CHAPTER 1: ACCOUNTING IN ACTION
Accounting Activities and Users
- Accounting consists of three basic activities – it identifies, records, and communicates the
economic events of an organization to interested users.
Three Activities
- As a starting point for the accounting process, a company identifies the economic events
relevant to its business.
- After that, it records those events in order to provide a history of its financial activities.
Consisting of keeping a systematic chronological diary of events, measured in monetary
units.
- Finally, the company communicates the collected information to interested users by
means of accounting reports (the most common are financial statements)
- The company accumulates information resulting from similar transactions, such data are
said to be reported in the aggregate.
- A vital element in communicating economic events: the accountant’s ability to analyze
and interpret the reported information.
Analysis: use of ratios, percentages, graphs, and charts to highlight significant
financial trends and relationships.
Interpretation: explaining the uses, meaning, and limitations of reported data.
- The accounting process includes the bookkeeping function (involves only the recording
of economic events).
Who Uses Accounting Data
- There are two broad groups of users of financial information: internal users and external
users.
Internal Users
- Internal users of accounting information are managers who plan, organize, and run the
business.
- Managerial accounting provides internal reports to help users make decisions about their
companies.
External Users
- External users are individuals and organizations outside a company who want financial
information about the company (most common: investors and creditors).
Investors (owners) use accounting information to decide whether to buy, hold, or sell
ownership shares of a company.
Creditors (suppliers and bankers) use to evaluate the risks of granting credit or
lending money.
- Financial accounting answers these questions. The information needs of external users
vary considerably.
Taxing authorities: whether the company complies with tax laws.
Regulatory agencies: whether the company is operating within prescribed rules.
, Customers: whether the company will continue to honor product warranties and
support its product lines.
Labor unions: whether companies have the ability to pay increased wages and
benefits to union members.
The Building Blocks of Accounting
Ethics in Financial Reporting
- A sound, well-functioning economy depends on accurate and dependable financial
reporting.
- The standards of conduct by which actions are judged as right or wrong, honest or
dishonest, fair or not fair, are ethics.
- When analyzing these various ethics cases, as well as experiences in your own life, it is
useful to apply the three steps:
Recognize an ethical situation and the ethical issues involved.
Identify and analyze the principal elements in the situation
Identify the alternative, and weigh the impact of each alternative on various
stakeholders.
Accounting Standards
- In order to ensure high-quality financial reporting, accountants present financial
statements in conformity with accounting standards that are issued by standard-setting
bodies.
- Two primary accounting standard-setting bodies:
International Accounting Standard Board (IASB) (International Financial Reporting
Standards (IFRS) are determined by the IASB)
Financial Accounting Standards Board (FASB)
- Most companies in the US follow standards issued by the FASB, referred to as generally
accepted accounting principles (GAAP).
- The two standard-setting bodies made efforts to reduce the differences between IFRS and
US GAAP (this process is referred to as convergence).
Measurement Principles
- IFRS generally uses one of two measurement principles:
The historical cost principle
The fair value principle
- Selection of which principle to follow relates to trade-offs between relevance and faithful
representation.
Relevance: Financial information is capable of making a difference in a decision
Faithful representation: The numbers and descriptions match what really existed or
happened – they are factual.
Historical Cost Principle
, - The historical cost principle dictates that companies record assets at their cost.
Fair Value Principle
- 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).
- In determining which measurement principle to use, companies weigh the factual nature
of cost figures versus the relevance of fair value.
Assumptions
- Two main assumptions are the monetary unit assumption and the economic entity
assumption.
Monetary Unit Assumption
- The monetary unit assumption requires that companies include in the accounting records
only transaction data that can be expressed in money terms.
- The monetary unit assumption is vital to applying the historical cost principle.
Economic Entity Assumption
- An economic entity can be any organization or unit in society. It may be a company, a
government unit, a municipality, or a temple.
- 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.
The Accounting Equation
Assets = Liabilities + Equity
- This relationship is the basic accounting equation.
- Liabilities appear before equity in the basic accounting equation because they are paid
first if a business is liquidated.
- The accounting equation applies to all economic entities.
Assets
- The common characteristic possessed by all assets is the capacity to provide future
services or benefits.
Liabilities
- Liabilities are claims against assets – that is, existing debts and obligations.
- The economic activities result in payables of various sorts: accounts payable, note
payable, salaries and wages payable, and sales and real estate taxes payable
- All of these persons or entities to whom the company owes money are its creditors
Equity
- The ownership claim on a company’s total assets is equity
- Residual equity: The equity “leftover” after creditors’ claims are satisfied.
- Equity generally consists of:
, Share Capital-ordinary
- Share capital-ordinary is the term used to describe the amounts paid in by shareholders
for the ordinary shares they purchase.
- Is affected when the company issues new ordinary shares in exchange for cash.
Retained Earnings
- Retained Earnings is determined by three items:
Revenues: the gross increases in equity resulting from business activities entered into
for the purpose of earning income. Revenues usually result in an increase in an asset.
Expenses: the cost of assets consumed or services used in the process of earning
revenue. They are decreases in equity that result from the operation of the business.
Dividends: The distribution of cash or other assets to shareholders is called a
dividend. Dividends are not expenses.
- Is affected when the company earns revenue, incurs expenses, or pays dividends.
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.
- Factors that shape an accounting information system include the nature of the company’s
business, the types of transactions, the size of the company, the volume of data, and the
information demands of management and others.
- Most businesses use computerized accounting systems (electronic data processing (EDP)
systems).
- Accounting information systems rely on a process referred to as the accounting cycle
(begins with the analysis of business transactions and ends with the preparation of a post-
closing trial balance).
Accounting Transactions
- Transactions are 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.
- Companies carry on many activities that do not represent business transactions.
- The company must analyze each event to find out if it affects the components of the
accounting equation.
- Each equation must have a dual effect on the accounting equation.
