Chapter 16

Basic Accounting: Concepts, Techniques, Conventions. Read and interpret the basic financial statements.

The Need for Accounting
Managers, investors, and other internal groups want the answers to two important questions: How well did the organization perform? Where does the organization stand?

The Need for Accounting
Accountants answer these questions with two major financial statements:

Income Statement Balance Sheet

Balance Sheet 

The balance sheet (also called statement of financial position or statement of financial condition) is a snapshot of the financial status of an organization at a point in time.

Balance Sheet
Assets = Equities
Assets are economic resources that are expected to benefit future activities of the organization. Equities are the claims against, or interests in, the assets of the organization.

Business Transactions

A transaction is any event that affects the financial position of an organization and requires recording.

King Hardware Transactions
1 2 3 4

Initial investment by owners, ¼100,000 cash. Acquisition of inventory for ¼75,000 cash. Acquisition of inventory for ¼35,000 on open account. Merchandise costing ¼100,000 was sold on open account for ¼120,000.

King Hardware Transactions
Value in the company Borrowed Owners claim

Stockholders¶ Assets = Liabilities + Equity

1) Cash 2) Cash Inventory 3) Inventory 4) Receivable 4b) Cost

+ $100,000 ± 75,000 + 75,000 + 35,000 + 120,000 ± 100,000

+ $100,000

+ 35,000 + 120,000 ± 100,000

King Hardware Transactions
5 6 7

Cash collections of accounts receivable, $30,000. Cash payments of accounts payable, $10,000. On March 1, paid $3,000 cash for rent for March, April, and May. Rent is $1,000 per month.

King Hardware Transactions
Stockholders¶ Assets = Liabilities + Equity

5) Cash Receivable 6) Cash 7) Cash 7a) Prepaid 7b) Expense Totals

+ 30,000 ± 30,000 ± 10,000 ± 3,000 + 3,000 ± 1,000 $144,000



± 1,000 $119,000

Revenues are increases in ownership claims arising from the delivery of goods or services. Revenues must be earned. Revenues must be realized.

Expenses are decreases in ownership claims arising from delivering goods or services or using up assets.

Profits (or earnings or income) are the excess of revenues over expenses.

Income Statement
The income statement measures the performance of an organization by matching its accomplishments (revenue from customers, which is usually called sales) and its efforts (cost of goods sold and other expenses).

Income Statement
Balance Sheet February 28 20 2 Balance Sheet March 31 20 2 Balance Sheet April 30 20 2


Income Statement for March

Income Statement for April


The Analytical Power of the Balance Sheet Equation
The balance sheet equation can highlight the link between the income statement and balance sheet.

Assets (A) = Liabilities (L) + Stockholders¶ equity (SE)

The Analytical Power of the Balance Sheet Equation

A = L + Paid-in capital + Retained income

A = L + Paid-in capital + Revenue ± Expenses

Learning Objective Distinguish between the accrual basis of accounting and the cash basis of accounting.

Accrual Basis versus Cash Basis
The accrual basis of accounting recognizes revenues and expenses when they occur instead of when cash is received or disbursed. The cash basis of accounting recognizes revenue and expense when cash is received and disbursed.

Accrual Basis versus Cash Basis
The accrual basis is the principal conceptual framework for relating accomplishments (revenues) with efforts (expenses). The cash basis fails to match expenses and revenues in a manner that properly measures financial position.

Learning Objective Relate the measurement of expenses to the expiration of assets.


Under the accrual basis of accounting, adjustments are used to record implicit transactions, in contrast to the explicit transactions that trigger nearly all day-today routine entries.  Adjustments are generally prepared by the accountant at month or year end.

Types of Adjustments
Expiration of unexpired costs Recognition (earning) of unearned revenues Accrual of unrecorded expenses Accrual of unrecorded revenues

Accountants usually« predict the residual value. predict the length of the useful life. allocate the cost to the years of its useful life.

Learning Objective Explain the nature of dividends and retained income.

Dividends are distributions of assets to stockholders that reduce retained income. Cash dividends are distributions of assets that liquidate a portion of the ownership claim. The distribution is made possible by profitable operations.

Retained Income
Retained income is a result of profitable operations, it is not a pot of cash awaiting distribution to stockholders. The retained income is, in effect, invested in the assets and liabilities of the entity.

Learning Objective Select relevant items from a set of data and assemble them into a balance sheet, an income statement, and a statement of retained income.

King Hardware Company
Income Statement for the Month Ended April 30, 20x1

Sales Cost of goods sold Gross profit Operating expenses: Rent ¼1,000 Wages 6,600 Net income

¼85,000 70,000 ¼15,000

7,600 ¼ 7,400

King Hardware Company
Statement of Retained Income for the Month Ended April 30, 20x1

Retained income, March 31, 20X1 Add: Net income for April Total Deduct: Dividends Retained income, April 30, 19X1

¼19,000 7,400 26,400 18,000 ¼ 8,400

King Hardware Company
Balance Sheet as of April 30, 20x1

Assets Cash Accounts receivable Inventory Prepaid rent Total assets ¼ 85,000 87,000 20,000 1,000 ¼193,000

King Hardware Company
Balance Sheet as of April 30, 20x1

Liabilities and Stockholders¶ Equity Liabilities Accounts payable ¼ 81,000 Accrued wages payable 600 Unearned sales revenue 3,000 ¼ 84,600 Stockholders¶ equity Paid-in capital ¼100,000 Retained income 8,400 108,400 Total equities ¼193,000

Learning Objective Distinguish between the reporting of corporate owners¶ equity and the reporting of owners¶ equity for partnerships and sole proprietorships.

Sole Proprietorship/ Partnership
A sole proprietorship is a business entity with a single owner. A partnership is an organization that joins two or more individuals together as co-owners.

Comparison of Owners¶ Equity Reporting
Owners¶ Equity for a Corporation Stockholders¶ equity Capital stock (paid-in capital) Retained income Total stockholders¶ equity ¼100,000 8,400 ¼108,400

Comparison of Owners¶ Equity Reporting
Owner¶s Equity for a Sole Proprietorship

Alice Walsh, capital


Comparison of Owners¶ Equity Reporting
Owners¶ Equity for a Partnership Susan Zingler, capital John Martin, capital Total partners¶ equity ¼ 54,200 54,200 ¼108,400

Generally Accepted Accounting Principles (GAAP) Årsregnskabslov (ÅL) International Accounting Standards Committee (IASC)

Accounting is based on a set of principles on which there is general agreement, not on rules that can be ³proved.´


An audit is an examination or in-depth inspection of financial statements and companies¶ records that is made in accordance with generally accepted auditing standards.

Learning Objective Understand how managers and investors can learn about the financial position and prospects of an organization from its financial statements.

Financial Statements
Managers and investors can learn about the financial position and prospects of an organization from its financial statements.
Financial statements describe the financial results of an organization in a consistent way that allows comparison to historical results of the organization and to the results of other organizations.


16-A1 16-A2 16-B1 16-B2 16-B3 16-22 to 16-25 16-27 to 16-33 16-35 to 16-36

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

16 - 42

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