Chapter 1

Accounting and
the Business
Environment

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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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 Generally Accepted Accounting
Principles
• Accounting guidelines are called Generally
Accepted Accounting Principles (GAAP).
• GAAP is the main U.S. accounting rule
book.
• GAAP is created by and governed by the
FASB.
• 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.
• Types of business organizations:
– Sole proprietorship
– Partnership
– Corporation
– Limited-liability company (LLC)

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The Economic Entity Assumption

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Generally Accepted Accounting
Principles

Economic entity Cost principle

assumption
GAAP

Going concern Monetary unit

assumption assumption

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 International Financial Reporting
Standards
• 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.

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Learning Objective 3

Describe the accounting

equation and define assets,
liabilities, and equity

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 What is 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 owner’s equity
• Increases in equity result from:
– Owner’s capital (owner contributions)
– Revenues
• Decreases in equity result from:
– Owner’s Withdrawals (dividends)
– Expenses

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 Equity

The accounting equation is expanded to show

the components of equity:

• Net income
Revenues > Expenses
• Net loss
Revenues < Expenses
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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 Is it a transaction?
financial position of the
business and can be
measured with faithful
 Buying a
computer for the
representation. office for $2,000
cash

x Hiring a new
employee

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 How Do You Analyze a Transaction?

• Transactions can be analyzed in 3 steps:

– Step 1: Identify the account and account type.
– Step 2: Decide if each account increases or
decreases.
– Step 3: Determine if the accounting equation is
in balance.

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 Transaction Analysis for Smart Touch
Learning
Transaction 1—Owner Contribution
Sheena Bright contributes $30,000 cash to start a new business
as a sole proprietorship named Smart Touch Learning. 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 Cash
Smart 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 earns $5,500 of
revenue and collects this amount 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
Transaction 9—Owner Withdrawal of Cash
Sheena Bright withdraws $5,00 cash from the business.

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

Statement Statement
Income Balance
of Owner’s of Cash
Statement Sheet
Equity Flows

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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 owner’s equity reports
how the owner’s capital account balance
changed from the beginning to the end of
the period.
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The balance sheet reports on the assets,
liabilities, and owner’s 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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How Do You Use Financial Statements
to Evaluate Business Performance?
• 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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