Chapter 1: Accounting in action
1.2 Explain what accounting is.
Accounting consists of three basic activities: identifying, recording and communicating the
economic events of an organization to interested users.
- Economic events relevant to its business are identified;
- Events are then recorded in a systematic, chronological diary of events
- Finally, information is communicated to its interested users by means of accounting
records. The most common are financial statements, in which data is showed in
aggregated form.
Accountants analyze and interpret information as part of the communication step.
Bookkeeping involves only the recording of economic events; it is just one part of the
process.
1.2 Identify the users and uses of accounting.
Internal users of accounting information are managers who plan, organize and run the
business. E.g. marketing managers, and production supervisors. Internal users need detailed
information on a timely basis. 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. Two most common types:
- Creditors (suppliers and bankers, use accounting information to evaluate the risk of
granting credit or lending money).
- Investors (who make decisions about buying, holding and selling ownership shares).
Financial accounting answers these questions. Economic and financial information to
investors, creditors and other external users. Taxing authorities, regulatory agencies,
customers and labor unions.
11.3 Understand why ethics is a fundamental business concept.
Information provided in the financial statements must be credible. Effective financial
reporting depends on sound ethical behavior.
1. Recognize an ethical situation and the ethical issues involved.
2. Identify and analyze the principal elements in the situation
3. Identify the alternatives and weigh the impact of each alternative on various
stakeholders.
11.4 Explain accounting standards and the measurement principles.
More than 130 countries accept the International Financial Reporting Standards (IFRS). Most
companies in the US follow GAAP. These two are getting closer to each other, they are
converging.
IFRS generally uses one of the two measurement principles; the historical cost principle or
the fair value principle. Relevance means that financial information is capable of making a
,difference in a decision. Faithful representation means that the numbers and description
match what really existed or happened.
The historical cost principle dictates that companies record assets at the cost.
The fair value principle states that assets and liabilities should be reported at fair value. This
may be more useful than the historical cost principle. In situations in which assets are
actively trades, do companies apply their fair value principle.
11.5 Explain the monetary unit assumption and the economic entity assumption
The monetary unit assumption requires that companies include in the accounting records
only a transaction data that can be expressed in money terms. Vital in applying the historical
cost principle.
An economic entity can be any organization or unit in society. The 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.
A business owned by one person is generally a proprietorship. The owner is often the
manager of the business. Only a small amount of money is needed to start one. The owner
receives any profits, suffers any losses, and is personally liable for all debts of the business.
No legal distinction between the business as an economic unit and the owner.
A partnership is a business owned by two or more persons. Each member has unlimited
liability for the debts of the partnership.
A business organization as a separate legal entity under corporation law and having
ownership divided into transferable shares is a corporation. The holder of the shares have
limited liability. Shares can be sold and issued. Ownership can be transferred without
dissolving the corporation, so it has unlimited life.
11.6 State the accounting equation and define its components.
Assets are the resources a business owns. Liabilities and equity are the rights or claims
against these resources. Claims of owners are equity, claims of creditors and liabilities.
ASSETS = LIABILITIES + EQUITY
This is the basic accounting equation. It applies to all economic entities.
The common characteristic of an asset is that it is the capacity to provide future services or
benefits. Usually in the form of cash inflows.
Liabilities are claims against an asset. It exists of notes payable, accounts payable, salaries
and wages payable and sales and real estate tax payable. Claims of creditors are to be paid
before claims of owners.
Equity is the ownership claim on a company’s total assets. Often residual equity, what is left
over when the creditors had their claims. Usually consists of Share Capital-Ordinary and
Retained Earnings.
,Retained Earnings is determined by revenues, expenses and dividends. Revenue is the gross
increase in equity resulting from business activities entered into for the purpose of earning
income. Usually results in an increase in an asset or decrease in a liability.
Expenses are the decreases in equity that result from operating the business. It are the costs
of assets consumed or services used in the process of earning revenue. Results in a decrease
in a decrease in assets or an increase in liabilities.
A dividend is the distribution of cash or other assets to shareholders. It is not an expense. If
a company has net income, it may decide to distribute some of that to its shareholders.
RETAINED EARNINGS = REVENUES – EXPENSES – DIVIDENDS
11.7 Analyze the effects of business transactions on the accounting equation.
Transactions (business transactions) are a business’ economic events recorded by
accountants. They may be internal or external. 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 consists of two parts, debit and credit.
11.8 Understand the five financial statements and how they are prepared.
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 statement of financial position (balance sheet) reports the assets, liabilities and equity
of a company at a specific date.
4. A statement of cash flows summarizes information about the cash inflows (receipts) and
cash outflows (payments) for a specific period of time.
5. A comprehensive income statement presents other comprehensive income items that are
not included in the determination of net income.
Net income on the income statement is added to the beginning balance of the retained
earnings. Retained earnings at the end of the reporting period is reported on the statement
of financial position. Cash on the statement of financial position is reported on the
statement of cash flows.
The income statement reports the success or profitability of the company’s operations over
a specific period of time. It lists revenues, followed by expenses. Then, net income/loss is
calculated. When revenues (credit) exceed expenses (debit), we have net income.
The period covered in the retained earnings statement is the same as in the income
statement. The first step is the retained earnings value of the beginning period, then net
income/loss is added. Dividends are subtracted from this. The, the retained earnings ending
balance is shown.
,The Statement of financial position reports the assets, liabilities and equity at a specific
date. Total assets must equal total liabilities and equity.
The Statement of cash flows provides information on the cash receipts and payments for a
specific period. It reports:
- The cash effects of a company’s operations during a period;
- Its investing activities
- Its financing activities
- The net increase or decrease in cash during the period
- The cash amount at the end of the period
The comprehensive income statement exists in addition to the income statement. It is
prepared when other comprehensive income exists, which is added to net income.
APPENDIX 1A
Individuals in public accounting offer expert service to the general public, like e.g. lawyers
do. A major portion of public accounting involves auditing. In auditing, an independent
accountant examines the company financial statements and provides an opinion as to how
accurately the financial statements present the company’s results and financial positions.
Taxation is another major part of accounting. The third area is managerial consulting.
In private accounting (managerial accounting), you would be involved in activities such as
cost accounting, budgeting, design and support and tax planning. You might be part of your
company’s internal audit team.
Governmental accounting exists too. As well as forensic accounting, where accounting,
auditing and investigative skills to conduct investigations into theft and fraud is used.
Chapter 2: The Recording Process
2.1 Explain what an account is and how it helps in the recording process.
An account is an individual accounting record of increases and decreases in a specific asset,
liability or equity item. When we refer to an account, we capitalize the name. An account
exists of three parts; a title, a left or debit side and a right or credit side. We refer to it as a T-
account.
2.2 Define debits and credits and explain their use in recording business transactions.
Debit, the left side of an account, is usually abbreviated to Dr. Credit, the right side of an
account, is usually abbreviated to Cr. This is NOT AN INCREASE/DECREASE. It indicates where
the entry is made.
When the totals are compared, the side with the exceeding amount shows the balance. So,
when debits exceed credits, there is a debit balance. In the account form, we record an
increase in cash as debits, and the decrease in cash as credits.
,The equality of the debits and credits provides the basis for the double-entry system of
recording transactions. It provides accuracy and prevents errors.
Debits Credits
- Increase assets - Decrease assets
- Decrease liabilities - Increase liabilities
- Decrease revenues - Increase revenues
- Increase expenses - Decrease expenses
Asset accounts normally show debit balances. Liabilities normally show credit balances.
These are normal balances, as they come naturally.
Share Capital-Ordinary normally shows a credit balance, because when shares are issued,
they bring equity.
Retained earnings is net income that is retained in the business. Net income (credit)
increases the retained earnings account, and debits (expenses) decrease it.
A dividend is a company’s distribution to its shareholders. Cash dividends are the most
common form. Credits decrease the dividends account.
Revenues are a subdivision of equity that provides information as to why equity increased.
Credits increase the revenue accounts. The effect of debits and credits on revenue accounts
is the same as their effect on equity.
Expenses decrease equity. The increases and decreases in expenses are the opposite of
increases and decreases in revenue.
2.3 Identify the basic steps in the recording process.
1. Analyze each transaction for its effects on the accounts;
2. Enter the transaction information in a journal;
3. Transfer the journal information to the appropriate accounts in the ledger.
2.4 Explain what a journal is and how it helps in the recording process.
The journal is referred to as the book of original entry. For each transaction, the journal
shows the debit and credit effects on specific accounts. A general journal has spaces for
dates, account titles and explanations, references and two amount columns. The
contributions of the general journal:
- It discloses in one place the complete effects of a transaction;
- It provides a chronological record of transactions;
- It helps to prevent or locate errors because the debit and credit amounts for each
entry can be easily compared.
Entering a transaction in a journal is called journalizing. It exists of the date, the account and
a brief explanation.
A simple entry is an entry where only two accounts are involved. A compound entry
involves more accounts. Debits are listed before credits.
2.5 Explain what a ledger is and how it helps in the recording process.
, The entire group of accounts maintained by a company is the ledger. Every company has a
general ledger, which contains all the assets, equity accounts and liability accounts.
The three-column form of account has debit, credit and balance.
2.6 Explain what posting is and how it helps in the recording process.
Transferring journal entries to the ledger accounts is called posting. It involves:
- In the ledger, enter, the columns of accounts debited, the date, journal page and
debit amount;
- In the reference column of the journal, write the account number to which the debit
amount was posted;
- In the ledger, enter, in the appropriate columns of the accounts credited, the date,
journal page, and credit column shown in the journal;
- In the reference column of the journal, write the account number to which the credit
column was posted.
Most companies have a chart of accounts, which indicates the number of the accounts used
in the company.
The purpose of transaction analysis is to identify the type of account involved, and then to
determine whether to make a debit or a credit to the account.
Investment of cash by shareholders
Dr. Cash x
Cr. Share Capital-Ordinary x
Purchase of office equipment (on account or in cash)
Dr. Equipment x
Cr. Notes Payable/Cash x
Receipt of cash for future service (so, a liability)
Dr. Cash x
Cr. Unearned Service Revenue x
Payment of monthly rent
Dr. Rent Expense x
Cr. Cash x
Payment of insurance (in advance, so an asset)
Dr. Prepaid Insurance x
Cr. Cash x
Purchase of supplies on credit
Dr. Supplies x
Cr. Accounts Payable x
Declaration and payment of dividend
