EFR Summaries

Accounting IBEB 2016-2017

Lecture 1, Week 1
30-08-2016

Details:
Subject: Accounting IBEB 2016-2017
Lecture: 17:00 18:30, 30-08-2016
Teacher: Dr. Dal Maso
Date of publishment: 8/9/2016

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Faculty association Rotterdam (EFR). All rights reserved.
The content of this summary is not in any way a
substitute for the lectures or any other study material.
We cannot be held liable for any missing or wrong
information. The Erasmus School of Economics is not
involved nor affiliated with the publication of this
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Accounting IBEB - Lecture 1 Week 1

Topics Covered:
-

What is accounting, and what are the general principles

The Basic Accounting Equation
Financial Statements
Ratio Analysis

Summary:
What is accounting & what are the general principles?
Accounting is employed to identify, record and communicate the economic events within a
given organization, which includes bookkeeping. The users of the data often include internal
departments such as marketing, HR and finance, but also external users such as investors and
creditors. The reason that firms require accounting is because it is a universal way of
presenting the companies finances via statements.
In order to make comparison between companies easier, especially internationally, there are
Generally Accepted Accounting Principles (GAAP) set forth by the SEC1, FASB2 and IASB3.
There are two measurement principles by which a firm may keep book:
- (Historical) Cost Principle stipulates that the company must record its assets at the
purchase cost.
- Fair Value Principle states that companies should report their assets at the price they
would receive should they sell it at that moment.
All companies must choose one or the other principle to follow when accounting.
There are also two base assumptions guiding accounting:
- Monetary Entity Assumption states that companies should only record transactions
that can be displayed in terms of money.
- The Economic Entity Assumption says that all activities of one entity (company) should
be distinct from the activities of the owner and other economic entities.
Furthermore, three types of business ownership are important to accounting:
- Proprietorship: one person owns the company, and is personally liable for all debts.
- Partnership: very similar to proprietorship, but now the company is owned by two or
more persons, who are generally all liable for all debts.
Corporation: A separate legale entity owned by its shareholders with limited liability.
-

The Basic and Expanded Accounting Equation

The basic accounting equation is the framework upon which accounting and bookkeeping are
built. The equation is as follows:

1.
2.

Securities and Exchange Commission

Financial Accounting Standards Board

3. International Accounting Standards Board

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Assets represent the resources that a firm owns, and that are primarily owned for their
potential in providing future benefits to the firm. For example, a firm might own an office, this
would be considered an asset. Common categories include: Cash, Supplies and Equipment.
Liabilities are obligations and debts to outside entities. These are sums that the company has
borrowed on some form of credit to be repaid at a later date. For instance, a loan would be a
liability. If the company goes bankrupt or is forced to shut down, liabilities always get paid to
creditors before ownership claims.
Owners Equity This category is the owners claim to the assets of the firm. Owners equity can
increase with company revenue and the owner investing more capital into the firm, and it will
decrease with expenses (costs that the firm has to make) and the owners drawing (for
example the owner taking cash out of the company).
In Transaction Analysis the expanded accounting equation is used. This means that generally a
table as such is used:
Assets
Cash

Accounts
Receivable

= Liabilities
Supplies
and
Equipment

Accounts
payable

+ Owners Equity
Owners
Capital

Owners
Drawings

Revenues

Expenses

The idea of transaction analysis is to record the effects of transactions on the accounting
equation. A transaction is deemed recordable if it changes a companys financial position.
Furthermore the accounting equation must always hold.
As an example, the following may occur in a taxi company:
1. The owner invests 50.000 in cash.
2. The company buys 2 used taxis for 15.000 each.
3. The company has its first revenue of 1.000.
4. The company sells a taxi to another company, who will pay 17.000 in the next year.
5. The company expands and buys an office for 20.000, by taking a loan from a bank.
And would be recorded as such:
Assets
Step
1
2
3
4
5
Total

Cash

Accounts
Receivable

+50.000
-30.000
+1.000

= Liabilities
Supplies and
Equipment

Accounts
payable

+ Owners Equity
Owners
Capital
+50.000

Revenues

Expenses

+30.000
+1.000
+17.000

+17.000
36.000

Owners
Drawings

17.000

+20.000
35.000

+20.000
20.000

50.000

18.000

As we can see here, the accounting equation always holds and we have a clear organization
for the financial changes within the company across this period of time.

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The Four Financial Statements

Within a given period, a company submits four financial statements in order to present its
accounts. These statements are prepared for different periods depending on location (the US
for example generally presents these figures every quarter).
- The Income Statement is a breakdown of the revenues and expenses within the
company, during the period. The statement is concluded by the net gain or loss the
company has made during the period. The order of objects on the statement is
income first, followed by expenses. The statement does NOT however include any
withdrawals made by the owners or investment decisions by the ownership.
- The Balance Sheet presents the accounting equation; this includes the assets, liabilities
and owners equity that the company currently has on its books. They are commonly
ordered as if reading the accounting equation from left to right: assets followed by
liabilities and owners equity.
- The Owners Equity Statement reports the owners equity as seen in the expanded
accounting equation, as such reporting net income/loss (from income statement),
investments and withdrawals by the owner. The period is the same as that of the
income statement. It can be considered an explanation for changes in owners equity.
- The Statement of Cash Flows aims to answer several questions such as where any cash
originated, what it was spent on and what the resulting change was. This is reported
by listing a companys operating (e.g. selling products), investing (e.g. the purchase of
equipment) and financing activities (e.g. drawings by owner) during the period. This
results in the final balance.

Ratio Analysis
Now that we have seen how a company presents its period accounting data, the question is
how the user can analyse the statements to gain perspective.
There are several types of comparative analysis that can give insight into the companys
financials. One can compare between similar companies in order to judge any competitive
advantages, one could also compare to the industry averages as benchmark for performance
or one could look within the company itself.
In order to complete the comparative analysis there are several utensils that can be applied
to the financial statements. Vertical Analysis compares data as percentage of benchmark base
value, Horizontal Analysis compares data across time and Ratio Analysis compares select
values.
As in the lecture, the focus here will lie with Ratio Analysis, which in itself allows the user to
gain insight into three categories: liquidity (short term flexibility of a company financially),
profitability (companys operational success), and solvency (The companies ability to sustain in
the long term).

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LIQUIDITY RATIOS
1. The Current Ratio =

Looking at Apples third quarter of 2016 this would surmount to: 290479/171124,
which brings a ratio of 1:1.69. Meaning for every one dollar liability Apple has 1.69
dollars in assets.
The benefit of the current ratio is to look at a companys short term ability to finance
its debt.

2. The Acid-Test Ratio =

+ +

This ratio gives an indication about the liquidity short term of a company, as cash,
accounts receivable and investment are some of the most acutely liquid assets in a
company.

3. The Accounts Receivable Turnover =

This ratio displays how effective a company is in giving out credit while getting back
debts on credit. It measures how effectively a firm uses its assets.

4. The Inventory Turnover = =

+
)

The essence of this ratio is to measure how efficiently a company is selling its goods. A
high ratio would indicate strong sales or large discounts, while a lower suggests weak
sales. The higher the ratio the more immediately liquid is the company as less cash is
used on the inventory.

PROFITABILITY RATIOS
5. The Profit Margin =

This generally depends largely on the industry and the goods sold. Low turnover goods
generally sell for a higher price providing higher margins, while cheap products have
lower margins. Effectively this measures how much of every dollar in sales a company
keeps.

6. Asset Turnover = =

+
)

A higher ratio implies that the companys performance is good, as it shows a company
is generating more revenue per unit of assets.

7. Return on Assets =

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This value gives an overview on the general profitability of the business itself. How
much are they retaining or gaining per asset they own. Generally speaking, the higher
the ratio the better.
8. Return on Common Stockholders Equity =

The preferred divided must be subtracted to calculate the profit available to the
common stockholders. This too gives an overall view of profitability, albeit from the
perspective of the common stockholder. As with Return on Assets, the higher the ratio
the better.

9. Earnings Per Share (EPS) =

This gives a perspective on profitability for the stakeholder. However, industry

comparisons are not recommended as the amount of outstanding shares for each
company varies wildly, meaning that any information gained is only marginally useful.
10. Price to Earnings Ratio =

This ratio essentially gives a perspective on the markets view on the companys future
earnings. It expresses how much an investor must pay to receive a dollar out of the
companys income.
11. The Payout Ratio =

This is the amount of money that the company gives back to its shareholders in
comparison to its earnings. Companies focused on growth will usually reinvest their
earnings and so their ratio would be lower. This might indicate how growth focused a
company is.

SOLVENCY RATIOS
12. Debt to Assets Ratio =

This ratio measures how much of the assets are provided by the creditors. This
indicates a companys degree of leverage4. It is preferred that the companies have a
lower ratio as that makes it easier to pay off the creditors in the future.
4. Leverage: The use of credit or other instruments to increase the potential return of an investment

13. Times Interest Earned =

+ +

This is a measurement of how capable the company is to make its interest payments
over the liabilities as they come due.

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Works Cited
Apple Inc. (2016, July 26). Apple - Press Info - Apple Reports Third Quarter Results. Retrieved
September 04, 2016, from http://www.apple.com/pr/library/2016/07/26Apple-ReportsThird-Quarter-Results.html
Dal Maso, (2016). Lecture 1 Accounting in Action 1 [Powerpoint slides]. Retrieved from:
https://bbapp01.ict.eur.nl/webapps/blackboard/execute/displayIndividualContent?mode=view&conten
t_id=_125213_1&course_id=_29806_1
Wygandt, Kimmel & Keiso (2016). Chapter 1: Accounting In Action [Book] Retrieved from:
Accounting Principles 12th Edition
Wygandt, Kimmel & Keiso (2016). Chapter 18: Financial Statement Analysis [Book] Retrieved
from: Accounting Principles 12th Edition

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Accounting IBEB - Lecture 2 Week 1

Topics Covered:
-

Defining an Account, Debits, and Credits

How to use a Journal
Using a Ledger and Posting
Trial Balances

Summary:
Defining an Account, Debits and Credits
The account is a way of recording increases or decreases in specific part of the accounting
equation. For example there could be an account for a specific asset, or cash, or owners
capital. They are commonly illustrated in a T form with credit on the right and debit on the
left.
Account Title
Debit and credit do not refer to increases and Debit
Credit
decreases as is commonly assumed. They simply
represent where entries are made. Debiting
simply means that there is an entry on the left
side of the account. As such each account has
its own normal balance side.
In the debiting and crediting procedure the total debits of all accounts must always be equal
to the total credits of all accounts. This is an extended form of the accounting equation that
the accounts follow. Furthermore for each transaction the two-sided effect must be recorded
in the appropriate accounts.
At the bottom of an account the normal balance can be found. The idea of the normal
balance is that it is on the increase side of that account. This means that an increase in the
account will always be entered in the normal side of the account (as a credit or debit
depending on the account).
Assets & Liabilities: The normal balance is a debit for assets, and a credit for liabilities
=> a debit increases assets, and decreases liabilities. Meanwhile a credit increases
liabilities and decreases assets.
Owners Equity: This can be broken down into the expanded equation of owners
capital - owners drawings + revenues expenses. Capital and revenue increase an
owners equity and have a normal balance of a credit. Drawings and expenses
decrease owners equity and have a normal balance of debit.

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In an algebraic summary:
= +
= + +
+ + = + +
Normal Balance (+) of a Debit
Normal Balance (+) of a Credit
(Note: in practice do not write the accounting equation this way, this is merely an illustration)

The Use of a Journal in Double Entry Bookkeeping

The journal is the book where all transactions are initially recorded. The general journal
records the date, the relevant account titles, explanation of the transaction, and where and
how much was credited and debited to an account. This provides a chronological and
complete record of the transaction and is useful in avoiding errors.
A general journal often looks as such, and if for example an owner would invest 50.000 then
an entry would look as follows:
General Journal
Date Transaction Explanation and Account titles
Account Reference Debit
Credit
01Cash
01
50.000
09Owners Capital
07
50.000
2016
(Investment of 50.000 by the owner)

This can be the case for a transaction involving only two accounts. Should more accounts be
involved in the transaction, the list of accounts simply becomes longer and the debit and
credit columns would have more entries.

The Use of a Ledger

The ledger is the set of all accounts that are maintained by a firm. The general ledger for
instance would incorporate all the subaccounts for assets, liabilities and owners equity
accounts. The ledger is arranged in an order in which the company displays its accounts, this
generally follows the order of the accounting equation: assets, followed by liabilities, owners
capital. The ledger essentially shows the balance in each account.
The amount of accounts depends on each companys desire for detail. However, most
companies do have a chart of accounts which lists each of the accounts and their reference
number and location in the ledger for overview purposes.

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The standard form of an account would look similar to the following table:
ACCOUNT 101: Cash
Date Explanation

Account
Reference

Debit

Credit

Balance

The Practice of Posting11

Posting refers to the method of transferring entries of the general journal to their specific
accounts in order to keep the ledger up to date. This occurs in the following steps:
1. In each account of the ledger the columns of debit and credit are updated together
with the date, journal location and the amounts debited in the journal. Update the
balance of the ledger accounts every time.
2. Proceed to updating the journals reference column to show the relevant accounts.
3. Repeat this process with the credits.
This is also where transaction analysis is useful, as its purpose was to determine for each
transaction whether to make a debit or credit and which account this affects.
It might be a good idea to follow this scheme:
1. Start with a basic analysis of the transaction (and whether it counts as a transaction).
2. Analyse the given transaction in terms of the basic accounting equation.
3. Consider whether to put each transaction as a debit or credit in the relevant accounts.
4. Update the journal.
5. Posting into the ledger.

The Trial Balance

In principle a trial balance is the list of accounts and their balances at a given point in time,
often at the end of an accounting period. It is designed to check and show the mathematical
correctness of the accounts (whether the basic accounting equation holds).
In order to create a trial balance:
1. Create two columns, one for debit and one for credit (in that order).
2. List the account titles and their balances in the relevant columns, generally in order of
appearance in the ledger.
3. Calculate the total of each column to prove equality.
However useful this trial balance is for checking the accounting equation, it has its drawbacks.
For instance it cannot check whether all transactions were recorded, whether the entries are
posted twice, or incorrect columns are used when journalizing, or whether there are

1 For a detailed example, please consult the accounting textbook Accounting Principles 12th Edition by Wygandt,

Kimmel and Kieso

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offsetting errors in entering the values. In short, it doesnt definitively prove the correctness
of the ledger.
Note on formatting: Dollar signs are generally omitted in the journals and ledgers, they are
typed only in the trial balance and financial statements (often only once in the header or
beginning).
A single totalling line is placed under the column of figures to be summed, and the total is
written beneath the line. Total amounts are double underlined to show they are final.
A sample trial balance might look as follows (the values entered are arbitrary).

Works Used
Dal Maso, (2016). Lecture 2 The Recording Process [Powerpoint slides]. Retrieved from:
https://bbapp01.ict.eur.nl/webapps/blackboard/content/listContent.jsp?course_id=_29806_1&co
ntent_id=_125212_1
Wygandt, Kimmel & Keiso (2016). Chapter 2: The Recording Process [Book] Retrieved from:
Accounting Principles 12th Edition

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