CHAPTER 1
ACCOUNTING IN BUSINESS
Related Assignment Materials
Student Learning Objectives Questions
Quick
Studies* Exercises* Problems*
Beyond the
Numbers
Conceptual objectives
C1. Explain the purpose and
importance of accounting
1, 5, 1-1 1-1, 1-4, 1-6 1-6
C2. Identify users and uses of, and
opportunities in accounting.
2, 3, 4, 6, 7,
8, 9, 10, 11,
12, 23
1-2 1-2, 1-3, 1-4 1-4, 1-8
C3. Explain why ethics are crucial to
accounting.
11, 12, 14 1-3 1-4, 1-5 1-3
C4. Explain the meaning of generally
accepted accounting principles,
and define and apply several key
accounting principles.
13, 14, 15,
16, 19, 32
1-4, 1-5,
1-6, 1-16,
1-17
1-6, 1-7 1-7, 1-8, 1-9 1-3
C5. B Identify and describe the three
major activities in organizations.
(Appendix 1B)
14, 16, 30,
31
1-21 1-13, 1-14
Analytical objectives:
A1. Define and interpret the
accounting equation and each of
its components.
17, 33, 34 1-7, 1-8,
1-9
1-8, 1-9 1-1, 1-2,
1-8, 1-10
1-1, 1-2,
1-4, 1-7,
1-9
A2. Compute and interpret return on
assets.
28 1-14 1-18 1-10, 1-11 1-1, 1-2,
1-5, 1-9
A3. A Explain the relation between
return and risk. (Appendix 1A)
29 1-12 1-1, 1-2,
1-9
Procedural objectives:
P1. Analyze business transactions
using the accounting equation.
18 1-10, 1-11
1-10, 1-11,
1-12, 1-13
1-1, 1-2, 1-7,
1-8, 1-9
1-7
P2. Identify and prepare basic
financial statements and explain
how they interrelate.
20, 21, 22,
23, 24, 25,
26, 27, 28,
33, 35
1-12, 1-13,
1-14
1-14, 1-15,
1-16, 1-17,
1-18, 1-19,
1-20
1-3, 1-4, 1-5,
1-6, 1-7, 1-8,
1-9
*See additional information on next page that pertains to these quick studies, exercises and problems.
Additional Information on Related Assignment Material
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick Studies, all
Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or
Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be used
in practice, homework, or exam mode.
The Serial Problem for Success Systems starts in this chapter and continues throughout many chapters of
the text. It is most readily solved manually if you use the working papers that accompany text.
Synopsis of Chapter Revisions
Apple: NEW opener with new entrepreneurial assignment
Added titles to revenue and expense entries in columnar layout of transaction
analysis
Streamlined section on Dodd-Frank act
Bulleted presentation for accounting principles
Deleted world map of IFRS coverage
Bulleted layout for ‘fraud triangle’
New discussion on FASB and IASB convergence.
Updated return on assets for Dell
Chapter Outline Notes
I. Importance of Accounting—we live in the information age, where
information, and its reliability, impacts the financial well-being of us
all.
A. Accounting Activities
Accounting is an information and measurement system that
identifies, records and communicates relevant, reliable, and
comparable information about an organizations business activities.
B. Users of Accounting Information
1. External Information Users—those not directly involved with
running the company. Examples: shareholders (investors),
lenders, directors, external auditors, non-executive employees,
labor unions, regulators, voters, legislators, government
officials, customers, suppliers, lawyers, brokers, etc.
a. Financial Accounting—area of accounting aimed at
serving external users by providing them with
general-purpose financial statements.
b. General-Purpose Financial Statements—statements that
have broad range of purposes which external users rely on.
2. Internal Information Users—those directly involved in
managing and operating an organization.
a. Managerial Accounting—area of accounting that serves
the decision-making needs of internal users.
b. Internal Reports—not subject to same rules as external
reports. They are designed with special needs of external
users in mind.
C. Opportunities in Accounting
Four broad areas of opportunities are financial, managerial,
taxation, and accounting related.
1. Private accounting offers the most opportunities.
2. Public accounting offers the next largest number of
opportunities
3. Government (and not-for-profit) agencies, including business
regulation and investigation of law violations also offer
opportunities.
II. Fundamentals of Accounting—accounting is guided by principles,
standards, concepts, and assumptions.
A. Ethics—a key concept. Ethics are beliefs that distinguish right
from wrong.
B. Fraud Triangle—model that asserts three factors must exist for
person to commit fraud: opportunity, pressure, and rationalization.
Chapter Outline Notes
C. Internal Controls—procedures set up to protect company property
and equipment and insure reliable accounting reports, promotes
efficiency, and encourage adherence to company policies.
D. Generally Accepted Accounting Principles (GAAP)—concepts
and rules that govern financial accounting. Purpose of GAAP is to
make information in accounting statements relevant, reliable and
comparable.
1. Setting Accounting Principles
a. In U.S. major rule-setting bodies are the Securities and
Exchange Commission (SEC) and the Financial
Accounting Standards Board (FASB). SEC delegated
authority to set U.S. GAAP to the FASB.
b. The International Accounting Standards Board (IASB)
issues standards (International Financial Reporting
Standards or IFRS) that identify preferred accounting
practices in the global economy. IASB hopes to create
harmony among accounting practices in different
countries.
c. Differences between U.S. GAAP and IFRS are decreasing
as the FASB and IASB pursue convergence.
2. Conceptual Framework and Convergence—The FASB and
IASB are attempting to converge and enhance the conceptual
framework that guides standard setting. Framework consists
of:
a. Objectives—to provide information useful to investors,
creditors, and others.
b. Qualitative Characteristics—to require information that is
relevant, reliable and comparable.
c. Elements—to define items that financial statements can
contain.
d. Recognition and Measurement—to set criteria that an item
must meet for it to be recognized as an element; and how
to measure that element.
3. Principles and Assumptions of Accounting—two types are
general principles (basic assumptions, concepts and guidelines
for preparing financial statements; stem from long used
accounting practices) and specific principles (detailed rules
used in reporting transactions; from rulings of authoritative
bodies). The four principles discussed in this chapter are:
Chapter Outline Notes
a. Measurement principle also called the cost principle—
financial statements are based on actual costs (with a
potential for subsequent adjustments to market) incurred
in business transactions. Cost is measured on a cash or
equal-to-cash basis. This principle emphasizes reliability
and verifiability; information based on cost is considered
objective. Objectivity means information is supported by
independent unbiased evidence: more than someone’s
opinion.
b. Revenue recognition principle—revenue is recognized
(recorded) when earned. Proceeds need not be in cash.
Revenue is measured by cash received plus the cash value
of other items received.
c. Expense recognition principle, also called matching
principle—prescribes that a company records expenses
incurred to generate revenues it reported.
d. Full disclosure principle—prescribes reporting the details
behind the financial statements that would impacts users’
decisions; often in footnotes to the statements.
The four assumptions discussed in this chapter are:
a. Going-concern assumption—accounting information
reflects the assumption that the business will continue
operating instead of being closed or sold.
b. Monetary unit assumption—transactions and events are
expressed in monetary, or money, units. Generally this is
the currency of the country in which it operates but today
some companies express reports in more than one
monetary unit.
c. Time period assumption—the life of the company can be
divided into time periods, such as months and years, and
that useful reports can be prepared for those periods.
d. Business entity assumption—a business is accounted for
separate from other business entities and separate from its
owner. Necessary for good decisions
4. Business Entity Legal Forms
a. Sole proprietorship is a business owned by one person that
has unlimited liability. It is a separate entity for accounting
purposes. The business is not subject to an income tax but
the owner is responsible for personal income tax on the
net income of entity.
b. Partnership is a business owned by two or more people,
called partners, who are subject to unlimited liability. The
business is not subject to an income tax, but the owners
are responsible for personal income tax on their individual
share of the net income of entity.
Chapter Outline Notes
c. Three special partnership forms that limit liability
i. Limited partnership (LP)—has a general partner(s) with
unlimited liability and a limited partner(s) with limited
liability restricted to the amount invested.
ii. Limited liability partnership (LLP)—restricts partner’s
liabilities to their own acts and the acts of individuals
under their control.
iii.Limited liability company (LLC)—offers the limited
liability of a corporation and the tax treatment of a
partnership.(Note: most proprietorships and
partnerships are now organized as LLC)
d. Corporation is a business that is a separate legal entity
whose owners are called shareholders or stockholders.
These owners have limited liability. The entity is
responsible for a business income tax and the owners are
responsible for personal income tax on profits that are
distributed to them in the form of dividends.
5. Accounting Constraints There are two basic constraints on
financial reporting.
a. The materiality constraint prescribes that only information
that would influence the decisions of a reasonable person
need be disclosed. It looks at both the importance and
relative size of an amount.
b. The cost-benefit constraint prescribes that only
information with benefits of disclosure greater than the
costs of providing it need be disclosed.
c. Conservatism and industry practices are sometimes
referred to as constraints as well.
6. Sarbanes-Oxley (SOX)—Law passed by congress that
requires public companies to apply both accounting oversight
and stringent internal controls to achieve more transparency,
accountability and truthfulness in reporting.
7. Dodd-Frank (Wall Street Reform and Consumer Protection
Act)—Law recently passed as a response to financial systems
near collapse. Details of the law are yet to be set forth by
regulators.
III. Transactions Analysis and the Accounting Equation
A. Accounting equation (Assets = Liabilities + Equity)—elements of
the equation include:
1. Assets—resources a company owns or controls that are
expected to carry future benefits. (i.e. cash, supplies,
equipment and land)
2. Liabilities—creditors’ claims on assets. These claims reflect
obligations to transfer assets or provide products or services to
others.
Chapter Outline Notes
3. Equity—owner’s claim on assets; assets minus liabilities. Also
called net assets or residual equity. Changes in Equity—result
from investments, revenues, withdrawals, expenses.
a. Investments—assets an owner puts into the company results in
an increase in equity. Recorded under the title Owner, Capital.
b. Revenues—are sales of products or services to customers.
Revenues increase equity (via net income) and result from a
company’s earnings activities.
c. Owner’s withdrawals—assets an owner takes from the
company for personal use (results in decrease in equity).
d. Expenses—cost of assets or services used to earn revenues
(results in decrease in equity).
B. Expanded Accounting Equation:
Assets = Liabilities + Owner’s Capital – Owner’s Withdrawal +
Revenues – Expenses
C. Transaction Analysis—each transaction and event always leaves
the equation in balance. (Assets = Liabilities + Equity)
1. Investment by owner:
ASSET = LIABILITIES + OWNERS’ EQUITY
+ Cash + Owner Name, Capital
reason: investment
Increase on both sides of equation– keeps equation in balance.
2. Purchase supplies for cash:
ASSET = LIABILITIES + OWNERS’ EQUITY
+ Supplies
– Cash
Increase and decrease on one side of the equation keeps the
equation in balance.
3. Purchase equipment for cash:
ASSET = LIABILITIES + OWNERS’ EQUITY
+ Equipment
– Cash
Increase and decrease on one side of the equation keeps the
equation in balance.
4. Purchase supplies on credit:
ASSET = LIABILITIES + OWNERS’ EQUITY
+ Supplies + Accounts Payable
Increase on both sides of equation keeps equation in balance.
Chapter Outline Notes
5. Provide services for cash:
ASSET = LIABILITIES + OWNERS’ EQUITY
+ Cash + Revenue Earned
Increase on both sides of equation keeps equation in balance.
6. Payment of expense in cash (salaries, rent etc.):
ASSET = LIABILITIES + OWNERS’ EQUITY
– Cash – (+ Expense)
Decrease on both sides of equation keeps equation in balance.
7. Provided services and facilities for credit:
ASSET = LIABILITIES + OWNERS’ EQUITY
+ Acct. Rec. + Revenue Earned
Increase on both sides of equation keeps equation in balance.
8. Receipt of cash from account receivable (customers paying on
their accounts):
ASSET = LIABILITIES + OWNERS’ EQUITY
+ Cash
– Acct. Rec
Increase and decrease on one side of the equation keeps the
equation in balance.
9. Payment of accounts payable:
ASSET = LIABILITIES + OWNERS’ EQUITY
– Cash – Accounts Payable
Decrease on both sides of equation keeps equation in balance.
10. Withdrawal of cash by owner:
ASSET = LIABILITIES + OWNERS’ EQUITY
– Cash – (+ Owner Name, Withdrawal)
Decrease on both sides of equation keeps equation in balance.
(note: since withdrawals are not expenses they are not used in
computing net income.)
Chapter Outline Notes
IV. Financial Statements
A. The four financial statements and their purposes are:
1. Income Statement—describes a company’s revenues and
expenses along with the resulting net income or loss over a
period of time. (Net income occurs when revenues exceed
expenses. Net loss occurs when expenses exceed revenues.)
2. Statement of Owner’s Equity—explains changes in equity
from net income (or loss) and from owner investment 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.
B. Statement Preparation from Transaction Analysis—prepared in the
following order using the procedure indicated below.
1. Income Statementinformation about revenues and expenses
is conveniently taken from the owner’s equity column. Total
revenues minus total expenses equals net income or loss.
Notice that owner’s withdrawals and investments are not part
of measuring income or loss.
2. Statement of Changes in Owner’s Equitythe beginning
owner’ equity is taken from the owner’s equity column and
any investments of owner are added. The net income, from the
income statement is added (or the net loss is subtracted) and
finally the owner’s withdrawals are subtracted to arrive at the
ending capital. Ending capital is carried to the Balance Sheet.
3. Balance Sheetthe ending balance of each asset is listed and the
total of this listing equals total assets. The ending balance of
each liability is listed and the total of this listing equals total
liabilities. The ending capital (note that this is taken from the
statement of owner’s equity), is listed and added to total
liabilities to get total liabilities and owner’s equity. This total
must agree with total assets to prove the accounting equation.
Either the account form or the report form may be used to
prepare the balance sheet.
4. Statement of Cash Flowsthe cash column must be carefully
analyzed to organize and report cash flows in categories of
operating, investing, and financing. The net change in cash is
determined by combining the net cash flow in each of the three
categories. This change is combined with the beginning cash.
The resulting figure should be the ending cash that was shown
on the balance sheet.
Chapter Outline Notes
V. Global View—Financial Accounting using U.S. GAAP is similar, but
not identical to IFRS. Similarities and differences:
A. Basic Principles—both GAAP and IFRS include broad and similar
guidance for accounting.
B. Transaction Analysis—identical as shown in this chapter. Later,
some differences will arise. GAAP is rules-based whereas IFRS is
more principles-based.
C. Financial Statements—both systems require preparation of the same
four basic financial statements
VI. Decision Analysis—Return on Assets (ROA)—a profitability measure.
Also called Return on Investment (ROI)
A. Useful in evaluating management, analyzing and forecasting profits,
and planning activities.
B. The return on assets is: calculated by dividing net income for a
period by average total assets. (Average total assets is determined by
adding the beginning and ending assets and dividing by 2.)
C. As with all analysis tools, results should be compared to previous
business results as well as competitor’s results and industry norms.
VII. Risk and Return Analysis—Appendix 1A
A. Risk—the uncertainty about the return we will earn on an
investment.
B. The lower the risk, the lower the return.
C. Higher risk implies higher, but riskier implied returns.
VIII. Business Activities and the Accounting Equation—Appendix 1B
A. The accounting equation is derived from business activities.
B. Three major business activities are:
1. Financing activities—activities that provide the means
organizations use to pay for resources such as land, buildings, and
equipment to carry out plans. Two types of financing are:
a. Owner financing—refers to resources contributed by owner
including income left in the organization.
b. Non-owner (or creditor) financing—refers to resources
contributed by creditors (lenders).
2. Investing activities—are the acquiring and disposing of resources
(assets) that an organization uses to acquire and sell its products
or services.
3. Operating activities—involve using resources to research,
develop, purchase, produce, distribute, and market products and
services.
C Investing (assets) is balanced by Financing (liabilities and equity).
Operating activities is the result of investing and financing.
VISUAL #1-1
WARNING: NO MATTER WHAT HAPPENS
ALWAYS KEEP THIS SCALE
IN BALANCE
ASSETS L + OE
Basic Accounting Equation
ASSETS = LIABILITIES + OWNER’S EQUITY
TRANSACTION ANALYSIS RULES
1) Every transaction affects at least two items.
2) Every transaction must result in a balanced equation.
TRANSACTION ANALYSIS POSSIBILITIES:
A = L + OE
(1) + and +
OR(2) – and –
OR(3) + and – and No change
OR(4) No change and + and –