CHAPTER

ACCOUNTING IN ACTION
 THE ACCOUNTING PROCESS

Communication

Identification Recording Accounti

ng
Reports

200
0

Prepare
accounting reports
SOFTBYTE
Select economic events Record, classify, Annual Report

(transactions) and summarize

Analyse and interpret

for users
Accounting is the identifying, recording
and communicating the economic
events of an organization to interested
users.
 Events
1. Made cash investment to start business.
2. Signed a MoU with ‘X’ Company.
3. Purchased equipment on account.
4. Selected Engineers to Set-up machineries.
5. Paid salaries.
6. Billed customers for services performed.
7. Received cash from customers billed in (6).
8. Withdrew cash for owner’s personal use.
9. Owner’s paid income tax
10. Incurred advertising expense on account.
11. Purchased additional equipment for cash.
12. Received cash from customers when service was performed.
 Use of ratios,
percentages, Explaining the
graphs, and charts uses, meaning, and
to highlight limitations of
significant financial reported data.
trends

Analysis and Interpretation

 BOOKKEEPING DISTINGUISHED
FROM ACCOUNTING
Accounting
1. Includes bookkeeping
2. Also includes much more
Bookkeeping
1. Involves only the recording of economic
events
2. Is just one part of accounting
 QUESTIONS ASKED BY INTERNAL USERS

What is the cost of manufacturing each unit of

Is cash sufficient to pay bills? product?

Can we afford to give employees pay raises Which product line is the most profitable?
this year?
• To answer these and other questions, internal
users need detailed information on a timely
basis.
• Managerial accounting provides internal
reports to help users make decisions about
their companies.
• The two most common types of external users
are investors and creditors.
• Investors (owners) use accounting
information to decide whether to buy, hold, or
sell ownership shares of a company.
• Creditors (such as suppliers and bankers) use
accounting information to evaluate the risks
of granting credit or lending money.
QUESTIONS ASKED BY EXTERNAL USERS

How does the company compare in size and

Is the company earning profitability with its competitors?
satisfactory income?

What do we
do if they
catch us?

Will the company be able to pay its debts as they come due?
 ETHICS

Ethics To Solve Ethical Dilemma

1. Recognize situation
● Standards of conduct and ethical issues
involved
2. Identify and analyse
elements
3. Identify alternatives
and weigh effects on
stakeholders
Generally Accepted Accounting
Principles
• generally accepted accounting principles
(GAAP) indicate how to report economic
events.
• Measurement Principle
• Historical Cost Principle
• Fair Value Principle
Historical Cost Principle
• The historical cost principle (or cost principle) dictates
that companies record assets at their cost. This is true
not only at the time the asset is purchased, but also
over the time the asset is held.
• For example, if Best Buy purchases land for $300,000,
the company initially reports it in its accounting
records at $300,000.
• But what does Best Buy do if, by the end of the next
year, the fair value of the land has increased to
$400,000?
• Under the historical cost principle, it continues to
report the land at $300,000.
FAIR VALUE PRINCIPLE
• The fair value principle states that assets and
liabilities should be reported at fair value (the
price received to sell an asset or settle a liability).
• Fair value information may be more useful than
historical cost for certain types of assets and
liabilities.
• For example, certain investment securities are
reported at fair value because market price
information is usually readily available for these
types of assets.
Measurement Principles
Selection of which principle to follow generally
relates to trade-offs between
• Relevance means that financial information is
capable of making a difference in a decision.
and
• Faithful representation means that the
numbers and descriptions match what really
existed or happened—they are factual.
Assumptions
• Assumptions provide a foundation for the
accounting process. Three main assumptions
are the
• Going Concern,
• Monetary unit assumption and the
• Economic entity assumption
Going Concern
• assumes organization will continue into
foreseeable future.
MONETARY UNIT ASSUMPTION
• The monetary unit assumption requires that
companies include in the accounting records
only transaction data that can be expressed in
money terms. This assumption enables
accounting to quantify (measure) economic
events.
ECONOMIC ENTITY ASSUMPTION
• An economic entity can be any organization
or unit in society. It may be a company, a
governmental unit, a municipality, a school
district, or a church.
• The economic entity assumption requires that
the activities of the entity be kept separate
and distinct from the activities of its owner
and all other economic entities.
BUSINESS ENTERPRISES
• A business owned by two or more persons
associated as partners is a partnership (partners’
equity).
• A business owned by one person is generally a
proprietorship (owner’s equity).
• A business organized as a separate legal entity
under corporation law and having ownership
divided into transferable shares is called a
corporation (shareholders’ equity).
PROPRIETORSHIP

Owner is the Small service type

manager/operato /small retail
r stores

Relatively small
amount of capital Owner receives
is necessary profits, suffers
losses, and is
liable for all debts
No legal
distinction
between the
business and the
owner,
PARTNERSHIP
Like a
A partnership
proprietorship
agreement
except that
(written or
more than
oral).
one owner is
involved.

Unlimited
Transactions
personal
must be kept
liability for
separate from
the debts of
the personal
the
activities of
partnership.
the partners.
CORPORATION

Stockholders
Ownership
enjoy
or shares are
limited
transferable.
liability

Unlimited
life.
 BASIC ACCOUNTING EQUATION

Assets are the Claims of those Claims of

to whom the
resources a owners
company owes
business money (Residual
owns. (creditors) equity)

Assets = Liabilities + Owner’s Equity

Capital
Drawings
Revenues
Expenses
 INVESTMENTS BY OWNERS
AS A BUILDING BLOCK

● Investments (Capital) by owner are the assets

put into the business by the owner.
● These investments in the business increase
owner’s equity.
 DRAWINGS AS A
BUILDING BLOCK

● Drawings are withdrawals of cash or other

assets by the owner for personal use.
● Drawings decrease total owner’s equity.
 REVENUES AS A
BUILDING BLOCK

● Revenues are the gross increases in owner’s equity

resulting from business activities entered into for
the purpose of earning income.
● Revenues may result from sale of merchandise,
performance of services, rental of property, or
lending of money.
● Revenues usually result in an increase in an asset.
 EXPENSES AS A
BUILDING BLOCK

● Expenses are the decreases in owner’s equity that

result from operating the business.
● Expenses are the cost of assets consumed or
services used in the process of earning revenue.
● Examples of expenses include utility expense, rent
expense, and supplies expense.
 INCREASES AND DECREASES IN
OWNER’S EQUITY

INCREASES DECREASES
Investments by Withdrawals by
Owner Owner
Owner’s
Equity
Revenues Expenses
INCREASES AND DECREASES
IN OWNER’S EQUITY
TRANSACTION ANALYSIS
• Transactions: a business’s economic events
recorded by accountants.

– External transactions-economic events between

the company and some outside enterprise.
– Internal transactions-economic events that occur
entirely within one company.
Transaction Identification Process
 • Each transaction must have a dual effect on
the accounting equation. For example, if an
asset is increased, there must be a
corresponding
(1) decrease in another asset,
(2) increase in a specific liability, or
(3) increase in owner’s equity.
• Two or more items could be affected. For
example, as one asset is increased $10,000,
another asset could decrease $6,000 and a
liability could increase $4,000.
 TRANSACTION ANALYSIS

M. Doucet decides to open a computer

programming service.

BANK

Softbyt
e
1. On September 1, he invests $15,000 cash in the business, which
he names Softbyte.
2. Softbyte purchases computer equipment for $7,000 cash.
3. Softbyte purchases computer paper and supplies expected to last
several months from Chuah Supply Company for $1,600 on
account.
4. Softbyte receives $1,200 cash from customers for programming
services it has provided.
5. Softbyte receives a bill for $250 for advertising its business but
pays the bill on a later date.
6. Softbyte provides programming services of $3,500 for customers
and receives cash of $1,500, with the balance payable on
account.
7. Expenses paid in cash for September are store rent, $600, salaries
of employees, $900, and utilities, $200.
8. Softbyte pays its advertising bill of $250 in cash.
9. The sum of $600 in cash is received from customers who have
previously been billed for services in Transaction 6.
0. Marc Doucet withdraws $1,300 in cash from the business for his
personal use.
 TRANSACTION ANALYSIS
TRANSACTION 1
On September 1, he invests $15,000 cash in the
business, which he names Softbyte.

There is an increase in the asset Cash, $15,000, and an

equal increase in the owner’s equity, M. Doucet,
Capital, $15,000.
 TRANSACTION ANALYSIS
TRANSACTION 2

Softbyte purchases computer equipment for $7,000 cash.

Cash is decreased $7,000, and the asset

Equipment is increased $7,000.
 TRANSACTION ANALYSIS
TRANSACTION 3
Softbyte purchases computer paper and supplies expected to last several months from
Chuah Supply Company for $1,600 on account.

The asset Supplies is increased $1,600, and the liability

Accounts Payable is increased by the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 4
Softbyte receives $1,200 cash from customers for
programming services it has provided.

Cash is increased $1,200, and

M. Doucet, Capital is increased $1,200.
 TRANSACTION ANALYSIS
TRANSACTION 5
Softbyte receives a bill for $250 for advertising its business
but pays the bill on a later date.

Accounts Payable is increased $250, and M.

Doucet, Capital is decreased $250.
 TRANSACTION ANALYSIS
TRANSACTION 6
Softbyte provides programming services of $3,500 for
customers and receives cash of $1,500, with the balance
payable on account.

Cash is increased $1,500; Accounts Receivable is

increased $2,000; and M. Doucet, Capital is
increased $3,500.
 TRANSACTION ANALYSIS
TRANSACTION 7
Expenses paid in cash for September are store rent,
$600, salaries of employees, $900, and utilities, $200.

Cash is decreased $1,700 and M. Doucet,

Capital is decreased the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 8
Softbyte pays its advertising bill of $250 in cash.

Cash is decreased $250 and Accounts

Payable is decreased the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 9
The sum of $600 in cash is received from customers who
have previously been billed for services in Transaction 6.

Cash is increased $600 and Accounts Receivable

is decreased by the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 10
Marc Doucet withdraws $1,300 in cash from
the business for his personal use.

Cash is decreased $1,300 and M. Doucet,

Capital is decreased by the same amount.
 FINANCIAL STATEMENTS

After transactions are identified, recorded, and

summarized, four financial statements are prepared
from the summarized accounting data:
1. An income statement presents the revenues and
expenses and resulting net income or net loss of a
company for a specific period of time.
2. A statement of owner’s equity summarizes the
changes in owner’s equity for a specific period of
time.
 FINANCIAL STATEMENTS

In addition to the income statement and statement of

owner’s equity, two additional statements are
prepared:
3. A balance sheet reports the assets, liabilities, and
owner’s equity of a business enterprise at a
specific date.
4. A cash flow statement summarizes information
concerning the cash inflows (receipts) and outflows
(payments) for a specific period of time.
The notes are an integral part of the financial
statements.
 ILLUSTRATION 1-10
FINANCIAL STATEMENTS AND THEIR
INTERRELATIONSHIPS

Net income of $2,750 shown on the income statement is added to the

beginning balance of owner’s capital in the statement of owner’s equity .
 ILLUSTRATION 1-10
FINANCIAL STATEMENTS AND THEIR
INTERRELATIONSHIPS

Net income of $2,750 is carried forward from the income statement to

the statement of owner’s equity. The owner’s capital of $16,450 at the
end of the reporting period is shown as the final total of the owner’s
equity column of the Summary of Transactions (Illustration 1-9 in text).
 ILLUSTRATION 1-10
FINANCIAL STATEMENTS AND THEIR
INTERRELATIONSHIPS
Owner’s capital
of $16,450 at
the end of the
reporting
period – shown
in the
statement of
owner’s equity
– is also shown
on the balance
sheet. Cash of
$8,050 on the
balance sheet is
reported on the
cash flow
statement.
 ILLUSTRATION 1-10
FINANCIAL STATEMENTS AND THEIR
INTERRELATIONSHIPS

Cash of
$8,050 on the
balance sheet
and cash flow
statement is
shown as the
final total of
the cash
column of the
Summary of
Transactions
(Illustration
1-9 in text).