Week 1 (Lecture) chapter 1

Chapter 1: Financial Statements: Personal Accounting

Purpose of Accounting

• Definition: A system to identify, measure, and communicate all financial activities of an individual or business.

• Importance: Essential for maintaining records of activities affecting net worth, including earnings, investments, and expenditures.

Key Learning Objectives (LO)

• LO 1-1: Describe the purpose of accounting.

• LO 1-2: Describe the balance sheet.

• LO 1-3: Describe the income statement.

• LO 1-4: Define an accounting period.

• LO 1-5: Explain how the accounting equation works.

• LO 1-6: Explain accrual-based accounting.

• LO 1-7: Explain how to account for debt.

• LO 1-8: Explain how to account for assets.

• LO 1-9: Define capital.

• LO 1-10: Demonstrate how double entries are recorded in T-accounts.

Assets, Liabilities, and Net Worth

• Assets: What you own (e.g., cash, home, car).

• Liabilities: What you owe (e.g., loans, unpaid accounts).

• Net Worth Calculation:

  • Formula: Net worth = Assets − Liabilities

  • Example:

    • Total Assets: $104,000

    • Total Liabilities: $72,000

    • Net Worth: $32,000

The Balance Sheet

• Definition: A document recording assets, liabilities, and net worth on a specific date.

• Components:

  • Assets: Cash, car, house

  • Liabilities: Bank loans, mortgages

  • Net Worth: Total Assets - Total Liabilities

• Snapshot: Provides a financial position at a specific date, labeled as "As at ..."

Income Statement

• Definition: Summarizes revenues and expenses over a specific period.

• Revenue:

  • Increase in net worth from providing goods/services (e.g., salary, sales revenue).

• Expenses:

  • Costs incurred to generate revenue (e.g., rent, food, utilities, salaries).

• Purpose: Determine the net worth change during the period (surplus if revenue > expenses).

Accounting Periods

• Definition: Time frame for preparing financial statements (e.g., monthly, quarterly, annually).

• Benefits of Monthly Accounting:

  • Track living expenses, assess expectations, control errors effectively.

Accounting Equation

• Formula: Assets = Liabilities + Net Worth

• Double Entry: Every transaction has equal and opposite effects, ensuring balance maintenance in accounting records.

Accrual-Based Accounting

• Definition: Records revenue and expenses when they occur, not when cash is exchanged.

• Importance: Recognizes the financial position based on actual activities and events rather than just cash flow, providing a clearer picture of financial health.

Accounting for Debt

• Impact of Borrowing: Increases both assets (e.g., cash from a loan) and liabilities (e.g., the loan itself) without affecting net worth.

• Loan Repayment: Paying down principal reduces both assets and liabilities, affecting cash flow but not net worth.

• Interest Payments: Recognized as expenses, which do reduce net worth and are essential for tracking ongoing costs related to borrowed funds.

Capital

• Definition: Amounts that increase net worth not considered revenue (e.g., gifts, lottery winnings, investments).

• Importance: Helps in managing finances by distinguishing between capital (often one-time inflows) and regular revenue sources, providing insight into sustainable income.

T-Accounts and Double Entries

• T-Accounts: Used to record transactions and visualize changes in the accounting equation.

• Entry Rules: Increases and decreases are recorded on respective sides of T-accounts based on the type (assets, liabilities).

• Balance Maintenance: Must always keep the accounting equation balanced when recording transactions, ensuring the integrity of all financial statements.

The understanding of these concepts is vital for effective personal and business financial management and reporting.