CHAPTER1 Accounting in Action

Chapter 1: Accounting in action What is accounting? The building blocks of accounting The basic accounting equation Using the accounting equation Financial Statements

What is Accounting? The Three basic activities of accounting & The Purpose of accounting is to: identify, record, and communicate the economic events of an organization to interested users. SO 1 Explain what accounting is.

What is accounting? Identify Record Communicate Bookkeeping Relevant to business Financial Statements

What is accounting? Three Activities The accounting process includes Illustration 1-1 Accounting process The accounting process includes the bookkeeping function.

Who Uses Accounting Data? Users of accounting data Internal User Various Department: Finance, Marketing, Human resource, Top management External User Investors, Creditors, Tax authorities, Customers, Labor Unions, SEC

Who Uses Accounting Data? Common Questions Asked User 1. Can we afford to give our employees a pay raise? Human Resources 2. Did the company earn a satisfactory income? Investors 3. Do we need to borrow in the near future? Management 4. Is cash sufficient to pay dividends to the stockholders? Finance 5. What price for our product will maximize net income? Marketing 6. Will the company be able to pay its short-term debts? Creditors

Building blocks of accounting Ethics in Financial reporting - Sarbanes-Oxley Act 2002 Generally Accepted Accounting Principles - Measurement Principles - Standard setting bodies - Forms of business ownerships Assumptions

Building blocks of accounting Ethics In Financial Reporting Standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are Ethics. Congress passed Sarbanes-Oxley Act of 2002. Effective financial reporting depends on sound ethical behavior.

Building blocks of accounting Sarbanes-Oxley Act 2002 Reduce unethical behavior Top management has to certify accuracy of financial information Severe penalties for fraud Increased independence of outside auditors

Building blocks of accounting Generally Accepted Accounting Principles (GAAP) - A set of rules and practices, that the accounting profession recognizes as a general guide for financial reporting purposes. Which is generally accepted & universally practiced. Standard-setting bodies determine these guidelines: Securities and Exchange Commission (SEC) Financial Accounting Standards Board (FASB) International Accounting Standards Board (IASB)

Building blocks of accounting Measurement Principles Cost Principle – Or historical cost principle, dictates that companies record assets at their cost. Fair Value Principle – Indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

Building blocks of accounting Assumptions Monetary Unit – include in the accounting records only transaction data that can be expressed in terms of money. Economic Entity – 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. Forms of Business Ownership

Building blocks of accounting Forms of business ownership Proprietorship Partnership Corporation Generally owned by one person. Often small service-type businesses Owner receives any profits, suffers any losses, and is personally liable for all debts. Ex-Small service-type businesses (beauty salons), and small retail stores Owned by two or more persons. Often retail and service-type businesses Generally unlimited personal liability Partnership agreement Ex- retail and service type, including professional practices (lawyers, doctors, architects, and certified public accountants). Ownership divided into shares of stock Separate legal entity organized under state corporation law Limited liability of shareholders Transferrable ownership Unlimited life of corporation. Ex- large enterprises like-General Motors, Wal-Mart, Citigroup, and Microsoft

Basic accounting Equation Assets Liabilities Owner’s Equity = + The accounting equation Provides the underlying framework for recording and summarizing economic events. The two basic elements of a business are what it owns and what it owes. In essence, a business uses liabilities and shareholders' equity to obtain sufficient funding for the assets its needs to operate. Assets are claimed by either creditors or owners. Claims of creditors must be paid before ownership claims. The basic accounting formula must balance at all times. If not, then a transaction was entered incorrectly, and must be corrected before financial statements can be issued.

Basic accounting Equation Assets Liabilities Owner’s Equity = + Provides the underlying framework for recording and summarizing economic events. Assets Resources a business owns. Provide future services or benefits. Cash, Supplies, Accounts receivable, inventory, and fixed assets (Furniture, Equipment, Land) etc.

Basic accounting Equation Assets Liabilities Owner’s Equity = + Provides the underlying framework for recording and summarizing economic events. Liabilities Claims against assets (debts and obligations). Creditors - party to whom money is owed. Accounts payable(An example of a accounts payable is- the due amount of any purchase that must be paid to the supplier), Notes payable (An example of a notes payable is- a loan issued to a company by a bank.(interest involved)), etc.

Basic accounting Equation Assets Liabilities Owner’s Equity = + Provides the underlying framework for recording and summarizing economic events. Owner’s Equity Ownership claim on total assets. Referred to as residual equity. Capital (investments), Drawings, etc.

Basic accounting Equation Liabilities:- Outsider’s claims against assets; borrowings; payables Owner’s Equity:- Owner’s claim on assets Asset:- Resources a business owns that have capacity to provide future services or benefits

Basic accounting equation Owner’s Equity increases with Investment (Capital): When owner puts in cash in the business Revenues: Anything coming into the business due to business activity. Owner’s Equity decreases with Drawings: When owners withdraw cash from business Expenses: Costs of assets and services consumed or used Liabilities Investment or Capital – Drawings + Revenues - Expenses Assets

Owners’ Equity Illustration 1-6 Revenues result from business activities entered into for the purpose of earning income. Common sources of revenue are: sales, fees, services, commissions, interest, dividends, royalties, and rent.

Owners’ Equity Illustration 1-6 Expenses are the cost of assets consumed or services used in the process of earning revenue. Common expenses are: salaries expense, rent expense, utilities expense, tax expense, etc. Expenses - reduce net income, decrease equity Revenues - increase net income, increase equity Shareholder investments in capital stock - increase equity Dividends - reduce retained earnings, decrease equity

Using the accounting equation Transactions are a business’s 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.

Transactions (Question?) Q1-15: Are the following events recorded in the accounting records? Owner withdraws cash for personal use. Supplies are purchased on account. An employee is hired. Event Is the financial position (assets, liabilities, or owner’s equity) of the company changed? Criterion Record/ Don’t Record

Using the accounting equation Transaction (1): Ray Neal decides to open a computer programming service which he names Softbyte. On September 1, 2012, Ray Neal invests $15,000 cash in the business.

Using the accounting equation Transaction (2): Purchase of Equipment for Cash. Softbyte purchases computer equipment for $7,000 cash.

Using the accounting equation Transaction (3): Softbyte purchases for $1,600 from Acme Supply Company computer paper and other supplies expected to last several months. The purchase is made on account.

Using the accounting equation Transaction (4): Softbyte receives $1,200 cash from customers for programming services it has provided.

Using the accounting equation Transaction (5): Softbyte receives a bill for $250 from the Daily News for advertising but postpones payment until a later date.

Using the accounting equation Transaction (6): Softbyte provides $3,500 of programming services for customers. The company receives cash of $1,500 from customers, and it bills the balance of $2,000 on account.

Using the accounting equation Transaction (7): Softbyte pays the following expenses in cash for September: store rent $600, salaries of employees $900, and utilities $200.

Using the accounting equation Transaction (8): Softbyte pays its $250 Daily News bill in cash.

Using the accounting equation Transaction (9): Softbyte receives $600 in cash from customers who had been billed for services [in Transaction (6)].

Using the accounting equation Transaction (10): Ray Neal withdraws $1,300 in cash from the business for his personal use.

Using the accounting equation Illustration 1-8 Tabular summary of Softbyte transactions

Financial Statements Companies prepare four financial statements : Income Statement Owner’s Equity Statement Balance Sheet Statement of Cash Flows

Financial Statements Income Statement: Presents the revenues and expenses and resulting net income or net loss for a specific period of time. Owner’s Equity Statement: Summarizes the changes in the owner’s equity for a specific period of time.

Financial Statements Balance Sheet: Reports the assets, liabilities, and owner’s equity at a specific date. It ensures that the accounting equation is maintained.

Financial Statements Statement of Cash Flows: Summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time Answers the following: Where did cash come from? What was cash used for? What was the change in the cash balance?

Financial Statements Statement of Cash Flows Balance Sheet

Financial Statements Statement of Cash Flows Where did cash come from? Information for a specific period of time. Answers the following: Where did cash come from? What was cash used for? What was the change in the cash balance?

Financial Statements Review Question Which of the following financial statements is prepared as of a specific date? Balance sheet. Income statement. Owner's equity statement. Statement of cash flows.