Chapter 1Accounting and

the Business Environment

Learning Objectives

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

2. Describe the organizations and rules that govern accounting

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

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Learning Objectives

4. Use the accounting equation to analyze transactions

5. Prepare financial statements

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

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Learning Objective 1

Explain why accounting is important and list the users of accounting information

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Why Is Accounting Important?

• Accounting is the information system that: – Measures business activities– Processes the information into reports– Communicates the results to decision makers

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Decision Makers: The Users of Accounting Information

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Decision Makers: The Users of Accounting Information

• Financial accounting provides information for external decision makers, such as:– Investors who own a portion of the business– Creditors to whom the business owes money– Taxing authorities, to whom the business owes

taxes

• Managerial accounting provides information to internal decision makers.

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The Accounting Profession

• Types of accountants:– Certified Public Accountants (CPA) serve the

general public.– Certified Management Accountants (CMA)

specialize in accounting and financial management knowledge and work for a single company.

• Accounting positions:– Public– Private– Governmental

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Learning Objective 2

Describe the organizations and rules that govern accounting

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What Are the Organizations and Rules That Govern Accounting?

• Governing organizations:– Financial Accounting Standards Board (FASB)

oversees creation and governance of accounting standards.

– Securities and Exchange Commission (SEC) oversees the U.S. financial markets.

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What Are the Organizations and Rules That Govern Accounting?

• Accounting guidelines are called Generally Accepted Accounting Principles (GAAP). Useful accounting information must be:– Relevant– Faithfully representative

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The Economic Entity Assumption

• An organization that stands apart as a separate economic unit follows the economic entity assumption.

• Features of a corporation:– Separate legal entity– Continuous life and transferability of ownership– No mutual agency– Limited liability of stockholders

• A stockholder is a person who owns stock.

– Separation of ownership and management

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The Economic Entity Assumption

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Rules That Govern Accounting

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Economic entity assumption

Cost principle

Going concern assumption

Monetary unit assumption

GAAP

Rules That Govern Accounting

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• International Financial Reporting Standards (IFRS)– Principles-based standards– Used or required by more than 120 nations– Published by the International Accounting

Standards Board (IASB)

• Ethics in accounting and business– An audit is an examination of a company’s

financial statements and records.– The Sarbanes-Oxley Act (SOX) requires

companies to review internal controls.

Learning Objective 3

Describe the accounting equation and define assets, liabilities, and equity

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The Accounting Equation

• The accounting equation is the basic tool of accounting, measuring the resources of the business and the claims to those resources.

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Assets

• An asset is an economic resource that is expected to benefit the business in the future.

• Examples:– Cash– Merchandise inventory– Furniture– Land

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Liabilities

• Liabilities are debts that are owed to creditors.

• Many liabilities have the word payable in their titles.

• Examples:– Accounts payable– Notes payable– Salaries payable

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Equity

• The owners’ claims to the assets of the business are called equity. – Also called stockholders’ equity

• Increases in equity result from:– Contributed capital (owner contributions)– Revenues

• Decreases in equity result from:– Dividends (owner distributions)– Expenses

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Equity

• Equity consists of two components:– Contributed capital – Retained earnings

• Contributed capital:– Also called paid-in capital, it is the amount

invested in the corporation by its owners, the stockholders.

– Common stock represents the basic ownership of every corporation.

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Equity

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The accounting equation is expanded to show the components of equity:

• Net income Revenues > Expenses

• Net lossRevenues < Expenses

Learning Objective 4

Use the accounting equation to analyze transactions

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How Do You Analyze a Transaction?

A transaction is any event that affects the financial position of the business and can be measured with faithful representation.

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Is it a transaction?

Buying a computer for the office for $2,000

cash

x Hiring a new employee

Transaction 1—Owner ContributionSheena Bright contributes $30,000 cash to Smart Touch Learning, a corporation, in exchange for stock. The effect of this transaction on the accounting equation is:

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Transaction Analysis for Smart Touch Learning

Transaction 2—Purchase of Land for CashSmart Touch Learning purchases land for an office location, paying cash of $20,000.

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Transaction Analysis for Smart Touch Learning

Transaction 3—Purchase of Office Supplies on Account

Smart Touch Learning buys office supplies on account, which is a liability called Accounts Payable, agreeing to pay $500 within 30 days.

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Transaction Analysis for Smart Touch Learning

Transaction 4—Earning of Service Revenue for Cash Smart Touch Learning earns service revenue by providing training services for clients. The business collects $5,500 in cash.

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Transaction Analysis for Smart Touch Learning

Transaction 5—Earning of Service Revenue on Account

Smart Touch Learning performs a service for clients who do not pay immediately. The clients promise to pay $3,000 within one month. This promise is an asset called accounts receivable.

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Transaction Analysis for Smart Touch Learning

Transaction 6—Payment of Expenses with Cash

Smart Touch Learning pays $3,200 in cash expenses: $2,000 for office rent and $1,200 for employee salaries.

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Transaction Analysis for Smart Touch Learning

Transaction 7—Payment on Account (Accounts Payable)

Smart Touch Learning pays $300 to the store from which it purchased office supplies in Transaction 3.

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Transaction Analysis for Smart Touch Learning

Transaction 8—Collection on Account (Accounts Receivable)Smart Touch Learning now collects $2,000 from the client from Transaction 5.

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Transaction Analysis for Smart Touch Learning

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Transaction 9—Payment of Cash DividendSmart Touch Learning distributes a $5,000 cash dividend to the stockholder, Sheena Bright.

Transaction Analysis for Smart Touch Learning

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Learning Objective 5

Prepare financial statements

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How Do You Prepare Financial Statements

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How Do You Prepare Financial Statements?

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Statement of Cash Flows

Balance Sheet

Statement of

Retained Earnings

Income Statement

• Financial statements are business documents that are used to communicate information for decision making.

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The income statement reports the net income or net loss of the business for a specific period.

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The statement of retained earnings reports how the company’s retained earnings balance changed from the beginning to the end of the period.

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The balance sheet reports on the assets, liabilities, and stockholders’ equity of the business as of a specific date.

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Learning Objective 6

Use financial statements and return on assets (ROA) to evaluate business performance

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Return on Assets

• Return on assets (ROA) measures how profitably a company uses it assets.– ROA is calculated by dividing net income by

average total assets.

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