Chapter 2:

Accounting Methodology

Contents:

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2.1

The Accounting Equation

2.1 The Accounting Equation 

A Fundamental characteristic of every statement of financial position is that the total for assets always equals the total of liabilities plus owners' equity. This agreement or balance of THE total assets with the total of liabilities and owners' equity is the reason for calling this financial statement a balance sheet. But why do assets equal total of liabilities and owners' equity?  

The dollar totals on the two sides of the balance sheet are always equal because these two sides are two views of the same business. The listing of assets shows us what things the business owns: the listing of liabilities and owners' equity tells us who supplied these resources to the business and how much each group supplied. Everything that a business owns has been supplied to it either by creditors or by the owners. Therefore, the total claims of the creditors plus the claims of the owners equal the total assets of the business.

 The equality of assets on one hand and of the claims of creditors and the owners on the other hand is expressed in the following accounting equation:

Assets = Liabilities + Owners' Equity

     $300,000 = $80,000 + $220,000

The amounts listed in the equation were taken from the balance sheet illustrated. The balance sheet is simply a detailed statement of this equation. To illustrate this relationship, compare the balance sheet of Summit Travel Agency with the above equation.

 To emphasize that the owners' equity is a residual claim, secondary to the claims of creditors. It is often helpful to transpose the terms of the equation, as follows:

Assets   - Liabilities = Owners' Equity

     $300,000 - $80,000   = $220,000

 Notice that if a business has liabilities in excess of its assets the owners' equity will be a negative amount.

Every business transaction, no matter how simple or how complex, can be expressed in terms of its effect on the accounting equation. A thorough understanding of the equation and some practice in using it are essential to the student of accounting.

 Regardless of whether a business grows or contracts, the equality between the assets and the claims against the assets is always maintained. Any increase in the amount of total assets is necessarily accompanied by an equal increase on the other side of the equation that is by an increase in either the liabilities or the owners' equity. Any decrease in total assets is necessarily accompanied by a corresponding decrease in liabilities or owners' equity.

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2.2

The Effects of Business Transactions: An Illustration

2.2 The Effects of Business Transactions: An Illustration 

How does a statement of financial position come about? What has occurred in the past for it to exist any point time? The statement of financial position is a picture of the results of past business transactions that has been captured by company's information system and organized into a concise financial description of where the company stands at a point in time. The specific items and dollar amounts are direct results of the transactions in which the company has engaged. The balance sheets of two separate companies would almost certainly be different due to the unique nature, timing, and dollar amounts of each company's business transaction.  

To illustrate how a balance sheet comes about, and later to show how the income statement and statement of cash flows relate to the balance sheet, we use an example of a small auto repair business, Summit Travel Agency.

2.3

The Business Entity

2.3 The Business Entity 

A business entity is an economic unit that engages in business activities

 Assume that Hendrickson Michael, an experienced auto mechanic, opens his own Travel Agency Summit Company. This company is a business entity.

2.4

Income Statement

Summit's income statement 

Relationship of net income

The income statement is a summarization of the company's revenue and expense transactions for a period of time. It is particularly important for the company's creditors, and other interested parties to understand the income statement. Ultimately the company will succeed or fail is based on its ability to earn revenue in excess of its expenses. Once the company's assets are acquired and business commences, revenues and expenses are important source of cash flows for the enterprise. Revenues are increases in the company's assets from its profit-directed activities, and they result in positive cash flows. Similarly, expenses are decreases in the company's assets from its profit-directed activities, and they resulting negative cash flows. Net income is the difference between the two. Should a company find itself in the undesirable condition of having expenses greater than revenues; we call the difference a net loss.

 Summit's income statement for January is relatively simple because the company did not have a large number of complex revenue and expense transactions. Taking information directly from the owner's equity column of the previous table, we can prepare the company's income statement as shown in Table 2.1: 

Table 2.1: Income statement

 Notice that heading for the income statement refers to a period of time rather than a point in time, as was the case with the balance sheet. The income statement reports on the financial performance of the company in terms of earning revenue and incurring expenses over a period of time and explains, in part, how the company's financial position changed the beginning and ending of that period.  

The relationship of net income to revenue or sales can vary considerably form company to company. For example, in the 1999 income statement of Microsoft, net income ($3.454million) is reported to be almost 29% of sales. In the 1999 income statement of H.J. Heinz, net income ($474 million) is only slightly more than 5% of sales. Between these two the 1999 income statement of Cisco Systems reports net income ($2.096 million) at slightly more than 17% of sales.

2.5

Statement of Cash Flows

We already have established the importance of cash flows to investors and creditors and that the cash flows of the company are an important consideration in investors' and creditors' assessments of cash flows. As a result, a second set of information that is particularly important concerning how the financial position changed between two points in time (that is, the beginning and end of a month or year) is cash flows for Summit Travel Agency. The statement classifies the various cash flows into three categories- operating, investing, and financing – and relates these categories to the beginning and ending cash balances. Cash flows from operating activities are the cash effects of revenue and expense transactions that are included in the income statement. Cash flows from investing activities are the cash effects of purchasing and selling assets. Cash flows from financing activities are the cash effects of the owners investing in the company and creditors loaning money to the company and the repayment of either or both.  

The statement of cash flows for Summit Company for the period January 31, 2003 is as shown in Table 2.2: 

Table 2.2: The statement of cash flows 

 Notice that the operating investing and financing categories include both positive and negative cash flows. (The negative cash flows are in parentheses), Also notice that the combined total of the three categories of the statement (Increase of $ 16,600) explains the total change from the beginning to the end of the month. On January 20, the beginning balance was zero because the company was started at that time. For February summit's beginning cash balance will be $16.600 and the statement of cash flows will explain how that number cither increased to a higher balance or was or was reduced to a lower balance as a result of its cash activities during that month. Notice also there are several transactions in the cash flow statement.

 Let us now explore the mining of the accounting terms revenue and expenses in more detail.

2.6

Revenue

Revenue is the price of goods sold and services rendered during a given accounting period. Earning revenue causes owners equity to increase. When a business renders services or sells merchandise to its customers. It usually receives cash or acquires account receivable from the customers.

 The inflow of cash and receivables from customers increases the total assets of the company. On the other side of the accounting equation the liabilities do not change but owner's equity increases to match the increase in total assets. Thus revenue is the grosses increase in owner's equity resulting from operation of the business.

2.7

Cash Effects

Assume that on July 25 Dagpo Radio company contracts with Rancho Ford company to run 200 one – minute advertisements during August. Dagpo runs these ads and receives full payment from Rancho Ford on September 6. In which month should Dagpo recognize the advertising revenue earned from Rancho Ford – July, August, or September?

 The answer is August, the month in which Dagpo rendered the services that earned the revenue. In other words, the revenue is recognized when it is earned. Without regard to when cash payment for goods or services is received.

2.8

Expenses

Expenses are the costs of the goods and services used up in the process of earning revenue. Examples include the cost of employee's salaries, advertising, rent, utilities and the depreciation of building, automobiles, and office equipment. All these costs are necessary to attract and serve customers and thereby earn revenue. Expenses are often called the "costs of doing business", that is, the cost of the various activities necessary to carry on a business.

 An expense always causes a decrease in owner's equity. The related changes in the accounting equation can be either a decrease in the assets or (2) an increase in the liabilities. An expense reduces assets if payment accurse at the time that the expense is incurred. If the expense will not be paid until later, as, for example, the purchase of advertising services on account. The recording of the expense will be accompanied by an increase in the liabilities.