CH 16

Chapter 16
Basic Accounting:
Concepts, Techniques,
and Conventions
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
16 - 1
Learning Objective 1
Read and interpret the basic
financial statements.
The Need for Accounting

Managers, investors, and other internal groups
want the answers to two important questions:
How well did the
organization perform?
Where does the
organization stand?
The Need for Accounting

Accountants answer these questions
with two major financial statements:
Income Statement
Balance Sheet
Business Transactions
A transaction is any event that affects the

financial position of an organization
and requires recording.
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.
Balance Sheet
Assets = Equities
Assets are economic resources that are expected
to benefit future activities of the organization.
Equities are the claims against, or interests in,
the assets of the organization.
Balance Sheet Equation

Assets = Liabilities + Owners equity
Liabilities are the entitys economic
obligations to nonowners.
Owners equity is the excess
of the assets over the liabilities.
The owners equity of a corporation
is called stockholders equity.
Balance Sheet Accounts

Stockholders Equity
Paid-in Capital
Retained Earnings
Balance Sheet Accounts

Accounts receivable are the amounts due
from customers for sales on open accounts.
Accounts payable are the amounts owed to
vendors for purchases on open accounts.
Analyze typical business
transactions using the
balance sheet equation.
King Hardware Transactions

1
2
3
4
Initial investment by owners, $100,000

cash.
Acquisition of inventory for $75,000 cash.
Acquisition of inventory for $35,000 on
open account.
Merchandise costing $100,000 was sold on
open account for $120,000.

Stockholders
Assets = Liabilities + Equity
1) Cash
2) Cash
Inventory
3) Inventory
4) Receivable
4b) Cost
+ $100,000
75,000
+ 75,000
+ 35,000
+ 120,000
100,000
+ $100,000
+ 35,000
+ 120,000
100,000

5
6
7
Cash collections of accounts receivable,

$30,000.
Cash payments of accounts payable,
$10,000.
On March 1, paid $3,000 cash for rent for
March, April, and May. Rent is $1,000 per
month.

Stockholders
Assets = Liabilities + Equity
5) Cash
Receivable
6) Cash
7) Cash
7a) Prepaid
7b) Expense
Totals
+ 30,000
30,000
10,000
3,000
+ 3,000
1,000
$144,000
10,000
$25,000
1,000
$119,000
Revenues
Revenues are increases in ownership
claims arising from the delivery
of goods or services.
Revenues must be earned.
Revenues must be realized.
Expenses
Expenses are decreases in
ownership claims arising
from delivering goods or
services or using up assets.
Profits
Profits (or earnings or income) are
the excess of revenues over expenses.
Income Statement
The income statement measures
the performance of an organization
by matching its accomplishments
(revenue from customers, which
is usually called sales) and its
efforts (cost of goods sold and
other expenses).
Income Statement
Balance
Balance Sheet
Sheet
February
February 28
28
202
202
Time
Balance
Balance Sheet
Sheet
March
March 31
31
202
202
Income
Statement
for March
Balance
Balance Sheet
Sheet
April
April 30
30
202
202
Income
Statement
for April
Time
The Analytical Power of the

The balance sheet equation
can highlight the link between
the income statement and balance sheet.
Assets (A) = Liabilities (L)

+ Stockholders equity (SE)
The Analytical Power of the

A = L + Paid-in capital + Retained income
A = L + Paid-in capital + Revenue Expenses
Distinguish between the accrual
basis of accounting and the
cash basis of accounting.
Accrual Basis versus Cash Basis

The accrual basis of accounting recognizes
revenues and expenses when they occur
instead of when cash is received or disbursed.
The cash basis of accounting recognizes
revenue and expense when cash is
received and disbursed.
Accrual Basis versus Cash Basis

The accrual basis is the principal conceptual
framework for relating accomplishments
(revenues) with efforts (expenses).
The cash basis fails to match expenses and
revenues in a manner that properly
measures financial position.
Relate the measurement of
expenses to the expiration
of assets.
Adjustments
Under the accrual basis of accounting,
adjustments are used to record implicit
transactions, in contrast to the explicit
transactions that trigger nearly all day-today routine entries.
Adjustments are generally prepared by the
accountant at month or year end.
Types of Adjustments
Expiration of unexpired costs
Recognition (earning) of unearned revenues
Accrual of unrecorded expenses
Accrual of unrecorded revenues
Depreciation
Accountants usually
predict the residual value.
predict the length of the useful life.
allocate the cost to the years of its useful life.
Explain the nature of dividends
and retained income.
Dividends
Dividends are distributions of assets to
stockholders that reduce retained income.
Cash dividends are distributions of assets
that liquidate a portion of the ownership claim.
The distribution is made possible by profitable
operations.
Retained Income
Retained income is a result of profitable
operations, it is not a pot of cash awaiting
distribution to stockholders.
The retained income is, in effect, invested
in the assets and liabilities of the entity.
Select relevant items from a set
of data and assemble them into
a balance sheet, an income
statement, and a statement
of retained income.
King Hardware Company

Income Statement for the Month Ended April 30, 20x1
Sales
Cost of goods sold
Gross profit
Operating expenses:
Rent
$1,000
Wages
6,600
Net income
$85,000
70,000
$15,000
7,600
$ 7,400

Statement of Retained Income
for the Month Ended April 30, 20x1
Retained income, March 31, 20X1

Add: Net income for April
Total
Deduct: Dividends
Retained income, April 30, 19X1
$19,000
7,400
26,400
18,000
$ 8,400

Balance Sheet as of April 30, 20x1
Assets
Cash
Accounts receivable
Inventory
Prepaid rent
$ 85,000
87,000
20,000
1,000
Total assets
$193,000

Balance Sheet as of April 30, 20x1
Liabilities and Stockholders Equity

Liabilities
Accounts payable
$ 81,000
Accrued wages payable
600
Unearned sales revenue
3,000
$ 84,600
Stockholders equity
Paid-in capital
$100,000
Retained income
8,400
108,400
Total equities
$193,000
Distinguish between the
reporting of corporate owners
equity and the reporting of
owners equity for partnerships
and sole proprietorships.
Sole Proprietorship/
Partnership
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.
Comparison of
Owners Equity Reporting
Owners Equity for a Corporation
Stockholders equity
Capital stock (paid-in capital)
Retained income
Total stockholders equity
$100,000
8,400
$108,400
Comparison of
Owners Equity for a Sole Proprietorship
Alice Walsh, capital
$108,400
Comparison of
Owners Equity for a Partnership
Susan Zingler, capital
John Martin, capital
Total partners equity
$ 54,200
54,200
$108,400
Generally Accepted
Accounting Principles (GAAP)
Accounting is based on a set of principles

on which there is general agreement, not
on rules that can be proved.
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.
Financial Accounting
Standards Board (FASB)
The Financial Accounting Standards Board
(FASB) is the primary regulatory body over
accounting principles and practices in the
U.S.
It consists of seven full-time members and
is an independent creation of the private
sector.
International Accounting
Standards Committee (IASC)
International GAAP is set by the

International Accounting Standards
Committee (IASC), a group sponsored
by accountancy bodies in more than 80
countries.
Securities and Exchange

Commission (SEC)
By federal law, the Securities and Exchange

Commission (SEC), a government agency,
has the ultimate responsibility for
specifying GAAP for U.S. companies
whose stock is held by the general investing
public.
Identify how the measurement
conventions of recognition,
matching and cost recovery,
and stable monetary unit
affect financial reporting.
Three Measurement Conventions

Recognition
Three broad measurement
or valuation conventions
(principles) underlie
accrual accounting:
Matching and
cost recovery
Stable monetary
unit
Understand how managers and
investors can learn about the
financial position and prospects
of an organization from its
Financial Statements
Managers and investors
can learn about the
financial position
and prospects of an
organization from its
Financial Statements
Financial statements describe the financial

results of an organization in a consistent
way that allows comparison to historical
results of the organization and to
the results of other organizations.
End of Chapter 16
16 - 53

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Chapter 16

The Need for Accounting

The Need for Accounting

A transaction is any event that affects the

The balance sheet (also called statement of

Balance Sheet Equation

Balance Sheet Accounts

Balance Sheet Accounts

King Hardware Transactions

Initial investment by owners, $100,000

King Hardware Transactions

King Hardware Transactions

Cash collections of accounts receivable,

King Hardware Transactions

The Analytical Power of the

Assets (A) = Liabilities (L)

The Analytical Power of the

A = L + Paid-in capital + Revenue Expenses

Accrual Basis versus Cash Basis

Accrual Basis versus Cash Basis

King Hardware Company

King Hardware Company

Retained income, March 31, 20X1

King Hardware Company

King Hardware Company

Liabilities and Stockholders Equity

Alice Walsh, capital

Accounting is based on a set of principles

An audit is an examination or in-depth

International GAAP is set by the

Securities and Exchange

By federal law, the Securities and Exchange

Three Measurement Conventions

Financial statements describe the financial

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