Accounting Fundamentals Explained

Chapter 1

Accounting in Action

Financial Accounting, IFRS Edition
Weygandt Kimmel Kieso
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1-2

Study Objectives
Study Objectives
1. Explain what accounting is.
2. Identify the users and uses of accounting.
3. Understand why ethics is a fundamental business concept.
4. Explain accounting standards and the measurement principles.
5. Explain the monetary unit assumption and the economic entity
assumption.
6. State the accounting equation, and define its components.
7. Analyze the effects of business transactions on the accounting
equation.
8. Understand the four financial statements and how they are
prepared.
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1-3


The Building
The Building The Basic
The Basic Using the
Using the
What is
What is Financial
Financial
Blocks of
Blocks of Accounting
Accounting Accounting
Accounting
Accounting?
Accounting? Equation Statements
Statements
Accounting
Accounting Equation
Equation Equation

Three Ethics in Assets Transaction Income
activities financial Liabilities analysis statement
Who uses reporting Summary of Retained
Equity
accounting Accounting transactions earnings
data? standards statement
Assumptions Statement of
financial
position
Statement of
cash flows

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1-4

What is Accounting?
What is Accounting?

The purpose of accounting:
(1) to identify, record, and communicate the economic
identify record
events of an

(2) organization to

(3) interested users.

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1-5 SO 1 Explain what accounting is.

What is Accounting?
What is Accounting?
Illustration 1-1
The activities of the
Three Activities accounting process

The accounting process includes
the bookkeeping function.

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1-6 SO 1 Explain what accounting is.

What is Accounting?
What is Accounting?

Who Uses Accounting Data
External
Internal Users
Human Taxing
Users
Resources Authorities
Labor
Unions
Finance
Management Customers

Creditors

Marketing Regulatory
Agencies
Investors

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1-7 SO 2 Identify the users and uses of accounting.

What is Accounting?
What is Accounting?
Common Questions Asked User
1. Can we afford to give our
employees a pay raise? Human Resources
2. Did the company earn a
satisfactory income? Investors
3. Should any product lines be
eliminated? Management
4. Is cash sufficient to pay
dividends to shareholders? Finance
5. What price for our product will
maximize net income? Marketing
6. Will the company be able to
pay its debts? Creditors
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1-8 SO 2 Identify the users and uses of accounting.

The Building Blocks of Accounting

Ethics In Financial Reporting
Standards of conduct by which one’s actions are judged
as right or wrong, honest or dishonest, fair or not fair,
are Ethics.

Recent financial scandals include: Enron (USA),
Parmalat (ITA), Satyam Computer Services (IND), AIG
(USA), and others.

Effective financial reporting depends on sound ethical
behavior.

Slide
1-9 SO 3 Understand why ethics is a fundamental business concept.


Ethics In Financial Reporting

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1-10 SO 3 Understand why ethics is a fundamental business concept.


Review Question
Ethics are the standards of conduct by which one's
actions are judged as:
a. right or wrong.
b. honest or dishonest.
c. fair or not fair.
d. all of these options.

Solution on
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1-11 notes page SO 3 Understand why ethics is a fundamental business concept.


Accounting Standards

International Accounting Standards Board (IASB)
http://www.iasb.org/

International Financial Reporting Standards (IFRS)

Financial Accounting Standards Board (FASB)
http://www.fasb.org/

Generally Accepted Accounting Principles (GAAP)

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1-12 SO 4 Explain accounting standards and the measurement principles.


Measurement Principles
Cost Principle (Historical) – dictates that companies record
assets at their cost.

Issues:
Reported at cost when purchased and also over the time the
asset is held.

Cost easily verified, market value is often subjective.

Fair value information may be more useful.

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Measurement Principles
Fair Value Principle – indicates that assets and liabilities should
be reported at fair value.

In determining which measurement principle to use, companies
weigh the factual nature of cost figures versus the relevance of
fair value.

Only in situations where assets are actively traded, such as
investment securities, is the fair value principle applied.

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Assumptions
Monetary Unit Assumption – include in the accounting records
only transaction data that can be expressed in terms of money.

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.

Proprietorship.
Forms of Business
Partnership. Ownership
Corporation.

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1-15 SO 5 Explain the monetary unit assumption and the economic entity assumption.


Proprietorship Partnership Corporation

Generally owned Owned by two or Ownership divided
by one person. more persons. into shares
Often small Often retail and Separate legal
service-type service-type entity organized
businesses businesses under state
Owner receives corporation law
Generally unlimited
any profits, suffers personal liability Limited liability
any losses, and is
Partnership
personally liable for
agreement
all debts.
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Review Question
Combining the activities of Kellogg and General Mills
would violate the
a. cost principle.
b. economic entity assumption.
c. monetary unit assumption.
d. ethics principle.

Solution on SO 5 Explain the monetary unit assumption
Slide
notes page
1-17 and the economic entity assumption.


Review Question
A business organized as a separate legal entity under
state law having ownership divided into shares is a
a. proprietorship.
b. partnership.
c. corporation.
d. sole proprietorship.

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notes page

Indicate whether each of the following
statements presented below is true or false.

1. The three steps in the accounting process are
True
identification, recording, and communication.

2. The two most common types of external users
False
are investors and company officers.

3. Shareholders in a corporation enjoy limited legal
True
liability as compared to partners in a partnership.

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notes page

Indicate whether each of the following
statements presented below is true or false.

4. The primary accounting standard-setting body
outside the United States is the International True
Accounting Standards Board (IASB).

5. The cost principle dictates that companies
record assets at their cost. In later periods, False
however, the fair value of the asset must be
used if fair value is higher than its cost.

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notes page

Answer on notes page
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The Basic Accounting Equation

Assets = Liabilities + Equity

Provides the underlying framework for recording and
summarizing economic events.

Applies to all economic entities regardless of size.

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1-22 SO 6 State the accounting equation, and define its components.




Assets
Resources a business owns.
Provide future services or benefits.
Cash, Inventory, Equipment, etc.
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Liabilities
Claims against assets (debts and obligations).
Creditors - party to whom money is owed.
Accounts payable, Notes payable, etc.
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Equity
Ownership claim on total assets.
Referred to as residual equity.
Share capital and retained earnings.
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Illustration 1-7

Revenues result from business activities entered into for the purpose
of earning income.
Generally results from selling merchandise, performing services,
renting property, and lending money.

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Illustration 1-7

Expenses are the cost of assets consumed or services used in the
process of earning revenue.
Common expenses are salaries expense, rent expense, utilities
expense, tax expense, etc.

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Illustration 1-7

Dividends are the distribution of cash or other assets to shareholders.
 Reduce retained earnings
 Not an expense

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Classify the following items as issuance of
shares, dividends, revenues, or expenses.
Then indicate whether each item increases or decreases
equity.
Classification Effect on Equity

1. Rent expense Expense Decrease

2. Service revenue Revenue Increase

3. Dividends Dividends Decrease

4. Salaries expense Expense Decrease

Solution on
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1-29 notes page SO 6 State the accounting equation, and define its components.

Using The Accounting Equation

Transactions are a business’s economic events
recorded by accountants.
May be external or internal.

Not all activities represent transactions.

Each transaction has a dual effect on the accounting
equation.

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1-30 SO 7 Analyze the effects of business transactions on the accounting equation.

Illustration: Are the following events recorded in the
accounting records?
Discuss Illustration 1-8

Purchase product
Event Pay rent.
computer. design with
customer.

Criterion Is the financial position (assets, liabilities, or
equity) of the company changed?

Record/
Don’t Record

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Transaction Analysis

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Transactions Analysis

Transaction (1). Investment by Shareholders. Ray and
Barbara Neal decides to open a computer programming service
which he names Softbyte. On September 1, 2011, they invest
$15,000 cash in exchange for capital shares. The effect of this
transaction on the basic equation is:

Solution on SO 7 Analyze the effects of business transactions
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1-33 on the accounting equation.


Transaction (2). Purchase of Equipment for Cash. Softbyte
purchases computer equipment for $7,000 cash.

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Transaction (3). Purchase of Supplies on Credit. Softbyte
purchases for $1,600 from Acme Supply Company computer
paper and other supplies expected to last several months.

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Transaction (4). Services Provided for Cash. Softbyte
receives $1,200 cash from customers for programming services
it has provided.

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Transaction (5). Purchase of Advertising on Credit. Softbyte
receives a bill for $250 from the Daily News for advertising but
postpones payment until a later date.

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Transaction (6). Services Provided for Cash and Credit.
Softbyte provides $3,500 of programming services for
customers. The company receives cash of $1,500 from
customers, and it bills the balance of $2,000 on account.

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Transaction (7). Payment of Expenses. Softbyte pays the
following Expenses in cash for September: store rent $600,
salaries of employees $900, and utilities $200.

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Transaction (8). Payment of Accounts Payable. Softbyte
pays its $250 Daily News bill in cash.

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Transaction (9). Receipt of Cash on Account. Softbyte
receives $600 in cash from customers who had been billed for
services [in Transaction (6)].

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Transaction (10). Dividends. The corporation pays a dividend
of $1,300 in cash.

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Illustration 1-10
Summary of Transactions Tabular summary of
Softbyte transactions

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Financial Statements

Companies prepare four financial statements from the
Companies prepare four financial statements from the
summarized accounting data:
summarized accounting data:

Retained Statement Statement
Income
Earnings of Financial of Cash
Statement
Statement Position Flows

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1-44 SO 8 Understand the four financial statements and how they are prepared.


Review Question
Net income will result during a time period when:
a. assets exceed liabilities.
b. assets exceed revenues.
c. expenses exceed revenues.
d. revenues exceed expenses.

Solution on
notes page

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Financial Statements Income Statement

Reports the revenues and expenses for a specific period of time.
Net income – revenues exceed expenses. Illustration 1-11
Financial statements and
Net loss – expenses exceed revenues. their interrelationships

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Net income is needed to determine the
Financial Statements ending balance in retained earnings.

Illustration 1-11
their interrelationships

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1-47 SO 8

Retained Earnings
Financial Statements Statement

Statement indicates the reasons why Illustration 1-11
retained earnings has increased or their interrelationships
decreased during the period.

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Financial
Financial
Statements
Statements

The ending
balance in
retained
earnings is
needed in
preparing the
statement of
financial position

Illustration 1-11

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Financial Statements Balance Sheet

Illustration 1-11

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Financial
Financial
Statements
Statements

Illustration 1-11

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1-51


Statement of Cash Flows
Information for a specific period of time.

Answers the following:

1. Where did cash come from?
2. What was cash used for?
3. What was the change in the cash balance?

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Financial Statements Statement of Cash Flows

Illustration 1-11

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Answer on
notes page
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Review Question
Which of the following financial statements is prepared
as of a specific date?
a. Balance sheet.
b. Income statement.
c. Retained earnings statement.
d. Statement of cash flows.

Solution on
notes page.

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Understanding U.S. GAAP

Key Differences Accounting in Action

In 2002, the U.S. Congress issued the Sarbanes-Oxley Act (SOX),
which mandated certain internal controls for large public
companies listed on U.S. exchanges. Debate about international
companies (non-U.S.) adopting SOX-type standards centers on
whether the benefits exceed the costs. The concern is that the
higher costs of SOX compliance are making the U.S. securities
markets less competitive.
Financial frauds have occurred at companies such as Satyam
Computer Services (IND), Parmalat (ITA), and Royal Ahold (NLD).
They have also occurred at large U.S. companies such as Enron,
WorldCom, and AIG.

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1-56



IFRS tends to be less detailed in its accounting and disclosure
requirements than GAAP. This difference in approach has resulted
in a debate about the merits of “principles-based” (IFRS) versus
“rules-based” (GAAP) standards.
U.S. regulators have recently eliminated the need for foreign
companies that trade shares in U.S. markets to reconcile their
accounting with GAAP.
GAAP is based on a conceptual framework that is similar to that
used to develop IFRS.

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1-57



The three common forms of business organization that are
presented in the chapter, proprietorships, partnerships, and
corporations, are also found in the United States. Because the
choice of business organization is influenced by factors such as
legal environment, tax rates and regulations, and degree of
entrepreneurism, the relative use of each form will vary across
countries.
Transaction analysis is basically the same under IFRS and GAAP
but, as you will see in later chapters, the different standards may
impact how transactions are recorded.

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Looking to the Future Accounting in Action

Both the IASB and the FASB are hard at work developing
standards that will lead to the elimination of major differences in
the way certain transactions are accounted for and reported.
Consider, for example, that as a result of a joint project on the
conceptual framework, the definitions of the most fundamental
elements (assets, liabilities, equity, revenues, and expenses) may
actually change. However, whether the IASB adopts internal
control provisions similar to those in SOX remains to be seen.

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Career Opportunities
Career Opportunities APPENDIX

Public accounting Government

Private accounting Forensic accounting

“Show me
the Money”

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1-60 SO 9 Explain the career opportunities in accounting.

Copyright
Copyright

Copyright © 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.

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Accounting Fundamentals Explained

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