CHAPTER 1

ACCOUNTING IN ACTION
Accounting Principles, Eighth Edition
Chapter 1-1

What is Accounting? What is Accounting?

Three Activities
Illustration 1-1 Accounting process

The accounting process includes the bookkeeping function.

Chapter 1-2

Accounting is an information system that identifies, records, communicates, analyze, and interpret the economic events of any business entity to interested users for decision making.

Identifying economic events involves selecting the economic activities relevant to a particular organization. Example: The sale of soft drink by Pepsi Co, the paying of wages by Ford Motor company to its workers etc. Once identified, economic events are recorded to provide a history of the organizations financial activities. Recording consists of keeping a systematic chronological diary of events, measured in monetary terms. The identifying and recording activities are of little use unless the information is communicated to interested users. Financial information is communicated through accounting reports, commonly known as financial statements. A vital element in communicating economic events is the ability to analyze the reported information. Analysis involves the use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Distinguishing between Bookkeeping and Accounting: Bookkeeping usually involves only the recording of economic events. However, accounting process involves the bookkeeping function and much more. In total, accounting involves the entire process of identifying, recording, communicating, analyzing and interpreting of economic events.

Chapter 1-3

Who Uses Accounting Data? Who Uses Accounting Data?

Internal Users Human Resources Finance Management IRS Investors

There are two broad groups of users of financial information: internal users and external users.
Customers SEC

Labor Unions Creditors External Users

Marketing

Chapter 1-4

The Building Blocks of Accounting The Building Blocks of Accounting

Ethics In Financial Reporting
Standards of conduct by which ones actions are judged as right or wrong, honest or dishonest, fair or not fair, are Ethics. Recent financial scandals include: Enron, WorldCom, HealthSouth, AIG, and others. Congress passedSarbanes-Oxley Act of 2002. Effective financial reporting depends on sound ethical behavior.
Chapter 1-5

The Building Blocks of Accounting The Building Blocks of Accounting

Various users need financial information Financial Statements
Balance Sheet Income Statement Statement of Owners Equity Statement of Cash Flows Note Disclosure

The accounting profession has attempted to develop a set of standards that are generally accepted and universally practiced.
Chapter 1-6

Generally Accepted Accounting Principles (GAAP)

The Building Blocks of Accounting The Building Blocks of Accounting

Organizations Involved in Standard Setting:
Securities and Exchange Commission (SEC)
http://www.sec.gov/

Financial Accounting Standards Board (FASB)

http://www.fasb.org/

International Accounting Standards Board http://www.iasb.org/ (IASB)

Chapter 1-7

The Building Blocks of Accounting The Building Blocks of Accounting

Cost Principle (Historical) dictates that companies
record assets at their cost. Issues: Reported at cost when purchased and also over the time the asset is held. Cost easily verified, whereas market value is often subjective. Fair value information may be more useful.

Chapter 1-8

Assumptions Assumptions
Monetary Unit Assumption include in the accounting
records only transaction data that can be expressed in terms of money.

Economic Entity Assumption requires that

activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. Proprietorship. Partnership. Corporation.
Chapter 1-9

Forms of Business Ownership

Proprietorship , Partnership and Corporation

Proprietorship: A business owned by one person is generally a proprietorship. The owner is often the manager/operator of the business. There is no legal distinction between the business as an economic unit and the owner, but the accounting records of the business activities are kept separate from the personal records and activities of the owner. Example: Small service-type businesses ( clothing store, plumbing store, beauty salon, auto repair shop), farms etc. Characteristics of Proprietorship: 1) Relatively small amount of capital required. 2) The owner receives any profits, suffers any losses, and is personally liable for all debts of the business. 3) Limited life. 4) Unlimited liability. 5) Ownership is not easily transferable.

Chapter 1-10

Proprietorship , Partnership and Corporation

is a partnership. In most respects partnership is like a proprietorship except that more than one owner is involved. Typically a partner ship agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner or partners. Like a proprietorship, for accounting purposes the partnership affairs must be kept separate from the personal activities of the partners. Example: Partnerships are often used to organize retail and service-type businesses, including professional practices (lawyers, doctors, architects, certified public accountants) etc. Characteristics of Partnership: 1) Relatively small amount of capital required. 2) The partners receive any profits, suffer any losses, and is personally liable for all debts of the business. 3) Limited life. 4) Unlimited liability. 5) Ownership is not easily transferable. Corporation: A business organized as a separate legal entity under state corporation law and having ownership divided into transferable shares of stock is corporation. For example: ExxonMobil, General Motors, Wal-mart etc. Characteristics of corporation: 1) Large amount of capital required 2) The holders of the shares (stockholders) enjoy limited liability. 3) Stockholders may transfer all or part of their shares to others at any Chapter time. 1-11 4) Unlimited life.

Partnership: A business owned by two or more persons associated as partners

The Basic Accounting Equation The Basic Accounting Equation

Assets

Liabilities

Owners Equity

The most essential building blocks of accounting are the categories into which economic events are classified. The two basic elements of a business are what it owns and what it owes. Assets are the resources owned by a business. Liabilities and owners equity are the rights or claims against these resources. Claims of creditors are called liabilities and claims of owners are called owners equity. This relationship of assets, liabilities, and owners equity can be expressed as an equation as shown above. This relationship is referred to as the basic accounting equation. Assets must equal the sum of liabilities and owners equity. Because creditors claims must be paid before of ownership claims if a business is liquidated, liabilities are shown before owners equity in the basic accounting equation. This accounting equation applies to all business entities regardless of size, nature of business, or form of business organization. The equation provides the underlying framework for recording and summarizing the economic events of a business enterprise.
Chapter 1-12

The Basic Accounting Equation The Basic Accounting Equation

Assets = Liabilities + Owners Equity
Assets: are resources owned by a business. They are used in carrying out such activities as production, consumption, and exchange. The common characteristics possessed by all assets is the capacity to provide future services or benefits. In a business enterprise, that service potential or future economic benefit eventually results in cash inflows. Assets are the first component of the balance sheet. For example, the XYZ Pizza store owns a delivery truck that provides economic benefits from its use in delivering pizzas. Other assets of XYZ Pizza store are tables, chairs, oven, cash register and of course cash. Assets are further classified into two main categories: 1) Current assets: are cash, cash equivalents and other assets that can be converted into cash with in an operating cycle. Current assets are first major components of balance sheet. Example: cash, short term deposits, account receivables, prepaid and other current assets etc. 2) Long term assets: Assets that are not intended to be turned into cash or be consumed within one year of the balance sheet. Long term assets include land, property, plant, building, equipment, intangible assets (copy rights, goodwill, patents) etc.
Chapter 1-13

The Basic Accounting Equation The Basic Accounting Equation

Assets = Liabilities + Owners Equity

Liabilities: Obligations of a company or organization. Amounts owed to lenders, suppliers, vendors, governments, employees etc. Liabilities often have the word "payable" in the account title. Liabilities also include amounts received in advance for a future sale or for a future service to be performed. Liabilities are the second major component of the balance sheet. For example, the XYZ Pizza store also has a notes payable to ABC bank for the money borrowed to purchase the delivery truck. XYZ Pizza store may also have wages payable to its employees. Liabilities are divided into two main categories: 1) Current liabilities: In general, if liabilities or obligations must be paid with in a year, it is considered current. These include bills, money you owe to your vendors and suppliers, employee payroll, short-term loans etc. 2) Long term liabilities: Obligations of the enterprise that are not payable within one year of the balance sheet date. Examples are bonds payable, long term notes payable, mortgage payable etc.

Chapter 1-14

The Basic Accounting Equation The Basic Accounting Equation

Assets = Liabilities + Owners Equity

Owners (stockholders) equity: The ownership claim on total assets is known as owners equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are supplied or claimed by either creditors or owners. In publicly traded companies, outstanding preferred and common stocks represent the stockholders equity.

Chapter 1-15

Owners Equity Owners Equity

Illustration 1-6

Investments by owner are the assets the owner puts into the business. These investments increase owners equity. Revenues are the gross increase in owners equity resulting from business activities entered into for the purpose of earning income. Revenue increases owners equity. Common sources of revenue are: sales, fees, services, commissions, interest, dividends, royalties, and rent.
Chapter 1-16

Owners Equity Owners Equity

Illustration 1-6

Drawings An owner may withdraw cash or other assets for personal use. We use a separate classification called drawings to determine the total withdrawals for each accounting period. Drawings decrease owners equity. Expenses are the cost of assets consumed or services used in the process of earning revenue. Expenses decreases owners equity that result from operating the business. Common expenses are: salaries expense, rent expense, Chapter utilities expense, tax expense, etc.
1-17

Using The Basic Accounting Equation Using The Basic Accounting Equation
Transactions are a businesss economic events
recorded by accountants.
May be external or internal. Not all activities represent transactions. Each transaction has a dual effect on the accounting equation.

Chapter 1-18

Transactions (Question?) Transactions (Question?)

Q1-15: Are the following events recorded in the accounting records? Owner Event
Supplies are purchased on account. An employee is hired.

withdraws cash for personal use.

Criterion Record/ Dont Record

Chapter 1-19

Is the financial position (assets, liabilities, or owners equity) of the company changed?

TRANSACTION ANALYSIS
TRANSACTION 1

Ray Neal decides to open a computer programming service. On September 1, 2008 he invests $15,000 cash in the business, which he names Softbyte.

Softbyte
Chapter 1-20

TRANSACTION ANALYSIS
TRANSACTION 1 SOLUTION

Assets Cash + 15,000 $15,000

Liabilities

+ Owners Equity R. Neal, Capital

Investment =

+ 15,000 $15,000

There is an increase in the asset Cash, $15,000, and an equal increase in the owners equity, R. Neal, Capital, $15,000.
Chapter 1-21

TRANSACTION ANALYSIS

TRANSACTION 2

Softbyte purchases computer equipment for $7,000 cash.

Chapter 1-22

TRANSACTION ANALYSIS
TRANSACTION 2 SOLUTION

Cash Old

Assets = Liabilities + Owners Equity + Equipment = + R. Neal, Capital

$15,000 = $15,000 (2) - 7,000 + 7,000______________________________ New $ 8,000 + $7,000 = $15,000

Cash is decreased by $7,000 and the asset Equipment is increased by $7,000.

Chapter 1-23

TRANSACTION ANALYSIS

TRANSACTION 3

Softbyte purchases computer paper and other supplies expected to last for several months for $1,600 from Acme Supply Company. Acme agrees to allow Softbyte to pay this bill next month, in October. This transaction is referred to as a purchase on account or a credit purchase.

Acme Supply
Company

Softbyte
Chapter 1-24

TRANSACTION ANALYSIS
TRANSACTION 3 SOLUTION

Assets = Liabilities + Owners Equity Cash + Supplies + Equip. = Accts. Pay. + R. Neal, Capital Old $8,000 + $7,000 = $15,000 (3) _____ + $1,600 _______ + $1,600 ________ New $8,000 + $1,600 + $7,000 = + $1,600 + $15,000 $16,600 $16,600

The asset Supplies is increased by $1,600, and the liability Accounts Payable is increased by the same amount.
Chapter 1-25

TRANSACTION Softbyte receives $1,200 cash from customers for ANALYSIS programming services it has provided.
TRANSACTION 4

This transaction represents the Softbytes principal revenue-producing activity.

Softbyte

Chapter 1-26

TRANSACTION ANALYSIS
TRANSACTION 4 SOLUTION

Assets = Liabilities + Owners Equity Cash + Supplies + Equip. = Accts. Pay. + R. Neal, Capital Old $8,000 + $1,600 + $7,000 = $1,600 + $15,000 (4) + 1,200 _____ _____ _______________ + 1,200 New $9,200 + $1,600 + $7,000 = $1,600 $16,200 $17,800 $17,800

Cash is increased by $1,200 and R. Neal, Capital is increased by $1,200.

Chapter 1-27

TRANSACTION ANALYSIS
TRANSACTION 5

Softbyte receives a bill for $250 from the

Daily News for advertising but postpones payment of the bill until a later date.

Softbyte
Chapter 1-28

Bill
Daily News

TRANSACTION ANALYSIS
TRANSACTION 5 SOLUTION

Assets

= Liabilities + Owners Equity

Cash + Supplies + Equip. = Accts. Pay. + R. Neal, Capital Old $9,200 + $1,600 + $7,000 = $1,600 + $16,200 (5) ___Advertising Expense__ + 250 _250 New $9,200 + $1,600 + $7,000 = $1,850 + $15,950 $17,800 $17,800

Accounts Payable is increased by $250 and R. Neal, Capital is decreased by $250.

Chapter 1-29

TRANSACTION ANALYSIS

TRANSACTION 6

Softbyte provides $3,500 of programming services for customers. Cash of $1,500 is received from customers, and the balance of $2,000 is billed on account.

Softbyte

Bill

Chapter 1-30

TRANSACTION ANALYSIS
TRANSACTION 6 SOLUTION

Assets

= Liabilities + Owners Equity

Accts. Pay. $1,850 + + $1,850 + $21,300 + R. Neal, Capital $15,950 3,500 $19,450

Cash + Accts. Rec. + Supplies + Equip. = Old $ 9,200 + $1,600 + $7,000 = (6) + 1,500 + 2,000 New $10,700 + $2,000 + $1,600 + $7,000 = $21,300

Cash is increased by $1,500; Accounts Receivable is increased Chapter $2,000, and R. Neal, Capital is increased by $3,500. by
1-31

TRANSACTION ANALYSIS
TRANSACTION 7

Expenses paid in cash for September are store

rent, $600; employees salaries, $900; and utilities, $200.

$600
Softbyte

$900 $200

Chapter 1-32

TRANSACTION ANALYSIS
TRANSACTION 7 SOLUTION

Assets

= Liabilities + Owners Equity

+ + + R. Neal, Capital $19,450 600 900 200 $17,750

Cash + Accts. Rec. + Supplies + Equip. = Accts. Pay. Old $10,700 + $2,000 + $1,600 + $7,000 = $1,850 (7) - 1,700 Rent Expense Salaries Expense Utilities Expense New $ 9,000 + $2,000 + $1,600 + $7,000 = $1,850 $19,600

$19,600

Cash is decreased by $1,700 and R. Neal, Capital is decreased by Chapter the same amount. 1-33

Softbyte pays its $250 Daily News advertising bill in cash.

TRANSACTION ANALYSIS

TRANSACTION 8

Softbyte
Daily
Chapter 1-34

News

TRANSACTION ANALYSIS
TRANSACTION 8 SOLUTION

Assets

= Liabilities + Owners Equity

= = Accts. Pay. $1,850 - 250 $1,600 + + R. Neal, Capital $17,750 . + $19,350 $17,750

Cash + Accts. Rec. + Supplies + Equip. Old $9,000 + $2,000 + $1,600 + $7,000 (8)- 250 New $8,750 + $2,000 + $1,600 + $7,000 $19,350

Chapter 1-35

Both Cash and Accounts Payable are decreased by $250. Since the expense was previously recorded, it is not recorded now.

TRANSACTION ANALYSIS
The sum of $600 in cash is received from
TRANSACTION 9

customers who have previously been billed for services (in Transaction 6).

Softbyte

Chapter 1-36

TRANSACTION ANALYSIS
TRANSACTION 9 SOLUTION

Assets

= Liabilities + Owners Equity

R. Neal, Capital $17,750 . $17,750

Cash + Accts. Rec. + Supplies + Equip. = Accts. Pay. + Old $8,750 + $2,000 + $1,600 + $7,000 = $1,600 + (9) + 600 600 New $9,350 + $1,400 + $1,600 + $7,000 = $1,600 +

$19,350

$19,350

Cash is increased by $600 and Accounts Receivable is decreased by the same amount. R. Neal, Capital is not increased because Chapter revenue was already recorded. the
1-37

TRANSACTION ANALYSIS
TRANSACTION 10

Ray Neal withdraws $1,300 in

cash from the business for his personal use.

Softbyte

$1,300

Chapter 1-38

TRANSACTION ANALYSIS
TRANSACTION 10 SOLUTION

Assets

= Liabilities + Owners Equity

= = Accts. Pay. $1,600 + + + R. Neal, Capital $17,750 1,300 $16,450

Cash + Accts. Rec. + Supplies + Equip Old $9,350 + $1,400 + $1,600 + $7,000 (10) - 1,300 New $8,050 + $1,400 + $1,600 + $7,000 $18,050

Drawing = $1,600

$18,050

Chapter 1-39

Cash is decreased by $1,300 and R. Neal, Capital is decreased by the same amount. This is not an expense, but rather a withdrawal of owners equity.

Four financial statements are prepared from the summarized accounting data:

FINANCIAL STATEMENTS

Income Statement revenues and expenses and resulting net income or net loss for a specific period of time.

Owners Equity Statement summarizes the changes in owners equity for a specific period of time. Balance Sheet reports the assets, liabilities, and owners equity at a specific date.

Statement of Cash Flows summarizes about the cash inflows (receipts) and outflows (payments) for a specific period of time.

Chapter 1-40

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE, INC. Income Statement For the Month Ended September 30, 2008
Revenues Service revenue Expenses Salaries expense Rent expense Advertising expense Utilities expense Total expenses Net income $ 4,700 $ 900 600 250 200 1,950
$

2,750

Net income of $2,750 shown on the income statement is added to the Chapter beginning balance of owners capital in the owners equity statement.
1-41

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE, INC. Owners Equity Statement For the Month Ended September 30, 2008
R. Neal, Capital September 1, 2008 Add: Investments Net income Less: Drawings $ 15,000 2,750 $ -017,750 17,750 1,300 $16,450

R. Neal, Capital September 30, 2008

Net income of $2,750 carried forward from the income statement to the owners equity statement. The owners capital of $16,450 at the end of the reporting period is shown as the final total of the owners equity column of the Summary Chapter of Transactions (Illustration 1-8).
1-42

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE, INC. Balance Sheet September 30, 2008
Assets Cash Accounts receivable Supplies Equipment Total assets Liabilities and Owners Equity Liabilities Accounts payable Owners equity R. Neal, capital Total liabilities and owners equity $ 1,600
16,450

$ 8,050 1,400 1,600 7,000 $ 18,050

$ 18,050

Chapter 1-43 in the owners

Owners capital of $16,450 at the end of the reporting period shown equity statement is shown on the balance sheet.

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE, INC. Balance Sheet September 30, 2008
Assets Cash Accounts receivable Supplies Equipment Total assets Liabilities and Owners Equity Liabilities Accounts payable Owners equity R. Neal, capital Total liabilities and owners equity
Chapter Cash of $8,050 1-44

$ 8,050

1,400 1,600 7,000 $ 18,050 $ 1,600 16,450 $ 18,050

on the balance sheet is reported on the statement of cash flows.

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE, INC. Statement of Cash Flows For the Month Ended September 30, 2008
Cash flows from operating activities Cash receipts from revenues Cash payments for expenses Net cash provided by operating activities Cash flows from investing activities Purchase of equipment Cash flows from financing activities Investments by owner Drawings by owner Net cash provided by financing activities Net increase in cash Cash at the beginning of the period Cash at the end of the period $ 3,300 (1,950) 1,350 (7,000) $ 15,000 (1,300) 13,700 8,050 0

$ 8,050

ChapterCash of $8,050 on the balance sheet and statement of cash flows is shown as the 1-45 final total of the cash column of the Summary of Transactions (Illustration 1-8).

End of the Chapter!

Chapter 1-46