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Hult International Business School - Dubai

Accounting
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Accounting
Handout 1 – Introduction, Transaction
Recognition, Accounts, Financial Statements
October - November 2013
Introduction to Accounting
Accounting is (generally) made out to be a complex
subject … however the essence of accounting is
simple. Accountant’s job is quite simple … to keep
track of:
• Assets, and
• Equities (i.e. equity in the assets).
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• Equities (i.e. equity in the assets).
Assets – Definition
• Something that is needed in order to run a/the
business, provides a benefit to the business (now
and in the future).
• Something that is owned by the business.
• Business (not necessarily owns 100% of the asset) has
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• Business (not necessarily owns 100% of the asset) has
legal title to the asset.
• Examples of Assets:
• Production equipment;
• Office buildings;
• Most office building are never purchased in whole by the owner
(there is usually a mortgage on a building).
• Supplies and office equipment.
Equity – Definition
• Represents ownership in the assets.
• In case of a building … it would be the down-payment;
• Title holder now has an equity interest in the building.
• Most likely the rest of the purchase price would be
financed by a lender.
• The lender has an interest / claim on asset.
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• The lender has an interest / claim on asset.
Owner(s) Assets
Contribution of Assets (I)
A business is a collection (a basket) of assets (otherwise it does not
exist.
• Assets can be contributed into the business by the owner(s).
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• In order to start the business, the owner may make a contribution to the business of
items like: cash; production equipment; buildings, office equipment, etc.
• A contribution needs to be accounted for / recorded as a business transaction.
Owner(s) Assets Lender(s)
Contribution of Assets (II)
There is another way for a company to get assets ...
• Assets can be also be contributed into the business by a lender /
creditor.
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• An obvious example is a loan arranged by the company.
• The bank provides cash to the business, whereas the owner signs a “note”
promising to repay the loan (with interest) at some point in the future.
• Also, equipment (or a building) may be purchased with a potion of it financed by a bank
loan.
Recording Transaction (I)
Once transactions have been recorded ... a report can be prepared
which will list:
• What assets are held by the business.
• Who has interest in / claim on the assets.
Assets must be owned by someone: either creditors or owners.
• Whatever is the value of the assets ... must be equal to the sum total of the
claims of creditors and owners.
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claims of creditors and owners.
Owner(s) Assets Lender(s)
Accounting Fundamental Equation
All assets must be owned by either lenders of shareholders.
Owner(s) Assets Lender(s)
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+ Assets Liabilities Shareholder Equity =
Recording Transaction (II)
A transaction is an event that makes a change to:
• Assets;
• Liabilities;
• Shareholder’s Equity
Every transaction must be recorded (how ?)
Let’s start with a table below where each asset, liability and equity has a
column (i.e. An account) in which changes are recorded.
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column (i.e. An account) in which changes are recorded.
= +
Shareholder's
Equity
Cash A/R
Office
Supplies
PPE
Computer
Workstation
= A/P Debt +
John Doe
Capital
Liabilities Assets
Transactions (I)
Transaction impacting Shareholder’s Equity:
1. Shareholder (Winston Wolfe) starts a consulting business by contributing
$20,000 of cash and $1,000 office supplies to the business;
2. WW contributes his workstation computer (worth $2,000) to the business;
3. WW performs a service job for a Customer A and receives $500 from him.
4. WW performs another service job for a Customer B and is promised to be paid
$700 in the near future (no payment received yet).
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= +
Shareholder's
Equity
Cash A/R
Office
Supplies
PPE
Computer
Workstation
= A/P Debt +
Winston Wolfe
Capital
Transaction 1 +20,000 +1,000 +21,000
Transaction 2 +2,000 +2,000
Transaction 3 +500 +500
Transaction 4 +700 +700
Balance 20,500 700 1,000 2,000 = 0 0 + 24,200
Liabilities Assets
Revenue Recognition
Under Generally Accepted Accounting Principals (GAAP) and under
International Financial Reporting Standards (IFRS) ... rules of
“accrual accounting” must be followed.
1. Revenues are to be recognized (recorded) when they have been earned;
2. It does not matter whether cash for services performed or goods delivered has
been received yet or not.
3. Revenues are to be recognized the moment invoice is issued;
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Shareholder’s Equity in Detail
Shareholder’s Equity is affected by:
1. Capital investments made into the business (recorded in Common Stock
account);
• In case of a small business (sole proprietorship) called Capital account;
2. Capital withdrawals made from the business (recorded in Dividends account);
• In case of a small business (sole proprietorship) called Drawing account;
3. Business revenues; recorded in Revenue account(s);
4. Business expenses; recorded in Expense account(s);
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4. Business expenses; recorded in Expense account(s);
Dividends Common Stock Expense(s) Revenue(s)
+21,000
+2,000
+500
+700
0 23,000 0 1,200
Shareholder's Equity
Transactions (II)
Transaction impacting Shareholder’s Equity:
5. Shareholder (Winston Wolfe) takes $3,000 out of the business to use for home
improvement work around his house.
6. WW pays the $200 monthly business internet bill.
• This is for the past month’s internet usage; not any future usage.
• It is an expense incurred and not a prepayment for future usage (asset).
7. WW receives a $250 council tax bill for the month just ended and is payable in
two weeks time (no payment made yet).
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two weeks time (no payment made yet).
8. $300 of office supplies are used up (portion of an asset has become an expense).
= +
Shareholder's
Equity
Cash A/R
Office
Supplies
PPE
Computer
Workstation
= A/P Debt +
Winston Wolfe
Capital
Balance 20,500 700 1,000 2,000 = 0 0 + 24,200
Transaction 5 -3,000 -3,000
Transaction 6 -200 -200
Transaction 7 +250 -250
Transaction 8 -300 -300
Balance 17,300 700 700 2,000 = 250 0 + 20,450
Liabilities Assets
Expense Recognition
Under Generally Accepted Accounting Principals (GAAP) and under
International Financial Reporting Standards (IFRS) ... rules of
“accrual accounting” must be followed.
1. Expenses are to be recognized (recorded) when they have been incurred;
2. It does not matter whether cash for services received or goods delivered has
been made yet or not.
3. Expenses are to be recognized the moment invoice is received;
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Transactions (III)
Transaction impacting Assets only:
9. WW purchases office supplies for $1,500 of company cash.
10. WW sells $200 worth of office supplies to another party.
• These office supplies originally cost $200.
11. WW collects $500 worth of A/R balance from the transaction when services
were performed on account.
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= +
Shareholder's
Equity
Cash A/R
Office
Supplies
PPE
Computer
Workstation
= A/P Debt +
Winston Wolfe
Capital
Balance 17,300 700 700 2,000 = 250 0 + 20,450
Transaction 9 -1,500 +1,500
Transaction 10 +200 -200
Transaction 11 +500 -500
Balance 16,500 200 2000 2,000 = 250 0 + 20,450
Liabilities Assets
Transactions (IV)
Transaction impacting Liabilities:
12. WW purchases another computer workstation for $2,000 and agrees to pay at
a later date (on account).
13. $3,000 is borrowed from a bank.
• WW (as a director of the company) signed a “promissory note” to repay the debt at a later
date.
• Interest will be charged on this loan as long as it is outstanding.
14. WW pays off the council tax bill received earlier.
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14. WW pays off the council tax bill received earlier.
= +
Shareholder's
Equity
Cash A/R
Office
Supplies
PPE
Computer
Workstation
= A/P Debt +
Winston Wolfe
Capital
Balance 16,500 200 2000 2,000 = 250 0 + 20,450
Transaction 12 +2,000 +2,000
Transaction 13 +3,000 +3,000
Transaction 14 -250 -250
Balance 19,250 200 2000 4,000 = 2000 3000 + 20,450
Liabilities Assets
Transactions Summary (I)
Balance of Assets = $25,450;
Balance of Liabilities and shareholder’s Equity = $25,450;
= +
Shareholder's
Equity
Cash A/R
Office
Supplies
PPE
Computer
Workstation
= A/P Debt +
Winston Wolfe
Capital
Transaction 1 +20,000 +1,000 +21,000
Transaction 2 +2,000 +2,000
Transaction 3 +500 +500
Liabilities Assets
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Transaction 3 +500 +500
Transaction 4 +700 +700
Transaction 5 -3,000 -3,000
Transaction 6 -200 -200
Transaction 7 +250 -250
Transaction 8 -300 -300
Transaction 9 -1,500 +1,500
Transaction 10 +200 -200
Transaction 11 +500 -500
Transaction 12 +2,000 +2,000
Transaction 13 +3,000 +3,000
Transaction 14 -250 -250
Balance 19,250 200 2000 4,000 = 2000 3000 + 20,450
Transactions Summary (II)
Sum total of individual balances in each of Shareholder’s Equity
accounts = $20,450;
Shareholder's
Equity
Winston Wolfe
Capital
Dividends Common Stock Expense(s) Revenue(s)
+21,000 Transaction 1 +21,000
+2,000 Transaction 2 +2,000
+500 Transaction 3 +500
Shareholder's Equity
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+500 Transaction 3 +500
+700 Transaction 4 +700
-3,000 Transaction 5 -3,000
-200 Transaction 6 -200
-250 Transaction 7 -250
-300 Transaction 8 -300
Transaction 9
Transaction 10
Transaction 11
Transaction 12
Transaction 13
Transaction 14
20,450 Balance -3,000 23,000 -750 1,200
Financial Reporting
At the end of an accounting period, financial information needs to be
reported to interested parties.
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Three standard financial reports are constructed:
1. The Balance Sheet (Statement of Financial Position) reports balances of
Assets, Liabilities and Shareholder’s Equity accounts.
2. Income Statement presents a summary of revenues and expenses recorded in
the Shareholder’s Equity Account in order to determine the profit earned by the
business.
3. Statement of changes in Shareholder’s Equity summarizes the evolution of all
Shareholder’s Equity accounts.
Balance Sheet
At the end of an accounting period, financial information needs to be
reported to interested parties.
Assets Liabilities
Cash 19,250 A/P 2000
Winston Wolfe Services Inc.
Balance Sheet ($s)
December 31, 20X5
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Cash 19,250 A/P 2000
A/R 200 Debt 3000
Office Supplies 200 Total Liabilities 5,000
PPE 0
Computer Workstation 4,000 Shareholder's Equity
Total Assets 25,450 Winston Wolfe Capital 20,450
Total Liabilities
& Shareholder's
Equity
25,450
Income Statement
At the end of an accounting period, financial information needs to be
reported to interested parties.
Revenue(s)
Consulting Service Revenues 1,200
Winston Wolfe Services Inc.
Income Statement ($s)
For the year ended December 31, 20X5
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Consulting Service Revenues 1,200
Expense(s)
Internet Expense -200
Council Tax Expense -250
Supplies Expense -300
Total Expenses -750
Net Income 450
Statement of Shareholder’s Equity (I)
At the end of an accounting period, financial information needs to be
reported to interested parties.
For the year ended December 31, 20X5
Statement of Changes in Shareholder's Equity ($s)
Winston Wolfe Services Inc.
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Winston Wolfe Capital, December 31, 20X4 0
Add: Stock Issuance 23,000
Add: Net Income 450
Total 23,450
Subtract: Payment of Dividends -3,000
Increase in Shareholder's Equity 20,450
Winston Wolfe Capital, December 31, 20X5 20,450
Retained Earnings (I)
Retained earnings is the portion of corporation’s Net Income that is
kept / “retained” by the corporation as opposed to distributed to
shareholders in the form of dividends.
• If a corporation produces a net loss for the period, then this loss decreases the
corporation's retained earnings balance.
• If the balance of the retained earnings account is negative it may be called
retained losses, accumulated losses or accumulated deficit.
• Retained earnings and losses accumulate from one year to the next.
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• Retained earnings are reported as part of the shareholder’s equity section of
the corporation's balance sheet.
• Net accumulated losses may lead to negative shareholders' equity, also known
as shareholders' deficit.
Statement of Shareholder’s Equity (II)
Since
Net Income – Dividends = Retained Earnings
It is more common to see the following.
For the year ended December 31, 20X5
Winston Wolfe Services Inc.
Statement of Changes in Shareholder's Equity ($s)
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Winston Wolfe Capital, December 31, 20X4 0
Add: Stock Issuance 23,000
Add: Retained Earnings -2,550
Total 20,450
Winston Wolfe Capital, December 31, 20X5 20,450
The Accounts (I)
Using a table (below) is not practical, nor is it even feasible for large
businesses that have to record thousands of transactions in
thousands of accounts every day.
= +
Shareholder's
Equity
Cash A/R
Office
Supplies
PPE
Computer
Workstation
= A/P Debt +
John Doe
Capital
Liabilities Assets
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New concepts will help:
• Instead of using one sheet of paper for all
the accounts, a single sheet of paper will
be used for each account;
• A stack of these papers (accounts) is called
a General Ledger.
The Accounts (II)
Once accounts have been separated, they are further subdivided into
two sides.
• Increases in each account are recorded on one side, whereas the
decreases are recorded on the other side.
• Each side can now be added up, sub-totalled separately;
• Increases and decreases can then be netted out in order to determine
the balance in each account.
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the balance in each account.
Example of a T account for Cash:
• $33.8K subtotal on the Left hand side;
• $7.5K subtotal on the Right hand side;
• $26.3K balance on the Left hand side;