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Chapter 15 Basic Accounting: Concepts, Techniques, and Conventions Copyright © 2014 Pearson Education, Inc.

Chapter 15 Learning Objectives 1. Read and interpret basic financial statements. 2. Analyze typical business transactions using the balance sheet equation. 3. Distinguish between the accrual basis of accounting and the cash basis of accounting. 4. Make adjustments to the accounts under accrual accounting. 5. Explain the nature of dividends and retained earnings. 6. Select relevant items from a set of data and assemble them into a balance sheet and an income statement. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 3

Chapter 15 Learning Objectives 7. Distinguish between the reporting of corporate owners’ equity and the reporting of owners’ equity for partnerships and sole proprietorships. 8. Explain the role of auditors in financial reporting and how accounting standards are set. 9. Identify how the measurement principles of recognition, matching and cost recovery, and stable monetary unit affect financial reporting. 10. Define continuity, relevance, faithful representation, materiality, conservatism, and cost benefit (Appendix 15 A). 11. Use T-accounts, debits, and credits to record transactions (Appendix 15 B). Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 4

The Need for Accounting information can be used to assess past financial performance of a company and help predict its future performance. All kinds of organizations— government agencies, nonprofit organizations, and others —rely on accounting to gauge their progress. The accounting process begins with a transaction. A transaction is any event that affects the financial position of an organization and requires recording. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 5

The Need for Accounting Many concepts, conventions, and rules determine what events a company records as accounting transactions and how accountants measure the financial impact of each transaction. Financial statements are used to summarize the recorded accounting transactions. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 6

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? Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 7

Learning Objective 1 The Need for Accounting Accountants answer these questions with three major financial statements: Balance sheet Income statement Statement of cash flows Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 8

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. The balance sheet has two sections (1) assets and (2) liabilities plus owners’ (stockholders’) equity. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 9

Balance Sheet Assets are economic resources that are expected to benefit future activities of the organization. Liabilities are the entity’s economic obligations to nonowners. Owners’ equity is the excess of the assets over the liabilities. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 10

Balance Sheet The owners’ equity of a corporation is called stockholders’ equity. Stockholders’ equity

Learning Objective 2 King Hardware Transactions An Example King Hardware Company began business as a corporation—a business organized as a separate legal entity and owned by its stockholders. The company’s first transaction occurred on February 28, 20 X 1, when its stockholders invested a total of $100, 000 cash. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 12

King Hardware Transactions The following additional transactions occurred during March: Copyright © 2014 Pearson

King Hardware Transactions Analysis of Transactions (in dollars) for March 144, 000 Copyright ©

Balance Sheet The balance sheet for King Hardware Copyright © 2014 Pearson Education, Inc.

Revenues and Expenses Revenues are increases in ownership claims arising from the delivery of goods or services. Recognize revenue by formally recording it in the accounting records during the current period only after it meets two tests: 1. The company must earn the revenues. That is, it must deliver the goods or render the services to customers. 2. The revenue must be realized or realizable. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 16

Revenues and Expenses are decreases in ownership claims (stockholders’ equity) arising from delivering goods or services or using up assets. Income (also called net income, profits, or earnings), is the excess of revenues over expenses. It increases stockholders’ equity. An income statement summarizes revenues and expenses. It measures an organization’s performance by matching its revenue and its expenses for a span of time, often a month, a quarter, or a year. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 17

Relationship Between Balance Sheet and Income Statement Copyright © 2014 Pearson Education, Inc. publishing

Income Statement The income statement shows that General Mills’ stockholders’ equity (retained earnings) increased by $1, 804 million because of profitable operations in the year ended May 29, 2011. This $1, 804 million is included in the $6, 612 million of stockholders’ equity on the May 29, 2011, balance sheet. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 19

The Analytical Power of the Balance Sheet Equation The balance sheet equation can highlight the link between the income statement and balance sheet. Assets (A) = Liabilities (L) + Stockholders’ equity (SE) A = L + Paid-in capital + Retained income A = L + Paid-in capital + Revenue – Expenses Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 20

Learning Objective 3 Accrual Basis and Cash Basis The accrual basis of accounting recognizes revenues and expenses when they occur regardless of when cash is received or disbursed. The cash basis of accounting recognizes revenue and expense when cash is received and disbursed. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 21

Accrual Basis and Cash Basis The major deficiency of the cash basis of accounting is that it is incomplete. It fails to match efforts and accomplishments in a manner that properly measures economic performance and financial position. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 22

Nonprofit Organizations Nonprofit organizations, such as government agencies and charitable organizations, also use balance sheets and income statements. For years, most nonprofit organizations used cash-basis rather than accrual accounting. As these organizations face more pressure to develop accurate measures of performance, they are increasingly using accrual accounting. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 23

Nonprofit Organizations The basic concepts of assets, liabilities, revenues, and expenses apply to all organizations, whatever their goals and wherever they are located. However, organizations that do not seek profits do not measure income. Further, because they have no owners, there is no owners’ equity. Balance sheets of nonprofit organizations show a category of “net assets” instead of “owners’ equity” To measure the difference between assets and liabilities. Instead of an income statement, nonprofit organizations have a “statement of activities” that reports changes in net assets. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 24

Adjustments to the Accounts Under the accrual basis of accounting, record: 1. Explicit transactions-day-to-day routine events 2. Implicit transactions - events that day-to-day recording procedures temporarily ignore, such as expiration of prepaid rent or accrual of interest due to the passage of time. Explicit transactions are easy to identify because they are supported by source documents. Implicit transactions are recorded at the end of each accounting period by using adjusting entries. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 25

Principal Adjustments Four types of principal adjustments: Expiration of unexpired costs Recognition (earning) of unearned revenues Accrual of unrecorded expenses Accrual of unrecorded revenues Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 26

Learning Objective 4 Adjustment Type I: Expiration of Unexpired Costs Assets other than cash and receivables are viewed as economic services awaiting future use—prepaid or stored costs, and they are carried forward to future periods. The values of assets frequently decline (and eventually disappear) because of the passage of time. When a company uses services represented by a particular cost, the cost expires. An unexpired cost is any asset that managers expect to become an expense in future periods. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 27

Adjustment Type I: Expiration of Unexpired Costs Rather than immediately charge these costs as expenses, they are charged as expenses in future periods when the services are used. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 28

Expiration of Unexpired Costs Assets frequently expire because of the passage of time. Assets other than cash and receivables are viewed as economic services awaiting future use. Unexpired costs are assets that managers expect to become expenses in future accounting periods. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 29

Depreciation To account for long-lived assets, assets that will provide services for more than one year: (1) predict the length of the asset’s useful life (2) predict the residual value (3) allocate the cost of the equipment to the years of its useful life in a systematic way. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 30

Adjustment Type II: Unearned Revenue (Deferred Revenue) Unearned Revenue (deferred revenue) is. . . A liability recorded when a company receive collections from customers before it earns the revenue. Because customers have already paid in advance for merchandise or services. . . An obligation exists to deliver merchandise or service or refund the customers’ deposits if the goods or services are not delivered. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 31

Adjustment Type III: Accrual of Unrecorded Expenses Accrue means to accumulate a receivable or payable during a given period, even though no explicit transaction occurs. Interest expense Employee wages Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 32

Adjustment Type IV: Accrual of Unrecorded Revenues The recognition of revenues that a company has earned but has not yet recorded in its accounts is. . . the mirror image of the accrual of unrecorded expenses. Interest Revenue Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 33

Adjustment Type IV: Accrual of Unrecorded Revenues Summary of accruals of expenses and revenues (in the columns) and the timing of the accrual compared to the cash flows (in the rows). Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 34

Learning Objective 5 Dividends and Retained Earnings Dividends are distributions of assets to stockholders that reduce retained earnings. Cash dividends are distributions of cash rather than some other asset. The distribution reduces both assets and owners’ equity and is made possible by profitable operations. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 35

Dividends and Retained Earnings Dividends reduce retained earnings, But they are not expenses. Companies do not deduct dividends from revenues when measuring income because they do not help generate sales or conduct operations. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 36

Retained Earnings Stockholders’ equity represents the claims of owners arising out of their initial investment (paid -in capital) and subsequent profitable operations (retained earnings). Retained earnings and paid-in capital represent a general claim against, or undivided interest in, total assets, not a specific claim against any asset. Retained earnings and paid-in capital result from profitable operations. Equity is not a pot of cash awaiting distribution to stockholders. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 37

Retained Earnings Retained earnings and paid-in capital result from profitable operations. Equity is not a pot of cash awaiting distribution to stockholders. Do not confuse retained earnings and cash. Cash can increase while retained earnings decreases, and vice versa. There is no direct relationship between retained earnings and available cash. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 38

Learning Objective 6 King Hardware Company Select relevant items from a set of data and assemble them into a balance sheet and an income statement. The balance sheet uses totals from the asset, liability, and stockholders’ equity columns. The income statement uses the revenue and expense entries in the retained earnings column. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 39

Balance Sheet King Hardware Company Balance Sheet as of April 30, 20 X 1

Income Statement King Hardware Company Income Statement for the Month Ended April 30, 20

Changes in Retained Earnings King Hardware Company Changes in Retained Earnings for the Month Ended April 30, 20 X 1 This statement shows the linkage between the balance sheet and income statement. It starts with the beginning balance, adds net income for April, and deducts cash dividends, to arrive at an ending balance. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 42

Learning Objective 7 Sole Proprietorships and Partnerships 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. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 43

Comparison of Owners’ Equity Reporting Copyright © 2014 Pearson Education, Inc. publishing as Prentice

Comparison of Owners’ Equity Reporting Unlike corporations, sole proprietorships and partnerships do not distinguish between paid-in capital (i. e. , amounts invested by owners) and retained earnings. Instead, they typically accumulate a single amount for each owner’s original investment, subsequent investments, share of net income, and withdrawals. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 45

Learning Objective 8 Generally Accepted Accounting Principles (GAAP) Accounting is more an art than a science. It is commonly misunderstood as being a precise discipline that produces exact measurements of a company’s financial position and performance. Accounting is based on a set of principles on which there is general agreement, not on rules that can be “proved. ” The principles and procedures that together make up accepted accounting practice at any given time are known as generally accepted accounting principles (GAAP). Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 46

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. Auditing standards are approved by the Public Company Accounting Oversight Board (PCAOB) which is a part of the Securities and Exchange Commission (SEC), a government agency that regulates the financial markets in the U. S. including financial reporting. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 47

Accounting Standard Setters The Financial Accounting Standards Board (FASB) is the primary regulatory body over accounting principles and practices in the U. S. The FASB consists of seven full-time members plus a staff of nearly 60 members, and it is an independent creation of the private sector. The IASB is a similar independent organization whose pronouncements, called International Financial Reporting Standards (IFRS) define GAAP in more than 100 other countries. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 48

Accounting Standard Setters In 2008 the SEC started accepting financial statements based on IFRS for non-U. S. Companies whose stock is traded in U. S. capital markets. It defined a “road-map” for eventual adoption of IFRS by U. S. companies as well. the FASB and IASB are currently working on converging their separate standards into one set of world-wide standards. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 49

Accounting Standard Setters The public sector–private sector relationship: The SEC has the ultimate responsibility for specifying GAAP for U. S. companies with publicly traded stock. The SEC has informally delegated much rule-making power to the FASB. If and when the pending move to international Standards occurs, such power will also be delegated to the IASB. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 50

Ethics The public sector–private sector relationship: Confidence in financial information is important to the smooth functioning of the world’s capital markets, and confidence in financial statements depends on the competence and integrity of accountants and auditors. A hallmark of the accounting profession has been its ethics and integrity. Most accountants and auditors are highly ethical and truthfully report their financial results in accordance with GAAP. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 51

Learning Objective 9 Three Measurement Conventions U. S. GAAP is based on a conceptual framework that contains three broad measurement or valuation conventions (principles) that underlie accrual accounting: Recognition Matching and cost recovery Stable monetary unit Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 52

Recognition Principle The recognition principle specifies when a company should record revenue in the accounting records. Generally, companies recognize revenue when it is both earned and realized or realizable. In some industries revenue recognition is not so straightforward. These judgment issues require company accountants together with its auditor to decide when earning and realization are sufficiently complete to recognize the revenue. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 53

Matching and Cost Recovery The timing of revenue recognition is important because it leads to the recording of expenses through the concept of matching—the linking of revenues with expenses incurred to generate them. Accountants apply matching as follows: 1. Identify the revenue recognized during the period. 2. Record expenses that relate directly to the recognized revenue. 3. Record expenses that are costs of operations during a specific time period that have no measurable benefit for a future period and must be linked to the current period’s revenues. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 54

Matching and Cost Recovery The heart of recognizing expense is the cost recovery concept. Companies carry forward as assets such items as inventories, prepayments, and equipment because they expect to recover the costs of these assets in the form of cash inflows (or reduced cash outflows) in future periods. At the end of each period, accountants examine evidence to assure themselves that they should not write off these assets—the unexpired costs—as an expense of the current period. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 55

Stable Monetary Unit The monetary unit (for example, the dollar in the United States, the yen in Japan, or the euro in the European Union) is the principal means for measuring assets, liabilities, and stockholders’ equity. This measurement assumes that the monetary unit— the dollar, for example—is an unchanging yardstick. Yet, a 2010 dollar does not have the same purchasing power as a 2000 or 1990 dollar. Therefore, users of accounting statements that include dollars from different years must recognize the limitations of the basic measurement unit. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 56

Learning Objective 10 Appendix 15 A: Additional Accounting Concepts that are prominent parts of the body of GAAP: Continuity (going concern) Relevance Predictive value Confirmatory value Faithful representation Comparability Consistency Verifiability Timeliness Understandable Materiality Conservatism Cost-benefit Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 57

Learning Objective 11 Appendix 15 B: Using Ledger Accounts Some techniques that accountants use to record transactions. T-Accounts Ledger Accounts Double-Entry System Debits and Credits Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 58

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 15 - 59