BASICS OF

ACCOUNTING
Tuulia Potka-Soininen
M.SC (Econ. & Bus.Adm.)

COURSE OBJECTIVES
Understanding of the theory of financial
accounting
To identify and describe the core
processes of a company
To have an understanding of the basic
budgeting process
To be able to analyze and evaluate a
company

COURSE OBJECTIVES
To be aware of the different
stakeholder groups and their need
for financial information and the use
of it
To develop learning skills and the
ability to reflect

LEARNING METHODS
AND ASSESSMENT

Lectures
Demonstrations
Exercises
Case studies, etc.
Assessment is based on the final
exam and some collected homework

ACCOUNTING
information system that
measures,
processes, and
communicates financial information
about an enterprise (Gray-Needles)

ACCOUNTING
system for
measuring business performance
and
translating those measures into
information for management
decisions

ACCOUNTING
a link between business activities and
decision makers:
measures business activities by
recording data
processes and stores data
reports data to the decision
makers through various reports

FINANCIAL
ACCOUNTING

tasks:
1. to keep an entitys income, expenses,
assets and liabilities separated from
those of other economic units
2. to enable utilization of information:

planning and follow-up of activities

information for operative purposes

FINANCIAL
ACCOUNTING
3. to calculate net result
Income statement
How well did the company do?
revenue exceeds expenses => profit
expenses exceed revenue => loss
to clarify, which are the factors that have
impacted the net result

FINANCIAL
ACCOUNTING
3. to calculate financial position
Balance sheet
What is the companys financial position?
4. to calculate retained earnings
Statement of retained earnings
Why did the retained earnings change?
Net income increases, net loss and
dividends declared decrease retained
earnings

10

FINANCIAL
ACCOUNTING
5. To calculate the change in companys cash
Statement of cash flows
How much cash did the company generate
and spend?

11

FINANCIAL
ACCOUNTING
accounting is done solely for
companys own purposes =>
management accounting => not
public
or for stakeholders (and the company
itself) => financial accounting

12

STAKEHOLDER GROUPS
stakeholder groups: e.g. owners/investors,
managers, government/agencies, lenders,
suppliers, employees, customers
owners/investors
provide the capital at risk;
are interested in the returns from their
investments;
accounting information needed for decision
making

13

STAKEHOLDER GROUPS
managers use accounting information to

set goals,
develop plans,
set budgets and
evaluate future prospects

government/agencies: e.g. tax authorities

use accounting information
to plan for tax inflows,
determine the tax liabilities of individuals and
businesses and
ensure that correct amounts are paid on time

14

STAKEHOLDER GROUPS
lenders use accounting information to
determine a companys growth
prospects,
determine whether it is a good credit
risk before lending;
liquidity

suppliers: assessment of liquidity

15

STAKEHOLDER GROUPS
employees use accounting information to
get paid and
to plan for and receive benefits: health care,
vacation time, retirement pay;
assessment of employers

customers: prospects of an enterprise,

especially in case of a long-term
relationship or dependency
Competitors?

16

TYPES OF BUSINESS
ORGANIZATIONS
a business is a separate unit, whose
earnings and expenses as well as
assets and liabilities are kept
separately from e.g. the owners
respective items

17

TYPES OF BUSINESS
ORGANIZATIONS
Proprietorship
Partnership
Corporation

18

TYPES OF BUSINESS
ORGANIZATIONS
a proprietorship:
a business owned by one person
the owner receives all profits or losses
the owner is liable for all obligations of
the business
typically small in size
legally, the business and the owner are
the same
19

TYPES OF BUSINESS
ORGANIZATIONS
a partnership:
two or more co-owners
partners share profits and losses
according to an agreement
any partner can bind the partnership to
another party
Exception to this: Limited-liability
partnerships (LLPs)

20

TYPES OF BUSINESS
ORGANIZATIONS
a partnership:
personal resources of each partner can be
called on to pay the obligations of the
partnership
a partnership is a separate legal entity, but not
a separate taxable entity
a flexible form of an enterprise
partners have a right to transfer the
partnerships assets to their private use
without restrictions

21

TYPES OF BUSINESS
ORGANIZATIONS
limited partnership
two types of partners:
general (responsible) partner
limited partner

22

TYPES OF BUSINESS
ORGANIZATIONS
limited partnership
general partners
share profits and losses according to
an agreement
are personally liable for business
debts
run the day-to-day operations
have a right to transfer the
partnerships assets to their private
use without restrictions

23

TYPES OF BUSINESS
ORGANIZATIONS
limited partnership
limited partners
invest in the partnership
are paid interest as a return on their
investment according to an agreement
do not take part in running the
company
are not personally liable for the
companys debts
24

TYPES OF BUSINESS
ORGANIZATIONS
Corporation (Inc., Corp., Company)
a business unit that is legally separate
from its owners (shareholders)
owners liability is limited to their
investment in the company
ownership is represented by shares

25

TYPES OF BUSINESS
ORGANIZATIONS
corporation
owners do not directly run the company
a corporation is an independent legal and
a separate taxable entity
ownership can be transferred without
dissolving the corporation

26

TYPES OF BUSINESS
ORGANIZATIONS
corporation
management: shareholders (general
meeting) => board of directors =>
corporate officers
owners are paid dividends as a return on
their investment

27

TYPES OF BUSINESS
ORGANIZATIONS
all businesses have similar financial
goals:
profitability
liquidity

and business activities:

financing activities to obtain and repay
capital
investing activities in productive ways
operating activities
28

ACCOUNTING
PRINCIPLES AND
CONCEPTS
1. ENTITY CONCEPT:
most basic concept in accounting
an accounting entity is an organization
or section of an organization that
stands apart as a separate economic unit
each entity has to be evaluated
separately

29

ACCOUNTING
PRINCIPLES AND
CONCEPTS
2. TIME-PERIOD CONCEPT
Financial statements are prepared at
regular intervals, usually annually
Accounting period usually 12 months

3. REALIZATION
Sales/purchases are entered in the
accounts when the legal title for the
products has been transferred from one
party to another
30

ACCOUNTING
PRINCIPLES AND
CONCEPTS
4. MATCHING
Incomes and the corresponding
expenses are entered in the accounts in
the same period
Sales => cost of goods sold (COGS)

5. MATERIALITY
Other rules can be ignored if the
effects are not significant (applying
would involve a considerable amount of
work)

31

ACCOUNTING
PRINCIPLES AND
CONCEPTS
6. RELIABILITY (OBJECTIVITY)
PRINCIPLE:
reliable data: verifiable and can be
confirmed

7. (HISTORICAL) COST PRINCIPLE:

acquired assets and services should be
recorded at their actual cost

32

ACCOUNTING
PRINCIPLES AND
CONCEPTS
8. GOING-CONCERN CONCEPT:
the entity will remain in operation for the
foreseeable future
most assets are acquired for use rather than
for sale
assumption: business will remain in operation
long enough to use existing assets for their
intended purpose

33

ACCOUNTING
PRINCIPLES AND
CONCEPTS
9. STABLE-MONETARY-UNIT
CONCEPT:
the monetary value of the money used is
relatively stable => effect of inflation is
ignored

10. PRUDENCE
If in doubt, overstate losses and
understate profits.
34

ACCOUNTING
PRINCIPLES AND
CONCEPTS
11. CONSISTENCY
Once specific accounting policies have
been adopted, they should be followed in
all subsequent periods

12. COMPLETENESS
All transactions are recorded
All assets, owners equity and liabilities
are included in the balance sheet
35

ACCOUNTING
PRINCIPLES AND
CONCEPTS
13. RELEVANCE
Financial accounting information is such
that the users need it and can use it

14. BALANCE BETWEEN BENEFIT

AND COST
The benefits derived from information
should exceed the cost of providing it
36

ACCOUNTING
PRINCIPLES AND
CONCEPTS
15. SUBSTANCE OVER FORM
Financial statements should show the
financial reality of the entity rather
than the legal form of transactions

16. COMPARABILITY
A set of financial statements can be
compared with those of prior years
37

ACCOUNTING
PRINCIPLES AND
CONCEPTS
17. TIMELINESS
Accounting information is presented to
the users in time for their decision
making

18. TRUE AND FAIR VIEW

An entity has to provide true and fair
view about its financial conditions and
operating results
38

ACCOUNTING
PRINCIPLES AND
CONCEPTS
financial year, fiscal year:
financial statements are prepared for a
specific period = time-period concept
ensures that information is reported at
regular intervals
most basic accounting period is one year
(12 months), often times calendar year

39

ACCOUNTING
PRINCIPLES AND
CONCEPTS
transactions:
any event that both affects the financial
position of a business entity and can be reliably
recorded

expenditures
revenues
financial transactions
readjustments and carrying forward

40

ACCOUNTING EQUATION

economic resources (assets) = nonowners equities (liabilities) +

owners equities
these two sides of the equation
always must equal, be in balance

41

ACCOUNTING EQUATION

assets:

bring revenue to the entity in future

of economic value
for example plant, equipment, accounts
receivable, cash etc.

42

ACCOUNTING EQUATION

liabilities:

an obligation of a business to pay cash

or transfer assets
debts of the business, amounts owed
to suppliers for goods and services
bought on credit, salaries owed to the
employees
debts payable to the outsiders

43

ACCOUNTING EQUATION

owners equity:

Stockholders equity, shareholders

equity
owners investments in the company
owners claims to the assets of the
company
owners equity = assets liabilities

44

ACCOUNTING EQUATION

owners equity:

Corporations:
= Paid-in capital + retained earnings
Paid-in or contributed capital =
amount invested by the owners
All corporations have common stock
(from shares issued to stockholders)
retained earnings = equity generated
from the profit-producing activities
45
of the business

ACCOUNTING EQUATION

owners equity:
Retained earnings are increased by
revenues (=> through profits),
decreased by expenses (=> through
profits) and dividends
Proprietorships and partnerships:
Capital;
no difference between what is
invested and what is earned
46

EXPENDITURES

expenditures are a result of acquiring

input (production factors)

raw material, materials and supplies,

machinery and equipment etc.

division into two types of expenditures:

long-term assets and short-term
expenditure (expenses)

47

EXPENDITURES

Long-term assets:

expenditures that produce revenues

under several financial years
machinery, equipment, buildings,
estates

48

EXPENDITURES

short-term expenditures, expenses:

no more revenue expected

used up in production (during one financial year)
e.g. raw material, contribution by the workforce,
external services

an expenditure is born when a commodity is

received => accrual-basis accounting
regardless when the payment takes place =>

cash-basis accounting

49

REVENUE
created as a result of sales
revenue is realized when a commodity
is delivered to a customer =>

accrual-basis
not dependent on when payment is
received => cash-basis

50

INCOME STATEMENT
How well a company has done during a
financial year?

Revenues
./. Expenses
= Net income/net loss

51

BALANCE SHEET
What is a companys financial position in
the end of a financial year?
Assets?
Owners equity?
Liabilities?
Two-sided calculation with assets on the
left side and liabilities and owners equity
on the right side
Assets = liabilities + owners equity

52

BALANCE SHEET
Assets:
Current assets: assets that the company
expects to sell, consume or convert to
cash within the next 12 months

Cash
Receivables
Inventory
Prepaid expenses

53

BALANCE SHEET
Assets:
Long-term assets produce revenue
over several years
Property, plant, equipment (PPE)
Long-term assets are depreciated:
used part of assets is written off as
an expense

54

BALANCE SHEET
Liabilities:
Current liabilities: payable within
one year
Notes payable: a promissory note has been
signed
Accounts payable: credit on goods and
services bought on account
Short-term expenses payable: amounts owed
to employees, to the government etc.
55

BALANCE SHEET
Liabilities:
Long-term liabilities: payable after
one year
Owners equity

56

RETAINED EARNINGS
How did the retained earnings
change during a financial year?
Beginning retained earnings
+ Net income/-Net loss
- Dividends
= Ending retained earnings
57

STATEMENT OF CASH
FLOWS
How much money did the company
generate and spend during a financial
year?
Cash flows from operations
+/- Cash flows from investments
+/- Cash flows from financing
= increase/decrease in cash
58

STATEMENT OF CASH
FLOWS
Operations: cash inflow from revenue ./.
cash outflow for expenses paid
Adjusted to reconcile net income to net cash
provided by operations

Investments: cash spent on investments,

cash received from sales of investments
Financing: cash received from owners or
lenders, repayments of loans and capital

59

FINANCIAL
TRANSACTIONS
1. financial transactions are results of
expenditures and revenues

cash inflow (receipts) from revenues

cash outflow (disbursements) from
expenditures
expenditures precede revenues, cash
outflow precedes cash inflow => need
of outside financing

60

FINANCIAL
TRANSACTIONS
2. paid-in capital from the owners or
3. debt (creditors)
4. financial flows also include
distribution of profits among
creditors, government and owners
=> interest, taxes and dividends

61

FINANCIAL
TRANSACTIONS

sources of cash:

revenue (payments from outputs)

capital (paid-in capital from owners or debt
capital)
difference in the restitution obligation

sinks of cash:

expenditures (payments for inputs)

repayment of capital
distribution of profit

62

MANAGEMENT
ACCOUNTING
Reports are
for internal use only
usually very detailed
Often provide forecasts as well as
historical information
Not regulated by external bodies
Prepared for a specific purpose
Produced more frequently than financial
accounting reports
63

MANAGEMENT
ACCOUNTING
Three core activities
Participation in the planning process
Provide guidance for the management
decisions
Contribution to the monitoring and
control of perfomance

64

BUDGETS
Monetary plans prepared in advance
for the forthcoming period
Quantified
For a given period of time

Planning:
Provides direction, targets for the
organization
Helps coordination with different parts
of the business
65

BUDGETS
Planning:
Helps exercising control (actual vs.
planned)
Forces to think ahead

Quantification:
A definite target for planning purposes
A yardstick for control purposes

66

BUDGETS
Two main roles:
1. Act as authorities to spend or as
targets to achieve
Give authority to incur expenses
Provide targets for revenue-generating

2. Act as comparators for current

perfomance

67

BUDGET PROCESS
1. Set overall objectives & how to get
there
Products, services, markets, resources
required

2. Annual budjet is an interim step

towards the achievement of the
long-term plan

Sales revenues, expenses => in more

detail
68

BUDGET PROCESS
3. Identify the principal budget factor

Limits the activities of the

organization: sales, capacity etc.
Determines, where to start budgeting

4. Preparation of the master budget

Budgeted income statement

Cash flow budget
Budgeted balance sheet

69

BUDGET PROCESS
5. Cooperation throughout the planning
process!

70

ACCOUNTS
transactions are recorded in accounts
an account is a two-sided calculation
(debit-side and credit-side), which is used
to keep track of changes in revenues,
expenditures and financial transactions
left side is debit and right side is credit

71

ACCOUNTS
the other side of the account is used for
recording increases to the account and the
other side for decreases
Double-entry system: transactions are
always recorded on
one accounts debit-side and
another accounts credit-side

72

ACCOUNTS
each account is named according to the
type of transaction it handles
account names are written with a capital
letter
e.g. Cash-account is used for tracking
changes in the amount of cash in hand,
Purchases handles the amount of money
used for the purchase of goods to be sold

73

ACCOUNTS
Some concepts:
on account
Purchase of an asset on account => assets
and liabilities (account payable) increase
Perform a service or sell a good on account
=> assets (receivables) increase and
revenues increase
Payment on account => assets (cash)
decrease and liabilities (account payable)
decrease
Collect cash on account => increases assets
(cash) and decreases another asset
(receivable)
74

ACCOUNTS
to record
transactions, a Taccount is often
used:

Name of account
debit

credit

75

ACCOUNTS
cash is used as a reference account:
increase in cash:
debit-side (left side)

decrease in cash:
credit-side (right side)

76

ASSET ACCOUNTS
increases in the amount of money in
hand are recorded on the debit-side
= to debit the Cash account: debit
Cash
decreases in the amount of money in
hand are recorded on the credit-side
= to credit the Cash account: credit
Cash

77

LIABILITIES AND
OWNERS EQUITY
ACCOUNTS
show, how much an entity has capital from
owners and what are its liabilities
e.g. Accounts Payable, Notes Payable =
debt accounts
the types of accounts used for recording
paid-in capital depends on the type of
ownership structure
78

LIABILITIES AND
OWNERS EQUITY
ACCOUNTS
Liabilities and Owners'
Equity accounts
beginning
balance
decrease
increase
79

EXPENSE ACCOUNTS
various types of expenses => variety
of expense accounts
with expense accounts a company
keeps track of its money usage

80

EXPENSE ACCOUNTS
Expense account
increase decrease

81

REVENUE ACCOUNTS
the type of revenue a company has varies
from a company to a company:

sales revenue
income from work
rent income
repair income
proceeds of freight
dividend income
income from interest

82

REVENUE ACCOUNTS
Revenue account
decrease increase

83

ACCOUNTS
ending balance is always calculated as
a difference between the debit- and
credit-sides

84

RECORDING BUSINESS
TRANSACTIONS
1.

Specify transaction: accounts affected

by it, classify each account (easiest to
start with the effect on cash)
2. Are the accounts increased or decreased
by the transaction?
3. Record the transaction in a journal:

Use double-entry accounting

making the journal entry
journalizing the transaction
85

RECORDING BUSINESS
TRANSACTIONS
4. Copy information from the journal to the
ledger:

posting

5. Close the books

86

JOURNALIZING

journal = a chronological record of

all transactions listed by date
a journal entry has:
name of the debit account + the amount
debited
name of the credit account + the amount
credited
a brief explanation

87

POSTING

ledger = grouping of all the accounts

showing their balances
accounts are grouped in a ledger:
first assets, then liabilities, and
stockholders equity, revenues and
expenses

88

POSTING

debits in journal are debits in

ledger, credits are credits
all transactions need to be keyed by
date or number
After all transactions have been
posted, account balances are
calculated as a difference between
the debit-side and the credit-side
of the account
89

ETHICAL ISSUES
When to record expenses?
Asset vs. Expense
Omitting an expense
effect on net income and liabilities

When to record revenues?

Accelerating revenue recognition.
Recording sales based on anticipated orders.
Recording projects as revenue while still in
progress.

90

ACCOUNTING
ADJUSTMENTS

are used to ensure, that

revenues and expenses (=> net income)

are correct
balance sheet accounts carry correct
balances

Accounting adjustments are a tool

to ensure correct accrual
accounting.
91

1. DEFERRALS

an adjustment for an item that the

business paid or received cash in advance
prepaid expenses:

cash is paid in one period, but the resource is

not completely used until a later period
e.g. prepaid rent, prepaid insurance
prepaid expense is an asset (because they
provide a future benefit to the owner)

92

1. DEFERRALS

unearned revenues:

cash is received in one period, but it,

or all of it, is not earned until a later
period
a business owes the customer a good
or service
an unearned revenue is a liability

93

2. DEPRECIATIONS AND
AMORTIZATIONS
depreciation is the allocation of the cost
of a tangible long-lived asset over its
estimated useful life
amortization is the allocation of the cost
of an intangible asset over its revenueproducing life-span
the unexpired part (not yet allocated as an
expense) of these costs is called book
value or carrying amount

94

2. DEPRECIATIONS AND
AMORTIZATIONS
book value = cost ./. depreciations
(amortizations)
matching rule:
what is the useful life of an asset
how much of the cost should be written off as
an expense each financial year = how much the
asset wears out
how much of the cost should remain on the
balance sheet as an asset

95

2. DEPRECIATIONS AND
AMORTIZATIONS
all tangible assets (except land &
water) have a limited useful life:
physical deterioration
obsolescence (becoming out of date)

depreciation is the allocation of cost:

cost of an asset (balance sheet) =>
expense (income statement)

96

2. DEPRECIATIONS AND
AMORTIZATIONS
depreciation is not a process of
valuation: accounting records do not
reflect market price
depreciation is recorded as a credit
on Accumulated Depreciation account
(the original asset account is not
reduced)

97

2. DEPRECIATIONS AND
AMORTIZATIONS
and as a debit on Depreciation
Expense account
Accumulated Depreciation account is
a contra asset account (opposite to
the original asset account).

98

2. DEPRECIATIONS AND
AMORTIZATIONS
factors affecting the calculation of
depreciation:
cost of an asset
residual value: estimated net scrap,
salvage or trade-in value of an asset as
of the estimated date of disposal
depreciable amount: cost ./. residual
value
estimated useful life
99

2. DEPRECIATIONS AND
AMORTIZATIONS
straight-line method depreciation:
cost ./. residual value
estimated useful life

production method of depreciation:

cost ./. residual value
total estimated units of useful life
annual depreciation = depreciation
per unit of useful life x units
of useful life per year

100

2. DEPRECIATIONS AND
AMORTIZATIONS
declining-balance method of
depreciation:
fixed rate for depreciation
fixed rate is applied to the remaining
carrying amount at the end of each year

101

3. ACCRUALS
a business records an expense or
revenue before paying or receiving
cash
accrued expenses:
expenses have incurred by the end of
the period, but will not be paid until a
later period
adjusting entry records the expense and
a liability

102

3. ACCRUALS
accrued revenues:
revenue has been earned, but cash not
yet received for it
adjusting entry records an increase to a
revenue and to a receivable

103

ACCRUAL ACCOUNTING
1)
JOURNALIZING
AND POSTING

2) ACCOUNTING
ADJUSTMENTS

3) CLOSING
THE BOOKS

4) FINANCIAL
STATEMENTS

104

FINANCIAL
STATEMENTS
INCOME
STATEMENT
BALANCE
SHEET
105

CLOSING THE BOOKS

Objective: to enable the preparation
of financial statements and to
prepare the accounts for next
accounting period by
1. Calculating the balances on each
account

106

CLOSING THE BOOKS

2. transferring the balances into profit
and loss account or balance sheet
account
Profit and loss account: revenues
and expenses
Balance sheet account: assets,
liabilities, owners equity
107

CLOSING THE BOOKS

3. Calculating the net income on the
profit and loss account as the
difference between revenues and
expenses = ending balance on the
profit and loss account.

108

CLOSING THE BOOKS

4. Posting the net income as a balance
on the profit and loss account
(debit-side profit, credit-side loss)
and on the opposite side of the
balance sheet account.

on both accounts, debits = credits

after posting the net income

109

CLOSING THE BOOKS

5. On the balance sheet, net income is
part of the owners equity: profit
increases and loss decreases it.
6. Preparing financial statements using
the information on the profit and
loss account and the balance sheet
account.

110

CLOSING THE BOOKS

7. Permanent accounts (assets,
liabilities, owners equity, on the
balance sheet) are carried on to the
next financial year.

111

CLOSING THE BOOKS

CLOSING ENTRIES

DEBIT REVENUE CREDIT PROFIT AND LOSS ACCOUNT

CREDIT EXPENSE DEBIT PROFIT AND LOSS ACCOUNT

CREDIT DIVIDENS DEBIT BALANCE SHEET ACCOUNT

112

CLOSING THE BOOKS

CREDIT ASSETS- DEBIT BALANCE SHEET ACCOUNT

DEBIT OWNERS EQUITY CREDIT BALANCE SHEET ACCOUNT

DEBIT LIABILITIES- CREDITBALANCE SHEET ACCOUNT

CALCULATE THE BALANCE ON THE PROFIT AND LOSS ACCOUNT

113

CLOSING THE BOOKS

DEBIT-BALANCE = REVENUES EXCEED EXPENSES => PROFIT

CREDIT-BALANCE= EXPENSES EXCEED REVENUES => LOSS

POST THE BALANCE ON THE PROFIT AND LOSS ACCOUNT AND THE
BALANCE SHEET ACCOUNT

PREPARE FINANCIAL STATEMENTS

114