Lecture 2 – Fundamentals of

Accounting
Outline
I. Objectives and Types of Accounting
II. The Balance Sheet: Assets, Liabilities, and Owner Equity
III. Accounts and the recording process
IV. Activities of a company and revenue, cost, expense, and
income

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 Principles and Process of Accounting
 Accounting is to record, measure, and verify financial transactions (events
resulting in exchange in values), and to produce and present relevant
information to stake holders (who are they again?) and government/regulator
 Head by the controller, who focuses
on what happened in the past.
 Should have a separate person to manage
money – the treasurer
 Large companies usually have a CFO (Chief
Financial Officer) overseeing the controller
and treasurer.
 Public companies require independent
internal and external auditors
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Role of the CFO

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Objectives and the Three Types of Accounting
Company needs three accounting systems:
 Financial Accounting – to produce financial statements (1.Balance Sheet,
2.Income Statement, and 3.Statement of Cash Flow) to report financial
positions to external users. Need to comply with standards.
 Managerial Accounting – to produce cost and profitability data for
decisions, control and performance evaluation by internal users. Emphasis on
timeliness and focus on individual business segments and costs allocation -> cost
accounting. May keep track of whatever monetary or non-monetary data
deemed useful.
 Tax Accounting – for tax computation. Need to comply with tax laws.

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 Standards

 For financial accounting, developed

countries first have their own standards: e.g.,
in the US, GAAP (Generally Accepted
Accounting Principles) set by the Financial
Accounting Standards Board (FASB)
 Converging to IFRS created by IASB
(International Accounting Standard Board),
an independent international group
 Accounting standards are constantly being
updated to keep up with developments:
digital transformation, new business and
compensation models, etc.

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 The Balance Sheet

To understand accounting, we start with the balance sheet.

The balance sheet provides a breakdown of a firm’s wealth by listing a summary
of its assets, liabilities, and owners’ equity:
 Assets (A) – all resources of value, current or non-current, tangible or intangible,
possessed by the firm: cash, account receivables (AR), inventory, equipment,
building, prepayment, licenses, patent rights, goodwill, other intangibles, etc.
 Liabilities (L) – what the firm owes others: account payable (AP), debts, accrued
tax, deferred revenue, warranty, etc.
 Owners’ Equity (OE) – It is the total value of assets less the total value of
liabilities. It represents the wealth, or net worth of company to shareholders. It is
also called the book value of the firm.

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The Balance Sheet Equation
The balance sheet lists the firm’s assets on the left, and liabilities and
owners’ equity on the right

The balance sheet equation:

Assets = Liabilities + Owners’ Equity
Left Side Right Side

The balance sheet is produced at the end of each accounting period. The
values on the two sides must equal. This is called balancing the book.

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Where Does OE Come From?

 OE is what the owners has originally invested plus what the firm has earned but
not given back to owners as dividend:
Owners’ Equity = Paid-In Capital + retained earning
Owners’ Equity = Paid-In Capital + earning – dividend

 Earning is what the firm has brought in by providing its goods or services, minus
the cost of goods sold (COGS) or cost of services (COS) plus other expenses
(administration, general marketing and R&D, depreciation of building, tax, etc.).
Hence:
Owners’ Equity = Paid-In Capital + revenue – cost & expense – dividend

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Example Tangible Assets
 Cash – bills/bank notes, checking account, bank deposit, and everything readily
convertible to cash (cash equivalent): treasury bills, commercial paper, money
market funds, etc.
 Account Receivables (AR) – what is to be collected from customers after the
company has delivered the goods or service and issued the invoice
 Inventory – of finished goods (FG), work-in-progress (WIP), and raw materials (RM)
 Property, Plant, and Equipment (PP&E) – Land, building/factory, and equipment
 Prepayment – company may have pre-paid rent, tax, etc.
 Deferred Tax Asset – expected reduction in future tax liability because of
overpayment, loss carry-forward, differences in tax rules and accounting rules, etc.
For some assets, we know explicitly when their values change. For others (building,
equipment), we need to depreciate them according to some schedule as they are used.
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Example Intangible Assets
 Licenses – e.g., a mobile operator may have paid $B to acquire a spectrum license
 Patents and other IPs – company may have paid $$ to obtain patents and designs
 Goodwill – It is an intangible asset that arises very often in acquisitions. It captures
the surplus that the company has paid over the book value to acquire another
company. We will come back to it
 Capitalized R&D – If a company has spent $millions on a research team to develop
designs and patents, it has the option to treat these $millions as an intangible asset
(to capitalize the money spent).
 Promotion/subsidy – A company may have the option to capitalize money spent to
acquire customers: e.g., HKT giving free rice cookers to new subscribers, or allowing
new subscribers to buy new iPhone at a discount.

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Example Liabilities

 Account Payable (AP) – This is what the company needs to pay its supplier soon
after the company has received the goods or services and has been billed. There
may also be salary payable
 Debt – Loans from banks and others, or bonds outstanding
 Accrued tax – To allow for the tax that the company knows it has to pay given its
profit
 Deferred tax liability – opposite of deferred tax asset
 Deferred revenue – This is for pre-payment company has received for goods or
services to be provided in the future.
 Warranty – A company may need to allow for expenses that may be incurred in
the future because of warranty

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An Example Balance Sheet
XX COMPANY - Balance Sheet
December 31, 2018
Assets Liabilities
Current assets:
Cash & equivalent $ 1,525 Accounts payable $ 3,705
Accounts receivable 2,040 Debt 9,860
Total 3,565 Total liabilities 13,565
Non-Current assets:
Inventory (RM, WIP, FG) $ 3,004
Plant & Equipment PP&E 9,731
Patents, Goodwill 6,520 Owners’ Equity
Total 16,255 Peter 1,851
Mary 7,404

Total liabilities and

Total assets $22,820
=============
Owners’ equity $22,820
=============

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 Accounts
 The process of accounting is to use a set of “accounts” to keep track of the values of all items of
financial interest as the firm conducts its activities.
 In accounting, there are 3 types and 6 categories of accounts:
I. Balance Sheet Accounts which track items on the balance sheet. These are permanent accounts.
1) Asset: all the different assets
2) Liability: all the different liabilities
3) Owner Equity: for all the individual owners or shares

II. Income and Expense Accounts which track income and expenses in a period. These are temporary
accounts as they are zeroed out at the end of a period, with adjustments made if necessary.
4) Income (or Revenue): sales, interest income, etc.
5) Expense: Cost of goods sold, G&A expense, M&S, R&D, depreciation, etc.

III. Contra Accounts which keep track of the deduction from a parent account.
6) Contra: used optionally to allow the original value of the parent account to be visible.

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Contra Account Examples

Equipment (Tooling Machine 123) $100,000 Parent

- Accumulated Depreciation $25,000 Contra

Account Receivable $40,000 Parent

- Allowance for bad debt $400 Contra

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 Activities of a Firm
In accounting, activities conducted by a firm is classified into three types. This allows the
firm’s performance in each type of activities to be measured:
 Investing – To acquire the assets (building, equipment, licenses, etc.) needed for the
firm to produce goods or services.
 Operating – Activities associated with the production and delivery of goods or services
to customers. In addition, the firm must also perform administrative, marketing, and
R&D works. Depreciation is also an operating expense.
 Financing – Raising of share capital from shareholders or buying back shares, assuming
debt by borrowing from banks or issuing bonds, or paying back the principals.
Paying or receiving interest and dividends can be classified as financing (more common)
or operating (for financial institutions) depending on the type of company and standard.

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Tracking a Firm’s Activities By Accounts
Activities are tracked by the various accounts.
 Financing and investing involve changes in assets and liabilities only and do
not generate operational gain or loss. Investing creates a capital item that will
be used for a long time. Financing and investing may generate non-operational
financing and interest expenses and/or incidental gain or loss.
 Operating activities generate revenue and operating expenses. These incomes
and expenses are tracked by the temporary accounts, and adjustments are
made as necessary (customers may return goods, etc.). At the end of the
accounting period, the income and cost/expense are reported in the income
statement as operating gain/loss and flow-through to increase or decrease
the equity.

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Some Terms - Cost, Expense, and Expenditure
 Cost refers to how much it takes to get something. Calculating cost is a major part of
managerial accounting.
 Expense refers to the using up of something. Expense reduces the OE.
Cost and expense are closely related. When a firm uses up something, to know what is the expense,
one has to know what the cost is. For example, when a firm shipped a product that has costed $100K
to make, it records $100K in the “Cost of Goods Sold (COGS)” account. COGS is actually an expense
account reflecting the value of inventory that has been shipped away (expensed).
 Expenditure refers to a payment or an incurrence of liability, which can be for expense
or for investing (e.g., buying a machine). Investing exchanges cash for a capital asset
and does not reduce OE until asset is expensed via depreciation or amortization.
Example:
1. Firm pays $100K for a car. There is an expenditure of $100K, but there is no expense until the car
is used and its value is reduced.
2. Firm pays outside lawyer $50K for legal advice. There is both an expenditure and expense of $50K
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 Depreciation and Amortization
 Company buy assets - machines, buildings, car, patents, etc. - that can be used for
many years or repeatedly.
 We account for the expense of use of such an asset by depreciating its acquisition
cost, minus the residual value at end of life, over the years or other measures of use.
 Different depreciation schedule can be adopted – linear, accelerated, etc.
 Some depreciation are allocated to cost of goods sold. Some depreciation are not
directly associated with goods or services produced and are stated separately as
operating expenses.
 Upon disposal of an assets, the value may be different from the depreciated value on
the book, resulting in a disposal gain/loss adjustment
 Amortization is like depreciation but it refers to intangible assets such as patents,
goodwill, capitalized R&D, etc.

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To Capitalize or Not?
 For certain expenditures it is not clear-cut whether it is an expense or an
investment. For example, if the company paid for a group of researchers to do
R&D, should this expenditure be expensed right away, or should it be
capitalized to be amortized in the future?
 The answer depends on what type of accounting we are talking about:
• For tax accounting, usually we can expense right away
• For financial accounting, there are rules to allow us to choose to capitalize. The
company may capitalize the expenditure into an intangible asset called “Capitalized
R&D”.
• For managerial accounting, we may capitalize and allocate expense to different
business units enjoying the results of the R&D

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Fall 2024
 Chart of Accounts and Ledger
 Chart of accounts - a list of accounts used by the firm. The accounts are numbered according to
classification and sub-classifications and are chosen based on the financial information that the
firm wants to keep track of. A firm may have hundreds to millions of accounts.
 Ledger - a group of related accounts and subsidiary accounts kept current in a systematic
manner
Example:
400 Sales Revenue
410 LAN Switches sales
420 Routers sales
421 Big Routers
Subsidiary accounts
422 Small Routers

 General Ledger - the collection of the 6 categories of accounts that are reflected on the firm’s
major financial statement. Outside of the general ledger, there can be numerous other accounts
for managerial accounting.
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Chart of Accounts Example - ABC Company
Account # Account Title
100 Cash
101 Petty Cash Subsidiary accounts
102 Hang Seng Bank
120 Accounts receivable
130 Inventory
140 Equipment
140A Accumulated depreciation Contra-account
150 Goodwill
202 Notes payable
203 Accounts payable
300 Paid-in capital
320 Retained income
400 Sales revenue
500 Cost of goods sold
510 Salary expense
Temporary accounts
520 Depreciation Expense
530 Interest Expense
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Transactions
 A transaction is an event that leads to changes in account values. A firm has numerous
explicit and implicit transactions everyday.

Explicit transactions:
• Raw materials is received by the receiving department
• Raw material is turned into finished goods
• Finished goods shipped to customers
• The billing department determines that the uncollected bill a customer owes is uncollectible

Implicit transactions: In the accrual basis for accounting, we need to account for
things even if they do not explicit happen
• Building and equipment are depreciated for each day
• A worker puts in a day of work although he is not yet paid

 Transactions are recorded in a journal and posted to various accounts

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 Example - Journalizing Transactions for ABC Company
 The followings are the first three transactions of a new ABC Company. They are
recorded in the journal and changes in account values are indicated.
(1) Mr. Pan, the only shareholders, injected capital of $400K
(2) ABC Company issued promissory notes to Big Bank to borrow $100K
(3) Purchased LAN switches for resale with cash of $150K
Date Ref. Accounts and Explanations Debit Credit What do “Debit”
2017/12/31 (1) Mr. Pan invest capital of 400K and “Credit” mean?
100 Cash 400,000
300 Paid-in Capital 400,000

12/31 (2) Borrow 100K from Big Bank

100 Cash 100,000
202 Notes Payable 100,000
2018/01/02 (3) Purchase LAN switches for resell
130 merchandise inventory (LAN switches) 150,000
100 Cash 150,000
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The T-Accounts
 What do Debit and Credit mean?
 To answer that, we need to understand how an account is Account Title
often presented as a T-account, where increases are always
recorded on one side and decreases recorded on the other
side. This was how each account was managed on paper in Left Side Right Side
the old days!
 Any item recorded on the left side of an account is called a
Debit and any item recorded on the right side is called a credit
 The Balance of an account at any given time is the sum of all
entries on one side minus the sum of all entries on the other
side. The balance of an account can be on the left side or on
the right side.

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 Left-Side Balance and Right-Side Balance Accounts
 Asset is on the left side of balance sheet. Asset and Expense accounts are left-side
balance accounts. They are increased by entries on the left side and decreased by
entries to the right side.
 Liabilities, Owners’ Equity, and Income accounts are right-side balance accounts. They
are decreased by entries to the left side and increased by entries to the right side.
 Contra accounts are opposite of their parent accounts

left-side balance right-side balance

Assets
Liabilities Owners’ Equity
Increases Decreases Decreases
Decreases Increases Increases

Balance Balance Balance

Expense Income

Increases Decreases Decreases Increases

Balance Balance 26
Left-Side Balance and Right-Side Balance
Acc # Account Title
100 Cash Left-Side Accounts Right-Side Accounts
120 Accounts receivable
130 Inventory • Assets • Liability
140 Equipment • Expenses • Owner Equity
140A Accumulated depreciation • Income
202 Notes payable
203 Accounts payable
300 Paid-in capital
320 Retained income
Right-side
400 Sales revenue balance accounts
500 Cost of goods sold
510 Salary expense
520 Depreciation expense
530 Interest Expense
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 From Journal Entries to T-Accounts
Date Explanation Ref.
2017
12/31 Pay-in capital $400,000 by Mr. Pan (1)
12/31 Borrow $100,000 from Big Bank on notes (2)
2018
1/2 Purchase 150 units LAN switches (3)

 The journal entries above would lead to these T-account entries:

100 Cash 300-1 Pay-In-Capital (Mr. Pan) 202 Note Payable

(1) 400,000
(1) 400,000 (2) 100,000
(2) 100,000 borrow from
(3) 150,000 Big Bank)

Balance =400,000 Balance =100,000

Balance =350,000

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The Double Entry System of Accounting

 In accounting, each transactions must lead to debit and credit of the same
amount in two or more accounts. This is the double-entry system of
accounting.
 A simple entry affects only two accounts. A compound entry affects more
than two accounts.
 Sum of all balances on the left minus sum of all balances on the right over all
accounts should always equals zero.
 Remember:
• debit is always the left side
• credit is always the right side
 With computerization, we no longer have T-accounts on paper. From now on,
we will only talk about debit and credit.

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More Transactions – ABC Company
(4) Purchased testing equipment using $60K cash
(5) Sold half of product in inventory “on account” (i.e., not paid right away) at
$120,000 – this leads to a compound entry

Date Ref. Accounts and Explanations Debit Credit

2018
1/3 (4) Purchased testing equipment
140 Equipment 60,000
100 Cash 60,000

1. COGS – An Expense account:

1/20 (5) Shipped 75 switches to Customer A
left-sided, goes up -> debit
500 Cost of Goods Sold 75,000
130 Merchandise Inventory (switches) 75,000 2. Shipped half of inventory
3. AR increase by $100K
120 Account Receivable 120,000
400 Sales Revenue 120,000 4. Revenue: right-sided,
goes up -> credit
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 More Examples – Selling the Product
(6) Paid salary of $14,000 to all workers
(7) Paid interest of $600 to Big Bank
(8) Recognized depreciation of $1,000 or testing equipment which has life of 5 years.

Date Ref. Accounts and Explanations Debit Credit

2018
1/29 (6) Paid salary to all workers
510 Salary Expense 14,000
100 Cash 14,000

1/29 (7) Paid Interest to Big Bank

530 Interest Expense 600
100 Cash 600
1/30 (8) Depreciation of testing equipment
520 Depreciation expense 1,000
140A Accumulated Depreciation 1,000
(or, 140 Equipment) 1,000

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 Zeroing the Temporary Accounts

 Now, on 2018/01/31, ABC Company is ready to determine how it has done during
its first month. The accountant zeros out all the revenue and expense accounts and
determine that there is a profit of $29,400 (increase in OE by $29,400)
Sales Revenue OE OE
Debit $120,000 Credit $120,000 120,000

COGS OE 75,000
Credit $75,000 Debit $75,000 14,000

Salary Expense OE 1,000

Credit $14,000 Debit $14,000 600
Depreciation Expense OE
Net credit of
Credit $1,000 Debit $ 1,000
$120,000 – 75,000 –
14,000 – 1,000 – 600
Interest Expense OE
= $29,400 in OE
Credit $600 Debit $600
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Income Statement - Top-Line and Bottom-Line

 ABC Company will prepare an Income Statement, which has the following format:
Revenue
(minus) Cost of Goods Sold (COGS)/Services
= Gross Margin
(minus) Operating Expenses (OPEX)
Typical Breakdown of OPEX
• Marketing and Sales for tech company (e.g.,
• General and Administration equipment vendors)
• R&D
(minus) Depreciation and Amortization For what is not allocated to COGS or OPEX

= Operating Income
+ non-operating income/loss (interests, real-estates, dividends from other companies, etc.)
= Income Before Tax
- Tax
= Net Income Revenue is called the top line and net
income is the bottom line.
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Income Statement - Top-Line and Bottom-Line

 For the ABC Company example, the income statement would look like this:
Revenue 120,000
Cost of Goods Sold (COGS) 75,000
Gross Margin 45,000
Operating Expenses (salary) 14,000
Depreciation and Amortization 1,000
Operating Income 30,000

Interest Paid 600

Income Before Tax 29,400
Less Tax (Assumed = 0)
Net Income 29,400

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 The Ending Balance Sheet – ABC Company
 And on 2018/01/31 ABC Company’s balance sheet would look like this:
ABC COMPANY - Balance Sheet
January 31, 2018
Assets Liabilities
Current assets:
Cash & equivalent $275,400 Accounts payable $0
Accounts receivable 120,000 Debt 100,000
Total 395,400 Total liabilities 100,000
Non-Current assets:
Inventory $ 75,000
Equipment 59,000
Total 134,000 Owners’ Equity
Mr. Pan 429,400

Total liabilities and

Total assets $529,400
===============
Owners’ equity $529,400
=============

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Statement of Cash Flow
 Besides the balance sheet and the income statement, the statement of cash flow is
the third standard financial statement.
 A company may choose to break down its cash flow by source of fund and use of
fund, or by operating, investing, and financing activities.
 Often, a company may highlight its cash flow from operating activities – whether
the business operation is generating or losing cash

36
 Cash Flow Statement by Sources and Uses of Funds
Matching source and use of cash
For ABC Company:
Sources of Funds

Decrease of Assets Cash at Beginning of Period 0

Increase of Liabilities Net Income 29,400
Sources of Funds
Uses of Funds
Depreciation 1,000
Increase of Assets Borrowing from Big Bank 100,000
Decrease of Liabilities Uses of Funds
Increase in AR -120,000
Increase in Inventory -75,000
Cash at beginning of period
+ Net Cash Flow ( = Net Income Increase in Equipment -60,000
+ Decrease in noncash assets Net Cash Flow -124,600
+ Increase in liability) Paid-in-Capital 400,000
- Dividend
+ Paid-In-capital Cash at End of Period 275,400
= Cash at end of period
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 Cash Flow Statement by Types of Activities
 We can also divide Net Cash Flow (NCF)
based on types of activities: For ABC Company:
Cash at Beginning of Period 0
NCF =
Cash Flow from Operating Activities -164,000
Cash Flow from operating activities
Purchase of LAN Switches -150,000
– Taxes paid
+ Cash Flow from Investment activities Salary Payment -14000
+ Cash Flow from Financing activities Cash Flow from Investing Activities -60,000
Purchase of Testing Equipment -60,000
Cash Flow from Financing Activities 99,400
Borrow from Big Bank 100,000
Interest Payment -600
Net Cash Flow -124,600
Paid-in-Capital 400,000
Cash at End of Period 275,400

38
 Statement of Equity

 Optionally, ABC Company may also present an equity statement that explains the
change in owner’s equity:

Owner’s Equity as of 2017/12/30 0

Paid-in Capital by Mr. Pan 400,000
Net Income 29,400
- dividend 0 Retained earnings is $29,400
since no dividend is paid
Owner’s Equity as of 2018/01/31 429,400

39