1. Accounting in Business
Chapter 1
Accounting in Business
Chapter 1: Accounting in Business
Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.

2. Importance of Accounting
Identifying Select transactions and events
Recording
Input, measure and classify
Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities. Identifying business activities requires selecting transactions and events relevant to an organization. Recording business activities requires keeping a chronological log of transactions and events measured in dollars and classified and summarized in a useful format. Communicating business activities requires preparing accounting reports such as financial statements. It also requires analyzing and interpreting such reports.
Communicating
Prepare, analyze and interpret

3. Users of Accounting Information
Internal Users
External Users
Accountants prepare reports for both external and internal users. External users of accounting information are not directly involved in running the organization. Examples of external users are lenders, shareholders (investors), governments, consumer groups, customers, and the external auditors.
Internal users of accounting information are those directly involved in managing and operating an organization. They use the information to help improve the efficiency and effectiveness of an organization. Examples of internal users are managers, officers/directors, internal auditors, sales staff, budget officers and controllers.
Lenders
Shareholders
Governments
Consumer Groups
External Auditors
Customers
Managers
Officers/Directors
Internal Auditors
Sales Staff
Budget Officers
Controllers

4. Users of Accounting Information
Internal Users
External Users
Financial accounting is the area of accounting aimed at serving external users by providing them with financial statements.
Managerial accounting is the area of accounting that serves the decision-making needs of internal users.
Financial accounting provides external users with financial statements.
Managerial accounting provides information needs for internal decision-makers.

5. Opportunities in Accounting
Careers in accounting can follow many paths.
There is great demand for financial accountants in the preparation of financial statements, dealing with regulatory agencies like the Internal Revenue Service, and consulting.
Management accountants help track product costs, prepare budgets and serve as consultants to managers.
The field of taxation includes everything from the preparation of tax returns to consulting with clients about estate and gift planning.
Individuals with accounting backgrounds may move into other areas of importance within an organization. Individuals with accounting training often become business owners and managers. They are in high demand in all financial and investigative fields.

6. Ethics Ethics - A Key Concept
Beliefs that distinguish right from wrong
Accepted standards of good and bad behavior
Ethical behavior is the cornerstone of the accounting profession. Recently, we have seen many corporate scandals involving individuals who acted in an unethical, and often times, illegal, way.
Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior.

7. C 3
Ethics - A Key Concept
Identifying the ethical path is sometimes difficult. The preferred path is a course of action that avoids casting doubt on one’s decisions. For example, accounting users are less likely to trust an auditor’s report if the auditor’s pay depends on the success of the client’s business. To avoid such concerns, ethics rules are often set. For example, auditors are banned from direct investment in their client and cannot accept pay that depends on figures in the client’s reports. On your screen are guidelines for making ethical decisions.

8. Generally Accepted Accounting Principles
Financial accounting practice is governed by concepts and rules known as generally accepted accounting principles (GAAP).
Relevant Information
Affects the decision of its users.
Financial accounting is governed by a set of rules we call Generally Accepted Accounting Principles, or GAAP for short.
Generally accepted accounting principles identify three major characteristics of information. First, the information must be relevant. Relevant information impacts the decision of the informed user for financial information. Second, the information must be reliable. Finally, the information must be comparable. Comparability helps us evaluate financial information from one period with that of the next period.
Reliable Information
Is trusted by users.
Comparable Information
Is helpful in contrasting organizations.

9. International Standards
C 4
The International Accounting Standards Board (IASB), an independent group (consisting of 16 individuals from many countries), issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices.
In today’s global economy, there is increased demand by external users for comparability in accounting reports. This demand often arises when companies wish to raise money from lenders and investors in different countries.
If standards are harmonized, one company can potentially use a single set of financial statements in all financial markets. Differences between U.S. GAAP and IFRS are slowly fading as the FASB and IASB pursue a convergence process aimed to achieve a single set of accounting standards for global use.
IASB

10. Generally Accepted Accounting Principles
The four common general principles are measurement, revenue recognition, expense recognition, and full disclosure. There are four common accounting assumptions: the going concern assumption, the monetary unit assumption, the time period assumption, and the business entity assumption.

11. Principles and Assumptions of Accounting
Revenue Recognition Principle
Recognize revenue when it is earned.
Proceeds need not be in cash.
Measure revenue by cash received plus cash value of items received.
Cost Principle
Accounting information is based on actual cost. Actual cost is considered objective.
Expense Recognition or Matching Principle
A company must record its expenses incurred to generate the revenue reported.
Listed on your screen are four fundamental principles of accounting. The revenue recognition principle states that revenue is to recognized when it is earned, that the revenue need not be in the form of cash and that we measure revenue by the cash received plus cash value of other items received. The cost principle tells us that accounting information is based upon actual cost incurred. We refer to this cost as historical cost. The matching principle dictates that expenses incurred by a company must be matched against revenue generated as a result of those expenses. The full disclosure principle states that a company is required to report the details behind the financial statements if the details so disclosed would impact the users’ decision-making process. Most of the details are reported in the notes to the financial statements.
Full Disclosure Principle
A company is required to report the details behind financial statements that would impact users’ decisions.

12. Accounting Assumptions
Now
Future
Going-Concern Assumption
Reflects assumption that the business will continue operating instead of being closed or sold.
Monetary Unit Assumption
Express transactions and events in monetary, or money, units.
Business Entity Assumption
A business is accounted for separately from other business entities, including its owner.
Time Period Assumption
Presumes that the life of a company can be divided into time periods, such as months and years.
Now we will look at four fundamental assumptions of accounting. The going-concern assumption states that, in the absence of information to the contrary, the business entity is assumed to continue operations into the foreseeable future. The monetary unit assumption tells us that we will only record accounting information that can be expressed in monetary units, usually dollars in the United States. The business entity assumption tells us that we must separate out the transactions of individual owners of a business from those of the business. Finally, the time period assumption presumes that the life of a company can be divided into time periods such as months and years, and that useful reports can be prepared for those periods.

13. Forms of Business Entities
C 4
Sole Proprietorship
Partnership
Corporation
There are three general forms of business operations. A sole proprietorship is a business owned by just one individual. A partnership is owned by two or more individuals. A corporation is a business legally separate from its owners, meaning it is responsible for its own acts and its own debts. Separate legal status means that a corporation can conduct business with the rights, duties, and responsibilities of a person. A corporation acts through its managers, who are its legal agents. A corporation is owned by individuals who normally are not active in the day-to-day operations of that business. For example, you may become an owner of IBM by purchasing shares on the New York Stock Exchange. While you are a part owner, you do not necessarily work for IBM nor are active in the operations of the company.

14. Corporation
C 4
Owners of a corporation or company are called shareholders (or stockholders). Shareholders are not personally liable for corporate acts. When a corporation issues only one class of shares, we call it ordinary shares (or common stock).
Corporate owners are referred to as shareholders or stockholders because they own ordinary shares or common stock.

15. IASB Conceptual Framework for Financial Reporting
The Conceptual Framework for Financial Reporting deals with (a) the objective of financial reporting; (b) the qualitative characteristics of useful information; (c) the definition, recognition, and measurement of the elements from which financial statements are constructed; and (d) concepts of capital and capital maintenance.

16. Conceptual Framework 2 Fundamental Qualitative Characteristics
4 Enhancing Qualitative Characteristics
The qualitative characteristics of useful financial information identify the types of information that are likely to be most useful to the existing and potential investors, lenders, and other creditors for making decisions about the reporting entity on the basis of information in its financial report (financial information). The framework identifies two fundamental qualitative characteristics and four enhancing qualitative characteristics as depicted.
Cost-benefit constraint: The cost of providing the information must be weighed against the benefits that can be derived from using it.

17. Fundamental Qualitative Characteristics
Relevant financial information is capable of making a difference in users’ decisions.
Predictive value: can be used as an input to processes to predict future outcomes。
Confirmatory value: provides feedback about (confirms or changes) previous evaluations.
Financial information must have relevance, i.e., capable of making a difference in the decisions made by users. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value, or both. Predictive value means that it can be used as an input to processes employed by users to predict future outcomes.
Confirmatory value means that it provides feedback about (confirms or changes) previous evaluations. Materiality is also part of relevance—information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information.
Materiality: Information is material if omitting it or misstating it could influence decisions.

18. Fundamental Qualitative Characteristics
Complete: includes all information necessary for a user to understand the phenomenon.
Neutral: without bias in the selection or presentation of financial information.
Free from error: no errors or omissions in the description of the phenomenon, and the process used to produce the reported information.
Financial information must be a faithful representation of the phenomena that it purports to represent. To be a faithful representation, a depiction would be complete, neutral and free from error.

19. Enhancing Qualitative Characteristics
Comparability: enables users to identify and understand similarities in, and differences among, items.
Verifiability: different knowledgeable and independent observers could reach consensus.
Timeliness: having information available to decision-makers in time.
Understandability: Classifying, characterizing and presenting information clearly and concisely makes it understandable. Users are assumed to have reasonable knowledge of business.
Comparability enables users to identify and understand similarities in, and differences among, items. Closely related is consistency which refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal.
Verifiability enables different knowledgeable and independent observers to reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation.
Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is, the less useful it is.
Understandability means classifying, characterizing, and presenting information clearly and concisely. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently.

20. Transaction Analysis and the Accounting Equation
Assets =
Liabilities +
Equity
The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because in a general way it states that assets must be equal to the claims against those assets. If you have an asset, we can have two broad categories of claims against that asset. First, we may have claims by creditors (liabilities). Finally, after all creditor claims are satisfied, the residual owners, the shareholders, have a claim on those assets.

21. Assets Cash Accounts Receivable Notes Receivable
Resources owned or controlled by a company expected to yield future benefits.
Vehicles
Land
Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are web servers for an online services company, musical instruments for a rock band, and land for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of resources. A company that provides a service or product on credit is said to have an account receivable from that customer.
Buildings
Store Supplies
Equipment

22. Creditors’ claims on assets
Liabilities
A 1
Accounts Payable
Notes Payable
Creditors’ claims on assets
Liabilities are creditors’ claims on assets. These claims reflect company obligations to provide assets, products or services to others. The term payable refers to a liability that promises a future outflow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes payable to banks, and taxes payable to the government.
Wages Payable
Taxes Payable

23. Owner’s Claims on Assets
Equity
A 1
Owner’s Claims on Assets
Equity is the owner’s claim on assets. Equity is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity. Net profit occurs when revenues exceed expenses. Net profit increases equity. A net loss occurs when expenses exceed revenues, which decreases equity.

24. Transaction Analysis
P 1
Business activities can be transactions and events.
Record those that affect the accounting equation and can be reliably measured.
Examples of transactions:
Selling of products and services (external transactions).
The business used its supplies, which are reported as expenses (internal transactions).
Examples of events:
Changes in the market value of certain assets and liabilities and natural events such as floods and fires that destroy assets and create losses.
Business activities can be described in terms of transactions and events. We record those that affect the accounting equation and can be reliably measured. Examples of transactions include the selling of products and services (external transactions) and the using of supplies, which are reported as expenses (internal transactions). Examples of events include changes in the market value of certain assets and liabilities and natural events such as floods and fires that destroy assets and create losses.

25. The accounting equation MUST remain in balance after each transaction.
Transaction Analysis
P 1
The accounting equation MUST remain in balance after each transaction.
Liabilities
Equity
Assets = +
During the process of recording business transactions, it is important that we always keep the accounting equation in balance. We can’t let our books get out of balance. You have probably heard this saying before, but may not have been sure what we meant by keeping the books in balance.

26. Transaction 1: Investment by Owners
P 1
On December 1, Chas Taylor invests $30,000 cash to start a consulting business, Fast Forward, which records:
The accounts involved are:
(1) Cash (asset)
(2) Owner Capital (equity)
Let’s look at the identification and recording of business transactions. We can begin by analyzing a transaction where Chas Taylor contributes $30,000 cash to get the business started. First, we have to identify the assets, liability or equity accounts involved in this transaction. We can see that the cash account will increase by $30,000 and the owner capital will increase by $30,000.
You can see what the books of Chas Taylor’s business look like after we analyze this transaction. The accounting equation is in balance because assets are equal to liabilities plus equity.

27. Transaction 2: Purchase Supplies for Cash
FastForward purchases supplies paying $2,500 cash.
The accounts involved are:
(1) Cash (asset)
(2) Supplies (asset)
In this transaction, the company purchases general office supplies by paying $2,500 cash. The asset account, cash, will decrease by the $2,500 paid. The asset account, supplies, will increase by $2,500, the cost of the supplies. In this transaction, we are giving up one asset, cash, and receiving another asset, supplies.
We can see the decrease in cash and the increase in supplies. The total assets are still equal to $30,000 but are divided between cash and supplies. There is no change on the liabilities plus equity section of our books, and they are still in balance.

28. Transaction 3: Purchase Equipment for Cash
FastForward purchases equipment for $26,000 cash.
The accounts involved are:
(1) Cash (asset)
(2) Equipment (asset)
This transaction is similar to the last one we recorded. Here we purchase equipment by paying $26,000 cash. The asset account, cash, will decrease by $26,000. The asset account, equipment, will increase by $26,000. Once again, we are exchanging one asset for another.
Cash is reduced by $26,000 and equipment is increased by $26,000. The balance in our cash account is now $1,500. We have a current balance in supplies of $2,500, and equipment of $26,000. The three asset accounts total $30,000. Once again, there has been no change in the liabilities plus equity side of the equation.

29. Transaction 4: Purchase Supplies on Credit
FastForward purchases Supplies of $7,100 on account.
The accounts involved are:
(1) Supplies (asset)
(2) Accounts Payable (liability)
In this transaction, the company purchases supplies of $7,100 on account. The company has only $1,500 cash available for expenses. We do not pay cash, but agree to pay off the account at some point in the future. The asset account, supplies, increases by $7,100 and the liability account, accounts payable, increases by $7,100.
You can see the balance in the cash, supplies and equipment accounts. The total on the asset side of the equation is $37,100. We acquired the assets without paying cash. If you use a credit card to purchase gas for your car, you receive an asset, gas, and incur an account payable to the credit card company. The balance in the liabilities account is now $7,100, and the owner capital account balance is still $30,000.

30. Transaction 5: Provide Services for Cash
FastForward provides consulting services receiving $4,200 cash.
The accounts involved are:
(1) Cash (asset)
(2) Revenues (equity)
The company rendered consulting services to a customer receiving $4,200 cash in full payment. The asset account, cash, will increase by $4,200. The equity account, revenues, will also increase by the same amount. Let’s look at our expanded book balances.
You see that our cash account increases by $4,200, to a current balance of $5,700. Total assets amount to $41,300. The revenue account also increases by $4,200. Recall that from our expanded accounting equation that revenues increase equity and expenses decrease equity. The total of our liabilities plus equity is now $41,300.

31. Transaction 6 and 7: Payment of Expenses in Cash
FastForward pays $1,000 rent and $700 in salary to the company’s only employee.
The accounts involved are:
(1) Cash (asset)
(2) Expenses (equity)
FastForward pays $1,000 rent to the landlord of the building where its facilities are located. Paying this amount allows FastForward to occupy the space for the month of December. FastForward also pays the biweekly $700 salary of the company’s only employee. The cash account decreases and the expense accounts increase. When expense accounts increase, equity accounts decrease.
The two expenses, rent and salaries, reduced equity as expenses are recorded. The accounting equation is in balance because the total assets of $39,600 are equal to the total liabilities plus equity of the same amount.

32. Transaction 8: Provide services and facilities for credit
FastForward provides consulting services of $1,600 and rents out its test facilities for $300, both on account.
The accounts involved are:
(1) Accounts Receivable (asset)
(2) Revenues (equity)
FastForward provides consulting services of $1,600 and rents its test facilities for $300 to a podiatric services center. The rental involves allowing members to try recommended footwear and accessories at FastForward’s testing area. The center is billed for the $1,900 total. This transaction results in a new asset, called accounts receivable, from this client. It also yields an increase in equity from the two revenue components reflected in the Revenues column of the accounting equation.

33. Transaction 9: receipt of cash from accounts receivable
FastForward receives $1,900 from client of test facilities in transaction 8.
The accounts involved are:
(1) Cash (asset)
(2) Accounts Receivable (asset)
The client in transaction 8 (the podiatric center) pays $1,900 to FastForward 10 days after it is billed for consulting services. This transaction 9 does not change the total amount of assets and does not affect liabilities or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward rendered the services in transaction 8, not when the cash is now collected. This emphasis on the earnings process instead of cash flows is a goal of the revenue recognition principle and yields useful information to users.

34. Transaction 10: Payment of accounts payable
FastForward pays $900 as partial payment for transaction 4 on supplies.
The accounts involved are:
(1) Cash (asset)
(2) Accounts Payable (liability)
FastForward pays CalTech Supply $900 cash as partial payment for its earlier $7,100 purchase of supplies (transaction 4), leaving $6,200 unpaid. The accounting equation shows that this transaction decreases FastForward’s cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an expense even though cash flows out of FastForward (instead the expense is recorded when FastForward derives the benefits from these supplies).

35. Transaction 11: Withdrawal of Cash by Owner
P 1
The owner withdraws $200 cash.
The accounts involved are:
(1) Cash (asset)
(2) Withdrawals (equity)
The owner of FastForward withdraws $200 cash for personal use. Withdrawals (decreases in equity) are not reported as expenses because they are not part of the company’s earnings process. Since withdrawals are not company expenses, they are not used in computing net profit.

36. Summary of Transactions
P 1
The summary of all transactions is shown below:
This is a summary of all eleven transactions entered into by FastForward during the month of December. Why don’t you add all the assets and get a total? Compare the total assets to the total of liabilities and equity. The books are still in balance after analyzing the eleven transactions.

37. Financial Statements
P 2
Statement of profit or loss and other comprehensive income
Statement of changes in equity
Statement of financial position
Statement of cash flows
IAS 1 Presentation of Financial Statements states that a complete set of financial statements comprises:
1. A statement of profit or loss and other comprehensive income for the period;
2. A statement of changes in equity for the period;
3. A statement of financial position as at the end of the period;
4. A statement of cash flows for the period, and
5. Notes, comprising a summary of significant accounting policies and other
explanatory information.
An entity may use different titles for the statements. The title balance sheet is traditionally used instead of statement of financial position.

38. Income Statement
P 2
to Statement of Changes in Equity
The concept of comprehensive income and hence the statement of profit or loss and other comprehensive income will be explained later in the book. From now on, we will focus on the income statement which describes a company’s revenues and expenses along with the resulting net profit or loss over a period of time due to earnings activities.
Net profit is defined as the difference between revenues and expenses. If expenses exceed revenues, we have a net loss rather than net profit. Financial statements have a three line title with the company name, the name of the statement, and the period covered by the report. In our case, we had total revenues of $6,100 and total expenses of $1,700, so net profit for the month ended December 31, 2011, was $4,400. After completing the income statement, we can prepare the statement of changes in equity.
The income statement describes a company’s revenues and expenses along with the resulting net profit or loss over a period of time due to earnings activities.

39. STATEMENT OF CHANGES IN EQUITY
P 2
from Income Statement
The statement of changes in equity reports information about how equity changes over the reporting period. This statement shows beginning share capital, events that increase it (issuance of shares and net profit), and events that decrease it (dividends and net loss). Cumulative net profit (and loss) not distributed to shareholders is known as retained earnings. Ending equity is computed in this statement and is carried over and reported on the statement of financial position. The beginning equity balances for share capital and retained earnings are measured as at the start of business on December 1. They are zeroes because FastForward did not exist before then. An existing business reports a beginning balance equal to that as at the end of the prior reporting period (such as from November 30). FastForward’s statement of changes in equity shows that Taylor’s initial contributed capital created $30,000 of equity. It also shows the $4,400 of net profit earned during the period. The statement also reports the $200 cash dividends and FastForward’s end-of-period equity balance.
to Statement of Financial Position
The statement of changes in equity reports information about how equity changes over the reporting period.

40. Statement of Financial Position
The Statement of Financial Position describes a company’s financial position at a point in time.
from Statement of Changes in Equity
The statement of financial position refers to FastForward’s financial condition at the close of business on December 31. The top portion lists FastForward’s assets: equipment, supplies, and cash. The next portion shows the liabilities: FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity balance is $34,200.
to Statement of Cash Flows

41. Statement of Cash Flows
P 2
from Statement of Financial Position
We will cover the statement of cash flows in detail in a later chapter. Notice that the statement is divided into three major sections: (1) cash flows from operating activities; (2) cash flows from investing activities; and (3) cash flows from financing activities. The statement reconciles to the ending cash balance of $4,800. Recall that the ending cash balance of $4,800 flows from the statement of financial position to the statement of cash flows.
The Statement of Cash Flows describes a company’s cash flows for operating, investing, and financing activities.

42. Decision Analysis
A 2
Return on assets (ROA) is stated in ratio form as profit divided by assets invested.
Net profit
Average total assets
Return on assets =
Return on assets (ROA) is stated in ratio form as net profit divided by average assets. Here is a table to illustrate, showing the return on assets for Adidas and Puma for 2012 and 2013.

43. 1A Return and Risk Analysis
Many different returns may be reported.
Risk is the uncertainty about the return we will earn.
The lower the risk, the lower our expected return.
ROA
Interest return on savings accounts.
Interest return on corporate bonds.
Net profit is often linked to return. Return on assets (ROA) is stated in ratio form as profit divided by assets invested. For example, banks report return from a savings account in the form of an interest return which in some economic environments can be less than 1%. If we invest in debt instruments such as government bonds, we can expect a higher return. We could also invest in a company’s shares, or even start our own business. How do we decide among these investment options? The answer depends on our trade-off between return and risk.
Risk is the uncertainty about the return we will earn. All business investments involve risk, but some investments involve more risk than others. The lower the risk of an investment, the lower is our expected return. The reason that savings accounts pay such a low return is the low risk of not being repaid with interest (the government guarantees most savings accounts from default). If we buy a share of Adidas or any other company, we might obtain a large return. However, we have no guarantee of any return; there is even the risk of loss.
The chart in the slide shows the trade-off between expected return and risk. The trade-off between return and risk is a normal part of business. Higher risk implies higher, but riskier, expected returns. To help us make better decisions, we use accounting information to assess both return and risk.

44. 1B - Business Activities and the Accounting Equation
There are three major types of activities in any organization:
Financing Activities – Provide the means organizations use to pay for resources such as land, buildings, and equipment to carry out plans.
Investing Activities - Are the acquiring and disposing of resources (assets) that an organization uses to acquire and sell its products or services.
Operating Activities – Involve using resources to research, develop, and purchase, produce, distribute, and market products and services.
There are three major types of activities in any organization:
Financing Activities – Provide the means organizations use to pay for resources such as land, buildings, and equipment to carry out plans.
Investing Activities - Are the acquiring and disposing of resources (assets) that an organization uses to acquire and sell its products or services.
Operating Activities – Involve using resources to research, develop, and purchase, produce, distribute, and market products and services.

45. END OF CHAPTER 1
End of Chapter 1.