Chapter 2

Accounting
equation and basic
financial
statements
Chapter Introduction to Accounting
2-1
 Study Objectives

1. Explain 4 basis assumptions of Accounting.

2. State the accounting equation, and define assets,

liabilities, and stockholders’ equity.

3. Explain the cost principle in recording assets.

4. Analyze the effects of business transactions on the

accounting equation.

5. Understand the four financial statements and how

they are prepared.

Chapter
2-2
 Preview of chapter 2

The basis The Basic Using the

Basic Financial
assumptions of Accounting
Accounting Statements
Accounting Equation Equation

Monetary units Assets Transaction Income

Business entity Liabilities analysis statement
Going concern Stockholders' Summary of Statement of
equity transactions retained
Periodic
earnings
Income
Balance
Expense
sheet
Statement of
cash flows

Chapter
2-3
 Objectives of financial accounting
 Financial accounting provide information on
financial position of an accounting entity:
 Financial position:
 Resources and financing sources of resources
 Or: Assets – Liabilities and Owner’s equity
 Changes in financial position:
 Income, expense, profits or loss
 Cash flows
 Based on basis assumptions
Chapter
2-4
 Assumptions

Assumptions provide a foundation for the

accounting process.

Monetary Unit
Economic Entity
Periodicity
Going Concern

Chapter
2-5
 Assumptions

Monetary Unit

Only transaction data capable of being expressed in terms of

money should be included in the accounting records of the
economic entity.
Chapter
2-6
 Assumptions

Economic events can Economic Entity

be identified with a
particular accounting
entity.
The activities of the
entity are to be kept
separate from the
activities of its owner
and all other economic
entities

Chapter
2-7
 Assumptions

Time Period

The economic life of a business can be divided into

artificial time periods.
Chapter
2-8
 Assumptions

Going Concern

The enterprise will continue in operation long enough to

carry out its existing objectives.
Chapter
2-9
 Assumptions
Illustration: Identify which basic assumption of accounting is
best described in each item below.
(a) The economic activities of FedEx Corporation
are divided into 12-month periods for the Periodicity
purpose of issuing annual reports.
(b) Solectron Corporation, Inc. does not adjust
Monetary
amounts in its financial statements for the
effects of inflation.
Unit

(c) Walgreen Co. reports current and noncurrent

classifications in its balance sheet. Going Concern

(d) The economic activities of General Electric and

its subsidiaries are merged for accounting and Economic
reporting purposes. Entity
Chapter
2-10
 Accounting basic equation

Chapter
2-11
 Objectives of financial accounting
 Provide information about economic
resources, claims to resources, and
changes in resources and claims.
 What is the relationship between
resources and claims?

Chapter
2-12
 The Basic Accounting Equation

Resources Owned . . . Resources Owed . . .

by the company to creditors to stockholders

Provides the underlying

framework for recording and
summarizing economic
events.

Chapter
2-13
 Assets

Resources controlled by the

company that have
measurable value and are
expected to provide future
benefits to the company.

Cash Equipment

Supplies Furniture

Chapter
2-14
 Assets
VAGABOND TRAVEL AGENCY
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2015
Assets Liabilities & Owners' Equity
Cash
Assets are
$ 22,500 Liabilities:
Notes Receivable 10,000 Notes economic
Payable $ 41,000
Accounts Receivable 60,500 Accounts Payablethat 36,000
resources are
Supplies 2,000 Salaries Payable 3,000
Office Equipment 15,000 owned
Total Liabilitiesby the
$ 80,000
Building business
90,000 Owners' Equity: and are
Land 100,000 Capital Stock 150,000
expected
Retained Earnings to benefit
70,000
Total future operations
$300,000 Total $300,000

2-15
 Assets and cost principle

Cost Principle (Historical) – dictates that companies

record assets at their cost.
Issues:
Reported at cost when purchased and also over the
time the asset is held.
Cost easily verified, whereas market value is often
subjective.
Fair value information may be more useful.

Chapter
2-16
 Assets and cost principle - Example
For example, The coffee wholesaler purchased an
office building in 1990 for $1.2 million. Over time
this asset has most likely appreciated in
value. However, in accordance with the cost
principle, the original (historical) price of the
building is what is recorded as the cost of the
building in the books of the business.

Chapter
2-17
 Liabilities

•Present obligation of the entity

•Arising from past events,
•The settlement is expected to result
in an outflow of economic resources

Notes Accounts
Payable Payable

Chapter
2-18
 Liabilities
VAGABOND TRAVEL AGENCY
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2015
Assets Liabilities & Owners' Equity
Liabilities are
Cash $ 22,500 Liabilities:
Notes Receivable 10,000 Notes Payable $ 41,000
debts that
Accounts Receivable 60,500 Accounts Payable 36,000
represent
Supplies
Office Equipment
2,000
15,000
Salaries Payable
Total Liabilities
3,000
$ 80,000
negative future
Building 90,000 Owners' Equity:
Land 100,000 Paid in Capital 150,000
cash flows for Retained Earnings 70,000
the enterprise.
Total $ 300,000 Total $ 300,000

2-19
 Stockholders’ Equity

The residual interest in the assets of

the entity after deducting all its liabilities
Owners’ claim to the business
resources.

Stock Certificate

Chapter
2-20
 Owners’ Equity
VAGABOND TRAVEL AGENCY
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2015
Assets Liabilities & Owners' Equity
Owners’ equity
Cash $ 22,500 Liabilities:
Notes Receivable 10,000 Notes Payable $ 41,000
represents the
Accounts Receivable 60,500 Accounts Payable 36,000
owners’ claims
Supplies 2,000 Salaries Payable 3,000
Office Equipment 15,000 Total Liabilities $ 80,000
on the assets of
Building 90,000 Owners' Equity:
Land 100,000 Paid in Capital 150,000
the business. Retained Earnings 70,000
Total $ 300,000 Total $ 300,000

2-21
 Comparing Stocks and Bonds
Stocks Bonds
A form of equity financing or A form of debt financing or
raising money by allowing raising money by borrowing
investors to be part of from investors
owners of the company
Stock prices vary everyday. Investors are guaranteed
Stockholders can receive interest payment and a
dividends from the company return of their money at the
maturity date.
Higher risk but with Lower risk but lower yield
possibility of higher returns.
Dividends are based on the
company’s earnings
2-22
 Exercise 2.1

Assets Liabilities Stockholders’

Equity

Pep Boys $? $60,000 $21,000

Eddie Bauer 72,000 ? 40,000

Benbrook
100,000 79,000 ?
Exxon

Chapter
2-23
 Exercise 2.2
 Please determine each item below is Asset, Liability
or Owners’ Equity

____ 1. Accounts Payable ____11. Investment in bonds

____ 2. Accounts Receivable ____12. Rent payables
____ 3. Common Stock issued ____ 13. Finished goods
____ 4. Office Supplies ____ 14. Bond issued
____ 5. Machines ____ 15. Land
____ 6. Tax payables ____ 16. Salaries payables
____ 7. Cash ____ 17. Deposits at bank
____ 8. Loans and borrowings ____ 18. Fixed assets
____ 9. Goods in stock ____ 19. Interest payables
____ 10. Notes Payable ____ 20. Interest receivalbes
Chapter
2-24
 Stockholders’ Equity

Stockholders’ Equity

Paid-in Capital Retained Earnings

Common Stock + Net Income

- Dividends
Chapter
2-25
 Components of Retained Earnings

Income for
the period
–
Expenses for
the period
Start of End of
the period = the period
Beginning Net income Ending
+ Dividends
balance of (or Net loss) balance of
or – for the =
retained for the retained
– period
earnings period earnings

Chapter
2-26
 Owners’ Equity

Changes in Owners’
Equity

•Owners’ •Payments
Investments to Owners
•Business •Business
Earnings Losses

Chapter
2-27
 The Accounting Equation
Assets VAGABOND
= Liabilities + AGENCY
TRAVEL Owners’ Equity
STATEMENT OF FINANCIAL POSITION
$300,000 = DECEMBER
$80,000 31,+ 2015 $220,000
Assets Liabilities & Owners' Equity
Cash $ 22,500 Liabilities:
Notes Receivable 10,000 Notes Payable $ 41,000
Accounts Receivable 60,500 Accounts Payable 36,000
Supplies 2,000 Salaries Payable 3,000
Office Equipment 15,000 Total Liabilities $ 80,000
Building 90,000 Owners' Equity
Land 100,000 Capital Stock 150,000
Retained Earnings 70,000
Total $300,000 Total $300,000

2-28
 Income

 Increases in economic benefits during the

accounting period
 Result in increases in equity
 Not include: contributions from the owner.
 Including revenue and gains:
 Revenues
 Result from business activities entered into for the
purpose of earning income.
 Generally results from selling merchandise, performing
services, renting property, and lending money.
Chapter
2-30
 Expense

 Formal definition:
 Decreases in economic benefits during the
accounting period.
 Result in decreases in equity.
 Not include: distributions to equity participants.
 In other words: Expenses are the cost of
assets consumed or services used in the
process of earning revenue.
 Common expenses are: salaries expense, rent
expense, utilities expense, tax expense, etc.

Chapter
2-31
 Exercise 2.3
 Please determine each item below is Asset, Liabitity,
Owners’ Equity, Expense or Income

____ 1. Utilities expense ____11. rent expense, office

____ 2. Accounts Receivables ____12. Rent payables
____ 3. Common Stock issued ____ 13. revenues from selling
____ 4. Supplies used goods
____ 5. Machines depreciation ____ 14. interest earned on
____ 6. Tax payables deposits at banks
____ 7. Interest expense ____ 15. rent earned
____ 8. Cost of goods sold ____ 16. rent expense, computer
____ 9. Service revenues ____ 17. Interest payables
____ 10. Salaries expense ____ 18. dividend earned on
Chapter
2-32 investments in shares
 Using The Basic Accounting Equation

Transactions are a business’s economic events

recorded by accountants.

May be external or internal.

Not all activities represent transactions.

Each transaction has a dual effect on the

accounting equation.

Chapter
2-33
 Transactions

Question: Are the following events recorded in the

accounting records?
Supplies are An employee Dividends are
Event purchased is hired. paid to
on account. stockholders’.

Criterion Is the financial position (assets, liabilities, or

stockholders’ equity) of the company changed?

Record/
Don’t Record

Chapter
2-34
 Exercise 2.4
 How the following transactions affect to Basic
Accounting equation?
 Buy a machine and pay by cash 100
 Receive a borrowing of 300 from the local bank
 Deposit 100 into a bank account
 The owners invest 400 in cash
 Buy inventory on account/on credit 300
 Buy a car for 600, pay by cash 200, issue a note payables for the
remaining.
 Pay an account payables of 300 by cash
 Borrow 1000 from the local bank to buy an equipment.

Chapter
2-35
 Excercise 2.5

Please analyses the effect of following transactions of

Barone’s Repair Shop in May to the accounting equation:
1. Barone invested $10,000 cash to start the repair shop.
2. Purchased equipment for $5,000 cash.
3. Paid $400 cash for May office rent.
4. Received $5,100 from customers for repair service.
5. Paid dividends of $1,000 cash.
6. Paid part-time employee salaries of $2,000.
7. Incurred $250 of advertising costs, on account.
8. Provided repair services on account to customers $750.
9. Collected $120 cash for services previously billed.
Chapter
2-36
 Financial Statements

Companies prepare four financial statements from the

summarized accounting data:

Retained
Earnings Statement
Income Balance
Statement of Cash
Statement Sheet
or Flows
Statement
of changes
in equity
Chapter
2-37
 Financial Statements

Income Statement

Barone’s Repair Shop Reports the revenues and

Income Statement expenses for a specific
For the Month Ended May 31, 2007
period of time.
Revenues:
Service revenue $ 5,850
Net income – revenues
Expenses: exceed expenses.
Salary expense 2,000
Rent expense 400 Net loss – expenses
Advertising expense 250 exceed revenues.
Total expenses 2,650
Net income $ 3,200

Chapter
2-38
 Financial Statements
Retained Earnings
Statement
Statement indicates the Barone’s Repair Shop
reasons why retained Retained Earnings Statement
For the Month Ended May 31, 2007
earnings has increased or
decreased during the Retained earnings, May 1 $ -

period. Add: Net income 3,200

Less: Dividends (1,000)
Retained earnings, May 31 $ 2,200

Chapter
2-39
 Financial Statements
Retained Earnings
Income Statement Statement
Barone’s Repair Shop Barone’s Repair Shop

Income Statement Retained Earnings Statement

For the Month Ended May 31, 2007 For the Month Ended May 31, 2007

Retained earnings, May 1 $ -

Revenues:
Add: Net income 3,200
Service revenue $ 5,850
Less: Dividends (1,000)
Expenses:
Retained earnings, May 31 $ 2,200
Salary expense 2,000
Rent expense 400
Advertising expense 250 Net income is needed to determine
Total expenses 2,650 the ending balance in retained
Net income $ 3,200 earnings.

Chapter
2-40
 Financial Statements
Balance Sheet Retained Earnings
Barone’s Repair Shop Statement
Balance Sheet
Barone’s Repair Shop
May 31, 2007
Retained Earnings Statement
Assets
For the Month Ended May 31, 2007
Cash $ 6,820
Accounts receivable 630 Retained earnings, May 1 $ -
Equipment 5,000 Add: Net income 3,200
Total assets $ 12,450
Less: Dividends (1,000)
Liabilities Retained earnings, May 31 $ 2,200
Accounts payable $ 250
Stockholders' Equity
Common stock 10,000 The ending balance in retained earnings
Retained earnings 2,200 is needed in preparing the balance
Total liab. & equity $ 12,450 sheet.
Chapter
2-41
 Financial Statements
Balance Sheet or statement of financial position
Barone’s Repair Shop
Balance Sheet Reports the assets,
May 31, 2007
liabilities, and stockholders’
Assets
Cash $ 6,820
equity at a specific date.
Accounts receivable 630
Equipment 5,000
Assets listed at the top,
Total assets $ 12,450 followed by liabilities and
Liabilities stockholders’ equity.
Accounts payable $ 250
Stockholders' Equity Total assets must be equal
Common stock 10,000
to the total of liabilities and
Retained earnings 2,200
Total liab. & equity $ 12,450
stockholders’ equity.
Chapter
2-42
 Financial Statements
Balance Sheet Statement of Cash Flows
Barone’s Repair Shop
Barone’s Repair Shop
Balance Sheet Statement of Cash Flows
May 31, 2007 For the Month Ended May 31, 2007
Assets Cash flow from Operations
Cash receipts from customers $ 5,220
Cash $ 6,820
Cash paid for expenses (2,400)
Accounts receivable 630 Cash provided by operations 2,820
Equipment 5,000 Cash flow from Investing
Total assets $ 12,450 Purchase of equipment (5,000)
Cash flow from Financing
Liabilities
Investment by owners 10,000
Accounts payable $ 250
Drawings by owners (1,000)
Stockholders' Equity Cash provided by financing 9,000
Common stock 10,000 Net increase in cash 6,820
Retained earnings 2,200 Cash balance, May 1 -
Cash balance, May 31 $ 6,820
Total liab. & equity $ 12,450
Chapter
2-43
 Financial Statements

Information for a specific

Statement of Cash Flows
Barone’s Repair Shop
period of time.
Statement of Cash Flows
For the Month Ended May 31, 2007
Answers the following: Cash flow from Operations
Cash receipts from customers $ 5,220
1. Where did cash come Cash paid for expenses (2,400)
from? Cash provided by operations 2,820
Cash flow from Investing
2. What was cash used Purchase of equipment (5,000)
Cash flow from Financing
for? Investment by owners 10,000
Drawings by owners (1,000)
3. What was the change Cash provided by financing 9,000
Net increase in cash 6,820
in the cash balance?
Cash balance, May 1 -
Cash balance, May 31 $ 6,820

Chapter
2-44
 Relationships Among
Financial Statements

Date at Date at
beginning of end of
period period
Time

Statement of Financial Statement of Financial

Position (Balance Sheet) Position (Balance Sheet)

Income Statement
Statement of Cash Flows

2-45
 Financial Statements

Review Question
Which of the following financial statements is
prepared as of a specific date?
a. Balance sheet.
b. Income statement.
c. Statement of stockholders’ equity.
d. Statement of cash flows.

Chapter
2-46
 Financial Statements

Discussion Question
“A company’s net income appears directly on the
income statement and the retained earnings
statement, and it is included indirectly in the
company’s balance sheet.” Do you agree? Explain.

Chapter
2-47
 End of chapter 2

Chapter
2-48