Teaching financial accounting: How to start and build a strong foundation
Every accounting teacher knows how important it is for students to develop a strong conceptual understanding of financial accounting. A strong foundation is necessary before any critical thinking can occur. You cannot think critically about something you do not understand. Unfortunately, many introductory students spend their time memorizing procedures and never develop this foundation. Part of the problem is financial accounting topics are generally introduced all at once. Most introductory accounting texts start with an overview of a full set of financial statements. When students start with financial statements, they are not equipped to comprehend many of the items shown. Terms such as accounts receivable, accumulated depreciation, prepaid expenses, and so on are not easily explained to a beginner. If a student asks, "What is accumulated depreciation?", the only option is to say don't worry about that, we will cover it later. Students adapt by memorizing instead of understanding and confusion and boredom follow in quick pursuit.
A better option, is to introduce accounting using a sequential, or step-by-step approach. Start with the events rather than the statements that result from the events. Each time a new event is introduced, the terms presented in the event are defined and the effects of the event on the accounting equation are explained. Finally, students are shown how the information in the accounting equation is used to prepare financial statements. At no time are students exposed to terms that have not been fully explained. In other words, information is presented in a step-wise fashion with each new step following logically from the previous one.
Example of how to introduce financial accounting using a step-by-step, sequential approach:
Step 1: Define assets. Use the simplest definition possible. It is extremely important to use words that students can understand. They will read the technical terminology in the text. For example: Assets are things of value to a business. The value is the capacity of the asset to be used in the production of greater quantities of other assets. Use the classroom to provide specific examples. For example, the chairs, desks, and building are assets of the university because they are used to produce tuition dollars (other assets).
Step 2: Introduce the accounting equation. You can make a smooth transition from defining assets to introducing the accounting equation by noting that assets belong to some person or organization. The individual or institutional interests in the assets are called claims. Accountants keep track of not only assets but also who has claim to the assets. Keeping track of assets and claims is the foundation of double-entry accounting. The accounting equation expresses the relationship between assets and claims as follows:
Assets = Claims
Discuss that both creditors and owners can have claims on assets. Expanding the equation to:
Assets = Liabilities + Stockholders' Equity
Step 3: Introduce simple cash events and show how these events affect assets and claims in an accounting equation.
There are three primary sources of assets. Events 1, 2, and 4 illustrate the three sources. Discuss each event separately. Define the appropriate terms, and explain how the event affects the accounting equation.
Event No. 1: Use Event No. 1 to introduce and define common stock. Explain that when a business acquires assets from the owners, the assets of the business increase and the business establishes a corresponding claims account called common stock. Introduce the accounting equation and the term equity. Show students how to record the event under the accounting equation. Note that equity represents ownership interest in the business. As you lead in to Event No. 2, tell the students that creditors also have an interest in the assets of a business.
Event No. 2: Use this event to introduce liabilities. Define liabilities as obligations of a business. Note that RCS is obligated to return $400,000 of assets to creditors. Therefore, the creditors have a $400,000 claim on assets.
Event No. 3: The first two events dealt with financing the business. Now that the business has cash, it can invest in other assets that it can use. RCS is in the business of renting campsites. Therefore, it must invest in land. Note that the investment does not change total assets. RCS just exchanges one asset (Cash) for another (Land).
Event No. 4: This event introduces the concept of revenue. Define revenue as an increase in assets resulting from operating activities. This definition defines revenue in terms of its relationship with assets. It is extremely important that students understand how the elements of financial statements articulate. You can achieve this goal by defining various elements in terms of their relationship to other elements. Expand the accounting equation to include retained earnings and record Event No. 3 under the equation.
Event No. 5: This event introduces the concept of expenses. Define expenses as decreases in assets that occur in the process of attempting to earn revenue. Point out the (revenue – expenses) is the amount of net income or profit the company earned during the year.
Event No. 6: This event introduces dividends. Clearly distinguish dividends from expenses. While both use assets transactions, dividends represent a transfer of wealth rather than a sacrifice made to obtain revenue. You may be thinking that revenues can also result from activities that decrease liabilities. While this is true, revenue recognition within this context requires an understanding of deferrals. Deferrals are introduced in Chapter 3. Within the context of cash basis accounting, which is the underlying assumption for Chapter 1, revenue can be defined simply as an increase in assets and expenses as decreases in assets. These definitions will be expanded as accrual accounting topics are gradually introduced.
Event No. 7: This event simply illustrates that assets are typically held at historical cost.
Step 4: Prepare a formal balance sheet using the ending balances from the accounting equation.
Step 5: Go through another accounting cycle. Again, students are shown how simple cash events affect the accounting equation. This is a good point to explain how ending balances for one period become next period's beginning balances.
Step 6: Prepare a year 2 balance sheet using the ending balances from the accounting equation. Have students go through multiple accounting cycles just preparing a balance sheet. It is important to have students master one statement before introducing the others.
Step 7: Introduce the other financial statements. Emphasize that financial statements are designed to provide information useful in decision-making. Discuss how users desire more information than what is presented on the balance sheet at the end of the accounting period. Users also want to know what happened during the accounting period. The other financial statements provide this information. Specifically, the other financial statements tell us how balance sheet accounts changed. Present the other financial statements in this order: (1) statement of changes in stockholders’ equity, (2) income statement, and (3) statement of cash flows.
Statement of Changes in Stockholders' Equity
To find out how stockholders’ equity changed, refer students back to the Year 2 accounting equation. Show students how Common Stock changed (i.e. Beg. Balance 120,000 + 32,000 stock issue = End Balance 152,000).
Then, explain how Retained Earnings changed. Remind students that (revenue – expense) is the company’s net income (loss). Show students how Retained Earnings changed (i.e. Beg. Balance 31,000 + Net Income 54,000 – Dividend 9,000 = End Balance 76,000).
This is also a good time to reemphasize the difference between expenses and dividends. Expenses affect the measurement of net income, after which a decision is made regarding how much of the income to distribute versus how much to retain in the business. Emphasize that net income is a periodic measurement, while retained earnings is a cumulative amount.
Show how these changes in the accounting equation can be presented formally on the Statement of Changes in Stockholders’ Equity.
Discuss that while the Statement of Changes in Stockholders’ Equity provides investor with the amount of net income (loss) during the period it does not provide any information on how that net income (loss) was derived. Emphasize the importance of the net income as a performance measure for the business and how investors want more information about this number.
Refer back to the Year 2 accounting equation. Identify the revenue (Event 2) and expense (Event 3) transactions. Reiterate that revenue increases assets from providing services and expenses decrease assets in efforts to earn revenue. Help them understand that net income represents the change in wealth (net assets) resulting from business operations during the accounting period. If you want your students to understand interrelationships, you must emphasize those relationships in your classroom discussions and your examinations.
Show students how these changes in the accounting equation are presented formally on the Income Statement. Point out that the net income would be view favorably by investors and it indicates that it is revenue of providing services to its customers exceeds the cost (or expenses) of providing those services.
Statement of Cash Flows
Introduce the categories of the statement of cash flows in a sequence consistent with forming a business. First, a business must obtain financing. Once a business has cash, it invests the cash. Finally, the business uses and generates cash through its operations.
Preparing a cash flow statement is not difficult as we are not teaching the indirect method. Students must merely learn to identify cash transactions as operating, investing, or financing. You can easily prepare the statement by analyzing changes in the cash account. Refer back to the year 2 accounting equation. Classify the year 2 events as either an operating, investing, or financing activity. The use these classifications to prepare a formal Statement of Cash Flows:
Point out that this statement simply provides investors with information on how cash changed during the accounting period. Since the first chapter covers only cash transactions, the amount of cash flow from operating activities will equal the amount of net income. Therefore, we do not contrast these two amounts until Chapter 2
Step 8: Tie it all together. Spend a little time analyzing the articulation model below. The purpose is for students to see that the balance sheet provides investors with end of period balances and the other statements explain how the balance sheet balances changed. Students may wonder why some of the other changes in the two balance sheets are not explained by other financial statements. For example, why is there no statement of changes in liabilities to explain the changes in the notes payable account balances? Indeed, there could be different statements that would explain all of the differences in the Year 1 versus Year 2 balance sheet account balances. However, the demand for information that would be provided by additional statements has not been sufficient to merit the creation of such statements. In summary, the current set of financial statements are designed to satisfy the most pressing needs of today’s stakeholders. Other statements may be developed if the benefits of providing additional information justify the cost that would be incurred to produce and distribute that information.
Now that students have an understanding of how events lead to statements and can read basic financial statements, they are ready for more advanced events. The financial statements should evolve throughout the class as more events are introduced. We introduce topics in the following order:
Chapter 2: Accounting for Accruals
Chapter 3: Accounting for Deferrals
Chapter 4: Account for a Merchandising Firms (Add inventory, CGS, multi-step IS)
Chapter 5: Accounting for Inventories
Chapter 6: Internal Controls and Accounting for Cash
Chapter 7: Accounting for Receivables
Chapter 8: Accounting for Long-term Operational Assets
Chapter 9: Accounting for Current Liabilities and Payroll
Chapter 10: Accounting for Long-term Debt
Chapter 11: Proprietorships, Partnerships, and Corporations
Chapter 12: Statement of Cash Flows
Chapter 13: The Double-Entry Accounting System
The example above used simple cash events for a service company to prepare financial statements. We start with accounting events and build to financial statements.
Moving to a sequential learning approach will help your students develop a conceptual understanding of accounting. The approach fosters understanding over memorization. Remember it is important to go slowly. Students need time to practice and reinforce concepts. Spend extra time on Chapter 1. You are building the foundation for all future knowledge.