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Learning Objective C1

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Learning Objective C1

    CHAPTER 1

    ACCOUNTING IN BUSINESS

    Learning Objective C1:

    Explain the purpose and importance of accounting in the information age.

    Summary

    Accounting is an information and measurement system that aims to identify, record, and communicate

    relevant, reliable, and comparable information about business activities. It helps assess opportunities, products,

    investments, and social and community responsibilities.

    Learning Objective C2:

    Identify users and uses of accounting.

    Summary

    Users of accounting are both internal and external. Some users and uses of accounting include: (a)

    management for controlling, monitoring, and planning; (b) lenders for measuring the risk and return of loans;

    (c) shareholders for assessing the return and risk of stock; (d) directors for overseeing management; and (e)

    employees for judging employment opportunities.

    Learning Objective C3:

    Identify opportunities in accounting and related fields.

    Summary

    Opportunities in accounting include financial, managerial, and tax accounting. They also include accounting-

    related fields such as lending, consulting, managing, and planning.

    Learning Objective C4:

    Explain why ethics are crucial to accounting.

    Summary

    The goal of accounting is to provide useful information for decision making. For information to be useful, it

    must be trusted. This demands ethics behavior in accounting.

    Learning Objective C5:

    Explain generally accepted accounting principles and define and apply several key accounting principles. Summary

    Generally accepted accounting principles are a common set of standards applied by accountants. Accounting

    principles aid in producing relevant, reliable and comparable information. Accounting principles aid in

    producing relevant, reliable, and comparable information. Four principles underlying financial statements

    were introduced: cost, revenue recognition, matching and full disclosure. Financial statements also reflect

    four assumptions: going-concern, monetary unit, time period, and business entity.

     The McGraw-Hill Companies, Inc., 2009

    Study Guide, Chapter 1 1

    B Learning Objective C6(Appendix B):

    Identify and describe the three major activities in organizations.

    Summary

    Organizations carry out three major activities: financing, investing, and operating. Financing is the means

    used to pay for resources such as land, buildings, and machines. Investing refers to the buying and selling of

    resources used in acquiring and selling products and services. Operating activities are those necessary for

    carrying out of the organization’s plans.

    Learning Objective A1:

    Define and interpret the accounting equation and each of its components.

    Summary

    The accounting equation is Assets = Liabilities + Equity. Assets are resources owned by a company.

    Liabilities are creditors’ claims on assets. Equity is the owner’s claim on assets (the residual).The expanded

    accounting equation is Assets = Liabilities + [Owner Capital Owner Withdrawals + Revenues Expenses].

    Learning Objective A2:

    Analyze business transactions using the accounting equation.

    Summary

    A transaction is an exchange of economic consideration between two parties. Examples include products,

    services, money and rights to collect money. Transactions always have at least two effects on one or more

    components of the accounting equation. The equation is always in balance.

    Learning Objective A3:

    Compute and interpret return on assets.

    Summary

    Return on assets, also called return on investment is computed as net income divided by the average assets. For

    example, if we have an average balance of $100 in our savings account and it earns interest of $5 for the year,

    then our return on assets is $5/$100 or 5%.

    A Learning Objective A4(Appendix A):

    Explain the relation between return and risk.

    Summary

    Return refers to income, and risk is the uncertainty about the return we hope to make. All investments involve

    risk. The lower the risk of an investment, the lower is its expected return. Higher risk implies higher, but

    riskier, expected return.

     The McGraw-Hill Companies, Inc., 2009

    2 Fundamental Accounting Principles, 19/e

Learning Objective P1:

    Identify and prepare basic financial statements and explain how they interrelate. Summary

    Four basic financial statements report on an organization’s activities: balance sheet, income statement,

    statement of owner’s equity, and statement of cash flows.

     The McGraw-Hill Companies, Inc., 2009

    Study Guide, Chapter 1 3

    Chapter Outline Notes

     I. Importance of Accountingwe 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 Usersthose not directly involved with

    running the company. Examples: shareholders (investors),

    lenders, customers, suppliers, regulators, lawyers, brokers, the

    press etc.

     a. Financial Accountingarea of accounting aimed at serving

    external users by providing them with general-purpose

    financial statements.

    b. General-Purpose Financial Statementstatements that

    have broad range of purposes which external users rely on.

     2. Internal Information Usersthose directly involved in

    managing and operating an organization.

     a. Managerial Accountingis the area of accounting that

    serves the decision-making needs of internal users.

    b. Internal Reportsnot subject to same rules as external

    reports. They are designed with special needs of external

    users in mind.

     3. Internal Controlsprocedures set up to protect company

    property and equipment, ensure reliable accounting reports,

    promote efficiency, and encourage adherence to company

    policies.

     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 Accountingaccounting is guided by principles,

    standards, concepts, and assumptions.

    A. Ethicsa key concept. Ethics are beliefs that distinguish right

    from wrong.

     The McGraw-Hill Companies, Inc., 2009

    4 Fundamental Accounting Principles, 19/e

    Chapter Outline Notes

    B. 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).

     b. The International Accounting Standards Board (IASB)

    issues standards that identifies preferred accounting

    practices in the global economy and hopes to create

    harmony among accounting practices in different countries.

     2. Principles and Assumptions of Accountingtwo types are

    general (basic assumptions, concepts and guidelines for

    preparing financial statements; stem from long used accounting practices) and specific (detailed rules used in reporting

    transactions; from rulings of authoritative bodies). The four principles discussed in this chapter are:

     a. Cost principlefinancial statements are based on actual

    costs incurred in business transactions. Cost is measured

    on a cash or equal-to-cash basis. This principle emphasizes

    reliability and verifiability, and information based on cost

    considered objective. Objectivity means information is

    supported by unbiased evidence: more than someone's

    opinion.

    b. Revenue recognition principlerevenue 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. Matching principlea company must record expenses

    incurred to generate revenues it reported.

    d. Full disclosure principlerequires reporting the details

    behind the financial statements that would impacts users’

    decisions.

    The four assumptions discussed in this chapter are:

    a. Going-concern assumptionaccounting information

    reflects the assumption that the business will continue

    operating instead of being closed or sold.

    b. Monetary unit assumptiontransactions 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.

     The McGraw-Hill Companies, Inc., 2009

    Study Guide, Chapter 1 5

    Chapter Outline Notes

     c. Time period assumptionthe 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 assumptiona business is accounted for

    separate from other business entities and separate from its

    owner.

     3. Business Entity Forms

     a. Sole proprietorship is a business owned by one person that

    has unlimited liability. 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.

     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.

     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.

    4. 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.

    III. Transactions Analysis and the Accounting Equation

     A. Accounting equation (Assets = Liabilities + Equity)elements of

    the equation include:

     1. Assetsresources owned or controlled by a company that are expected to yield future benefit. (i.e. cash, supplies, equipment

    and land)

    2. Liabilitiescreditors’ claims on assets. These claims reflect obligations to transfer assets or provide products or services to others.

     The McGraw-Hill Companies, Inc., 2009

    6 Fundamental Accounting Principles, 19/e

    Chapter Outline Notes

     3. Equityowner’s claim on assets. Also called net assets or

    residual equity.

     B. Changes in Equityresult from investments, revenues, withdrawals, expenses.

     1. Investmentsassets an owner puts into the company results in

    an increase in equity. Recorded under the title Owner, Capital.

    2. Revenuesgross increases in equity resulting from a

    company’s earning activities.

     3. Owner’s withdrawalsassets an owner takes from the

    company for personal use (results in decrease in equity).

    4. Expensescost of assets or services used to earn revenues

    (results in decrease in equity).

     C. Expanded Accounting Equation:

     Assets = Liabilities + Owner’s Capital Owner’s Withdrawal + Revenues Expenses

     D. Transaction Analysiseach transaction and event always leaves

    the equation in balance. (Assets = Liabilities + Equity)

     1. Investment by owner =

    +Asset (Cash) = + Owner’s Equity (Owner’s Name, Capital)

     reason: investment

    Increase on both sides of equation keeps equation in balance.

    2. Purchase supplies for cash =

    +Asset (Supplies) = Asset (Cash)

    Increase and decrease on one side of the equation keeps the

    equation in balance.

    3. Purchase equipment for cash =

    + Asset (Equipment) = Asset (Cash)

    Increase and decrease on one side of the equation keeps the

    equation in balance.

    4. Purchase supplies on credit =

    + Asset (Supplies) = + Liability (Account Payable)

    Increase on both sides of equation keeps equation in balance.

    5. Provide services for cash =

    + Asset (Cash) = + Owner’s Equity (reason: revenue earned)

    Increase on both sides of equation keeps equation in balance.

    6. Payment of expense in cash (salaries, rent etc.) =

     Asset (Cash) = Owner’s Equity (reason: expense incurred)

    Decrease on both sides of equation keeps equation in balance.

    7. Provided services and facilities for credit =

    + Asset (Accts Receivable) = + O E (reason: revenue earned)

    Increase on both sides of equation keeps equation in balance.

     The McGraw-Hill Companies, Inc., 2009

    Study Guide, Chapter 1 7

    Chapter Outline Notes

     8. Receipt of cash from account receivable =

    + Asset (Cash) = Asset (Accounts Receivable)

    Increase and decrease on one side of the equation keeps the

    equation in balance.

     9. Payment of accounts payable =

    Asset (Cash) = Liability (Accounts Payable)

    Decrease on both sides of equation keeps equation in balance.

     8. Withdrawal of cash by owner =

    Asset (Cash) = Equity (reason: owner’s 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.)

     IV. Financial Statements

     A. The four financial statements and their purposes are:

    1. Income Statementdescribes 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 Equityexplains changes in equity from

    net income (or loss) and from owner investment and

    withdrawals over a period of time.

    3. Balance Sheetdescribes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point

    in time.

    4. Statement of Cash Flowsidentifies cash inflows (receipts)

    and cash outflows (payments) over a period of time.

    B. Statement Preparation from Transaction Analysisprepared in the following order using the procedure indicated below.

    1. Income Statement;information 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 Equity;the 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.

     The McGraw-Hill Companies, Inc., 2009

    8 Fundamental Accounting Principles, 19/e

    Chapter Outline Notes

    3. Balance Sheet;the 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 changes in 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 Flows;the cash column must be carefully analyzed to organize and report cash flows in categories of

    operating, financing, and investing. 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.

    V. Decision AnalysisReturn 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.

    VI. Risk and Return AnalysisAppendix 1A

    A. Riskthe 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.

     The McGraw-Hill Companies, Inc., 2009

    Study Guide, Chapter 1 9

    Chapter Outline Notes

    VII. Business Activities and the Accounting EquationAppendix 1B

    A. The accounting equation is derived from business activities.

    B. Three major business activities are:

    1. Financing activitiesactivities 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 financingrefers to resources contributed by owner

    including income left in the organization.

    b. Nonowner (or creditor) financingrefers to resources

    contributed by creditors (lenders).

    2. Investing activitiesare the acquiring and disposing of

    resources (assets) that an organization uses to acquire and sell

    its products or services.

    3. Operating activitiesinvolve 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 results of investing and financing.

     The McGraw-Hill Companies, Inc., 2009

    10 Fundamental Accounting Principles, 19/e

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