accounting for the nonfinancial manager chapter 2: the accounting equation

Accounting for the Nonfinancial Manager

Chapter 2: The Accounting Equation

Accounting for Non-Financial Managers, Revised 2nd ed.© Captus Press Inc. All Rights Reserved© Harvard University Division of Continuing Education, 2011

Chapter 2: The accounting equation

The basic accounting framework:

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The accounting equation


Total assets = Total claims

= Total debt claims + total owners’ (“equity”) claims

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The accounting equation




Or most commonly,

Total assets = Total liabilities + total shareholders’ equity

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Framework: the basic accounting equation




Or most commonly,

Total assets = Total liabilities + total shareholders’ equity

The last form of the equation uses the terminology of the balance sheet of an incorporated company. In fact, the balance sheet is a direct expression of the accounting equation.

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The accounting equation as a framework for financial reporting

The basic accounting equation is a powerful framework for collecting, organizing and reporting financial information. With this one conceptual tool we can simultaneously:

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Measure how the company has been doing (income statement)

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Show where it stands financially at the end of the period (balance sheet)

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Summarize transactions with its owners (statement of retained earnings or statement of owners’ equity).

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Summarize transactions with its owners (statement of retained earnings or statement of owners’ equity).

One further extension allows us to summarize balance sheet changes (statement of cash flows).

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The accounting cycle

The steps involved in using the accounting equation from the initial recording of transactions to the production of the financial statements comprise the accounting cycle.

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The accounting cycle

events

Id en tify tran sa c tio n s & rec o rd in jo u rn a l

P re p a re fin a n c ia l s ta tem en ts

users

P o st to g e n e ra l le d g er

Correct, adjust & close books

Begin cycle againfor next period

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A simple example

Consider the following situation:

You know a bit about computers and have decided to go into business selling specialized computer accessories to other small businesses.

You will operate out of your home as a sole proprietor.

You have savings from part-time and summer jobs and you are prepared to commit that money to your new business.

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Example: details

1. On 1 September you deposit $6,000 in a bank account in name ofyour company, Handywares & Co.

2. You order $7,000 of your product line from a supplier. You make apartial payment of $4,000 and the supplier ships all the goods. Theterms are that you pay the balance by 15 October.

3. In September, you pay $2,000 cash (including tax) for an officecomputer with programs. This should be useful for 2 years.

4. September sales are $4,500. Of this, $3,000 is collected in cash, thebalance is expected to be received in first two weeks of October.

5. At end of September, you still have one half the goods that youpurchased in the month.

Write answers to the following questions.

" How well did you do in September?" Where do you stand financially at the end of September? " Other than you, who else has an interest in these results and why?

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Procedure

This involves:a. Identifying transactionsb. Recording them in an accounting frameworkc. Balancing the accountsd. Drawing up financial statements

Drawing up the financial statements will allow us to answer questions 1 & 2 and suggest the answers to question 3.

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Recording transactions

The accounting cycle starts by recording transactions. Each transaction must be recorded in a way that maintains the basic accounting equation.

Writing ΔX to represent a change in X, this means that each transaction must satisfy the following equation:

Δ Assets = Δ Liabilities + Δ Shareholders’ Equity

For each transaction, the algebraic sum of value changes on one side of the balance sheet must equal the algebraic sum of value changes on the other side.

If each transaction is balanced, the accounting equation will remain in balance.

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Examples of transactions

Issue of shares for $600 cash: increase the asset cash by $600and increase shareholders’ equity, share capital, by $600

Purchase of $75 inventory on account: increase the asset inventory by $75,

and increase the liability, accounts payable, by $75

Purchase of land for $200 cash and $300 bonds payable: increase the asset, land, by $500)and decrease the asset, cash, by $200)and decrease the liability, bonds payable, by $300

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Handywares & Co.Analysis of transactions, Sep 2006

LINES are TRANSACTIONS, COLUMNS are ACCOUNTS

LIABILITIES +# ITEM CASH ACCO'S INV'TORY OFFICE CHECK TOTALS* ACCO'S J DOE REVENUE EXPENSES

REC'BLE EQUIP TOT. ASSETS TOT. L & O/ E PAYABLE CAPITAL

1 Initial deposit 0 0

2 Purchases 0 0

3 Office computer 0 0

4 Sales 0 0

5 Inventory 0 0

0 0

0 0 0 0 0 0 0 0 0 0

TRANSACTIONS (journal) are recorded line by line, and at the same time sorted by column into ACCOUNTS (general ledger)

=ASSETS OWNERS' EQUITY

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Handywares & Co.

Analysis of transactions, Sep 2003LINES are TRANSACTIONS, COLUMNS are ACCOUNTS

LIABILITIES +

# ITEM CASH ACCO'S INV'TORY OFFICE CHECK TOTALS* ACCOS J DOE REVENUEEXPENSES

REC'BLE EQUIP T OT . A T OT . L & O/ EPAYABLE CAPITAL

1 Initial deposit 6,000 6,000 6,000 6,0002 Purchases -4,000 7,000 3,000 3,000 3,0003 Office computer -2,000 2,000 0 0

4 Sales 3,000 1,500 4,500 4,500 4,5005 Inventory -3,500 -3,500 -3,500 -3,500

Amortization -83 -83 -83 -833,000 1,500 3,500 1,917 9,917 9,917 3,000 6,000 4,500 -3,583

=ASSETS OWNERS' EQUITY

THE LAST LINE IS THE TRIAL BALANCE

From here you can preparea set of financial statements

in good form

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Now prepare the statements

The following order will be the easiest1. Income Statement2. Statement of Capital

– This is because this is an unincorporated company

– for an incorporated company we would prepare a Statement of Retained Earnings

3. Balance Sheet4. Cash Flow Statement

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Handywares & Co.Income Statement

For the month of September 2006

RevenueSales …………………………………………….. $

4,500Expenses

Cost of goods sold ………….. $ 3,500Amortization ………………….. 83

Total expenses ………………………………..… 3,583Net income ………………………………………………… $ 917

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Handywares & Co.Statement of CapitalAs at 30 September 2006

Initial investment …………………………………….. $ 6,000Net income for the month …………………….…… 917

6,917

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Handywares & Co.Balance Sheet

As at 30 September 2006

Assets

Cash ……………………… $ 3,000Accounts receivable …….

1,500Inventory ………………….. 3,500Total current assets …… $

8,000 Equipment, net ………….. 1,917

$ 9,917

Liabilities and Owner’s Equity

LiabilitiesAccounts payable .…. $ 3,000

Owner’s equityJ. Doe, Capital ……….. 6,917

$ 9,917

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Handywares & Co.Cash Flow Statement

For the month of September 2006

Cash received from (used in) operating activitiesNet income …………………………………………….. $ 917Add back amortization ……………………………. 83

1,000Increase in non-cash working capital …….… (2,000)

$ (1,000) Cash received from (used in) investing activities

Purchase of equipment …………………..……… (2,000)Cash received from (used in) financing activities

Investment by owner ………..…………………… 6,000

Cash at end of the year ….…………………………………… $ 3,000

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Dimensions of the financial statements

• With respect to Time– Stock – Flow

• Scope– Comprehensive – Specific focus on evolution of the

shareholders’ claim

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The financial statements

• Statement– Balance sheet

– Income statement

– Statement of retained earnings

– Statement of cash flows

• Dimensions & purpose– Stock/Comprehensive

• where does the company stand financially at end of period

– Flow/Shareholders’ claim• Details of operations for benefit

of shareholders over the period– Flow/Shareholders’ claim

• Summary of operations• How much of shareholders’

claim was distributed to them in the period

– Flow/Comprehensive• In what ways and why did the

balance sheet change over the period

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Purpose of principal financial statements

Balance sheet• Business valuation:

– What it has; what it owes; owners’ equity

• To assess ability to pay debts as they come due – Liquidity (short-term)– Solvency/risk (long-

term)

Income statement• Size of market• Structure of

expenses• to predict long-term

profits• ability to pay future

dividends

Both Scale of operations To predict long-term profitability

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Double entry transactions

If every accounting transaction must satisfy the following equation

Assets = Liabilities + Shareholders’ Equity

then we have these possiblilities:

+ Assets with + Liabilities or + Shareholders’ Equity

- Assets with - Liabilities or - Shareholders’ Equity

+ Assets with + Liabilities or + Shareholders’ Equity - Assets with - Liabilities or - Shareholders’ Equity

Note revenue is an increase in shareholders’ equity expense and dividends are decreases in S/E

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Double entry transaction, continued

Increase inan asset

Increase in aliability or equity,includingrevenue

Decrease inan asset

Decrease in aliability or equity,includingexpense ordividend

And we can generalizes as follows--for simple doubleentry transactions, only those combinations linked bybars maintain the basic accounting equation:

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Double entry transactions, concluded

And even more consisely

Left side entry

Right sideentry

Debit Credit

Dr CrThus the terms debit (Dr) and credit (Cr) are simply shorthand ways of describing transactions. If the (dollar value of) the debits in a transaction equal the credits, the basic accounting equation is respected.

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ASSETS = LIABILITIES AND OWNERS' EQUITY

INCREASES ON LEFT SIDE--DECREASES ON RIGHT SIDE DECREASES ON LEFT SIDE--INCREASES ON RIGHT SIDE

# ITEM CASH ACCO REC 'BLE INVENTORY OFFICE EQUIP ACCO PAYABLE J . DOE, CAP ITAL REVENUE EXPENSES

LS RS LS RS LS RS LS RS LS RS LS RS LS RS LS1 Initial deposit 6,000 6,0002 Purchases 4,000 7,000 3,0003 Office computer 2,000 2,0004 Sales 3,000 1,500 4,5005 Inventory 3,500 3,500

TOTAL 9,000 6,000 1,500 7,000 3,500 2,000 3,000 6,000 4,500 3,500

ACCOUNTS, NET 3,000 1,500 3,500 2,000 3,000 6,000 4,500 3,500

Total RS/LS LS RS

Assets 10,000 0 LS RS

Liabilities & O/E 3,500 13,500

Overall LS RS

13,500 13,500

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ASSETS = LIABILITIES AND OWNERS' EQUITY

INCREASES ON LEFT SIDE--DECREASES ON RIGHT SIDE DECREASES ON LEFT SIDE--INCREASES ON RIGHT SIDE

therefore, DEBITS ON LEFT SIDE -- CREDITS ON RIGHT SIDE

# ITEM CASH ACCO REC 'BLE INVENTORY OFFICE EQUIP ACCO PAYABLE J . DOE, CAPITAL REVENUE EXPENSES

Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr1 Initial deposit 6,000 6,0002 Purchases 4,000 7,000 3,0003 Office computer 2,000 2,0004 Sales 3,000 1,500 4,5005 Inventory 3,500 3,500

TOTAL 9,000 6,000 1,500 7,000 3,500 2,000 3,000 6,000 4,500 3,500

ACCOUNTS, NET 3,000 1,500 3,500 2,000 3,000 6,000 4,500 3,500

Total Dr/Cr Dr Cr

Assets 10,000 0 Dr Cr

Liabilities & O/E 3,500 13,500

Overall Dr Cr

13,500 13,500

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Form of a transaction

A transaction is normally recorded first as a journal entry in the journal. For example, if a company borrows $5,000 from the bank on 1 Sep 06, the transaction is recorded in its books as follows:

Dr Cr1 Sep 06 Dr Cash [A] 5,000

Cr Bank loan [L] 5,000

Demand loan taken from Bank of XYZ, secured on inventory

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Form of a transaction--Notes

Notes1. Form is important. Debits, both account titles and dollar amounts,

are aligned to the left in their columns and the credits accounts titles and amounts are aligned to the right.

2. Statement signifiers [Asset, Liability, Shareholders’ Equity, REVenue, EXPense, DIVidend] are used only for teaching purposes.

Dr Cr1 Sep 06 Dr Cash [Asset] 5,000

Cr Bank loan [Liab’y] 5,000

Demand loan taken from Bank of XYZ, secured on inventory

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The accounting cycle in practice

events

rec o rd tran s ac tio n s in jo u rn a l

P re p a re fin a n c ia l s ta tem en ts

users

P o st to g e n era l le d g er

JournalSalary exp….500

cash…………..…500

Acc rec…….2000

Sales……………2,000

etc

cashxxxxx

xx

xx

xx

xx xx

A/Rec

Inv Equip

A/Pay

C/S Rev

Sal Rent

xxx

GL

xx

Add adjusting journal entries

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What are adjustments?

Adjustments are journal entries (AJEs) made at period-end to ensure that the books are on a full accrual basis.

The accrual basis of accounting is the principle that revenues and expenses are recognized in the period that the underlying event takes place (rather than when the associated cash transactions occur).

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Why adjustments?

• Day-to-day accounting normally just picks up transactions involving cash, receivables, payables

• This gives cash flow information• Income measurement needs value flow

information, in particular:– Revenue, not receipts– Expense, not expenditure

• Also, day-to-day accounting misses time-based transactions

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Types of adjustments

• Accruals – From cash flow to value flow

• Adjust expenditure to expense, receipt to revenue• Examples: accrued salaries payable, prepaids, COGS, income

taxes • Also allowances such as warranties & bad debts

– Accrue pure time-based revenue and expenses such as interest & depreciation

• Other– Correction of errors– Exceptional events such as major write downs

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Adjustments: procedure

• Review accounts in light of all available information

• Compare actual balance of relevant account (income statement, balance sheet or both) to what it should be

• Make entry to income statement, balance sheet accounts pairs to bring them to what they should be, e.g., so income statement measures resource flows, not cash flows

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Relationship between convention set of books

and the spreadsheet

• A conventional set of books comprises the A conventional set of books comprises the journal and the general ledgerjournal and the general ledger

• The spreadsheet combines the twoThe spreadsheet combines the two– The lines are the journal entries The lines are the journal entries – The columns are the general ledger The columns are the general ledger – Analytically very neat, but practically very Analytically very neat, but practically very

cumbersome for traditional paper systems cumbersome for traditional paper systems • As time passes it gets very longAs time passes it gets very long• After more than a few accounts, it gets very wideAfter more than a few accounts, it gets very wide

– The spreadsheet, however, is well suited to The spreadsheet, however, is well suited to computerized accounting systems.computerized accounting systems.

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From journal to general ledger

• Journal: chronological• Ledger: analytical• Journal entries are ournal entries are

posted (copied), line by posted (copied), line by line, to corresponding line, to corresponding accountaccount in the general in the general ledgerledger

• Use a Use a T-accountT-account to to represent an accountrepresent an account

Account name

Debit

Credit

xxxxx

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1. Identify amount of discrepancya. look for that number in source document & missing from TB; if notb. look for half that number in a column; if notc. divisible by 9? look for transposition*

2. If these don’t work (& they only work for a single error)a. add again in opposite directionb. check postings....

3. Just start again

For example, consider 5this trial balance: 7

1448

*a transposition is any 60 rearrangement of all digits 67 67

Errors in a Trial Balance or other self-balancing columns

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accounting for the nonfinancial manager chapter 2: the accounting equation

Documents

accounting equationaccounting

total claims

total assets

total debt

nonfinancial managers

financial information

powerful framework

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