111 Chapter 01 Handout 22e

ACC 111CHAPTER 1 HANDOUT

INTRODUCTION TO ACCOUNTING AND BUSINESS

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39

STUDYING SUGGESTIONS

Always READ the chapter! No exceptions. Be sure to review the At a Glance on page 224 and 25, which relates to key points of the chapter to the key learning outcomes to specific examples and exercises. Review the list of key terms and go back to the page reference listed for any that you have difficulty with. Finally, attempt to complete the illustrative problem on page 26 on your own. The solution is provided on in the text on page 75.

Be sure to complete the assigned exercises and problems (by the due date) in ThomsonNOW. Feel free to complete additional exercises and problems if you feel you have not mastered the material.

CHAPTER OVERVIEW

For many of you, Chapter 1 is your first taste of the business or accounting disciplines. The challenge is to have you understand and accept the importance of learning business and accounting concepts. Because this chapter will set the tone for the entire course and your business career, avoid the temptation to rush through the material. Budget sufficient time to learn the basics!

Chapter 1 begins with a discussion of the nature of a business and the different types of businesses (service, merchandising, and manufacturing) and types of business organizations (proprietorship, partnership, corporation, and limited liability corporations). Next, the chapter describes different types of business stakeholders, introduces business ethics, and discusses three factors of individual character, firm culture, and laws and enforcement that affect ethics as well as accounting/business fraud.

In addition, Generally Accepted Accounting Principles (GAAP), the business entity concept, and the cost concept are presented. The accounting equation is introduced then the discussion of how business transactions affect accounts in the accounting

Copyright protected, 2007: Janice Stoudemire, CPACertain material used with permission of Thomson/South-Western Publishing

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39 equation begins. The chapter ends with examples of how to prepare all four financial statements using the accounting equation information and with explanations of how the four financial statements are interrelated. Following this, the text explains the accounting equation and begins the discussion of recording business transactions in accounts. Sounds like a lot of fun doesn’t it! Good luck.

CHAPTER OBJECTIVES

After studying the chapter, you should be able to:

1. Describe the nature of a business and the role of ethics and accounting in business.2. Summarize the development of accounting principles and relate them to practice.3. State the accounting equation and define each element of the equation.4. Describe and illustrate how business transactions can be recorded in terms of the

resulting changes in the basic elements of the accounting equation.5. Describe the financial statements of a proprietorship form of business and explain

how the statements interrelate.

Learning Objective 1: Describe the nature of a business and the role of ethics and accounting in business.

NATURE OF BUSINESS AND ACCOUNTING:

KEY TERMS: Accounting Manufacturing BusinessBusiness Merchandising BusinessCapital Market Stakeholders PartnershipCorporation ProfitEthics Product or Service Market Stakeholders Government Stakeholders ProprietorshipInternal Stakeholders StakeholderLimited Liability Corporation Service Business

NATURE OF BUSINESS AND ACCOUNTING:

What is a business? Everyone has heard the term “business’ but what is it?


1. “An organization in which basic resources (inputs), such as materials and labor, are assembled and processed to provide goods or services (out-puts) to customers.”

2. An economic unit that sells goods and/or services to customers in order to provide a return to its owners.

All businesses have similar goals:1. Profitability – Difference between amounts received from customers and amounts

paid in order to provide goods/services.

2. Liquidity – Do you have enough cash on hand to pay your bills?

TYPES OF BUSINESSES: 1. SERVICE COMPANY - performs a service for a fee

2. MERCHANDISING COMPANY - buys goods and resells them to customers

3. MANUFACTURING COMPANY - buys materials, makes a product, and sells the product to customers; We cover in ACC 102

BUSINESS ORGANIZATIONS

PROPRIETORSHIP: ONE owner; Owner usually runs the business;

Legally, the business is the same economic unit as the owner – so the owner gets allprofits/losses and is PERSONALLY liable for all of the debts of the business;

They make up the largest number of businesses, but are typically the smallest in size.

NOTE: In the early chapters of the text, we will be learning about accounting concepts related to service businesses organized as proprietorships- I know you just can’t wait.

PARTNERSHIP: TWO OR MORE owners Partners usually run the business;

Legally, the business is not separate from partners – so the partners share


profits/losses and at least one is PERSONALLY liable for all of the debts of the business.

May be formed with verbal or written agreement;

Partnership is dissolved if partner dies, withdraws, etc.

We cover in ACC 102

CORPORATION: A business incorporated under the laws of a state; A separate legal entity – business

is legally separate from its owners (unlike proprietorships and partnerships);

Issues shares of stock to its owners, who do NOT run the business day-to-day;

Limited liability - stockholders are NOT personally liable for the corporation's debts;

Ownership of the business and management of it are separate - stockholders elect board of directors, and the board then appoints managers to run company;

Make up the smallest number of businesses, but are typically the largest in size;

We cover in ACC 115.

LIMITED LIABILITY CORPORATION (LLC:) Has the characteristics of both a partnership and a corporation! It is set up like a

corporation but is treated for TAX purposes as a partnership. We do not cover in this course!

FUN FACTS: 1. More than 70% of the businesses in the United States are organized as

proprietorships.2. About 10% of businesses are organized as partnerships.3. About 20% of businesses are organized as corporations; however, they generate

over 90% of the total dollars of business receipts.


WHO USES ACCOUNTING INFORMATION?

BUSINESS STAKEHOLDER:

“a person or entity that has an interest in the economic performance of the business”;

Includes owners, managers, employees, customers, creditors, and various government agencies;

Use accounting data to gauge the economic performance of businesses.

FOUR CATEGORIES OF BUSINESS STAKEHOLDERS:

1. Capital market stakeholders: provide major financing (i.e. banks, long-term creditors)

2. Product or service market stakeholders: customers3. Government stakeholders: local, state and federal 4. Internal stakeholders: employees, managers

MANAGEMENT: People responsible for operating the business: Their goals are to ensure that the

business is profitable and liquid! They need accounting information to help them perform the following functions:

1. Finance the business2. Invest the resources of the business3. Produce goods and services4. Market goods and services5. Manage employees6. Provide information to decision makers, both inside and outside the

company


BUSINESS ETHICS

WHAT IS BUSINESS ETHICS? The difference between right and wrong!

Moral principles that guide the conduct of individuals;

Sometimes mangers/ employees can feel pressured into violating ethics!

Normally develop a Conduct of Ethics

Used to help accountants make difficult decisions.

THREE FACTORS THAT INFLUENCE ETHICAL BEHAVIOR:

1. Individual character: Does the person display characteristics of honesty, integrity and fairness when under pressure? Who you “bend” or “break” rules when faced with the threat of losing your job?

2. Firm culture: Does the behavior and attitude of senior mangers of the company set the tone? Set example for others?

3. Laws and enforcement: Is there a lack of laws or enforcement? We have new laws and procedures to help address this.

PROFESSIONAL ETHICS: Accountants have obligation (to their employers and clients, as well as society as a

whole) to uphold the highest ethical standards.

Codes of conduct apply to profession: these codes can be used to help accountants make difficult decisions. Includes integrity, objectivity, independence, due care.

Example of Codes: American Institute of Certified Public Accountants Codes of Professional Conduct

1. Exercise sensitive professional and moral judgment.2. Act in a way that will serve the public interest, honor the public trust,

and demonstrate commitment to professionalism.


3. Perform all professional responsibilities with the highest sense of integrity.4. Maintain objectivity and be free of conflicts of interest.5. Observe the profession's technical and ethical standards and continually

improve competency and quality of services.6. Use ethical standards when determining the scope and nature of services

to be provided.

Institute of Management Accountants Standards of Ethical Conduct1. Maintain an appropriate level of professional competence.2. Refrain from disclosing confidential information.3. Avoid conflicts of interest.4. Communicate information fairly and objectively.

EXAMPLES: For the following situations comment whether the person’s actions were ethical or unethical considering the circumstances. Explain.

1. Lauren Smith is the controller for Sports Central, a chain of sporting goods stores. She has been asked to recommend a site for a new store. Lauren has an uncle who owns a shopping plaza in the area of town where the new store is to be located, so she decides to contact her uncle about leasing space in his plaza. Lauren also contacted several other shopping plazas and malls, but her uncle's store turned out to be the most economical place to lease. Therefore, Lauren recommended locating the new store in her uncle's shopping plaza. In making her recommendation to management, she did not disclose that her uncle owns the shopping plaza.

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39 2. John Jones is the chief accountant for the Southwest district office of Security Life

Insurance Company. While preparing the fourth-quarter sales report, John overheard the company president say that he would close Security's Phoenix office if it did not meet its fourth-quarter sales quota. John's best friend from college works at the Phoenix office. Anxious to find out whether the office was in jeopardy, John immediately finished the Phoenix office's report, only to find that it showed sales 25% below the quota. Later that afternoon, the company president called John for Phoenix's sales results. John told the president that he had not finished preparing the sales report for the Phoenix office. John wanted time to compile data that might convince the president to continue operations in Phoenix, despite lagging sales.

3. Tech-Smart Computer Company recently discovered a defect in the hard disks installed in its model R24 computer. The hard disk head in these units retracts too violently whenever the computers are turned off. As a result, the hard disks are destroyed after the computer is turned on and off approximately 500 times. Tech-Smart has sold 4,000 model R24 computers nationwide.The marketing department at Tech-Smart contacted most of the 4,000 owners of the model R24 computer and discovered that 20% (or 800) use their computers in businesses that operate 24 hours per day. These customers never turn their computers off; therefore, the defect should not damage their hard disk units.Judy Govan, Tech-Smart's controller, has been asked to determine the cost to correct the hard disk problem and recommend a course of action. After studying the marketing department's report, Judy decides to recommend that Tech-Smart replace the hard drives only in the 3,200 units used by customers who actually turn their computers off.

4. Tom Brown, the controller for MicroTech Software Company, is responsible for preparing the company's financial statements. He learns that sales for the first quarter


of the year have dropped so dramatically that the company is in danger of bankruptcy. As a result, he applies for an accounting position with another software company that competes with MicroTech. During his job interview, Tom is asked why he wants to leave MicroTech. He replies truthfully, "The company's sales are down another 10% this quarter. I fear they will go out of business." At that time, MicroTech had not released its sales results to the public.

WHAT IS ACCOUNTING? DEFINITION: “an information system that provides reports to stakeholders about the economic activities and condition of a business.”

Language of business

An information system 1. MEASURES - by recording data about business activities2. PROCESSES - by storing and preparing the data3. COMMUNICATES - through reports called financial statements

WHAT IS THE PURPOSE OF ACCOUNTING? To provide information that can be used in making decisions; Accounting provides a

critical service to society

Goal of accounting = Record + Report + Interpret economic data for use by decision makers

Process: Identify stakeholders, assess their information needs, design accounting system to meet needs, record the economic data, prepare useful reports

Important: different accounting data are needed by different people and organizations. For example, a banker evaluating an application for a short-term loan and a public utility commission considering a rate increase would not consider the same types of accounting information.

EXAMPLE: Provide a reason why the parties listed below would be interested in the economic data in the chart.


Interested In Reason1. Owner Sales

ProfitCash

2. Investors/Stockholders Profit Dividends

3. Bankers Debts

4. IRS Profit

5. Managers ExpensesSales

6. Employees Profit

7. Customers Amount spent on warranty claims

8. Competitors Amount spent on ads

STANDARDIZED ACCOUNTING PROCEDURES: Must realize that there is a need for standardized accounting procedures and for

recording business transactions and rules on how to determine profit if that information is going to be useful to decision makers.

There would be too much diversity in financial reporting that would occur without accounting standards. The following example illustrates this!

EXAMPLE: LEARNING ACTIVITY

Required: Can you compute the profit for the company based on the data given?

CLASSIC UPHOLSTERY SHOPTyler Smith has worked in an upholstery shop for 10 years. Last year, Tyler's wages were $20,000. Lately, Tyler has been unhappy

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39 with the shop's owner. Convinced that he could run an upholstery shop that did better work at a lower cost, Tyler decided to go into business for himself and opened CLASSIC UPHOLSTERY SHOP.

To get the business going, Tyler decided to invest heavily in advertising. He spent $6,000 on advertising aimed at consumers and another $2,000 on advertising aimed at getting work from interior decorators and interior design stores. Tyler also purchased industrial sewing machines costing $4,000 and other tools and equipment costing $3,000. He estimated that the sewing machines can be used for about 5 years, before maintenance costs will be too high and the machines will need to be replaced. The other tools and equipment are not as durable and will have to be replaced in 3 years.

At the end of the first year of business, Tyler had received $80,000 in cash from customers for upholstery work. Tyler was owed another $2,500 from customers who are not required to pay cash, but are billed every 30 days.

A review of Tyler's checkbook shows he paid the following expenses (in addition to those mentioned previously) during the first year of business:

Upholstery fabric $40,000Other supplies 10,000Wages–––part-time assistant 9,500Rent 4,800Insurance (2-year policy) 3,200Utilities 2,500Miscellaneous expenses 1,700

Tyler's utility bill for the last month of the year has not arrived. He estimated that the bill would be approximately $320.

Tyler keeps some stock of upholstery fabric in popular colors on hand for customers who do not want to wait for special-order fabric to arrive. At the end of the year, about $14,000 of the fabric purchased during the year was in his store stock. In addition, $2,300 in supplies had not been used.

HOW MUCH PROFIT DID TYLER MAKE IN HIS FIRST YEAR OF BUSINESS? DO YOU THINK IT WAS A GOOD IDEA TO OPEN THE UPHOLSTERY SHOP, OR WOULD TYLER BE BETTER OFF WITH HIS OLD JOB?

Answer:


THE ACCOUNTING PROFESSION

NEWSFLASH: Accountants do more than just prepare tax forms! There

are the many employment alternatives available in accounting- just look at the advertisements for accounting positions from the newspaper. There is the diversity in the accounting profession and we need to move away from the “bean-counter” image.

In fact there are some nontraditional accounting careers.

Two government organizations who hire accountants to help with investigations of fraud and criminal activities are the FBI and the IRS.

PRIVATE ACCOUNTING: Management accountants: provide accounting services for a single business - their

employer! Goal – to give management the information it needs to make wise decisions; Includes controller (chief accountant), treasurer, internal auditor, financial accountant, cost accountant

Professional Certifications: Certified Management Accountant (CMA) and Certified Internal Auditor (CIA)

PUBLIC ACCOUNTING: Offer professional accounting services to many clients

Certified Public Accountants (CPA): Licensed by the state to protect the public; Requirements include education, exam, experience

Primary Activities are:1. AUDITING - examine client's financial statements to see if they comply with GAAP:

Purpose - to lend credibility to the client's financial statements; Auditor is INDEPENDENT of the client - must have no financial, employment, or other compromising ties to the client


2. TAX SERVICES - planning and preparation3. MANAGEMENT ADVISORY SERVICES - consulting, system design, etc.4. SMALL BUSINESS SERVICES - bookkeeping, advising, etc.

SPECIALIZED ACCOUNTING: Financial Accounting ––– preparing reports that show the profits and financial health of

the company using the rules of accounting, known as generally accepted accounting principles (GAAP)

Auditing ––– evaluating financial records and reports to determine whether they present the results of a company's operations fairly

Management Accounting ––– providing data to management to assist in running day-to-day operations

Cost Accounting ––– tracking costs, particularly those to manufacture a product

Tax Accounting ––– preparing tax returns and helping companies and individuals reduce the amount of taxes paid by carefully planning their business activities

Accounting Systems ––– designing accounting systems that collect accurate data and protect a company's assets (cash, inventory, etc.) from misuse or theft; since most accounting systems today are maintained on a computer, this area requires computer hardware and software knowledge

International Accounting ––– focusing on issues related to international trade; for example, buying or selling goods in a foreign currency

Not-for-Profit Accounting ––– reporting on the operations of nonprofit organizations (such as churches, charities, educational institutions, and governmental agencies)

Social Accounting ––– measuring the social costs and benefits of various actions

Accounting Instruction ––– teaching accounting to students

FINANCIAL ACCOUNTING VERSUS MANAGERIAL ACCOUNTING FINANCIAL – accounting that is primarily for EXTERNAL users (owners, creditors,

employees, government, etc.); Purpose - to provide financial statements (Report sent to external users are called financial statements) and other accounting info to third parties

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39 MANAGERIAL – accounting that is primarily for INTERNAL use by management; To help

them achieve their goals of profitability and liquidity by giving them information about their financing, investing, and operating activities

Learning Objective 2: Summarize the development of accounting principles and relate them to practice.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

KEY TERMS:

Business Entity ConceptObjectivity ConceptCost ConceptUnit of Measure ConceptFinancial Accounting Standards Board (FASB)Generally Accepted Accounting Principles (GAAP)

WHAT ARE GENERALLY ACCEPTED ACCOUNTING PRINCIPLES? Guidelines accountants follow in preparing financial statements.They are not "empirical

truths" or "laws of nature", but they are constantly being changed as better methods are developed or circumstances change

Everyone must follow the same set of rules; otherwise, financial statements would be meaningless because we couldn't compare them!

WHO HAS HAD A PART IN ESTABLISHING GAAP? FINANCIAL ACCOUNTING STANDARDS BOARD (FASB): The primary source of GAAP

since 1973

Issues accounting standards that are to be followed in the recording, reporting and presentation of financial transactions (the “laws, rules, guidelines of accounting”)

OTHERS THAT INFLUENCE GAAP: American Institute Of Certified Public Accountants (AICPA): Professional organization of

CPA's that set financial accounting standards through 1973


Securities And Exchange Commission (SEC): Government agency that has the legal authority to set standards but it has historically let the private sector (through FASB now) set GAAP

Internal Revenue Service (IRS): Sets rules for determining taxable income (but not GAAP!)

Governmental Accounting Standards Board (GASB): Sets standards for governmental accounting

BASIC “CONCEPTS”

WHAT ARE THEY? Four principles that govern how accounting data are accumulated!

1. Business Entity Concept2. Cost Concept3. Objectivity Concept4. Unit of Measure Concept

Remember that accounting data would be inconsistent from company to company if standardized procedures were not followed (as demonstrated in the Classic Upholstery Shop example earlier).

BUSINESS ENTITY CONCEPT: Sometimes called Separate Entity Concept

For accounting purposes, business is separate and distinct from its owners, creditors, and customers. So it keeps a separate set of records, reports, etc. Business keeps its records separate from those of any other business and also separate from its owners’ personal records

If an individual owned a dry cleaner, a video store, and a gas station, how would the owner know the profitability of each? Answer: by keeping separate accounting records.

COST CONCEPT:

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39 For accounting purposes we need a “basis” for valuing and recording transactions

What amount do we use? The “cost” of the item in the transaction, but what is the “cost”? Normally the amount we incur!

OBJECTIVITY CONCEPT : Requires that the accounting records be based on objective evidence; this ensures reliability (You can’t just go make up amounts!!)

UNIT OF MEASURE CONCEPT Sometimes called the Money Measurement Concept

This concept prescribes that all economic data should be recorded in dollars. Why? We measure, record and report transactions in terms of money and in the USA, we measure them in terms of dollars.

EXAMPLES:

1. Sally Vertrees purchased a personal computer for use at home. Sally owns a dental practice. She occasionally uses the computer for a task related to her dental practice; however, the computer is used primarily by Sally's children. Can the computer be recorded as an asset in the accounting records of Sally's dental office? Why or why not?

2. Jason Thompson purchased an office building 10 years ago for $780,000. The building was just appraised at $1.25 million. What value should be used for the building in Jason's accounting records? Support your answer.

Learning objective 3: State the accounting equation and define each element of the equation.


ASSETS, LIABILITIES AND OWNER’S EQUITY

KEY TERMS:

Accounting Equation ExpensesAssets LiabilitiesCapital Owner’s EquityDrawing Revenue Accounts

WHAT ARE THESE FUNNY SOUNDING TERMS? Part of the language of accounting! You need to understand what each term means and be able to identify accounts as assets, liabilities or owner’s equity.

WHAT ARE ASSETS? Resources owned by a business: what are resources? Things of

value! Resources that will benefit us in the future

Examples:1. CASH - coins, currency on hand and in bank2. ACCOUNTS RECEIVABLE (AR) - amounts owed to us by others

who have promised to pay us (but did NOT give us a promissory note)3. A RECEIVABLE to us because we will RECEIVE payment later!

4. NOTES RECEIVABLE (NR) - amounts owed to us by others who HAVE given us a promissory note as a promise to pay us

5. INVENTORY - goods we hold to resell to customers6. PREPAID EXPENSES - goods or services we have paid for in advance but not yet used

up (prepaid insurance, prepaid rent, office supplies, etc.)7. LAND, BUILDING, EQUIPMENT, FURNITURE, etc.

WHAT ARE LIABILITIES? Rights or claims to the resources by CREDITORS; Liabilities

are our DEBTS, the amounts we OWE

Examples:1. ACCOUNTS PAYABLE (AP) - amounts we owe to

others for purchases we made on account (but we have NOT issued a promissory note, we just promised to pay)


2. A PAYABLE to us because we must PAY it later!3. A RECEIVABLE to the lender is a PAYABLE to the borrower!!!4. NOTES PAYABLE (NP) - amounts we owe to others for which we HAVE issued

a promissory note as a promise to pay5. WAGES PAYABLE, TAXES PAYABLE, MORTGAGE PAYABLE, etc.

WHAT IS OWNER'S EQUITY? Rights or claims to the resources by OWNERS; what is left after the assets were used to

pay off all the business's debts. Theoretically, owner’s equity represents how much of business the owner owns outright, meaning how much the owner would get out of the business if it were to go out of business, selling off all assets and paying all debts.

For example: let’s compare it to the "equity" that a homeowner has in his or her home. A homeowner's equity is that portion of his or her home's value that would be received if the home were sold–––it's what would be left after paying off the mortgage. In the same way, the owner's equity in a business is that owner's residual interest–––what would be left if the assets were used to pay off all the business's debts.

Owner contributions make owner’s equity go UP and owner withdrawals make it go DOWN!

Examples: Good news, there is only ONE type of Owner’s Equity account! It is called Capital. We normally write the “Name of the owner, Capital”.

ACCOUNTING EQUATION

Note: This equation is very important! It is the foundation of ALL accounting. Be sure you have a solid understanding of the equation!!

WHAT IS IT? Special Relationship: There is a special relationship

between Assets, Liabilities and Owner’s Equity.

This relationship is true for ALL businesses!

Foundation of accounting transactions!

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39 The Cost of Items Used in Where the Funds Came From, Either to Running a Business = Buy Those Items or from Creditors or Owner

ACCOUNTING EQUATION: Also called the Balance Sheet equation- MEMORIZE THIS!!!

ASSETS = LIABILITIES + OWNER'S EQUITY

Note: You can “rewrite” this equation many ways, but it will also be balanced; For example:

1. Assets – Liabilities = Owner’s Equity2. Assets- Owner’s Equity = Liabilities

WHAT DOES THIS REALLY MEAN? What you OWN minus what you OWE equal what you are WORTH! Assets always

EQUAL the claims to creditors and the owners. After all, who is entitled to the assets of a business?

1. First the people you OWE 2. Second, the reminder goes to the owner of the business.

EXAMPLE: How does the equation work? Let’s try some examples.

ASSETS = LIABILITIES + OWNER'S EQUITY

1. A business buys a $20,000 delivery van by using $5,000 of the owner's money as a down payment and financing the rest.

2. If you have Assets of $20,000 and Liabilities of $3,000, what is the Owner’s Equity?


3. If you have Liabilities of $16,000 and Owner’s Equity of $10,000, what do the Assets equal?

4. If you have Owner’s Equity of $5,000 and Assets of $12,000, what do the Liabilities equal?

5. If Assets increase $7,000 and Liabilities decreased $5,000, what was the change on Owner’s Equity?

Learning objective 4: Describe and illustrate how business transactions can be recorded in terms of the resulting changes in the basic elements of the accounting equation.

BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION

KEY TERMS:

Account Payable Prepaid ExpensesAccount Receivable RevenueBusiness Transaction SuppliesExpenses


WHAT DO WE MEASURE? BUSINESS TRANSACTIONS – “Economic events or condition

that directly changes the entity's financial position or directly affects its results of operations."

Record business transactions within the framework of the accounting equation. This means that AFTER recording every transaction, Assets must equal Liabilities plus Owner’s Equity. NO EXCEPTIONS!

EVENTS/CONDITIONS RECORDED IN ACCOUNTING RECORDS 1. Receipt of cash 2. Payment of cash3. Events that create a legal obligation to pay out cash (or other assets) in the future4. Events that obligate another party to pay you cash (or other assets) in the future5. Sale of a product or completion of a service for a customer––this is known as earning revenue6. The use of products or services in running your business––this is known as

incurring an expense.

NEED TO LEARN A NEW LANGUAGE: THE LANGUAGE OF BUSINESS: Before we can start recording business transactions, we need to discuss some additional terms.

REVENUES: What we earn by selling a product or performing a service! The price charged for the

sale of goods or services.

Sometimes we are paid in cash, and other times people promise to pay us later (called Accounts Receivable). Either way, when we "do the work", we have earned the revenue (whether or not we are paid in cash then is irrelevant – we record all revenue when we “do the work”)

Earning revenue makes the business worth MORE!

Other words used for revenue include "income" or "earned". Examples of revenues: Rent Revenue, Fees earned, Interest Income, Services Earned, Advertising Revenue, Advertising Fees earned etc! The type of business you are in will determine the name of your revenue. A company can have revenue from MORE than one source!

Important Note:


Receiving investments from the owner (owner contributions) are NOT revenue; instead they increase the Owner’s Equity.

Borrowing by the business, such as a bank loan, is NOT revenue because we have not done any work!

EXPENSES: Costs we incur to produce revenue; The costs of doing business (i.e., using up

goods and services in the process of producing revenue.)

Sometimes we pay them in cash, and other times we promise to pay them later (called Accounts Payable)

Either way, when we “use up” the goods/services to produce revenue, we have incurred the expense (whether or not we pay it in cash then is irrelevant – we must record all expenses when they are INCURRED).

Incurring expenses makes the business worth LESS. Examples of Expenses: Wage Expense, Supply Expense, Insurance Expense, Advertising Expense, Rent Expense, Tax Expense, Utility Expense, etc.

Important Note: Withdrawals by the owner are NOT expenses (because they do not generate revenue; owner withdrawals decrease the equity (capital account)

DON'T GET CONFUSED IN THESE AREAS!

DON'T GET CONFUSED BETWEEN ASSETS AND EXPENSES.

Assets are items we have NOT yet used up; Assets become expenses to us only when we USE THEM UP!

DON'T GET CONFUSED BETWEEN REVENUES AND ASSETS.We like them both - but they are completely different! Think of REVENUE as the ACTIVITY – a measure of the work we do; It is intangible. Earning revenue typically results in us receiving an

asset -- either Cash or Accounts Receivable.

Think of ASSETS as the BY-PRODUCT (RESULT) of earning revenue; Assets are tangible items (Cash, Accounts Receivable, etc.) that revenue produces But we may also receive an asset WITHOUT earning revenue (i.e., without doing work -- for


example, receiving an investment from the owner or borrowing money increases our assets without us having “done any work”)

DON'T GET CONFUSED BETWEEN EXPENSES AND LIABILITIES.

We don't like either one - but they are completely different! Think of expenses as the COSTS OF THE ACTIVITIES UNDERTAKEN to generate revenue; They are intangible.

Sometimes we pay expenses in cash immediately as they are incurred; only if we do NOT pay them immediately do they become a LIABILITY (unpaid debt) to us.

Think of liabilities as the BY-PRODUCT (RESULT) of incurring expenses if we do not pay them immediately! Liabilities are tangible items (Accounts Payable, Notes Payable, etc.) that expenses produce - they go on the Balance Sheet. But we may also incur a liability WITHOUT having an expense (for example, borrowing money increases our liabilities but also increases our assets)

ANALYZING BUSINESS TRANSACTIONS USING THE ACCOUNTING EQUATION

ACCOUNTING EQUATION (BALANCE SHEET EQUATION) REMEMBER: ASSETS = LIABILITIES + OWNER'S EQUITY

All transactions can be recorded so that they fit into this equation!! It must be balanced after each transaction.

Ask this question - "What do I have MORE of?" or "What do I have LESS of?"

The accounting equation must always stay in balance. Transactions may require additions to both sides, subtractions from either sides, or an addition and subtraction on the same side, but the equation must always balance.

Revenue represents the receipt of assets for goods sold or services rendered. Revenues are recognized when services are rendered, not when the cash is received.

The receipt of assets from the owner is an investment.

Expenses are costs incurred in generating revenues.

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39 Purchases of assets, payments of liabilities, and owner's withdrawals are not

recorded as expenses.

LET’S PRACTICE: It is important to be able to analyze a transaction and determine the type of accounts that are affected or involved. Once we do that, we can then apply the accounting equation to it. So we will first practice with identifying accounts!

EXAMPLE: For the transactions below for Frank Flintstone Lawn Care Company, determine the accounts affected. Do not worry about increases and decreases or the accounting equation!

1. Frank began a lawn care business in May by depositing $800 in a business bank account.

2. Purchased lawnmowers and other lawn equipment on account, $1,000.

3. Paid cash for supplies, $50.

4. Performed lawn care services for credit customers and billed them $700.

5. Received $700 cash from the customers billed in #4.

6. Paid $1,000 cash for the lawn equipment purchased in #2.

7. Paid for an advertisement in a local newspaper, $150.


8. Performed lawn care services for cash customers and immediately received $420.

9. Paid wages to a part-time assistant, $85.

10. Performed lawn care services for credit customers and billed them $600.

11. Received an invoice from Gas-n-Go for gasoline purchased on account during May, $110. The invoice will not be paid until next month.

12. At the end of May, Frank withdrew $100 from the business for personal use.

EXAMPLE: For the transactions below for Frank’s Lawn Care Company, above, let’s apply increases and decreases and the accounting equation. Use the chart below.

ASSETS = LIABILITIES + OWNER’S EQUITY

TRANSACTION CASH ACCTSREC.

SUPPLIES LAWN EQUIP.

ACCTSPAYABLE

FRANKFLINTSTONECAPITAL

TYPE

Frank Flintstone began a lawn care business in May by depositing $800 in a business bank account.

Purchased lawnmowers and other lawn equipment on account, $1,000.

Paid cash for supplies, $50.

Performed lawn care services for


credit customers and billed them $700.

Received $700 cash from the customers billed.

Paid $1,000 cash for the lawn equipment purchased earlier.

Paid for this week’s advertisement in the newspaper, $150.


SUPPLIES LAWN EQUIP.

ACCTSPAYABLE

FRANKFLINTSTONECAPITAL

TYPE

Performed lawn care services for cash customers and immediately received $420.

Paid wages to a part-time assistant, $85.

Performed lawn care services for credit customers and billed them $600.

Received an invoice from Gas-n-Go for gasoline purchased on account during May, $110. The invoice will not be paid until next month.


Frank withdrew $100 from the business for personal use.

TOTALS

EXAMPLE: We are recording the transactions For Bugs Bunny’s advertising company for the month of August.

ASSETS = LIABILITIES + OWNER’S EQUITY


EQUIP. ACCTSPAYABLE

BUGS BUNNY,CAPITAL

TYPE

Bugs Bunny contributed $9,000cash to start business.Buy camera for $2,000 cash

Create ads for Ralphie, whopays us $600 cashPurchase $3,000 computer,promising to pay laterPay $900 for the monthlyrent on our officeCreate ads for Liz, whopromises to pay us $1,900 soon

Pay $800 salary to our helper,


Arnold

Pay half owed on computer

Receive (but don’t pay) a $300 bill for electricity used this month

Bugs Bunny takes $1,200 from business for personal useTOTALS

Learning Objective 5: Describe the financial statements of a proprietorship form of business and explain how the statements interrelate.

FINANCIAL STATEMENTS

WHAT ARE FINANCIAL STATEMENTS? After we record and summarize the transactions, we need to prepare “reports” They help communicate information, so everyone prepares the reports the same The reports are called Financial Statements

FOUR BASIC FINANCIAL STATEMENTS:

1. INCOME STATEMENT - shows how PROFITABLE a business was during a period of time; it matches the revenue earned against the expenses incurred to determne the profit or loss for the period.

2. STATEMENT OF OWNER'S EQUITY - shows changes in a business' NET WORTH during a period of time

3. BALANCE SHEET - shows the FINANCIAL POSITION of a business at a point in time


4. STATEMENT OF CASH FLOWS – Summary of cash receipts and cash payments; covered in ACC 102

INTERRELATIONSHIPS OF THE FOUR FINANCIAL STATEMENTS:

All four financial statements are interrelated; Each one ties into one of the other statements. For example the Income Statement provides a key figure for the Statement of Owner’s equity, which provides a key figure for the balance Sheet. The Statement of Cash Flow derives its accounts from both the Income Statement and the Balance Sheet!

See example on page 20 in the textbook.

HEADINGS OF ALL FINANCIAL STATEMENTS Need to provide the “who, what, where and when!”

Every statement has the following 3-line heading-No exceptions!1. FIRST LINE - company name2. SECOND LINE - name of the statement (Income Statement, Balance Sheet, etc.)3. THIRD LINE - either a specific date (for the Balance Sheet) or a period of time (for

the Income Statement, Statement of Owner’s Equity, and Statement of Cash Flows)

Examples of specific dates: “December 31, 2007”; “As of July 31, 2008”Examples of periods of time: “For the month ended June 30, 2008”; “For the year Ended December 31, 2007”; “For the Quarter Ended March 31, 2008”

INCOME STATEMENT

WHAT DOES IT TELLS US ABOUT THE BUSINESS? Shows how profitable a business was during a period of time; Also called “Profit

and Loss (P&L) Statement”

Contains only revenues and expense for the business; NO other accounts!!!

The third line of the heading is for a PERIOD of time (month, quarter, year, etc.) For example: For the Month Ended May 31, 2007 or For the Quarter Ended June 30,

2008


INCOME STATEMENT FORMULA (MEMORIZE THIS!!!):

If Revenues > Expenses, then the result is Net Income If Revenues < Expenses, then the result is Net Loss

How do you remember what accounts go on Income Statement?Real EasyRevenues Expenses

INCOME STATEMENT FORMAT (MEMORIZE THIS!!!):

Name of CompanyIncome Statement

For the Year ended 12/31/08REVENUES:

Rent Revenue xxInterest Income xxTotal Revenues xxx

EXPENSES: Wage Expense xxTax Expense xxSupply Expense xxTotal Expenses xxx

NET INCOME xxx

Helpful hints:1. List ALL types of revenues and expense under

each heading. 2. Subtotal revenues and expense; the difference

is Net income (or Net loss if a negative number). If a net loss we do NOT use negative signs-instead you put the amount in brackets.

3. Double line underscore Net Income or Net Loss amount

REVENUES - EXPENSES = NET INCOME ( or LOSS)


STATEMENT OF OWNER’S EQUITY

WHAT DOES IT TELLS US ABOUT THE BUSINESS? Connects the Income Statement and Balance Sheet

It shows the changes that have occurred in capital (the business' net worth) during a period of time

What affects the net worth of a business? Remember “wire”W ithdrawals from the business by the owner make the business

worth less I nvestments (contributions) into the business by the owner make

the business worth moreEarning Revenues make the business worth more Incurring Expenses make the business worth less

HEADING IS FOR A PERIOD OF TIME (month, quarter, year, etc.); It is the SAME period of time that the Income Statement covered!

STATEMENT OF OWNER’S EQUITY FORMULA (MEMORIZE THIS!!!): FORMULA (BINWE) Just use the acronym BINWE to help remember what goes on the

statement!

Beginning Capital + Investments by Owner ± Net Income/Net Loss (+ Net Income OR - Net Loss) - W ithdrawals = Ending Capital

Note: We said above that revenues and expenses both affect the net worth of a business, but these are NOT reported separate on the Statement of Owner’s Equity; instead, the net difference between the two (Net Income/Loss) is reported instead!

STATEMENT OF OWNER’S EQUITY FORMAT (MEMORIZE THIS!!!):


Name of CompanyStatement of Owner’s equityFor the Year ended 12/31/08

Name of Owner, Capital, Beginning of period xxxADD:

Investments by Owner xxNet Income xx

LESS:Net Loss Withdrawals xx

Increase or decrease in owner’s equity xxx Name of Owner, Capital, End of period xxx

Helpful Hints:1. For example, don’t just write “Beginning Capital”, but instead write the

owner’s name, then the word “Capital,”, then the beginning date of the period; Do the same for Ending Capital – but use the ending date for the period instead!

2. You can’t have BOTH net Income and Net Loss; It has to be one or the other! Remember, you use the Net income/Net loss you generated from the Income Statement!

3. If the owner didn’t make any contributions and/or any withdrawals, just leave it off the statement

BALANCE SHEET

WHAT DOES IT TELLS US ABOUT THE BUSINESS? Shows the financial position of a business at a particular point in time

What is “financial position”? The amount of Assets, Liabilities and Owner’s Equity at any given point in time. Remember, these amounts change daily so the statement is always at a point in time and not for a period of time.

Third line of heading is as of a PARTICULAR DATE (not covering period of time); It is the last day of the period covered by the Income Statement

For example: March 31, 2006 or December 31, 2006


CAPITAL - personal resources the owner has invested in the business; Terms "owner's equity" and "capital" used interchangeably

WITHDRAWALS – when the owner takes assets (usually cash) out of the business for personal use; This is NOT an expense and it is NOT shown on Income Statement; Not on Balance Sheet; it goes on Statement of Owner’s Equity

To Summarize The Balance Sheet LEFT side = resources of the business (assets) RIGHT side = who provided these resources: creditors (liabilities) and owners

(capital)

BALANCE SHEET FORMULA (MEMORIZE THIS!!!): The formula is easy; we already learned it! It is the Accounting Equation (remember it

is also called the Balance Sheet equation).

Only Assets, Liabilities and Owner’s Equity account go the Balance Sheet. Since we only have ONE Owner’s Equity account (Capital) you can remember the formula by using these acronyms:

Aliens Live On Earth or Aliens Love Cake Assets Liabilities Owner’s Equity Assets Liabilities Capital

BALANCE SHEET FORMAT (MEMORIZE THIS!!!):

Name of CompanyBalance Sheet

12/31/08

ASSETS: LIABILITIES: Cash Accounts PayableAccounts Receivable Taxes PayableLand Total Liabilities BuildingTotal Assets OWNER’S EQUITY:

Name of Owner, Capital


Total Liabilities and Owner’s Equity

Helpful hints:1. The Capital Account amount is from the Statement of Owner’s Equity

2. Total Assets MUST equal Total Liabilities plus Owner’s Equity (Remember the Accounting Equation)

3. Assets can be listed on the left, with Liabilities and Owner's Equity on right (Know as the “Account form”)OR Assets can be listed on top, with Liabilities and Owner's Equity below (know as the “report form”)

4. If you only have ONE liability, then you do NOT need a line called Total liabilities.

5. The Assets have a special order for listing the accounts; it is know as the order of liquidity- cash first then A/R, Inventory, prepaids, Land, Building , Equipment! We will work on the order more in the next two chapters!

IN WHAT ORDER DO WE PREPARE FINANCIAL STATEMENTS? Because of the interrelationships that exist among the financial statement, we prepare

them in the following order:

INCOME STATEMENT FIRST: Why? We need to know net income/loss to go on the Statement of Owner's Equity

STATEMENT OF OWNER'S EQUITY SECOND: Why? We need to know the ending capital balance to go on the Balance Sheet

BALANCE SHEET is completed last! (Remember we do not cover the Statement of Cash Flows in this course, therefore, the Balance Sheet is the last statement)

TIPS ON PRESENTATION ADDING TWO NUMBERS TOGETHER? Put them in the same

column and draw a single line under the last number

SUBTRACTING ONE NUMBER FROM ANOTHER? Put them in the same column and draw a single line under the last number

HELPFUL TIPS

Accounting 111 – Handout - Chapter 1 Revised Summer 2007 Janice Stoudemire of 39 IS THIS NUMBER THE FINAL TOTAL on the statement (i.e., Net Income, Ending Capital,

Total Assets)? Draw a double line under it to show it has been checked

WHERE DO DOLLAR SIGNS GO? Before the first amount in each column AND before the first amount after each ruled line

DO YOU ONLY HAVE ONE OF AN ITEM (like only one expense)? Don’t have to show a total for it also if there is only one

EXAMPLE - PREPARING FINANCIAL STATEMENTS

Let’s prepare the three financial statements for Bugs Bunny’s business and Frank Flintstone’s business. We will use the data from our earlier summary of transactions.

INCOME STATEMENT



BALANCE SHEET

INCOME STATEMENT



BALANCE SHEET

111 Chapter 01 Handout 22e

Documents

Transcript of 111 Chapter 01 Handout 22e