Chapter 1 – Accounting in Action
1.1 – Accounting Activities and Users
Accounting is the information system that identifies, records, and communicates
the economic events of an organization to interested. Financial statements make the reported
financial information meaningful. Interpretation involves explaining the uses, meaning, and
limitations of reported data. Bookkeeping only involves the recording of economic events, while
accounting is the entire process. Users of accounting information can be divided into two groups:
1. Internal users; mangers who plan, organize and run a business. Managerial accounting is
the field of accounting that provides internal reports to help users make decisions about
their companies.
2. External users; individuals and organizations outside a company who want financial
information about the company. The are mostly investors, who use accounting information
to decide whether to buy, hold or sell ownership shares of a company, or creditors, who use
accounting information to evaluate the risks of granting credit or lending money. Financial
accounting is the field of accounting that provides economic and financial information for
investors, creditors and other external users.
1.2 – The Building Blocks of Accounting
The standards of conduct by which actions are judged as right or wrong, honest or dishonest, fair or
not fair, are ethics. Effective financial reporting depends on sound ethical behavior. The accounting
profession has developed standards that are generally accepted and universally practiced, this
common set of standards is called generally accepted accounting principles (GAAP). These
standards indicate how to report economic events. The primary accounting standard-setting body in
the United States is the Financial Accounting Standards Board (FASB). The Securities and Exchange
Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and
accounting standard-setting bodies. Many countries outside of the United States have adopted the
accounting standards issued by the International Accounting Standards Board (IASB). These
standards are called International Financial Reporting Standards (IFRS). GAAP generally uses one of
two measurement principles, the historical cost principle or the fair value principle. Selection of
which principle to follow generally relates to trade-offs between relevance and faithful
representation, which are two primary qualities that make accounting information useful for
decision-making. Relevance means that financial information is capable of making a difference in a
decision. Faithful representation means that the numbers and descriptions match what really
existed or happened. The historical cost principle (or cost principle) dictates that companies record
assets at their cost. The fair value principle states that assets and liabilities should be reported at
fair value, the price received to sell an asset or settle a liability. Fair value information may be more
useful than historical cost for certain types of assets and liabilities. Assumptions provide a
foundation for the accounting process, two main assumptions are:
1. Monetary unit assumption; requires that companies include in the accounting records only
transaction data that can be expressed in money terms. This enables accounting to quantify
economic events.
2. 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. A proprietorship is a
business owned by one person in general and usually, only a small amount of money is
necessary to start in business as a proprietorship. The owner receives any profits, suffers any
losses, and is personally liable for all debts of the business. There is no legal distinction
between the business as an economic unit and the owner, but the accounting records of the
business activities are kept separate from the personal records and activities of the owner. A
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, business owned by two or more persons associated as partners is a partnership. In most
respects, a partnership is like a proprietorship except that more than one owner is involved.
Like a proprietorship, for accounting purposes the partnership transactions must be kept
separate from the personal activities of the partners. n A business organized as a separate
legal entity under state corporation law and having ownership divided into transferable
shares of stock is a corporation. The holders of the shares (stockholders) enjoy limited
liability, they are not personally liable for the debts of the corporate entity. Stockholders
may transfer all or part of their ownership shares to other investors at any time.
1.3 – The Accounting Equation
Assets are resources a business owns, the business uses its assets in carrying out such activities as
production and sales. The common characteristic possessed by all assets is the capacity to provide
future services or benefits. Liabilities are a claim against those assets by whom the company owes
money (creditors). Creditors may legally force the liquidation of a business that does not pay its
debts. In that case, the law requires that creditor claims be paid before ownership claims. The
ownership claim on a corporation’s total assets is stockholders’ equity. The residual equity, is the
equity left over after creditors’ claims are satisfied. The stockholders’ equity section of a
corporation’s balance sheet generally consists of two types:
1. Common stock; total amount paid in by stockholders for the shares they purchase.
2. Retained earnings; determined by three items:
a. Revenues; the increase in assets or decrease in liabilities resulting from the sale of
goods or the performance of services in the normal course of business.
b. Expenses; 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.
c. Dividends; Net income
represents an increase in net
assets which are then available to distribute to stockholders. The distribution of cash
or other assets to stockholders is called a dividend. Dividends reduce retained
earnings. However, dividends are not an expense.
The basic accounting equation is that
assets must equal the sum of liabilities
and stockholders’ equity. The accounting equation applies to all economic entities, the equation
provides the underlying framework for recording and summarizing economic events.
1.4 – Analyzing Business Transactions
The system of collecting and processing
transaction data and communicating
financial information to decision-makers is
known as the accounting information
system. Accounting information systems
rely on a process referred to as the
accounting cycle.
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, Transactions are a business’s
economic events recorded by
accountants. 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. With the
use of some basic transactions, you
can make a summary of transactions very easily.
1.5 – The Financial Statement
Companies prepare four financial statements from the summarized accounting data:
1. Income statement; presents the
revenues and expenses and resulting
net income or loss for a specific period
of time. Also referred to as statement
of operations, earning statements or
profit and loss statement.
2. Retained earnings statement;
Summarizes the changes in retained
earnings for a specific period of time.
3. Balance sheet; reports the assets,
liability and stockholders’ equity of a
company at a specific date.
4. Statement of cash flows; summarizes
information about the cash inflows and
outflows for a specific period of time.
The income statement lists revenues first,
followed by expenses and finally, the statement
shows net income. When revenues exceed
expenses, net income results, when expenses
exceed revenues, a net loss results
Chapter 2 – The Recording Process
2.1 – 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 three
parts: (1) a title, (2) a left or debit side and (3) a
right or credit side. Because the format of an
account resembles the letter T, we refer to it as
a T-account. The term debit indicates the left
side of an account, and credit indicates the
right side. When comparing the totals of the
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