Basic Accounting Concepts Chapter 2 Basic Accounting Concepts

Learning Objectives After studying this chapter, you should be able to… Describe the basic elements of a financial accounting system. Analyze, record, and summarize transactions for a corporation’s first period of operations. Prepare financial statements for a corporation’s first period of operations. Analyze, record, and summarize transactions for a corporation’s second period of operations. Prepare financial statements for a corporation’s second period of operations.

Describe the basic elements of a financial accounting system Learning Objective 1 Describe the basic elements of a financial accounting system

Basic Rules of an Accounting System Rules determine: WHAT transactions are to be recorded WHEN transactions are to be recorded HOW transactions are to be recorded AMOUNT of the transaction to be recorded Rules determine what, when, and the amount recorded. Rules are derived from the accounting concepts covered in chapter 1. Rules govern how transactions are recorded in an accounting system. A transaction is an economic event that affects the financial statements. A transaction can affect one, two, or more items within the financial statements. A transaction is an economic event that can affect one, two or more items in the financial statements.

Framework of an Accounting System Assets = Liabilities + Equity The Accounting Equation

Integrated Financial Statement Framework: Template By expanding the accounting equation, transactions can be analyzed, summarized, and recorded within the integrated financial statement framework. The left-hand column in Exhibit 1 shows the effects of the transactions on the statement of cash flows; this can be done by analyzing the impact of a transaction on the cash balance. The right-handed column in Exhibit 1 shows the effects of transactions on the income statement; Net income will ultimately become part of retained earnings linked to balance sheet in stockholders’ equity section. By examining Exhibit 1, the link between the balance sheet, cash flow statement, and income statement is clearly demonstrated. Impact of transaction on cash Impact of transaction on income statement

Controls of an Accounting System Ending Cash on Balance Sheet = Statement of Cash Flows Net Income on Income Statement = Net Effects of Revenues/Expenses on Retained Earnings THE ACCOUNTING EQUATION MUST BALANCE The accounting equation that serves as the basis of the framework of an accounting system has a built in control: The accounting equation MUST balance. The ending cash balance on the statement of cash flows must equal the ending cash balance on the balance sheet. The net income on the income statement must equal the net effects of revenues and expenses on retained earnings and, ultimately, the net income reported on the statement of retained earnings. Just because the accounting equation is in balance that does not mean the financial statements are error-free.

Learning Objective 2 Analyze, record, and summarize transactions for a corporation’s first period of operations

Integrated Financial Statement Framework: Starting Family Health Care, P.C. Dr. Landry invests $6,000 to start a practice Using the integrated financial statement framework, recording the first period transactions of a business can be demonstrated. A “P.C.” is a professional corporation. Cash on the balance sheet increases $6,000 to reflect Dr. Landry’s cash investment. Stock issued to owners is referred to as Capital Stock. Under the Statement of Cash Flows column, Cash from Financing activities increases by $6,000; no income statement accounts are affected.

Integrated Financial Statement Framework: Borrowing Money Family Health Care, P.C. borrows $10,000 from First National Bank Cash again increases on the balance sheet by the $10,000 borrowed and this also impacts the Statement of Cash Flow as a financing activity. Since the company has incurred an obligation, the liability account Notes Payable also increases $10,000. No income statement accounts are affected by this transition.

Integrated Financial Statement Framework: Buying Land Family Health Care, P.C. pays $12,000 in cash to purchase a parcel of land. Since Family Health purchased the land with cash, the cash balance on the balance sheet decreases by $12,000. To balance the accounting equation, the asset ‘Land’ is increased by $12,000, reflecting the purchase price of the land. Under the Statement of Cash Flows column, Cash from Investing activities is decreased by $12,000.

Integrated Financial Statement Framework: Earning of Fees Family Health Care, P.C. earns fees of $5,000 and receives those fees in cash. Since the $5,500 of fees were received in cash, the cash balance on the balance sheet increases by $5,500. This $5,500 is also shown in the Statement of Cash flows as an increase to Cash from Operating Activities. Since the $5,500 represents revenue earned, to balance the accounting equation, the retained earnings balance increases by $5,500. Retained Earnings is increased because fees earned contribute to net income and net income increases stockholders’ equity. Under the Income Statement column, Fees Earned is reflected as a positive $5,500.

Integrated Financial Statement Framework: Paying of Expenses Family Health Care, P.C. pays $2,900 in cash for various expenses of doing business. The expenses add up to a total of $2,900 ($1,125 + $950 + $450 + $100 + $275) Since the expenses are paid in cash, the cash balance on the balance sheet decreases by $2,900 which is the total of the. Under the Statement of Cash Flows column, Cash from Operating activities decreases by $2,900. On the Balance Sheet, Retained Earnings is decreased for the $2,900 of expenses. Expenses have the opposite effect from revenues on net income and stockholders’ equity. Under the Income Statement column, each expense is listed as a negative amount.

Integrated Financial Statement Framework: Paying of Dividends Family Health Care, P.C. pays dividends of $1,500 to their only stockholder, Dr. Lee Landry. Since the $1,500 is paid in cash, the cash balance on the balance sheet decreases by $1,500. Under the Statement of Cash Flows column, the cash paid is shown as a decrease in Cash from Financing activities. To balance the accounting equation, Retained Earnings is decreased for the $1,500 dividend paid. Dividends represent a payout to the owners, they are not considered expenses.

Integrated Financial Statements: Family Health Care, P.C. The summary of the first period transactions of Family Health Care is shown on the next slide. The accounting equation under the Balance Sheet columns balances. (Total Assets of $17,100 = Total Liabilities of $10,000 + Total Stockholders’ Equity of $7,100) The ending cash balance of $5,100 on the balance sheet equals the cash balance under the Statement of Cash Flows column. The net income under the Income Statement column of $2,600 equals the net effects of revenues and expenses on the Retained Earnings column of the balance sheet. (remember to not include Dividends as an expense!) The balance sheet reflects the accounting equation. The two sides of the accounting equation are always equal. Every transaction increases or decreases one or more of the balance sheet elements of assets, liabilities and stockholders’ equity. A transaction may not have impact on the Statement of Cash Flows or the Income Statement. Every transaction that affects cash must impact the cash balance on the balance sheet and the Statement of Cash Flows.

Observations from Family Health that apply to all companies … Stockholders’ equity is increased by amounts invested by stockholders and decreased by amounts paid in dividends to stockholders. Revenues increase retained earning and expenses decrease retained earnings. The effects of revenue and expense transactions must also be reflected on the Income Statement.

Learning Objective 3 Prepare financial statements for a corporation’s first period of operations

Preparation of Financial Statements This exhibit lists Family Health’s transactions in the order they occurred; it does not group and summarize the transactions in a meaningful manner. Balance Sheet components Family Health Care, P.C. prepares financial statements to summarize the financial activity for September. The Income Statement is prepared using the Income Statement column. The Retained Earnings Statement is prepared next because net income links the two statements and the ending retained earnings is needed in order to prepare the Balance Sheet. The Balance Sheet is prepared using the balances shown under the Balance Sheet columns. The Statement of Cash Flows can be prepared by using the Statement of Cash Flows columns. Statement of Cash Flow components Income Statement components

Income Statement The income statement shows fees earned of $5,500 and total expenses of $2,900 for a net income of $2,600. The amounts can be found in the Income Statement column of Exhibit 2. Operating expenses are normally listed in order of size, beginning with the largest expense. Miscellaneous expense is usually shown as the last expense item, regardless of amount.

Retained Earnings Statement Since Family Health Care began operations at the beginning of the month, there is not a retained earnings beginning balance for this Statement of Retained Earnings. Net Income and Dividends are the only items that affected Retained Earnings for this period.

Balance Sheet Family Health Care’s assets, liabilities, and stockholders’ equity as of September 30, 2011 are taken from the last lines of the Balance Sheet columns on Exhibit 2. In the Assets section of a Balance Sheet, Assets are normally listed in order of liquidity, starting with cash. Liquidity refers to the ability to convert an asset to cash. Notes Payable is the only liability of Family Health Care. When a company has more than one liability, they are listed in the order they will be paid in cash. Stockholders’ Equity is made up of Capital Stock and Retained Earnings.

Statement of Cash Flows Family Health Care’s statement of cash flows can be prepared from the Statement of Cash Flows column on Exhibit 2. Since this was the first month of operations, cash at the beginning of the month was zero. Cash increased $5,100 during the month due to operating activities that generated $2,600 of cash and financing activities that provided $14,500 of cash. Cash was used to purchase land in the amount of $12,000. This was cash used for an investing activity.

Integrated Financial Statements Statement of cash flows links to cash on balance sheet. The ending cash balance of $5,100 on the balance sheet equals the ending cash balance on the Statement of Cash Flows. Net income from income statement links to retained earnings statement. Net income of $2,600 is reported on the Income Statement and also the Statement of Retained Earnings. Retained earnings links to balance sheet in stockholders’ equity. The ending retained earnings balance of $1,100 is reported on the Statement of Retained Earnings and as a part of Stockholders’ Equity on the Balance Sheet.

Learning Objective 4 Analyze, record, and summarize transactions for a corporation's second period of operations

Summary of October Transactions During October, Family Health received fees of $6,400 in cash. They also paid expenses in cash of: Wages, $1,370 Rent, $950 Utilities, $540 Interest, $100 Miscellaneous, $220 They also paid $1,000 of dividends in cash. The Balance Sheet columns of the new exhibit will start with the ending balances carried forward from the September exhibit. The Balance Sheet is always the cumulative total of an organization’s assets, liabilities and stockholders’ equity. In contrast, the Statement of Cash Flows and Income Statement columns only report the transactions of the period.

Learning Objective 5 Prepare financial statements for a corporation’s second period of operations

Summary of October Transactions The October transactions summarized on Exhibit 6 can be used to prepare the financial statements for October. The Income Statement will be prepared first, followed by the Statement of Retained Earnings, then the Balance Sheet and the Statement of Cash Flows.

Income Statement The amounts can be found in the Income Statement column of Exhibit 6. The income statement shows fees earned of $6,400 which is a 16.4% increase over September fees earned. Expenses for October are reported at $3,180 which is a 9.7% increase over September. Net income of $3,220 for October is a 23.8% increase over the Net income of September. This suggests Family Health Care’s operations are profitable and expanding.

Retained Earnings Statement The beginning Retained Earnings balance of $1,100 was the ending Retained Earnings balance as of September 30, 2011. Net Income increased Retained Earnings this period $3,220 and Dividends decreased Retained Earnings by $1,000, resulting in an ending Retained Earnings balance of $3,320.

Balance Sheet Family Health Care’s assets at the end of October amounted to $19,320, which is an increase of $2,220; this increase is in the cash account. Total liabilities did not change during October. Since total assets increased by $2,220 and liabilities remained the same- total stockholders’ equity must increase by $2,220 in order for the accounting equation to remain in balance. The $2,220 increase in stockholders’ equity equals the increase in Retained Earnings during October.

Statement of Cash Flows Family Health Care’s statement of cash flows for October shows an increase in cash of $2,220. The increase in cash is due to operating activities less the financing activity of $1,000 in dividends paid during the year. The net increase in cash of $2,220 is added to the beginning balance of cash for October of $5,100 to yield the ending cash balance of $7,320. The cash balance of $7,320 appears on the Statement of Cash Flows and the Balance Sheet.

Statement of cash flows links to cash on balance sheet Statement of cash flows links to cash on balance sheet. The ending cash balance of $7,320 on the balance sheet equals the ending cash balance on the Statement of Cash Flows. Net income from income statement links to retained earnings statement. Net income of $3,220 is reported on the Income Statement and also the Statement of Retained Earnings. Retained earnings links to balance sheet in stockholders’ equity. The ending retained earnings balance of $3,320 is reported on the Statement of Retained Earnings and as a part of Stockholders’ Equity on the Balance Sheet.

End of Chapter 2