University of Economics and

Human Sciences in Warsaw

INTERNATIONAL
FINANCIAL ACCOUNTING
Lecture II
RAFAŁ KUSY
Ph. D. 1
 Learning objectives
After studying this session you should be able to
1. explain how accountants measure income,
2. determine when a company should record revenue from a
sale,
3. use the concept of matching to record the expenses for a
period,
4. prepare an income statement and show how it is related to a
balance sheet,
5. account for dividends and prepare a statement of retained
earnings,
6. explain how the following assumptions and principles affect
financial statements: entity, monetary unit, time period, going
concern, historical cost, revenues recognition, and matching,
7. explain how accounting regulators trade off relevance and
reliability in setting accounting standards.
 Financial Statements
Questions answered by
The Balance Sheet
• What do we have?

The Income Statement

• How well did the company do in a certain period?
• How did the company's performance change its net assets,
i.e. Owners‟ equity?
 Income
Measuring Income
• Income is a measure of the increase in the
“wealth” of an entity over a period of time.
• Accountants have agreed on a common set of
rules for measuring income and wealth.
• Income is generated primarily through the
operating cycle.
 The Accounting Time Period
Companies measure their performance over
discrete time periods.
The calendar year is the most common time
period for measuring income or profits.
The fiscal year-end date is often the low point
in annual activity when inventories can be
counted more easily.
Companies also prepare financial statements
for interim periods.
 Revenues and Expenses
• Revenues and expenses are the key inflows and
outflows of assets that occur during a busyness's
operating cycle.
• Revenues are the amount of assets received in
exchange for the delivery of goods or services to
customers.
• Expenses are measures of the assets that a
company gives up or consumes in order to
deliver goods or services to a customer
Revenues and Expenses -Examples
Revenues
• Sales revenues
• Service revenues
• Rent revenues
• Interest revenues
Expenses (costs incurred to generate revenues)
• Cost of goods sold
• Personnel expenses
• Energy expenses
• Depreciation expense
The Bottom Line of the Income
Statement

• If revenues exceed expenses in a certain period, it

is called “Net profit”.
• If expenses exceed revenues in a certain period, it
is called “Net loss”.
• Profits or earnings are common synonyms for
income.
• Retained earnings is the total cumulative equity
generated by income.
 Revenues and Expenses -Example
• Sales on open account of January amount to
$200,000. The corresponding cost of the
inventory sold is $ 150,000.
Assets `= Liabilities `+ Owners‟ Equity

Accounts
Receivables Merchandise inventory `= Retained Earnings

Balance Balance
$ 200,000 `= $ 200,000
`+$ 200,000 `= `+$ 200,000
(sales revenues)

`-$ 150,000 `= `-$ 150,000

(cost of goods sold)
 Accrual Basis and Cash Basis

Accrual Basis (Standard for Income Statement)

Record of
• Revenues when earned (goods/services delivered)
• Expenses when incurred regardless of
collection/payment.

Cash Basis (Standard for Statement of Cash Flows)

Record of
• Revenues when collected.
• Expenses when paid.
 Matching
There are two kinds of expenses in every
accounting period:
1. Product costs are those linked with the
revenues earned that period (e.g. Cost of
goods sold)
2. Period costs are those linked with the time
period itself (e.g. Rent expense)
Matching occurs when the expenses incurred in
a period are matched to the revenues
generated in the same period.
Applying Matching-Depreciation
Depreciationis the systematic allocation
of the acquisition cost of long-lived assets
to the periods that benefit from the use of
the assets.
Land is not subject to depreciation because
it does not deteriorate over time.
Application of Matching -Example
• Depreciation of Store Equipment: $ 2,000.

Assets `= Liabilities `+ Owners‟ Equity

Store Equipment `= Retained Earnings

Beginning Balance Balance

$ 20,000 `= $ 20,000

`-$ 2,000 `= `-$ 2,000

(depreciation exp.)
Expanded Balance Sheet Equation
• The income statement collects all the
changes in owners‟ equity for the
accounting period and combines them in
one place.
• Revenue and expense accounts are nothing
more than subdivisions of stockholders‟
equity –temporary stockholders‟ equity
accounts.
Relationship Income Statement and
Balance Sheet
• A balance sheet shows the financial
position of the company at a discrete
point in time.
• An income statement explains the
changes that take place between those
points in time.
 The Income Statement -Example
• Company Income Statement for February
Sales $ 176,000
Deduct expenses
Cost of goods sold $ 110,000
Rent $ 2,000
Depreciation $ 100

Total
expenses $ 112,100

Net income $ 63,900

 Relationship Income Statement
and
Balance Sheet at the
Balance Sheet
Balance Sheet at the
Beginning of the Beginning of the
year 200X year 200X

Assets Liabilities Assets Liabilities

Owner`s Owner`s
equity equity
Difference
+ Owners‟ withdrawals
-Owners‟ new capital contributions
= Profit or loss
MUST be Income Statement for 200X
EQUAL Expenses Revenues
Profit
Transactions Changing Owners‘
Equity
Revenues Expenses
and and
Owners‟
Gains Losses
contributions to
the business

(+) Owner`s equity INCOME

(-)
Paid-in capital
(+) Profit
Retained Earnings
(-) (-) Loss
 Periodic Income vs.Retained
Earnings
Periodic Income
• Revenues minus expenses of a certain accounting
period;

Retained Earnings („Reinvested“ Earnings)

• Additional owners„ equity generated by income minus
dividends since the firm began operations;
• Balance sheet position „Retained Earnings“ consists of:
Dividend Declaration and Payment
• Cash dividends are distributions of income
in the form of cash to the stockholders.
• At the point of declaration it reduces
retained earnings and creates a liability
towards the stockholders.
• On the payment date it reduces cash and the
liability „dividends payable“.
 Dividend Declaration and Payment
-Example
(1) Declaration of dividends $ 10,000.
(2) Cash payment of dividends.
Assets `= Liabilities `+ Owners‟ Equity

Cash `= Dividends payable Retained Earnings

Balance $ 500,000 `= Balance $ 500,000

`(1)
`(2)
 Statement of Retained Earnings
• gives detailed information on the changes in
retained earnings during a certain period.
• consists of
Beginning balance
+/-Periodic net income
-Declaration of dividends

=Ending balance
Statement of Retained Earnings -
Example
INCOME STATEMENT February 200X
Sales $ 176,000
Deduct expenses
Cost of goods sold $ 110,000
Rent $ 2,000
Depreciation $ 100
Total expenses $ 112,100
Net income

STATEMENT OF RETAINED EARNINGS

Retained Earnings, Jan. 31, 200X $ 57,900

`+ Net income February
Total
`-Dividends declared $ 50,000
`= Retained Earnings, Feb. 28, 200X
 Statement of Retained Earnings –
Example
STATEMENT OF RETAINED EARNINGS

Retained Earnings, Jan. 31, 200X

`+ Net income February

Total
`-Dividends declared

`= Retained Earnings, Feb. 28, 200X

Extract from the BALANCE SHEET on Feb. 28, 200X

Stockholders‟ Equity
Paid-in Capital $ 400,000
Retained earnings (after decl. Of dividends)

Total stockholders‟ Equity

 Assumptions and Principles
underlying Financial Reporting
Assumptions
• Entity
• Monetary Unit
• Time Period
• Going Concern
Principles
• Historical Cost
• Revenue Recognition
• Matching
 The Separate Entity Assumption
• An accounting entity is an organization that
stands apart from other organizations and
individuals as a separate economic unit.
• Personal transactions are not recorded by a
business entity (e.g. Payment of the
owners‟ life insurance).
The Monetary Unit Assumption
• Only items that can be expressed in
monetary units (PLN, $, ...) are included in
the financial statements.
 The Time-Period Assumption
• The life of a business can be divided into
artificial time periods for financial
reporting.
• These periods are presented at the top of
each financial statement
The Going-Concern Assumption
Is the assumption that the company will
remain in business for the foreseeable
future.
For a going concern, it is reasonable to
– Use historical cost to record long-lived assets.
– Report liabilities at the amount to be paid at maturity.
 The Historical Cost Principle
Assets are recorded on the balance sheet at
cost.
Cost includes all costs necessary to get the
asset ready for its intended purpose.
The Revenue Recognition Principle
• Revenues are recorded on the income
statement
–when they are earned and
–the amount is reasonably assured.
 The Matching Principle
• Expenses are recorded on the income
statement in the same time period as
the revenues they helped generate.
 The Quality of Accounting
Information

Information is only good if it is

• Relevant
• Reliable
• Comparable
• Consistent.