chapter 1 accounting and the business...

Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page | 1

Chapter 1

Accounting and the Business Environment

Use accounting vocabulary:

Business, as a general system, has a number of systems (purchasing, production, marketing, human

resource, accounting, and so on). The accounting system is just one of the systems within a business, all of

which must work together in an active and efficient way. An Information system is a set of interrelated

subsystems that work together to collect, process, store, transform, and distribute information for planning,

decision making, and control.

Accounting information system: is a collection of resources, such as people and equipment, design to

transform financial and other data into information. This information is communicated to a wide range of

decision makers.

- It collects and stores data about activities and transactions.

- It processes data into information that is useful for making decisions.

- It provides adequate controls to safeguard the organization’s assets.

Accounting can be defined as an information system that provides reports to stakeholders about the

economic activities and conditions of a business. Accounting is the information system that; measures

business activity, Processes the information into reports, and communicates the results to decision makers. It

also called the language of business that helps decision making. The primary role of accounting is to evaluate

the performance of business and convey this information to users.

Objectives of financial reporting: It Provides;

- Information about economic resources, claims to resources, and changes in resources and claims.

- Information useful in assessing amount, timing and uncertainty of future cash flows.

- Information useful in making investment and credit decisions.

Financial reporting is not an end in itself but is intended to provide information that is useful in making

business and economic decisions.

Decision Makers: The Users of Accounting Information (stakeholders);

- External users: make decisions concerning their relationship to the entity (investors, creditors,

customers, suppliers, Taxing Authorities, public);

- Internal users: make decisions that directly affect the internal operations of the entity (investors

‘owners’, managers, and employees).

Decision makers need information. The bigger the decision, the greater the need.

Bookkeeping and Accounting:

- Bookkeeping:

Involves only the recording of monetary economic transactions or events.

Is just one part of accounting.

- Accounting:

Includes bookkeeping.

Also includes much more.


Fields of Accounting:

- Financial accounting: is primarily concerned with the recording and reporting of economic data and

activities for a business. It provides information for people outside the company, such as investors and

creditors.

- Managerial accounting: focuses on information for internal decision making by the company’s

managers. It focuses on information for internal decision makers, such as mangers of the company.

Governing Organizations:

In US, the following organizations relate to the regulation of accounting.

- FASB (Financial Accounting Standards Board): formulates accounting standards (www.fasb.org).

Develops acceptable accounting practices and issues pronouncements that firms must follow to be in

compliance with GAAP.

- SEC (The Securities and Exchange Commission): regulate security markets (www.sec.gov).

- AICPA (The American Institute of Certified Public Accountants): regulate Certified Public

Accountants (www.aicpa.org).

- CPA (Certified Public Accountant): a professional accountant who is licensed to serve the general

public.

- CMA (Certified Management Accountant): is licensed professional who work for a single company.

- IMA (Institute of Management Accountants).

The rules that govern public accounting information are called Generally Accepted accounting

Principles (GAAP). Rules of financial accounting established by the FASB. Designed to protect the

public from harm caused by false and misleading statements about the performance, cash flows and

financial position of a firm.

Ethics in Accounting and Business:

- Audit:

Examination of company’s financial situation.

Performed by independent accountants.

- Investors and creditors need relevant and reliable information about a company.

- But is the accounting information of the company reliable?

- Some famous accounting scandals:

Enron Corp. (report fewer debts).

WorldCom. (record assets as expenses).

Xerox (manipulating reported profits).

- Reliability is a function of representational faithfulness, verifiability and neutrality.

The building block of accounting:

- Ethics: standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest.

- Most individuals in business are ethical. Their actions are both legal and responsible.

http://www.fasb.org/

http://www.sec.gov/

http://www.aicpa.org/


Types of Business Organizations: A business can be organized as: Proprietorships, Partnerships, Corporations, and Limited-Liability

Partnerships (LLPs) and Limited –Liability Companies (LLCs).

1- Proprietorships:

- Owned by one individual (single owner).

- Small local business such as hardware store, repair shops, laundries.

- From accounting viewpoint, each proprietorship is distinct from its proprietor.

- From legal perspective, the business is the proprietor.

2- Partnership:

- Owned by two or more individuals.

- Each owner is called ”partner”.

- Small or medium-sized business such as automotive repair shops, music stores, beauty shops.

- Specifically, Professional organizations such as legal firms (Big 4).

- Accounting treats partnership as a separate organization, distinct from partners.

- From legal perspective ,a partnership is the partners.

3- Corporations:

- Organized as a separate legal entity.

- Ownership divided into shares of stock.

- Therefore owned by shareholders.

- A business becomes a corporation when the state approves its articles of incorporation.

- Continuous life and transferability of ownership.

- No mutual agency.

- Limited liability of stakeholders.

- Separation of ownership and management.

4- Limited-Liability Partnerships (LLPs) and Limited –Liability Companies (LLCs):

- A Limited-Liability Partnerships is one in which a wayward partner cannot create a large liability for

the other partner. Each partner is liable only for his or her own actions and those under his or her

control. Similarly, a business can be organized as a Limited –Liability Companies. In an LLC the

business, and not the members of the LLC, is liable for the company's debts.

Comparison of the Four Forms of Business Organization:

Proprietorship Partnership Corporation LLC

1- Owner(s) Proprietorship - only

one owner

Partners - two or

more owners

Stockholders -

generally many

owners

Members

2- Life of the organization Limited by the owner's

choice, or death

Limited by the

owner's choice,

or death

Indefinite Indefinite

3- Personal liability of the

owner(s) for the business's

debts

Proprietor is personally

liable

Partners are

personally liable*

Stockholders are

not personally

liable

Members are

not personally

liable

*Unless it is a Limited-Liability Partnership (LLP)


Accounting Concepts and Principles

Generally Accepted Accounting Principles (GAAP)

- GAAP rests on a conceptual framework.

- FASB: objective of financial reporting is to provide information useful for making investment and

lending decisions.

- Basic objective of financial reporting is to provide information that is: Useful to those making

investment and credit decisions. To be useful, information must be:

1- Relevance:

To be useful, the accounting information must be relevant to the needs of decision makers.

Relevant accounting information is capable of making a difference in a decision by helping users to

form predictions about the outcomes of past, present, and future events or to confirm or correct prior

expectations.

Relevance is a function of predictive value, feedback value and timelines.

2- Reliability (objectivity):

To be useful, information must also be reliable.

Reliability of information means that the information is free of error and bias, it can be depended on.

Reliability is a function of Verifiability, representational faithfulness, and neutrality.

Qualitative Characteristics of Accounting Information

1. The Entity Concept:

An accounting entity: an organization or a section of an organization that stands apart as a separate

economic unit.

Entity decides boundary of accounting.

The entity concept applies to any economic unit that needs to be evaluated separately.

2. The Cost Principle:

Assets and services acquired should be recorded at their actual cost (historical cost).

Historical cost represents the amount of cash or cash equivalents paid in acquiring an asset, this is

sometimes called original acquisition cost. This is objective because it is based on actual invoices and

other documents. Depreciated cost is determined based on original acquisition cost.

Historical cost is the most objective measure of the value of an asset. However, it cannot reflect the

current value of an asset.

This principle also holds that accounting records should maintain the historical cost of an asset over its

useful life.

3. The Going Concern Concept:

Assume the entity will continue to operate in the future. This concept implies that the business will

continue to operate for the foreseeable future.

This concept is another reason for measuring assets at historical cost.

4. The Stable-Monetary-Unit Concept:

The dollar’s purchasing power is relatively stable.

This allows us to add and subtract dollar amounts as each dollar has the same purchasing power as any

other dollar at any time.


The Accounting Equation:

The algebraic relationship in the fundamental accounting model. Accounting data is represented

by the following relationship among the assets, liabilities and owners’ equity of a business:

Economic Resources = Claims to Economic Resources

- Assets:

Definition: Economic resources that are expected to bring benefits in the future.

Examples: Cash, Land, Building, Equipment, patent, Merchandise inventory, and Goodwill.

Tangible assets (Ex. Cash, Land, Building, Equipment).

Intangible assets (Ex. patent, Goodwill, and Trademark).

- Liability:

Definition: Outsider claims – debt that is payable to outsider. Examples: Accounts payable,

Notes payable, Salary payable and Bank loan.

- Owner’s equity:

Also called “shareholder’s funds” or “stockholder’s funds”.

It is what’s left of the assets after liabilities have been deducted.

Equals net assets in balance sheet.

The insider-owner’s claim on the entity’s assets.

The purpose of business is to increase owner’s equity through revenues (income) i.e. maximize

shareholder’s value.

Owner withdrawals and expenses decrease owner’s equity.

- Stockholder’s Equity:

The equity section of a corporation’s balance sheet consists of:

1- Paid-in (contributed) capital: is the term used to describe the total amount paid in by

stockholders.

2- Retained earnings: the principal source of paid-in-capital is the investment of cash and other

assets in the corporation by stockholders in exchange for capital stock.

- Retained Earnings:

The retained earnings section of the balance sheet is determined by three items:

1- Revenues.

2- Expenses.

3- Dividends.

Retained earnings = Revenues – Expenses – Dividends


1- Revenue (income):

- Definition: amounts received or to be received from customers for sales of products or services

provided during a specific period, usually result in an increase in an asset.

- Examples: Sales revenue, Service revenue, Interest revenue and Dividend revenue.

2- Expenses:

- Definition: The economic costs that a business incurs through its operations to earn revenue.

- Examples: Salaries and Wages, Tax, Insurance, Advertising, Factory leases, Utilities, Interest,

Rent and Depreciation.

3- Dividends:

- Net income represents an increase in net assets which then become available for distribution to

stockholders.

- Cash or other assets that are distributed to stockholders are called dividends.

- Dividends reduce retained earnings but are not corporate expenses.

- A corporation decides whether or not to distribute a dividend after determining its net income or

net loss.

Owner’s Equity Structure:

The Accounting Equation: The Principle of The balance Sheet:

Owner’s equity

Revenue

Investment

Expense

Dividends

Increase Decreas

e

Assets Liabilities + owner’s equity


Accounting for Business Transactions:

Transaction Analysis:

- Transaction: An event that affects the financial position of a particular entity and can be

recorded reliably. Or exchanges of economic consideration between two parties.

Example:

- Pay monthly telephone bill of $168.

- Purchasing land for $50000.

They may be identified as external or internal:

1- External transactions: involve economic events between the company and some outside

enterprise or party.

2- Internal transactions: are economic events that occur entirely within one company.

Example 1: Sheena Bright, INC.

Sheena Bright starts her new business as a corporation named Smart Touch Learning, Inc.

The Inc. in the company name abbreviates Incorporated, which lets people know the business is a

corporation:

Transaction 1: Starting the Business

The e-learning agency received $30,000 cash from the President, Sheena Bright, and issued common

stock to her.

There is an increase in the asset Cash, $30,000, and an equal increase in the stockholders’ equity,

Common Stock by $30,000.

Assets = Liabilities + Stockholders’ Equity

Cash = Common

Stock

(1) Issued

Stock + $30,000 = 0 + + $30,000

Balance 30,000 = 30,000


(Cash) Increase by 30,000 Increase by 30,000


Transaction 2: Purchase of Land

The business purchased land for an office location, paying cash of $20,000.

There is a decrease in the asset – Cash by $20,000 and an equal increase in asset - Land for the

same amount, by $20,000.


Cash Land = + Common

Stock

Old Balance 30,000 = 0 + 30,000 (2) Purchase

Land - 20,000 + 20,000

New

Balance

10,000 20,000 = 0 + 30,000

30,000 = 30,000

Transaction 3: Purchase of Office Supplies

The e-learning agency bought stationery and other office supplies, agreeing to pay $500 within 30 days.

- This transaction is often referred to as a purchase on account or a credit purchase.

There is an increase in the asset – Office Supplies by $500 and an equal increase in - Accounts

Payable (to suppliers) for the same amount, by $500.


Cash Office

Supplies Land =

Accounts

Payable +

Common

Stock

Old Balance 10,000 20,000 = 0 + 30,000 (3) Purchase

Office Supplies + 500 + 500

New Balance 10,000 500 20,000 = 500 + 30,000

30,500 = 30,500


(Cash) decrease by 20,000

Land increase by 20,000


(Office Supplies) Increase by 500 (Accounts payable) increase by 500


Transaction 4: Earning of Service Revenue

Smart Touch Learning earned service revenue by providing travel service for clients. The business

earned $5,500 revenue and collected this amount in cash.

- This transaction represents the principal revenue-producing activity of the business.

Cash is increased by $5,500 and Retained Earnings is increased by $5,500. Revenue will be

recognized in the income statement and increase the retained earnings figure in the balance

sheet as a result.


Cash Office

Supplies Land =

Accounts

Payable +

Common

Stock

Retained

Earning

Old

Balance 10,000 500 20,000 = 500 + 30,000

(4) Service

Revenue + 5,500 + 5,500

New

Balance

15,500 500 20,000 = 500 + 30,000 5,500

36,000 = 36,000

Transaction 5: Earning of Service on Account

Smart Touch performed service for clients who do not pay immediately. The business received the

clients’ promises to pay $3,000 within one month.

- Accounts Receivable (Assets) is increased by $3,000, and Retained Earnings is increased by the

same amount, $3,000.

- Revenue service will be recognized in the income statement.


Cash Accounts

Receivable

Office

Supplies Land =

Accounts

Payable +

Common

Stock

Retained

Earning

Old Balance 15,500 500 20,000 = 500 + 30,000 5,500

(5) Service

Revenue + 3,000 + 3,000

New Balance 15,500 3,000 500 20,000 = 500 + 30,000 8,500

39,000 = 39,000


(Cash) Increase by 5,500 (Retained Earning) increase by 5,500

(Accounts Receivable) Increase by 3,000 (Retained Earning) increase by 3,000



Transaction 6: Payment of Expenses

During the month, the business paid $3,300 in cash expenses: rent expense on a computer, $600; office

rent, $1,100; employee salary, $1,200; and utilities, $400.

Expenses have the opposite effect of revenue. Expenses paid in cash are: $600 + $1,100 +

$1,200 + $400 = $3,300

Cash is decreased by $3,300 and Retained Earnings is decreased by $3,300.

Rent expense on a computer; office rent; employee salary; and utilities will be recognized

as expenses in the income statement and decrease the retained earning figure and cash in

the balance sheet as a result. (If actual payment is made).


Cash Accounts

Receivable

Office

Supplies Land =

Accounts

Payable +

Common

Stock

Retained

Earning

Old Balance 15,500 3,000 500 20,000 = 500 + 30,000 8,500

(6) Pay

Expenses - 3,300 - 3,300

New

Balance

12,200 3,000 500 20,000 = 500 + 30,000 5,200

35,700 = 35,700

Transaction 7: Payment of Account

The business paid $300 to the store from which she purchased supplies in transaction 3.

- Cash is decreased $300 and Accounts Payable is decreased by $300.


Cash Accounts

Receivable

Office

Supplies Land =

Accounts

Payable +

Common

Stock

Retained

Earning

Old Balance 12,200 3,000 500 20,000 = 500 + 30,000 5,200

(7) Pay on

Account - 300 - 300

New Balance 11,900 3,000 500 20,000 = 200 + 30,000 5,200

35,400 = 35,400


(Cash) decrease by 3,300 (Retained Earning) decrease by 3,300


(Cash) decrease by 300 (Accounts payable) decrease by 300


Transaction 8: Personal Transaction

Sheena Bright remodeled her home at a cost of $40,000, paying cash from personal funds.

- This transaction is not a transaction of Sheena Bright. It has no effect on the travel agency and,

therefore, is not recorded by the business. It is a transaction of the Sheena Bright personal entity,

not the business. This transaction illustrates the entity concept.

Transaction 9: Collection on Account

The business collected $1,000 from the client (in transaction 5).

Cash is increased by $1,000 and Accounts Receivable is decreased by the same amount.


Cash Accounts

Receivable

Office

Supplies Land =

Accounts

Payable +

Common

Stock

Retained

Earning

Old Balance 11,900 3,000 500 20,000 = 200 + 30,000 5,200

(9)

Collection

on Account

+ 1,000 - 1,000

New

Balance

12,900 2,000 500 20,000 = 200 + 30,000 5,200

35,400 = 35,400

Transaction 10: Sale of Land

The business sold some of land by the travel agency. The sale price of $9,000 is equal to the cost of the

land. The business received $9,000 cash.

- Cash is increased by $9,000 and Land is decreased by the same amount.


(Cash) Increase

by 1,000

(Accounts Receivable)

decrease by 1,000


(Cash) Increase

by 9,000

(Land)

decrease by 9,000



Cash Accounts

Receivable

Office

Supplies Land =

Accounts

Payable +

Common

Stock

Retained

Earning

Old Balance 12,900 2,000 500 20,000 = 200 + 30,000 5,200

(10) Sale of

Land + 9,000 - 9,000

New Balance 21,900 2,000 500 11,000 = 200 + 30,000 5,200

35,400 = 35,400

Transaction 11: Payment of Cash Dividend

The business declared and paid Sheena Bright a $2,000 cash dividend.

- Cash is decreased by $2,000 and Stockholders’ Equity is decreased by $2,000. Payment of

dividends will decrease the retained earnings figure in the income statement.


Cash Accounts

Receivable

Office

Supplies Land =

Accounts

Payable +

Common

Stock

Retained

Earning

Old Balance 21,900 2,000 500 11,000 = 200 + 30,000 5,200

(11) Dividend - 2,000 - 2,000

New Balance 19,900 2,000 500 11,000 = 200 + 30,000 3,200

33,400 = 33,400

Summary of all transactions:


Cash Accounts

Receivable

Office

Supplies Land =

Accounts

Payable +

Common

Stock

Retained

Earning

(1) Issued Stock + $30,000 + $30,000

(2) Purchase Land - 20,000 + 20,000

(3) Purchase Office

Supplies + 500 + 500

(4) Service

Revenue + 5,500 + 5,500

(5) Service

Revenue + 3,000 + 3,000

(6) Pay Expenses - 3,300 - 3,300

(7) Pay on Account - 300 - 300

(9) Collection on

Account + 1,000 - 1,000

(10) Sale of Land + 9,000 - 9,000

(11) Dividend - 2,000 - 2,000

Balance 19,900 + 2,000 500 11,000 = 200 + 30,000 3,200


(Cash) decrease by 2,000 Retained Earnings decrease

by Dividends (2,000)


Prepare Financial Statements:

- Daily business transactions are recorded in order to prepare financial statements for shareholders.

- After transactions are identified, recorded, and summarized financial information about the company

can be reflected in financial statements to stakeholders of the company and any parties who are

interested.

- Financial statements are the final product of the whole accounting process which starts at the business

transaction recording phase. Financial statements report on a business in monetary terms.

- Tells how the business is performing and where it stands.

- Usually published by listed company at the end of a fiscal year or season.

Major financial statements include:

1. Income statement:

- A statement showing revenues and expenses for a specific period of time. Income statement or

profit and loss statement reflecting financial performance (profitability). Summary of an entity’s

revenues, expenses, and net income or net loss for a specific period.

- The income statement is more like a video of the firm’s operations for a specified period of time,

rather than having been prepared at a point of time.

- Income - expenses = net income (profit or loss).

Net Income: Revenues > Expenses

Net Loss: Revenues < Expenses

2. Retained earnings statement:

- Summarizes the changes in retained earnings for a specific period of time.

3. Balance sheet:

- A statement showing the resources of a company (the assets), the company’s obligations (the

liabilities), and the equity of the owners at a certain point in time. The balance sheet is a snapshot

of the entity’s assets and liabilities at a given point in time.

- Reports the assets, liabilities, and stockholders’ equity of a business enterprise at a specific date.

- The balance sheet is a snapshot of the entity’s assets and liabilities at a given point in time.

- It is produced based on the accounting equation:

Asset – liabilities = owner’s equity

Asset = owner’s equity + liabilities

4. Cash flow statement:

- Reports cash receipts and cash payments during a period (covered in subsequent chapter).

Summarizes information concerning the cash inflows (receipts) and outflows (payments) for a

specific period of time.

- The statement classifies the various cash flows into three categories: operating, investing, and

financing; and relates these categories to the beginning and ending cash balances.


Relationships among the Four Basic Financial Statements:

SMART TOUCH LEARNING, INC.

Income Statement

For the Month Ended April 30, 2010

Revenues:

Service revenue $ 8,500

Expenses:

Salary expense $1,200

Rent expense, office 1,100

Rent expense, computer 600

Utilities expense 400

Total expenses 3,300

Net income $ 5,200


Retained Earnings Statement


Retained earnings, April 1, 2010 $ - 0 -

Add: Net income (From the Income Statement) 5,200

5,200

Less: Dividends (2,000)

Retained earnings, April 30, 2010 $ 3,200

- Note the headings for both of these statements

Name of company.

Name of financial statement

For the period ended …….

- Both of these statements report activity over a period of time.

- Final sums are double-underlined.

- Negative amounts are presented in parentheses

- Net income is computed first because you need that number to complete the ending balance in owner’s

equity.

- When preparing a financial statement, clearly label each line in the statement.

- If you are using columnar paper, always start your number columns in the far right-hand column.

- Numbers that are added or subtracted from each other should be in the same column.


Balance Sheet

At April 30, 2010

Assets Liabilities & Stockholders’ Equity

Cash $19,900 Liabilities:

Accounts receivable 2,000 Accounts payable $200

Office supplies 500 Stockholders’ equity:

Land 11,000 Common stock 30,000

Retained earnings 3,200

Total stockholders’ equity 33,200

Total assets $33,400 Total liabilities and stockholders’ equity $33,400

- Note the heading for the balance sheet is different from the other statements:

Name of company

Name of financial statement

Date

- This statement reports what the company owns and who has claims to the assets at a specific point in

time.



Statement of Cash Flows


Cash flows from operating activities:

Cash receipts from customers (5,500 + 1000) $6,500

Cash payments to suppliers (6,00 + 1,100 + 400 +300) (2,400)

Cash payments to employees (1,200)

Net cash provided by operating activities 2,900

Cash flows from investing activities:

Acquisition of land (20,000)

Sale of land 9,000

Net cash provided by investing activities (11,000)

Cash flows from financing activities:

Issuance of stock $30,000

Payment of cash dividends (2,000)

Net cash provided by financing activities 28,000

Net increase in cash 19,900

Cash at the beginning of the period - 0 -

Cash at the end of the period $19,900

chapter 1 accounting and the business...

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