lesson 1. chapters 1 and 2

8/21/2019 Lesson 1. Chapters 1 and 2

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Lesson 1: The Accounting Process

(Textbook Libby et al. Chapters 1 and 2).

Objectives:

When you have successfully completed this lesson, you ill be able to!!!

Define accounting and explain its purpose

Define business and identify the different types of businesses

Explain the accounting euation! "ssets" Liabilities # $%ner&s Euity

'isualie the start of a business create accounting transactions for it and prepare si*ple

financial state*ents

#eading Assignment

+lease read chapters 1 and 2 of your textbook.

#ecommended Problem Assignment

$hapter 1! +lease co*plete ,C uestions plus Exercises 1-1 1- 1-/ 1-0 1- and 1-11

$hapter %! +lease co*plete ,C uestions plus Exercises 2- 2-/ 2- 2-12 and 2-1

"ns%ers to these assign*ents are a3ailable in the folder 4"ns%ers to "ssigned ,ultiple Choiceand Exercises.5

Outline of #eadings: $hapter 1

6e3ie%s the infor*ation con3eyed in 7inancial 8tate*ents and ho% accounting is used

for decision *aking.

o 9alance 8heet (8tate*ent of 7inancial +osition)

o :nco*e 8tate*ent (8tate*ent of :nco*e 8tate*ent of Earnings 8tate*ent of$perations)

o 8tate*ent of 6etained Earnings (or the *ore co*prehensi3e 8tate*ent of

8tockholder;s Euity)

o 8tate*ent of Cash 7lo%s

Discusses financial analysis. 7inancial analysis is a %ay to use financial infor*ation to

ans%er uestions about the financial strength and %ell being of a co*pany.


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"lso re3ie%s cash flo% analysis as a useful tool for e3aluating financial gro%th and

success.


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&'($)(('O*


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focuses on financial accounting? therefore %e %ill focus on ho% *anagers report theiroperations to external parties.

,any outside users take an interest in ho% %ell a co*pany is doing. External users *ay bein3estors creditors the go3ern*ent (:68 federal state and local) and other interested parties

like unions consu*er groups and the general public (potential custo*ers). @i3en all theinterested parties and all the infor*ation that could be pro3ided the accounting professionfor*ed a go3erning body to deter*ine %hat and ho% accounting infor*ation should bereported and disclosed. The-inancial Accounting (tandards +oard.-A(+/ is the pri3atesector rule-*aking body that deter*ines ho% accounting is practiced. $PAs .$ertified PublicAccountants/*ake sure that the rules set do%n by the 7"89 are being follo%ed by thereporting businesses. :nternational 7inancial 6eporting 8tandards (:768) are also beco*ingi*portant as A.8. @enerally "ccepted "ccounting +rinciples (@""+) is con3erging %ith:nternational 6eporting reuire*ents. "lthough beyond the scope of this pri*er *orereferences %ill be *ade to :nternational 6eporting reuire*ents as you progress further into thefield of financial accounting.

-orms of +usiness Organi0ation

9usinesses usually fall into three *aBor organiational types! proprietorships partnerships andcorporations.

:n a proprietorship, a single o%ner hires people to conduct a needed ser3ice. Exa*ples includea dentist a la%yer a C+" or the proprietor of a la%n care ser3ice.

" group of o%ners *ay for* a partnership! 8o*e of the large C+" fir*s doing o3er a billiondollars of business %ere partnerships for *any years. 6ecently these fir*s ha3e beco*e

professional associations in order to li*it the indi3idual liability of the partners. o%e3er beinga partnership for tax purposes can ha3e so*e real ad3antages and *any businesses continue tokeep that for*.

,ost businesses e3entually beco*e corporations! Corporations can start or re*ain s*all butoften they beco*e huge o%ned by *any stockholders and are clearly the largest and *ostpo%erful business for*. 8o*e corporations are larger than *ost countries.


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Types of +usinesses

9usinesses can pro3ide *any different types of ser3ices and acti3ities. ere are so*e exa*ples.

anufacturing $ompanies: " *anufacturing fir* transfor*s basic resources into finishedgoods. These co*panies add 3alue by taking si*ple inputs such as labor and *aterials andco*bining the* to create a co*plex product like an auto*obile. 8uccess is *easured by theability of the *anufacturer to sell the co*plex product for *ore than the cost of the inputs.Exa*ples are 9oeing Caterpillar and 7ord.

erchandising $ompanies: " *erchandising fir* *o3es the product fro* the *anufacturer tothe ulti*ate consu*er. The product does not change 3ery *uch %hile the *erchandising fir*holds it. 7or exa*ple in the auto*obile business 7ord ,otor Co*pany is the *anufacturer%hile the local 7ord dealership is the *erchandising co*pany.

The difference bet%een the t%o types of businesses abo3e is that *anufacturing co*panieschange ra% *aterials into usable products %hile *erchandising co*panies lea3e the productessentially unchanged.


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4enerally Accepted Accounting Principles .4AAP/

4AAP is the set of accounting rules that the 7"89 has set do%n for the financial reporting ofbusiness transactions. "d3anced accounting courses re3ie% *any @""+ issues in detail. This

course introduces so*e basic principles and concepts that are %idely used and understood.9efore discussing the accounting *odel let us re3ie% a fe% basic concepts that apply to *ostaccounting transactions.

+A('$ $O*$5PT(

5ntity: To *ake sense accounting *ust define the entity. "ccounting is related to specificentities (proprietorships partnerships corporations).

#eliable: " recorded transaction can only be *eaningful if the source docu*ents are reliabledependable and trust%orthy.

#elevant! +ro3ides feedback and predicti3e 3alue on a ti*ely basis.

$ostPrinciple: Transactions are recordedat their actual or historical cost. "ccountants recordthe a*ount paid not ho% *uch so*ething 4should5 be %orth. Kote ho%e3er that *ost initialtransactions reflect the *arket 3alue of the transaction. That *arket price is designated as thecost (historical cost).

-air 2alue: 8o*eti*es @""+ reuires ite*s to be reportedat fair 3alue in financial state*ents.7air 3alue is the a*ount that could be recei3ed to sell the ite* in an orderly *anner.

4oing $oncern: To *eaningfully *easure accounting transactions accountants assu*e inabsence of e3idence to the contrary that a business %ill continue to operate for the foreseeablefuture. Therefore the business is called 4a going concern.5 9usinesses that are currentlybankrupt or liuidating reuire special accounting treat*ents not ordinarily used by healthycontinuing businesses.

(table onetary )nit:


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The Accounting 56uation

To begin the process of recording and then reporting accounting transactions %e need a *odelthat captures the e3ents %e are trying to *easure. The accounting *odel is represented by the

accounting e6uation and itis a po%erful tool %e use to *easure record classify and reportaccounting transactions. The accounting euation allo%s all the co*plexities of accounting to becondensed into a fe% si*ple concepts.

The accounting euation states! Assets " Liabilities 7 Oner8s 56uity

6e*e*ber that accounting is related to entities. The accounting e6uation shos that assets ofthe entity are financed by to sources: creditors and oners!

$nce %e understand each of the ter*s the *odel *akes *ore sense. "lso note that accountingis based upon one algebraic euation %ith three 3ariables. 8tudents need to kno% basic algebra

and be able to add subtract *ultiple and di3ide to learn accounting.

Assets: Assets are economic resources oned or controlled by a business entity.Assets musthave a future economic benefit for the business that owns them. "n asset like a truck that abusiness uses to haul its product is clear and *easurable. " ri3er that runs by a business thatallo%s for the discharge of excess %ater is clearly an asset but is not o%ned or controlled by thebusiness entity? therefore it is not recorded by accounting in the business books. Co**onexa*ples of assets are cash inventory(goods held for the purpose of resale) and producti3efixed assets(such as cars buildings and co*puters). "ssets can also be intangible such aspatents copyrights and trade*arks. The key to measuring and recording an asset is that thebusiness entity has a current benefit by owning these resources in the future.

Liabilities: Liabilities are claims against the assets of a business! Liabilities are obligationsof the business entity encu*brances or debts *eaning that outsiders control the ter*s ofrepay*ent. " business %ill e3entually ha3e to use its assets to pay off these debts. Co**onexa*ples are! accounts payable(a*ounts o%ed for the purchase of in3entory) bank loans andbonds payable(long-ter* obligations o%ed to in3estors %ho %ant a fixed return on their*oney).

Oner9s 56uity: $%ners; euity euals assets liabilities (net assets). :t represents theincrease in net assets by financing pro3ided by o%ners and by earnings fro* the businessoperations. :f %e take our assets and subtract our liabilities %hat re*ains is the euity in our

business. To illustrate if a co*pany has assets of 1FFFFFFFF and liabilities of 0FFFFFFFthen euity is 2FFFFFFF. 8i*ply put if a co*pany pays off its creditors the re*aininga*ount (2FFFFFFF) represents the euity of the business. :n accounting o%ner;s euity doesnot reflect the 3alue of the business? it is si*ply the a*ount left o3er fro* subtracting liabilitiesfro* assets.


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To better understand ho% the *odel %orks %e %ill go through se3eral exa*ples of accountingtransactions. Mournal entries introduced in Chapter 2 are used to illustrate ho% the businessaccounts for transactions.

An 5ample of a Proprietorship +usiness 5ntity, L'O $ompany

:n this lesson %e illustrate the creation of a proprietorship. (Starting in Chapter 5 almost allexamples will be of corporations.! :*agine a rural co**unity that has a nu*ber of touristattractions. +at Mohnson an entrepreneur decides to for* a li*ousine ser3ice business (%hich%e %ill call L:,$ Co.) to take 3isitors to these nearby attractions. :n Mune 2FNN +at in3ests1FFFF of her personal sa3ings in the business. 8he sets up a business checking account that isseparate fro* her personal checking account and transfers the 1FFFF. The pri*ary operatingasset of the business %ill be a 3ehicle to carry tourists to the local fishing lodge or ski resort.Therefore +at decides to purchase a *ini3an so that it can carry skis in %inter and ca*pingsupplies in su**er. ("ote# this example problem will be continued and built upon in

subse$uent %essons!.

The *ini3an selected costs FFFF and the business borro%s 2FFF fro* the local bank tofinance the purchase. "ccountants record transactions as Bournal entries. Learning ho% to *akeBournal entries is one of the key concepts in learning accounting. To reflect the pre3ioustransactions %e *ake the follo%ing accounting Bournal entries!

1! The business records the investment of ;1


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O 1FFFF O 1FFFF


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7ro* the accounting euation note that assets to the left of the eual sign ha3e debit (left-handside) balances and liabilities and o%ner;s euity to the right of the eual sign ha3e credit (right-hand side) balances.

Assets " Liabilities 7 56uity"ssets ha3e Debit

9alancesLiabilities ha3e Credit

9alances$%ners; Euity has Credit

9alances

:n "ccounting each account is a unit of infor*ation tracked by the accounting syste*."ccountants use a 3isual T account(looks like a T) to represent the infor*ation. :nfor*ationentered on the left in the T account is a debit and infor*ation entered on the right is a credit. :f%e created t%o T3accounts,as the textbook illustrates they %ould appear as follo%s!

$ash

1FFFF

Oners9 56uity

1FFFF

These T-accounts sho% the debit on the left and the credits on the right. 8o the nor*al balance%e %ould expect to see in asset accounts is a debit and the nor*al balance of o%ner;s euity is acredit. :f %e conduct another transaction by debiting the cash account the account %ould getlarger? ho%e3er if %e spend cash then %e %ould credit the cash account and then the balancegets s*aller.

%! #ecord the ban= loan to be used for the purchase of the minivan:

Journal Entry for Bank Loan Transaction#

&ebit $redit

Cash 2FFF

Kotes +ayable (or Loans +ayable)P 2FFF

&xplanation# To record a loan from the bank to be used to purchase a business vehicle(minivan!.

*ote! the accepted practice is to indent accounts that are to be credited.


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The effect on the accounting euation is as follo%s.

Assets " Liabilities 7 56uity

Cash

O 2FFF

Kote +ayable

O 2FFF

Kote that after the transactions the accounting euation sho%s the follo%ing!

'pdated Accounting &$uation to reflect the first two transactions.


FFF (1) 2FFF 1FFFF

(1) (1FFFF # 2FFF)

Kotice ho% the cash account a*ount reflects t%o entries! Cash increased fro* 1FFFF to

FFF reflecting the deposit of 2FFF fro* the bank loan into the checking account.'mportantly, the accounting e6uation continues to remain in balance, meaning totals on the

left e6ual totals on the right> assets " liabilities 7 oner9s e6uity!

" list of the accounts and their balances can also be sho%n in the follo%ing *anner.

Accounts ? +alances &ebit $redit

Cash FFF

Kotes payable 2FFF

$%ners; Euity 1FFFF

Total @,


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. #ecord the minivan purchase.

Journal Entry for "ini#an Transaction!

&ebit $redit

Euip*ent FFFF

Cash FFFF

&xplanation# urchased minivan for %)*+.

The effect of this transaction on the accounting euation is as follo%s!


Euip*entO FFFFCash

Q FFFF

'pdated Accounting &$uation (to reflect the first , -ournal entries!#


FFF (1) 2FFF 1FFFF

(1) cash R FFF? euip*ent R FFFF

Kotice that the totals for "ssets and Liabilities re*ain unchanged. o%e3er the detail haschanged. .


Cash FFF

Euip*ent FFFF

Kotes payable 2FFF

$%ners; Euity 1FFFF

Total ;@,


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The follo%ing T for cash illustrates the effect of the three transactions on Cash. Kote! thedescriptions are not part of the T account but are pro3ided for explanation.

$ash

F beginning balance

1FFFF o%ner contribution2FFF bank borro%ing

FFFF purchase *ini3an

FFF ending balance

To su**arie to start a business the business recei3ed a capital contribution fro* an o%nerborro%ed *oney and bought assets %ith the intent to use the asset to generate a profit by usingthe asset.

Bo &oes the Limousine +usiness a=e Profit

+at Tho*as the o%ner*anager of L:,$ uses her 3ehicle and her kno%ledge of the area to help3isitors find acti3ities to do on their 3acations. :f a fa*ily co*es in for a %eek and decides toengage +at as a guide then she is ready to do business. Let us say that +at agrees to a se3en-dayfee of 1FFF to take the fa*ily sight-seeing and fishing. "fter the end of the %eek +at recei3es1FFF plus a 1FS tip. The accounting Bournal entry to record the transaction is sho%n belo%.

Cournal 5ntry for (ervice #evenue

&ebit $redit

Cash 11FF

8er3ice 6e3enue 11FF

&xplanation# eceived /0011 for guide services.

(ervice #evenueis a ne% account. #evenue is part of the oner9s e6uity section of ouraccounting e6uation. evenue is defined as an inflow of resources resulting from performing aservice or selling a product.


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'pdated Accounting &$uation!


J1FF (1) 2FFF 111FF (2)

(1) FFF # FFFF # 11FF.(2) (2) 1FFFF # 11FF

" listing of the accounts and their balances sho%s the detail!


Cash J1FF

Euip*ent FFFF

Kotes +ayable 2FFF

$%ners; Euity 1FFFF

8er3ice 6e3enue ;1,1


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"t the end of the first *onth of business if all the accounts are listed putting 4debits5 first and onthe left follo%ed by 4credits5 second and on the right %e ha3e created a su**ary listing calleda trial balance:

L'O $o! Trial +alance


Cash JFF

Euip*ent FFFF

Kotes +ayable 2FFF

$%ners; Euity 1FFFF

8er3ice 6e3enue >JFF

Total @E,D


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8econd Accounts Payable is a liabilityaccount sho%ing that the business o%es outsiders(creditors) for ser3ices and products it purchased. Kotice that the bills ha3e not yet been paid?rather the business is recogniing its co**it*ent to pay the*. 6ecording a transaction basedon a pro*ise to pay is called accrual accounting!

Accrual accounting is re6uired by 4AAP and is the process of employing the revenuerecognition rule and the matching principle to the recognition of revenue and epense!

"ccrual accounting is uite different fro* si*ply *easuring cash pay*ents. The accountingprocess reuires that accrual accounting *easure e3ents based on the exchange of pro*ises andser3ices (co**it*ents) rather than %aiting for the si*ple exchange of cash. 6e*e*ber %eassu*e the business is a 4going concern5 *eaning that %e expect these bills to be paid.

Kotice that the trial balance is gro%ing due to the ne% accounts being for*ed.

L'O $o! Trial +alance


Cash >0F

Euip*ent FFFF

Kotes +ayable 2FFF

$%ners; Euity 1FFFF


@as H Car Expense 12F6oo* and ,eals Expense FF

,iscellaneous Expense 0F

"ccounts payable 0F

Total F


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:f +at %ants calculate %hether L:,$ has been profitable so far %e can prepare an inco*estate*ent. "n inco*e state*ent lists re3enues and expenses and sho%s %hether the business*ade a profit (net inco*e) or loss (net loss).

L'O $o! 'ncome (tatement


Expenses

@as H Car Expense 12F

6oo* and ,eals Expense FF


Total Expenses /FF

Ket :nco*e FF

*ote that the income statement does not use debits and credits! "lso the inner colu*n isused for detail to sho% the lists of expenses.

+an= Loan

Anfortunately the 'ncome (tatement is not co*plete.


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F

$%ners; Euity 1FFFF


@as H Car Expense 12F

6oo* and ,eals Expense FF


"ccounts payable 0F

:nterest expense 2F

Total @E,JJ< @E,JJ

lesson 1. chapters 1 and 2

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