1. Accounting and the Business Environment
Summary

2. Learning Objectives
Explain why accounting is important and list the users of accounting information
Describe the organizations and rules that govern accounting
Describe the accounting equation, and define assets, liabilities, and equity

3. Learning Objectives
Use the accounting equation to analyze transactions
Prepare financial statements
Use financial statements and return on assets (ROA) to evaluate business performance

4. Learning Objective 1
Explain why accounting is important and list the users of accounting information

5. Why Is Accounting Important?
Accounting is the information system that measures business activities, processes the information into reports, and communicates the results to decision makers.
Financial Accounting
Financial accounting focuses primarily on reporting financial information related to the financial position of the company, the results of its operations, and its cash flows to external stakeholders. The processes used to develop this information are prescribed and governed by a set of accounting rules, standards, and principles.
Managerial accounting focuses on the processes that generate information that can be used by internal management to make better decisions about the day-to-day operations of the company. Accordingly, this information is not as prescribed. While the concepts may be constant across companies, the specific kinds of information and reports often differs depending upon the company and situation.
Managerial Accounting

6. Users of Financial Information
External Decision Makers, or stakeholders, include people like stockholders, creditors, suppliers, customers, employees and regulatory agencies and bodies. Each of these groups have a need to know how the company is doing; how financially “healthy” it is.
Internal Decision Makers are primarily employees and management. Their goal relates more toward using the information to help them be more successful in their work efforts.

7. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

8. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

9. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

10. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

11. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

12. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

13. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

14. Describe the organizations and rules that govern accounting
Learning Objective 2
Describe the organizations and rules that govern accounting

15. The Organizations That Govern Accounting
FASB
Financial Accounting Standards Board
Privately funded
Creates the rules and standards that govern financial accounting
SEC
Securities and Exchange Commission
Oversees the US financial markets
The SEC was established by the Securities Act of 1934 during the administration of President Franklin D. Roosevelt. Prior to 1934, there was essentially no organized government structure for overseeing the financial reporting of companies that were publicly traded. Among other things, the SEC requires that all publicly traded companies have an annual financial statement audit that is conducted by a Certified Public Accountant. In addition, the SEC is charged with establishing the accounting standards and principles by which financial accounting information is developed.
The SEC delegated that standard-setting responsibility to the accounting profession. Through a series of different bodies and over many years, the body of accounting standards thought of as Generally Accepted Accounting Principles was developed.
Currently, the body that is responsible for setting accounting standards in the United States is the Financial Accounting Standards Board, or FASB. Located in Connecticut, it is a body of seven highly qualified individuals supported by several hundred staff members that spends its time considering the most appropriate way to properly account for and subsequently report on the results of business transactions.
In addition to the FASB, the International Accounting Standards Board (IASB), located in London, UK, has established a body of International Financial Reporting Standards, IFRS, that are used by a majority of other countries. Currently, the US is expected to begin using IFRS as early as 2015 or 2016.

16. Generally Accepted Accounting Principles (GAAP)
Issued by the FASB.
Establishes the rules for recording transactions and preparing financial statements.
Published online as part of the Accounting Standards Codification.
Requires that information be useful.
Relevant = The info allows users to make a decision.
Faithfully Representative = The info is complete, neutral, and free from material error.
Generally Accepted Accounting Principles are referred to as GAAP. The entire body of GAAP is constantly evolving and changing. In the past, GAAP was published annually by the FASB in a multi-volume set of books. However, recently, the FASB has made the body of GAAP available online as part of its Accounting Standards Codification project. The Accounting Standards Codification can be found at
One of the guiding philosophies of GAAP is that the information generated by the financial accounting process should be “useful.” Usefulness can be defined, for accounting purposes, as a function of two related concepts; relevance and faithfulness of representation.

17. Accounting Assumptions
Economic Entity Assumption
Cost Principle
Monetary Unit Assumption
Going Concern Assumption
In addition to the concept of “usefulness,” there are other guiding principles underlying all GAAP standards.
Economic Entity Assumption—a business stands apart as a separate economic unit that is separate from its owners, and that keeps its affairs distinct from those of other businesses.
Cost Principle all assets and liabilities should be recorded at their actual cost on the date of acquisition. Assets and liabilities will continue to be reported at their historical cost over their useful life. In other words, except in certain cases, we will not adjust the carrying and reported amounts of assets and liabilities to their relative market values.
Going Concern Assumption—we assume that a company that is currently in business will remain in operation for the foreseeable future. This assumption is essential if we expect businesses to engage in long term agreements. For example, it might not make sense for a business to acquire an asset that will last for a number of years, if the expectation is that the business will soon discontinue operations. Also, a manufacturer would not likely enter into a long-term sales agreement with a customer, if it believed that that customer would soon be out of business.
Monetary Unit Assumption—in the US, transactions are recorded in US dollars ($). We continue to use dollars as the unit of measurement, even when the underlying value of the currency changes (for example, if there is inflation). This also puts a limitation on what we can record on the balance sheet. We can only record assets and obligations on the balance sheet if we can measure them in dollars. For example, a company may have spent many years developing a valuable name recognition in the community. However, since there is no cost that can be measured for this “good name,” the asset does not show up on the balance sheet, even though we all know good and well that it is there.

18. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

19. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

20. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

21. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

22. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

23. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

24. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

25. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

26. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

27. >TRY IT!
Let’s see if we can match the definitions with the proper benefit.

28. Learning Objective 3
Describe the accounting equation, and define assets, liabilities, and equity

29. The Accounting Equation
Assets =
Liabilities +
Equity
Rule: The Balance Sheet Equation must ALWAYS be in balance.
The Accounting Equation is the essential foundation of modern accounting. Stated as a mathematical equality, it establishes that an “equilibrium” must exist at all times. This equilibrium is stated as Assets = Liabilities + Equity. We will define each of the elements of the accounting equation. For now, understand that this equation must always stay in balance. If something happens to change one part of the equation, there must be an equal, but opposite, change somewhere else in the equation to keep it in balance.

30. The Accounting Equation
Assets =
Liabilities +
Equity
Assets are economic resources that are expected to benefit the business in the future.
Inventory
Assets are defined as economic resources that are expected to benefit the business in the future. Generally, these economic resources are owned, or controlled, by the business. They can be tangible such as Cash, Land, Inventory, Buildings, or Equipment. Alternatively, assets can be representative of claims that the company has against other entities. These can include Accounts Receivable, Notes Receivable, or Investments in other companies. Finally, there are actual rights to assets that lack physical substance, but that are owned by the company. These include things like Patents, Copyrights, Trademarks and Databases.
Land
Cash
Furniture

31. The Accounting Equation
Assets =
Liabilities +
Equity
Accounts Payable
Liabilities are debts that are owed to creditors.
Liabilities include all of the debts and obligations that the company owes to others. They can also be thought of as creditors’ claims against the assets of the company.
Liabilities can include obvious debts like Loans Payable, Utilities Payable, Accounts Payable, Taxes Payable, and Salaries Payable. In addition, that are obligations that are created in the process of doing business such as, Unearned Revenues (the obligation that is created when we accept cash from a customer before we have performed a service or delivered a product), Warranty Liability (the estimate of the amount of warranty work we will have to perform on products we have sold), and Contingent Liabilities (the amounts we are likely to owe to others as a result of a lawsuit).
Notes Payable
Salaries Payable

32. The Accounting Equation
Assets =
Liabilities +
Equity
Equity is the owner’s residual claim against the assets of the company.
Owner’s Capital
Equity represents the concept of the owner’s residual claim against the assets of the company. So, all assets can be claimed by either the creditors of the company, or by the owner of the company.
Owner’s With-drawals

33. The Accounting Equation
Assets =
Liabilities +
Equity
The owner’s claim on the resources increase and decrease as the company engages in earnings activities.
Owner’s Capital
– Owner’s Withdrawals
+ Revenues
- Expenses
As the company earns resources, the assets increase and the owner’s claim against the assets of the company will increase. Likewise, as the company incurs expenses, the owner’s claim against the assets of the company will decrease. The other thing that can change the owner’s claim against the assets of the company is the amount of resources that the owner puts into the company and the amount of resources that the owner takes out of the company (Owner’s Withdrawals).
The amount of the annual withdrawals is usually limited by the business to prevent an owner from taking out more resources in a given period than the company can sustain.

34. The Accounting Equation
Assets =
Liabilities +
Equity
Revenues are economic resources that have been earned by delivering products or services to customers.
Owner’s Capital
– Owner’s Withdrawals
+ Revenues
- Expenses
A company’s revenues represent the monetary value of the goods sold to or services performed for customers. Revenues are always recorded at the time they are earned, even if the related cash has not yet been collected. In financial accounting, it is important to begin thinking of the earnings process as being separate from the collection process.

35. The Accounting Equation
Assets =
Liabilities +
Equity
Expenses are the costs associated with selling goods or services.
Owner’s Capital
– Owner’s Withdrawals
+ Revenues
- Expenses
Expenses represent the dollar value, or cost, of the resources we have consumed or used in the process of generating revenues. When matched against revenues, we have the concept of income. When Revenues > Expenses, we call the difference Net Income. When Revenues < Expenses, we call the difference Net Loss.

36. >TRY IT!
Use the Accounting Equation to solve for Owner’s Capital.

37. >TRY IT!
Use the Accounting Equation to solve for Owner’s Capital.

38. Use the accounting equation to analyze transactions
Learning Objective 4
Use the accounting equation to analyze transactions

39. How Do You Analyze A Transaction?
Think of a transaction as a very special kind of historical event.
It involves the exchange of economic resources.
We must be able to measure the economic impact in monetary units.
Is it a transaction?
Buying a copying machine for the office for $4,000 cash.
Meeting with a potential customer.
All transactions are essentially very special forms of historical events that involve the exchange of economic resources for the purpose of commerce. Not all commerce events are transactions, only those that we can measure in US dollars. For example, if we buy a copying machine for $4,000 cash, this is a transaction; economic resources exchanged hands and the transaction can be measured in US dollars. However, meeting with a customer, while arguably an extremely essential business practice, is not a transaction as no economic resources were exchanged.

40. How Do You Analyze A Transaction?
Sheena Bright starts a new business named Smart Touch. She puts $30,000 into the business. How does this impact the Accounting Equation?
When we merge the concept of the accounting equation (both sides of the equation must always stay in balance) with the structure of a transaction, we can begin to analyze how transactions impact the financial accounting system.
In the first example, Sheena Bright has started a new business called Smart Touch. She puts $30,000 of her own cash into the business. From the perspective of the company, Smart Touch has increased its Cash by $30,000. However, if we stop here, then the left side of the equation will have $30,000 and the right side of the equation will have $0. Clearly, this would make the equation unbalanced, and we know that the equation must always be balanced.
So, we recognize that when the cash went up by $30,000, the owner’s claim against the business also went up by $30,000 as a result of this transaction.
Note: You can make the analysis easier if the first question you ask is whether cash exchanged hands.

41. How Do You Analyze A Transaction?
Next, Smart Touch purchases land for $20,000 cash.
In Transaction #2, Smart Touch purchases land for $20,000 cash. In this case, Cash is decreased by $20,000. At the same time, Land is increased by $20,000. Essentially, we effectively turned one kind of economic resource (Cash) into a different kind of economic resource (Land). All of the changes necessary to keep the Accounting Equation in balance occurred on the left side of the equality.
In this transaction, all the change occurred on the left side of the equation. One asset was converted into a different asset.

42. How Do You Analyze A Transaction?
In Transaction #3, Smart Touch buys $500 of office supplies, offering to pay in 30 days.
In Transaction #3, Smart Touch buys office supplies of $500. Rather than pay for the supplies at the time of purchase, the supplier has offered to let Smart Touch pay later (usually in 30 days). Although it is highly unusual for you and I to purchase goods in this manner, it is not unusual for businesses. When an individual consumer purchases goods, they are usually paid for on the spot with either cash, a check, or a credit card (when you use a credit card, the store gets paid almost immediately). In the later case, the credit relationship is between you and the card company, not with the store. Business transactions are most often done on “account,” meaning that the purchaser will take possession of the goods now, but will not have to pay for them until later.
Remember, in business it is quite common for a business to purchase something now, and pay for it later.

43. How Do You Analyze A Transaction?
In Transaction #4, Smart Touch provides training services to customers for $5,500 cash.
In Transaction #4, Smart Touch provides training services to customers. The customers pay cash for the services. You should think of the earnings process and the collection process as two separate processes. In this case, they both happened at the same time. Often, however, a company will earn revenues, by providing a service or delivering a product, but will not collect the cash until a later date.

44. How Do You Analyze A Transaction?
In Transaction #5, Smart Touch performs $3,000 of services for a customer who will pay in one month.
In Transaction #5, we have an example of what was discussed in Transaction #4. Smart Touch performed $3,000 of services for a customer, but did not collect the cash. The customer is not expected to pay until the end of the month.

45. How Do You Analyze A Transaction?
In Transaction #6, Smart Touch pays $3,200 in cash expenses; $2,000 for office rent and $1,200 for employee salaries.
In Transaction #6, Smart Touch pays $3,200 for two expenses; $2,000 for office rent and $1,200 for employee salaries.

46. How Do You Analyze A Transaction?
In Transaction #7, Smart Touch pays $300 to the store from which it purchased office supplies in Transaction #3.
In Transaction #7, Smart Touch pays for part of the office supplies that it purchased on account in Transaction #3. This decreases Smart Touch’s cash, while reducing the amount that Smart Touch still owes to the supplier.

47. How Do You Analyze A Transaction?
In Transaction #8, Smart Touch collects $2,000 from the client for which Smart Touch performed services in Transaction #5.
In Transaction #8, Smart Touch collects $2,000 from the client to whom services were provided in Transaction #5. Note that while cash goes up, the amount owed to Smart Touch from the customer declines by an equal amount.

48. LO4: How Do You Analyze A Transaction?
When we put all of the transactions together, we can see the “balance” in each account. In addition, we can see that the left side of the equation balances with the right side of the equation.

49. Prepare Financial Statements
Learning Objective 5
Prepare Financial Statements

50. How Do You Prepare Financial Statements?
Income Statement
These same four basic financial statements are used by all companies as the primary means of communicating to stakeholders.
Statement of Owner’s Equity
Balance Sheet
Statement of Cash Flows
There are four primary financial statements used by all companies; the Income Statement, the Statement of Owner’s Equity, the Balance Sheet, and the Statement of Cash Flows. Together, these statements tell us about the financial health of the company. The statements are also linked to one another. The Income Statement is produced first. The Net Income number then flows forward to the Statement of Owner’s Equity.
The Net Income number is combined with the beginning balance in Owner’s Capital and any Contributions or Withdrawals made by the owner during the period to arrive at an end-of-period balance for Owner’s Capital.
The ending balance in Owner’s Capital flows forward to the Balance Sheet and serves as an important balancing element.
The Statement of Cash Flows is based on information from the other statements and then is reconciled back to the cash balance on the Balance Sheet.

51. How Do You Prepare Financial Statements?
Reports the success or failure of the company’s operations for a period of time.
Income Statement
Statement of Owner’s Equity
Balance Sheet
Statement of Cash Flows
The Income Statement tells us the results of operations for a company for a period of time. The statement is always produced first.

52. How Do You Prepare Financial Statements?
Here we see the Income Statement for Smart Touch Learning. After the heading (which identifies the name of the company, which statement is being presented, and the period covered by the statement), we list the revenues for the period first, followed by the expenses for the period. Generally, the largest expenses are listed first. Net Income is shown at the bottom of the statement as the difference between Revenues and Expenses. In the event that Expenses exceed Revenues, we would show a Net Loss, instead of Net Income.

53. How Do You Prepare Financial Statements?
Income Statement
Shows amounts and causes of changes in owner’s capital during the period.
Statement of Owner’s Equity
Balance Sheet
Statement of Cash Flows
The Statement of Owner’s Equity shows how the owner’s claim against the assets of the company have changed during the year as a result of the company’s operations and ongoing contribution and withdrawal activities.

54. How Do You Prepare Financial Statements?
As an owner contributes additional money and assets to the company, the owner’s claim against the company’s assets increases. On occasion, an owner will pull cash out of the business (called Owner Withdrawal). This will reduce the owner’s claim against the assets of the company. As a company has net income, the owner’s capital in the business also increases.
The ending balance in Bright Capital will also appear in the Equity section of the Balance Sheet.

55. How Do You Prepare Financial Statements?
Income Statement
Reports assets and claims to those assets at a specific point in time.
Statement of Owner’s Equity
Balance Sheet
Statement of Cash Flows
The Balance Sheet, also called the Statement of Financial Position, reports the company’s assets at a point in time. Each account is measured as of the date of the statement. The Owner’s Capital balance comes from the Statement of Owner’s Equity.

56. Note that the Balance Sheet follows the Accounting Equation.
Essentially, a Balance Sheet has two major sections; one for assets and a second section for liabilities and owner’s equity accounts. These two sections must balance, just as the Accounting Equation requires.
Note that the Balance Sheet follows the Accounting Equation.

57. How Do You Prepare Financial Statements?
Income Statement
Answers the question of whether the business generates enough cash to pay its bills.
Statement of Owner’s Equity
Balance Sheet
Statement of Cash Flows
Finally, the company prepares the Statement of Cash Flows. This statement helps to explain where the company’s cash came from, where it went, and whether, as a net result, the company is able to pay its obligations. The statement has three main sections; Cash Flows from Operating Activities, Cash Flows from Investing Activities, and Cash Flows from Financing Activities. The net total of these three categories of cash flows should equal the net change in cash from the beginning of the period to the end of the period. The statement is completed by preparing a short reconciliation. By adding the net change in cash for the period to the beginning cash balance, the result should be equal to the ending cash balance.

58. For Smart Touch Learning, the majority of cash for the period comes from Financing Activities. However, it is a positive sign that Smart Touch collected more cash than they spent in the operating activities section.

59. Learning Objective 6
Use financial statements and return on assets (ROA) to evaluate business performance

60. How Do You Use Financial Statements to Evaluate Performance?