Basic Accounting Concepts:

The Balance Sheet

Basic Concepts

1. Money measurement.
2. Entity.
3. Going concern.
4. Cost.
5. Dual aspect.
6. Accounting period.
7. Conservatism.
8. Realization.
9. Matching.
10. Consistency.
11. Materiality.
 Money Measurement

Accounting records are recorded in monetary terms at value at time

transaction is recorded.
Severe limitation.
• Can’t be valued, can’t be recorded; e.g. president’s health, affect of
strike.
• Price changes ignored.
Entity
For Accounting purpose, business is a separate entity and owner is a separate
entity and any transaction between owner and business must be recorded in
the Books of Accounts of business.
• For whom accounts are kept.
• Distinguish from owner.
• May or may not be separate legal entity.
• One entity may be part of a larger entity.
– General Electric Company presents one set of financial statements
with parent company operations combined with all subsidiaries
around the world.

Transaction
 Going Concern

• Assumed to continue in operation for an indefinite

period.
• Alternative assumption:
– Liquidation/bankruptcy.
– Only liquidation values would be meaningful.

The impact of this assumption is that fixed

assets like land are not revalued at higher
levels due to increase in market prices
 Cost

• Assets defined:
• = economic resources.
• = cash or something that helps generate cash.
• Assets recorded at cost, that is, price paid.
• Fair value = amount for which asset could be currently purchased or sold.
• Book value of asset = recorded value.
Cost Concept
Non-monetary Assets

• Land, buildings, machinery and similar.

• Generally, book value = fair value only at time of acquisition.
• Depreciation or amortization = systematic allocation of cost over life of asset.
• B.V. = recorded cost - depreciation to date.
• Rationale for cost concept:
– Relevance sacrificed for objectivity.
Cost Concept: Monetary Assets
• Cash, marketable securities.
• Initially recorded at cost.
• Adjusted to fair value (=market value, if available).
• Rationale: FV is relevant, objective & feasible.
• Why is FV relevant & objective for monetary assets but not for non-
monetary assets?
Dual-Aspect
• Assets = economic resources.
• Equities = claims against assets.
– Liabilities = claims of creditors (everyone other than owners).
– Owners’ equity (Shareholders’ or stockholders’ equity for a
corporation).
• Fundamental accounting equation:
¤ Assets = Equities.
¤ Assets = Liabilities + Owners’ equity.
¤ For a corporation:
¤ Assets = Liabilities + Stockholders’ equity.
¤ Assets = Liabilities + Paid-in-capital + Retained earnings.
Dual Aspect (Concluded)

• Transactions = events that affect accounting records.

• Every transaction has a dual impact on accounting records.
• Dual impact:
– Results in maintenance of fundamental accounting equation.
– Double-entry system.
Balance Sheet
• Point in time or status report.
• More formally, Statement of Financial Position.
• Contains (and shows equality of amounts of):
– Assets.
– Liabilities and Owners’ equity.
Interpretations of Dual Aspect:
Resources and Claims View
• Assets = Claims on assets.
• Owners’ equity is a residual claim.
• Shortcomings:
– Balance Sheet is not at market or liquidating values, Owners’ equity
as a claim is unclear.
– Claim is a legalistic view.
• Better suited to liquidation, not to going concern.
Interpretations of Dual Aspect:
Sources and Uses of Funds View
• Left hand side = assets = how funds used or invested.
• Right hand side = liabilities + owners’ equity = sources of funds = how
assets were financed.
• Financing supplied by owners:
– Paid-in-capital (= contributed capital).
– Retained earnings.
Account Categories
• Groups of related items.
• Classifications of:
– Assets.
– Equities (i.e. liabilities, owners’ equity)
– Revenues.
– Expenses.
• Discretion of management.
Assets
• Acquired in a transaction.
• Economic resources (i.e. provide future benefits).
– Cash or convertible to cash.
– Goods to be sold for cash.
– Items to be used to generate cash.
• Controlled by the entity.
• Objectively measurable cost at time of acquisition.
Current Assets
• Cash.
• Other assets expected to be realized in cash or sold or consumed within
longer of one year or normal operating cycle.
Cash
• Funds available for disbursement
Marketable Securities
• Investments that are:
–Readily marketable.
–Expected to be converted to cash within 1 year.
Current Assets
Accounts Receivable
• Owed by customers.
• Reported at amount owed less estimated uncollectible.
• Other receivables:
– Owed by other than customers.
• Notes receivable:
– Evidence by written promises to pay (notes).
Inventories
• Aggregate of those items that are:
– Held for sale in ordinary course of business,
– In process of production for sale, or
– To be consumed in production of goods or services to be sold.
Current Assets
Prepaid Expenses
• Intangible.
• Usefulness will expire in near future.
• Examples:
– Prepaid rent expense.
– Prepaid insurance expense.
Property, Plant, and Equipment
• Also, called fixed assets.
• Tangible.
• Long-lived.
• Used to produce goods and services to generate cash inflows.
• Land is not depreciated.
• Building and equipment shown at:
– Cost less accumulated depreciation.
Other Assets
• Investments (not expected to be sold within a year).
• Intangible assets
– Goodwill, patents, trademarks, copyrights.
– Longer life than prepaid expenses.
 Liabilities
• Obligations to transfer assets or provide services to outside parties.
• Arising from past transactions or events.
• Claims against entity’s assets.
• Not against specific assets, unless indicated.
• Reported at amount that would satisfy obligations on BS date.
– Principal + interest (through BS date).
Current Liabilities

• Satisfied or extinguished within one year or current operating cycle,

whichever is longer.

Accounts Payable
• Suppliers (i.e. vendors) claims for goods or services furnished but not
yet paid.
• Unsecured.
• Notes payable or short-term loans.
– Formal written note.
– Includes amounts owed to financial institutions.
Taxes Payable
• Owed to government for taxes.
• Income taxes often shown separately because of size.
 Current Liabilities
Accrued Expenses
• Earned by outside parties but not yet paid.
• Usually no invoice.
• Includes interest payable, wages payable.
Deferred Revenues
• Also called unearned revenues or pre-collected revenues.
• Advance payment received but company has not yet performed service
or delivered product.
Other Liabilities
• Current liability:
– Current Portion of Long-Term Debt
• Portion due within next year.
• Long-term debt or non-current liabilities.
Owners’ Equity
• Amount owners’ invested in entity.
• = Assets – Liabilities = Net assets
• For a corporation: shareholders’ or stockholders’ equity .
– Shares of stock evidence ownership interest.
• Could be invested in any assets on Balance Sheet.
Two Categories of Shareholders’ Equity
• Paid-in or contributed capital.
• Retained earnings.
Let the Game Begins
Show the accounting equation on the basis of the following transactions:
a) Shri Ganesh commenced business with cash Rs.35,000, goods Rs.8,000 and furniture Rs.7,000.
b) Bought furniture from M/s Mohan Furnitures on credit for Rs.3,000.
c) Purchased goods from Sohan for cash Rs.35,000.
d) Sold goods to Shyam for cash Rs.40,000(costing Rs.30,000).
e) Bought goods from Ramesh Rs.30,000.
f) Sold goods to Shyam costing Rs.30,000 for Rs.50,000.
g) Received Rs.49,500 from Shyam in full settlement.
h) Paid Rs.29,700 to Ramesh in full settlement.
i) Paid half the amount owed to M/s Mohan.
j) Withdrew Rs.1,000 for personal use.
k) Withdrew goods for personal use(cost Rs.500, sale price Rs.600).
l) Purchased household goods for Rs.15,000 giving Rs.5,000 in cash and the balance through a loan.
m) Paid cash Rs.500 for loan and Rs.300 for interest.
n) Goods destroyed by fire (cost Rs.500, sale price Rs.600)
o) Paid salary Rs.500 and salary outstanding Rs.100.
p) Paid rent in advance Rs.2,000.
q) Accrued interest Rs 500.
r) Commission received in advance Rs 1,000.
s) Charged depreciation of Rs 400 on furniture.
Let the Game Begins
Give an example for each of the following types of
transactions:
a) Increase in one asset, decrease in another asset.
b) Increase in asset, increase in liability.
c) Increase in asset, increase in owner’s capital.
d) Decrease in asset, decrease in liability.
e) Decrease in asset, decrease in owner’s capital.
f) Increase in one liability, decrease in another liability.
g) Increase in liability, decrease in owner’s capital.
h) Decrease in liability, increase in owner’s capital.