Recording Financial

Transactions and the

Principles of Accounting

Dott.ssa Cristina Campanale

c.campanale@santannapisa.it

Pisa, a.y. 2017-2018

Overview
n Business events & the accounting
system
n Recording transactions: the double entry
n Simplified financial reports
n Principles of accounting
n Understanding the notion of cost and
the limitations of financial accounting

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 2
makes a profit and its human capital is increased when employees become better trained.

3.2 This Background Paper for <IR> explores the six categories of capital identified by the IIRC, which are
The plurality of the Capital concept in
depicted in Figure 1. Together, these capitals are the basis of an organizations value creation. As shown, the
capitals are not entirely independent. The exact nature of their interaction is a function of organizational focus

contemporary organizations
and beliefs. While most organizations rely on all capitals to an extent, some dependencies will be relatively
minor or so indirect that they are immaterial for reporting purposes.

(Traditional) Accounting domain

n All organizations depend on

Financial
various forms of capital for their
capital success.
Figure 1: This diagram is one way
n These capitals are stores of value
to depict the capitals. Financial
Manufactured
that, in one form
and manufactured or another,
capitals are the
capital become inputsmost
ones organizations to the
commonly
report on. <IR> takes a broader
Intellectual Human organizations business model
view by also considering intellectual,
capital capital
n They arerelationship,
social and also increased,
and human
capitals (all of which are linked
Social and decreased or transformed through
to the activities of humans) and
relationship the activities
natural of the
capital (which organization in
provides
capital the environment
that they 5areinenhanced,
which the other
capitals sit).
consumed, modified or otherwise
affected by those activities
Natural
capital For example, an organizations
financial capital is increased when it
makes a profit and its human capital is
increased when employees become
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3
better trained. 3
 Understanding the effects of business
events on Financial Capital: the cash cycle

Business events
occur during the 4
stages of the cash
cycle
FINANCING
INVESTING
OPERATING
RETURNING
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 4
The cash cycle - Financing

(OWNERS ) (LENDERS)

EQUITY LIABILITIES

CASH
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 5
The cash cycle - Investing

CASH

LABOR, MATERIALS,
FIXED ASSETS
OVERHEAD,ETC.

INVENTORY
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 6
The cash cycle - Operating

ACCOUNTS
CASH RECEIVABLE

SG&A

INVENTORY REVENUE

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 7
The cash cycle Returning

STATE OWNERS LENDERS

TAXES EQUITY LIABILITIES

CASH

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 8
 The cash cycle: general overview

EQUITY LIABILITIES

TAXES

ACCOUNTS
CASH RECEIVABLE

FIXED LAB, MTLS, ETC SG&A

ASSETS

INVENTORY REVENUE
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 9
 The financial performance of
the business
n If we could measure financial performance at the end of the
lifecycle of the business, then we should have:

Result = Total Cash Inflow Total Cash Outflow

n Unfortunately financial performance has to be periodically

measured during the lifecycle of the business (quarter, year)
n Estimations are therefore needed about the amount of
investments and returns that can be considered developed
by the business activities in that period of time
Accounting
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 Period 10
Business events, transaction & the
accounting system
Business events (related to the cash cycle, e.g.
buying, selling)

Transaction (financial description and meaning

of event)

Source document (record of transaction, e.g.

invoices, cheques)

Entered to accounting system

Accounts
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 11
Forms of transactions
n On Cash
Bank (receipts, payments)
n On Credit
Debtors (customers who owe money to the
business)
Creditors (suppliers to whom the business
owes money)

Every transaction has a cash/credit source

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 12
Account and the Chart of Accounts

n Accounts: the n Bank

buckets within n Equipment
the accounting n Inventory
system that collect n Creditor
similar n Wages
transactions. n Debtors
n Sales
n Cost of Sales
n Advertising
n .

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 13
Types of accounts
n Assets
Things the business owns [investments: e.g. fixed;
inventory (products, materials, WIP); debtors; bank]
n Liabilities
Debts the business owes (creditors; loans; bank
overdraft)

n Income
Revenue generated from the sale of goods/services
n Expenses
Costs incurred in producing goods/services
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 14
Types of Accounts

(Investments)

( financing)
Liabilities

Expense
Income
Assets
Account

Bank
Equipment

Inventory

Creditor
Wages

Debtors

Sales

Cost of Sales

Advertising

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 15
Types of accounts &
the two basic accounting equations
The worth created by
business in the year

Income vs
Expenses
Profit = Income Expenses
Positive Negative
components components

Assets vs
Capital = Assets Liabilities
Liabilities
Positive Negative
The owners total amount of elements elements
(accounting) value of the business at
the end of the year
Not all the transactions affect Income or
Expenses and have a profit effect
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 16
 Examples of transactions and their
effect on accounts and profit

n Pay cheque to buy n Pay salaries by bank

new equipment for Increase expense
production (salary)
Increase asset Reduce asset (bank)
(equipment) Profit effect (reduction)
Reduce asset (bank)
No effect on profit

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 17
Examples of transactions and their
effect on accounts and profit

n The owner invests cash to

start the business
Increase asset (cash)
Increase capital (equity)
No profit effect

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 18
 Business events, transactions and the accounting
system: an overview
Business is conducted through a series of Business events

which are described in financial terms as Transactions

and recorded on Source documents (i.e. invoices)

that are recorded in an Accounting System

comprising a series of Accounts

of which there are four types

Assets Liabilities Income Expenses

which determine the
Capital of the business Profit of the business
and which are presented
in financial reports Income Statement
Balance Sheet
(Profit and Loss Account)
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3
 Business transactions and the double entry
Accounts Assets Liabilities Income
Business event Transaction Capital Expense
affected (Investments) ( financing)

Investment by the owner Receive 50,000

by the owner
Install new equipment for Buy equipment
production for cash (25,000)
Receive stock of goods for Purchase stock on
resale credit (15,000)
Pay weekly wages Pay wages
(3,000)
Sell goods to customer Sell stock on
from stock credit (9,000)
Deliver goods from stock The goods that
were sold for
9,000 cost 4,000
to buy
Advertising Pay 1,000 for
advertising
Receive payment Receive 4,000
for earlier sale on credit from debtor
Pay supplier for goods Pay 9,000 to
previously bought on credit creditor

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 20
 Summary of business transactions in a ledger
Capital Assets Liabilities Income Expense
Advertising 1000
Advertising 1000
Bank 16000
Advertising -1000
Install new equipment for -25000
Investment by the owner 50000
Pay supplier for goods -9000
Pay weekly wages -3000
Receive payment 4000
Capital 50000
Investment by the owner 50000
Cost of Sales 4000
Deliver goods from stock 4000
Creditor 6000
Pay supplier for goods -9000
Receive stock of goods for 15000
Equipment 25000
Install new equipment for 25000
Inventory 11000
Deliver goods from stock -4000
Receive stock of goods for 15000
Sales 9000
Sell goods to customer from stock 9000
Wages 3000
Pay weekly wages 3000
Debtor 5000
Receive payment -4000
Sell goods to customer from stock 9000
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 21
Inside the accounting machine

The T shape of the account

n The tipical representation of an account is by a
T shape. Variations of value in the account
determined by transactions are recorded in the
left or the right side according with the
accounting rules applied to that type of account.
Account XXX

Transaction A .000 Transaction B .000

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 22
 Inside the accounting machine
The fundamental accounting rule of
double entry bookeeping
n In recording transactions in the accounting system, double entry
bookeeping rules work in a way that each transaction involves at least
two accounts. Variations of value are recorded in the opposite sides of
each of the accounts involved (balance of accounts)
Asset/Expense account Liabilities/Capital/Income account

(+) Increase of value (-) Decrease of value (-) Decrease of value (+) Increase of value

n This way, the sum of the values of transactions recorded in the left side
of all the accounts is always equivalent to the sum of the values of
transactions recorded in the right side of all the accounts
23

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3
 Inside the accounting machine

Business transactions and the double entry

Business event Transaction Accounts Capital Assets Liabilities Income Expense
affected (Investments) ( financing)
+ - + -
Investment by the owner Receive 50,000 1. Bank +50,000
by the owner 2. Capital +50,000

Bank Capital

50,000 50,000

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 24
 Inside the accounting machine

Business transactions and the double entry

Business event Transaction Accounts Capital Assets Liabilities Income Expense
affected (Investments) ( financing)
+ - + -
Receive stock of goods for Purchase stock on 1. Inventory +15,000
resale credit (15,000) 2. Creditors +15,000

Inventory Creditors

15,000 15,000

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 25
 Inside the accounting machine

Business transactions and the double entry

Business event Transaction Accounts Capital Assets Liabilities Income Expense
affected (Investments) ( financing)
+ - + -
Sell goods to customer Sell stock on 1. Debtors +9,000
from stock credit (9,000) 2. Sales +9,000

Debtors Sales

9,000 9,000

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 26
 The two basic accounting equations

Income vs
Expenses
Profit = Income Expenses
Positive Negative
components components

Assets vs
Capital* = Assets Liabilities
Liabilities
Positive Negative
elements elements

*or Equity

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 27
 Accounting Equation of Capital: example
Capital = Assets Liabilities
Assets = Liabilities + Capital

Assets = Liabilities + Capital

(a) 50,000 20,000

(b) 30,000 10,000

(c) 40,000 15,000

1-28
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28
 Accounting equations &
Financial reports

Income
Expenses
Profit = Income Expenses
Income Statement

Assets
Liabilities
Capital = Assets Liabilities
Balance Sheet

Financial reports

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 29
 Financial reports

n Income Statement n Balance Sheet

Income statement Balance sheet (UK;
(IASB) IASB)
Profit and loss account Statement of Financial
(UK) Position (USA)
Statement of
operations (USA)

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 30
 From the ledger to Financial reports
Capital Assets Liabilities Income Expense
Advertising 1000
Advertising 1000
Bank 16000
Advertising -1000
Install new equipment for -25000
Investment by the owner 50000
Pay supplier for goods -9000
Pay weekly wages -3000
Receive payment 4000
Capital 50000
Investment by the owner 50000
Cost of Sales 4000
Deliver goods from stock 4000
Creditor 6000
Pay supplier for goods -9000
Receive stock of goods for 15000
Equipment 25000
Install new equipment for 25000
Inventory 11000
Deliver goods from stock -4000
Receive stock of goods for 15000
Sales 9000
Sell goods to customer from stock 9000
Wages 3000
Pay weekly wages 3000
Debtor 5000
Receive payment -4000
Sell goods to customer from stock 9000
Total 50000 57000 6000 9000 8000
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 31
From the ledger to Financial reports

Asset Liabilities = Capital Income Expenses = Profit

57,000 6,000 = 51,000 9,000 8,000 = 1,000

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 32
 From the ledger to Financial reports

Asset Liabilities = Capital Income Expenses = Profit

57,000 6,000 = 51,000 9,000 8,000 = 1,000

50,000(Owners
2015 John Wiley &original investment)
Sons, Ltd, Accounting for Managers, 5th+ 1,000
ed., (Profit)
9780470777640, Ch 3 33
 Financial reports: Income Statement
Income Profit = Income Expenses
Expenses

Income Statement
Income 9,000
Less expenses:
Cost of goods sold 4,000
Wages 3,000
Advertising 1,000 8,000
Profit 1,000
Matching Principle: income is
recognized when it is earned and
expenses when they are incurred, rather
34
than on a cash basis
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3
Financial reports: Balance Sheet (1)
Assets Capital = Assets Liabilities
Liabilities Assets = Liabilities + Capital

Balance Sheet
Assets Liabilities + Capital
Equipment 25,000 Creditors 6,000
Inventory 11,000 Capital
Debtors 5,000 Owners original
Bank 16,000 investment 50,000
+ profit for period 1,000
Total capital 51,000
Total liabilities
Total assets 57,000 plus capital
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3
57,000
35
Financial reports: Balance Sheet (2)
Assets Capital = Assets Liabilities
Liabilities Assets = Liabilities + Capital

Balance Sheet (vertical form)

Assets:
Equipment 25,000
Inventory 11,000
Trade receivables (Debtors) 5,000
Bank 16,000
Total assets: 57,000
Total liabilities:
Trade payables (Creditors) 6,000
Net assets: 51,000
Capital
Owners original investment 50,000
Plus profit for period 1,000
Owners equity 51,000
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 36
 Depreciation: an expense without financial
transaction
n Fixed assets are capitalized in the Balance Sheet: the purchase of fixed
assets does not affect profit.
n Depreciation is an expense that spreads the cost of the asset over its useful
life. The following example illustrates depreciation.
An asset costs 100,000. It is expected to have a life of four years and have a
resale value of 20,000 at the end of that time. The depreciation charge is:
asset cost resale value = Matching Principle: income
expected life is recognized when it is
earned and expenses when
100,000 20,000 = 20,000 p.y.
they are incurred, rather than
4 on a cash basis
Original asset cost Depreciation Net value in
(cumulated) Balance Sheet

End of year 1 100,000 20,000 80,000

End of year 2 100,000 40,000 60,000
End of year 3 100,000 60,000 40,000
End of year 4 100,000 80,000 20,000
End of year 5 100,000 100,000
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3
Nil 37
 Depreciation
In our example:
nEquipment purchase cost: 25,000
nResale value = 0
nExpected life: 5 years
nAnnual depreciation = (25,000 0) / 5 = 5,000

Original asset cost Depreciation Net value in

(cumulated) Balance Sheet

End of year 1 25,000 5,000 20,000

End of year 2 25,000 10,000 15,000
End of year 3 25,000 15,000 10,000
End of year 4 25,000 20,000 5,000
End of year 5 25,000 25,000 Nil

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 38
Financial reports: Income Statement
(including depreciation) Matching Principle: income
is recognized when it is
earned and expenses when
they are incurred, rather than
Income Statement on a cash basis

Income 9,000
Less expenses:
Cost of goods sold 4,000
Depreciation 5,000
Wages 3,000
Advertising 1,000 13,000
Loss 4,000
Earnings management:
when companies smooth
their reported performance to
satisfy the expectaction of 39
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3
stockholders
Financial reports: Balance Sheet
(including depreciation)

Balance Sheet
Assets Liabilities
Equipment 20,000* Creditors 6,000
Inventory 11,000 Capital
Debtors 5,000 Owners original
Bank 16,000 investment 50,000
- loss for period 4,000
Total capital 46,000
Total liabilities
Total assets 52,000 plus capital 52,000
* (25,000 5,000)
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3
40
 Points to remember
n Sales are based on the selling price
n Cost of sales are based on the purchase cost of
the goods sold (or cost of services supplied)
n Profit is not equal to cash flow
Capitalizing assets
Working capital (debtors, creditors, inventory
& bank)
Matching (or accrual) principle
n Profit is an addition to the owners Capital
n Loss is a deduction to the owners Capital
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 41
The limitation of financial accounting in
relation to cost concepts
n Accounting consider only financial costs
Human, social and environmental costs are also relevant
n Financial accounting produces reports based on line
items (resource input, e.g. materials, labour)
Many other relevant cost objects for decision making:
n Output (Product/Service)
n Process (e.g. customer order processing)
n Area of responsibility (department or cost centre)

n There are several definition of costs

Cost is a resource sacrificed or foregone to achieve a specific
objective (Horngren et al., 1999), but:
Cash cost or opportunity cost?
If Cash cost, historical or future?
2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 42
Conclusion
n How accounting systems capture,
record, summarise and report financial
information
n Accounts
n Financial reports
n Principles of accounting
n Different understandings of cost and
limitation of financial accounting

2015 John Wiley & Sons, Ltd, Accounting for Managers, 5th ed., 9780470777640, Ch 3 43
 Recording Financial
Transactions and the
Principles of Accounting

Dott.ssa Cristina Campanale

c.campanale@santannapisa.it

Pisa, a.y. 2017-2018