CHAPTER 1

1. CHAPTER 1 Financial Statements: Personal Accounting

2. Checklist

3. Meaning of Accounting The purpose of accounting: • To accurately measure all the financial activities of an individual or business. • It is important to maintain records of activities that increase or decrease your net worth.

4. Introduction to Net Worth Net Worth is what would remain if you choose to cash out by selling all your assets and paying everything that you owe. It compares: How much you owe (liabilities) vs. How much you own (assets)

5. Introduction to Net Worth Net Worth is what would remain if you choose to cash out by selling all your assets and paying everything that you owe. The most common way to increase your net worth: Revenue increase in net worth caused by providing goods or services (e.g. earning salary). The most common way to decrease your net worth: Expenses decrease in net worth from the costs of day-to-day activities (e.g. paying your utilities and gas bill).

6. Checklist

7. The Balance Sheet Records what we own (assets) vs. what we owe (liabilities) OWE OWN Provides a snapshot of your financial position at a specific date

8. The Balance SheetSample Personal Balance Sheet The following is a sample balance sheet that lists the values of an individual’s assets, liabilities and resulting net worth at a particular date (December 31, 2011).

9. The Balance SheetPersonal Balance Sheet A large cash balance does not necessarily imply a high net worth. Similarly, a low cash balance does not necessary imply a low net worth. Shown below are two personal balance sheets that illustrate this concept. Here, there is a negative cash balance, meaning that the bank account is over-drawn. This is known as bank overdraft.

10. The Balance Sheet - Question • Record expenses • Record what we own versus what we owe • Record what we earn versus what we owe • Record all financial transactions What is the role of the balance sheet?

11. Checklist

12. The Income StatementRevenues and Expenses The income statement allows you to keep a clean record of changes to net worth relating to revenues and expenses. The excess of revenues over expenses is called a surplus. If expenses exceeds revenues, then the difference is called a deficit. As will be shown later, a surplus increases net worth and deficit decreases net worth. Surplus Expenses Revenues

13. The Income Statement E.g. Salary earned (increases net worth) Costs of day-to-day activities (decreases net worth) Surplus (Deficit)

14. The Income StatementAccounting Periods Changes to net worth are tracked for separate periods called accounting periods. Because the income statement covers a summary of activities for a period of time, the date of income statement is presented in the following form: ‘For the Period Ended…’. For example, an income statement prepared on March 30, 2013 covering three months would have the date ‘For the Three Months Ended March 30, 2013’.

15. The Income Statement - Question • Record only cash sales and expenses • Record what we own versus what we owe • Record revenues and expenses • Record all financial transactions What is the role of the income statement?

16. The Income Statement - Question • Permanent accounts • Temporary accounts • Transaction accounts • Reserve accounts What does the income statement consist of?

17. Solution b. Temporary accounts • Why? • Only required during a period to track the changes to net worth (revenue and expenses). • A new period commences with a fresh income statement.

18. Checklist

19. The Accounting Equation Assets = Liabilities + Net Worth Double entry system: Each transaction has at least two entries The logic is similar to Newton’s Third Law (‘For every action, there is an equal and opposite reaction.’) In the absence of a logical opposite entry, the balance sheet will not balance The accounting equation re-arranged: Net Worth = Assets - Liabilities

20. Accounting Equation as a Scale The scale must always be in balance.

21. Accounting Equation as a Scale What initially happens to the scale when depositing $3,000 of salary? The scale goes out of balance.

22. Accounting Equation as a Scale To get the scale back in balance you must increase net worth. An increase to net worth (recording the revenue side of the transaction) brings the scale back into balance.

23. The Accounting EquationNet Worth Calculation Ending Net Worth = Beginning Net Worth + Capital + Surplus (Deficit) Beginning Net Worth: Balance of net worth at the beginning of the period being considered. Capital: Increases to net worth other than revenue (e.g. gifts or lottery winnings). Surplus (Deficit): The amount by which revenues exceed expenses (or expenses exceed revenues) for the period. The amount is taken from the personal income statement. A surplus increases net worth and a deficit decreases net worth.

24. Net Worth Calculation - Question • $18,000 • $11,000 • $24,000 • $17,000 In year 2013, your opening net worth was $14,000 and total assets were $7,000. Your personal income statement showed a deficit of $3,000. What is your net worth as at December 31, 2013?

25. The Accounting EquationIntroduction to T-Accounts An account allows us to track detailed information about the values of individual items (e.g. cash, unpaid accounts, food expense, etc.). A sample, empty T-Account: A T-Account, a chart in the shape of a ‘T’, records transactions and tracks the balances of each account.

26. The Accounting EquationIntroduction to T-Accounts: The Process Recording information in a T-Account: • Enter the opening balances in the appropriate accounts (if applicable). Also, check that the accounting equation is in balance before you begin entering transactions. $80,000

27. The Accounting EquationIntroduction to T-Accounts: The Process • Enter both sides of the transaction under the correct account in the balance sheet and/or income statement. Be sure to record the transaction numbers so that you can check your work. For instance, assume the transaction is as follows: #1: Earned and deposited $3,000 in salary ASSETS (what we own) INCREASE (DR) DECREASE (CR) DECREASE (DR) INCREASE (CR) + CASH - - REVENUE + $5,000 1. $3,000 Opening Balance 1. $3,000 Total: $8,000 Note: each transaction will have at least one entry on the left side of the T-Account and at least one entry on the right side of another T-Account.

28. The Accounting EquationIntroduction to T-Accounts: The Process • Calculate the surplus or deficit in the income statement and transfer the amount to net worth in the balance sheet.

29. The Accounting EquationIntroduction to T-Accounts: The Process • Calculate the surplus or deficit in the income statement and transfer the amount to net worth in the balance sheet. The following worksheet can be found on page 20 of the textbook.

30. T-Account Worksheet This form allows you to record the double entries for each transaction on opposite sides of each account.

31. Checklist

32. Accrual Accounting and Matching Principle The principle of accrual accounting: • Revenue (an increase to net worth) and expenses (a decrease to net worth) should be recognized in the time period in which they occur, regardless of when the cash payment is received or made. There are two key principles to understand: - Cash flow relates to cash flowing into and out of the bank account, which is not necessarily directly connected to net worth. - Accruals relate to net worth, which does not necessarily connect to cash flow. The matching principle states: Expenses should be recorded in the same period as the revenues to which they are related

33. - 100 Expense Accrual Accounting - Scenario #1 January: Use $100 worth of cell phone calls and pay in January. - 100 What happened to your net worth in January? Net worth decreased by $100

34. Your net worth decreased in January when you increased your expense. - $100 Expense Accrual Accounting - Scenario #2 February: Use $100 worth of cell phone calls in January, but receive and pay the bill in February. • In which month did your net worth decrease? • January when you used the phone, or • February when you paid the bill? + $100

35. Accrual Accounting - Question If you record a $500 credit card bill for gas expenses (due in one month), what is the effect on net worth? • Stays the same • Increases by $500 • Decreases by $500 • Not enough information is provided

36. EXPENSES The Matching Principle January Assets less Liabilities Salary = $3,000 Expenses = $1,000 $3,000 $1,000 1. In January you deposit $3,000 salary – how much are you worth? 2. Charge $1,000 of expenses to your credit card to be paid in February. Are you still worth $3,000 in January? 3. Your Net Worth changed to $2,000 because you recognized the expense of $1,000 (decrease to net worth) $2,000 $3,000

37. The Matching Principle January Had you chosen to ignore these expenses in January, you would be under the impression that you were richer in the amount of $3,000, which is not true. You cannot ignore the fact that you incurred expenses in January, even if you didn’t pay for them in January and will pay for them in the future. Salary = $3,000 300 Remember, under accrual accountingyour net worth changes when expenses are incurred, not when cash is paid.

38. Accrual Accounting - Summary Recognize an expense (decrease to net worth) in the period in which you incurred the expense, regardless of whether or not you paid for it in that month. The matching principle states: Expenses should be recorded in the same period as the revenues to which they are related

39. Checklist

40. Borrowing Money and Repaying Debt When you borrow money, you have more cash, but your net worth does not change. When you repay the principal portion of your debt, you have less cash, but your net worth still does not change

41. Borrowing Money and Repaying Debt Example: Borrowing cash from a friend • When borrowing $100 from a friend: - You are richer in cash, but there is no change to net worth - You still owe the cash. • When repaying your friend: - You are cash poorer, but there is still no change to net worth. 1 +$100 -$100 2 +$100 1 -$100 2 NO CHANGE

42. Borrowing Money and Repaying Debt – Question • Net worth increases • Net worth decreases • Net worth stays the same • Net worth will change only when you repay the loan What is the effect on net worth when borrowing money?

43. Solution c. Net worth stays the same • When borrowing cash you are: • cash flow richer • NOT net worth richer NO CHANGE

44. Borrowing Money and Repaying Debt – Question • Reduces net worth • Increases net worth • Has nothing to do with net worth • Could increase or decrease net worth Paying the interest portion of a loan you borrowed:

45. Solution a. Reduces net worth Interest expense will decrease net worth because cash will be used to pay the expense without an asset replacement or debt reduction. An expense means a reduction to net worth. [ DECREASES]

46. Buying and Selling Assets Buying or selling assets (according to the value stated in the balance sheet) also has no impact on net worth. Buying the car Selling the car NO CHANGE NO CHANGE

47. Buying and Selling AssetsCar Example Cost of the car $15,000 Deposit paid from your savings $5,000 Balance borrowed from ABC Finance $10,000 In exchange for a $5,000 cash deposit, the dealer only sends you the front of the car. Take a loan for $10,000 in exchange for the balance of the car.

48. -$5,000 +$5,000 Buying and Selling AssetsCar Example Pay $5,000 cash for the front of the car. ? What is the transaction?

49. +$10,000 +$10,000 Buying and Selling AssetsCar Example Take a loan for $10,000 in exchange for the balance of the car. ? What is the transaction?

50. Buying and Selling AssetsCar Example What happened to your NET WORTH? No change! You just feel better with a new car!