Chapter 1 Accounting in action
LO1: Accounting Activities and Users
Accounting involves the entire process of identifying, recording and communicating
economic events.
A company identifies the economic events relevant to the business. Once it identifies
economic events, it records those events in order to provide a history of its financial
activities (bookkeeping). Finally, the company communicates the collected information to
interested users by means of accounting reports.
Internal users of accounting information are the managers who plan, organize, and run a
business. Managerial accounting provides internal reports to help users make decisions
about their companies.
External users are individuals and organizations outside a company who want financial
information about the company. The two most common types of external users are investors
and creditors.
LO2: The Building Blocks of Accounting
Ethics are the standards of conduct by which actions are judged as right or wrong, honest or
dishonest, fair or not fair.
The monetary unit assumption requires that companies include in the accounting records
only transaction data that can be expressed in money terms.
The economic entity assumption requires that the activities of the entity be kept separate
and distinct from the activities of its owner and all other economic entities.
LO3: The Accounting Equation
'
Assets=liabilities +stockholder s equity
This relationship is the basic accounting equation. Assets must equal the sum of liabilities
and stockholders’ equity.
Assets are the resources a business owns. Assets have the common characteristic to have
the capacity to provide future services or benefits.
Liabilities are claims against assets of those to whom the company owes money (creditors) –
that is, existing debts and obligations.
,The ownership claim on a corporation’s total assets is stockholders’ equity. The
stockholders’ equity section of a corporation’s balance sheet generally consists of common
stock and retained earnings.
Common stock is the term used to describe the total amount paid in by stockholders for the
shares they purchase.
The retained earnings section of the balance sheet is determined by three items: revenues,
expenses and dividends.
Revenues are the increases in assets or decreases in liabilities resulting from the sale of
goods or the performance of services in the normal course of business.
Expenses are the cost of assets consumed or services used in the process of generating
revenue. They are decreases in stockholders’ equity that result from operating the business.
The distribution of cash or other assets to stockholders is called a dividend. Dividends
reduce retained earnings. However, dividends are not an expense. If a company has net
income and has no better use for that income, it can decide to distribute dividend to its
owners.
LO4: Analyzing Business Transactions
Transactions are a business’s economic events recorded by accountants. Transactions may
be external or internal. External transactions involve economic events between the
company and some outside enterprise. Internal transactions are economic events that occur
entirely within one company.
Each transaction must have a dual effect on the accounting equation. If one thing goes up,
another one has to go down.
The expanded accounting equation:
LO5: The Financial Statements
Companies prepare 4 financial statements from the summarized accounting data:
, 1. An income statement presents the revenues and expenses and resulting net income
or net loss for a specific period of time.
2. A retained earnings statement summarizes the changes in retained earnings for a
specific period of time.
3. A balance sheet reports the assets, liabilities, and stockholders’ equity of a company
at a specific date.
4. A statement of cash flows summarizes information about the cash inflows (receipts)
and outflows (payments) for a specific period of time.
The income statement reports the success or profitability of the company’s operations over
a specific period of time. The income statement lists revenues first, followed by expenses.
The expenses are listed in order of magnitude.
The retained earnings statement reports the changes in retained earnings for a specific
period of time. The first line of the statement shows the beginning retained earnings
amount. Then come net income and dividends. The retained earnings ending balance is the
final amount of the statement.
The balance sheet reports the assets, liabilities, and stockholders’ equity at a specific date. It
lists assets at the top, followed by liabilities and stockholders’ equity. Total assets must equal
total liabilities and stockholders’ equity.
The primary purpose of a statement of cash flows is to provide financial information about
the cash receipts and cash payments of a company in a specific period of time.
Chapter 2 The recording process
LO1: Accounts, debits and credits
An account is an individual accounting record of increases and decreases in a specific asset,
liability or stockholders’ equity item. In its simplest form, an account consists of 3 parts: 1. A
title, 2. A left or debit side, and 3. A right of credit side. Due to the format of an account, we
refer to it as a T-account.
The term debit indicates the left side of an account, and credit indicates the right side.
Entering an amount on the left side of an account is called debiting the account. Making an
entry on the right side is crediting the account.
The account balance is determined by netting the two sides (subtracting one amount from
another).
The equality of debits and credits provides the basis for the double-entry system of
recording transactions. Under the double-entry system, the dual (two-sided) effect of each
transaction is recorded in the appropriate accounts.
Increases and decreases in liabilities have to be recorded opposite from increases and
decreases in assets. Thus, increases in liabilities are entered on the right or credit side, and
decreases in liabilities are entered on the left or debit side.
, Asset account normally show debit balances. Debits to a specific asset should exceed credits
to that account. Likewise, liability accounts normally show credit balances, credits to a
liability account should exceed debits to that account. The normal balance of an account is
on the side where an increase in the account is recorded.
Companies issue common stock in exchange for the owners’ investment paid in the
corporation. Credits increase the common stock account, and debits decrease it.
Retained earnings is net income that is kept (retained) in the business. Credits (net income)
increase the retained earnings account, and debits (dividends or losses) decrease it.
A dividend is a company’s distribution to its stockholders on an equal basis. Debits increase
the dividends account, and credits decrease it.
The purpose of earning revenues is to benefit the stockholders of the business. Credits
increase revenue accounts and debits decrease them.
Expenses have the opposite effect. Expenses decrease stockholders’ equity. Expense
accounts are increased by debits and decreased by credits.
Credits to revenue accounts should exceed debits. Debits to expense accounts should
exceed credits.
LO2: The Journal
Practically every business uses the following process to record transactions:
1. Analyze each transaction in terms of its effect on the accounts.
2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger.
Companies initially record transactions in chronological order. Therefore, we use a general
journal. This journal has spaces for dates, account titles and explanations, references and
two amount columns. Entering transactions in the journal is known as journalizing.
Companies make separate journal entries for every transaction. A complete entry consists
of:
1. The date of the transaction,
2. The accounts and amounts to be debited and credited,
3. A brief explanation of the transaction.
