11 Basic Concepts

1. Money measurement.
2. Entity.
3. Going concern.
4. Cost.
5. Dual aspect.
6. Accounting period.
7. Conservatism.
8. Realization.
9. Matching.
10. Consistency.
11. Materiality.
Concept #1:
Money Measurement

 Accounting records are recorded in monetary

terms at the value at time transaction is recorded.
 This is a severe limitation.
 If something can’t be valued it can’t be recorded;
e.g., president’s health, affect of strike.
 Price changes are ignored.
Concept #2: Entity

 For whom accounts are kept.

 Distinguish from owner.
 May or may not be separate legal entity.
 One entity may be part of a larger entity.
 Motorola, Inc. presents one set of financial
statements with parent company operations
combined with all of its subsidiaries around the
world.
Concept #3: Going Concern

 Assumed to continue in operation for an indefinite

period.
 Alternative assumption: liquidation/bankruptcy.
 If an entity were in liquidation, only meaningful asset
values are liquidation values.
Concept #4: Cost

 Assets defined:
 = economic resources.
 = cash or something that helps generate cash.

 Assets are recorded at cost, that is, price paid.

 Fair value = amount for which asset could be
currently purchased or sold.
 Book value of asset = recorded value.
Cost Concept
Non-monetary Assets

 Land, buildings, machinery and similar.

 Generally, book value = fair value only at time of
acquisition.
 Depreciation or amortization = systematic
allocation of cost over life of asset.
 B.V. = recorded cost - depreciation to date.
 Rationale for cost concept:
 Relevance sacrificed for objectivity.
Cost Concept: Monetary Assets

 What are monetary assets?

 Cash and marketable securities.
 Initially recorded at cost.
 Adjusted to fair value (=market value, if available).
 Rationale: FV is relevant & objective.
 Why is FV relevant & objective for monetary assets but
not for nonmonetary assets?
Concept #5: Dual-Aspect

 Assets = economic resources.

 Equities = claims against assets.
 Liabilities =claims of creditors (everyone other than
owners).
 Owners’ equity (Shareholders’ or stockholders’
equity for a corporation).
Dual Aspect (Continued)

 Fundamental accounting equation:

¤ Assets = Equities.
¤ Assets = Liabilities + owners’ equity.
¤ For a corporation:
¤ Assets = Liabilities + stockholders’ equity.
¤ Assets = Liabilities + paid-in-capital + retained
earnings.
Dual Aspect (Concluded)

 Transactions = events that affect accounting

records.
 Every transaction has a dual impact on
accounting records.
 Dual impact:
 Results in maintenance of fundamental accounting
equation.
 Double-entry system.
Balance Sheet

 Point in time or status report.

 More formally, Statement of Financial Position.
 Contains (and shows equality of amounts of):
 Assets.
 Liabilities and Owners’ equity.
Interpretations of Dual Aspect:
Resources and Claims View

 Assets = Claims on assets.

 Owners’ equity is a residual claim.
 Shortcomings:
 Balance Sheet is not at market or liquidating values,
Owners’ Equity as a claim is unclear.
 Claim is a legalistic view.
 Better suited to liquidation, not to going concern.
Interpretations of Dual Aspect:
Sources and Uses of Funds View

 Left hand side = assets = how funds used or

invested.
 Right hand side = liabilities + owners’ equity =
sources of funds = how assets were financed.
 Financing supplied by owners:
 Paid-in-capital (= contributed capital).
 Retained earnings.
Account Categories

 Groups of related items.

 Classifications of:
 Assets.
 Equities (i.e., liabilities, owners’ equity)
 Revenues.
 Expenses.
 Discretion of management.
Assets

 Acquired in a transaction.
 Economic resources (i.e., provide future benefits).
 Cash or convertible to cash.
 Goods to be sold for cash.
 Items to be used to generate cash.
 Controlled by the entity.
 Objectively measurable cost at time of
acquisition.
Reporting of Assets on Balance
Sheet

 Grouped into categories.

 Decreasing order of liquidity.
 Current assets (almost) always shown separately.
Current Assets

 Cash.
 Other assets expected to be realized in cash or
sold or consumed within longer of one year or
normal operating cycle.
Cash

 Funds that are available for disbursement.

Marketable Securities

 Investments that are:

 Readily marketable.
 Expected to be converted to cash within 1 year.
Accounts Receivable

 Owed by customers.
 Reported at amount owed less estimated
uncollectible.
 Other receivables:
 Owed by other than customers.
 Notes receivable:
 Evidence by written promises to pay (notes).
Inventories

 Aggregate of those items that are:

 Held for sale in ordinary course of business,
 In process of production for sale, or
 To be consumed in production of goods or services
to be sold.
Prepaid Expenses

 Intangible.
 Usefulness will expire in near future.
 Examples:
 Prepaid rent expense.
 Prepaid insurance expense.
Property, Plant, and Equipment

 Also, called fixed assets.

 Tangible.
 Long-lived.
 Used to produce goods and services to generate
cash inflows.
 Land is not depreciated.
 Building and equipment shown at:
 Cost less accumulated depreciation.
Other Assets

 Investments (not expected to be sold within a

year).
 Intangible assets
 Goodwill, patents, trademarks, copyrights.
 Longer life than prepaid expenses.
Liabilities

 Obligations to transfer assets or provide services to

outside parties.
 Arising from past transactions or events.
 Claims against entity’s assets.
 Not against specific assets, unless indicated.
 Reported at amount that would satisfy obligations
on BS date.
 Principal + interest (through BS date).
Current Liabilities

 Satisfied or extinguished within one year or current

operating cycle, whichever is longer.
Accounts Payable

 Claims against suppliers (i.e., vendors) for goods

or services furnished but not yet paid.
 Unsecured.
 Notes payable or short-term loans.
 Formal written note.
 Includes amounts owed to financial institutions.
Taxes Payable

 Owed to government for taxes.

 Income taxes often shown separately because of
size.
Accrued Expenses

 Earned by outside parties but not yet paid.

 Usually no invoice.
 Includes interest payable, wages payable.
Deferred Revenues

 Also called unearned revenues or pre-collected

revenues.
 Advance payment received but company has
not yet performed service or delivered product.
Long-term Debt

 Current liability:
 Current Portion of Long-Term Debt
 Portion due within next year.

 Long-term debt are non-current liabilities.

Owners’ Equity

 Amount owners’ invested in entity.

 For a corporation: shareholders’ or stockholders’
equity .
 Shares of stock evidence ownership interest.
 Could be invested in any assets on Balance
Sheet.
Two Categories of
Shareholders’ Equity

 Paid-in or contributed capital.

 Retained earnings.
Paid-in Capital

 Capital stock (at stated or par value) + additional

paid-in-capital.
 Amount owners have paid in to purchase shares
of stock.
Retained Earnings

 Earnings reinvested from inception to date less

dividends to date. If negative, deficit.
 Residual interest in assets.
 No necessary relation between RE and Cash.
Unincorporated Businesses

 Proprietorship.
 Business owned by one person.
 Partnership.
 Business owned jointly by two or more persons.
 Capital (not SE) account.
 Drawings.
 Withdrawals by owner(s).
Balance Sheet Changes
Music Mart Start Up

 Assets = liabilities + Paid-in capital + Retained

earnings
 Dual effect of transactions.
 Transactions:
 On 1/1 Owner invests $25,000 for stock.
 On 1/2 borrows $12,500 from bank.
 On 1/3 purchases $5,000 of mdse for cash.
 On 1/4 sells made for $750 cash that cost $500.