are also classified and summarized.

Finally, information about classified and summarized economic events is communicated to interested parties. Such communication may take several forms. One such form is a financial statement which you will read about later in this tutorial.

2. Users of accounting information

There are two broad categories of interested parties, or accounting information users:

·         external users

·         internal users

External users are parties outside the reporting entity or company who are interested in the accounting information.

Types of external users include:

·         Investors (i.e., owners), who use accounting information to make buy, sell or keep decisions related to shares, bonds, etc.

·         Creditors (i.e., suppliers, banks), who utilize accounting information to make lending decisions.

·         Taxing authorities (i.e., Internal Revenue Service), who need accounting information to determine a company's tax liabilities.

·         Customers, who may need accounting information to decide which products to buy from which companies.

Internal users are parties inside the reporting entity or company who are interested in accounting information.

Types of internal users include:

·         A company's senior and middle management, who use accounting information to run the business.

·         Employees who use accounting information to determine a company's profitability and profit sharing.

Financial accounting provides information that is designed to satisfy the needs of external users. Such reporting is usually done in the form of financial statements.

Managerial accounting provides information that is useful in running a company by internal users. Such reporting is usually accomplished through custom-designed (or managerial) reports.

The illustration below shows relationships between the types of accounting and accounting information users.

Illustration 1: Types of accounting and accounting information users

. Generally Accepted Accounting Principles (GAAP)

People and organizations make decisions based on financial information prepared by accountants. That is why it is important for people and organizations to understand the ways in which accounting information is measured. To ensure consistency, rules are established that business people can use to make sure they are comparing oranges to oranges.

For example, assume a store sells goods. Should the store's accountant record the sale at the moment the goods are shipped (accrual accounting) or at the time cash for these goods is received (cash accounting)?

Whether the store owner applies accrual or cash accounting is not important to interested parties, as long as the owner follows a rule requiring him to disclose the chosen accounting method for the reporting purposes.

Accounting rules such as these are grouped together and called Generally Accepted Accounting Principles (GAAP).

Generally Accepted Accounting Principles (GAAP) are common standards that guide accountants in reporting economic events.

The Financial Accounting Standards Board (FASB) regularly issues Statements of Financial Accounting Standards (SFAS) that comprise a large portion of GAAP. You can find more information about SFAS, their issuance process and current projects on FASB's website.

In 2009, all SFAS statements and other pronouncements were included in the Accounting Standards Codification (ASC), which is the single source of authoritative U.S. accounting and reporting standards, other than guidance issued by the Securities and Exchange Commission (SEC).

Other organizations playing a significant role in regulating the accounting profession are the Securities and Exchange Commission and the Public Company Accounting Oversight Board (PCAOB). The SEC and PCAOB mostly regulate public companies, while the FASB establishes standards for private companies.

4. Financial reporting and financial statements

Businesses communicate accounting information to the public through a process known as financial reporting.

Financial reporting is the process through which companies communicate information to the public.

The central means of external financial reporting is a set of financial statements. There are four general-purpose financial statements:

·         Income Statement

·         Statement of Changes in Equity

·         Balance Sheet

·         Statement of Cash Flows

An income statement presents revenues and expenses and resulting net income or net loss for a period of time. An income statement is also called a Statement of Operations, an Earnings Statement, or a Profit and Loss Statement (P/L).

A statement of changes in equity shows all changes in owners' equity for a period of time. This statement is also called an Owners' Equity Statement.

A balance sheet presents assets, liabilities and owners' equity on a specific date. A balance sheet is also called a Statement of Financial Position.

A cash flow statement summarizes information about cash outflows (payments) and inflows (receipts). This statement may also include certain information not related to actual cash flows.

Notes to the financial statements are another important aspect of reporting. Notes can be found in most financial statements and are required to be included in the financial statements of publicly traded companies. Notes include, among other things, additional information about the financial condition and performance of a company. The information presented in the notes may differ greatly from one company to another.

4.1. Elements of financial statements

All financial statements consist of classes or categories known as elements. There are ten elements: assets, liabilities, equity, contributed capital, revenue, expenses, distributions, net income, gains, and losses. These elements are explained later in this tutorial or are covered in other tutorials.

Assets are the economic resources a business uses to accomplish its main goal (i.e., increasing the owners' wealth).

Formally recognized assets must meet the following two conditions:

·         they must represent a potential economic benefit that is assignable to a particular entity, and

·         an event giving rise to the assignment must have occurred (i.e., a transaction resulting in an asset has already occurred).

For example, if a company has purchased a piece of equipment and uses it to generate profits, it is considered as an asset. However, if the company just considers buying new equipment, it can't be deemed or recorded as an asset.

Basic accounting equation

Before we can proceed with the basic accounting equation we need to understand claims:

A company's assets belong to the resource providers who are said to have claims on the assets.

In other words, each asset has its own source provided by an owner or creditor. So, there can't be a claim without an appropriate asset and vice versa. Based on this statement, we can define the basic accounting equation as:

Assets = Claims

Claims are divided into two categories:

·         Creditors' claims that are called liabilities

·         Owners' claims that are called equity

Taking this into account, the basic accounting equation can also be presented as follows:

Assets	=	Claims
Assets	=	Liabilities + Equity

Liabilities are debts and obligations of a company.

Equity is what the company "owes" to owners. Equity is also called net assets or residual equity.

The amount of total assets minus total liabilities equals equity. Because equity equals the difference between assets and liabilities, it is also called net assets.

If a company goes bankrupt, liabilities are paid off first to creditors, while equity is the last to be distributed. Therefore, owners' equity is also called residual equity.

Let us look at an example of the basic accounting equation. Suppose a company has assets of $800, liabilities of $300, and equity of $500. These amounts will be shown in the basic accounting equation as follows:

Illustration 2: Example of basic accounting equation

Assets	=	Claims
Assets	=	Liabilities	+	Equity
$800	=	$300	+	$500

6. Effects of transactions on the basic accounting equation

Let us know examine how different transactions affect the basic accounting equation. We will take a look at several transactions separately.

1) Friends Company is created when the owners pool $5,000 into the business. The effect of the contributions on the accounting equation is as follows:

Illustration 3: Effect of cash contribution

		Claims
Assets	=	Liabilities	+	Equity
+$5,000	=		+	+$5,000

Note that the amount of this single transaction is recorded twice. The first time it is recorded as an asset and the second time it is recorded as equity (the asset source). In accounting any transaction is recorded at least twice, as a rule. This rule is known as double-entry bookkeeping.

The double-entry bookkeeping rule states that any transaction is recorded at least twice.

Because this transaction provided assets to the company, it is called an asset source transaction. An asset source transaction is one of the four types of accounting transactions.

Asset source transactions result in an increase in an asset account and in one of the claim accounts (liability or equity accounts).

2) Next, assume that Friends Company acquires an additional $2,000 of assets by borrowing cash from creditors (e.g., taking a loan from a bank). This is also an asset source transaction. In the table below the beginning balances are derived from the ending balances of the previous transaction:

Illustration 4: Effect of borrowing

			Claims
	Assets	=	Liabilities	+	Equity
Beginning balance	$5,000	=		+	$5,000
Effect of borrowing	+$2,000	=	+$2,000
Ending balance	$7,000	=	$2,000	+	$5,000

Equity is usually viewed as a source of assets, and that's why it is necessary to subdivide the owner's interest into two components. First, owners' claims are established when a business acquires assets from owners. These claims result from the contributions of capital resources by the owners; therefore, they are frequently called contributed capital.

Contributed capital is a component of equity resulting from contributions of capital resources by owners.

The second source of assets associated with equity occurs when a business obtains assets through its earnings activities. This source is called retained earnings.

Retained earnings are a component of equity resulting from earnings activities.

Taking into account the definitions above, the basic accounting equation can be presented like this:

Assets	=	Liabilities	+	Equity
				Contributed Capital	+	Retained Earnings

7. Effects of transactions on the basic accounting equation, cont.

3) An increase in assets resulting from rendition of goods or services to customers is called revenue.

Earning revenue can be an asset source transaction. To illustrate the effect of a revenue transaction, let's assume that Friends Company received $3,000 cash for services it provided to customers. Note in the illustration below that both assets and retained earnings increase which is a characteristic of an asset source transaction.

Illustration 5: Effect of revenue transaction

					Equity
	Assets	=	Liabilities	+	Contributed Capital	+	Retained Earnings
Beginning balance	$7,000	=	$2,000	+	$5,000	+	$0
Effect of revenue	+3,000	=		+		+	+3,000
Ending balance	$10,000	=	$2,000	+	$5,000	+	$3,000

4) Assets acquired through operating activities are called revenues. Assets used in the process of generating revenues are called expenses. Expenses decrease retained earnings.

Assume Friends Company used $1,000 in assets to earn the $3,000 (see above) in revenues. This is an example of an asset use transaction.

Asset use transactions result in a decrease in an asset account and in one of the claim accounts (liability or equity accounts).

The effect of an asset use transaction (assets and claims decrease) on the basic accounting equation is as follows:

Illustration 6: Effect of expense recognition

					Equity
	Assets	=	Liabilities	+	Contributed Capital	+	Retained Earnings
Beginning balance	$10,000	=	$2,000	+	$5,000	+	$3,000
Effect of expenses	(1,000)	=		+		+	(1,000)
Ending balance	$9,000	=	$2,000	+	$5,000	+	$2,000

Take a note of how decreases or negative amounts are shown in accounting records. Instead of prefixing a minus sign ("-"), a number is taken into parenthesis. This is a common way of showing a decrease in accounting.

5) If a business chooses to transfer part of its assets (particularly its retained earnings) to the owners, the transfer is called distribution. Assume Friends Company transfers $500 of assets to its owners. This is an asset use transaction:

Illustration 7: Effect of cash distribution

					Equity
	Assets	=	Liabilities	+	Contributed Capital	+	Retained Earnings
Beginning balance	$9,000	=	$2,000	+	$5,000	+	$2,000
Effect of distribution	(500)	=		+		+	(500)
Ending balance	$8,500	=	$2,000	+	$5,000	+	$1,500

Both distributions and expenses result in decreases in retained earnings and thus, in equity.

The table below is a summary of the effects of the three asset source transactions (events 1 through 3) and two asset use transactions (events 4 and 5):

Illustration 8: Summary of transaction effects

					Equity
	Assets	=	Liabilities	+	Contributed Capital	+	Retained Earnings
Beginning balance	$0	=	$0	+	$0	+	$0
Effect of contribution	+5,000	=		+	+5,000	+
Effect of borrowing	+2,000	=	+2,000	+		+
Effect of revenue	+3,000	=		+		+	+3,000
Effect of expenses	(1,000)	=		+		+	(1,000)
Effect of distribution	(500)	=		+		+	(500)
Ending balance	$8,500	=	$2,000	+	$5,000	+	$1,500

. Closing the books: permanent and temporary accounts

At the end of an accounting period, all accounts are prepared for the next period. In this regard, it is important to distinguish between permanent and temporary accounts. Balance sheet accounts (i.e., assets, liabilities, and equity) have a continual nature; therefore, they are not closed after each period. That's why they are called permanent accounts.

Permanent accounts are balance sheet accounts. They are not closed after each period. Their balances are carried forward into the next period. Permanent accounts are also called real accounts.

In contrast, revenue, expense, and distribution accounts are used to collect information about a single accounting period. At the end of a period, amounts in revenue, expense, and distribution accounts are transferred to the Retained Earnings account. Accordingly, the revenue, expense, and distribution accounts must have zero balances after closing the books at the end of one accounting period and at the beginning of the next period.

Temporary accounts are closed at the end of each period. These are mostly income statement accounts, except for a distribution account that is an equity statement account. Temporary accounts are also called nominal accounts.

The process of transferring the balances from the temporary accounts to the permanent account (i.e., the Retained Earnings account), is referred to as closing the accounts or closing the books.

9. Financial statements description

Using the five transactions described above, we can now prepare the company financial statements for the period. Recall that there are four general-purpose financial statements:

·         Income Statement

·         Statement of Changes in Equity

·         Balance Sheet

·         Statement of Cash Flows

9.1. Presentation of the income statement

An income statement is presented below. (We will not go into detail on the preparation of financial statements process in this tutorial. That topic will be covered in future tutorials. The financial statements below are presented to give you an idea of what an income statement looks like.)

Illustration 9: Income statement for Friends Company

Friends Company Income Statement For the Period Ended 20X6
Revenue (i.e., assets increase)	3,000
Expenses (i.e., assets decrease)	(1,000)
Net Income (i.e., change in net assets)	$ 2,000

The income statement measures the change in net assets or the difference between asset increases and asset decreases from operating activities. The asset increases from the operating activities are labeled revenues. The asset decreases from the operating activities are called expenses. The difference between revenues and expenses is called net income if revenue is greater than expenses or a net loss if vice versa.

Note: At this point we don't consider liabilities in the determination of revenues and expenses. Liabilities and how they impact revenues and expenses are covered in other tutorials.

Net income is the excess of revenues over expenses for an accounting period.

Net loss is the opposite of net income. Net loss results from the excess of expenses over revenues for an accounting period.

9.2. Presentation of the statement of changes in equity

The statement of changes in equity has the following format:

Illustration 10: Statement of changes in equity for Friends Company

Friends Company Statement of Changes in Equity Period Ended 20X6
Beginning Contributed Capital	$0
Plus: Capital Acquisition	5,000
Ending Contributed Capital	5,000
Beginning Retained Earnings	$0
Plus: Net Income	2,000
Less: Distribution	(500)
Ending Retained Earnings	1,500
Total Equity	$ 6,500

The statement of changes in equity explains the effects of transactions on owner's equity during an accounting period. The statement includes the beginning and ending balances of contributed capital and reflects any new capital acquisitions made during the accounting period in the contributed capital section. The statement also shows the portion of net earnings retained in the business in the retained earnings section.

9.3. Presentation of the balance sheet

The balance sheet is presented as follows:

Illustration 11: Balance sheet for Friends Company

Friends Company Balance Sheet Period Ended 20X6
Assets	$8,500
Total Assets	8,500
Liabilities	2,000
Equity
Contributed Capital	5,000
Retained Earnings	1,500
Total Equity	6,500
Total Liability and Equity (Claims)	8,500

The balance sheet lists assets and corresponding claims (liabilities and equity). Any asset has a source, so assets balance with claims. That is why total assets equal the sum of total liabilities and equity.

9.4. Presentation of the statement of cash flows

The statement of cash flows has the following format:

Illustration 12: Statement of cash flows for Friends Company

Friends Company Statement of Cash Flows For the Period Ended 20X6
Cash Flows from Operating Activities
Cash Receipts from Customers	$3,000
Cash Payments for Expenses	(1,000)
Net Cash Flow from Operating Activities	2,000
Cash Flows from Investing Activities	0
Cash Flows from Financing Activities
Cash Receipts from Borrowing	2,000
Cash Receipts from Capital Acquisitions	5,000
Cash Payments for Distributions	(500)
Net Cash Flow from Financing Activities	6,500
Net Increase in Cash	8,500
Plus: Beginning Cash Balance	0
Ending Cash Balance	$8,500

The statement of cash flows explains how the company obtained and used cash during a period. Sources of cash are called cash inflows, and uses of cash are known as cash outflows.

Cash inflows are sources of cash; for example, payments from customers, capital acquisitions, etc.

Cash outflows are uses of cash; for example, payments to vendors, paying off bank loans, etc.

The statement classifies cash inflows and outflows into three categories:

·         Operating activities explain cash generated through revenue and cash spent for expenses.

·         Investing activities include cash received or spent on productive assets and investments in the debt or equity of other companies.

·         Financing activities describe cash transactions associated with resource providers (i.e., owners and lenders.)

Illustration 13: Cash flow categories

Previous Page

Next Page

Not a member?

See why people join our
online accounting course:

10. Financial statements model

To better understand the effects of transactions on financial statements and see the relationships between a financial statement's elements, a statements model can be created. There are two forms of a statements model: vertical and horizontal. As its name implies, the vertical model arranges financial statement elements from top to bottom on a page.

The horizontal model arranges financial statement elements horizontally across a page. In the horizontal model, the balance sheet is presented to the left, followed by the income statement, and the statement of cash flows.

Let us demonstrate the usefulness of the horizontal model and apply it to the five transactions we covered earlier. Note that if a transaction does not affect the model, a related cell in the table below shows "n/a". In the statement of cash flows, FA means cash flows from financing, IA means cash flows from investing, and OA means cash flows from operating activities.

1. Obtained capital acquisition: $5,000

2. Borrowed cash: $2,000

3. Received cash revenue: $3,000

4. Paid expenses with cash: $1,000

5. Distributed cash to owners: $500

Illustration 14: Horizontal statements model for Friends Company

Event No	Balance Sheet					Income Statement					Cash Flow
	Cash	=	Liabilities	+	Equity	Rev.	-	Exp.	=	Net Income
1	5,000	=	n/a	+	5,000	n/a	-	n/a	=	n/a	5,000	FA
2	2,000	=	2,000	+	n/a	n/a	-	n/a	=	n/a	2,000	FA
3	3,000	=	n/a	+	3,000	3,000	-	n/a	=	3,000	3,000	OA
4	(1,000)	=	n/a	+	(1,000)	n/a	-	(1,000)	=	(1,000)	(1,000)	OA
5	(500)	=	n/a	+	(500)	n/a	-	n/a	=	n/a	(500)	FA
Totals	8,500	=	2,000	+	6,500	3,000	-	(1,000)	=	2,000	8,500

With respect to Events 1 and 2, it is clear that only the balance sheet and the statement of cash flows are affected. There is no effect on the income statement. Furthermore, you can see that Event 1 increases assets and equity and that the cash inflow is defined as a financing activity. Event 2 has a similar effect, except that liabilities increase instead of equity.

Event 3 affects three financial statements. Assets and equity increase on the balance sheet. The revenue recognition causes net income to increase, and the cash inflow is shown as an operating activity on the statement of cash flows.

Event 4 is the opposite of Event 3. Assets, equity and net income decrease. Cash flow statement shows this decrease as an operating activity.

Finally, Event 5 shows a decrease in cash and equity. The cash distribution is not shown anywhere in the income statement. That's because distribution is not an expense and thus, it is not included in the determination of net earnings. The cash distribution is categorized as a financing activity in the cash flow statement.

Using the horizontal model helps in understanding the effects produced by each event, so it is advisable to use it as often as possible while learning the principles of financial accounting.

Question Information

An owner contributed $10,000 cash into the business.

Top of Form

Which of the following correctly represents the cash contribution transaction?

a)

Option No.1:

Assets	=	Claims
Assets	=	Liabilities	+	Equity
+$10,000	=	+$10,000	+

b)

Option No.2:

Assets	=	Claims
Assets	=	Liabilities	+	Equity
+$10,000	=		+	+$10,000

c)

Option No.3:

Assets	=	Claims
Assets	=	Liabilities	+	Equity
+$10,000	=		+	+$5,000

d)

Option No.4:

Assets	=	Claims
Assets	=	Liabilities	+	Equity
-$10,000	=		+	-$10,000

Question Information

Total assets and liabilities at the beginning and end of the year for Company XYZ were as follows:

	Beginning of Year	End of Year
Assets	$95,000	$180,000
Liabilities	$48,000	$96,000

The owner made an additional investment (contribution) to the company in amount of $13,000 and withdrew (distribution) $34,000 from the business.

Top of Form

What is the amount of Company XYZ’s net income (loss) for the year?

a)

Net income of $63,000

b)

Net income of $58,000

c)

Net loss of $63,000

d)

Net loss of $58,000