Financial Accounting
environment
Learning Objectives
After studying this chapter, you should be able to:
1.
Explain what accounting is.
2.
Explain accounting standards and the measurement principles.
3.
State the accounting equation, and define its components.
4. Explain what an account is and how it helps in the recording process.
5. Define debits and credits and explain their use in recording business transactions.
1-1
What is Accounting?
Accounting consists of three basic activities - it

identifies,

records, and

communicates
the economic events of an organization to interested users.
1-2
LO 1 Explain what accounting is.
What is Accounting?
Three Activities
Illustration 1-1
The activities of the
accounting process
The accounting process includes
the bookkeeping function.
1-3
LO 1 Explain what accounting is.
Who Uses Accounting Data
Internal
Users
External
Users
Human
Resources
Taxing
Authorities
Labor
Unions
Finance
Management
Customers
Creditors
Marketing
1-4
Regulatory
Agencies
Investors
LO 2 Identify the users and uses of accounting.
Who Uses Accounting Data
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
1-5
LO 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.
1-6

Recent financial scandals include: Enron (USA),
Parmalat (ITA), Satyam Computer Services (IND), AIG
(USA), and others.

Effective financial reporting depends on sound ethical
behavior.
LO 3 Understand why ethics is a fundamental business concept.
The Building Blocks of Accounting
Ethics In Financial Reporting
Illustration 1-4
Steps in analyzing ethics cases
and situations
1-7
LO 3 Understand why ethics is a fundamental business concept.
The Building Blocks of Accounting
Measurement Principles
Cost Principle – or historical cost principle, dictates that
companies record assets at their cost.
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).
1-8
LO 4 Explain accounting standards and the measurement principles.
The Building Blocks of Accounting
Assumptions
Monetary Unit – include in the accounting records only
transaction data that can be expressed in money terms.
Economic Entity – requires that activities of the entity be
kept separate and distinct from the activities of its owner and
all other economic entities.
1-9

Proprietorship.

Partnership.

Corporation.
Forms of Business
Ownership
LO 5 Explain the monetary unit assumption
and the economic entity assumption.
Forms of Business Ownership
Proprietorship

Generally owned
by one person

Owned by two or
more persons

Often small
service-type
businesses

Often retail and
service-type
businesses
Owner receives
any profits,
suffers any
losses, and is
personally liable
for all debts


1-10
Partnership

Generally
unlimited
personal liability
Corporation

Ownership
divided into
shares

Separate legal
entity organized
under corporation
law

Limited liability
Partnership
agreement
LO 5 Explain the monetary unit assumption
and the economic entity assumption.
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.
1-11
LO 6 State the accounting equation, and define its components.
The Basic Accounting Equation
Assets
=
Liabilities
+
Equity
Provides the underlying framework for recording and
summarizing economic events.
Assets
1-12

Resources a business owns.

Provide future services or benefits.

Cash, Inventory, Equipment, etc.
LO 6 State the accounting equation, and define its components.
The Basic Accounting Equation
Assets
=
Liabilities
+
Equity
Provides the underlying framework for recording and
summarizing economic events.
Liabilities
1-13

Claims against assets (debts and obligations).

Creditors - party to whom money is owed.

Accounts payable, Notes payable, etc.
LO 6 State the accounting equation, and define its components.
The Basic Accounting Equation
Assets
=
Liabilities
+
Equity
Provides the underlying framework for recording and
summarizing economic events.
Equity
1-14

Ownership claim on total assets.

Referred to as residual equity.

Share capital-ordinary and retained earnings.
LO 6 State the accounting equation, and define its components.
The Basic Accounting Equation
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.
1-15
LO 6 State the accounting equation, and define its components.
The Basic Accounting Equation
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, interest
expense, property tax expense, etc.
1-16
LO 6 State the accounting equation, and define its components.
The Basic Accounting Equation
Illustration 1-7
Dividends are the distribution of cash or other assets to shareholders.
1-17

Reduce retained earnings

Not an expense
LO 6 State the accounting equation, and define its components.
Using the Accounting Equation
Transactions are a business’s economic events recorded
by accountants.
1-18

May be external or internal.

Not all activities represent transactions.

Each transaction has a dual effect on the accounting
equation.
LO 7 Analyze the effects of business transactions on the accounting equation.
Using the Accounting Equation
Illustration: Are the following events recorded in the accounting
records?
Event
Criterion
Purchase
computer.
Discuss
product
design with
customer.
Illustration 1-8
Pay rent.
Is the financial position (assets, liabilities, or equity)
of the company changed?
Record/
Don’t Record
1-19
LO 7 Analyze the effects of business transactions on the accounting equation.
Using the Accounting Equation
Transaction Analysis
Illustration 1-9
Expanded accounting equation
1-20
LO 7 Analyze the effects of business transactions on the accounting equation.
Transaction Analysis
Transaction (1). Investment by Shareholders. Ray and Barbara Neal
decides to open a computer programming service which he names
Softbyte. On September 1, 2014, they invest €15,000 cash in exchange for
€15,000 of ordinary shares.
Illustration 1-10
1-21
LO 7
Transaction Analysis
Transaction (2). Purchase of Equipment for Cash. Softbyte purchases
computer equipment for €7,000 cash.
Illustration 1-10
1-22
LO 7
Transaction Analysis
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. The purchase is on account.
Illustration 1-10
1-23
LO 7
Transaction Analysis
Transaction (4). Services Provided for Cash. Softbyte receives €1,200
cash from customers for programming services it has provided.
Illustration 1-10
1-24
LO 7
Transaction Analysis
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.
Illustration 1-10
1-25
LO 7
Transaction Analysis
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.
Illustration 1-10
1-26
LO 7
Transaction Analysis
Transaction (7). Payment of Expenses. Softbyte pays the following
expenses in cash for September: store rent €600, salaries and wages of
employees €900, and utilities €200.
Illustration 1-10
1-27
LO 7
Transaction Analysis
Transaction (8). Payment of Accounts Payable. Softbyte pays its €250
Daily News bill in cash.
Illustration 1-10
1-28
LO 7
Transaction Analysis
Transaction (9). Receipt of Cash on Account. Softbyte receives €600 in
cash from customers who had been billed for services [in Transaction (6)].
Illustration 1-10
1-29
LO 7
Transaction Analysis
Transaction (10). Dividends. The corporation pays a dividend of €1,300
in cash.
Illustration 1-10
1-30
LO 7
The Account

Record of increases and decreases
in a specific asset, liability, equity,
revenue, or expense item.

Debit = “Left”

Credit = “Right”
Account
An account can be
illustrated in a Taccount form.
1-31
Account Name
Debit / Dr.
Credit / Cr.
LO 1 Explain what an account is and how it helps in the recording process.
The Account
Debits and Credits
Double-entry system
►
Each transaction must affect two or more accounts to
keep the basic accounting equation in balance.
►
Recording done by debiting at least one account and
crediting another.
►
1-32
DEBITS must equal CREDITS.
LO 2 Define debits and credits and explain their use
in recording business transactions.
Debits and Credits
If Debit amounts are greater than Credit amounts, the
account will have a debit balance.
Account Name
Debit / Dr.
Credit / Cr.
Transaction #1
$10,000
$3,000
Transaction #3
8,000
Balance
1-33
Transaction #2
$15,000
LO 2 Define debits and credits and explain their use
in recording business transactions.
Debits and Credits
If Debit amounts are less than Credit amounts, the
account will have a credit balance.
Account Name
Transaction #1
Balance
1-34
Debit / Dr.
Credit / Cr.
$10,000
$3,000
Transaction #2
8,000
Transaction #3
$1,000
LO 2 Define debits and credits and explain their use
in recording business transactions.
Debits and Credits
Assets
Debit / Dr.

Assets - Debits should exceed
credits.

Liabilities – Credits should
exceed debits.

Normal balance is on the
increase side.
Credit / Cr.
Normal Balance
Chapter
3-23
Liabilities
Debit / Dr.
Credit / Cr.
Normal Balance
Chapter
3-24
1-35
LO 2 Define debits and credits and explain their use
in recording business transactions.
Debits and Credits
Equity
Debit / Dr.

Issuance of share capital and
revenues increase equity (credit).

Dividends and expenses
decrease equity (debit).
Credit / Cr.
Normal Balance
Chapter
3-25
Retained Earnings
Share Capital
Debit / Dr.
Credit / Cr.
Debit / Dr.
Normal Balance
Chapter
3-25
1-36
Chapter
3-25
Dividends
Credit / Cr.
Debit / Dr.
Normal Balance
Normal Balance
Credit / Cr.
Chapter
3-23
LO 2
Debits and Credits
Revenue
Debit / Dr.

The purpose of earning
revenues is to benefit the
shareholders.

The effect of debits and credits
on revenue accounts is the
same as their effect on equity.

Expenses have the opposite
effect: expenses decrease
equity.
Credit / Cr.
Normal Balance
Chapter
3-26
Expense
Debit / Dr.
Credit / Cr.
Normal Balance
Chapter
3-27
1-37
LO 2 Define debits and credits and explain their use
in recording business transactions.
Debit/Credit Rules
Liabilities
Normal
Balance
Debit
Assets
Credit / Cr.
Normal Balance
Chapter
3-24
Equity
Credit / Cr.
Debit / Dr.
Debit / Dr.
Normal
Balance
Credit
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Chapter
3-23
Expense
Debit / Dr.
Chapter
3-25
Revenue
Credit / Cr.
Debit / Dr.
Normal Balance
Chapter
3-27
1-38
Credit / Cr.
Normal Balance
Chapter
3-26
LO 2
Debit/Credit Rules
Statement of
Financial Position
Income Statement
Asset = Liability + Equity
Revenue - Expense
Debit
Credit
1-39
LO 2 Define debits and credits and explain their use
in recording business transactions.
Summary of Debit/Credit Rules
Relationship among the assets, liabilities and equity of a
business:
Illustration 2-12
The equation must be in balance after every transaction.
For every Debit there must be a Credit.
1-40
LO 2 Define debits and credits and explain their use
in recording business transactions.
APPENDIX 1A: Explain the career opportunities
in accounting.
Public Accounting
Careers in auditing, taxation,
and management consulting
serving the general public.
Private Accounting
Careers in industry working in
cost accounting, budgeting,
accounting information systems,
and taxation.
Governmental Accounting
Forensic Accounting
Careers with the IRS, the FBI,
the SEC, public colleges and
universities, and in state and
local governments.
Uses accounting, auditing, and
investigative skills to conduct
investigations into theft and
fraud.
1-41
LO 6
“Show Me the Money”
Salary estimates for jobs in public and corporate accounting
Illustration 1A-1
Upper-level management salaries in corporate accounting
Illustration 1A-2
1-42
LO 6