Conceptual Framework and Financial Statements
Accounting is an information system. It records and measures business activities, processes data into information, and
communicates them to decision makers who make decisions that will impact on business activities.
Financial statements are the business documents that companies use to report the results of their activities to various
user groups, which can include managers, investors, creditors, and regulatory agencies.
The core of financial accounting revolves around the following financial statements:
1. INCOME STATEMENT
Presents the revenues, expenses, and profits/losses generated during the reporting period.
This is usually considered the most important of the financial statements, since it presents the operating results
of an entity.
2. BALANCE SHEET
Presents the assets, liabilities, and equity of the entity as of the reporting date.
Thus, the information presented is as of a specific point in time.
The report format is structured so that the total of all assets equals the total of all liabilities and equity (known as
the accounting equation).
This is typically considered the second most important financial statement, since it provides information about
the liquidity and capitalization of an organization.
3. STATEMENT OF CASH FLOWS
Presents the cash inflows and outflows that occurred during the reporting period.
This can provide a useful comparison to the income statement, especially when the amount of profit or loss
reported does not reflect the cash flows experienced by the business.
This statement may be presented when issuing financial statements to outside parties.
4. STATEMENT OF RETAINED EARNINGS (CHANGES IN EQUITY)
Presents changes in equity during the reporting period.
The report format varies, but can include the sale or repurchase of stock, dividend payments, and c hanges caused
by reported profits or losses.
This is the least used of the financial statements and is commonly only included in the audited finan cial statement
When the financial statements are issued internally, the management team usually only sees the income
statement and balance sheet, since these documents are relatively easy to prepare.
Both external and internal users of accounting information exist:
- External: FINANCIAL ACCOUNTING provides information for decision makers outside the reporting entity, such as
investors, creditors, government agencies, and the public.
- Internal: MANAGEMENT ACCOUNTING provides information for the managers.
Examples of management accounting information include budgets, forecasts, and projections that are used in
making strategic decisions of the entity.
Types of businesses:
1. PROPRIETORSHIP: a proprietorship typically has a single owner, called the proprietor.
Legally, the business is the proprietor, and the proprietor is personally liable for all the business’s debts.
But for accounting purposes, a proprietorship is a distinct entity, separate from its proprietor.
Thus, the business records should not include the proprietor’s personal finances.
2. PARTNERSHIP: a partnership has two or more parties as co-owners, and each owner is a partner.
A partnership is a form of business organization in which owners have unlimited personal liability for the
actions of the business.
A partnership is not a taxpaying entity. Instead, each partner takes a proportionate share of the entity’s taxable
income and pays tax according to that partner’s individual or corporate rate.
► General partnerships have mutual agency and unlimited liability, meaning that each partner may conduct business
in the name of the entity, and can make agreements that legally bind all partners without limit for the partnership’s
Partnerships are therefore quite risky, because an irresponsible partner can create large debts for the other general
partners without their knowledge or authorization.
This feature of general partnerships has spawned the creation of limited-liability partnerships (LLPs).
► A limited-liability partnership is one in which a wayward partner cannot create a large liability for the other
In LLPs, each partner is liable for partnership debts only up to the extent of his or her investment in the partnership,
plus his or her proportionate share of the liabilities.
Each LLP, however, must have one general partner with unlimited liability for all partnership debts.
3. CORPORATION: a corporation is a legal entity whose investors purchase shares of stock as evidence of their
ownership interest in it.
This entity acts as a legal shield for its owners, so that they are generally not liable for the corporation's
A corporation has most of the rights and obligations of an individual, such as being able to enter into
contracts, hire employees, own assets, incur obligations, and pay taxes.
It is organized under state law.
The interests of shareholders are represented by a board of directors, which they elect.
The shareholders have no personal obligation for the corporation’s debts and have limited liability.
Qualitative characteristics: describe the attributes that will most likely make the information provided in financial
statements useful to users.
The degree of relevance may be influenced by the materiality of the information.
• Comparability: users usually compare financial statements of an entity over a period of time in order to identify
trends in its financial position and performance. Thus, it is important that the basis of preparation and
presentation remains comparable over time.
• Verifiability: verifiability helps assure users that information faithfully represents the economic phenomenon it
purports to represent.
• Timeliness: timeliness means that the information must be made available to users early enough to help them
make decisions, thus making the information more relevant to their needs.
• Understandability: understandability means that accounting information must be classified, characterized, and
presented clearly and concisely.
Accrual Basis: transactions and other events are recognized when they occur and not when cash is received or paid.
Going Concern: a company that has the resources needed to continue operating indefinitely until it provides evidence
to the contrary.
This term also refers to a company's ability to make enough money to stay afloat or avoid bankruptcy.
If a business is not a going concern, it means it's gone bankrupt and its assets were liquidated.
The two main types of assets are current assets and non-current assets.
These classifications are used to aggregate assets into different blocks on the balance sheet so that one can
discern the relative liquidity of the assets of an organization.
Current assets are expected to be consumed within one year, and commonly include the following line it ems:
• Marketable Securities
• Prepaid expenses
(An example of a prepaid expense is insurance, which is frequently paid in advance for multiple future
periods; an entity initially records this expenditure as a prepaid expense, and then charges it to expe nse
over the usage period.)
• Accounts receivable
• Inventory (Raw Materials, Work-In-Progress, Finished Goods)
Non-current assets are also known as long-term assets and are expected to continue to be productive for a
business for more than one year. The line items usually included in this classification are:
• Tangible assets or PPE
• Intangible assets
A liability is a legally binding obligation payable to another entity. Liabilities are incurred in order to fund the
ongoing activities of a business.
• Accounts Payable (Accounts payable are considered a source of cash, since they represent funds being
borrowed from suppliers. When accounts payable are paid, this is a use of cash)
• Accrued Expenses
• Wages Payable
• Taxes Payable
These obligations are eventually settled through the transfer of cash or other assets to the other party.
Liabilities expected to be settled within one year are classified as current liabilities on the balance sheet. All other
liabilities are classified as long-term liabilities.
Equity is the net amount of funds invested in a business by its owne rs, plus any retained earnings (retained
earnings are the profits that a company has earned to date, less any dividends or other distributions paid to
It is also calculated as the difference between the total of all recorded assets and liabilities on an entity's balance
The equity concept also refers to the different types of securities available that can provide an ownership interest
in a corporation. In this context, equity refers to common stock and preferred stock.
For an individual, equity refers to the ownership interest in an asset.
For example, a person owns a home with a market value of $500,000 and owes $200,000 on the related
mortgage, leaving $300,000 of equity in the home.
Share capital is the amount shareholders have invested in the entity (usually in the form of shares) and retained
earnings is the amount earned by income-producing activities and kept for use in the business.
Income refers to increases in economic benefits during an accounting period (i.e. increases in assets or decreases in
liabilities) that result in an increase in equity.
Recording Business Transactions
A Transaction: is any event that has a financial impact on the business and can be measured reliably.
An account: is the record of all the changes in a particular asset, liability, or equity during a period.
• Accounts receivable
• Notes receivable (A note receivable is similar to an account receivable, but it is usually more binding because
the customer signed the promissory note to pay on a certain day (or after a certain period). Notes receivable
usually specify an interest rate)
• Prepaid Expenses
• Accounts payable
• Notes Payable (A note payable is the opposite of a note receivable. The Notes Payable account includes the
amounts a company must pay because that company signed notes promising to pay a future amount. Notes
payable, like notes receivable, usually carry interest.)
• Accrued liabilities (An accrued liability is a liability for an expense you have not yet paid.)
Share capital (Share capital consists of all funds raised by a company in exchange for shares of either common
or preferred shares of stock.
→ issue and sell additional shares, thereby increasing its share capital.)
• Retained earnings (Retained earnings are the profits that a company has earned to date, less any
dividends or other distributions paid to investors)
• Income (Income is the revenue a business earns from selling its goods and services or the money an individual
receives in compensation for his or her labor, services, or investments.)
• Expenses (Common expenses are: Cost of Goods Sold, Rent Expense, Wages Expense, Utilities Expense)
Rules of Debit and Credit
Dividends and Expense accounts are “contra” accounts, i.e. the bigger they are, the smaller the total equity will be.
Thus, increases in dividends and expenses are recorded as debits because they will ultimately reduce equity.
• A credit increases income, which will ultimately increase equity
• A debit decreases income, which will ultimately reduce equity
• A debit increases dividend and expense, which will ultimately reduce equity.
• A credit decreases dividend and expense, which will ultimately increase equity.
T-Account: A T account is a graphic representation of a general ledger account. The name of the account is placed
above the "T" (sometimes along with the account number). Debit entries are depicted to the left of the "T" and
credits are shown to the right of the "T".
The left side of each account is called the debit side, and the right side is called the credit side. Often, students are
confused by the words debit and credit. To become comfortable using these terms, remember that for every account,
Debit is on the left, Credit is on the right.
A Ledger is a grouping of all the T-accounts, with their balances. For example, the balance of the Cash T-account shows
how much cash the business has.
A ledger is sometimes referred to as the general ledger, which is the aggregate set of records covering all
accounts for which a business stores transactional information.
A trial balance lists all accounts with their balances—assets first, then liabilities and shareholders’ equity. The trial
balance summarizes all the account balances for the financial statements and shows whether total debits equal total
credits. A trial balance may be constructed at any time, but the most common time is at the end of the period.
Accrual accounting records the impact of business transactions and events on an entity’s assets and liabilities in the
period in which those transactions and events occur, even if the resulting cash receipts or payments occur in a prior or
For example, when a business performs a service, makes a sale, or incurs an expense, the accountant records the
transaction even if it receives or pays no cash in the same period.
Cash Basis Accounting: records only cash transactions—cash receipts and cash payments.
Cash receipts are treated as revenues, and cash payments are handled as expenses.
Profits occur when cash receipts are greater than cash payments, and similarly, loses occur when cash receipts is less
than cash payments.
Accrual accounting is a more faithful representation of economic reality than cash basis accounting.
Revenue Recognition Principle:
1. the entity has transferred to the buyer the significant risks and rewards of ownership of the goods
2. the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor
effective control over the goods sold
3. the amount of revenue can be measured reliably
4. it is probable that the economic benefits associated with the transaction will flow to the entity
5. the costs incurred or to be incurred in respect of the transaction can be measured reliably
Matching is a concept used to explain the relationship between expenses and revenues.
The Conceptual Framework states that expenses are recognized in the income statement on the basis of a direct
association between the costs incurred and the earning of specific items of income.
This process is commonly referred to as the “matching of costs with revenues.”
Unlike assets, expenses offer no future benefits to the company.
Matching includes two steps:
1. Identify decreases in assets or increases in liabilities that result in reduction in equity (excluding transactions with
owners) during the period. These are expenses.
2. Measure these expenses and subtract expenses from revenues to compute profit or loss.
A deferral is an adjustment for an item for which the business paid or received cash in advance. You might think of a
deferral as a prepayment of an expense or revenues. Because it is prepaid, it is not recognized immediately on the
income statement. Instead, it is deferred to a balance sheet account and will appear later on the income statement.
An Accrual allows an entity to record expenses and revenues for which it expects to expend cash or receive cash,
respectively, in a future reporting period. Using accruals allows a business to more closely adhere to the matching
principle, where revenues and related expenses are recognized together in the same period.
A contra account has two distinguishing characteristics:
1. It always has a companion account.