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Lesson I

An Introduction to Accounting

Accounting is a glorious but misunderstood field. The popular view is that it’s mostly mind-numbing

Number-crunching; it certainly has some of that, but it’s also a rich intellectual pursuit with an
abundance

Of compelling and controversial issues. Accountants are often stereotyped as soulless drones laboring

Listlessly in the bowels of corporate bureaucracies. But many accountants will tell you that it’s people

Skills, not technical knowledge, that are crucial to their success. And although it’s often thought of as a

Discipline of pinpoint exactitude with rigid rules, in practice accountants rely heavily on best estimates

And educated guesses that require careful judgment and strong imagination.

Actually, stereotyping accounting and accountants, either positively or negatively, is useless because
accounting involve so many different activities. The short-but-sweet description of accounting is “the
language of business.” A more formal definition is offered by The American Accounting Association. “The
process of identifying, measuring and communicating economic information to permit informed
judgments and decisions by the information.” However, defined, accounting plays a vital role in
facilitating all form of economic activity in the private, public and non-profit sectors, in endeavours
ranging from coal mining to Community Theatre to municipal finance.

HISTORY OF ACCOUNTING

The name that looms largest in early accounting is Luca Pacioli, who in 1494 first described the system of

double-entry bookkeeping used by Venetian merchants in his Summa de Arithmetica, Geometria,

Proportion et Proportionalita, OF course, business and governments had been recording business

information long before the Venetians. But it was Pacioli who the first to describe the system of debits

and credits in journals and ledgers is still the basis of today’s accounting systems.
The industrial revolution spurred the need for more advanced cost accounting systems, and the

development of corporations created much larger classes of external capital providers-shareowners and

bondholders- who were not part of the firm’s management but had a vital interest in its result. The
rising

public status of accountants helped to transform accounting into a profession, first in the United
Kingdom

and then in the United States. In 1887, thirty-one accountants joined together to create the American

Association of Public Accountants. The first standardized test for accountants was given a decade later,

and the first CPAs were licensed in 1896.

The Great Depression led to the creation of the Securities and Exchange Commission (SEC) in 1934.

Henceforth all publicly-traded companies had to file periodic report with the Commission to be certified

by members of the accounting profession. The American Institute of Certified Public Accountants
(AICPA)

and its predecessors had responsibility for setting accounting standards until 1973, when the Financial

Accounting Standards Board (FASB) was established. The industry thrived in the late 20th century, as the

large accounting firms expanded their services beyond the traditional auditing function to many forms
of

consulting.

The Enron scandals in 2001, however, had broad repercussions for the accounting industry. One of the

top firms, Arthur Andersen, went out of business and, under the Sarbanes-Oxley Act, accountants faced

tougher restrictions on their consulting engagements. One of the paradoxes of the profession, however,

is that accounting scandals generate more work for accountants, and demand for their services
continued

to boom throughout the early part of the 21st century.

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BRANCHES OF ACCOUNTING

Accounting can be divided into several areas of activity. These can certainly overlap and they are often

closely intertwined. But it’s still useful to distinguish them, not least because accounting professionals

tend to organize themselves around these various specialties.

Financial Accounting

Financial accounting is the periodic reporting of a company’s financial position and the results of

operations to external parties through financial statements, which ordinarily include the balance sheet

(statement of financial condition), income statement (the profit and loss statement, or P&L), and

statement of cash flows. A statement of changes in owner’s equity is also often prepared. Financial

statements are relied upon by suppliers of capital- eg., shareholder, bondholders and banks- as well as

customers, suppliers, government agencies and policymakers.

There’s little use in issuing financial statements if each company makes up its own rules about what and

how to report. When preparing statements, American companies use U.S. Generally Accepted
Accounting

Principles, or U.S. GAAP. The primary source of GAAP is the rules published by the FASB and its

predecessors, but GAAP also derives from the work done by the SEC and the AICPA, as well standard

industry practices.

Management Accounting

Where financial accounting focuses on external users, management accounting emphasizes the

preparation and analysis of accounting information within the organization. According to the Institute of

Management Accountants, it includes “designing and evaluating business process, budgeting and

forecasting, implementing and monitoring internal controls, and analyzing, synthesizing and aggregating

information, to help drive economic value.”

A primary concern of management accounting is the allocation of costs; indeed, much of what now is

considered management accounting used to be called cost accounting. Although a seemingly mundane

pursuit, how to measure cost is critical, difficult and controversial. In recent years, management

accountants have developed new approaches like activity-based costing (ABC) and target costing, but
they
continue to debate how best to provide and use cost information for management decision-making.

Auditing

Auditing is the examination and verification of company accounts and the firm’s system of internal
control.

There is both external and internal auditing. External auditors are independent firms that inspect the

accounts of an entity and render an opinion on whether its statements conform to GAAP and present

fairly the financial position of the company and the results of operations. In the U.S., four huge firm
known

as the Big Four Pricewaterhouse Coopers, Deloitte Touche Tomatsu, Ernst & Young, and KPMG.
Dominate

the auditing of large corporations and institutions. The group was traditionally known as the Big Eight,

contracted to a Big Five through mergers and was reduced to its present number in 2002 with the

meltdown of Arthur Andersen in the wake of the scandals.

The external auditor’s primary obligation is to users of financial statements outside the organization.
The

internal auditor’s primary responsibility is to company management. According to the Internal Auditors

(IIA), the internal auditor evaluates the risks the organization faces with respect to governance,
operation

and information systems. Its mandate is to ensure (a) effective and efficient operations; (b) the reliability

and integrity of financial and operation information; (c) safeguarding of assets; and (d) compliance with

laws, regulations and contracts.

Tax Accounting

Financial accounting is determinate by rules that seek to best portray the financial position and result of

an entity. Tax accounting, in contrast, is based on laws enacted through a highly political legislative

process. In the U.S., tax accounting involves the application of Internal Revenue Service rules at the

Federal level and state and city law for the payment of taxes at the local level. Tax accountants help

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entities minimize their tax payments. Within the corporation, they will also assist financial accountants

with determining the accounting for income taxes for financial reporting purposes.

Fund Accounting

Fund accounting is used for nonprofit entities, including governments and not-for-profit corporations.

Rather than seek to make a profit, governments and nonprofits deploy resources to achieve objectives.
It

is standard practice to distinguish between a general fund and special purpose funds. The general fund
is

used for day-to-day operations, like paying employees or buying supplies. Special funds are established

for specific activities like building a new wing of a hospital.

Segregating resource this way helps the nonprofit maintain control of its resources and measure its

success in achieving its various missions. The accounting rules for federal agencies are determined by
the

Federal Accounting Standards Advisory Board, while at the state and local level the Governmental

Accounting Standards Board (GASB) has authority.

THE BASICS

The Difference Between Accounting and Bookkeeping

Bookkeeping is an unglamorous but essential part of accounting. It is the recording of all the economic

activity of an organization-sales made, bills paid, capital received-as individual transactions and

summarizing them periodically (annually, quarterly, even daily). Except in the smallest organizations,

these transactions are now recorded electronically; but before computers they were recorded in actual

books, thus bookkeeping.

The accountants design the accounting systems the bookkeepers use. They establish the internal
controls

to protect resources, apply the principles of standards-setting organizations to the accounting records
and

prepare the financial statements, management reports and tax returns based on that data. The auditors
that verify the accounting records and express an opinion on financial statements are also accountants,

as are management, tax and forensic accounting specialists.

Double-Entry Bookkeeping

The economic events of a business are recorded as transactions and applied to the account (hence

accounting). For example, the cash account tracks the amounting of cash on hand, the sales account

records sales made. The chart of accounts of even small companies has hundreds of accounts; large

companies have thousands.

The transactions are posted in journals, which were (and for some small organizations, still are) actual

books; now a days, of course, the journals are typically part of the accounting software. Each transaction

includes the date, the amount and a description.

For example, suppose you have a stationery store. On April 19, a saleswoman for an antiques company

visits you, and you buy a lamp for your office for P250. A journal entry to record the transaction as a
debit

to the Office Furniture account and a P250 credit to Account Payable could be written as follows (Dr. is

the abbreviation for debit, while Cr. Is for credit):

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Date Account Dr. Cr.

April 19 Office

Furniture

250
Accounts

Payable

250

(Bought antique lamp; voucher #0016)

Each accounting transaction affects a minimum of two accounts; and there must be at least one debit
one

credit.

Keeping Good Accounting Records

Even a seemingly simple transaction like this one raises a host of accounting issues.

Date: Suppose you had already agreed by phone to buy the lamp on April 15, but the paperwork wasn’t

done until April 19. And the lamp wasn’t delivered on the 19th

, but the 23rd. Or even as you bought it, you

were thinking that you didn’t like it that much, and there’s a strong chance you’ll return it by the 30th

when the sale becomes final. On which date- 15th, 19th, 23th, or 30th

- did an economic event occur for

which a transaction should be recorded?

Amount: The sales price is P250, but you get a 10% discount (to P225) if you pay in 30 days: business is

bad, though, so you may need the full 90 days to pay. Similarly, however, you know the antique business

is also lousy; even though you agreed to pay P250, you can probably chisel another P50 off the price if
you

threaten to return it. On the other hand, being in the stationery business, you know one of your
customers
has been looking for lamp like that for a long time; he told you in February he’d pay P300 for one.

So what amounts should you record on April 19 (if indeed you record a transaction on that date)? P250
or

P225 or P200 or P300?

Accounts: You’ve debited the Office Furniture account. But actually, you buy and sell antiques frequently

to your customers, and you’re always ready to sell the lamp if you get a good offer. Instead of an Office

Furniture account used for fixed assets, should the lamp be recorded in a Purchases account you use for

inventory? And if this was a big company, there might be dozens of office furniture sub-accounts to
choose

from.

Accounts rely on various resource to answer such questions. There are basic, time-honored accounting

conventions: standards set forth by various rules-making bodies long-standing industry practices and,

most important, their own judgment honed through years of experience.

But the important point is that even the most basic accounting questions-when did an economic event

take place? What is the value of the transaction? Can get very complex and the right answers prove very

elusive. There’s no excuse for out-and-out misrepresentation of company results and sloppy auditing
that

certainly occurs. But the seeming precision of financial statements, no matter how conscientiously

prepared, is belied by the uncertainty and ambiguity of the business activities they seek to represent.

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Debits and Credits

We’re accustomed to thinking of a “credit” as something “good”-our account is credited when we get a

refund; you get “extra credit” for being polite. Meanwhile, a “debit” is something negative-a debit
reduces
our bank balance; it’s used to mean shortcoming or disadvantage.

In accounting, debt means one thing: left-hand side. Credit means one thing: right-hand side. When you

receive cash-a “good” thing- you increase the Cash account by debiting it. When you see cash- a “bad”

thing- you decrease Cash by crediting it. On the other hand, when you make a sale, which is nice, you

credit the Sales account; when someone returns what you sold, which is not nice, you debit sales.

“Good” and “bad” have nothing to do with debit and credit.

Debit = Left; Credit = Right.

That’s it. Period

Accrual vs. Cash Basic Accounting

As we’ve seen, deciding when an economic event occurs and an accounting transaction should be

recorded is a matter of judgment. Accrual accounting looks to the economic reality of the business
rather

than the actual inflows and outflows of cash.

Although cash basis statements are simpler and make good sense for many individual taxpayers and
small

businesses, it results in misleading financial statements. Consider a Halloween costume maker: it

conceives, produces and sells costumes throughout the year, but gets paid for its customer mostly in

October. If sales were recognized only when cash was received, October would show an enormous profit

while all other months would show losses. Accrual accounting seeks to match the revenues earned
during

a period with the expenses incurred to generate them, regardless of when cash comes in or goes out

THE ACCOUTING PROCESS

As implied earlier, today’s electronic accounting systems tend to obscure the traditional forms of the

accounting cycle. Nevertheless, the same basic process that bookkeepers and accountants used to

perform by hand are present in today’s accounting software. Here are the steps in the accounting

cycle.

(1) Identify the transaction from source documents, like purchase orders, loan agreements,

invoices, etc.

(2) Record the transaction as a jurnal entry (see the Double-Entry Bookkeeping Section above)

(3) Post the entry in the individual accounts in legers. Traditionally, the accounts have been
represented as Ts, or so-called T-accounts, with debits on the left and credits on the right

Office Furniture Account Payable

4/19 250 4/19 250

(4) At the end of the reporting period (usually the end of the month), create a preliminary trial

balance of all the accounts by (a) netting all the debits and credits in each account to calculate

their balances and (b) totaling all the left-side (i.e., debit balances and right-side (i.e., credit)

balances. The two columns should be equal.

(5) Make additional adjusting entries that are not generated through specific source documents. For

example, depreciation expense is periodically recorded for items like equipment to account for

the use of the assets and the loss of its value over time.

(6) Create an adjusted trial balance of the accounts. Once again, the left-side and right-side entries-

i.e. debits and credits-must total to the same account.

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(7) Combine the sum in the various accounts and present them in financial statements created for

both internal and external use.

(8) Close the books for the current month by recording the necessary reversing entries to start fresh

in the new period (usually the next month)

Nearly all companies create end-of year financial reports, and a new set of books is begun each year.

Depending on the nature of the company and its size, financial reports can be prepared at much more

frequent (even daily) intervals. The SEC requires public companies to file financial reports on both a

quarterly and yearly basis.

THE FINANCIAL STATEMENTS

Financial statement presents the results of operations and the financial position of the company. Four

statements are commonly prepared by publicly-traded companies: balance sheet, income statement,
cash

flow statement and statement of changes in equity.

Balance sheet (Statement of Financial Position)

The balance sheet tells you whether the company can pay its bill on time, its financial flexibility

to acquire capital and its ability to distribute cash in the form of dividends to the company’s

owners.

The top of the balance sheet has three items: (1) the legal name of the entity; (2) the title (i.e., balance

sheet or statement of financial positon); and (3) the date of the statement.

Importantly, the financial position presented is always for the entity itself, not its owners. And the
balance

sheet is always for a specific point in time: instead of just a date of, say, December 31, 20XX, it would be

more accurate to write December 31, 20XX, 11:59:59 or any particular moment on the 31st

The balance sheet itself presents the company’sassets, liabilities and shareholder’s equity.

Each is defined in Statement of Financial Accounting Concepts No. 6, but to oversimplify:

 Assets are items that provide probable future economic benefits

 Liabilities are obligations of the firm that will be settled by using assets

 Equity (variously called stockholders equity, shareowners equity or owners’ equity) is the residual

interest that remains after you subtract liabilities from assets

Hence the key accounting equation:

Assets = Liabilities + Owner Equity, or A = L + OE

In the most common format, known as the account form, the assets in a balances sheet are listed on the

left; they ordinarily have debit balances. Liabilities and owners’ equity are on the right, and typically
have

credit balance. These three main categories are separated and further dividend to show important

relationship and subtotals.

Assets are broken down into current and noncurrent (or long-term). Assets are listed from top to
bottom

in order of decreasing liquidity, i.e., how fast they can be converted to cash.

Current assets are cash and other assets that are expected to be used during the normal operating cycle

of the business, usually one year. They typically include cash and cash equivalents, short-term

investments, accounts receivables, inventory and prepaid expenses. Noncurrent assets will not be
realized

in full within one year. They typically include long-term investments: property, plant and equipment;

intangible assets and other assets.

Liabilities are listed in order of expected payment. Obligations expected to be satisfied within one year

are current liabilities. They include accounts payable, trade notes payable, advances and deposits,
current

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portion of long-term debt and accrued expenses. Noncurrent liabilities include bonds payable and other

forms of long-term capital.

The structure of the owners’ equity section depends on whether the entity is an individual, a partnership

or a corporation. Assuming it’s a corporation, the section will include capital stock, additional paid-in

capital, retained earnings, accumulated other comprehensive income and treasury stock.

Balance sheet data can be used to compute key indicators that reveal the company’s financial structure

and its ability to meet its obligations. These include working capital, current ratio, quick ration debt-
equity

ratio and debt-to-capital ratio.

Income Statement

The income statement (also known as the profit and loss statement or P&L) tells you both the earnings

and profitability of a business. The P&L is always for a specific period of time, such as a month, a quarter
or a year. Because a company’s operations are ongoing, from a business perspective these cut-offs are

arbitrary, and they result in many of the problems in income measurement. Nevertheless, periodic
income

statements are essential, because they allow users to compare results for the company over time and to

the result of other firms for the same period. Depending on the industry, year over year comparisons
that

eliminate seasonal variables may be especially useful.

Dr. Cr.

Asset (Cash, A/R) 100

Owners’ Equity (Sales) 100

The recording of P100 in expense for cost of goods sold (CGS), supplies, depreciation, insurances, etc.

decreases assets and owners’ equity.

Dr. Cr.

Owners’ Equity (CGS, supplies,

etc.

100

Assets (Cash, Inventory,

Equipment)

100
Of course, accounting is vastly more complicated than this representation, and debits and credits are

recorded under many rules and treatments for many accounts. But ultimately, if all the credits to OE

during a period are greater than the debits, you have net income and OE (in the form of retained
earnings)

increases; if there are more debits than credits you have a net loss and OE decreases.

The format of the income statement has been determined by a series of accounting pronouncements;

some of these are decades old, others released in the past few years.

Like the balance sheet, the income statement is broken into several parts:

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 Income from continuing operations

 Results from discontinued operation (if any)

 Extraordinary items (if any)

 Cumulative effect of a change in accounting principle (if any)

 Net income

 Other comprehensive income

 Earnings per share information

Income from continuing operations is the heart of the P&L. It includes sales (or revenue), cost of goods

sold, operating expenses, gains and losses, other revenue and expense items that are unusual or

infrequent but not both, and income tax expense.

This section of the income statement is used to compute the key profitability ratios of gross margin,

operating margin, and pretax margin that help readers assess the ability of the company to generate

income from its activities. Results from continuing operations are of primary interest because they

are going and can be predictive of future earnings; investors put less weight on discontinued
operations (which are about the past) and extraordinary items (unusual and infrequent, thus unlikely

to reoccur). Companies thus have an incentive to push negative items that belong in continuing

operations into other categories.

Net income is the “bottom line”, it is expressed both on an actual and, after comprehensive income,

on a per share basis. If a company has hybrid securities, like convertible bonds, there is the potential

for additional shares to be created and earnings to be diluted. Earnings per share may therefore be

presented on basic and diluted bases, in accordance with the complex rules of FAS 128.

Statement of Changes in Owner’s Equity

A separate Statement of Changes in Stockholders’ (or Owners) Equity is also prepared that reconciles

the various components of OE on the balance sheet for the start of the period with the same items at

the end of the period. The statement recognizes the primary of OE for investors and other readers of

financial statements.

Statement of Cash Flows

The cash flow statement tells you the sources and uses of cash during the period (in fact, the term

“sources and uses statement” is a synonym). It also provides information about the company’s

investing and financing activities during the period.

Under accrual accounting and the matching principle, accountants seek to record economic events

regardless of when cash is actually received or used, with a view toward matching the revenues for

the period with the costs incurred to generate them. But in addition to financial statements that

include accounting entries that are theoretical in nature, users are vitally interested in the actual cash

received and disbursed during the period. In fact, depending on the company and the user, the cash

flow statement may be of prime importance. Like the income statement, the statement of cash flows

is always for some period of time.

The format of a cash flow statement is typically:

 Net cash flow from operating activities (sales, inventories, rent, insurance, etc.)

 Cash flow from investing activities (e.g. buying and selling equipment)

 Cash flow from financing activities (e.g. selling common stock, paying off long-term debt
 Exchange rate impact

 Net increase (decrease) in cash

 Cash and equivalents at start of period

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 Cash and equivalent at end of period

 Schedule of non-cash financing and investing activities (e.g. conversion of bonds)

There are two methods for preparing the cash flow statement, direct and indirect. Using the direct

method, the accountant shows the items that affected cash flow, such as cash collected from customers,

interest received, cash paid to suppliers, etc. The indirect method adjust net income for any revenue
and

expense item that did not result from a cash transaction. Under FAS95, the direct method is preferred,

although the indirect method- the more traditional approach favored by preparers and less costly to

prepare- is still widely used.

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FINANCIAL REPORTING

Generally Accepted Accounting principle (GAAP)

A key prerequisite for meaningful statements is that they be comparable to those for other companies,

especially firms within the same industry. To meet that requirement, statements are prepared in

accordance with Generally Accepted Accounting Principles (or, more commonly, GAAP), which

“encompasses the conventions, rules and procedures, necessary to define accepted accounting practice

at a particular time.”

In the wake of the cash of 1929, the first serious attempt to codify GAAP was made by the AICPA (then
the American Institute of Accountants) working with the New York Stock Exchange, which culminated in

the creation of a Committee on Accounting Procedure. The Committee’s resources were limited and in

1959 the Accounting Principles Board (APB) was established within the AICPA to take over the rule-
making

function. The APB was superseded in 1972 by the Financial Accounting Standards Board (FASB), an

independent, not-for-profit organization with a governing board of seven members-three from public

accounting, two from private industry, one from academia and one from an oversight body.

Current GAAP in the U.S. (or U.S. GAAP) includes rules from the FASB and these predecessors. Over
time,

standards are eliminated and amended as business conditions change and new research performed.

Although in the U.S. the SEC has delegated the function of accounting rule-making to FASB, it is not the

only source of GAAP. Research from the AICPA, best industry practices as defined by research and

traditions, and the activities of the SEC itself all play a role in defining GAAP.

Further, within the FASB and AICPA themselves, there are various source of GAAP.

These include statements (of primary importance), interpretations, staff positions, statements of
position,

accounting guides, and so forth. Naturally, with so much documentation for GAAP, contradictions ensue.

To eliminate the uncertainties, in 2008 the FASB issued FAS 162 to clarify the hierarchy in deciding which

source of GAAP takes precedence over another.

According is how business keeps score, and business is no different than football when it comes to
setting

the rules of the game. Many accounting standards are firmly established, other continue to be debated

vigorously among the players and a few are so highly controversial they get even people on the sidelines

riled up. One example from the 2008 financial crisis is mark-to-market accounting, on which
accountants,

presidential candidates and pundits alike weighed in. Accounting standards setting then becomes part of

the political process, and depending on the strength and commitment of the various forces, the rules
are

eliminated, amended or left alone.

Disclosure
One seemingly technical element in accounting standards that is of huge importance is disclosure. In any

document, where you put information-in a screaming headline, or the 53rd footnote in Appendix Q- has
a

great deal to do with which readers view its relative importance. Financial statements are no different.

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Besides the actual numbers on the balance sheet, P&L and statement of cash flows, a great deal of

information is also provided in the notes to the financial statements. Some key financial formation is put

directly into the financial statements in parentheses (e.g. on the balance sheet and the number of
shares

authorized and issued for common stock). Notes contain information that should receive this favorable

treatment but because the information may be considerable and include tables, it is included as a
footnote

instead.

The admonition to readers that “the accompanying notes are an integral part of these statements”
alerts

them to the notes’ importance. But since they are at the bottom-and because they are often numerous,

lengthy and, at times, impenetrable-more casual users ignore them.

What’s included in the notes? There’s information on securities held, inventories, debt, pension plans
and

other key elements in determining the company’s financial position. In addition, the notes will contain

information about the company’s accounting policies. Under GAAP, companies often do have discretion

to use varying method for valuing assets, and recognizing costs and revenue. This “Summary of
Significant

Accounting Policies” will appear as the first note to the statement or in a separate section.

There are other required external to the financial statements and notes, such as the Management
Discussion and Analysis (MD&A), required by the SEC. In all, the list of required disclosures is long,
detailed

and complex. Although this exhaustive release of company information increase transparency, it does

mean that financial statements become unwieldy. And the financial meltdown of 2008-following the

reforms implements in the wake of the Enron scandals s few years before-had observes once again

wondering whether, despite all the disclosures, the necessary information for decision-making is being

included in financial statements.

Government Accounting

The operating environments of businesses and governments differ enormously. Companies compete
with

each other for customer revenue and constantly worry about becoming insolvent; governments are

funded through the involuntary payment of taxes, and face no threat of liquidation. Governments do
not

have equity owners who demand profits; instead, they are accountable to citizens for the use of
resources.

Governments thus require much different financial reports, and hence different accounting standards.

The Federal Accounting Standards Advisory Board (FASAB) was established in 1990 as a federal advisory

committee to develop accounting standards and principles for the United States government. In 1999,
the

AICPA recognized the FASAB as the board that sets generally accepted accounting principle “GAAP” for

federal entities. Its board has ten members. Four are from the federal government- one each from the

Treasury Department, Office of Management and Budget, the Comptroller General and the
Congressional

Budget Office. The six non-Federal members are recommended by a panel of the FAF, the AICPA, the

Accounting Research Foundation and the FASAB’s federal members.

The Government Accounting Standards Board (GASB) was established in 1984 to provide standards for

state and local governments. Like the FASB, the GASB is under the auspices of the Financial Accounting

Foundation (FAF), a private, not-for-profit entity, which chooses the seven members of its board.

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THE USERS OF FINANCIAL INFORMATION

We all know that Accounting is the language of business. It’s essential for the top management people
to

understand basic accounting principles because it can help them understand the financial health and

performance of the company at any given time. So that they can capitalize on it and make advantageous

decisions for the future of the business. Good for them, but why is it important to you?

1. Internal Users

Internal Users refer to the managers of the company who use the accounting information in

interpretation of past performance and basis for future decision. Also, the bottom management

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people are considered internal users as they are directly affected by it as well. These are the

common internal users of Financial Information:

 Owners – It’s important for them to see the financial health of the business because they

need how much money their investment is generating. Same as with stockholders, they

need to know how long they will need to hold on stocks, when to sell it, or when to buy

more.

 Management – These people has critical need for financial information. The management

needs to assess the company’s efforts through comparing the current financials to last

year’s result in order for them to make sound decisions in reaction to what variables they

see. They also need to know the cash flow of the company to know what their limitations

are.

 Employees – The workers of the company also need to know how to read financial

statements. It can increase their involvement and understanding of the business so they

can be more motivated. It can also give them the sense of when is the time to ask for an

increase and job security.

2. External Users

External users are individuals who are outside management but has special interest on the

financial information of the company.

 Creditors/Suppliers – These are banks or any supplier that you need to lend you money.

These creditors will assess your liquidity, cash flow and many more so they can be

confident that you can pay them back the money that you’ll borrowing from them.

 Government – The Bureau of Internal Revenue (BIR) will be the one to determine and

collect the tax your business will incur.

 Investors – These people will rely on your company’s financial statements to see its

performance and profitability. As an investor, a good track record can be a determining

factor if they would invest or not.

 Customers – Customers also need to study financial information if they are finding a long-

term supplier. They need to make sure that the company is stable enough to last as long

as they need supplies from them.

 Competitors –And lastly, if your competition are lucky enough to gain some financial

information about your business, it can only benefit them so they can have some form of

an advantage over you.

EXERCISE 1.1

1. What is Accounting?

2. Discuss the branches of Accounting

3. Explain the difference between Accounting and Bookkeeping

4. State the different Financial Statements and its uses

5. Enumerate the Users of Financial Statement and discuss its importance to each them
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EXERCISE 1.2

1. is the language of the business.

2. is the process of identifying, measuring and communicating economic

information to permit informed judgements and decisions by user of the information.

3. Who was the first to describe the system of Debit and Credit in the

journals and leger.

4. was the first standardized test for accounts was given and the from

CPA was licensed.

5. is the periodic reporting of a company’s financial position and the

results of operation to external parties through financial statements.

6. emphasize the preparation and analysis of accounting information

within the organization.

7. is the examination and verification of company accounts and the

firm’s system of internal control.

8. some from independent firm who inspect the accounts of an entity

and render opinion on whether its statement conform to GAAP.

9. is responsible in inspecting the financial statement of the company

where they belong.

10. is based on laws enacted through a highly political legislative

process.

11. is used for non-profit entities, including government and non-

profit corporation.

12. is use for legal matters, including litigation, support, investigation

and dispute resolution.

13. look to the economic reality of the business, rather than actual

inflows and outflows of cash.

14. tells you the earnings, profitability and loss of the business.

15. tells you the source and uses of cash during the period.

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LESSON 2

STATEMENT OF FINANCIAL POSITION

The Balance sheet (B/S) is one of the four primary financial statement that publicly held companies must

publish every quarter and year. The B/S is viewed as a summary of the firm’s financial position at one

point in time. In fact, some firms and most government organizations publish their Balance sheet under

the alternate name Statement of financial position.

The other mandatory statements are the income statement, the Statement of retained earnings, and
the

Statement of changes in financial position. In principle, a firm could publish a new and different Balance

sheet every day. In practice, they normally do so only at the end o fiscal quarters and years. The B/S

heading names a date with a phrase such as this at 31 December 2016. The B/S is thus a “snapshot” of
the

firm’s financial position on that date. The B/S therefore differs from other statements, which report
activity for a specific time period.

What does the balance sheet report?

For a given date, the balance sheet shows the firm’s

 Total Asset. Items of value the firm owns or controls, which it uses to ear revenues

 Total Liabilities. What the firm owes.

 Total Owners Equities. What the firm owns outright.

More accurately, the balance sheet show end-of-period balance in the firm’s Assets, Liabilities, and
Owner

Equity accounts. However, its name includes “Balance’’ for another reason. Note especially `that its 3
main

sections represent the accounting equation.

Assets = Liabilities + Owners Equity

The term Balance applies because the sum of the firm’s assets must equal (balance) the sum of its
liabilities

and owner’s equities. This balance holds, always, whether the firm’s financial position is very good, or

terrible. Double entry principles in accrual accounting ensure that every change to the total on one side

bring an equal, offsetting change on the other side.

Where I “Financial position” on the balance sheet?

Analysts evaluate a firm’s financial position not by the size of the Assets total, or its balancing

counterparts, but rather by comparing numbers on the sheet.

 The firm’s liquidity, for instance, is given by metrics that compare balance sheet figures, such as

Current ratio and Working capital.

 The firm’s capital and financial structure, for example, are built as ratios of Balance sheet figures

for Owners Equities and Liabilities. These structures define the firm’s Capitalization and level of

leverage.

 Other metric compares Balance sheet and Income statement figure to measure the firm’s stock

valuation, prospect for growth, and ability to use assets efficiently.

Where do firms publish the Balance sheet?

Firms normally publish a balance sheet just after the end of every fiscal quarter and year. Note that
firms
often publish different B/S versions, with different level of detail. For shareholders and the general
public,

the most accessible version is the edition in the firm’s Annual Report to Shareholders. Public companies

publish and send this report to shareholders before their annual meeting to elect directors.
Shareholders

normally receive printed copies by mail, but these reports are also available to everyone on the firm’s

internet site. Annual Reports and financial statements usually appear under site headings such as
Investor

Relations or Investor Services.

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For the annual report, the firm is legally responsible for publishing a balance sheet and other statements

that serve two purposes.

 Firstly, to enable shareholders to make informed decisions when electing directors.

 Secondly, to enable shareholders and investors to evaluate the firm’s recent financial

performance and prospect for future growth. This is to support decisions on holding, Buying, or

selling stock shares.

Firms also publish financial statements that serve different audiences and other purposes.

Balance sheet structure: Simple example

The Balance sheet essentially report end-of-period balance in a firms Assets, Liabilities, and Owners
Equity

account. This information is arranged so as to represent a detailed version of the accounting equation.

Assets = Liabilities +Owner Equity

The level of detail in a published B/S depends on the intended and audience its purposes for using
Balance

sheet information.
 Exhibit 1, below is a high-level Balance sheet with minimal detail.

 Exhibit 2, below is the same Balance sheet with more detail.

Annual Report version of the Balance sheet normally carry a level of detail no less than Exhibit 1 and no

more than Exhibit 2.

Figure in S1,000s

Grande Corporation

Balance Sheet at 31 December 20YY

Assets

Current Assets 9,609

Long term investments & funds 1,460

Property, Plant & Equipment 9,716

Intangible Assets 1,222

Other Assets 68

Total Assets 22,075

Liabilities

Current Liabilities 3,464

Long term liabilities 5,474

Total Liabilities 8,938

Owner’s Equity

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Contributed capital 9,439

Retained Earnings 3,698

Total Stockholder’s Equity 13,137

Total Liabilities and Equities 22,075

Exhibit 1. The simple example balance sheet in above shows the general structure and major Balance

Sheet categories under Assets, Liabilities, and Owners Equity. The entire sheet sometimes appears in

horizontal layout, with an “Assets” Page on the left and a “Liabilities and Equities” page on the right. This

explains why people refer to side of the balance sheet. Alternatively, the sheet appears in vertical form,

as in Exhibits 1 and 2. In such cases, people still refer to the Assets side” or the Liabilities and Equities”

side of the sheet.

HOW DO DEBITS AND CREDITS MAINTAIN THE BALANCE?

Most business people readily understand the structure and mathematics of the Income statement.
Never

the less, many have trouble understanding the balance sheet.

 One reason for this, probably is the income statement simply starts with Revenues, and then

subtracts expenses to reach bottom line Net profit.

 However, understanding balance sheet mathematics requires familiarity with basic principles of

double entry accounting.

Those familiar with accounting systems may also note the most of the balance sheet line items are really

the name of accounts from the firm’s Chart of Account. These are, specifically, the “Assets”, Liability”,
and

Equity” category accounts. For more on building the Balance sheet from accounts and account balance,

see the article Trial Balance.

START WITH THE BASIC EQUATIONS

Both the income statement and the balance sheet start with simple equation. The basic INCOME

STATEMENT EQUATON is this.

Income = Revenues – Expenses

The balance sheet starts with an equally simple equation, the so-called Accounting Equation, or Balance

sheet equation.

Assets = Liabilities + Owners Equity

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Regarding the balance sheet and double entry accounting, it is sometimes said that the Accounting

Equation above must also include this component.

Debits = Credits

In everyday usage, people think of debits to a checking account, for example, simply as reduction. And,

they think of credits as additions. Banks in fact use these terms on account holder statements.

Debit and Credit impacts depend on the account category

Debits and credits, however, have different results on different side of the balance sheet.

 Firstly, consider the ‘’ Liabilities+ Owner Equity “side of the B/S. To accounts, the bank’s usage is

technically correct. However, this only because banks regard an account holder as a Liability

account. In double entry accounting.

o A credit increases the balance in a liability or Equity account.

o A debit decreases the balance in a Liability or Equity account

 Secondly, consider the “Assets’ side of the Balance sheet. Here, the rules for debits and credits

reverse

o A credit decreases the balance in an Assets account

o A debit increases the balance in an Assets account.

In double entry accounting every financial event must impact at least two accounts. Whether each
impact

is a “debit” or a “credit’’ depends on the kinds of accountings involved. The double entry approach,

moreover, ensure that the Balance sheet always balance.

Example: Debits and credits maintain the balance:

Suppose the firm acquires assets for P1,000. An asset account (perhaps under Current Assets) increases

P1,000. This could be for instance, an Inventories account increase results from a debit because the

Inventories account is an Asset account. The sheet is now temporarily out of balance until a credit of the

same size appears. This could be either.

 A reduction in another account on the Assets side of the sheet. This could be for instance, a credit

to a cash account also under Current assets.

 An increase in an account on the Liabilities and Equities side. This could be due to a credit of

P1,000 to a long-term liabilities account. This would occur if firm borrows the purchase funds.

In this way, total Balance sheet Assets always equal Liabilities and Equities. And Total debits always
equal

Total credits.

Balance sheet structure and contents: Detailed example

Exhibit 2 below shows the same Balance sheet from Exhibit 1, but with more detail. Definitions for the

major categories and line items appear below the example.

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Figures in S1,000s

Grande Sheet at 31 December 20YY

Assets

Current Assets

Cash 1,368

Short term investments 137

Account receivable 1,969

Less allowance doubtful account 137

Net accounts receivable 1,632

Note receivable short term 20

Inventories

Raw materials 611

Work in progress 1,692

Finished good/merchandise 3,664

Operating & office supplies 19

Total inventories 5,986

Prepaid exp. Insurance, deferred taxes 265

Total current assets 8,609

Long term investments & funds

Common stock held 493

Preferred stock held 164

Bonds held/ banking funds 364

Other long-term investments 419

Total long-term investments & funds 1,460

Property, Plant & Equipment

Factory manufacturing equipment 5,893

Less accumulated depreciation 2,782

Net factory manufacturing equipment 3,201

Store/ equipment selling assets 5,456

Less accumulated depreciation 1,292

Net store equipment 4,164

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Computer system 4,721

Less accumulated depreciation 2,370

Net computer systems 2,351

Total Property, Plant & Equipment 9,716

Intangible Assets

Copyrights 1,014

Trademarks and patents 106

Goodwill 100

Total intangible assets 1,222

Other Assets 66

Total Assets 22,075

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Liabilities

Current Liabilities

Account payable 1,642

Note payable, short term 912

Current portion of long-term debt 349

Accrued expenses/ interest payable 146

Unearned revenues 274

Taxes payable/ other withholding 141

Total current liabilities 9,464

Long Term Liabilities

Bank notes payable 912

Bonds payable, other long-term liabilities 4,562

Total Long-term liabilities 5,474

Total Liabilities 8,936

Owners’ Equity

Contributed Capital

Preferred stock 3,798

Common stock 4,164

Contributed capital excess of par 1,457

Total contributed capital 9,439

Retained Earnings 3,686

Total Stockholder’s Equity, 13,137

Total Liabilities and Equities 22,075

Exhibit 2. A version of the example statement from Exhibit 1 but with more detail. Exhibit 2 represent

about the maximin detail must firms present in the Annual Report Balance Sheet

BALANCE SHEET CATEGORIES

Assets Categories

Major categories on the Assets side of the Balance sheet may include the following:

 Current assets

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These are assets that, I principle the firm could turn into cash in the near term. “Near term”

generally means one year or less. Current assets include, of course Cash on hand, but also Short-term

investment, Accounts receivable, Inventories, and Prepaid expenses.

 Long term investments and funds

These are assets that do not converted to cash quickly. These may include stocks and bonds

from other companies or other long-term investments.

 Property, plant & equipment

 These are the company’s major physical assets, such as buildings, factory machines, vehicles, and

large computer system. Firm normally charge the cost of these assets against income as

depreciation expense across the life of the asset. Note that each year of asset’s depreciable life,

the expense contributes to Accumulated depreciation. As result, total assets “book value”

decrease.

 Intangible assets

Intangible assets contrast with physical assets. Intangible cannot be seen or touched, but they are

still assets because

 Firms acquire intangible assets at a cost.

 The firm has exclusive right to them.

 They contribute to the firm’s ability to earn.

Examples including copyrights and patents, trademarks, brand image, and goodwill.

Liabilities and Owner s Equities categories

On the Liabilities and Owners Equities side, the major categories usually include.

 Current Liabilities

These are obligations the firm must meet in the near term (one year or less). They may include

such things as Accounts payable, the due portion of long-term debt, and short-term warranty
obligations.

 Long term liabilities

These are obligations due for a period longer than one year. Long term liabilities may include bank

notes, bonds, or long-term financing arrangements for purchases.

Contributed capital

This is one of the two main categories under Owner’s Equity (the other is Retained earnings).

Contributed capital is what stockholders invest by purchasing of stock directly from the company.

Contributed capital in turn, has two main components. Stated capital, which represents the stated, or
par

value of the shares, and Additional paid-in capital, which represents money paid to the company above

the par value.

Retained earning

After a profitable period, a company can (at the discretion of its board of directors) pay some of

its income to shareholders, as dividends, and keep the remainder as Retained earnings. The firm’s

cumulative Retained earnings appear on the Balance Sheet under Owner’s Equity.

What are balance sheet contributions to financial statement metrics and ratio?

The balance sheet is a primary data source for financial metrics and financial statement ratios that
address

question like these?

1. What are the firm’s future earning prospect?

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Valuation metrics such as the price to earnings ratio deal with such questions.

2. Can the firm meet its short-term financial needs?

Liquidity metrics such as current ratio address such questions.

3. Is the firm using its resources efficiently?

Activity metrics such as inventory turns address such question.

4. Do the firm’s fund come primarily from owners or from creditors?

Leverage metrics, such as debt to asset ratio provide answers

5. Is the company profitable? Is it making good use of its assets?

Profitability metrics such as operating margin address such questions.

Exercises 2.1

Discuss the following:

1. Statement of financial position

2. Retained Earnings

3. Liabilities

4. Capital

5. Assets

6. Working capital

7. Users of financial statements

8. Financial statement

9. Current Liabilities

10. Depreciation
Exercise 2.2

1. _____________ shows end of period balances in the firm’s Assets, Liabilities, and Capital.

2. _____________ is the equation for income statement.

3. _____________ is the equation for balance sheet.

4. _____________ these are assets that, in principle, the firm could turn into cash in the near future.

5. _____________ these are the residual of current assets. It is not easily convertible into cash.

6. _____________ these are the obligation the firm must meet in the near term.

7. _____________ these are the obligation due for a period that is longer than one year.

8. _____________ is a contributions or investment of Stockholders in the company.

9. _____________ is a balance sheet account where the Net Income or Net Loss is added or deducted.

10. ____________ is one of the users of the financial statement.

Lesson 3

Income Statement

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The income statement measures a company’s financial performance over a specific

accounting period. Financial performance is a assessed by giving a summary of how the business

incurs its revenues and expenses through both operating and non-operating activities. It also shows

the net profit or loss incurred over a specific accounting period typically over a fiscal quarter or

year. The income statement is also known as the “profit or loss statement” or “statement of revenue

and expense.”
The income statement is divided into two parts: the operating items section and the non-

operating items section.

The operating items section discloses information about revenues and expenses that are a

direct result of the regular business operations. For example, if a business creates sports equipment,

then the operating items section would talk about the revenues and expenses involved with the

production of sports equipment.

The non-operating items section discloses revenue and expense information about

activities that are not tied directly to a company’s regular operations. For example, if the sport

equipment company sold a factory and some old plant equipment, then this information would be

in the non-operating items section. Income statements can be presented in one of two ways: multi-

step and single-step. Both single and multi-step formats conform to GAAP standards. Both yield

the same net income figure, the main difference is how they are formatted, not how figures are

calculated. The two formats are illustrated below in two simplistic examples:

Multi-Step Format Single-Step Format

Net Sales Net Sales

Cost of Sales Materials and Production

Gross Income* Marketing and Administrative

Selling, General and Administrative Expenses

(SG&A)

Research and Development Expenses (R&D)

Operating Income* Other Income & Expenses

Other Income & Expenses Pretax Income

Pretax Income* Taxes

Taxes Net Income

Net Income (after tax) * _

Sample Income Statement

Now let’s take a look at a sample income statement for company XYZ for Fiscal Year (FY) ending

2008 and 2009. Expenses are in parentheses.

Income Statement for Company XYZ FY 2015 and 2016

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(Figure PHP) 2015 2016

Net Sales 1,500,000 2,000,000

Cost of Sales (350,000) (375,000)

Gross Income 1,150,000 1,625,000

Operating Expenses (SG&A) (235,000) (260,000)

Operating Income 915,000 1,365,000

Other Income (Expense) 40,000 60,000

Extraordinary Gain (Loss) - (15,000)

Interest Expense (50,000) (50,000)

Net Profit Before Taxes (Pretax Income) 905,000 1,360,000

Taxes (300,000) (475,000)

Net Income 605,000 885,000

Here are some of the different entries that may be found on the income statement and what each

one means.
 Sales – These are defined as total sales (revenues) during the accounting period.

Remember these sales are net of returns, allowances and discounts.

 Cost of Goods Sold (COGS) – These are all the direct costs that are related to the product

or rendered service sold and recorded during the accounting period.

(Reminder: matching principle.)

 Operating Expenses – These include all other expenses that are not included in COGS but

are related to the operation of the business during the specified accounting period. This

account is most commonly referred to as “SG&A” (sales general and administrative) and

includes expenses such as selling, marketing administrative salaries, sales salaries,

maintenance, administrative office expenses (rent, computers, accounting fees, legal fees),

research and development (R&D), depreciation and amortization, etc.

 Other revenues & expenses – These are all non-operating expenses such as interest earned

on cash or interest paid on loans.

 Income taxes – This account is a provision for income taxes for reporting purposes.

The Components of Net Income:

 Operating income from continuing operations – This companies all revenues net of

returns, allowances and discounts, less the cost and expenses related to the generation of

these revenues. The costs deducted from revenues are typically the COGS and SG&A

expenses.

 Recurring income before interest and taxes from continuing operations – In addition to

operating income from continuing operations, this component includes all other income,

such as investment income from unconsolidated subsidiaries and/or other investments and

gains (or losses) from the sale of assets. To be included in this category, these items must

be recurring in nature. This component is generally considered to be the best predictor of

future earnings. However, non-cash expenses such as depreciation and amortization are not

assumed to be good indicators of future capital expenditures. Since this component does
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not take into account the capital structure of the company (use of debt), it is also used to

value similar companies.

 Recurring (pre-tax) income from continuing operations – This component takes the

company’s financial structure into consideration as it deducts interest expenses.

 Pre-tax earnings from continuing operations – Included in this category are items that are

either unusual or infrequent in nature but cannot be both. Examples are an employee-

separation cost, plant shutdown, impairments, write-offs, write-downs, integration

expenses, etc.

 Net income from continuing operations – This component takes into account the impact

of taxes from continuing operations.

Non-Recurring Items

Discontinued operations, extraordinary items and accounting changes are all reported as separate

items in the income statement. They are all reported net of taxes and below the tax line, and are

not included in income from continuing operations. In some cases, earlier income statements and

balance sheets have to be adjusted to reflect changes.

 Income (or expense) from discontinued operations – This component is related to income

(or expense) generated due to the shutdown of one or more divisions or operations (plants).

These events need to be isolated so they do not inflate or deflate the company’s future

earning potential. This type of nonrecurring occurrence also has a nonrecurring tax

implication and, as a result of the tax implication, should not be included in the income tax

expense used to calculate net income from continuing operations. That is why this
income (or expense) is always reported net of taxes. The same is true for extraordinary

items and cumulative effect of accounting changes (see below).

 Extraordinary items – This component relates to items that are both unusual and infrequent

in nature. That means it is a one-time gain or loss that is not expected to occur in the future.

An example is environmental remediation.

 Cumulative effect of accounting changes – This item is generally related to changes in

accounting policies or estimations. In most cases, these are non-cash-related expenses but

could have an effect on taxes.

 Unusual or Infrequent Items – Included in this category are items that are either unusual

or infrequent in nature but they cannot be both.

Examples of unusual or infrequent items:

 Gains (or losses) as a result of the disposition of a company’s business segment

including:

o Plant shutdown costs

o Lease-breaking fees

o Employee-separation costs

 Gains (or losses) as a result of the disposition of a company’s assets or investments

(including investments in subsidiary segments) including:

o Plant shut-down costs

o Lease-breaking fees

 Gains (or losses) as a result of a lawsuit

 Losses of operations due to an earthquake

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 Impairments, write-offs, write-downs and restricting costs

 Integration expenses related to the acquisition of a business

Extraordinary Items

Events that are both unusual and infrequent in nature are qualified as extraordinary

expenses.

Example of extraordinary items:

 Losses from expropriation of assets

 Gain (or losses) from early retirement of debt

Discontinued Operations

Sometimes management decides to dispose of certain business operation but either has not yet

done so or did it in the current year after it had generated income or losses. To be accounted for as

a discontinued operation, the business must be physically and operationally distinct from the rest

of the firm. Keep in mind these basic definitions:

 Measurement date – This is the date when the company develops a formal plan for

disposing.

 Phase-out period – This is the time between the measurement date and the actual disposal

date.

The income or loss from discontinued operations is reported separately, and past income

statements must be related, separating the income or loss from discontinued operations. On the

measurement date, the company will accrue any estimated loss during the phase-out period and

estimated loss on the sale of the disposal. Any expected gain on the disposal cannot be reported

Until after the sale is completed (the same rule applies to the sale of a portion of a business

Segment).

Accounting Changes

Accounting changes occur for two reasons:

1. As a result of a change in an accounting principle.

2. As a result of a change in accounting estimate.

The most common form of a change in accounting principle is the switch from the LIFO inventory

Accounting method to another method such FIFO or average cost basis.

The most common form of a change in accounting estimates is a change in depreciation method

For new assets or change in depreciable lives/salvage values, which is considered a change in

Accounting estimated and not a change in accounting principle. Note that past income does not

Need to be restated from the LIFO inventory accounting method to another method such FIFO or

Average cost basis.

In general, prior years’ financial statements do not need to be restated unless it is a change in:

 Inventory accounting methods (LIFO to FIFO)

 Change to or from full-cost method. (This is used in oil and gas exploration. The

Successful-efforts methods capitalize only the costs associated with successful activities

While the full-cost method capitalizes all the costs associated with all activities.)

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 Change from or to percentage-of-completion method (see revenue-recognition methods)

 All changes just prior to a company’s IPO

Prior Period Adjustments

These adjustments are related to accounting errors. These errors are typically not reported in the

income statement but are reported in retained earnings (found in changes in retained earnings).

These errors are disclosed as footnotes explaining the nature of the error and its effect on net

income.