CHAPTER 1

ACCOUNTING IN ACTION
After studying this chapter, you should be able to:
1 Explain what accounting is.
2 Identify the users and uses of accounting.
3 Understand why ethics is a fundamental
business concept.
4 Explain the meaning of generally accepted
accounting principles and the cost
principle.
 CHAPTER 1
ACCOUNTING IN ACTION
After studying this chapter, you should be able to:
5 Explain the meaning of the monetary unit
assumption and the economic entity assumption.
6 State the basic accounting equation and explain
the meaning of assets, liabilities, and owner’s
equity.
7 Analyze the effect of business transactions on the
basic accounting equation.
8 Understand what the four financial statements
are and how they are prepared.
 STUDY OBJECTIVE 1

Explain what accounting is.

 WHAT IS ACCOUNTING?
Accounting is an information system that
1) identifies, 2) records, and 3) communicates
the economic events of an organization to
interested users
 WHAT IS ACCOUNTING?
• Economic events are recorded to provide a
history of the organization’s financial activities.
• Recording consists of keeping a systematic.
chronological diary of events.
• Events measured in money unit $, SR .
 ILLUSTRATION 1-1
THE ACCOUNTING PROCESS
Communication
Accounting
Identification Recording Reports

Prepare accounting
reports

SOFTBYTE
Select economic events Record, classify Annual Report

(transactions) and summarize

Analyze and interpret

for users
 STUDY OBJECTIVE 2

Identify the users and uses of accounting.

 Who are the users?

• Internal users are managers who plan,

organize, and run a business.
• External users are those users outside of
the business who are:
– Investors or creditors
– Other external users
 ILLUSTRATION 1-2
QUESTIONS ASKED BY INTERNAL USERS

What is the cost of manufacturing

Is cash sufficient to pay bills? each unit of product?

Can we afford to give employee Which product line is the most

pay raises this year? profitable?
 ILLUSTRATION 1-3
QUESTIONS ASKED BY EXTERNAL USERS

How does the company compare

Is the company earning in size and profitability with its
satisfactory income? competitors?
What do we
do if they
catch us?

Will the company be able to pay its debts as they come due?
 Financial Accounting and
Managerial Accounting
⚫ Financial accounting is the field of accounting
that provides economic and financial information
for investors, creditors, and other external
users.

⚫ Managerial accounting provides economic and

financial information for managers and other
internal users.
What is the difference between bookkeeping
and accounting
Accounting
• Involves the entire process of
identifying, recording, and
communicating economic
events
Bookkeeping
• Involves only the recording
of economic events
• Is just one part of
accounting
 THE ACCOUNTING PROFESSION

⚫ Public accountants offer expert service to the

general public through the services they perform.
⚫ Private accountants are employees of individual
companies and are involved in a number of
activities including cost and tax accounting,
systems, and internal auditing.
⚫ Not for Profit accounting includes reporting and
control for government units, foundations,
hospitals, labor unions, colleges/universities, and
charities.
 STUDY OBJECTIVE 4

Explain the meaning of generally accepted

accounting principles and the cost principle.
 What is GAAP?

• Generally Accepted Accounting Principles -

primarily established by the Financial
Accounting Standards Board and the
Securities and Exchange Commission.
• Two organizations are responsible for
establishing GAAP:
– The Financial Accounting Standards Board (FASB)
– The Securities and Exchange Commission (SEC)
 STUDY OBJECTIVE 5

Explain the meaning of the monetary unit

assumption and the economic entity assumption.
 Assumptions

1 Monetary Unit - only transaction data that

can be expressed in terms of money is
included in the accounting records.
2 Economic Entity - includes any organization
or unit in society.
 BUSINESS ENTERPRISES
⚫ A business owned by one person is generally a
proprietorship.
⚫ A business owned by two or more as partners is a
partnership.
⚫ A business organized as a separate legal entity under
state corporation law and having ownership divided into
transferable shares of stocks is a corporation.
 STUDY OBJECTIVE 6

State the basic accounting equation and

explain the meaning of assets, liabilities,
and owner’s equity.
 ILLUSTRATION 1-6
BASIC ACCOUNTING EQUATION

The Basic Accounting Equation

Assets = Liabilities + Owner’s Equity

 ASSETS AS A BUILDING BLOCK

⚫ Assets are resources owned by a business.

⚫ They are used in carrying out such activities as
production, consumption and exchange.
LIABILITIES AS A BUILDING BLOCK

⚫ Liabilities are claims against assets.

⚫ They are existing debts and obligations.
 OWNER’S EQUITY AS
A BUILDING BLOCK

⚫ Owner’s Equity is equal to total assets minus total

liabilities.
⚫ Owner’s Equity represents the ownership claim
on total assets.
⚫ Subdivisions of Owner’s Equity:
1 Capital or Investments by Owner
2 Drawing
3 Revenues
4 Expenses
 INVESTMENTS BY OWNERS
AS A BUILDING BLOCK

⚫Investments by Owner are the assets the owner

puts in the business.
⚫These investments increase owner’s equity.
 DRAWINGS AS A
BUILDING BLOCK

⚫Drawings are withdrawals of cash or other

assets by the owner for personal use.
⚫Drawings decrease owner’s equity.
 REVENUES AS A
BUILDING BLOCK
⚫Revenues are the gross increases in owner’s
equity resulting from business activities
entered into for the purpose of earning
income.
⚫Revenues may result from sale of
merchandise, performance of services,
rental of property, or lending of money.
⚫Revenues usually result in an increase in an
asset.
 EXPENSES AS A
BUILDING BLOCK

⚫Expenses are the decreases in owner’s equity

that result from operating the business.
⚫They are the cost of assets consumed or
services used in the process of earning
revenue.
⚫Examples of expenses may be utility expense,
rent expense, supplies expense, and tax
expense.
 ILLUSTRATION 1-7
INCREASES AND DECREASES IN OWNER’S EQUITY

INCREASES DECREASES
Investments Withdrawals
by Owner by Owner
Owner’s
Equity
Revenues Expenses
 STUDY OBJECTIVE 7

Analyze the effect of business transactions

on the basic accounting equation.
 ILLUSTRATION 1-8
TRANSACTION IDENTIFICATION PROCESS

Purchase Answer Pay rent

computer telephone
Is the financial position (assets, liabilities, and
owner’s equity) of the company changed?

Yes No Yes

Don’t
Record Record
Record
 TRANSACTION ANALYSIS
TRANSACTION 1

⚫ Ray Neal decides to open a computer programming

service.
⚫ On September 1, he invests $15,000 cash in the business,
which he names Softbyte.
BANK

Softbyte
 TRANSACTION ANALYSIS
TRANSACTION 1 SOLUTION

Assets = Liabilities + Owner’s Equity

R. Neal,
Cash Capital
(1) +15,000 = +15,000 Investment

There is an increase in the asset Cash,

$15,000, and an equal increase in the
owner’s equity, R. Neal, Capital, $15,000.
 TRANSACTION ANALYSIS
TRANSACTION 2

Softbyte purchases computer equipment for $7,000 cash.

 TRANSACTION ANALYSIS
TRANSACTION 2 SOLUTION

Assets = Liabilities + Owner’s Equity

R. Neal,
Cash + Equipment = Capital
Old Bal. $15,000 $15,000
(2) -7,000 +$7,000
New Bal. $ 8,000 + $7,000 = $15,000

$15,000

Cash is decreased $7,000, and the asset

Equipment is increased $7,000.
 TRANSACTION ANALYSIS
TRANSACTION 3

⚫ Softbyte purchases for $1,600 from Acme Supply

Company computer paper and other supplies expected to
last several months.
⚫ Acme agrees to allow Softbyte to pay this bill next month,
in October.
⚫ This transaction is referred to as a purchase on account
or a credit purchase.
Acme Supply Company

Softbyte
 TRANSACTION ANALYSIS
TRANSACTION 3 SOLUTION

Assets = Liabilities + Owner’s Equity

Accounts R. Neal,
Cash + Supplies + Equipment = Payable + Capital
Old Bal. $8,000 $7,000 $15,000
(3) +$1,600 +$1,600
New Bal. $8,000 + $1,600 + $7,000 = $1,600 + $15,000

$16,600 $16,600

The asset Supplies is increased $1,600, and the liability

Accounts Payable is increased by the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 4

⚫ Softbyte receives $1,200 cash from customers for

programming services it has provided.
⚫ This transaction represents the Softbyte’s
principal revenue-producing activity.

Softbyte
 TRANSACTION ANALYSIS
TRANSACTION 4 SOLUTION

Assets = Liabilities + Owner’s Equity

Accounts R. Neal,
Cash + Supplies + Equipment = Payable + Capital
Old Bal. $8,000 $1,600 $7,000 $1,600 $15,000
(4) +1,200 +1,200 Service Revenue
New Bal. $9,200 + $1,600 + $7,000 = $1,600 + $16,200

$17,800 $17,800

Cash is increased $1,200, and R. Neal,

Capital is increased $1,200.
 TRANSACTION ANALYSIS
TRANSACTION 5

Softbyte receives a bill for $250 from the Daily News

for advertising but postpones payment of the bill
until a later date.

Softbyte Bill

Daily News
 TRANSACTION ANALYSIS
TRANSACTION 5 SOLUTION

Assets = Liabilities + Owner’s Equity

Accounts R. Neal,
Cash + Supplies + Equipment = Payable + Capital
Old Bal. $9,200 $1,600 $7,000 $1,600 $16,200
(5) +250 -250 Advertising Expense
New Bal. $9,200 + $1,600 + $7,000 = $1,850 + $15,950

$17,800 $17,800

Accounts Payable is increased $250, and

R. Neal, Capital is decreased $250.
 TRANSACTION ANALYSIS
TRANSACTION 6

⚫ Softbyte provides $3,500 of programming services

for customers.
⚫ Cash of $1,500 is received from customers, and
the balance of $2,000 is billed on account.

Softbyte
Bill
 TRANSACTION ANALYSIS
TRANSACTION 6 SOLUTION

Assets = Liabilities + Owner’s Equity

Accounts Accounts R. Neal,
Cash + Receivable + Supplies + Equipment = Payable + Capital
Old Bal. $ 9,200 $1,600 $7,000 $1,850 $15,950
(6) +1,500 +2,000 +3,500 Service
New Bal.
Revenue $10,700 + $2,000 + $1,600 + $7,000 = $1,850 + $19,450

$21,300 $21,300

Cash is increased $1,500; Accounts Receivable is increased

$2,000; and R. Neal, Capital is increased $3,500.
 TRANSACTION ANALYSIS
TRANSACTION 7

Expenses paid in cash for September are store rent

$600, salaries of employees $900, and utilities $200.

$600

$900
Softbyte

$200
 TRANSACTION ANALYSIS
TRANSACTION 7 SOLUTION

Assets = Liabilities + Owner’s Equity

Accounts Accounts R. Neal,
Cash + Receivable + Supplies + Equipment = Payable + Capital
Old Bal. $10,700 $2,000 $1,600 $7,000 $1,850 $19,450
(7) -1,700 -600 Rent Exp.
-900 Salaries Exp.
-200 Salaries Exp.
New Bal. $ 9,000 + $2,000 + $1,600 + $7,000 = $1,850 + $17,750

$19,600 $19,600

Cash is decreased $1,700 and R. Neal, Capital is decreased

by the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 8

Softbyte pays its $250 Daily News advertising bill in

cash.

Softbyte

Daily News
 TRANSACTION ANALYSIS
TRANSACTION 8 SOLUTION

Assets = Liabilities + Owner’s Equity

Accounts Accounts R. Neal,
Cash + Receivable + Supplies + Equipment = Payable + Capital
Old Bal. $9,000 $2,000 $1,600 $7,000 $1,850 $17,750
(8) -250 -250
New Bal. $8,750 + $2,000 + $1,600 + $7,000 = $1,600 + $17,750

$19,350 $19,350

Cash is decreased $250 and Accounts Payable is decreased

by the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 9

The sum of $600 in cash is received from

customers who have previously been billed
for services (in Transaction 6).

Softbyte
 TRANSACTION ANALYSIS
TRANSACTION 9 SOLUTION

Assets = Liabilities + Owner’s Equity

Accounts Accounts R. Neal,
Cash + Receivable + Supplies + Equipment = Payable + Capital
Old Bal. $8,750 $2,000 $1,600 $7,000 $1,600 $17,750
(9) +600 -600
New Bal. $9,350 + $1,400 + $1,600 + $7,000 = $1,600 + $17,750

$19,350 $19,350

Cash is increased $600 and Accounts

Receivable is decreased by the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 10

Ray Neal withdraws $1,300 in cash

from the business for his personal use.

$1,300
Softbyte
 TRANSACTION ANALYSIS
TRANSACTION 10 SOLUTION

Assets = Liabilities + Owner’s Equity

Accounts Accounts R. Neal,
Cash + Receivable + Supplies + Equipment = Payable + Capital
Old Bal. $9,350 $1,400 $1,600 $7,000 $1,600 $17,750
(10) -1,300 -1,300 Drawings
New Bal. $8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $16,450

$18,050 $18,050

Cash is decreased $1,300 and R. Neal, Capital is decreased

by the same amount.
 STUDY OBJECTIVE 8

Understand what the four financial

statements are and how they are
prepared.
 FINANCIAL STATEMENTS
After transactions are identified, recorded, and summarized,
4 financial statements are prepared 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 An owner’s equity statement summarizes the changes in
owner’s equity for a specific period of time.
3 A balance sheet reports the assets, liabilities, and owner’s
equity 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.
 ILLUSTRATION 1-11
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE
Income Statement
For the Month Ended September 30, 2002
Revenues
Service revenue $ 4,700
Expenses
Salaries expense $ 900
Rent expense 600
Advertising expense 250
Utilities expense 200
Total expenses 1,950
Net income 2,750

Net income of $2,750 shown on the income statement is added to the

beginning balance of owner’s capital in the owner’s equity statement.
 ILLUSTRATION 1-11
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE
Owner’s Equity Statement
For the Month Ended September 30, 2002
Capital, September 1 $ –0–
Add: Investments $ 15,000
Net income 2,750 17,750
17,750
Less: Drawings 1,300
Capital, September 30 $ 16,450

Net income of $2,750 is determined from the information in the owner’s

equity column of the Summary of Transactions (Illustration 1-7).
 ILLUSTRATION 1-11
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE
Owner’s Equity Statement
For the Month Ended September 30, 2002
Capital, September 1 $ –0–
Add: Investments $ 15,000
Net income 2,750 17,750
17,750
Less: Drawings 1,300
Capital, September 30 $16,450

Net income of $2,750 carried forward from the income statement to the
owner’s equity statement. The owner’s capital of $16,450 at the end of the
reporting period is shown as the final total of the owner’s equity column of the
Summary of Transactions (Illustration 1-7).
 ILLUSTRATION 1-11
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE
Balance Sheet
September 30, 2002
Assets
Cash $ 8,050
Accounts receivable 1,400
Supplies 1,600
Equipment 7,000
Total assets $ 18,050
Liabilities and Owner’s Equity
Liabilities
Accounts payable $ 1,600
Owner’s equity
16,450
R. Neal, capital
Total liabilities and owner’s equity $ 18,050

Owner’s capital of $16,450 at the end of the reporting period shown

in the owner’s equity statement is shown on the balance sheet.
 ILLUSTRATION 1-11
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE
Balance Sheet
September 30, 2002
Assets
Cash $ 8,050
Accounts receivable 1,400
Supplies 1,600
Equipment 7,000
Total assets $ 18,050
Liabilities and Owner’s Equity
Liabilities
Accounts payable $ 1,600
Owner’s equity

R. Neal, capital
Total liabilities and owner’s equity $ 18,050

Cash of $8,050 on the balance sheet is reported on the statement of cash flows.
 ILLUSTRATION 1-11
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE
Statement of Cash Flows
For the Month Ended September 30, 2002
Cash flows from operating activities
Cash receipts from revenues $ 3,300
Cash payments for expenses (1,950)
Net cash provided by operating activities 1,350
Cash flows from investing activities
Purchase of equipment (7,000)
Cash flows from financing activities
Investment by owners $ 15,000
Withdraws by owners (1,300)
Net cash provided by financing activities 13,700
Net increase in cash 8,050
Cash at the beginning of the period –0–
Cash at the end of the period $ 8,050

Cash of $8,050 on the balance sheet and statement of cash flows is shown as the
final total of the cash column of the Summary of Transactions (Illustration 1-7).
 COPYRIGHT

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 CHAPTER 1
ACCOUNTING IN ACTION