Chapter 1Accounting in Action

ACT 201 By: Ms. Adina Malik (ALK)

Accounting

What is Accounting? ◦ Accounting is an information system that

identifies, records and communicates the economic events of an organization to interested users.

Economic Events?◦ Monetary transactions◦ For e.g. Cement bags sold by Crown Cement for

Tk. 500,000.◦ For e.g. Payment of salaries to BRAC Bank

employees.

Users of Accounting DataInternal marketing managers,

production supervisors, finance directors, company officers

(more in Managerial Accounting)

External◦ Investors, creditors,

taxing authorities, regulatory agencies, labor unions, customers & so on.

(in financial accounting)

What is Accounting?

◦ Identification: Of economic events

◦ Recording: Systematic, chronological diary of

events. Classifies and summarizes economic

events.

◦ Communication involves analyzing and interpreting the reported information.

◦ Analysis involves use of ratios, graph, charts, and percentages to highlight significant financial trends and relationships.

◦ Interpretation involves explaining the uses, meaning & limitations of the reported data.

The Activities of the Accounting Process

The Accounting Process involves the bookkeeping

function, another name for recording.

Ethics in Financial Reporting

Ethics: The standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair.

Recent financial scandals include: Enron, WorldCom, AIG, etc.

Enron:◦ American natural gas pipeline company,

based in Texas◦ Company executives manipulated the

earnings report-showed more profit, losses were hidden

◦ Scandal was revealed in October 2001◦ Losses exceeded $70 billion and the

company went into bankruptcy◦ It led to the dissolution of the

accounting firm, Arthur and Anderson

Ethics in Financial Reporting Congress passes the Sarbanes Oxley Act of 2002: To

reduce unethical corporate behavior and decrease the likelihood of future corporate scandals.

Top management has to certify the accuracy of the financial statements

Top management will face huge penalty for fraudulent financial activity

The accuracy of the financial statements are required to be reviewed by external auditor

The Board of Directors will have an oversight role

Effective financial reporting depends on sound ethical behavior.

GAAP (Generally Accepted Accounting Principles): Generally Accepted & Universally Practiced Common set of standards or general guide for financial reporting

purpose

The Building Blocks of Accounting

Reporting Standards of Financial Information

FINANCIAL STATEMENTS:

• Income Statement• Statement of

Retained Earnings/ Owner’s Equity Statement

• Balance Sheet• Statement of Cash

Flow

*Note Disclosure

GAAP (Generally Accepted Accounting

Principles)

The Building Blocks of Accounting

Cost Principle (Historical)◦ It dictates that

companies record assets at their cost.

Issues:◦ Reported at cost

when purchased and also over the time the asset is held.

◦ Cost easily verified, whereas market value or fair value is often subjective.

Assumptions Assumptions are foundation for the accounting process:

Monetary Unit Assumption – include in the accounting records only transaction data that can be expressed in terms of money.

Economic Entity Assumption – requires that activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. An economic entity can be any organization or unit in a society.◦ Proprietorship.◦ Partnership.

◦ Corporation.

Forms of Business Ownership

Forms of Business Ownership

Proprietorship

•Generally owned by one person.•Often small service-type businesses•Owner receives any profits, suffers any losses, and is personally liable for all debts

Partnership

•Owned by two or more persons.•Often retail and service-type businesses•Generally unlimited personal liability•Partnership agreement

Corporation

•Separate legal entity.•Ownership divided into shares of stock•Stockholders enjoy Limited liability•Shares are transferrable•Corporation enjoys an unlimited life.

The Basic Accounting Equation

Assets

Liabilities

Owner’s Equity

The equation provides the underlying framework for recording and summarizing economic events

The Basic Accounting EquationAssets:

• Resources a business owns. E.g. Cash, Supplies, Equipment, Accounts Receivables, Inventories, Land, Building, etc.

• The capacity to provide future services or benefits.

• They are claimed by either creditors or owners.

The Basic Accounting Equation

Liabilities (debts & obligations):

• Claims against Assets• Creditors: Party to

whom money is owed • E.g. accounts payable,

note payable, wages payable, etc.

• Liabilities appear before owner’s equity because they are paid first if a business is liquidated.

The Basic Accounting Equation

Owner’s Equity The ownership claim on Total Assets are called Owner’s

Equity. Often referred to as Residual Equity. Owner’s Capital: Investments by owners or assets that

owners put into the business. Owner’s Drawings: Withdrawal of owner (cash/other

assets) for personal use. Revenues: Resulting from business activities entered into

for the purpose of earning income. E.g. sales, fees, services, commissions, etc.

Expenses: the cost of assets consumed or services used in the process of earning revenue. E.g. utility expense, salaries and wages, telephone expense, travel expense, rent expense, internet expense, etc.

Expanded Accounting Equation

Note:Revenue – Expenses=Net Income/Net Loss

Transactions Transactions are economic events of a business,

recorded by Accountants. May be external or internal. Not all activities represent transactions. Note that

‘Discussing about product design with potential customer’ is not a transaction.

Is the financial position (assets, liabilities or owner’s equity) of the company changed?

Each transaction must have a dual effect on the accounting equation.◦ An increase in asset must have a corresponding decrease

in another asset, or an increase in liability or an increase in owner’s equity

Two or more items could be affected.

Transaction (1): Ray Neal decides to open a computer programming service which he names Softbyte. On September 1, 2011, Ray Neal invests $15,000 cash in the business.

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Transaction Analysis

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

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Transaction Analysis

Transaction (3): Softbyte purchases for $1,600 from Acme Supply Company computer paper and other supplies expected to last several months. The purchase is made on account.

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Transaction Analysis

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

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Transaction Analysis

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

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Transaction Analysis

Transaction (6): Softbyte provides $3,500 of programming services for customers. The company receives cash of $1,500 from customers, and it bills the balance of $2,000 on account.

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Transaction Analysis

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

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Transaction Analysis

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

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Transaction Analysis

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

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Transaction Analysis

Transaction (10): Ray Neal withdraws $1,300 in cash from the business for his personal use.

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Transaction Analysis

Financial Statements

An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time.

An owner’s equity statement summarizes the changes in owner’s equity for a specific period of time.

A balance sheet reports the assets, liabilities and owner’s equity at a specific date.

A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.