1. Accounting in Business
Chapter 01
Accounting in Business
Chapter 1: Accounting in Business
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Importance of Accounting
Identifying Select transactions and events
Recording
Input, measure and classify
Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities. Identifying business activities requires selecting transactions and events relevant to an organization. Recording business activities requires keeping a chronological log of transactions and events measured in dollars and classified and summarized in a useful format. Communicating business activities requires preparing accounting reports such as financial statements. It also requires analyzing and interpreting such reports.
Communicating
Prepare, analyze and interpret

3. Users of Accounting Information
Internal Users
External Users
Accountants prepare reports for both external and internal users. External users of accounting information are not directly involved in running the organization. Examples of external users are lenders, shareholders (investors), governments, consumer groups, customers, and the external auditors.
Internal users of accounting information are those directly involved in managing and operating an organization. They use the information to help improve the efficiency and effectiveness of an organization. Examples of internal users are managers, officers/directors, internal auditors, sales staff, budget officers and controllers.
Lenders
Shareholders
Governments
Consumer Groups
External Auditors
Customers
Managers
Officers/Directors
Internal Auditors
Sales Staff
Budget Officers
Controllers

4. Users of Accounting Information
Internal Users
External Users
Financial accounting is the area of accounting aimed at serving external users by providing them with financial statements.
Managerial accounting is the area of accounting that serves the decision-making needs of internal users.
Financial accounting provides external users with financial statements.
Managerial accounting provides information needs for internal decision-makers.

5. Opportunities in Accounting
Careers in accounting can follow many paths.
There is great demand for financial accountants in the preparation of financial statements, dealing with regulatory agencies like the Internal Revenue Service, and consulting.
Management accountants help track product costs, prepare budgets and serve as consultants to managers.
The field of taxation includes everything from the preparation of tax returns to consulting with clients about estate and gift planning.
Individuals with accounting backgrounds may move into other areas of importance within an organization. Individuals with accounting training often become business owners and managers. They are in high demand in all financial and investigative fields.

6. Accounting Jobs by Area
About twenty-four percent of accountants work in public accounting. Public accounting firms offer accounting, tax, and consulting services to a wide variety of clients. About sixty percent of accountants work for businesses/corporations, and sixteen percent work for governmental, not-for-profit, and educational organizations.

7. Ethics Ethics - A Key Concept
Beliefs that distinguish right from wrong
Accepted standards of good and bad behavior
Ethical behavior is the cornerstone of the accounting profession. Recently, we have seen many corporate scandals involving individuals who acted in an unethical, and often times, illegal, way.
Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior.

8. C 3
Ethics - A Key Concept
Identifying the ethical path is sometimes difficult. The preferred path is a course of action that avoids casting doubt on one’s decisions. For example, accounting users are less likely to trust an auditor’s report if the auditor’s pay depends on the success of the client’s business. To avoid such concerns, ethics rules are often set. For example, auditors are banned from direct investment in their client and cannot accept pay that depends on figures in the client’s reports. On your screen are guidelines for making ethical decisions.

9. Generally Accepted Accounting Principles
Financial accounting practice is governed by concepts and rules known as generally accepted accounting principles (GAAP).
Relevant Information
Affects the decision of its users.
Financial accounting is governed by a set of rules we call Generally Accepted Accounting Principles, or GAAP for short.
Generally accepted accounting principles identify three major characteristics of information. First, the information must be relevant. Relevant information impacts the decision of the informed user for financial information. Second, the information must be reliable. Finally, the information must be comparable. Comparability helps us evaluate financial information from one period with that of the next period.
Reliable Information
Is trusted by users.
Comparable Information
Is helpful in contrasting organizations.

10. Setting Accounting Principles
Financial Accounting Standards Board is the private group that sets both broad and specific principles.
The Securities and Exchange Commission is the government agency that establishes reporting requirements for companies that issue stock to the public.
The Financial Accounting Standards Board is recognized as the group in the private sector that makes specific accounting principles. If an accountant departs from the principles established by the FASB, proper disclosure of the departure must be made.
In the public sector, the Securities and Exchange Commission has the authority to establish accounting principles for companies reporting to the agency. Currently, the Securities and Exchange Commission has accepted all pronouncements of the FASB for use by public reporting companies.
The International Accounting Standards Board (IASB) issues International Financial Reporting Standards that identify preferred accounting practices to create harmony among accounting practices of different countries.
The International Accounting Standards Board (IASB) issues International Financial Reporting Standards that identify preferred accounting practices to create harmony among accounting practices of different countries.

11. International Standards
C 4
The International Accounting Standards Board (IASB), an independent group (consisting of 16 individuals from many countries), issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices.
In today’s global economy, there is increased demand by external users for comparability in accounting reports. This demand often arises when companies wish to raise money from lenders and investors in different countries.
If standards are harmonized, one company can potentially use a single set of financial statements in all financial markets. Differences between U.S. GAAP and IFRS are slowly fading as the FASB and IASB pursue a convergence process aimed to achieve a single set of accounting standards for global use.
IASB

12. International Standards
C 4
Like the FASB, the IASB uses a conceptual framework to aid in revising or drafting new standards. However, unlike the FASB, the IASB’s conceptual framework is used as a reference when specific guidance is lacking.
The IASB also requires that transactions be accounted for according to their substance (not only their legal form), and that financial statements provide a fair presentation, whereas the FASB narrows that scope to fair presentation in accordance with U.S. GAAP.

13. Principles and Assumptions of Accounting
Revenue Recognition Principle
Recognize revenue when it is earned.
Proceeds need not be in cash.
Measure revenue by cash received plus cash value of items received.
Cost Principle
Accounting information is based on actual cost. Actual cost is considered objective.
Matching Principle
A company must record its expenses incurred to generate the revenue reported.
Listed on your screen are four fundamental principles of accounting. The revenue recognition principle states that revenue is to recognized when it is earned, that the revenue need not be in the form of cash and that we measure revenue by the cash received plus cash value of other items received. The cost principle tell us that accounting information is based upon actual cost incurred. We refer to this cost as historical cost. The matching principle dictates that expenses incurred by a company must be matched against revenue generated as a result of those expenses. The full disclosure principle states that a company is required to report the details behind the financial statements if the details so disclosed would impact the users’ decision-making process. Most of the details are reported in the notes to the financial statements.
Full Disclosure Principle
A company is required to report the details behind financial statements that would impact users’ decisions.

14. Accounting Assumptions
Now
Future
Going-Concern Assumption
Reflects assumption that the business will continue operating instead of being closed or sold.
Monetary Unit Assumption
Express transactions and events in monetary, or money, units.
Business Entity Assumption
A business is accounted for separately from other business entities, including its owner.
Time Period Assumption
Presumes that the life of a company can be divided into time periods, such as months and years.
Now we will look at four fundamental assumptions of accounting. The going-concern assumption states that, in the absence of information to the contrary, the business entity is assumed to continue operations into the foreseeable future. The monetary unit assumption tells us that we will only record accounting information that can be expressed in monetary units, usually dollars in the United States. The business entity assumption tells us that we must separate out the transaction of individual owners of a business from those of the business. Finally, the time period assumption presumes that the life of a company can be divided into time periods such as months and years, and that useful reports can be prepared for those periods.

15. Forms of Business Entities
C 4
Sole Proprietorship
Partnership
Corporation
There are three general forms of business operations. A sole proprietorship is a business owned by just one individual. A court can order an owner to sell personal belongings to pay a proprietorship’s debt. This unlimited liability of a proprietorship is a disadvantage.
A partnership is owned by two or more individuals. Some partnerships have several thousand partners. A limited partnership (LP) includes a general partner(s) with unlimited liability and a limited partner(s) with liability restricted to the amount invested. A limited liability partnership (LLP) restricts partners’ liabilities to their own acts and the acts of individuals under their control. A limited liability company (LLC) offers the limited liability of a corporation and the tax treatment of a partnership (and proprietorship). Most proprietorships and partnerships are now organized as LLCs.
A corporation is a business legally separate from its owners, meaning it is responsible for its own acts and its own debts. Separate legal status means that a corporation can conduct business with the rights, duties, and responsibilities of a person. A corporation acts through its managers, who are its legal agents. A corporation is owned by individuals who normally are not active in the day-to-day operations of that business. For example, you may become an owner of IBM by purchasing shares of stock on the New York Stock Exchange. While you are a part owner, you do not necessarily work for IBM nor are active in the operations of the company.

16. Characteristics of Businesses*
Here is a key summary of some of the various aspects of our three general type of businesses. Notice that a corporation is a separate legal entity. That means it can sue and be sued in court. If you wish to sue a partnership, you must sue all the individual partners. You should also be aware that a corporation is a separate taxable entity. The income or loss from proprietorships and partnerships are taxed as income or loss to the individuals involved. A corporation has a special tax return and tax schedule. A proprietorship or partnership may be set up as a limited liability corporation, or LLC. This form of business helps protect the assets of individual owners of the business entity.
* Proprietorships and partnerships that are set up as LLCs provide limited liability.

17. Corporation
C 4
Owners of a corporation are called shareholders (or stockholders). Shareholders are not personally liable for corporate acts. When a corporation issues only one class of stock, we call it common stock (or capital stock).
Corporate owners are referred to as stockholders or shareholders because they own shares of owner capital. An owner capital certificate serves as an ownership document for a corporation. Sometimes we refer to owner capital as capital stock. The two terms may be used interchangeably.

18. Sarbanes-Oxley (SOX)
C 4
Congress passed the Sarbanes-Oxley Act to help curb financial abuses at companies that issue their stock to the public. Management must issue a report stating that its internal controls are effective. Auditors must verify the effectiveness of internal controls.
Congress passed the Sarbanes-Oxley Act to help curb financial abuses at companies that issue their stock to the public. Management must issue a report stating that its internal controls are effective. Auditors must verify the effectiveness of internal controls. Here is a list of companies and the alleged accounting abuses. Many of these company actions lead directly to the passing of the Sarbanes-Oxley Act.

19. Transaction Analysis and the Accounting Equation
Assets =
Liabilities +
Equity
The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because in a general way it states that assets must be equal to the claims against those assets. If you have an asset we can have two broad categories of claims against that asset. First, we may have claims by creditors (liabilities). Finally, after all creditor claims are satisfied, the residual owners, the stockholders, have a claim on those assets.

20. Resources owned or controlled by a company
Assets
A 1
Cash
Accounts Receivable
Notes Receivable
Resources owned or controlled by a company
Vehicles
Land
Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are Web servers for an online services company, musical instruments for a rock band, and land for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of resources. A company that provides a service or product on credit is said to have an account receivable from that customer.
Buildings
Store Supplies
Equipment

21. Creditors’ claims on assets
Liabilities
A 1
Accounts Payable
Notes Payable
Creditors’ claims on assets
Liabilities are creditors’ claims on assets. These claims reflect company obligations to provide assets, products or services to others. The term payable refers to a liability that promises a future outflow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes payable to banks, and taxes payable to the government.
Wages Payable
Taxes Payable

22. Owner’s Claims on Assets
Equity
A 1
Owner’s Claims on Assets
Equity is the owner’s claim on assets. Equity is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity. Net income occurs when revenues exceed expenses. Net income increases equity. A net loss occurs when expenses exceed revenues, which decreases equity.

23. Transaction Analysis Equation
P 1
The accounting equation MUST remain in balance after each transaction.
Liabilities
Equity
Assets = +
During the process of recording business transactions, it is important that we always keep the accounting equation in balance. We can’t let our books get out of balance. You have probably heard this saying before, but may not have been sure what we meant by keeping the books in balance.

24. Transaction 1: Investment by Owners
P 1
On December 1, Chas Taylor invests $30,000 cash to start a consulting business.
The accounts involved are:
(1) Cash (asset)
(2) Owner Capital (equity)
Let’s look at the identification and recording of business transactions. We can begin by analyzing a transaction where Chas Taylor contributes $30,000 cash to get the business started. First, we have to identify the assets, liability or equity accounts involved in this transaction. We can see that the cash account will increase by $30,000 and the owner capital will increase by $30,000.
You can see what the books of Chas Taylor’s business look like after we analyze this transaction. The accounting equation is in balance because assets are equal to liabilities plus equity.

25. Transaction 2: Purchase Supplies for Cash
Chas Taylor’s company, FastForward purchases supplies paying $2,500 cash.
The accounts involved are:
(1) Cash (asset)
(2) Supplies (asset)
In this transaction, the company purchases general office supplies by paying $2,500 cash. The asset account, cash, will decrease by the $2,500 paid. The asset account, supplies, will increase by $2,500, the cost of the supplies. In this transaction, we are giving up one asset, cash, and receiving another asset, supplies.
We can see the decrease in cash and the increase in supplies. The total assets are still equal to $30,000 but are divided between cash and supplies. There is no change on the liabilities plus equity section of our books, and they are still in balance.

26. Transaction 3: Purchase Equipment for Cash
FastForward purchases equipment for $26,000 cash.
The accounts involved are:
(1) Cash (asset)
(2) Equipment (asset)
This transaction is similar to the last one we recorded. Here we purchase equipment by paying $26,000 cash. The asset account, cash, will decrease by $26,000. The asset account, equipment, will increase by $26,000. Once again, we are exchanging one asset for another.
Cash is reduced by $26,000 and equipment is increased by $26,000. The balance in our cash account is now $1,500. We have a current balance in supplies of $2,500, and equipment of $26,000. The three asset accounts total $30,000. Once again, there has been no change in the liabilities plus equity side of the equation.

27. Transaction 4: Purchase Supplies on Credit
FastForward purchases Supplies of $7,100 on account.
The accounts involved are:
(1) Supplies (asset)
(2) Accounts Payable (liability)
In this transaction, the company purchases supplies of $7,100 on account. The company has only $1,500 cash available for expenses. We do not pay cash, but agree to pay off the account at some point in the future. The asset account, supplies, increases by $7,100 and the liability account, accounts payable, increases by $7,100.
You can see the balance in the cash, supplies and equipment accounts. The total on the asset side of the equation is $37,100. We acquired the assets without paying cash. If you use a credit card to purchase gas for your car, you receive an asset, gas, and incur an account payable to the credit card company. The balance in the liabilities account is now $7,100, and the owner capital account balance is still $30,000.

28. Transaction 5: Provide Services for Cash
The company provides consulting services receiving $4,200 cash.
The accounts involved are:
(1) Cash (asset)
(2) Revenues (equity)
The company rendered consulting services to a customer receiving $4,200 cash in full payment. The asset account, cash, will increase by $4,200. The equity account, revenues, will also increase by the same amount. Let’s look at our expanded book balances.
You see that our cash account increases by $4,200, to a current balance of $5,700. Total assets amount to $41,300. The revenue account also increased by $4,200. Recall that from our expanded accounting equation that revenues increase equity and expenses decrease equity. The total of our liabilities plus equity is now $41,300.

29. Transaction 6 and 7: Payment of Expenses in Cash
The company pays $1,000 rent and $700 in salary to the company’s only employee.
The accounts involved are:
(1) Cash (asset)
(2) Expenses (equity)
FastForward pays $1,000 rent to the landlord of the building where its facilities are located. Paying this amount allows FastForward to occupy the space for the month of December. FastForward also pays the biweekly $700 salary of the company’s only employee. The cash account decreases and the expense accounts increase. When expense accounts increase, equity accounts decrease.
The two expenses, rent and salaries, reduced equity as expenses are recorded. The accounting equation is in balance because the total assets of $39,600 are equal to the total liabilities plus equity of the same amount.

30. Summary of Transactions
P 1
Other transactions were executed during December and the summary of all transactions is shown below:
We have now completed transactions 1 through 7. However, your text includes a total of eleven transactions. Take a few minutes to review the transactions from eight through eleven and come back to look at the summary in detail. This is a summary of all eleven transaction entered into by FastForward during the month of December. Why don’t you add all the assets and get a total. Compare the total assets to the total of liabilities and equity. The books are still in balance after analyzing the eleven transactions.

31. Financial Statements Income Statement Statement of Owner’s Equity
P 2
Let’s prepare the financial statements reflecting the transactions we have recorded.
Income Statement
Statement of Owner’s Equity
Balance Sheet
Statement of Cash Flows
There are four fundamental financial statements used in accounting.
1. Income statement—describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.
2. Statement of owner’s equity—explains changes in equity from net income (or loss) and from any owner investments and withdrawals over a period of time.
3. Balance sheet—describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.
4. Statement of cash flows—identifies cash inflows (receipts) and cash outflows (payments) over a period of time.
The first financial statement that we prepare is the income statement. Let’s get started.

32. Income Statement
P 2
Net income is defined as the difference between revenues and expenses. If expenses exceed revenues, we have a net loss rather than net income. Financial statements have a three line title with the company name, the name of the statement, and the period covered by the report. In our case, we had total revenues of $6,100 and total expenses of $1,700, so net income for the month ended December 31, 2011, was $4,400. After completing the income statement, we can prepare the statement of owner's equity.
The income statement describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.

33. STATEMENT OF OWNER’S EQUITY
P 2
In the statement of owner's equity, we start with the balance at the beginning of the period, add new owner investments and net income earned during the period, and deduct any withdrawals paid, resulting in the ending balance in owner's equity.
FastForward was started this month, so the beginning balance in owner's equity was zero. Chas Taylor invested $30,000 in the company at the beginning of the month. During December, net income of $4,400 was earned. Notice that the net income flows from the income statement to the statement of owner’s equity. We must complete the income statement before we can begin work on the statement of owner’s equity. In addition, $200 withdrawal was made by Chas Taylor, so the ending balance in owner's equity is $34,200. After we complete this statement, we can prepare the balance sheet.

34. Balance Sheet
P 2
The Balance Sheet describes a company’s financial position at a point in time.
The balance sheet is an summary of assets, liabilities and equity at the end of the month. Our total assets are equal to $40,400. This includes cash of $4,800, supplies of $9,600, and equipment of $26,000.
Liabilities include accounts payable of $6,200. Equity is composed of C. Taylor, Capital of $34,200. The account C.Taylor, Capital flows directly from the statement of owner’s equity. You can see that the books are in balance because total assets are equal to total liabilities plus equity.
Creditors have claims against our assets of $6,200. The owner has claims to assets of $34,200.

35. Statement of Cash Flows
P 2
We will cover the statement of cash flows in detail in a later chapter. Notice that the statement is divided into three major sections: (1) cash flows from operating activities; (2) cash flows from investing activities; and (3) cash flows from financing activities. The statement reconciles to the ending cash balance of $4,800. Recall that the ending cash balance of $4,800 flows from the balance sheet to the statement of cash flows.

36. Decision Analysis
A 2
Return on assets (ROA) is stated in ratio form as income divided by assets invested.
Net income
Average total assets
Return on assets =
Return on assets (ROA) is stated in ratio form as income divided by assets invested. Risk is the uncertainty about the return we will earn. The lower the risk of our investment, the lower is our expected return. Here is a table to illustrate showing the return on assets for Best Buy from 2005 through 2009, as well as the return on assets for the entire industry.

37. 1A Return and Risk Analysis
Many different returns may be reported.
Risk is the uncertainty about the return we will earn.
The lower the risk, the lower our expected return.
ROA
Interest return on savings accounts.
Interest return on corporate bonds.
Net income is often linked to return. Return on assets (ROA) is stated in ratio form as income divided by assets invested. For example, banks report return from a savings account in the form of an interest return such as 4%. If we invest in a savings account or in U.S. Treasury bills, we expect a return of around 2% to 7%. How do we decide among these investment options? The answer depends on our trade-off between return and risk.
All business investments involve risk, but some investments involve more risk than others. The lower the risk of an investment, the lower is our expected return. The bar graph shows recent returns for 10-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds provide a low expected return, but they also offer low risk since they are backed by the U.S. government. High-risk corporate bonds offer a much larger potential return but with much higher risk.

38. 1B - Business Activities and the Accounting Equation
There are three major types of activities in any organization:
Financing Activities – Provide the means organizations use to pay for resources such as land, buildings, and equipment to carry out plans.
Investing Activities - Are the acquiring and disposing of resources (assets) that an organization uses to acquire and sell its products or services.
Operating Activities – Involve using resources to research, develop, and purchase, produce, distribute, and market products and services.
There are three major types of activities in any organization:
Financing Activities – Provide the means organizations use to pay for resources such as land, buildings, and equipment to carry out plans.
Investing Activities - Are the acquiring and disposing of resources (assets) that an organization uses to acquire and sell its products or services.
Operating Activities – Involve using resources to research, develop, and purchase, produce, distribute, and market products and services.

39. END OF CHAPTER 01
End of Chapter 1.