Accounting Matters!
STUDY OBJECTIVES
After studying this chapter, you should understand:
What accounting is
Monetary unit & economic
entity assumptions
Uses and users of accounting
The accounting equation
Ethics as a fundamental
business concept
How business transactions
affect the accounting equation
GAAP
Basic financial statements
STUDY OBJECTIVE 1
WHAT IS ACCOUNTING?
Accounting is an information system that
identifies, records, and communicates
the economic events (transactions)
of an organization to interested users.
THE ACCOUNTING PROCESS
Communication
Identification
Recording
Accounting
Reports
Prepare accounting
reports
Select economic events
(transactions)
Record, classify
and summarize
SOFTBYTE
Annual Report
Analyze and interpret
for users
STUDY OBJECTIVE 2
USERS AND USES OF ACCOUNTING
Internal Users
Marketing managers
Production supervisors
Finance directors
Company officers
Investors
Creditors
Tax authorities
Regulatory agencies
Customers
Labor unions
External Users
QUESTIONS ASKED BY INTERNAL USERS
Is cash sufficient to pay bills?
Can we afford to give employee
pay raises this year?
What is the cost of manufacturing
each unit of product?
Which product line is the most
profitable?
QUESTIONS ASKED BY INTERNAL USERS
Is the company earning
satisfactory income?
How does the company compare
in size and profitability with its
competitors?
What do we
do if they
catch us?
Will the company be able to pay its debts as they come due?
STUDY OBJECTIVE 3
ETHICS: A FUNDAMENTAL BUSINESS CONCEPT
ETHICS:
A set of standards by
which one’s actions are
deemed right or wrong,
honest or dishonest.
STUDY OBJECTIVE 3
ETHICS: A FUNDAMENTAL BUSINESS CONCEPT
Steps for solving an ethical dilemma:
1. Recognize an ethical situation and the issues
involved.
2. Identify the principal elements of the situation
3. Identify alternatives: weigh the impact on
stakeholders
STUDY OBJECTIVE 4
GAAP
(Generally Accepted Accounting Principles)
What is GAAP?
A set of standards generally accepted and
universally practiced by accountants
1. Indicates how economic events are
reported
2. Generated by the Financial Accounting
Standards Board (FASB) and
Securities & Exchange Commission
(SEC)
STUDY OBJECTIVE 5
BASIC ACCOUNTING ASSUMPTIONS
MONETARY UNIT
ASSUMPTION
ECONOMIC ENTITY
ASSUMPTION
Only transaction data
that can be expressed
in terms of money
is included in the
accounting records.
An economic entity
includes any organization
or unit in society.
The unit of measure
(the dollar in the USA)
is assumed to remain
constant in value
All activities of an
entity are kept separate
from the activities
of its owners and
other economic entities.
BUSINESS ENTERPRISES
 A business owned by one person is generally a
proprietorship.
 A business owned by two or more persons associated 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 stock is a corporation.
STUDY OBJECTIVE 6
THE BASIC ACCOUNTING EQUATION
Assets
resources
owned by
a business
=
Liabilities
claims
against
those
assets
Stockholders’
+
Equity
owners’
residual
claim on
total assets
REVIEW QUESTION
THE BASIC ACCOUNTING EQUATION
As of December 31, 2006, Tetrick Company
has assets of $3,500 and stockholders’
equity of $2,000. What are the liabilities for
Tetrick Company as of December 31, 2006?
Answer: $1,500
Assets – Liabilities = Stockholders’ Equity
$3,500 = Liabilities + $2,000
Liabilities = $1,500
STOCKHOLDERS’ EQUITY
 Stockholders’ equity
is equal to total assets
minus total liabilities. It is also referred to as
residual equity. There are two general
categories of stockholders’ equity:
PAID-IN CAPITAL
and
RETAINED EARNINGS
PAID-IN CAPITAL
Paid in Capital represents the total amount
invested by stockholders in a corporation.
Stockholders invest cash or other assets in
exchange for common or preferred stock.
RETAINED EARNINGS
 Retained earnings represents cumulative
profits (or losses) retained in the business over
time.
 Three items make up the balance in retained
earnings:
REVENUES
EXPENSES
DIVIDENDS
REVENUES
Revenues are the gross increases in
stockholders’ equity from engaging in business
activities entered into for the purpose of
earning income.
Revenues result from sales of merchandise,
performance of services, rental of property, or
lending of money.
EXPENSES
Expenses are the decreases in stockholders’
equity that result from operating the business.
They are the cost of assets consumed or services
used in the process of earning revenue.
Examples are: utility expense, rent expense,
supplies expense, tax expense, insurance
expense, depreciation expense.
DIVIDENDS
When a company is successful, it generates
Net Income.
Dividends: the distribution of cash or other
assets to stockholders that are available as a
result of Net Income.
Dividends are NOT considered an expense of
the corporation.
INCREASES & DECREASES
IN STOCKHOLDERS’ EQUITY
Increases
Decreases
Investments by
stockholders
Dividends to
stockholders
Stockholders’
Equity
Revenues
Expenses
REVIEW QUESTION
STOCKHOLDERS’ EQUITY
Rebecca Sherrick, Inc., had a stockholders’ equity balance of
$164,000 at the beginning of the period. At the end of
the period, the stockholders’ equity balance was $198,000.
Assuming no additional investment or distributions
During the period, what is the net income for the period?
Beginning balance
Add: investments
net income ($198,000-$164,000)
$164,000
0
$34,000
Less: dividends
0
Ending balance
$198,000
STUDY OBJECTIVE 7
HOW BUSINESS TRANSACTIONS
AFFECT THE ACCOUNTING EQUATION
• Every transaction must have a dual
effect on the accounting equation.
Thus, if an asset is increased, there
must be a corresponding:
1. Decrease in another asset, or
2. Increase in a liability, or
3. Increase in stockholders’ equity
TRANSACTION IDENTIFICATION PROCESS
Purchase
Answer
Pay rent
computer
telephone
Is the financial position (assets, liabilities, and
stockholders’ equity) of the company changed?
Yes
No
Yes
Record
Don’t
Record
Record
TRANSACTION ANALYSIS
TRANSACTION 1
Ray and Barbara Neal open Softbyte, Inc., a programming
company by investing $15,000 in exchange for common stock.
Assets = Liabilities + Stockholders
Equity
Common
Cash
Stock
+15000
+15000
There is an increase in the asset cash, $15,000, and
an equal increase in the equity common stock.
TRANSACTION ANALYSIS
TRANSACTION 2
Softbyte purchases computer equipment for $7,000 cash
Assets
Cash + Supplies
Old Bal. $15,000
(2)
-7000
New Bal. $8,000 +
= Liabilities +
+
Equipment
+
+7000
$7,000
$15,000
Accounts
= Payable +
=
Stockholders’
Equity
Common
Stock
$15,000
+
$15,000
$15,000
Cash is decreased $7,000, and the asset Equipment is increased
$7,000. After transaction #2, total assets =total liabilities + equity.
TRANSACTION ANALYSIS
TRANSACTION 3
Softbyte purchases for $1,600 of supplies from Acme Supply. The supplies
will last several months. Softbyte will pay the bill next month.
Assets
Old
Bal.
(3)
New
Bal.
Cash
+
$8,000
$8,000 +
Supplies
=
+
+1600
$1,600 +
$16,600
Equipment
=
$7,000
$7,000 =
Liabilities
+
Accounts
Payable
+
Stockholders’
Equity
Common
Stock
$15,000
+1600
$1,600 +
$15,000
$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 providing programming services.
Assets
+
Old Bal.
Cash
$8,000
Supplies +
$1,600
Equipment =
$7,000
Liabilities +
Accounts
Payable
+
$1,600
New Bal.
$9,200
+
$1,600 +
$7,000 =
$1,600 +
$17,800
(4)
=
Stockholders Equity
Retained
Common
Earnings
Stock
$15,000
$16,200
$17,800
+1,200
Cash is increased $1,200, and retained earnings is
increased $1,200. (Retained earnings is indirectly
increased because revenue is increased).
+1,200
STUDY OBJECTIVE 8
BASIC FINANCIAL STATEMENTS
After all transactions for the period are recorded, financial data
is summarized and that summary
data is used to generate the basic financial statements
Balance Sheet
Statement of
Cash Flows
Income Statement
Statement of
Retained Earnings
FINANCIAL STATEMENTS
SOFTBYTE, INC.
Income Statement
For the Month Ended September 30, 2006
Revenues
Service revenue
Expenses
Salaries expense
Rent expense
Advertising expense
Utilities expense
Total expenses
Net income
$ 4,700
$ 900
600
250
200
1,950
2,750
Net income of $2,750 will be added to retained earnings.
FINANCIAL STATEMENTS
SOFTBYTE, INC.
Statement of Retained Earnings
For the Month Ended September 30, 2006
Retained earnings, September 1
Add: Net income
Less: Dividends
Retained earnings, September 30
$
–0–
2,750
2,750
1,300
$ 1450
Dividends of $1,300 is deducted from retained earnings. The net change in
retained earnings for the period is $1,450.
FINANCIAL STATEMENTS
SOFTBYTE, INC.
Balance Sheet
September 30, 2006
Assets
Cash
Accounts receivable
Supplies
Equipment
Total assets
$ 8,050
1,400
1,600
7,000
$ 18,050
Liabilities and Owner’s Equity
Liabilities
Accounts payable
Stockholders’ Equity
Common Stock
Retained Earnings
Total liabilities and owner’s equity
$ 1,600
$15,000
$1,450
16,450
$ 18,050
Cash of $8,050 will be shown in the statement of cash flows.
FINANCIAL STATEMENTS
SOFTBYTE, INC.
Statement of Cash Flows
For the Month Ended September 30, 2006
Cash flows from operating activities
Cash receipts from revenues
Cash payments for expenses
Net cash provided by operating activities
Cash flows from investing activities
Purchase of equipment
Cash flows from financing activities
Sale of common stock
Payment of cash dividends
Net cash provided by financing activities
Net increase in cash
Cash at the beginning of the period
Cash at the end of the period
$ 3,300
(1,950)
1,350
(7,000)
$ 15,000
(1,300)
13,700
8,050
–0–
$ 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.