2. 2
Learning Outcomes
Understand:
• The five main elements of financial accounts – Revenues, Expenses, Assets, Liabilities and Equity
• The three main financial statements
• The Income Statement
• The Balance Sheet
• The Cash Flow Statement
• The Accounting Equation
• The Tabular system ofAccounting
3. 3
The five key elements of Financial Accounts
Any set of accounting standards (GAAP) require that the financial accounts of a
company provide information about the following five elements of the business:
1. Revenues
2. Expenses
3. Assets
4. Liabilities
5. Owner’s Equity
4. 4
1. Revenues
• These represent the amount of money the business earns from its main / normal business activities
• For instance, money earned from:
• The sale of Coca-Cola bottles for the Coca-Cola company
• The sale of software for Microsoft
• Revenues form the main source of survival of the business (why else do you think businesses treat their
customers as kings?)
• The purpose of revenues is to help the business meet its big and small expenses
• Higher the revenues of an entity, higher its reported profitability
• Given their role in determining profitability, Revenues are reflected in the Income Statement of the company
5. 5
2. Expenses
• These represent money spent or costs incurred by the business, to generate revenues
• For instance,
• Payment to suppliers for raw material purchased
• Salaries to employees
• Income taxes paid to the State
• Depreciation on plant and machinery
• Though expenses are necessary to generate revenues, very high expenses can significantly affect profitability
• Given their role in determining profitability, Expenses are reflected in the Income Statement of the company
6. 6
3. Assets
• These represent resources owned and controlled by the entity, which are expected to generate some future economic
benefit
• In other words, they indicate items that the business hopes to convert into cash in the future (future cash inflows)
• For instance,
• Plant and machinery in the factory
• Computer equipment in the office building
• Goodwill, Patents, Copyrights and Trademarks
• Cash balances
• Higher the asset-size of the business, stronger its financialposition
• Assets are reflected in the Balance Sheet of the business
7. 7
4. Liabilities
• These represent debts or financial obligations, that will have to repaid/ settled by the business in
the future
• In other words, they indicate probable future outflows ofmoney
• For instance,
• Bank loan
• Unpaid salaries, taxes and other expenses
• Amounts due to suppliers for material purchased
• Given their direct impact on the financial position of the business, Liabilities are reflected in the
Balance Sheet of the business
8. 8
5. Equity
• This represents the total amount due from the business to its owners, which must be eventually
returned
• However, ownership entitles these providers of capital to any profit that may be earned through the
use of this money
• Therefore, the Equity balance at any given point is given as:
Total Equity contribution + Accumulated profits tilldate
• Since Equity represents an amount to be returned in the future, think of it as a ‘liability’, though an
internal one. Hence, the term Equity.
• Equity is reflected in the Balance Sheet of the company
9. Statement
of Financial
Position or
Balance
Sheet
Four Key Financial Statements
Statement
of Cash
Flows
Retained
Earnings
Statement
Income
Statement
Notes to The Financial Statements: An integral part of the financial statements.
Summary of significant accounting policies
Contingent liabilities
Subsequent events relating to conditions that existed at the balance sheet date
Subsequent events relating to conditions that did not exist at the balance sheet date.
9
10. Users And Uses Of Financial Information
10
Internal
Users
1
0
12. 12
The Balance Sheet
• Purpose: To reflect the financial position of the business on the last day of the accounting period
• By financial position, one means the relative mix (or proportions) of Assets, Liabilities and Equity
• The Balance Sheet can be condensed in a linear equation, called the Accounting Equation
• The Accounting Equation simply states that
Assets = Liabilities + Equity
• And this must hold true for any business, big or small, at any given point of time
• This can be interpreted in two ways:
Every $ in business assets must have come from somewhere – either through debt or equity OR
Every $ received in debt or equity must be invested in some or the other business asset
• Format
Account form (side by side)
Report form
13. Account
Format
Balance
Sheet
ABC Company
Statement of Financial Position
As at December 31, 2018 (in $000)
Assets Liabilities
Currents Assets Current Liabilities
Cash 32,800 Accounts payable 49,000
Accounts receivable 300 Accrued expenses 450
Prepaid rent 1000 Unearned revenue 1,000
Inventory 39,800 Total current liabilities 50,450
Total Current Assets 73,900 Non-Current Liabilities
Non-Current Assets Notes payable 99,500
Property plant & equipment 48,000 Total Non-Current liabilities 99,500
Total Liabilities 149,950
Leasehold improvements
Less: accumulated depreciation
45,000
(2,000)
43,000
Owner’s Equity
Goodwill 7,000 Common Stock 11,950
Total non-current assets 98,000 Retained Earnings 10,000
Total owner’s Equity 21,950
Total assets 171,900 Total Liabilities & Owner’s equity 171,900
13
14. ABC Company
Statement of Financial Position
As at December 31, 2018 (in $000)
Assets
Currents Assets
Cash 32,800
Accounts receivable 300
Prepaid rent 1000
Inventory 39,800
Total Current Assets 73,900
Non-Current Assets
Property plant & equipment 48,000
Leasehold improvements
Less: accumulated depreciation
45,000
(2,000) 43,000
Goodwill 7,000
Total non-current assets 98,000
Total assets 171,900
Liabilities
Current Liabilities
Accounts payable 49,000
Accrued expenses 450
Unearned revenue 1,000
Total current liabilities 50,450
Non-Current Liabilities
Notes payable 99,500
Total Non-Current liabilities 99,500
Total Liabilities 149,950
Owner’s Equity
Common Stock 11,950
Retained Earnings 10,000
Total owner’s Equity 21,950
Total Liabilities & Owner’s equity 171,900
14
Report
Format
Balance
Sheet
15. The Balance Sheet (Cont’d)
Usefulness:
• Computing rates of return.
• Evaluating the capital structure.
• Assess risk and future cash flows.
• Assess the company’s:
Liquidity,
Solvency, and
Financial flexibility.
15
16. Limitations
• Most assets and liabilities are reported at
historical cost.
• Use of judgments and estimates.
• Many items of financial value are
omitted.
16
The Balance Sheet (Cont’d)
17. Classification Of Balance Sheet Items
• Assets
Current assets
Non-current assets / Fixed assets
• Liabilities
Current liabilities
Non-current liabilities
• Owner’s Equity
Share capital
Retained earnings
17
18. 18
Classification of Assets on the Balance Sheet
• Assets are typically shown in the Balance Sheet, in the order of liquidity, from the most
liquid to the least
• By liquidity of assets, we mean the ease with which these can be converted into cash
• For the same reason, the typical order of presentation is as follows:
1. CurrentAssets
2. Long-term Investments
3. Property, Plant and Equipment (PPE)
4. Goodwill and other intangible assets
5. Other assets
19. 19
Current Assets
• These are assets that the business typically expects to convert into cash within the next 12
months
• These are therefore, highly liquid in nature
• These include:
Cash and bank balances (already in the form of cash)
Inventories
Prepaid expenses such as insurance, rent and taxes
Accounts receivables
Short-term investments
20. Non-Current Assets: Tangible
• Long term assets, that can not be easily converted into cash and
expected to be converted into cash after more than 1 year.
• Tangible assets are physical and measurable assets that are used
in a company's operations.
• Examples:
Long term Investments: Debt or Equity Securities
Property, Plant and Equipment (PPE)
Construction in Progress
20
21. 21
Long-term Investments
• An Investment represents an asset which the business creates:
By cutting down on current consumption of earnings
With the anticipation of earnings (such as dividends or interest) or value appreciation in the future
• Long-term investments are those which are created with the intention of being held for more than
a year
• Typical examples are:
Stocks/ shares of another company
Bonds of another company
Real-estate
22. 22
Property, Plant and Equipment (PP&E)
• This comprises the sum total of all fixed assets of the business, that it expects to use for more than a year
• Given that these are physical in nature, these assets are collectively called ‘Tangible assets’. Tangibility makes
it easier to
physically see and verify them, both for the management, auditors and analysts
• This class forms the biggest chunk of assets for a manufacturing company
• They are subject to an annual depreciation charge (except Land), which represents the decline in value of
these assets due to normal wear and tear and usage over time
• Typical examples include:
• Machinery
• Furniture
• Computers
• Land
23. 23
Non-Current Assets: Intangible Assets
• The polar opposite of Tangible assets described in the last slide, Intangibles represent assets on a
company’s balance sheet, that can be neither seen, touched nor felt
• Nonetheless, they have perceived value for the business
• Given their intangibility, they are hard to observe and worse, value. Their valuation is undertaken
by valuation experts in this area
• Just like Tangibles, even Intangibles undergo a reduction in value over time. This is called
Amortization
• Typical examples include:
Goodwill
Patents and Trademarks
Brand-name
Copyrights
24. 24
Other Assets
• This represents a residual category of assets on the balance sheet
• Comprise all those minor assets that do not fit in the current asset, long-
term investments, PPE and Intangibles category
• Typical examples include:
Deferred tax assets
Bond issue costs
Advances to employees
25. Classification of Liabilities on the Balance Sheet
• “Legal obligations or debt owed to another person or company.”
• “A liability is a present obligation of the enterprise arising from
past events, the settlement of which is expected to result in an
outflow from the enterprise of resources embodying economic
benefits.” (As per IFRS)
• Classification of Liabilities:
Current liabilities (short-term liabilities)
Non-current liabilities (long-term liabilities)
Contingent liabilities
25
26. Current Liabilities
• Obligations that are payable within one year, also known as short term
liabilities.
• Includes:
Payables resulting from the acquisition of goods and services.
Collections received in advance for the delivery of goods or performance of
services.
• Examples:
Accounts payable
Interest payable
Income taxes payable
Bills payable
26
Bank account overdrafts
Accrued expenses
Short-term loans
Unearned Income
27. Non-Current Liabilities
• Obligations that are payable after one year, also known as long
term liabilities.
• Includes:
Obligations arising from specific financing situations.
Obligations arising from the ordinary operations of the company.
Examples:
Bonds payable
Long-term notes payable
Deferred tax liabilities
Mortgage payable
Capital lease
27
28. Contingent Liabilities
• Potential liabilities that may occur depending on the outcome of a
future event.
• A contingent liability is only recorded if the liability is probable
and the amount can be reasonably estimated.
• Examples:
Lawsuits
Product warranties
28
29. Owner’s Equity
• The residual ownership interest in the assets of an entity that
remains after deducting its liabilities, also called shareholders’
equity.
• Paid-in capital
Two basic types of capital stock
Common
Preferred
• Retained earnings
Undistributed earnings of the corporation
Net income for all prior periods
Less dividends declared to shareholders
29
30. • An accounting method used to allocate the cost of a tangible or
physical asset over its useful life or life expectancy.
• Accumulated Depreciation
Carries the to-date depreciation of plant assets
It is subtracted from the cost of the asset to determine the book value
Factors used in depreciation calculation
• Asset cost
• Length of the life of the asset
• Estimated salvage (residual) value of asset when retired
Long-Term Tangible Assets: Depreciation
31. • Depreciation Methods
Straight-line
Declining-balance
Sum-of-the-years’-digits
Units-of-production
• Balance Sheet Presentation
Long-Term Assets:— Depreciation (Cont’d)
Cost of the asset
Less: Accumulated depreciation
Net book value
32. • Cost of asset $10,000
• Estimated salvage $ 2,000
• Estimated life 5 years
Depreciation: Straight-Line Method
Cost Salvage Value
= Annual Depreciation
Estimated Value
$10,000 $2,000
$1,600
5 Years
33. • The salvage value is not depreciated and it equals book value at end of
useful life
Depreciation: Straight-Line Method (Cont’d)
Year
Depreciation for
Year
Accumulated
Depreciation at
End of Year Cost
Book Amount
at End of Year
1 $1,600 $1,600 $10,000 $8,400
2 1,600 3,200 10,000 6,800
3 1,600 4,800 10,000 5,200
4 1,600 6,400 10,000 3,600
5 1,600 8,000 10,000 2,000
34. • Cost $10,000
• Estimated salvage $ 2,000
• Estimated life 5 years
Depreciation: Declining-Balance Method
1
× 2 = Double the straight-line rate*
EstimatedLife
1
× 2 × Book Value at Beginning of Year = AnnualDepreciation
5
*Double the straight-line rate is the maximum rate
35. • Salvage value is not used in the depreciation formula but depreciation
ends when the book value equals the salvage value
Depreciation: Declining-Balance Method (Cont’d)
Year Cost
Accumulated
Depreciation at
Beg. of Year
Book Amount
at Beginning
of Year
Depreciation
for Year
Book
Amount at
End of Year
1 $10,000 — $10,000 $4,000 $6,000
2 10,000 $4,000 6,000 2,400 3,600
3 10,000 6,400 3,600 1,440 2,160
4 10,000 7,840 2,160 160 2,000
5 10,000 8,000 2,000 — 2,000
36. • Cost $10,000
• Estimated salvage $ 2,000
• Estimated life 5 years
Depreciation: Sum-of-the-Years’-Digits Method
Number of Remaining Years
(Cost Salvage) = Annual Depreciation
Sum of Digits of Estimated Life
5
($10,000 $2,000) $2,666.67
(5 4 3 2 1) or 15
37. Depreciation: Sum-of-the-Years’-Digits Method (Cont’d)
Year
Cost Less
Salvage
Value
Fraction
Depreciation
for Year
Accumulated
Depreciation at End
of Year
Book
Amount at
End of Year
1 $8,000 5/15 $2,666.67 $2,666.67 $7,333.33
2 8,000 4/15 2,133.33 4,800.00 5,200.00
3 8,000 3/15 1,600.00 6,400.00 3,600.00
4 8,000 2/15 1,066.67 7,466.67 2,533.33
5 8,000 1/15 533.33 8,000.00 2,000.00
38. • Cost $10,000
• Estimated salvage $ 2,000
• Estimated total hours 16,000
• Actual hours of operation 2,000
Depreciation: Units-of-Production Method
Cost Salvage Value
Per Unit Depreciation
Estimated Life in Capacity
10,000 2,000
= $0.50
16,000 Hours
39. • Actual Hours of Operation × Rate = Depreciation
• 2,000 hours × $0.50 = $1,000
Therefore, the depreciation expense for year one is $1,000
• Asset is depreciated until book value equals salvage value
Depreciation: Units-of-Production Method (Cont’d)
40. 40
The Income Statement
• Purpose: To determine financial performance of the business for the relevant accounting period
• By financial performance, one means profitability
• Profitability is simply the difference between what is earned and that which is spent
• Profit for the period = Revenues – Expenses
• If Revenues > Expenses: The business reports a profit
• If Revenues < Expenses : The business reports a loss
• There are two common ways to prepare an Income Statement – Single and multi-step
41. 41
The types of Income Statement
• The Income Statement is prepared with the objective of measuring the
financial performance of the business, i.e. the profit or loss generated over
the last accounting period
• However, it can be prepared in two ways that differ only in the degree of
detail that they offer – the single-step and the multi-step income statement
• Ultimately, both offer the same end-result, the Net Income
42. 42
Single-Step Income Statement
• What it does: It simply calculates net profit/ loss in one step by subtracting
from sales revenue, total business expenses
• Advantages:
• Easy to prepare and read
• Disadvantages:
• Not very informative. Only one measure of profitability, the Net Income is calculated
and reported. All business expenses are treated as ‘homogenous’
44. 44
Multi-Step Income Statement
• What it does: It calculates net profit/ loss in multiple steps by subtracting
different categories of expenses from sales revenue
• Advantages:
Several measures of profotability available in addition to Net Income, such as Gross
Profit, EBIT etc.
• Disadvantages:
Very detailed. Takes time to both prepare as well as interpret.
45. Different types of earnings…
P&L statement Year t
Net Sales
- Cost of sales
= Gross Margin (A)
Selling expenses
+ General & Admin. Expenses
= Total Operation Expenses (B)
(A-B) EBITDA
- depreciation, amortisation
- impairment losses on assets
= EBIT
- Interest charges on debts
= EBT
- taxes
= EAT
- Dividends
= Retained earnings
The earnings before taxes and nonrecurring
items (EBT) are obtained by deducting
from the EBIT, the total interest charge of
borrowings.
Debt outstanding – reported on the B/S
Interests on debt – reported on the P&L
The earnings after taxes (or net income) (EAT)
are obtained by deducting taxes and non
recurring items from the EBT.
These go in
the B/S
General structure: Multi-step Income statement
46. Basic Elements Of The Income Statement
• Net Sales (Revenues)
Revenue from the sale of principal goods or services sold to customers.
Shown net of sales discounts, allowances and returns.
• Cost of Goods Sold (Cost of Sales)
direct costs associated with selling products to generate revenue.
This line item can also be called Cost of Sales if the company is a service business.
Examples: direct labor, direct materials, and an allocation of other expenses such
as depreciation
46
Retailer
Beginning Inventory
+ Purchases
− Ending Inventory
Cost of Goods Sold
Manufacturer
Beginning Inventory
+ Cost of Goods Manufactured
− Ending Inventory
Cost of Goods Sold
47. Cont…
• Gross Profit or Margin:
Calculated by subtracting Cost of Goods Sold (or Cost of Sales) from
Sales Revenue.
• Operating Expenses
Selling expenses
Administrative expenses
• Other Income or Expense
Secondary activities not directly related to operations
Dividend income. Interest income, Gains (losses) from sale of assets,
and Interest expense
47
48. Cont…
• Income Taxes
refer to the relevant taxes charged on pre-tax income.
• Net Income
calculated by deducting income taxes from pre-tax income.
This is the amount that flows into retained earnings on the
balance sheet, after deductions for any dividends.
48
54. 54
The Statement of Retained Earnings
• Purpose: To calculate the total balance of accumulated profits, due to the owners of the business, as at
the end of the accounting period
• The Statement of Retained Earnings can be thought of as the bridge between the Income Statement
and the Balance Sheet
• Steps in preparation:
• Start with the opening balance of Retained Earnings (from the last year’s balance sheet) (A)
• Add to it, the current year profit just calculated in the Income Statement (B)
• Subtract from this total (A + B), any dividends/ drawings in the current accounting period (C)
• This final balance (A + B – C), which represents the total accumulated business profit, not paid out as dividends, is
reflected as Retained Earnings in the Equity section of the Balance Sheet
55. 55
ABC Company
Statement of Retained Earnings
As at December 31, 2018 (in $000)
Retained earnings balance (January 1, 2018) 7,000
Plus: Net Income after tax for the current year 3,800
Less: Drawings by the owners during the current year (300)
Less: Cash dividend paid during the current year
Preferred stock (200)
Common stock (300)
Total dividends paid (500)
Retained Earnings balance ( December 31, 2018) 10,000
Sample Statement of Retained Earnings
56. Statement of Retained Earnings (Cont’d)
56
Income Statement
Retained Earnings
Statement
Net income is needed to determine
the ending balance in retained
earnings.
57. 57
The Statement of Cash Flows
• Purpose: To identify the sources and uses of cash and explain changes in cash balances
compared to the previous accounting period
• The preparation of the Cash Flow Statement became mandatory for all listed companies only
starting 1988 in the U.S.
• This was because by that time, it had become sufficiently clear that merely the Income Statement
and Balance Sheet were not enough to understand the cash position of abusiness
• The statement provides information about cash inflows and outflows for each business activity
separately – Operating, Investing and Financing
58. Categories in the Statement of Cash Flow
Cash flows from operating activities:
Net cash provided by the company’s operating activities.
A summary of how much cash is generated from the company’s core
business.
Cash flows from investing activities:
The total amount of cash provided by (used in) investing activities.
It reports changes in capital expenditures and long-term investments.
A change in the long-term assets in the balance sheet is reported in the
investing activities of the cash flow statement.
58
59. Cash flows from financing activities:
Reports any issuance or repurchases of stocks and bonds of the company,
as well as any dividend payments it makes.
This is also called the net cash provided by (used in) financing activities.
Cash inflows and outflows related to changes in long-term liabilities and
shareholders’ equity accounts.
59
Categories in the Statement of Cash Flow (Cont’d)
60. OPERATING ACTIVITIES
Cash received from customers $ 370,000
Cash paid to suppliers and employees (310,000)
Interest received 10,000
Interest paid (4,000)
Income taxes paid (15,000)
Net cash provided (used) by operating activities 51,000
INVESTING ACTIVITIES
Capital expenditures (30,000)
6,000
(24,000)
Proceeds from property, plant, and equipment disposals
Net cash provided (used) by operating activities
FINANCING ACTIVITIES
Net proceeds from repayment of commercial paper (4,000)
Proceeds from issuance of long-term debt 6,000
Dividends paid (5,000)
Net cash provided (used) by financing activities (3,000)
Increase in Cash 24,000
Beginning cash balance 8,000
Ending cash balance $ 32,000
60
ABC Company
Statement of Cash Flows
For the Year Ended December 31, 2018
61. Notes to the Financial Statements
• An integral part of the financial statements
• Required presentation
Summary of significant accounting policies
Contingent liabilities
Subsequent events relating to conditions that existed at the balance
sheet date
• Disclose and adjustment of the financial statements
Subsequent events relating to conditions that did not exist at the
balance sheet date
• Disclosure but no adjustment of the financial statements
62. A bird’s eye view
Revenues Expenses Assets Liabilities Equity
Income
Statement
Balance Sheet
Financial performance Financial position
62
63. The Accounting Cycle
• Sequence of accounting procedures completed during each accounting
period
Recording transactions
Recording adjusting entries
Preparing the financial statement
65. 65
What is an accounting transaction
• An accounting transaction is any event that alters the financial position of the business
• And if this is the case, it must necessarily be recorded in the financial accounting records of thecompany
• From the Money Measurement concept, we know that only those transactions/ events can be recorded in the books of the business
that are capable of measured and expressed in terms of money
• It must be noted that every accounting transaction affects at least two different accounts in the financial records. This is because of
what we call the Double Entry system of Accounts which is most commonly used today
• Common examples of accounting transactions:
• Purchase of raw material
• Payment of income taxes
• Cash received from customers
66. 66
Recording accounting transactions
• Typically, accountants use the debit-credit system for recording business transactions
• Business transactions are first recorded as journal entries in which one account is ‘debited’ and the other
is ‘credited’ with the same amount
• Since at any given point of time, debits exactly equal credits, the system of accounts is in balance
• However, as part of this course, we stay clear of preparing journal entries and learning the debit-credit
nature of different types of accounts
• Instead, we utilize another technique called the ‘Tabular System of Accounting’ which helps us achieve
the same results, which is the preparation of financial statements at the end of the accounting period
67. 67
The Tabular System of Accounting
• This is based on the Accounting Equation that states that:
Assets = Liabilities + Equity
• It is called a ‘tabular’ system because we use the above Equation in a ‘table’
format to record transactions as they take place
• Let’s understand the equation in greater detail
71. 71
Example – The Construction Experts Company Limited
Mr. X, an architect, set up the Construction Experts Company in June 2010. After one month, the business had the following balances:
Cash, $20,000; Accounts Receivable, $7,000; Office Supplies, $10,000; Office Equipment, $30,000; Payables, $9,000; Equity, X’s
Capital, $58,000.
The following transactions took place in July 2010:
(a) Billed clients for services, $29,000 (g) Paid electricity expenses, $1,300
(b) Paid assistant’s salary, $2,500 (h) Bought office supplies on credit, $2,800
(c) Provided services and received cash, $14,000 (i) Took a bank loan, $15,000
(d) Collected payments due from clients, $26,000 (j) Bought office equipment for cash, $16,000
(e) Bought equipment on credit, $11,000 (k) Dividends paid, $12,000
(f) Paid suppliers for past purchases, $3,000
Required:
1. Record each transaction using the Tabular System of Accounting (first enter beginning balances)
2. Prepare an Income Statement, Statement of retained Earnings and a Balance Sheet
72. Step 1: Preparing the Table
ASSETS = LIABILITIES + EQUITY
ASSETS LIABILITIES EQUITY
Cash Receivables Office
Supplies
Equipment Payables Creditors
for
Equipment
Creditors
for Supplies
Bank Loan Owner’s
Equity
Note:
As one can see above, all we have done is started with the basic accounting equation and eventually, added a
column for the different types of assets and liabilities that are relevant to this particular business, based on a
reading of its balances and transactions.
Before we can start recording any new transactions, we must remember to write old balances against all
relevant accounts. 23
73. Step 2: Writing opening balances
ASSETS = LIABILITIES + EQUITY
ASSETS LIABILITIES EQUITY
Cash Receivable
s
Office
Supplies
Equipment Payables Creditors
for
Equipment
Creditors
for
Supplies
Bank Loan Owner’s
Equity
Opening
balances
20,000 7,000 10,000 30,000 9,000 0 0 0 58,000
Total = $58,000
Total = $67,000 Total = $9,000
Assets = Liabilities + Equity
67,000 = 9,000 + 58,000
Indeed! We are good to go for recording new transactions. 24
74. 74
Step 3: Recording new transactions
(a) Billed clients for services, $29,000
ASSETS = LIABILITIES + EQUITY
ASSETS LIABILITIES EQUITY
Cash Receivable
s
Office
Supplies
Equipment Payables Creditors
for
Equipment
Creditors
for
Supplies
Bank Loan Owner’s
Equity
Opening
balances
20,000 7,000 10,000 30,000 9,000 0 0 0 58,000
(a) + 29,000 + 29,000
Note that the process of ‘billing’ implies that cash for this sale of services has not been received yet. This creates
a Receivable (an asset). On the other hand, billing generates revenue (even when not received yet), which
increases Owner’s Equity.
75. 75
(b) Paid assistant’s salary, $2,500
ASSETS = LIABILITIES + EQUITY
ASSETS LIABILITIES EQUITY
Cash Receivable
s
Office
Supplies
Equipment Payables Creditors
for
Equipment
Creditors
for
Supplies
Bank Loan Owner’s
Equity
Opening
balances
20,000 7,000 10,000 30,000 9,000 0 0 0 58,000
(a) + 29,000 + 29,000
(b) - 2,500 - 2,500
Payment of assistant’s salary is in the nature of an Expense. All expenses reduce Equity (since they reduce
profitability). Since the salary is paid in cash, Cash goes down too.
76. 76
(c) Provided services and received cash, $14,000
ASSETS = LIABILITIES + EQUITY
ASSETS LIABILITIES EQUITY
Cash Receivable
s
Office
Supplies
Equipment Payables Creditors
for
Equipment
Creditors
for
Supplies
Bank Loan Owner’s
Equity
Opening
balances
20,000 7,000 10,000 30,000 9,000 0 0 0 58,000
(a) + 29,000 + 29,000
(b) - 2,500 - 2,500
(c) + 14,000 + 14,000
Providing services results in Revenue. All Revenues increase Equity. On the other hand, Cash balance goes up
too.
77. 77
(d) Collected payments due from clients, $26,000
ASSETS = LIABILITIES + EQUITY
ASSETS LIABILITIES EQUITY
Cash Receivable
s
Office
Supplies
Equipment Payables Creditors
for
Equipment
Creditors
for
Supplies
Bank Loan Owner’s
Equity
Opening
balances
20,000 7,000 10,000 30,000 9,000 0 0 0 58,000
(a) + 29,000 + 29,000
(b) - 2,500 - 2,500
(c) + 14,000 + 14,000
(d) + 26,000 - 26,000
Collection from clients or customers increases the cash balance. However, customers who pay us now cease to
be Receivables. This is a classic case of ‘conversion of an asset into another’, without any change in either
Liabilities or Equity.
78. 78
(e) Bought equipment on credit, $11,000
ASSETS = LIABILITIES + EQUITY
ASSETS LIABILITIES EQUITY
Cash Receivable
s
Office
Supplies
Equipment Payables Creditors
for
Equipment
Creditors
for
Supplies
Bank Loan Owner’s
Equity
Opening
balances
20,000 7,000 10,000 30,000 9,000 0 0 0 58,000
(a) + 29,000 + 29,000
(b) - 2,500 - 2,500
(c) + 14,000 + 14,000
(d) + 26,000 - 26,000
(e) + 11,000 + 11,000
Equipment is an asset, so any purchase of it increases an asset balance. However, since payment for this purchase
has not been made, this creates a liability called ‘Creditors for Equipment’ till the time the payment is actually
settled.
86. 86
Step 5: Preparing Financial Statements
The Construction Experts Company
Income Statement, for the month ended July 2010
Amount (in $) Amount (in $)
Revenues (29,000 + 14,000) (A) 43,000
Less: Expenses (B)
- Assistant’s Salary 2,500
- Electricity 1,300 (3,800)
Net Income (A – B) 39,200
Statement of Retained Earnings, for the month ended July 2010
Opening balance of Retained Earnings (C) 0
Add: Net Income for the period (D) 39,200
Earnings available for distribution (C + D) 39,200
Less: Dividends paid (12,000)
Retained Earnings, transferred to Balance Sheet 27,200
87. 87
The Construction Experts Company
Balance Sheet, as on July 31, 2010
Amount (in $) Amount (in $)
ASSETS
Cash 40,200
Receivables 10,000
Office supplies 12,800
Equipment 57,000 120,000
LIABILITIES
Payables 6,000
Creditors for Equipment 11,000
Creditors for Supplies 2,800
Bank Loan 15,000 34,800
EQUITY
Opening balance of Equity 58,000
Add: Retained Earnings for the period 27,200 85,200
Total of Liabilities + Equity 120,000
88. 88
Temporary versus Permanent Accounts
• To recall, we have studied 5 basic elements of the Financial Accounting system – Revenues, Expenses,
Assets, Liabilities and Owner’s equity
• These can be classified into Temporary and Permanent, based on the length for which they are carried
on the financial statements
• Temporary Accounts: These are those are carried only for one accounting period to which they relate.
After the end of the period, these are closed and reset to zero. These are the Income Statement accounts.
• These include Revenue, Expense and Dividend accounts
• Permanent Accounts: These are those that are carried forward from year to year, for as long as they
exist. They are never reset to zero. These are the Balance Sheet accounts.
• These include Asset, Liability and Owner’s Equity accounts