Basic Accounting: Concepts, Techniques, and Conventions

Basic Accounting:
Concepts, Techniques,
and Conventions
Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 1

Learning Objectives
1. Read and interpret basic financial statements.
2. Analyze typical business transactions using the

balance sheet equation.
3. Distinguish between the accrual basis of accounting

and the cash basis of accounting.
4. Make adjustments to the accounts under accrual

accounting.
5. Explain the nature of dividends and retained earnings.
6. Select relevant items from a set of data and assemble

them into a balance sheet and an income statement.

Learning Objectives
7. Distinguish between the reporting of corporate owners’

equity and the reporting of owners’ equity for partnerships
and sole proprietorships.
8. Explain the role of auditors in financial reporting and

how accounting standards are set.
9. Identify how the measurement principles of recognition,

matching and cost recovery, and stable monetary unit
affect financial reporting.
10. Define continuity, relevance, faithful representation,

materiality, conservatism, and cost benefit (Appendix 15A).
11. Use T-accounts, debits, and credits to record

transactions (Appendix 15B).

The Need for Accounting
Accounting information can be used to assess past

financial performance of a company and help predict
its future performance.
All kinds of organizations—

government agencies, nonprofit organizations, and
others —rely on accounting to gauge their progress.
The accounting process begins with a transaction.

A transaction is any event that affects the financial
position of an organization and requires recording.

Many concepts, conventions, and rules

determine what events a company
records as accounting transactions and
how accountants measure the financial
impact of each transaction.
Financial statements are used to

summarize the recorded accounting
transactions.

Managers, investors, and other internal

groups
want the answers to two important questions:
How well
did
the
organization Where does
perform? the
organization
stand?
Learning
Objective
1
Accountants answer these questions

with three major financial statements:
Balance Income
sheet statemen
t
Statemen
t of
cash
flows
Balance Sheet
The balance sheet (also called statement

of financial position or statement of financial
condition) is a snapshot of the financial status
of an organization at a point in time.
The balance sheet has two sections

(1) assets and
(2) liabilities plus owners’ (stockholders’) equity.

Balance Sheet
Assets = Liabilities + Owners’ equity
Assets are economic resources that

are expected to benefit future
activities of the organization.
Liabilities are the entity’s economic

obligations to nonowners.
Owners’ equity is the excess

of the assets over the liabilities.
Balance Sheet
The owners’ equity of a corporation

is called stockholders’ equity.
Stockholders’ equity
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Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall
10
Balance Sheet
The balance sheet for King Hardware
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Revenues and Expenses
Revenues are increases in ownership

claims arising from the delivery
of goods or services.
Recognize revenue by formally recording it in the

accounting records during the current period only after
it meets two tests:
1.The company must earn the revenues. That is, it must

deliver the goods or render the services to customers.
2.The revenue must be realized or realizable.
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Revenues and Expenses
Expenses are decreases in ownership

claims (stockholders’ equity) arising from
delivering goods or services or using up assets.
Income (also called net income, profits, or

earnings), is the excess of revenues over
expenses. It increases stockholders’ equity.
An income statement summarizes revenues and

expenses. It measures an organization’s
performance by matching its revenue and its
expenses for a span of time, often a month, a
quarter, or a year.
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Income Statement
The income statement shows that General Mills’

stockholders’ equity (retained earnings) increased by
$1,804 million because of profitable operations in the
year ended May 29, 2011. This $1,804 million is
included in the $6,612 million of stockholders’ equity
on the May 29, 2011, balance sheet.
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The Analytical Power of the
Balance Sheet Equation
The balance sheet equation can highlight the link

between the income statement and balance
sheet.
Assets (A) = Liabilities (L) + Stockholders’ equity

(SE)
A = L + Paid-in capital + Retained income
A = L + Paid-in capital + Revenue – Expenses
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15
Learning
Objective
3
Accrual Basis and Cash Basis
The accrual basis of accounting

recognizes revenues and expenses
when they occur regardless of when
cash is received or disbursed.
The cash basis of accounting recognizes

revenue and expense when cash is
received and disbursed.
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Accrual Basis and Cash Basis
The major deficiency of the cash

basis
of accounting is that it is incomplete.
It fails to match efforts and accomplishments

in a manner that properly measures
economic
performance and financial position.
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Nonprofit Organizations
Nonprofit organizations, such as

government agencies and charitable
organizations, also use balance sheets
and income statements.
For years, most nonprofit organizations

used cash-basis rather than accrual accounting.
As these organizations face more pressure to

develop accurate measures of performance,
they are increasingly using accrual accounting.
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Nonprofit Organizations
The basic concepts of assets, liabilities, revenues,

and expenses apply to all organizations, whatever
their goals and wherever they are located. However,
organizations that do not seek profits do not
measure
income. Further, because they have no owners, there
is no owners’ equity.
Balance sheets of nonprofit organizations show a

category of “net assets” instead of “owners’ equity”
To measure the difference between assets and
liabilities. Instead of an income statement, nonprofit
organizations have a “statement of activities”
that reports changes in net assets.
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Learning
Objective
5
Dividends and Retained Earnings
Dividends are distributions of assets to

stockholders that reduce retained earnings.
Cash dividends are distributions of

cash rather than some other asset.
The distribution reduces both assets

and owners’ equity and is made
possible by profitable operations.
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Dividends and Retained Earnings
Dividends reduce retained earnings,

But they are not expenses.
Companies do not deduct dividends from

revenues when measuring income because they
do not help generate sales or conduct
operations.
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Retained Earnings
Stockholders’ equity represents the claims of

owners arising out of their initial investment
(paid-in capital) and subsequent profitable
operations (retained earnings).
Retained earnings and paid-in capital represent

a general claim against, or undivided interest in,
total assets, not a specific claim against any asset.
Retained earnings and paid-in capital result from

profitable operations. Equity is not a pot of cash
awaiting distribution to stockholders.
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Retained Earnings
Retained earnings and paid-in capital result from

profitable operations. Equity is not a pot of cash
awaiting distribution to stockholders.
Do not confuse retained earnings and cash. Cash

can increase while retained earnings decreases,
and vice versa. There is no direct relationship
between retained earnings and available cash.
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Learning
Objective King Hardware Company
6
Select relevant items from a set of data and

assemble them into a balance sheet and an
income statement.
The balance sheet uses totals from the asset,

liability, and stockholders’ equity columns.
The income statement uses the revenue and

expense entries in the retained earnings
column.
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Balance Sheet
King Hardware Company

Balance Sheet as of April 30, 20X1
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Income Statement
King Hardware Company Income Statement

for the Month Ended April 30, 20X1
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Changes in Retained Earnings
King Hardware Company Changes in Retained

Earnings for the Month Ended April 30, 20X1
This statement shows the linkage between the balance

sheet and income statement. It starts with the
beginning balance, adds net income for April, and
deducts cash dividends, to arrive at an ending balance.
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Learning Sole Proprietorships and
Objective 7
Partnerships
A sole proprietorship is a business

entity with a single owner.
A partnership is an organization
that joins two or more individuals
together as co-owners.
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Comparison of Owners’ Equity Reporting
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Comparison of Owners’ Equity Reporting
Unlike corporations, sole proprietorships

and partnerships do not distinguish
between paid-in capital (i.e., amounts
invested by owners) and retained earnings.
Instead, they typically accumulate a single

amount for each owner’s original
investment, subsequent investments, share
of net income, and withdrawals.
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Learning Generally Accepted
Objective 8 Accounting Principles (GAAP)
Accounting is more an art than a science. It is

commonly misunderstood as being a precise
discipline that produces exact measurements
of a company’s financial position and performance.
Accounting is based on a set of principles

on which there is general agreement,
not on rules that can be “proved.”
The principles and procedures that together make

up accepted accounting practice at any given time
are known as generally accepted accounting
principles (GAAP).
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Audit
An audit is an “examination” or in-depth

inspection of financial statements and
companies’
records that is made in accordance with
generally accepted auditing standards.
Auditing standards are approved by the Public

Company Accounting Oversight Board (PCAOB)
which is a part of the Securities and Exchange
Commission (SEC), a government agency that
regulates the financial markets in the U.S.
including financial reporting.
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Ethics
The public sector–private sector relationship:
Confidence in financial information is important to the

smooth functioning of the world’s capital markets, and
confidence in financial statements depends on the
competence and integrity of accountants and auditors.
A hallmark of the accounting profession has been its

ethics and integrity. Most accountants and auditors
are highly ethical and truthfully report their financial
results in accordance with GAAP.
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Learning
Objective 9 Three Measurement Conventions
Recognition
U. S. GAAP is based on a
conceptual framework
that contains three broad Matching
measurement or valuation and
conventions (principles) that cost
underlie accrual accounting: recovery
Stable
monetary
unit
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Recognition Principle
The recognition principle specifies when

a company should record revenue in the
accounting records.
Generally, companies recognize revenue when

it is both earned and realized or realizable.
In some industries revenue recognition is not so

straightforward. These judgment issues require
company accountants together with its auditor to
decide when earning and realization are
sufficiently complete to recognize the revenue.
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Matching and Cost Recovery
The timing of revenue recognition is important

because it leads to the recording of expenses
through the concept of matching—the linking of
revenues with expenses incurred to generate them.
Accountants apply matching as follows:

1. Identify the revenue recognized during the period.
2. Record expenses that relate directly to the
recognized revenue.
3. Record expenses that are costs of operations during
a specific time period that have no measurable benefit
for a future period and must be linked to the current
period’s revenues.
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Matching and Cost Recovery
The heart of recognizing expense is the cost

recovery concept. Companies carry forward
as assets such items as inventories, prepayments,
and equipment because they expect to recover
the costs of these assets in the form of cash
inflows (or reduced cash outflows) in future
periods.
At the end of each period, accountants examine

evidence to assure themselves that they should not
write off these assets—the unexpired costs—as an
expense of the current period.
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Stable Monetary Unit
The monetary unit (for example, the dollar in the

United States, the yen in Japan, or the euro in the
European Union) is the principal means for measuring
assets, liabilities, and stockholders’ equity.
This measurement assumes that the monetary unit—

the dollar, for example—is an unchanging yardstick.
Yet, a 2010 dollar does not have the same purchasing
power as a 2000 or 1990 dollar. Therefore, users of
accounting statements that include dollars from
different years must recognize the limitations of the
basic measurement unit.
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Basic Accounting:

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 1

1. Read and interpret basic financial statements.

2. Analyze typical business transactions using the

3. Distinguish between the accrual basis of accounting

4. Make adjustments to the accounts under accrual

5. Explain the nature of dividends and retained earnings.

6. Select relevant items from a set of data and assemble

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 2

7. Distinguish between the reporting of corporate owners’

8. Explain the role of auditors in financial reporting and

9. Identify how the measurement principles of recognition,

10. Define continuity, relevance, faithful representation,

11. Use T-accounts, debits, and credits to record

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 3

Accounting information can be used to assess past

All kinds of organizations—

The accounting process begins with a transaction.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 4

Many concepts, conventions, and rules

Financial statements are used to

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 5

Managers, investors, and other internal

Accountants answer these questions

The balance sheet (also called statement

The balance sheet has two sections

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 8

Assets = Liabilities + Owners’ equity

Assets are economic resources that

Liabilities are the entity’s economic

Owners’ equity is the excess

The owners’ equity of a corporation

The balance sheet for King Hardware

Revenues are increases in ownership

Recognize revenue by formally recording it in the

1.The company must earn the revenues. That is, it must

Expenses are decreases in ownership

Income (also called net income, profits, or

An income statement summarizes revenues and

The income statement shows that General Mills’

The balance sheet equation can highlight the link

Assets (A) = Liabilities (L) + Stockholders’ equity

A = L + Paid-in capital + Retained income

A = L + Paid-in capital + Revenue – Expenses

The accrual basis of accounting

The cash basis of accounting recognizes

The major deficiency of the cash

It fails to match efforts and accomplishments

Nonprofit organizations, such as

For years, most nonprofit organizations

As these organizations face more pressure to

The basic concepts of assets, liabilities, revenues,

Balance sheets of nonprofit organizations show a

Dividends are distributions of assets to

Cash dividends are distributions of

The distribution reduces both assets

Dividends reduce retained earnings,

Companies do not deduct dividends from

Stockholders’ equity represents the claims of

Retained earnings and paid-in capital represent

Retained earnings and paid-in capital result from

Retained earnings and paid-in capital result from

Do not confuse retained earnings and cash. Cash