Chapter 1 : Elements of Business Accounting

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Chapter 1
Elements of Business Accounting
In This Chapter
Working with the accounting equation
Understanding the differences between cash- and accrual-basis accounting
Examining the three primary business financial statements
Seeing the effects of crooked accounting on financial statements
The starting point in accounting is identifying the entitybeing accounted for. A business
entity can be legally organized as a partnership, corporation, limited liability company, or
other structures permitted by law. Alternatively, a business entity simply may consist of the
business activities of an individual, in which case it’s called a sole proprietorship. Regardless
of how the business entity is legally established, it’s treated as a separate entity or distinct
person for accounting purposes.
Keeping the Accounting Equation in Balance
If you’ve ever studied accounting, you probably recall the accounting equation:
Assets = Liabilities + Owners’ equity
The accounting equation says a lot in very few words. It’s like the visible part of an iceberg —
a lot of important points are hidden under the water. Notice the two sides to the equation:
assets on one side and the claims against the assets on the other side. These claims arise
from credit extended to the business (liabilities) and capital invested by owners in the busi-
ness (owners’ equity). (The claims of liabilities are significantly different than the claims of
owners; liabilities have seniority and priority for payment over the claims of owners.)
Suppose a business has $10 million total assets. These assets didn’t fall down like manna
from heaven (as my old accounting professor was fond of saying). The money for the assets
came from somewhere. The business’s creditors (to whom it owes its liabilities) may have
supplied, say, $4 million of its total assets. Therefore, the owners’ equity sources provided
the other $6 million.
Business accounting is based on the two-sided nature of the accounting equation. Both
assets and sources of assets are accounted for, which leads, quite naturally, to double entry
Double entry, in essence, means two-sided. It’s based on the general economic
exchange model. In economic transactions, something is given and something is received in
exchange. For example, I recently bought an iPod from Apple Computer. Apple gave me the
iPod and received my money. Another example involves a business that borrows money from

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8 Part I: Business Accounting Basics
its bank. The business gives the bank a legal instrument called a note promising to return the
money at a future date and to pay interest over the time the money is borrowed. In exchange
for the note, the business receives the money. (Chapter 3 explains how to implement double
entry accounting.)
Q. Is each of the following equations correct?
A. Each accounting equation offers an impor-
What key point does each equation raise?
tant lesson.
a. $250,000 Assets = $100,000 Liabilities +
a. Whoops! This accounting equation
$100,000 Owners’ equity
doesn’t balance, so clearly something’s
wrong. Either liabilities, owner’s equity,
b. $2,345,000 Assets = $46,900 Liabilities +
or some combination of both is $50,000
$2,298,100 Owners’ equity
too low, or the two items on the right-
c. $26,450 Assets = $675,000 Liabilities –
hand side could be correct, in which
$648,550 Owners’ equity
case total assets are overstated $50,000.
With an unbalanced equation such as
d. $4,650,000 Assets = $4,250,000 Liabilities +
this, the accountant definitely should
$400,000 Owners’ equity
find the error or errors and make appro-
priate correcting entries.
b. This accounting equation balances, but,
wow! Look at the very small size of liabil-
ities relative to assets. This kind of con-
trast isn’t typical. The liabilities of a
typical business usually account for a
much larger percentage of its total
c. This accounting equation balances, but
the business has a large negative owners’
equity. Such a large negative amount of
owners’ equity means the business has
suffered major losses that have wiped
out almost all its assets. You wouldn’t
want to be one of this business’s credi-
tors (or one of its owners either).
d. This accounting equation balances and
is correct, but you should notice that
the business is highly leveraged, which
means the ratio of debt to equity (liabili-
ties divided by owners’ equity) is very
high, more than 10 to 1. This ratio is
quite unusual.

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Chapter 1: Elements of Business Accounting
1. Which of the following is the normal way to
2. A business has $485,000 total liabilities and
present the accounting equation?
$1,200,000 total owners’ equity. What is the
amount of its total assets?
a. Liabilities = Assets – Owners’ equity
b. Assets – Liabilities = Owners’ equity
Solve It
c. Assets = Liabilities + Owners’ equity
d. Assets – Liabilities – Owners’ equity = 0
Solve It
3. A business has $250,000 total liabilities. At
4. A business has $175,000 total liabilities. At
start-up, the owners invested $500,000 in
start-up, the owners invested $250,000 cap-
the business. Unfortunately, the business
ital. The business has earned $190,000
has suffered a cumulative loss of $200,000
cumulative profit since its creation, all of
up to the present time. What is the amount
which has been retained in the business.
of its total assets at the present time?
What is the total amount of its assets?
Solve It
Solve It

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10 Part I: Business Accounting Basics
Distinguishing Between Cash- and
Accrual-Basis Accounting
Cash-basis accounting refers to keeping a record of cash inflows and cash outflows. An
individual uses cash-basis accounting in keeping his checkbook because he needs to
know his day-to-day cash balance and he needs a journal of his cash receipts and cash
expenditures during the year for filing his annual income tax return. Individuals have
assets other than cash (such as cars, computers, and homes), and they have liabilities
(such as credit card balances and home mortgages). Hardly anyone I know keeps
accounting records of their noncash assets and their liabilities (aside from putting bills
to pay and receipts for major purchases in folders). Most people keep a checkbook,
and that’s about it when it comes to their personal accounting.
Although it’s perfect for individuals, cash-basis accounting just doesn’t cut it for the
large majority of businesses. Cash-basis accounting doesn’t provide the information that
managers need to run a business or the information needed to prepare company tax
returns and financial reports. Some small personal service businesses (such as barber
shops, lawyers, and real estate brokers) can get by using cash-basis accounting because
they have virtually no assets other than cash and they pay their bills right away.
The large majority of businesses use accrual-basis accounting. They keep track of their
cash inflows and outflows, of course, but accrual-basis accounting allows them to
record all the assets and liabilities of the business. Also, accrual-basis accounting
keeps track of the money invested in the business by its owners and the accumulated
profit retained in the business. In short, accrual-basis accounting has a much broader
scope than cash-basis accounting.
A big difference between cash- and accrual-basis accounting concerns how they meas-
ure annual profit of a business. With cash-basis accounting, profit simply equals the
total of cash inflows from sales minus the total of cash outflows for expenses of making
sales and running the business, or, in other words, the net increase in cash from sales
and expenses. With the accrual-basis accounting method, profit is measured differently
because the two components of profit — sales revenue and expenses — are recorded
When using accrual-basis accounting, a business records sales revenue when a sale is
made and the products and/or services are delivered to the customer, whether the
customer pays cash on the spot or receives credit and doesn’t pay the business until
sometime later. Sales revenue is recorded before cash is actually received. The busi-
ness doesn’t record the cost of the products sold as an expense until sales revenue is
recorded, even though the business paid out cash for the products weeks or months
earlier. Furthermore, with accrual-basis accounting, a business records operating
expenses as soon as they’re incurred (as soon as the business has a liability for the
expense), even though the expenses aren’t paid until sometime later.
Cash-basis accounting doesn’t reflect economic reality for businesses that sell and buy
on credit, carry inventories of products for sale, invest in long-lived operating assets,
and make long-term commitments for such things as employee pensions and retire-
ment benefits. When you look beyond small cash-based business, you quickly realize
that businesses need the comprehensive recordkeeping system called accrual-basis
accounting. I like to call it “economic reality accounting.”

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Chapter 1: Elements of Business Accounting
The following example question focuses on certain fundamental differences between cash-
basis and accrual-basis accounting regarding the recording of sales revenue and expenses for
the purpose of measuring profit.
Q. You started a new business one year ago.
A. Profit according to cash-basis accounting
You’ve been very busy dealing with so
equals the cash inflow from sales minus
many problems that you haven’t had time
the total of cash outflows for expenses
to sit down and look at whether you made
(and the total of cash outflows for expenses
a profit or not. You haven’t run out of cash
equals the purchases of products plus
(which for a start-up venture is quite an
other expenses). Thus, under cash-basis
accomplishment), but you understand that
accounting, your business has a $157,000
the sustainability of the business depends
loss for the year ($558,000 sales revenue –
on making a profit. The following two sum-
$715,000 expenses = $157,000 loss).
maries present cash flow information for
Under accrual-basis accounting, you record
the year and information about two assets
different amounts for sales revenue and
and a liability at year-end:
the two expenses, which are calculated as
Revenue and Expense Cash Flows For
First Year
$558,000 cash receipts from sales +
$558,000 cash receipts from sales
$52,000 year-end receivables from
customers = $610,000 sales revenue
$375,000 cash payments for purchases of
$375,000 cash payments for purchases
of products – $85,000 year-end inventory
$340,000 cash payments for other
of unsold products = $290,000 cost of
products sold expense
Two Assets and a Liability at Year-End
$340,000 cash payments for other
$52,000 receivables from customers for
expenses + $25,000 year-end liability for
sales made to them during the year
unpaid expenses = $365,000 other
$85,000 cost of products in ending
inventory that haven’t yet been sold
Deducting cost of products sold and other
expenses from sales revenue gives a net
$25,000 liability for unpaid expenses
loss of $45,000 ($610,000 sales revenue –
Compare the profit or loss of your
$290,000 cost of products sold – $365,000
business for its first year according to
other expenses = $45,000 net loss for year).
the cash- and accrual-basis accounting
To answer Questions 5 through 8, please refer to the summary of revenue and expense cash
flows and the summary of two assets and a liability at year-end presented in the preceding
example question.

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12 Part I: Business Accounting Basics
5. What would be the amount of accrual-basis
6. What would be the amount of accrual-basis
sales revenue for the year if the business’s
cost of products sold expense for the year
year-end receivables had been $92,000?
if the business’s cost of products held in
inventory at year-end had been $95,000?
Solve It
Solve It
7. What would be the amount of accrual-basis
8. Based on the changes for the example
other expenses for the year if the busi-
given in Questions 5, 6, and 7, determine
ness’s liability for unpaid expenses at year-
the profit or loss of the business for its
end had been $30,000?
first year.
Solve It
Solve It

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Chapter 1: Elements of Business Accounting
Summarizing Profit Activities in the
Income (Profit & Loss) Statement
As crass as it sounds, business managers get paid to make profit happen. Management litera-
ture usually stresses the visionary, leadership, and innovative characteristics of business
managers, but these traits aren’t worth much if the business suffers losses year after year or
fails to establish sustainable profit performance. After all, businesses are profit-motivated,
aren’t they?
It’s not surprising that the income statement takes center stage in business financial reports.
The income statement summarizes a company’s revenue and other income, expenses, losses,
and bottom-line profit or loss for a period. The income statement gets top billing over the
other two primary financial statements (the balance sheet and the statement of cash flows),
which I discuss later in this chapter. The income statement is referred to informally as the
Profit & Loss or P&L statement, although these titles are seldom used in external financial
reports. (Alternatively, it may be titled Earnings Statement or Statement of Operations.)
Financial reporting standards demand that an income statement be presented in quarterly
and annual financial reports to owners. But financial reporting rules are fairly permissive
regarding exactly what information should be reported and how it’s presented (see Chapter 5
for the full scoop on income statement disclosure).
Q. Take a look at this extremely abbreviated
A. Income statement reporting requires a
and condensed income statement for a
company to show the cost of goods
business’s most recent year. (Note: A
(products) sold as a separate expense and
formal income statement in a financial
deduct it immediately below sales revenue.
report must disclose more information
The difference must be reported as gross
than this.)
margin (or gross profit). Therefore, the
condensed income statement should be
Income Statement for Year
expanded as follows:
Sales revenue
Income Statement for Year
Sales revenue
Net income
Cost of goods sold
This business sells products, which are
Gross margin
also called goods or merchandise. The cost
of products sold to customers during the
Other expenses
year was $14,300,000. Expand the con-
Net income
densed income statement to reflect this
additional information.

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14 Part I: Business Accounting Basics
9. One rule of income statement reporting is
10. No specific rule governs income statement
that interest expense and income tax
disclosure of advertising expense. Suppose
expense be reported separately. The
the $10,010,000 “Other expenses” in the
$10,010,000 “Other expenses” in the
income statement for the answer to the
income statement for the answer to the
example question includes $5,000,000 of
example question includes $350,000 inter-
advertising expense. Would you favor
est expense and $910,000 income tax.
reporting this as a separate expense in the
Rebuild the income statement given the
income statement? Hint: This question calls
information for these additional two
for your opinion only.
expenses. Hint: Profit before interest
expense is usually labeled “operating earn-
Solve It
ings,” and profit after interest and before
income tax expense is usually labeled
“earnings before income tax.”
Solve It
11. No specific rule governs income statement
12. Please refer to the income statement for
disclosure of executive-level compensa-
the answer to the example question.
tion. Suppose the $10,010,000 “Other
Suppose the business distributed $650,000
expenses” in the income statement for the
cash to its shareowners from its profit (net
answer to the example question includes
income) for the year. Is this cash disburse-
$3,000,000 of executive-level compensation
ment treated as an expense?
that includes both base salaries and gener-
ous bonuses. Would you favor reporting
Solve It
this as a separate expense in the income
statement? Hint: This question calls for
your opinion only.
Solve It

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Chapter 1: Elements of Business Accounting
Assembling a Balance Sheet
The balance sheet is one of the three primary financial statements that businesses report
(the other two being the income statement and the statement of cash flows). It’s also called
the financial condition statement or statement of financial position. The balance sheet summa-
rizes the assets, liabilities, and owners’ equity accounts of a business at an instant in time.
Prepared at the close of business on the last day of the profit period, the balance sheet pres-
ents a “freeze frame” look at the business’s financial condition.
Preparing and reporting a balance sheet takes time, so by the time you read a balance sheet,
it’s already somewhat out-of-date. The business’s stream of activities and operations doesn’t
stop, which means that from the date at which the balance sheet was prepared to when you
read it, the business will have engaged in many transactions. These subsequent transactions
may have significantly changed its financial condition. For more on the balance sheet, turn to
Chapter 6.
In accounting, the term balance refers to the dollar amount of an account, after recording all
increases and decreases in the account caused by business activities. The balance sheet
reports the balances of asset, liability, and owners’ equity accounts, but it also refers to the
equality, or balance, of the accounting equation (see the section “Keeping the Accounting
Equation in Balance” earlier in this chapter).
Q. The following list summarizes the assets and liabilities of a business at the close of business on the
last day of its most recent profit period:
Amounts owed by customers to the business: $485,000
Cost of unsold products (that will be sold next period): $678,000
Cash balance on deposit in checking account with bank: $396,000
Amounts owed by business for unpaid purchases and expenses: $438,000
Notes payable to bank (on which interest is paid): $500,000
Original cost of long-term operating assets that are being depreciated over their useful lives to the
business: $950,000
Accumulated depreciation of long-term operating assets: $305,000
Using this information, prepare the business’s balance sheet.
A. Cash
Accounts Payable
Accounts Receivable
Notes Payable
Owners’ Equity*
Fixed Assets (Net of
Accumulated Depreciation)
Total Assets
Total Liabilities and Owners’ Equity $2,204,000
*Owners’ equity is determined by deducting the sum of liabilities from total assets.
Note: This balance sheet isn’t classified into current assets and current liabilities. Also, owners’
equity isn’t classified. (Chapter 6 explains the balance sheet in greater detail.)
Use the balance sheet shown in the preceding example to answer Questions 13 through 16.

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16 Part I: Business Accounting Basics
13. Suppose $950,000 of owners’ equity con-
14. It appears that the business can’t pay its
sists of profit earned and not distributed
liabilities. The two liabilities total $938,000,
by the business. What is this amount usu-
but the business has a cash balance of only
ally called in the balance sheet? And, what
$396,000. Do you agree?
is the other amount of owners’ equity
called in the balance sheet?
Solve It
Solve It
15. Can you tell the amount of profit the busi-
16. In a balance sheet, assets usually are listed
ness earned in the period just ended?
in the order of their “nearness” to cash.
Cash is listed first, followed by the asset
Solve It
closest to being converted into cash, and
so on. Is the sequence of assets according
to normal rules for presenting assets in bal-
ance sheets?
Solve It