Accounting: Principles of Financial Accounting

1.1 Financial accounting: The big picture

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External Users of the company:

Financial accouting:
Economic Events in the  Current and potential
firm Records, classifies and sumarizes in investors
financial statments  Creditors (bank,
suppliers…)
 Costumers
 Government agencies
 Employes and trade unions
 competitors
Auditors
responsible for certifying that the
financial statements were prepared in
accordance with accounting principles

Who prepares the financial information? / Who prepares the financial statements?
-The company's managers are responsible for preparing this information and presenting it to the
company's shareholders.

Is there a conflict of interest?

- If the managers of the firm prepare the financial statements for external users to see,
what conflict of interest could arise?
On the one hand, we have the managers of the company who prepare the company's financial
statements that summarize the performance of its operations. On the other hand, we have the
managers of the company who prepare the company's financial statements and compensate the
managers according to how they are performing in the financial statements.

Managers, and accountants in the company record and classify all these transactions
and produce these financial statements with management's approval. these financial statements
are intended for external users, mainly theshareo,lders and have to be prepared according to the
rules, such as accounting principles, and it is the auditors who ensure that this is the case.

1
Current investors- current owners of the company who are interested in the company's performance for obvious reasons [invest
money], Potential investors- financial analysts who analyze companies on behalf of these potential investors.
Creditors- loans to the company, suppliers who are interested in the company's ability to pay its debts. Costumers-understand if
the supplier is solid and if the business is solid.
Therefore, financial accounting is the process that records, classifies,
and summarizes the business transactions that occur in a business.

Business Cycle
When you have an idea/business plan the first thing you need to do is raise capital.
when you have an idea/business plan the first thing you need to do is raise capital

Financing
(have
capital)

Reinvest
Reward (part of it Investing
(long term
(capital profits do resources of
providers) generate capital)
growth)

Operation
s (make
profit by
operating
efficiently)

With this, accounting helps to control the transactions that occur throughout the business
cycle.
EXAMPLE OF THE LIBRARY:
Cash receipts:
Shareholders 50.000
Bank Loan 20.000
TOTAL 70.000
Cashpaymentt Cash accounting
Furniture & Equipment 15.000
Software 3.000
Prepaid rent 6.000
TOTAL 24.000

What information is Cristina’s record-keeping missing?

 A list of payments and receipts is not enough to keep track of all the transactions that
have taken place in the business. The first thing we need is a document that tells us
what the sources of capital in the business are.

Where does the money come from?

Sources of capital:
- Shareholders;
- Creditors.

Where is this money now? what are the uses of this capital?
- Resources (land, buildings, equipment, inventories, cash…).

both sides have to be equal because we are talking about the same amount of money.

USES OF SOURCES OF
CAPITAL CAPITAL
Cash 50.000 Share capital 50.000
uncle's loan 20.000 Bank loan 20.000
Furniture 15.000 Other payables 10.000
(supplier of
equipment)
Prepaid rent 6.000 Accounts payable 40.000
software 3.000
Inventory (books) 40.000

TOTAL 120.000 TOTAL 120.000

Double Entry Accounting- at least in each different section you have two accounts that are in
both.
Questions:
Why isn’t accounting enough to keep tabs on the campus bookstore’s transactions?
1. It doesn’t reflect the full value of assets, only what has been paid for in cash.
2. It doesn’t include how much money is owed.
3. It doesn’t specify where the money is coming from (source of capital).
Sources of capital don’t always have to equal uses of capital
V/F
Balance sheet

Where does the money come from? Where is this money now?

ASSETS LIABILIT
IES

Cash 46.000 Accounts 40.000

payable
Inventory 40.000 Other payables 10.000
Prepaid rent 6.000 -
Current assets 92.000 Current 50.000
liabilities

Furniture 25.000 Bank loan 20.000

Software 3.000 -
Noncurrent 28.000 Noncurrent 20.000
assets liabilities
TOTAL 120.000 TOTAL 120.000
ASSETS LIABILITIES

Current asset- money that will turn into cash in the short term
Inventory- we expect to sell and collect money
Noncurrent assets- long-term resources that are here to stay and we will not make money
-
Current liabilities- capital sources that we need to return (have an expiration date)
noncurrent liabilities- payable in the long term in more than 1 year

Questions:
How would you explain the terms “assets” and “owner’s equity & Liability”?
1. Assets are how you are using the money, owner’s equity & liabilities are where the
money comes from.
2. Assets are the equivalent of sources of capital and the owner’s equity & lliabilityities
the same as uses of capital.
3. Assets are the same as uses of capital and the owner’s equity & lliabilitiesisarehe
equivalent of sources of capital.
What is the difference between current and noncurrent assets?
1. Currentnts assets are the ones you are using right now or at any time in the current year.
Non-current are those you will use starting next year.
 2. Current assets that will turn into cash or be consumed in the near term, such as
the inventory. Noncurrent assets are those that you don’t expect to turn into cash in
the near term because you plan to hold them for the long run, such as furniture or
software.
3. Current assets are those that you paid for in cash and non-current are the ones you
paid for with no credit.

What is the difference between current and non-current liabilities?

1. Current liabilities are those we need to return in 1 year. Non-current are those we
will repay in more than 1 year, like a 3-year bank loan.
2. Current liabilities are those we will repay with no interest. Non-current liabilities are
those that carry interest.
3. Current liabilities have a maturity date within the current year. Non-current
liabilities have a maturity date that is beyond the one-year horizon.

BALANCE SHEET = THE STATEMENT OF FINANCIAL POSITION

Assets & Liabilities

On the balance sheet, we find different accounts that can be classified as assets, liabilities &
owner's equity. To better understand the impact of each transaction on the balance sheet, it is
important to define very well each one of these types of transactions.

Assets- Definition:
There are three elements to define an asset:
1. An asset is a resource owned or controlled by the firm (ownership) - the
ownership or control of the asset is a necessary condition to define an asset. for
example: in the bookstore, we buy the furniture and equipment, and we count
the total value, regardless of whether we paid or not.
2. That it is expected to generate future economic benefits
3. And arises from a past event or transaction.

A necessary condition for recognizing these assets in our balance sheet is that:
1. We can estimate the value reliably- a reliable value
2. High probability of this future benefit and probable

with this in mind, we can use examples

Examples: Are these assets?
× A piece of equipment with a cost of 1milion purchased by the firm
o Yes, it going to generate future benefits & we own it;
o With this machine we are going to produce products that we can sell for a price
× The Diet Coke brand was developed by Coca-ColaCCompanypany
o Do they control and own this brand? -Yes
o Will it generate future benefits? - Yes
o Is the result of a past transaction? -No, which is why this example cannot be
considered an asset on the balance sheet.

BUT, WHY?
o Because the diet coke brand has been developed over time,
thanks to many different things. So, it's all a result of a past
transaction.
o Coke did not buy this brand from any other company. They
developed it internally thanks to advertising, excellence in
operations in product definition, and so on.
So, it doesn't matter if someone thinks that this is an asset or something that will generate future
benefits from an accounting perspective.
× Lottery tickets purchased by the firm
o No, in the first place the company owns the tickets, the result of a past
transaction, but probably the future benefit is too low.
o Therefore, this example is not an asset you should recognize on a balance sheet.
× are the employees the assets of a company?
o In a personal view, we can say that they are assets because they generate future
benefits for the company. But from accounting perspective employees are not
assets, why?
o First, they are not owned by the company.

It doesn't matter if the other conditions are met or not, this is enough to say that employees are
not assets.

QUESTIONS
Why isn’t the Diet Coke brand an asset that shows up once-Cola’s balance sheet?
1. Because you can’t quantify the value of the brand?
2. Because it’s not a tangible asset, aphysicall object that you can touch
3. Because the Diet Coke is not the result of a prior transaction

Given they produce value for the firm, why aren´t employees assets?
1. Because the value they produce is not quantifiable
2. Because the company does not own them.

EXAMPLE: Sports Club Employees

In the balance sheet of soccer clubs, you will see what is called transfer rights. A kind of
intangible asset. This right is what a club has for a player to play for a club in the next few years
for the duration of a contract. However, if a player has been contracted by another club, even if
he still has a contract with another team, the player must pay a certain amount for the transfer
rights.
While this amount, in this purchase, is the result of a past transaction, it gives the club the right
to receive the services of this player for a certain period during the duration of the contract, and,
finally, it will generate future benefits.

Liability- Definition
There are two elements to define Liability:
1. A liability is a present obligation of the firm to transfer economic benefits in
the future- for example: in the case of a loan, mustn to return the money;
2. That arises from a past event or transaction-for example: once again, in the
case of a loan, it is because we have already recognized the loan on December
31 in the case of the bookstore.
As with assets, a necessary condition for recognizing a liability is that, first, it is
probable that this economic benefit flows out of the company. So, it's very likely that
we have to pay, that we must provide a service, a product. Secondly, this economic
benefit has to be transferred in the future and measured reliably. example: For in the
case of a loan, one has tmustrn the money
Now, in the case where you could estimate the amount or the probability of these
economic benefits flowing out of the company was very low, the only thing you could
do is disclose that in the notes to the financial statements.

Examples: Are these Liabilities?

× A firm gets a bank loan
o Yes
o This case is easy because we already recognize it on the balance sheet. Why?
Because it is a present obligation that we have that arises from a past
transaction.
× A firm is likely to lose a lawsuit but cannot estimate the penalty (something illegal)
o Yes
o The reality is that you know that you have a present obligation, that you have to
pay something if you lose the case. It is the result of a past event, in this case
maybe something illegal that triggered this lawsuit, but the problem is that you
cannot estimate the amount, and therefore this is a necessary condition to be
able to reliably estimate the past amount.
So in this case, the only thing we could do is disclose it in the footnotes because
I am sure that investors would like to know that but without saying the value.
× A company sells cars with a 3-year warranty included.
o Yes
o Because the company is selling cars with a warranty contract at the very
moment that it sells the stick, it must honor that warranty.
 The only problem is that we need to estimate the value, but based on
experience, it is very likely that we can estimate the amount number guarantees
that are exercised, and therefore this is recognized as a liability on the balance
sheet.

RECAP- FIRST WEEK

We have seen that accounting is the process that records, classifies, and summarizes financial
transactions for the benefit of external users, primarily the shareholders.
We realized that the balance sheet tells us the sources of capital, that is, the owner’s equitity and
liabilities, the user sand of capital, the assets,. By definition both must be equal.

Assets are equal to the total amount of equity and liabilities.

TEST

1.
Pergunta 1
Suppose a business had assets totaling €20,000 and liabilities totaling €17,000. What was its owners’
equity?

€3,000

€10,000

€20,000

€37,000
2.
Pergunta 2
A building, an item of equipment, and an automobile for a company that manufactures and sells
clothes may all be examples of:

Current liabilities

Current assets

Non-current liabilities
Non-current assets

An asset is classified as “current” if:

It can be converted into cash in the near future

It is not cash

It can be sold in the near future

It can be converted into cash within 2 years .

A three-year bank loan to be repaid at maturity is an example of:

Current liability

Non-current asset

Current asset

Non-current liability

Which of the following statements is correct?

Investors and creditors are, among others, users of financial accounting.

Financial Accounting produces information for internal purposes only.

Auditors are responsible for preparing the annual report.

Only cash transactions should be recorded in the financial statements.

For the remaining questions, please consider the following transactions that happened upon
the incorporation of Berry Company by its owner, John Berry, during the first week of
January:
· It received €50,000 in cash from John Berry as capital.

· It borrowed €30,000 from a local bank.

· It purchased €15,000 of equipment for cash.

· It purchased €20,000 of inventory on account.

· It pre-paid €3,000 for the office rent and €2,000 for the insurance.
 What is the cash balance at the end of the week?
€40,000

€60,000

€50,000

€80,000

What are the total current assets at the end of the week?

€90,000

€75,000

€80,000

€85,000
8.What are the total liabilities at the end of the week?

€100,000

€20,000

€50,000

€30,000
9. What are the total assets at the end of the week?

€50,000

€15,000

€80,000

€100,000
10.The following table shows the balance of certain accounts on the Holmes, Inc. balance sheet
at the end of December 31 and the following three-day period. By December 31, the company
had not yet started its primary operations. However, they had begun some minor activities:
Balances at the close Cash Inventorie Fixed A/P Bank Sh.
of… s Assets* Loan Equity
Dec, 31 11,000 14,000 15,000 5,000 8,000 27,000
Jan, 3 7,000 14,000 15,000 1,000 8,000 27,000
Jan, 4 12,000 14,000 15,000 1,000 13,000 27,000
Jan, 5 8,000 20,000 15,000 3,000 13,000 27,000
*Fixed assets is the same as non-current assets.

What activity took place on January 3?

They paid their suppliers.

They borrowed additional money from the bank.

They purchased more inventories.

They repaid the bank loan.

11.The following table shows the balance of certain accounts on the Holmes, Inc. balance sheet
at the end of December 31 and the following three-day period. By December 31, the company
had not yet started its primary operations. However, they had begun some minor activities:
Balances at the Inventorie Fixed Bank Sh.
Cash A/P
close of… s Assets* Loan Equity
Dec, 31 11,000 14,000 15,000 5,000 8,000 27,000
Jan, 3 7,000 14,000 15,000 1,000 8,000 27,000
Jan, 4 12,000 14,000 15,000 1,000 13,000 27,000
Jan, 5 8,000 20,000 15,000 3,000 13,000 27,000
*Fixed assets is the same as non-current assets.

What activity took place on January 4?

They paid their suppliers.

They repaid the bank loan.

They borrowed additional money from the bank.

They purchased more inventories.

 12.The following table shows the balance of certain accounts on the Holmes, Inc. balance sheet
at the end of December 31 and the following three-day period. By December 31, the company
had not yet started its primary operations. However, they had begun some minor activities:
Balances at the close Inventorie Fixed Bank Sh.
Cash A/P
of… s Assets* Loan Equity
Dec, 31 11,000 14,000 15,000 5,000 8,000 27,000
Jan, 3 7,000 14,000 15,000 1,000 8,000 27,000
Jan, 4 12,000 14,000 15,000 1,000 13,000 27,000
Jan, 5 8,000 20,000 15,000 3,000 13,000 27,000
*Fixed assets is the same as non-current assets.

What activity took place on January 5?

They repaid the bank loan.

They paid their suppliers.

They purchased more inventory.

They borrowed additional money from the bank.

WEEK 2

The Income Statement

Is s financial statement that measures the performance of the firme over a period of time. It
shows the profit generated and its different components. The income statement contains the
revenues generated (the achievements) less the expenses incurred (the efforts).

Assets Owner’s equitity/

liabilitie

Cash 46, 000 Account payable 40,000

Inventory 40.000

Other payables 10.000

Prepaid rent 6.000 Bank loan 20.000

Furniture/equipment 25.000 Share capital 50.000

Software 3.000

Profit and loss 120.000

2.4 Equity Equation

EQUITY = ASSETS - LIABILITIES

If we consider that most companies have a set of assets and rights (ASSETS) greater than their
liabilities (LIABILITIES), we can state that the equity equation is better represented as follows:

ASSETS = LIABILITIES + EQUITY

This graphic representation is called BALANCE SHEET.

We can thus say that:

BALANCE SHEET is the quantitative and qualitative representation of Equity, at a given

moment.
Profit and loss account:

Revenue- increase in the net worth of the shareholders due to the operations of the firm.

Expense- decrease in the net worth of the shareholders due to the operation in the firm.

Profit (loss) = Revenues - Expenses

GLOSSARY

A
Accounting - It is a system that collects, processes, analyzes, measures, and records
financial information of a firm and reports that information to decision makers.

Accounting fraud - It is the intentional misrepresentation and abuse of accounting

information including sales, revenues, expenses, assets or liabilities to inflate earnings,
stock values, obtain more loans or avoid debt commitments.
Accounts receivables - They are promises to receive money from customers and are
generally classified as current assets.

Accrual accounting/ Accruals - It is the accounting principle that recognizes revenue

when earned and associated expenses when incurred, not when money is received/paid.

Annual report - It is a document used by most companies to disclose corporate

information to their shareholders. It includes an opening letter from the CEO, financial
data, results of operations, market segment information, new product plans, subsidiary
activities, and research and development activities on future programs.

B
Bad debt - Bad debts occur when debtors do not pay. Bad debts reduce the amount of
accounts receivable on the balance sheet and creates a loss in the income statement.

Balance sheet - It reports the amount of assets, liabilities, and stockholders’ equity of
an accounting entity at a point in time.

Building financial statements - It is the process of recording transactions and sorting

them to form balance sheet, income statement, and cash flow statement.

C
Cash accounting - It is the accounting principle that recognizes revenue when cash is
received and recognizes expense when cash is paid.

Cash discounts - They are discounts given over sale price if the customer pays in a
certain time period to encourage early payment.

Cash flows statement - It is the financial statement showing how cash of a firm
changes in a certain period.

Conservatism - Revenues/profits are recorded only when earned but provision is made
for all known losses, even when the amount is only a best estimate on the basis of
available information.

Consistency - Consistency of accounting treatment of like items within each accounting

period and from one period to the next.

Contingent liability - A potential liability that has arisen as the result of a past event; it
is not a liability until some future event occurs.

Creditors - Creditors lend money to a company for a specific length of time.

D
Deferrals - Receipts of assets/cash in advance before goods or services are delivered.
F
FIFO - It assumes that the first units purchased or manufactured are the first units sold.
This means that early purchases are expensed against revenues and recent costs are
included in inventory.

Financial statements - Balance sheet, income statement, cash flow statement, and
statements of shareholders’ equity.

Financial transaction - An exchange between a business and one or more external

parties to a business. It has a monetary impact on the financial statements of a business.

Fundamental accounting concepts - They are concepts governing the accounting

system and include going concern, consistency, accruals, matching principle, and
conservatism.

Fundamental accounting equation - Assets = Liabilities + Stockholders’ Equity.

G
Going concerned - The assumption that the business will continue to operate for the
foreseeable future.

I
Income statement - It is a financial statement that reports revenues, expenses, gains,
and losses during a period.

Inventory - They are goods of a firm to be sold to customers to generate revenues.

Inventory impairment - It occurs when the net realizable value of an inventory is less
than the cost. Inventory impairment requia res decreathe se in value of inventory
account on the balance sheet, a corresponding expense on the income statement.

L
LIFO - It assumes that the last units purchased or manufactured are the first units sold.
This method matches recent costs with revenues; earlier purchases remain in inventory.

Lower of the cost or the market - Valuation method used to value inventory on
balance sheet. It departs from the cost principle; it serves to recognize a loss when
replacement cost or net realizable value of an inventory drops below cost.

M
Matching - Revenues earned by a business are matched with the expenses incurred in
earning those revenues.

N
Net realizable value of receivables - Face value of receivables less cash discounts,
sales returns, and bad debts.

P
Percentage of sales method - Provision for bad debts is equal a certain percentage of
the credit sales. The percentage comes from either past experience or the bad debt rate
of other firms in the same industry.

Prepaid expenses - It is an asset account that records the prepayment of future

expenses.

Provision for doubtful accounts - It is the amount of estimated accounts receivables

that firms do not expect to collect from customers.

R
Recording financial transactions - It involves the following steps:

· Identify the accounts affected (at least two).

· Classify each account as an asset, liability or shareholders’ equity.

· Determine the direction of the effect on each account.

· Make sure that the fundamental accounting equation remains in balance.

Revenue recognition - The accounting principle governing when revenues need to be

recognized in financial statements.

S
Sales returns - It is a provision account to record the estimated amount sales returns by
customers.

Shareholders - Ultimate owners of firms.

U
Unearned revenue - It is a liability account recording the firm’s promise to perform
services or deliver goods in the future and is generated when customers pay in advance.
 What is accounting?
 How do users utilize accounting information?
 What are the main financial statements?
 What type of information is provided by the Balance Sheet?
 What type of information is provided by the Income Statement?
 What type of information is provided by the Cash Flows Statement?
 How are these financial statements related?