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CHAPTER1

Accounting in
Action

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PreviewofCHAPTER1

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Business Activities

All businesses are involved in three types of activity —


 financing,
 investing,
 and operating.

The accounting information system keeps track of


the results of each of these business activities.

1-3 SO 3 Explain the three principal types of business activity.


Business Activities

Financing Activities
Two primary sources of outside funds are:
1. Borrowing money
 Amounts owed are called liabilities.
 Party to whom amounts are owed are creditors.
 Notes payable and bonds payable are different
type of liabilities.

2. Issuing shares of stock for cash.


 Payments to stockholders are called dividends.

1-4 SO 3 Explain the three principal types of business activity.


Business Activities

Investing Activities
Purchase of resources a company needs to operate.
 Computers, delivery trucks, furniture, buildings, etc.

 Resources owned by a business are called assets.

1-5 SO 3 Explain the three principal types of business activity.


Business Activities

Operating Activities
Once a business has the assets it needs,
it can begin its operations.
 Revenues - Amounts earned from the sale of products
(sales revenue, service revenue, and interest revenue).

 Inventory - Goods available for sale to customers.

 Accounts receivable - Right to receive money from a


customer,in the future, as the result of a sale.

1-6 SO 3 Explain the three principal types of business activity.


Business Activities

Operating Activities
 Expenses - cost of assets consumed or services used.
(cost of goods sold, selling, marketing, administrative,
interest, and income taxes expense).

 Liabilities arising from expenses include accounts


payable, interest payable, wages payable, sales taxes
payable, and income taxes payable.

 Net income – when revenues exceed expenses.

 Net loss – when expenses exceed revenues.

1-7 SO 3 Explain the three principal types of business activity.


What is Accounting?

Purpose of accounting is to:


1. identify, record, and communicate the economic
events of an
2. organization to
3. interested users.

1-8 SO 1 Explain what accounting is.


What is Accounting?
Illustration 1-1
Three Activities Accounting process

The accounting process includes


the bookkeeping function.

1-9 SO 1 Explain what accounting is.


Who Uses Accounting Data

Internal Users
Management NBR

Human Investors
Resources There are two broad
groups of users of Labor
financial information: Unions
Finance
internal users and
external users.
Creditors
Marketing
SEC
Customers External
Users
1-10 SO 2 Identify the users and uses of accounting.
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
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If employees can read and use financial reports, a company will benefit in the following ways. The marketing department will
make better decisions about products to offer and prices to charge. The finance department will make better decisions about debt
and equity financing and how much to distribute in dividends. The production department will make better decisions about when
to buy new equipment and how much inventory to produce. The human resources department will be better able to determine
whether employees can be given raises. Finally, all employees will be better informed about the basis on which they are
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The 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.

 Recent financial scandals include: Enron, WorldCom,


HealthSouth, AIG, and others.

 Effective financial reporting depends on sound ethical


behavior.

1-13 SO 3 Understand why ethics is a fundamental business concept.


Ethics in Financial Reporting

Question
Ethics are the standards of conduct by which one's
actions are judged as:

a. right or wrong.

b. honest or dishonest.

c. fair or not fair.

d. all of these options.

1-14 SO 3 Understand why ethics is a fundamental business concept.


Accounting provides at least two benefits to not-for-profit
organizations. First, it helps to ensure that money is used in the
way that donors intended. Second, it assures donors that their
money is not going to waste and thus increases the likelihood of
future donations.
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Generally Accepted Accounting Principles

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

The accounting profession


has attempted to develop a
Generally Accepted
set of standards that are
Accounting
generally accepted and Principles (GAAP)
universally practiced.

1-16 SO 4 Explain generally accepted accounting principles.


Generally Accepted Accounting Principles

Generally Accepted Accounting Principles (GAAP) - A set of


rules and practices, having substantial authoritative support, that
the accounting profession recognizes as a general guide for
financial reporting purposes.

Standard-setting bodies determine these guidelines:

► Securities and Exchange Commission (SEC)

► Financial Accounting Standards Board (FASB)

► International Accounting Standards Board (IASB)

1-17 SO 4 Explain generally accepted accounting principles.


Generally Accepted Accounting Principles

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).

1-18 SO 4 Explain generally accepted accounting principles.


Generally Accepted Accounting Principles

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.
Forms of Business
 Partnership.
Ownership
 Corporation.

SO 5 Explain the monetary unit assumption


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and the economic entity assumption.
Forms of Business Ownership

Proprietorship Partnership Corporation

 Generally owned  Owned by two or  Ownership


by one person. more persons. divided into
 Often small shares of stock
 Often retail and
service-type service-type  Separate legal
businesses businesses entity organized
 Owner receives under state
 Generally
any profits, corporation law
unlimited
suffers any personal liability  Limited liability
losses, and is
 Partnership
personally liable
agreement
for all debts.
SO 5 Explain the monetary unit assumption
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and the economic entity assumption.
Generally Accepted Accounting Principles

Question
Combining the activities of Kellogg and General Mills
would violate the

a. cost principle.

b. economic entity assumption.

c. monetary unit assumption.

d. ethics principle.

SO 5 Explain the monetary unit assumption


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and the economic entity assumption.
Generally Accepted Accounting Principles

Question
A business organized as a separate legal entity under state
law having ownership divided into shares of stock is a

a. proprietorship.

b. partnership.

c. corporation.

d. sole proprietorship.

SO 5 Explain the monetary unit assumption


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and the economic entity assumption.
The Basic Accounting Equation

Owner’s
Assets = Liabilities + Equity

Provides the underlying framework for recording and


summarizing economic events.

Assets are claimed by either creditors or owners.

Claims of creditors must be paid before ownership claims.

1-23 SO 6 State the accounting equation, and define its components.


The Basic Accounting Equation

Assets
 Resources a business owns.
 Provide future services or benefits.
 Cash, Supplies, Equipment, etc.

Owner’s
Assets = Liabilities + Equity

1-24 SO 6 State the accounting equation, and define its components.


The Basic Accounting Equation

Liabilities
 Claims against assets (debts and obligations).
 Creditors - party to whom money is owed.
 Accounts payable, Notes payable, etc.

Owner’s
Assets = Liabilities + Equity

1-25 SO 6 State the accounting equation, and define its components.


The Basic Accounting Equation

Owner’s Equity
 Ownership claim on total assets.
 Referred to as residual equity.
 Investment by owners and revenues (+)
 Drawings and expenses (-).

Owner’s
Assets = Liabilities + Equity

1-26 SO 6 State the accounting equation, and define its components.


Owner’s 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.

1-27 SO 6 State the accounting equation, and define its components.


Owner’s 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.

1-28 SO 6 State the accounting equation, and define its components.


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.

1-29 SO 7 Analyze the effects of business transactions on the accounting equation.


Using the Accounting Equation

Illustration: Are the following events recorded in the accounting


records?
Owner
Supplies are An employee withdraws cash
Event purchased on is hired. for personal
account. use.

Criterion Is the financial position (assets, liabilities, or


owner’s equity) of the company changed?

Record/
Don’t Record

1-30 SO 7 Analyze the effects of business transactions on the accounting equation.


Transaction Analysis
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.

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SO 7
Transaction Analysis
Transaction (2): Purchase of Equipment for Cash. Softbyte purchases
computer equipment for $7,000 cash.

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SO 7
Transaction Analysis
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.

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SO 7
Transaction Analysis
Transaction (4): Softbyte receives $1,200 cash from customers for
programming services it has provided.

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SO 7
Transaction Analysis
Transaction (5): Softbyte receives a bill for $250 from the Daily News
for advertising but postpones payment until a later date.

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SO 7
Transaction Analysis
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.

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

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SO 7
Transaction Analysis
Transaction (8): Softbyte pays its $250 Daily News bill in cash.

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SO 7
Transaction Analysis
Transaction (9): Softbyte receives $600 in cash from customers who
had been billed for services [in Transaction (6)].

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SO 7
Transaction Analysis
Transaction (10): Ray Neal withdraws $1,300 in cash from the
business for his personal use. Illustration 1-8
Tabular summary of
Softbyte transactions

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SO 7
Financial Statements

Companies prepare four financial statements :

Owner’s Statement
Income Balance
Equity of Cash
Statement Sheet
Statement Flows

1-41 SO 8 Understand the four financial statements and how they are prepared.
 • To show how successfully your business performed during a
period of time, you report its revenues and expenses in an
income statement.

 • To present a picture at a point in time of what your business


owns (its assets) and what it owes (its liabilities), you prepare a
balance sheet.

 • To indicate how much of previous income was distributed to


you and the other owners of your business in the form of
dividends, and how much was retained in the business to allow
for future growth, you present a retained earnings statement.

 • To show where your business obtained cash during a period


of time and how that cash was used, you present a statement
of cash flows.

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Financial Statements

Question
Net income will result during a time period when:

a. assets exceed liabilities.

b. assets exceed revenues.

c. expenses exceed revenues.

d. revenues exceed expenses.

1-43 SO 8 Understand the four financial statements and how they are prepared.
Net income is needed to determine the
Financial Statements ending balance in owner’s equity.

Illustration 1-9
Financial statements and
their interrelationships

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The ending balance in owner’s equity is
Financial Statements needed in preparing the balance sheet

Illustration 1-9

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The balance sheet and income statement are
Financial Statements needed to prepare statement of cash flows.

Illustration 1-9

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Financial Statements

Statement of Cash Flows


 Information for a specific period of time.

 Answers the following:

1. Where did cash come from?


2. What was cash used for?
3. What was the change in the cash balance?

1-47 SO 8 Understand the four financial statements and how they are prepared.
Financial Statements

Question
Which of the following financial statements is prepared as
of a specific date?

a. Balance sheet.

b. Income statement.

c. Owner's equity statement.

d. Statement of cash flows.

1-48 SO 8 Understand the four financial statements and how they are prepared.
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Exercise

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(a) Creditors lend money to companies with the expectation
that they will be repaid at a specified point in time in the
future. If a company is generating cash from operations in
excess of its investing needs, it is more likely that it will be
able to repay its creditors. Not only did Xerox actually have
negative cash from operations, but all of the cash it received
in order to meet its cash deficiency was from issuing new
debt. Both of these facts would be of concern to the
company’s creditors, since it would suggest it will be less
likely to be able to repay its debts.

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(b) As a stockholder you are interested in the long-term
performance of a company and how that translates into its
stock price. Often during the early years of a company’s life
its cash provided by operations is not sufficient to meet its
investment needs, so the company will have to get cash from
outside sources. However, in the case of Xerox, the company
has operated for many years and has a well established
name brand. The negative cash from operations might
suggest operating deficiencies.

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(c) The statement of cash flows reports information on a cash
basis. An investor cannot get the complete story on the
company’s performance and financial position without
looking at the income statement and balance sheet. Also,
investors would want to look at more than one year’s worth
of data. The current year might not be representative of past
or future years.

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(d)Xerox is a well known company. It has a past record of
paying dividends. Its management probably decided to
continue to pay a dividend to demonstrate confidence in the
company’s future. They may have felt that by not paying the
dividend for the year they would send a negative message to
investors. However, by choosing to pay a cash dividend the
company obviously weakened its cash position, and
decreased its ability to repay its debts.

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Key Points
 International standards are referred to as International Financial
Reporting Standards (IFRS), developed by the International
Accounting Standards Board (IASB).
 Recent events in the global capital markets have underscored the
importance of financial disclosure and transparency not only in
the United States but in markets around the world. As a result,
many are examining which accounting and financial disclosure
rules should be followed. Much of the world has voted for the
standards issued by the IASB. Over 115 countries require or
permit use of IFRS.

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Key Points
 The more substantive definitions, using the IASB definitional
structure, are as follows.
► Assets. A resource controlled by the entity as a result of
past events and from which future economic benefits are
expected to flow to the entity.
► Liabilities. A present obligation of the entity arising from
past events, the settlement of which is expected to result in
an outflow from the entity of resources embodying economic
benefits. Liabilities may be legally enforceable via a contract
or law, but need not be, i.e., they can arise due to normal
business practice or customs.

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Key Points
 The more substantive definitions, using the IASB definitional
structure, are as follows.
► Equity. A residual interest in the assets of the entity after
deducting all its liabilities.
► Income. Increases in economic benefits that result in
increases in equity (other than those related to contributions
from shareholders). Income includes both revenues
(resulting from ordinary activities) and gains.
► Expenses. Decreases in economic benefits that result in
decreases in equity (other than those related to distributions
to shareholders). Expenses includes losses that are not the
result of ordinary activities.
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