CHAPTER ONE

ACCONTING AND BUSINESS ENVIROMENT

Accounting is the information system that measures business activity, processes the information
into reports, and communicates the results to decision makers. Accounting is “the language of
business.” The better you understand the language, the better your decisions will be, and the
better you can manage your finances. For example, how will you decide whether to borrow
money? You had better consider your income: The concept of income comes straight from
accounting.
A key product of accounting is a set of documents called financial statements. Financial
statements report on a business in monetary terms. Is Mega book shop making a profit? Should
Mega expand? Answering these questions calls for Mega’s financial statements. The process
starts and ends with people making decisions.

Business Businesses prepare

People make Transactions Occur reports to show the
results of their
Decision operations

BUSINESS REPORTFOR DECISION

The Users of Accounting Information

Decision makers need information. The bigger the decision, the greater the need. Here are some
decision makers who use accounting information.
INDIVIDUALS
You use accounting information to manage your bank account, evaluate a new job prospect, and
decide whether to rent or buy a house. Amazon.com employees in Seattle, Washington, make the
same decisions that you do.
BUSINESSES
Managers use accounting information to set goals for their organizations. They also evaluate
progress toward those goals, and they take corrective action when it’s needed. For example,
Amazon must decide which software to purchase, how many DVDs and books to keep on hand,

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and how much money to borrow. Accounting provides the information for making these
decisions.
INVESTORS
Investors provide the money to get a business going. To decide whether to invest, a person
predicts the amount of income on the investment. This means analyzing the financial statements
and keeping up with company developments using,
CREDITORS
Before lending money, a bank evaluates the borrower’s ability to make the payments. This
evaluation includes a report on the borrower’s financial position and predicted income. To
borrow money before striking it rich, Jeff Bezos, the president of Amazon.com, probably had to
document his income and financial position.
GOVERNMENT REGULATORY AGENCIES
Most organizations face government regulation. For example, the Securities and Exchange
Commission (SEC), a federal agency, requires businesses to report their financial information to
the public.
TAXING AUTHORITIES
Local, state, and federal governments levy taxes. Income tax is figured using accounting
information. Sales tax depends upon a company’s sales.
NONPROFIT ORGANIZATIONS
Nonprofit organizations—churches, hospitals, and colleges use accounting information the same
way as Amazon.com and the Coca-Cola Company.
Financial Accounting and Management Accounting
Accounting can be divided into two fields financial accounting and management accounting.
Financial accounting provides information for people outside the company. Lenders and outside
investors are not part of day-to-day management. These people use the company’s financial
statements.
Management accounting focuses on information for internal decision makers, such as the
company’s executives and the administrators of a hospital.
Types of Business Organizations
A business can have one of three forms of organization: proprietorship, partnership, or
corporation. You should understand the differences among the three.
PROPRIETORSHIPS
A proprietorship has a single owner, called the proprietor, who is often the manager.
Proprietorships tend to be small retail stores or professional businesses, such as physicians,
attorneys, and accountants. From the accounting viewpoint, each proprietorship is distinct from
its proprietor: The accounting records of the proprietorship do not include the proprietor’s
personal financial records. However, from a legal perspective, the business is the proprietor.
PARTNERSHIPS
A partnership joins two or more individuals as co-owners. Each owner is a partner. Many retail
establishments and professional organizations of physicians, attorneys, and accountants are
partnerships. Most partnerships are small or medium-sized, but some are gigantic, exceeding
2,000 partners. Accounting treats the partnership as a separate organization, distinct from the
personal affairs of each partner. But again, from a legal perspective, a partnership is the partners.
CORPORATIONS

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 A corporation is a business owned by stockholders, or shareholders. These are the people
who own shares of ownership in the business. A business becomes a corporation when the state
approves its articles of incorporation. A corporation is a legal entity that conducts business in its
own name. Unlike the proprietorship and the partnership, the corporation is not defined by its
owners. Corporations differ significantly from proprietorships and partnerships in another way.
If a proprietorship or a partnership cannot pay its debts, lenders can take the owners’ personal
assets—their cash—to satisfy the business’s obligations. But if a corporation goes bankrupt,
lenders cannot take the personal assets of the stockholders. This limited liability of stockholders
for corporate debts explains why corporations are so popular: People can invest in corporations
with limited personal risk.
Another factor in corporate growth is the division of ownership into individual shares. The Coca-
Cola Company, for example, has billions of shares of stock owned by many stockholders. An
investor with no personal relationship to Coca-Cola can become a stockholder by buying 50,
100, 5,000, or any number of shares of its stock.

Comparison of the Three Forms of Business Organization

Proprietorship Partnership Corporation
1. Owner(s) Proprietor- there is Partners—there are Stockholders-
only one owner two or more owners there are generally
many owners
2. Life of the Limited by the Limited by the
organization owner's choice, or owners' choices, or Indefinite
death death
3. Personal liability Proprietor is Partners are
of the owner(s) personally liable personally liable Stockholders are
for the
not personally
business's debts
liable
4. Legal status of The proprietorship The partnership is
the organization is the proprietor the partners The corporation is
separate from the
stockholders

Accounting Concepts and Principles

The rules that govern accounting fall under the heading GAAP, which stands for
generally accepted accounting principles. GAAP is the “law” of accounting rules
for providing the information that is acceptable to the majority of Americans.
GAAP rests on a conceptual framework written by the FASB: The primary
objective of financial reporting is to provide information useful for making
investment and lending decisions . To be useful, information must be relevant,
reliable, and comparable. We begin the discussion of GAAP by introducing basic
accounting concepts and principles.

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The Entity Concept
The most basic concept in accounting is that of the entity. An accounting entity is
an organization or a section of an organization that stands apart as a separate
economic unit. In accounting, boundaries are drawn around each entity so as not to
confuse its affairs with those of other entities.
Consider Amazon.com. Assume Jeff Bezos started Amazon.com on his own. Suppose
he began with $5,000 obtained from a bank loan. Following the entity concept,
Bezos would account for the $5,000 separately from his personal assets, such as
his clothing, house, and automobile. To mix the $5,000 of business cash with his
personal assets would make it difficult to measure the financial position of
Amazon.com.
Consider Toyota, a huge organization with several divisions. Toyota management
evaluates each division as a separate accounting entity. If sales in the Lexus
division are dropping, Toyota can find out why. But if sales figures from all
divisions of the company are combined, management will not know that
Lexus sales are going down. Thus, the entity concept applies to any economic unit
that needs to be evaluated separately.
The Reliability (Objectivity) Principle
Accounting information is based on the most reliable data available. This guideline
is the reliability principle, also called the objectivity principle. Reliable data are
verifiable. They may be confirmed by any independent observer. For example, an
Amazon.com bank loan is supported by a promissory note. This is objective evidence
of the loan. Without the reliability principle, accounting data might be based on
whims and opinions.
Suppose you want to open an electronics store. For a store location, you transfer a
small building to the business. You believe the building is worth $150,000.
To confirm its cost to the business, you hire two real estate appraisers, who value
the building at $140,000. Which is the more reliable estimate of the building’s
value, your estimate of $150,000 or the $140,000 professional appraisal? The
appraisal of $140,000 is more reliable because it is supported by an independent
observation. The business should record the building cost as $140,000.
The Cost Principle
The cost principle states that acquired assets and services should be recorded at
their actual cost (also called historical cost). Even though the purchaser may
believe the price is a bargain, the item is recorded at the price actually paid and
not at the “expected” cost. Suppose your electronics store purchases TV
equipment from a supplier who is going out of business. Assume that you get a good

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deal and pay only $2,000 for equipment that would have cost you $3,000
elsewhere. The cost principle requires you to record the equipment at its actual
cost of $2,000, not the $3,000 that you believe the equipment is worth.
The cost principle also holds that the accounting records should maintain the
historical cost of an asset over its useful life. Why? Because cost is a reliable
measure.
Suppose your store holds the TV equipment for six months. During that time TV
prices rise, and the equipment can be sold for $3,500. Should its accounting value
—the figure “on the books”—be the actual cost of $2,000 or the current market
value of $3,500? By the cost principle, the accounting value of the equipment
remains at actual cost: $2,000.
Example
You are considering the purchase of land for future expansion. The seller is asking
$50,000 for land that cost her $35,000. An appraisal shows a value of $47,000.
You first offer $44,000. The seller counteroffers with $48,000 and you agree on
a price of $46,000. What dollar value for this land is reported on your financial
statement? Which accounting concept or principle guides your answers?
Answer: According to the cost principle, assets and services should be recorded at
their actual cost. You paid $46,000 for the land, so report the land at $46,000.
The Going-Concern Concept
Another reason for measuring assets at historical cost is the going-concern
concept. This concept assumes that the entity will remain in operation for the
foreseeable future. Under the going-concern concept, accountants assume that the
business will remain in operation long enough to use existing resources for their
intended purpose. To understand the going-concern concept better, consider the
alternative which is to go out of business. A store holding a going-out-of-business
sale is trying to sell everything. In that case, instead of historical cost, the
relevant measure is current market value. But going out of business is the
exception rather than the rule.
The Stable-Monetary-Unit Concept
In the United States, we record transactions in dollars because the dollar is the
medium of exchange. British accountants record transactions in pounds sterling.
French and German transactions are measured in Euros. The Japanese record
transactions in yen. The value of a dollar or a Mexican peso changes over time. A
rise in the price level is called inflation. During inflation, a dollar will purchase less
milk, less gas for your car, and less of other goods. When prices are stable when
there is little inflation—the purchasing power of money is also stable. Accountants
assume that the dollar’s purchasing power is stable. It allows us to add and

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subtract dollar amounts as though each dollar has the same purchasing power as
any other dollar at any other time.
The Accounting Equation
The basic tool of accounting is the accounting equation. It measures the resources
of a business and the claims to those resources.

Assets and Liabilities

Assets are economic resources that are expected to be of benefit in the future.
Cash, merchandise inventory, furniture, and land are assets. Claims to those assets
come from two sources. Liabilities are outsider claims debts that are payable to
outsiders. These outside parties are called creditors. For example, a creditor who
has loaned money to Amazon.com has a claim to some of Amazon’s assets until
Amazon pays the debt.
These insider claims are held by the owners of the business. Owners have a claim
to some of the assets because they have invested in the business.
The accounting equation shows how assets, liabilities, and owner’s equity are
related. Assets appear on the left side of the equation, and the liabilities and
owner’s equity appear on the right side.

(Economic Resources) (Claims to Economic Resources)

ASSETS = LIABILITIES + OWNER’S EQUITY
1. If the assets of a business are $170,000 and the liabilities total $80,000,
how much is the owner’s equity?
2. If the owner’s equity in a business is $22,000 and the liabilities are
$36,000, how much are the assets?
.
Sony supplies cell phones to Amazon.com. Amazon may buy the cell phones on credit
and promise to pay Sony later. Sony’s claim against Amazon.com is an account
receivable, an asset that will benefit Sony. A written promise for future collection
is called a note receivable. Amazon.com has a debt to pay Sony. This liability is an
account payable. It is backed only by the reputation and the credit standing of
Amazon. A written promise of future payment is called a note payable. All
receivables are assets. All payables are liabilities. Most businesses have both
receivables and payables.

Owner’s Equity

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Owner’s equity is the amount of an entity’s assets that remain after its liabilities
are subtracted.
ASSETS - LIABILITIES = OWNER’S EQUITY
The purpose of business is to increase owner’s equity through revenues. Revenues
are increases in owner’s equity earned by delivering goods or services to customers.
Revenues also increase assets, or they decrease liabilities. As a result, the owner’s
share of the business’s assets increases.
Owner withdrawals are amounts removed from the business by the owner.
Withdrawals are the opposite of owner investments. Expenses are decreases in
owner’s equity that occur from using assets or increasing liabilities to deliver goods
and services to customers. Expenses are the cost of doing business; they are the
opposite of revenues. Expenses include the cost of:
Office rent Interest on loans
Salaries of employees Insurance
Advertisements Property taxes
Utility payments Supplies used up
Accounting for Business Transactions
Accounting records are based on actual transactions. A transaction is any event
that affects the financial position of the business and can be recorded reliably.
Many events affect a company, including elections and economic booms.
Accountants do not record the effects of those events because they can’t be
measured reliably. An accountant records only those events with effects that can
be measured reliably, such as the purchase of a building, a sale of merchandise to a
customer, and the payment of rent. The dollar amounts of these events can be
measured reliably, so accountants record these transactions. What are some of
your personal transactions? You may have bought a DVD player. Your purchase was
a transaction. If you are making payments on an auto loan, your payments are also
transactions. You need to record all your business transactions just as Amazon.com
does in order to manage your personal affairs.
Financial Statements
After transactions have been recorded and summarized, reports are prepared for
users. The accounting reports that provide this information are called financial
statements. The principal financial statements of a proprietorship are the income
statement, the statement of owner’s equity, the balance sheet, and the statement
of cash flows. The order in which the statements are normally prepared and the
nature of the data presented in each statement are as follows:
 Income statement-A summary of the revenue and expenses for a specific
period of time, such as a month or a year.
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  Statement of owner’s equity—A summary of the changes in the owner’s
equity that have occurred during a specific period of time , such as a month
or a year.
 Balance sheet—A list of the assets, liabilities, and owner’s equity as of a
specific date, usually at the close of the last day of a month or a year.
 Statement of cash flows—A summary of the cash receipts and cash
payments for a specific period of time, such as a month or a year.
All financial statements should be identified by the
 Name of the business,
 The title of the statement, and
 The date or period of time.
The data presented in the income statement, the statement of owner’s equity, and
the statement of cash flows are for a period of time. The data presented in the
balance sheet are for a specific date.

INCOME STATEMENT
The income statement reports the revenues and expenses for a period of time,
based on the matching concept. This concept is applied by matching the expenses
with the revenue generated during a period by those expenses. The income
statement also reports the excess of the revenue over the expenses incurred. This
excess of the revenue over the expenses is called net income or net profit. If the
expenses exceed the revenue, the excess is a net loss.
The effects of revenue earned and expenses incurred during the month for Net
income for a period has the effect of increasing owner’s equity (capital) for the
period, whereas a net loss has the effect of decreasing owner’s equity (capital) for
the period.
Example 1
The assets and liabilities of Chickadee Travel Service at April 30, 2008, the end of the
current year, and its revenue and expenses for the year are listed below. The capital of
the owner, Adam Cellini, was $80,000 at May 1, 2007, the beginning of the current year.
Accounts payable $ 12,200 miscellaneous expense $ 12,950
Accounts receivable 31,350 Office expense 63,000
Cash 53,050 Supplies 3,350
Fees earned 263,200 Wages expense 131,700
Land 80,000
Prepare an income statement for the current year ended April 30, 2008
STATEMENT OF OWNER’S EQUITY
The statement of owner’s equity reports the changes in the owner’s equity for a
period of time. It is prepared after the income statement because the net income

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or net loss for the period must be reported in this statement. Similarly, it is
prepared before the balance sheet, since the amount of owner’s equity at the end
of the period must be reported on the balance sheet. Because of this, the
statement of owner’s equity is often viewed as the connecting link between the
income statement and balance sheet.
Example 2
Using the data for Chickadee Travel Service shown in Example Above, prepare a
statement of owner’s equity for the current year ended April 30, 2008. Adam
Cellini invested an additional $50,000 in the business during the year and withdrew
cash of $30,000 for personal use.
BALANCE SHEET
The form of balance sheet is called the account form where it resembles the basic
format of the accounting equation, with assets on the left side and the liabilities
and owner’s equity sections on the right side. An alternative form of balance sheet,
called the report form. It presents the liabilities and owner’s equity sections below
the assets section.
The assets section of the balance sheet normally presents assets in the order that
they will be converted into cash or used in operations. Cash is presented first,
followed by receivables, supplies, prepaid insurance, and other assets. The assets
of a more permanent nature are shown next, such as land, buildings, and equipment.
Example 3
Using the data for Chickadee Travel Service shown in Example 1 and 2, prepare the
balance sheet as of April 30, 2008.

STATEMENT OF CASH FLOWS

The statement of cash flows consists of three sections, (1) operating activities, (2)
investing activities, and (3) financing activities. Each of these sections is briefly
described below.
Cash Flows from Operating Activities This section reports a summary of cash
receipts and cash payments from operations. The net cash flow from operating
activities will normally differ from the amount of net income for the period. This
difference occurs because revenues and expenses may not be recorded at the
same time that cash is received from customers or paid to creditors.
Cash Flows from Investing Activities This section reports the cash transactions
for the acquisition and sale of relatively permanent assets.

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Cash Flows from Financing Activities This section reports the cash transactions
related to cash investments by the owner, borrowings, and cash withdrawals by the
owner.
Example 4
A summary of cash flows for Chickadee Travel Service for the year ended April
30, 2008, is shown below.
Cash receipts:
Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $251,000
Cash received from additional investment of owner . . . . . . . . . . . . . 50,000
Cash payments:
Cash paid for expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000
Cash paid for land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Cash paid to owner for personal use . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
The cash balance as of May 1, 2007, was $72,050.
Prepare a statement of cash flows for Chickadee Travel Service for the year
ended April 30, 2008.
Exercise
On June 1 of the current year, Abebe established a business to manage rental
property. He completed the following transactions during June:
a. Opened a business bank account with a deposit of $25,000 from personal
funds.
b. Purchased supplies (pens, file folders, and copy paper) on account, $1,150.
c. Received cash from fees earned for managing rental property, $4,500.
d. Paid rent on office and equipment for the month, $1,500.
e. Paid creditors on account, $600.
f. Billed customers for fees earned for managing rental property, $2,250.
g. Paid automobile expenses (including rental charges) for month, $400, and
miscellaneous expenses, $180.
h. Paid office salaries, $1,200.
i. Determined that the cost of supplies on hand was $380; therefore, the cost
of supplies used was $770.
j. Withdrew cash for personal use, $1,000.
Instructions
1. Indicate the effect of each transaction and the balances after each
transaction.
Assignment
Hanna established an insurance agency on March 1 of the current year and
completed the following transactions during March:

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 a. Opened a business bank account with a deposit of $40,000 from personal
funds.
b. Purchased supplies on account, $1,500.
c. Paid creditors on account, $800.
d. Received cash from fees earned on insurance commissions, $7,250.
e. Paid rent on office and equipment for the month, $2,500.
f. Paid automobile expenses for month, $1,000, and miscellaneous expenses,
$400.
g. Paid office salaries, $2,000.
h. Determined that the cost of supplies on hand was $400; therefore, the cost
of supplies used was $1,100.
i. Billed insurance companies for sales commissions earned, $9,350.
j. Withdrew cash for personal use, $3,000.
Instructions
1. Indicate the effect of each transaction and the balances after each
transaction, using the tabular headings:
2. Prepare financial statements

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