Chapter 1 Review

PRINCIPLES OF ACCOUNTING
LO1: IDENTIFY THE ACTIVITIES AND USERS ASSOCIATED WITH ACCOUNTING

Accounting: The information system that identifies, records, and communicates the
economic events of an organization to interested users.

Two Main Types of Users:

1. Internal Users: Managers who plan, organize, and run a business.

Examples: Marketing managers, production supervisors, finance directors, and company officers.

2. External Users: Includes investors who use accounting information to make

decisions to buy, hold, or sell stock and creditors who use the accounting
information to evaluate the risks of selling on credit or lending money.

Other Examples: Taxing Authorities (Ex: IRS), customers, labor unions, and regulatory
agencies (Ex: Securities and Exchange Commission (SEC)).
 1
Chapter 1 Review

LO2: EXPLAIN THE BULDING BLOCKS OF ACCOUNTING: ETHICS,

PRINCIPLES, AND ASSUMPTIONS
Ethics In Financial Reporting
Sarbanes-Oxley Act (SOX): Passed by congress to reduce unethical corporate behavior and decrease
the likelihood of future corporate scandals. As a result of SOX….
1. Top management must now certify the accuracy of financial information.
2. Penalties for fraudulent financial activity are much more severe.
3. The independence of the outside auditors who review the accuracy of
corporate financial statements and the oversight role of the board of directors
hasincreased.

Standard-Setting Environment
1. GAAP: (Generally Accepted Accounting Principles) rules and concepts that
govern financial accounting. It attempts to make information RELEVANT, RELIABLE,
and COMPARABLE.

Standard-setting bodies that determine these guidelines:

• SEC (Securities and Exchange Commission): oversees the U.S. financial markets and
accounting standard-setting bodies.
• FASB (Financial Accounting Standards Board): The primary accounting standard
setting body in the United States.
• IASB (International Accounting Standards Board): The primary accounting
standard-setting body for countries outside the united States that use
International Financial Reporting Standards (IFRS).

2. Characteristics of Financial Information: Financial information needs to be USEFUL to

investors and creditors for making decisions about providing capital. Useful information
possesses two important qualities…
1. RELEVANCE: Has the potential to impact decision making. Information is relevant if it
has… • Predictive Value: helps provide accurate expectations about the future.
• Confirmatory Value: confirms or corrects prior expectations.
• Materiality: when its size makes it likely to influence the decision of an
investor or creditor.

2. FAITHFUL REPRESENTATION: The information accurately reflects an entity’s

economic activity or condition. To provide a faithful representation,
information must be…
• Complete: nothing important has been omitted.
 • Neutral: is not biased toward one position or another.
• Free from Error: no errors or omissions in amounts and process
used to report amounts.

3. Accounting Principles: MEASUREMENT PRINCIPALS

• Historical Cost Principle: Accounting information is based on actual cost. Cost is
measured on a cash or equal to cash basis. (Ex: Bob bought equipment for
$15,000 so the equipment should be valued at $15,000). In generally, most
2
Chapter 1 Review

assets have to be valued using the historical cost principle.

• Fair Value Principle: Indicates that assets and liabilities should be reported at fair
value (the price received to sell an asset or settle a liability). Only in situations
where assets are actively traded, such as investment securities, is the fair value
principle applied.

4. 2 Main Assumptions in the Accounting Process

• MONETARY UNIT ASSUMPTION: stable monetary unit of measure used in
U.S. financial statements such as the U.S. dollar.
• ECONOMIC ENTITY ASSUMPTION: business is accounted for separately from
other business entities, including its owner.

TYPES OF BUSINESS ENTITIES

1. Sole Proprietorship: business owned by ONE PERSON and that person and company are
viewed as ONE entity for tax and liability purposes. For example, if a customer sues Bill
who owns the proprietorship, the court can order Bill to sell his personal belongings
including his house to settle the debt.
• Simple to establish
• Owner controlled
• Tax advantages

2. Partnership: owned by TWO OR MORE PEOPLE who are JOINTLY liable for tax and other
obligations. Like a proprietorship, partnerships are NOT LEGALLY SEPARTE from owners.
Each partner’s share of profits is reported and taxed on that partner’s tax return. •
Simple to establish
• Shared control
• Broader skills and resources
• Tax advantages

3. Corporation: a business legally separate from its owner or owners, meaning it is

responsible for its own acts and its own debts. A corporation is owned by shareholders
who are NOT personally liable for corporate acts and debts. A corporation acts through
its managers.
• Easier to transfer ownership
 • Easier to raise funds
• No personal liability
• A major disadvantage is that corporations face double taxation (The corporation is
taxed as a separate entity and the owner’s (stockholders) are taxed on any
earnings distributed to them from the corporation.
Attribute Present Proprietorship Partnership Corporation

One owner allowed YES NO YES

Business taxed NO NO
3YES

Chapter 1 Review
Limited liability NO* NO* YES

Business entity YES YES YES

Legal entity NO NO YES

Unlimited life NO NO YES

*A proprietorship or partnership that is set up as an LLC (Limited Liability Corporation)

has limited liability. (LLCs are talked about more in business law courses)

LO 3: STATE THE ACCOUNTING EQUATION, AND DEFINE IT COMPONENTS

The two basic elements of a business are what it owns and what it owes. Assets are the
resources a business owns.

Liabilities and stockholders’ equity are the rights or claims against these resources.

The Basic Accounting Equation: Assets = Liabilities + Owners’

Equity
This relationship is the basic accounting equation. Assets must equal the sum of liabilities and
owners’ equity. The equation provides the underlying framework for recording and
summarizing economic events
Assets - resources a business owns. The business uses its assets in carrying out such
activities as production and sales.

Liabilities -claims against assets—existing debts and obligations. Businesses of all sizes
usually borrow money and purchase merchandise on credit. These economic activities
result in payables of various sorts.

Owners’ Equity - The ownership claim on total assets is owner’s equity. It is equal to total assets minus
total liabilities
 1. Increase in Owner’s Equity:
• Investment by Owner - are the assets the owner puts into the business. These investments increase
owner’s equity. They are recorded in a category called owner’s capital.
• Revenues - are the gross increase in owner’s equity resulting from business activities entered into
for the purpose of earning income.
2. Decrese in Owner’s Equity:
• Drawings - an owner may withdraw cash or other assets for personal use. Drawings decrease
owner’s equity. They are recorded in a category called owner’s drawings.
• Expenses - are the cost of assets consumed or services used in the process of earning revenue.
They are decreases in owner’s equity that result from operating the business.

4
Chapter 1 Review

Expanded Accounting Equation:

LO 4: ANALYZE THE EFFECT OF BUSINESS TRANSACTIONS ON THE BASIC

ACCOUNTING EQUATION
THE ACCOUNTING INFORMATION SYSTEM
• Accounting Information System: system of collecting, processing transaction data, and
communicating financial information to decision makers.
o Rely on the accounting process.
1. Analyze business transactions
2. Journalize
3. Post
4. Trial Balance
5. Adjusting Entries
6. Adjusted Trial Balance
7. Financial Statements
8. Closing Entries
9. Post-Closing Trial Balance

• Transactions: economic events that require recording in the financialstatements. o Assets,

liabilities, or stockholders’ equity items change as a result of some economicevent. o Dual
effect on the accounting equation (Assets = Liabilities + Owners’ Equity)
 o Not all activities represent transactions.
o Ex: The payment of rent, purchase of a building, and sale of goods all
represented transactions that need to be recorded.

5
Chapter 1 Review

ANALYZING TRANSACTIONS

When analyzing transactions keep in mind.

• The accounting equation MUST ALWAYS BALANCE.

• The cause of each change in Owners’ equity must be indicated.
Example Business Transactions (From Softbyte.):
Keep A = L + OE in Balance

TRANSACTION 1. INVESTMENT BY OWNER Ray Neal decides to start a smartphone app

development company which he names Softbyte. On September 1, 2017, he invests $15,000 cash in
the business. This transaction results in an equal increase in assets and owner’s equity.
TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte Inc. purchases computer
equipment for $7,000 cash.
TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte Inc. purchases for $1,600 headsets
and other accessories expected to last several months. The supplier allows Softbyte to pay this bill in
October.
TRANSACTION 4. SERVICES PERFORMED FOR CASH Softbyte Inc. receives $1,200 cash from
customers for app development services it has performed.
TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT Softbyte Inc. receives a bill for $250
from the Daily News for advertising on its online website but postpones payment until a later date.
TRANSACTION 6. SERVICES PERFORMED FOR CASH AND CREDIT. Softbyte performs $3,500 of
services. The company receives cash of $1,500 from customers, and it bills the balance of $2,000 on
account.
TRANSACTION 7. PAYMENT OF EXPENSES Softbyte Inc. pays the following expenses in cash for
September: office rent $600, salaries and wages of employees $900, and utilities $200.
TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE Softbyte Inc. pays its $250 Daily News bill in
cash. The company previously (in Transaction 5) recorded the bill as an increase in Accounts Payable.
TRANSACTION 9. RECEIPT OF CASH ON ACCOUNT Softbyte Inc. receives $600 in cash from
customers who had been billed for services (in Transaction 6).
TRANSACTION 10. WITHDRAWAL OF CASH BY OWNER Ray Neal withdraws $1,300 in cash in cash
from the business for his personal use.
6
Chapter 1 Review

LO 5: DESCRIBE THE FOUR FINANCIAL STATEMENTS AND HOW THEY

ARE PREPARED
 1. Income Statement
2. Retained Earnings Statement
3. Balance Sheet
Income Statement
• Describes a company’s revenues and expenses which result in net income (revenues exceed expenses)
or a net loss (expenses exceed revenues) over a specific period of time due to earnings activities.

Statement of Owner’s Equity

• Explains changes in owner’s equity from net income, net loss, and drawings over a specific period of
time. (Same time period as covered by the income statement)

• Balance Sheet
• Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a
point in time.

9
Chapter 1 Review

• Basic Accounting Equation: ASSETS = LIABILITIES + OWNERS’EQUITY

 10
Chapter 1 Review

Summary of Accounts

Name Category/ Quick Definition

Financial
Statement
 Cash Asset/Balance Sheet Includes money and any medium of exchange that bank has for deposit
(coins, checks, money orders, checking account balances.)

Accounts Receivable Asset/Balance Sheet Held by the SELLER. Promises of future payment to seller from
buyer. (RECEIVE money later)

Notes Receivable Asset/Balance Sheet A written promissory note that gives a business the right to receive cash in
the future. The receipt of cash includes the original amount (principal) and
interest.

Inventory Asset/Balance Sheet Goods a company owns and expects to sell in its normal operations.

Prepaid Accounts Asset/Balance Sheet Assets that represent payments of FUTURE expenses such as Prepaid
Insurance (pay for it ahead of the time you are going to use the insurance.)

Supplies Accounts Asset/Balance Sheet Assets such as paper, toner, and pens that become expenses when they are
used up.

Property, Plant, and Asset/Balance Sheet Incudes land, buildings, and equipment. Equipment and building accounts
Equipment Accounts get expensed by allocating their cost over the periods benefited by them.
Land accounts DO NOT get expensed over their life.

Accounts Payable Liability/Balance Promise by the BUYER to pay the seller at a later date.
Sheet

Notes Payable Liability/Balance A formal promise that includes signing a promissory note to pay a future
Sheet amount.

Unearned Revenue Liability/Balance Liability that is going to be settled in the future when a company delivers its
Accounts Sheet products or services. (Ex: Jim’s neighbor gave him $50 now to mow their
lawn while they are on vacation. Jim has an obligation to mow his
neighbor’s lawn in the future.)

Accrued Liabilities Liability/Balance Amounts owed that are not yet paid.
Sheet

Common Stock Stockholders’ Amount that shareholders (owners) invest in the company.
Equity/Balance Sheet

Dividends Stockholders’ Distribution of assets such as cash to the shareholders of the

Equity /Retained company. It REDUCES retained earnings. (NOT AN EXPENSE)
Earnings

Revenue (Ex: Sales, Revenue/Income INCREASE retained earnings and are resources generating by a
Professional Service, Statement company’s earning activities.
and Rent Revenue.)

Expenses (Ex: Expenses/Income DECREASE retained earnings and are the cost of assets or services used to
Advertising, Store Statement earn revenues.
Supplies, Rent, and
Utilities Expense)

11