Northwest Executive Education

Financial and Managerial Accounting Program

UCLA PGPX

Financial Accounting

Prof. Ravi Jain

 Agenda
• Understanding financial statements
– Balance Sheet
– Profit and Loss Statement
– Cash Flow Statement
 Accounting

• Accounting is an information system that

‒ Measures business activities
‒ Processes data into reports
‒ Communicates results to decision makers
 Conceptual Foundations of
Accounting

Accounting’s
Objective

Fundamental
Qualitative
Characteristics

Enhancing
Qualitative
Characteristics
Constraints
Assumptions and Principles
Entity Assumption: Organization stands apart from other
organizations and individuals as a separate economic unit

Continuity (Going-Concern) Assumption: Entity will

remain in operation for the foreseeable future

Historical Cost Principle: Assets should be recorded at their

actual cost

Stable-Monetary-Unit Assumption: Effect of inflation is

ignored, based on the assumption that purchasing power is
relatively stable
 Financial Statements
• Information in published financial
statements can be used to assess the
financial health of the company
– Balance Sheet
– Profit and Loss Statement
– Cash Flow Statement
 Balance Sheet
• Snapshot of the financial position of the
firm at a point in time.
• The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholders Equity
• Alternatively:
Assets – Liabilities ≡ Stockholders Equity
• Stockholders Equity is often referred to as
Owners Equity or Net Worth.
 Balance Sheet
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
1. Tangible
Shareholders
2. Intangible Equity
 Sample Balance Sheet
(as of the end of the year)

2017 2016 2017 2016

Current assets: Current Liabilities:
Cash and equivalents Rs.140 Rs.107 Accounts payable Rs.213 Rs.197
Accounts receivable 294 270 Short Term Debt payable 273 258
Inventories 269 280
Other 58 50 Total current liabilities Rs.486 Rs.455
Total current assets Rs.761 Rs.707
Long-term liabilities:
Fixed assets:
Property, plant, & equipment Rs.1,423 Rs.1,274 Long-term debt 588 562
Less accumulated depreciation (550) (460) Total long-term liabilities Rs.588 Rs.562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets Rs.1,118 Rs.1,035 Preferred stock Rs.39 Rs.39
Common stock (Rs.1 par value) 55 32
Capital surplus 347 327
Accumulated retained earnings 390 347
Less treasury stock (26) (20)
Total equity Rs.805 Rs.725
Total assets Rs.1,879 Rs.1,742 Total liabilities and stockholder's eq. Rs.1,879 Rs.1,742
 Sample Balance Sheet
• For balance sheet of Bharat Petroleum Corp., see:
http://www.moneycontrol.com/financials/bpcl/balance-
sheetVI/BPC
• There may be some variations in the format of the balance
sheet and the terms used globally
• In India, Fixed Assets are sometimes grouped and reported as
“Block”: Gross Block less Depreciation = Net Block
• Current Assets and Current Liabilities may sometime be
reported together:
Net Current Assets or Working Capital =
Current Assets – Current Liabilities
• Retained Earnings in India is usually reported as “Reserves”
 Value versus Cost
• Typically, accounting principles effectively
require that audited financial statements of
firms carry assets at cost (adjusted for
depreciation, where applicable)
• Market value is the price at which the
assets, liabilities, and equity could actually
be bought or sold, which may be quite
different from historical cost
Assets on the Balance Sheet

Current Assets

 Expected to be converted to cash, sold, or consumed during

the next 12 months or within the business’s operating cycle
if longer than a year
Cash equivalents include
 Includes money-market accounts or
► Cash and cash equivalents other financial instruments
that are easily convertible to
► Short-term investments cash
► Accounts receivable
► Inventory
► Prepaid expenses
Assets on the Balance Sheet

Current Assets

 Expected to be converted to cash, sold, or consumed during

the next 12 months or within the business’s operating cycle
if longer than a year

 Includes
► Cash and cash equivalents Includes stocks and bonds
of other companies that the
► Short-term investments company intends to sell
► Accounts receivable within the next year

► Inventory
► Prepaid expenses
Assets on the Balance Sheet

Current Assets

 Expected to be converted to cash, sold, or consumed during

the next 12 months or within the business’s operating cycle
if longer than a year

 Includes
► Cash and cash equivalents
► Short-term investments
Amounts collectible from
► Accounts receivable customers from the sale of
goods and services
► Inventory
► Prepaid expenses
Assets on the Balance Sheet

Current Assets

 Expected to be converted to cash, sold, or consumed during

the next 12 months or within the business’s operating cycle
if longer than a year

 Includes
► Cash and cash equivalents
► Short-term investments
Raw materials, goods in
► Accounts receivable
process, and finished
► Inventory merchandise that a
company sells to
► Prepaid expenses customers
Assets on the Balance Sheet

Current Assets

 Expected to be converted to cash, sold, or consumed during

the next 12 months or within the business’s operating cycle
if longer than a year

 Includes
► Cash and cash equivalents
► Short-term investments
► Accounts receivable Amounts paid in
advance for costs that
► Inventory include advertising, rent,
► Prepaid expenses insurance, and supplies
Assets on the Balance Sheet

Long-term Assets

 Expected to benefit the company for long periods of time

 Includes
Tangible assets that include
► Property and equipment land, buildings, computers,
and equipment
► Accumulated depreciation
► Long-term investments
► Intangibles
Assets on the Balance Sheet

Long-term Assets

 Expected to benefit the company for long periods of time

 Includes
Amount of the historical cost
► Property and equipment
of plant assets that has been
► Accumulated depreciation allocated to expense in the
income statement over time
► Long-term investments as the asset has been
► Intangibles used in producing revenue
Assets on the Balance Sheet

Long-term Assets

 Expected to benefit the company for long periods of time

 Includes
► Property and equipment
► Accumulated depreciation Includes stocks and bonds
of other companies that the
► Long-term investments
company does not intend to
► Intangibles sell within the next year
Assets on the Balance Sheet

Long-term Assets

 Expected to benefit the company for long periods of time

 Includes
► Property and equipment
► Accumulated depreciation
► Long-term investments
Assets with no physical
► Intangibles form, such as patents,
trademarks, and goodwill
Liabilities on the Balance Sheet

Current Liabilities

 Debts payable in the next year or within the business’s

operating cycle if longer than a year

 Includes
Amounts owed to vendors
► Accounts payable and suppliers for purchases
of inventory
► Income taxes payable
► Accrued expenses
► Current maturities of
long-term debt
Liabilities on the Balance Sheet

Current Liabilities

 Debts payable in the next year or within the business’s

operating cycle if longer than a year

 Includes
► Accounts payable
Tax debts owed to the
► Income taxes payable
government
► Accrued expenses
► Current maturities of
long-term debt
Liabilities on the Balance Sheet

Current Liabilities

 Debts payable in the next year or within the business’s

operating cycle if longer than a year

 Includes
► Accounts payable
Includes other liabilities such
► Income taxes payable as interest payable on
borrowed money, accrued
► Accrued expenses liabilities for salaries,
► Current maturities of utilities, and other expenses
that are owed but have not
long-term debt
been paid
Liabilities on the Balance Sheet

Current Liabilities

 Debts payable in the next year or within the business’s

operating cycle if longer than a year

 Includes
► Accounts payable
► Income taxes payable
► Accrued expenses Portion of long-term
liabilities that the company
► Current maturities of will have to pay off within the
long-term debt next year
Liabilities on the Balance Sheet

Long-term Liabilities

 Debts due beyond one year or the company’s normal

operating cycle if longer than a year

 Includes
► Long-term bonds payable
► Long-term bank loans
Equity on the Balance Sheet

Stockholders’ Equity

 Represents the stockholders’ ownership of the business’s

assets

 Includes
Amount represents the par
► Common stock value of the shares issued to
stockholders
► Additional paid-in capital
► Retained earnings
► Treasury stock
Equity on the Balance Sheet

Stockholders’ Equity

 Represents the stockholders’ ownership of the business’s

assets

 Includes
► Common stock Amount of cash received on
initial sale of the company’s
► Additional paid-in capital
stock in excess of the par
► Retained earnings value

► Treasury stock
Equity on the Balance Sheet

Stockholders’ Equity

 Represents the stockholders’ ownership of the business’s

assets

 Includes
► Common stock
► Additional paid-in capital
Portion of net income
► Retained earnings
reinvested into the business
► Treasury stock (listed as Reserves in India)
Equity on the Balance Sheet

Stockholders’ Equity

 Represents the stockholders’ ownership of the business’s

assets

 Includes
► Common stock
► Additional paid-in capital
► Retained earnings
Amounts paid by the
► Treasury stock company to repurchase its
own stock
 Owners’ Equity

The Components of Retained Earnings

 Retained Earnings (or Reserves)

Expenses
decrease

Revenues Dividends
increase decrease

Retained
Earnings
Example: Balance Sheet
Blue Diamond Corporation has current assets of $360 million;
property, plant, and equipment of $600 million; and other assets
totaling $220 million. Current liabilities are $210 million and long-
term liabilities total $560 million.
1. Use these data to write Blue Diamond Corporation’s
accounting equation.
2. How much in resources does Blue Diamond Corporation
have to work with?
3. How much does Blue Diamond Corporation owe creditors?
4. How much of the company’s assets do the Blue Diamond
Corporation stockholders actually own?
Example: Balance Sheet
Blue Diamond Corporation has current assets of $360 million;
property, plant, and equipment of $600 million; and other assets
totaling $220 million. Current liabilities are $210 million and long-
term liabilities total $560 million.

Stockholders’
Assets = Liabilities + Equity

$ 360 $ 210
600 560
220
$ 1,180 = $ 770 + $ 410
(Amount in millions)
 Balance Sheet Insights
• The balance sheet provides us with
some insights on various financial
strategies employed by the firm.
The Capital Budgeting Decision

Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
What long-
1 Tangible term Shareholder
investments
2 Intangible Equity
has the firm
made?
The Capital Structure Decision
Current
Liabilities
Current
Assets Long-Term
How has the Debt
firm raised
funds for the
Fixed Assets
investments?
1 Tangible
Shareholder
2 Intangible Equity
 Debt versus Equity
• Creditors generally receive the first claim
on the firm’s cash flow
• Shareholder’s equity is the residual
difference between assets and liabilities
Short-Term Asset Management
Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

How have
Fixed Assets
short-term
1 Tangible assets been
managed and Shareholder
2 Intangible financed? Equity
 Working Capital
• Working Capital = Current Assets - Current Liabilities
• The main components of working capital are current
assets such as cash, inventory, and receivables, and
current liabilities such as payables.
• Working capital management is the management of
the short-term investments and financing of a
company.
• Goals:
– Adequate cash flow for operations
– Most productive use of resources
 Liquidity
• Refers to the ease and quickness with
which assets can be converted to cash
without a significant loss in value
• Current assets are the most liquid
• Some fixed assets are intangible
• The more liquid a firm’s assets, the less
likely the firm is to experience problems
meeting short-term obligations
• However, liquid assets frequently have
lower rates of return than fixed assets
 The dividend versus retained
earnings decision

Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets How much of

earnings does
1 Tangible Shareholder
the firm retain
2 Intangible versus payout Equity
as dividends to
shareholders?
EVALUATE BUSINESS OPERATIONS
THROUGH THE FINANCIAL STATEMENTS
Data flow from one financial statement to the next

Statement of
Income
Retained
Statement
Earnings

Statement of
Balance Sheet
Cash Flows
 Profit and Loss Statement
(Income Statement)
• How profitable has the firm been during the
past year?
• Flow statement: Measures financial
performance over a specific period of time
(e.g. one quarter or one year)
• The accounting definition of income is:
• Revenue – Expenses ≡ Income
 Sample Income Statement
see https://www.moneycontrol.com/financials/ultratechcement/profit-
lossVI/UTC01 for Income Statement of UltraTech Cement)

Total operating revenues Rs.2,262

The operations Cost of goods sold 1,655
section of the Selling, general, and administrative expenses 327
Depreciation 90
income
Operating income Rs.190
statement Other income 29
reports the firm’s Earnings before interest and taxes Rs.219
Interest expense 49
revenues and Pretax income Rs.170
expenses from Taxes 84
principal
operations. Net income Rs.86
Addition to retained earnings Rs.43
Dividends: Rs.43
 Sample Income Statement
Total operating revenues Rs.2,262
The non- Cost of goods sold 1,655
operating section Selling, general, and administrative expenses 327
Depreciation 90
of the income
Operating income Rs.190
statement Other income 29
includes all Earnings before interest and taxes Rs.219
Interest expense 49
financing costs, Pretax income Rs.170
such as interest Taxes 84
expense.
Net income Rs.86
Addition to retained earnings: Rs.43
Dividends: Rs.43
 Sample Income Statement
Total operating revenues Rs.2,262
Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
Operating income Rs.190
Other income 29
Earnings before interest and taxes Rs.219
Interest expense 49
Pretax income Rs.170
Net income or Taxes 84
profit after tax is
the “bottom line.” Net income Rs.86
Any amount not Addition to Retained earnings: Rs.43
Dividends: Rs.43
paid in dividends is
added to retained
earnings.
 Revenues and Expenses
• Key components of income
• Revenue: Increase in net assets from sale
of products or services
– Also known as sales or sales revenue
– Increases owners’ equity
• Expense: Decrease in net assets as a
result of consuming or giving up resources
in the process of providing products or
services to a customer
– Decreases owners’ equity
 Revenues and Expenses
• Income: Excess of revenues over
expenses
– Also known as profits or earnings
• If expenses exceed revenues, loss is incurred
• Retained earnings: Total cumulative
owners’ equity generated by income or
profits (and shown on balance sheet)
– Also known as retained income
 Cost of Goods Sold
• Cost of Goods Sold: Original acquisition
and/or production cost of the goods that a
company sells to customers during the
reporting period
– Also known as cost of sales or cost of
revenue
 Income Statement Analysis
• The matching principle of accounting dictates
that revenues be matched with expenses.
• Accrual Accounting: Income is reported when it
is earned, even though no cash flow may have
occurred.
• Depreciation of fixed assets and amortization
of intangible assets are non-cash items.
• Net income or profit after tax is not the cash
that the firm makes in a given year.
Accrual Accounting and Cash Flows
Accrual accounting records cash transactions, such as the
following:
• Collecting cash from customers
• Receiving cash from interest earned
• Paying salaries, rent, and other expenses
• Borrowing money
• Paying off loans
• Issuing stock
Accrual Accounting and Cash Flow
Accrual accounting also records noncash transactions,
such as the following:
• Sales on account
• Purchases of inventory on account
• Accrual of expenses incurred but not yet paid
• Depreciation expense
• Usage of prepaid rent, insurance, and supplies
• Earning of revenue when cash was collected in advance
 THE REVENUE AND EXPENSE
RECOGNITION PRINCIPLES
The Revenue Principle
Deals with two issues:
1. When to record (recognize) revenue

2. What amount of revenue to record

Revenue is recognized when the business transfers promised

goods or services to a customer in an amount that reflects the cash
(or fair market value of other consideration) that the entity expects
to receive in exchange for those goods or services.
 THE REVENUE AND EXPENSE
RECOGNITION PRINCIPLES
The Expense Recognition Principle
Includes two steps:

1. Identify all the expenses incurred during the accounting

period.

2. Measure the expenses and recognize them in the same

period in which any related revenues are earned.
(1) A customer pays Starbucks $250 on March 15 for coffee to be served at a
party in April. Has Starbucks earned revenue on March 15? When will
Starbucks earn the revenue?
(2) Starbucks pays $6,000 on July 1 for store rent for the next three months.
Has Starbucks incurred an expense on July 1?

Answers:
(1) No. Starbucks has received the cash but will not deliver the coffee until later.
Starbucks earns the revenue when it delivers the product to the customer and the
customer assumes control over it.

(2) No. Starbucks has paid cash for rent in advance. No expense has yet been
incurred because the company has not yet occupied the space. This prepaid rent is
an asset because Starbucks has acquired the use of a store location in the future.
Depreciation

• Process that allocates a plant asset’s cost to expense over

its life.
• Allocates cost against the revenue the asset helps earn
each period.
• Depreciation expense (not accumulated depreciation) is
reported on the income statement.
• E.g., applying a simple straight-life depreciation scheme to
an asset with a purchase price of Rs. 100, expected life of 5
years, and no salvage value would lead to annual
depreciation expense of Rs. 20.
 Profit does not equal cash flow

• Some sales are made on credit, customers

pay later.
• Some purchases are made on credit, pay
suppliers later.
• Also, depreciation is a non-cash expense
that reduces profits.
 The Statement of Cash Flows
(see https://www.moneycontrol.com/financials/grasim/cash-flow/GI01 for
cash flow statement of Grasim Industries)

The Statement of Cash Flows reports three types of

activities
• Operating: Cash flows from selling goods and providing
services to customers
• Investing: Cash flows from the purchase and sale of
long-term assets
• Financing:
– Borrowing and repayment of borrowed funds
– Equity transactions, such as issuing stock, paying
dividends, and repurchase of company stock
Purposes of Cash Flow Statement
• Helps us understand the relationship of net
income to changes in cash balances
• Reports past cash flows, which helps to
– Predict future cash flows
– Evaluate how management generates and
uses cash
– Determine firm’s ability to pay interest,
dividends, and debts when due
• Identifies changes in assets of a firm
How Operating, Investing, and Financing
Activities Affect the Balance Sheet
Two Formats for Operating Activities
Reconciles from net income to net
Indirect cash provided by operating activities

Reports all cash receipts and cash

Direct payments from operating activities
DIRECT METHOD

Operating Activities
Positive Items Negative Items

 Collections from customers  Payments to suppliers

 Receipts of interest on  Payments to employees
investments  Payments of interest and
 Other operating receipts income taxes
 Other operating
payments

Investing and financing cash flows are

the same as in the indirect method
Direct Method Template: Operating

Cash Flows From Operating Activities

+ Collections from customers
+ Interest received
- Payments to suppliers
- Payments to employees
- Payments for income tax
- Payments for interest
= Net cash provided by (used for) operating activities
Indirect Cash Flows Template: Operating

Cash Flows From Operating Activities

Net income
Adjustments to reconcile net income to net cash provided by operating
activities:
+ Depreciation/depletion/amortization expense
+ Loss on sale of long-term assets
- Gain on sale of long-term assets
- Increases in current assets other than cash
+ Decreases in current assets other than cash
+ Increases in current liabilities
- Decreases in current liabilities
= Net cash provided by (used for) operating activities
 Cash Flow from Operations:
INDIRECT format
Operations
To calculate cash Net Income Rs.86
flow from Depreciation 90
Deferred Taxes 13
operations, start
Changes in Curr. Assets and Liabilities
with net income, Accounts Receivable -24
add back non-cash Inventories 11
Accounts Payable 16
items like Accrued Expenses 18
depreciation and Other -8
adjust for changes Total Cash Flow from Operations Rs.202
in current assets
and liabilities (other
than cash).
 Cash Flow from Investing

Cash flow from Acquisition of fixed assets -Rs.198

investing activities Sales of fixed assets 25
involves changes in Cash Flow from Investing Activities -Rs.173

capital assets:
acquisition of fixed
assets and sales of
fixed assets (i.e.,
net capital
expenditures).
 Cash Flow from Financing

Cash flows to and Retirement of debt (includes notes) -Rs.73

from creditors and Proceeds from long-term debt sales 86
Change in notes payable -3
owners include Dividends -43
changes in equity Repurchase of stock -6
and debt. Proceeds from new stock issue 43

Total Cash Flow from Financing Rs.4

 Statement of Cash Flows
Operations
Net Income Rs.86
The statement of Depreciation 90
Deferred Taxes 13
cash flows is the Changes in Assets and Liabilities
Accounts Receivable -24
addition of cash Inventories
Accounts Payable
11
16
flows from Accrued Expenses
Other
18
-8
Total Cash Flow from Operations Rs.202
operations, Investing Activities
Acquisition of fixed assets -Rs.198
investing, and Sales of fixed assets
Total Cash Flow from Investing Activities
25
-Rs.173
financing Financing Activities
Retirement of debt (includes notes) -Rs.73
Proceeds from long-term debt sales 86
Notes Payable -3
Dividends -43
Repurchase of stock -6
Proceeds from new stock issue 43
Total Cash Flow from Financing Rs.4
Change in Cash (on the balance sheet) Rs33
 The Statement of Cash Flows
and the Balance Sheet Equation
• The balance sheet equation can be
rearranged as
Assets = Liabilities + Stockholders' equity
Cash + Noncash assets = Liabilities + Stockholders' equity
Cash = Liabilities + Stockholders' equity – Noncash assets

• Any change in cash is accompanied by

change(s) in items on right
∆ Cash = ∆ Liabilities + ∆ Stockholders' equity – ∆ Noncash assets

Change in cash = Change in all noncash accounts

 Quick Quiz
• An increase in accounts payable is a ___________
(source/use) of cash.
• An increase in inventory is a ____________ (source/use)
of cash.
• An increase in the accounts receivable is a (source/use)
___________ of cash.
• A decrease in debt outstanding is a (source/use)
___________ of cash.
• An increase in depreciation will cause (an increase/a
decrease) _____________ in taxes for a profitable firm.
• Net income will be __________ (less / more) relative to
the operating cash flow, for a firm with no change in NWC
and positive depreciation.
 Transactions and the Accounting Process
• A transaction is any event that can be measured
reliably and that has a financial impact on the business
• Double-entry system: Each transaction affects at least
two accounts
• The accounting process starts from a journal followed
by ledger, trial balance, and final accounts (such a
sequence is less relevant in an age of advanced
accounting software in which everything is updated
simultaneously)
• The Journal (or book of first entry) is a book where all
the transactions are recorded in chronological order
when they take place, and is then classified and
transferred into the relevant Ledger of T-accounts
(such as Sales Ledger or Expenses Ledger)
 Transactions and the Accounting Process

• Once all transactions with outside entities are

recorded for the period, adjusting entries are
made to particular accounts such as those
related to deferrals, depreciation, and accruals.
• Closing entries are made to close or reset all
sales and expense accounts to zero by making
appropriate transfers to the retained earnings
account.
• Finally, the balance sheet and income statement
are prepared.
Example: Transaction Analysis for Freddy’s
Auto Service, Inc.
To illustrate the accounting for transactions, let’s assume that
Freddy Kish opened Freddy’s Auto Service, Inc., in April 2014.
 Transaction 1. On April 1, Freddy Kish and a few friends invest $50,000
to open Freddy’s Auto Service, Inc., in return for common stock.

1. +50,000 +50,000
 Transaction 2. Freddy’s purchases land for a new location and pays cash
of $40,000.

1. +50,000 +50,000
2. -40,000 +40,000
 Transaction 3. The business buys supplies on account, agreeing to pay
$3,700 within 30 days.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
 Transaction 4. Freddy’s received $7,000 cash by providing services for
customers.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
4. +7,000 Service revenue +7,000
 Transaction 5. Freddy’s repairs a fleet of UPS delivery trucks, and UPS
promises to pay Freddy’s $3,000 within one month.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
4. +7,000 +7,000
5. +3,000 Service revenue +3,000
 Transaction 6. Freddy’s Auto Service, Inc., pays $2,700 for the following
expenses: rent, $1,100; employee salaries, $1,200; and utilities, $400.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
4. +7,000 +7,000
5. +3,000 +3,000
6. -2,700 Rent expense - 1,100
Salary expense - 1,200
Utilities expense - 400
 Transaction 7. Freddy’s pays $1,900 on account, which means to make a
payment toward an account payable.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
4. +7,000 +7,000
5. +3,000 +3,000
6. -2,700 - 2,700
7. -1,900 -1,900
 Transaction 8. Freddy Kish, the major stockholder of Freddy’s Auto
Service, paid $30,000 from his personal bank account to remodel his home.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
4. +7,000 +7,000
5. +3,000 +3,000
6. -2,700 -2,700
7. -1,900 -1,900

No Entry
 Transaction 9. In transaction 5, Freddy’s performed services for UPS on
account. The business now collects $1,000 from UPS.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
4. +7,000 +7,000
5. +3,000 +3,000
6. -2,700 -2,700
7. -1,900 -1,900
9. +1,000 -1,000
 Transaction 10. Freddy’s receives $22,000 from the sale of land, which is
the same amount that Freddy’s paid for the land.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
4. +7,000 +7,000
5. +3,000 +3,000
6. -2,700 -2,700
7. -1,900 -1,900
9. +1,000 -1,000
10. +22,000 -22,000
 Transaction 11. Freddy’s Auto Service, Inc., declares a dividend and pays
the stockholders $2,100 cash.

1. +50,000 +50,000
2. -40,000 +40,000
3. +3,700 +3,700
4. +7,000 +7,000
5. +3,000 +3,000
6. -2,700 -2,700
7. -1,900 -1,900
9. +1,000 -1,000
10. +22,000 -22,000
11. -2,100 Dividends -2,100
 Financial Statements
Financial Statements of Freddy’s Auto Service, Inc.
 Financial Statements
Financial Statements of Freddy’s Auto Service, Inc.
The T-Account
 Graphical representation of ledger

Account  Record of increases and decreases in

a specific asset, liability, equity,
revenue, or expense element
 Debit = “Left”
 Credit = “Right”
An Account can
be illustrated in a
T-Account form
The Rules of Debit and Credit
Additional Stockholders’ Equity Accounts:
Revenues and Expenses

+
Common Stock
Assets Liabilities
+
Retained Earnings

-
Dividends
Stockholders’
Equity +
Revenues

-
Expenses
 The Rules of Debit and Credit

Exhibit 2-7
Increases and Decreases in the Accounts:
The Rules of Debit and Credit
To illustrate, Freddy’s Auto Service, Inc., received $50,000 and
issued (gave) stock. What is the effect on the accounts?

Cash Common Stock

Debit for Credit for
increase, increase,
50,000 50,000
Freddy’s’ second transaction is a $40,000 cash purchase of
land. What is the effect on the accounts?

Cash Common Stock

Bal 50,000 Credit for Bal 50,000
decrease,
40,000
Bal 10,000

Land
Debit for
increase,
40,000
Bal 40,000
Additional Stockholders’ Equity Accounts:
Revenues and Expenses
Two categories of income statement accounts

Increase in stockholders’ equity from

Revenues
delivering goods or services to customers

Decrease in stockholders’ equity due to

Expenses the cost of operating the business
 Recap
• Balance Sheet – Snapshot of a firm at a
point of time
• Profit & Loss Statement – Accounting
performance of firm over a period of time
• Cash Flow Statement – Categorizes cash
transactions during a period of time