Chapter One

Introduction to Accounting
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Explain what accounting is.
2 Identify the users and uses of accounting.
3 Explain accounting standards and measurement principles.
4 Explain the monetary unit assumption and the economic
entity assumption.
5 Explain the career opportunities in accounting.
6 State the accounting equation, and define its components.
7 Analyze effects of business transactions on the accounting
equation.
8 Understand the four FS’s and how they are prepared.
 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.
 Cont’d
o As a starting point to the accounting process, a company
identifies the economic events relevant to its business.
Examples of economic events are the sale of goods, the
providing of telephone services …

o Once a company identifies economic events, it records those

events in order to provide a history of its financial activities.

o Recording consists of keeping a systematic, chronological

diary of events, measured in monetary units.

o In recording, the company also classifies and summarizes

economic events.

o Finally, the company communicates the collected information

to interested users by means of accounting reports. The
most common of these reports are called FS’s
Three Activities
Illustration 1-1
The activities of the accounting process

The accounting process includes

the bookkeeping function.
Who Uses Accounting Data?
o There are two broad groups of users of financial
information: internal users and external users.
1) INTERNAL USERS

o Internal users of accounting information are managers who

plan, organize, and run the business. These include marketing
managers, production supervisors, finance directors, and
company officers.

o Managerial Accounting provides internal reports to help

users make decisions about their companies.

o Examples are financial comparisons of operating alternatives,

projections of income from new sales campaigns, & forecasts
of cash needs for the next year.
 Cont’d

INTERNAL
USERS

Illustration 1-2
Questions that internal
users ask
 Cont’d
2) EXTERNAL USERS

o External users are individuals and organizations outside a

company who want financial information about the company.

o The two most common types of external users are investors

and creditors.

o Investors (owners) use accounting information to make

decisions to buy, hold, or sell ownership shares of a company.

o Creditors (such as suppliers & bankers) use accounting

information to evaluate the risks of granting credit or
lending money.

o Financial Accounting provides economic and financial

information for investors, creditors, and others.
 Cont’d

EXTERNAL
USERS

Illustration 1-3
Questions that external users ask
 > DO IT!

Indicate whether the following statements are true or false.

1. The three steps in the accounting process are identification,
recording, and communication.
2. Bookkeeping encompasses all steps in the accounting
process.
3. Accountants prepare, but do not interpret, financial reports.
4. The two most common types of external users are investors
and company officers.
5. Managerial accounting activities focus on reports for internal
users.
 1.2. Accounting Standards, Measurement Principles
& Assumptions
Accounting Standards
o In order to ensure high-quality financial reporting,
accountants present FS’s in conformity with accounting
standards that are issued by standard setting bodies.
o Presently, there are two primary accounting standard-
setting bodies—the IASB and FASB.
o More than 140 countries follow standards referred to
IFRS.
o IFRS’s are determined by the IASB. The IASB is
headquartered in London, with its 15 board members
drawn from around the world.
 Cont’d
o Most companies in the US follow standards issued by the
FASB, referred to as GAAP.
o As markets become more global, it is often desirable to
compare the results of companies from different countries
that report using different accounting standards.
o In order to increase comparability, in recent years the two
standard-setting bodies have made efforts to reduce the
differences between IFRS and U.S. GAAP.
o This process is referred to as convergence.
o As a result of these convergence efforts, it is likely that
someday there will be a single set of high-quality accounting
standards that are used by companies around the world.
 Cont’d

International Accounting Standards Board

(IASB) http://www.iasb.org/

International Financial
Reporting Standards

Financial Accounting Standards Board

(FASB) http://www.fasb.org/

Generally Accepted Accounting Principles (GAAP)

Measurement Principles
o IFRS generally uses one of two measurement principles,
the historical cost principle or the fair value principle.
o The selection of which principle to follow generally
relates to trade-offs between relevance & faithful
representation.
o Relevance means that financial information is capable of
making a difference in a decision.
o Faithful representation means that the numbers and
descriptions match what really existed or happened—
they are factual.
 Cont’d
1) HISTORICAL COST PRINCIPLE (or Cost Principle)

o It dictates that companies record assets at their

cost.

o This is true not only at the time the asset is

purchased, but also over the time the asset is
held.

2) FAIR VALUE PRINCIPLE

o It states that assets and liabilities should be

reported at fair value (the price received to sell
an asset or settle a liability).
 Cont’d
o Fair value information may be more useful than HC for
certain types of assets and liabilities.

o For example, certain investment securities are

reported at FV because market value information is
usually readily available for these types of assets.

o In determining which measurement principle to use,

companies weigh the factual nature of cost figures
versus the relevance of fair value.

o In general, even though IFRS allows companies to revalue

PPE and other long-lived assets to FV, most companies
choose to use cost. Only in situations where assets are
actively traded, such as investment securities, do
companies apply the FV principle extensively.
Assumptions
o Assumptions provide a foundation for the accounting
process.
o Two main assumptions are the monetary unit assumption
and the economic entity assumption.

1) MONETARY UNIT ASSUMPTION

o The monetary unit assumption requires that companies
include in the accounting records only transaction data that
can be expressed in money terms.

o This assumption enables accounting to quantify (measure)

economic events.

o The monetary unit assumption is vital to applying the

historical cost principle.
 Cont’d
o This assumption prevents the inclusion of some relevant
information in the accounting records.
o For example, the health of a company’s owner, the quality
of service, and the morale of employees are not included.
o The reason: Companies cannot quantify this information in
money terms.
 Cont’d
2) ECONOMIC ENTITY ASSUMPTION
o It requires that activities of the entity be kept separate
and distinct from the activities of its owner and all
other economic entities.
 Proprietorship
 Partnership Forms of Business
Ownership
 Corporation
 Cont’d

Proprietorship Partnership Corporation

 Owned by one  Owned by two  Ownership

person or more persons divided into
shares
 Owner is often  Often retail and
manager/operator service-type  Separate legal
businesses entity organized
 Owner receives
under
any profits, suffers  Generally
corporation law
any losses, and is unlimited
personally liable personal liability  Limited liability
for all debts.
 Partnership
agreement
 Cont’d
Question #1
The historical cost principle states that:
a. Assets should be initially recorded at cost and adjusted
when the fair value changes.
b. Activities of an entity are to be kept separate and
distinct from its owner.
c. Assets should be recorded at their cost.
d. Only transaction data capable of being expressed in
terms of money be included in the accounting records.
 > DO IT!
Indicate whether each of the following statements presented
below is true or false.

1. Convergence refers to efforts to reduce differences between

IFRS and U.S. GAAP.

2. The primary accounting standard-setting body headquartered

in London is the International Accounting Standards Board
(IASB).

3. The historical cost principle dictates that companies record

assets at their cost. In later periods, however, the fair value of
the asset must be used if fair value is higher than its cost.
 > DO IT!
Indicate whether each of the following statements presented
below is true or false.

4. Relevance means that financial information matches what

really happened; the information is factual.

5. A business owner’s personal expenses must be separated

from expenses of the business to comply with accounting’s
economic entity assumption.
1.3. Accounting Career Opportunities
Public Accounting
Careers in auditing, taxation, Private Accounting
and management consulting Careers in industry
serving the general public. working in cost accounting,
budgeting, accounting
Governmental Accounting
Careers with the tax authorities, information systems, and
law enforcement agencies, and taxation.
corporate regulators.

Forensic Accounting
Uses accounting, auditing, and investigative skills to
conduct investigations into theft and fraud.
 1.4. The Basic Accounting Equation
Basic Accounting Equation
 Provides the underlying framework for recording and
summarizing economic events.

 Assets must equal the sum of liabilities and equity.

Assets = Liabilities + Equity

 Cont’d

Assets = Liabilities + Equity

Assets
 Resources a business owns.

 Provide future services or benefits.

 Cash, Inventory, Equipment, etc.

 Cont’d

Assets = Liabilities + Equity

Liabilities
 Claims against assets (debts and obligations).

 Creditors (party to whom money is owed).

 Accounts Payable, Notes Payable, Salaries and

Wages Payable, etc.
 Cont’d

Assets = Liabilities + Equity

Equity
 Ownership claim on total assets.

 Referred to as residual equity.

 Share Capital—Ordinary and Retained Earnings.

 Cont’d
Illustration 1-7: Increases and Decreases in Equity

Investments by shareholders represent the total amount

paid in by shareholders for the ordinary shares they
purchase.
 Cont’d
Illustration 1-7: Increases and Decreases in Equity

Revenues result from business activities entered into for

the purpose of earning income.
Common sources of revenue are: sales, fees, services,
commissions, interest, dividends, royalties, and rent.
 Cont’d
Illustration 1-7: Increases and Decreases in Equity

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, property tax expense, etc.
 Cont’d
Illustration 1-7: Increases and Decreases in Equity

Dividends are the distribution of cash or other assets to

shareholders.
Dividends reduce retained earnings. However, dividends
are not expenses.
 > DO IT!
Classify the following items as issuance of stock,
dividends, revenues, or expenses. Then indicate whether
each item increases or decreases stockholders’ equity.

Classification Effect on Equity

1. Rent Expense

2. Service Revenue

3. Dividends

4. Salaries and Wages Expense

 1.5. 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.
 Cont’d
Illustration: Are the following events recorded in the
accounting records?
Discuss product
Purchase
Event design with Pay rent
computer
potential customer

Criterion Is the financial position (assets, liabilities, or

stockholder’s equity) of the company changed?

Record/
Don’t Record

Illustration 1-8
Transaction-identification process
 Cont’d
Illustration 1-9
Expanded Accounting Equation
 Cont’d
TRANSACTION 1. INVESTMENT BY STOCKHOLDERS Ray and Barbara
Neal decide to start a computer programming company that they
incorporate as Softbyte Inc. On September 1, 2014, they invest €15,000
cash in the business in exchange for €15,000 of ordinary shares. The
ordinary shares indicates the ownership interest that the Neals have in
Softbyte SA. This transaction results in an equal increase in both assets
and equity.

Assets = Liabilities + Equity

Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte
Inc. purchases computer equipment for €7,000 cash.

Assets = Liabilities + Equity

Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte Inc.
purchases for €1,600 computer paper & other supplies expected to last
several months. The supplier allows Softbyte to pay this bill in October.

Assets = Liabilities + Equity

Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
TRANSACTION 4. SERVICES PERFORMED FOR CASH Softbyte Inc.
receives €1,200 cash from customers for programming services it has
provided.
Assets = Liabilities + Equity
Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
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.

Assets = Liabilities + Equity

Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
TRANSACTION 6. SERVICES PROVIDED FOR CASH AND CREDIT.
Softbyte Inc 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.
Assets = Liabilities + Equity
Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
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.
Assets = Liabilities + Equity
Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE Softbyte pays its
€250 Daily News bill in cash. The company previously (in Transaction 5)
recorded the bill as an increase in Accounts Payable and a decrease in
equity.
Assets = Liabilities + Equity
Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
TRANSACTION 9. RECEIPT OF CASH ON ACCOUNT Softbyte
receives €600 in cash from customers who had been billed for
services (in Transaction 6).
Assets = Liabilities + Equity
Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
TRANSACTION 10. DIVIDENDS The corporation pays a dividend of €1,300
in cash to Ray and Barbara Neal, the shareholders of Softbyte Inc.

Assets = Liabilities + Equity

Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
€8,050 + €1,400 + €1,600 + €7,000 = €1,600 + €15,000 + €4,700 - €1,950 - €1,300

€18,050 €18,050
Summary of Transactions
1. Each transaction must be analyzed in terms of its
effect on:
a. The three components of the basic accounting
equation.
b. Specific types (kinds) of items within each
component.
2. The two sides of the equation must always be equal.
3. The Share Capital—Ordinary and Retained Earnings
columns indicate the causes of each change in the
shareholders’ claim on assets.
Illustration 1.10: Tabular Summery of Softbyte Inc. Transactions

Assets = Liabilities + Equity

Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies +Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div.

1. +15,000 +15,000
2. -7,000 +7,000
3. +1,600 +1,600
4. +1,200 +1,200
5. +250 -250
6. +1,500 +2,000 +3,500
7. -1,700 -600
-900
-200
8. -250 -250
9. +600 -600
10. -1,300 -1,300
€8,050 + €1,400 + €1,600 + €7,000 = €1,600 + €15,000 + €4,700 - €1,950 - €1,300

€18,050 €18,050
 > DO IT!
Transactions made by Virmari & Co., a public accounting firm,
for the month of August are shown below. Prepare a tabular
analysis which shows the effects of these transactions on the
expanded accounting equation, similar to that shown in
Illustration 1-10.
1. The company issued ordinary shares for €25,000 cash.

2. The company purchased €7,000 of office equipment on credit.

3. The company received €8,000 cash in exchange for services

performed.

4. The company paid €850 for this month’s rent.

5. The company paid a dividend of €1,000 in cash to shareholders.

 > DO IT!

Solution:
Assets = Liabilities + Equity
Trans- Accounts Share Retained Earnings
Cash + Equipment = + +
action Payable Capital Rev. – Exp. – Div.
1. +25,000 +25,000

2. +7,000 +7,000

3. +8,000 +8,000

4. -850 -850

5. -1,000 -1,000

$31,150 + $7,000 = $7,000 + $25,000 + $8,000 - $850 - $1,000

$38,150 $38,150
1.6. Financial Statements
 Companies prepare four financial statements from the
summarized accounting data:

 An IS presents the revenues and expenses and resulting Net

Income or Net Loss for a specific period of time.

 A RE’s statement summarizes the changes in retained earnings

for a specific period of time.

 A SoFP (sometimes referred to as a balance sheet) reports the

assets, liabilities, and equity of a company at a specific date.

 A SCF summarizes information about the cash inflows and

cash outflows for a specific period of time.

 These statements provide relevant financial data for internal

and external users.
 Illustration 1-10
Financial statements and
their interrelationships

Illustration 1-11: Financial Statements and their Interrelationships

 SoFP & IS
are needed
to prepare
SCF.

Illustration 1-11:
FS’s and their
Interrelationships
Income Statement
 Reports the profitability of the company’s operations
over a specific period of time.

 Lists revenues first, followed by expenses.

 Shows net income (or net loss).

 Does not include investment and dividend transactions

between the shareholders and the business.
 Cont’d
Question #2
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.

Retained Earnings Statement
 Reports the changes in retained earnings for a specific
period of time.

 The time period is the same as that covered by the

income statement.

 Information provided indicates the reasons why

retained earnings increased or decreased during the
period.
Statement of Financial Position
 Reports the assets, liabilities, and equity at a
specific date.
 Lists assets at the top, followed by liabilities and
equity.
 Total assets must equal total liabilities and equity.
 Is a snapshot of the company’s financial condition
at a specific moment in time (usually the month-
end or year-end).
 Cont’d
Question #3
The financial statement that reports assets, liabilities,
and equity is the:

a. Income Statement.

b. Retained Earnings Statement.

c. Statement of Financial Position.

d. Statement of Cash Flows.

Statement of Cash Flows
 Information on the cash receipts and payments for a
specific period of time.

 Answers the following:

► Where did cash come from?

► What was cash used for?

► What was the change in the

cash balance? HELPFUL HINT
Investing activities pertain
to investments made by the
company, not investments
made by the owners.
 > DO IT!
Presented below is selected information related to Flanagan
Company at December 31, 2014. Flanagan reports financial
information monthly.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000

Required:
(a) Determine the total assets of Flanagan at December 31, 2014.
(b) Determine the net income that Flanagan reported for December 2014.
(c) Determine the equity of Flanagan at December 31, 2014.
Information related to Flanagan Company at December 31, 2014.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000
(a) Determine the total assets of Flanagan at December 31, 2014.

Equipment £10,000
Cash 8,000
Accounts Receivable 9,000
Total assets £27,000
Information related to Flanagan Company at December 31, 2014.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000
(b) Determine the net income reported for December 2014.
Revenues
Service revenue £36,000
Expenses
Rent expense £11,000
Salaries and wages expense 7,000
Utilities expense 4,000
Total expenses 22,000
Net income £14,000
Information related to Flanagan Company at December 31, 2014.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000
(c) Determine the equity of Flanagan at December 31, 2014.

Total assets [as computed in (a)] £27,000

Less: Liabilities
Notes payable £16,500
Accounts payable 2,000 18,500
Equity £ 8,500
The End of Chapter 1
Thank You!!!