Identify the following users of accounting information as either an (a) external or (b) internal
user
Regulator- external
CEO- internal
Shareholder- external
Marketing managers- internal
Executive employee- internal
External auditor- external
Production manager- internal
Nonexecutive employee- external
Bank lender-external
Internal users- of accounting information directly manage the organization
External users- of accounting information do not directly run the organization and have limited
access to the accounting information.
Accounting functions:
Identifying- select transactions and events
Recording- input, measure, and log
Communicating- prepare, analyze, and interpret.
Private Accounting: employees working for business
Public Accounting: offering audit, tax, and advisory services to others
Accounting: Is an information and measurement system that identifies , records, and
communicates an organization’s business activities.
Generally Accepted Accounting Principles: GAAP wants information to have relevance
and faithful representation. Relevant information affects decisions of users. Faithful
representation means information accurately reflects the business results.
Generally accepted accounting principles? The concepts and rules that govern financial
accounting practice.
Ethics and Accounting:
Ethics- are beliefs that separate right from wrong. They are accepted standards of good and bad
behavior.
Three-step process for making ethical decisions
1. Identify ethical concerns- Use ethics to recognize an ethical concern
2. Analyze options- consider all consequences
3. Make ethical decision- choose best option after weighing all consequences.
Fraud Triangle: Three factors
Opportunity- A person must be able to commit fraud with a low risk of getting caught
Pressure, or incentive- a person must feel pressure or have incentive to commit fraud
Rationalization, or attitude- A person justifies fraud or does not see its criminal nature.
The Key to stopping fraud is to focus on prevention. It is less expensive and more effective to prevent
fraud from happening than it is to detect it.
Conceptual Framework it consists of the following: Objectives, Qualitative Characteristics, Elements, and
Recognition and measurement.
Objectives- to provide information useful to investors, creditors, and others
Qualitative Characteristics- to require information that has relevance and faithful representation
Elements- to define items in financial statements
Recognition and measurements- to set criteria for an item to be recognized as an element; and how to
measure it.
Identify the accounting principle or assumptions that best reflects each situation
Principles governing the amount and/or timing of information to be reported in the financial statements.
There are four Principles:
Measurement Principle- also called the cost principle states the cost is measured on a cash or equal to
cash basis. Governs the evaluation of assets and liabilities in the balance sheet.
Revenue recognition principle- Governs the timing of revenues recognized on the income statement.
Revenue is recognized when it is earned at the time the work is performed.
Expense Recognition principle- a company records the expense it incurred to generate the revenue
reported. Also called the matching principle. Are reported at the same time period as the revenues they
help generate.
Full disclosure principle- A company reports the details behind financial statements that would impact
users’ decisions. Those disclosures are often in footnotes to the statements.
Accounting Assumptions: Generally related to the financial statement headings
Going-concern assumption- accounting information presumes that the business will continue operating
instead of being closed or sold.
Monetary unit assumption- Transaction and events are expressed in monetary, or money, units.
Time Period assumptions- The life of a company can be divided into time periods, such as months and
years, and useful reports can be prepared for those periods.
Business entity assumption- A business is accounted for separately from other business entities and its
owner.
Attributes of Business:
Sole Proprietorship: 1 owner; easy to set up
No additional business income tax
Unlimited liability. Owner is personally liable for proprietorship debts
Not a separate legal entity
Business ends with owner death or choice.
Partnership: 2 or more, called partners; easy to set up
No additional business income tax
Unlimited liability, partners are jointly liable for partnership debts
Not a separate legal entity
Business ends with a partner death or choice
Corporation: 1 or more, called shareholders; can get many investors by selling stock or shares of
corporate ownership
Additional corporate income tax
Limited liability. Owners called shareholders (or stockholders), are not liable for corporate acts and
debts.
A separate entity with the same rights and responsibilities as a person
Indefinite ending
Limited liability company (LLC): 1 or more, called members
No additional business income tax
Limited liability, owners, called members, are not personally liable for LLC debts
A separate entity with the same rights and responsibilities as a person.
Indefinite ending
When a corporation issues only one class of stock it is called common stock or (capital stock).
An LLC helps protect personal property from lawsuits directed at the business. Also, an LLC is not subject
to an additional business income tax. You must also examine the ethics of starting a business where
injuries are expected.
Business Transactions and Accounting
Assets- are resources a company owns or controls. These resources are expected to yield future
benefits.
*On credit and on account mean cash is received or paid at a future date.
A receivable is an asset that promises a future inflow of resources. A company that provides a
service or product on credit has an account receivable from that customer.
Liabilities are creditors claims on assets. These claims are obligated to provide assets, products,
or services to others.
A payable is a liability that promises a future outflow of resources.
Equity- is the owner’s claim on assets and is equal to assets minus liabilities. Equity is also called
net assets or residual equity.
Accounting equations: applies to all transactions and events, to all companies and organizations,
and to all points in time.
Assets=Liabilities (+) Equity
*This equation can be rearranged: Assets (-) Liabilities = Equity
We can separate equity into four parts to get the expanded accounting equation.
Assets = Liabilities (+) Contributed Capital (+) Retained Earnings
= Liabilities (+) Common Stock (-) Dividends (+) Revenues (-) Expenses
Equity increases from owner investments called stock issuances and from revenues. It decreases
from dividends and from expenses.
Definitions:
(+) Common Stock- reflects inflows of cash and other net assets from shareholders in exchange
for stock.
(-) Dividends- are outflows of cash and other assets to shareholders that reduce equity
(+) Revenues- increase equity (via net income) from sales of products and services to customers;
examples are sales of products, consulting services provided facilities rented to others and
commissions from services.
(-) Expenses- decrease equity (via net income) from cost of providing products and services to
customers; examples are cost o f employee time, use of supplies, advertising, utilities, and
insurance fees.
Financial Statements
Income statement: Revenues (-) Expenses =Net Income (describes a company’s revenues and
expenses and computes net income or loss over a period of time.
Statement of retained earnings: Beg. Retained earnings(+) Net income(-)Dividends =End.
Retained earnings (Explains changes in retained earnings from net income or loss and any
dividends over a period of time.
Balance Sheet: Assets=Liability (+)Equity (Describes a company’s financial position (types and
amounts of assets, liabilities, and equity at a point in time.
Statement of cash flows: +/- Operating C.F. +/- Investing C.F. +/- Financing C.F. = Change in cash
(Identifies cash inflows (receipts) and cash outflows (Payments) over a period of time).
Point: Arrow lines show how the statements are linked
Net income is used to compute retained earnings
Retained earnings is used to prepare the balance sheet
Cash from the balance sheet is used to reconcile the statement of cash flows
Point: The income statement, the statement of retained earnings, and the statement of cash
flows are prepared for a period of time. The balance sheet is prepared as of a point in time.
Point: A single ruled line means an addition or subtraction. Final totals are double underlined.
Negative amounts may or may not be in parentheses.
Point: net income is sometimes called earnings or profit.
Statement of Retained Earnings
The statement of retained earnings reports how retained earnings changes over the reporting
period. This statement shows beginning retained earnings, events that increase it (net income),
and events that decrease it (dividends and net loss).
Ending retained earnings is computed in this statement and is carried over and reported on the
balance sheet.
Balance Sheet
The Balance Sheet shows the financial position at the end of the business day. It lists the assets
cash, supplies, and equipment.
Account form- assets on the left and liabilities and equity on the right.
Report form- assets on top, followed by liabilities and then equity at the bottom.
Point: Payment for supplies is an operating activity because supplies are expected to be used
up in short-term operations (typically less than one year)
Return on Assets:
We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency,
(3) profitability, and (4) market prospects.
Return on assets helps evaluate if management is effectively using assets to generate net
income. Also called return on investment.
Return on assets = Net income
Average Total Assets
Net income is from the annual income statement, and average total assets is computed by
adding the beginning and ending amounts for that same period and dividing by 2.
1. A process of analyzing data to identify meaningful relations and trends is called data analytics.
2. A employee that is having trouble paying his personal bills might exhibit the following fraud factor
(pressure)
3. A graphical presentation of data to help in understanding their significance is called data
visualization.
Chapter 2 Basis of Financial Statements
The Process to go from transaction and events to financial statements includes the following:
1. Identify each transaction and event from source documents
2. Analyze each transaction and event using the accounting equations
3. Record relevant transactions and events in a journal
4. Post journal information to ledger accounts
5. Prepare and analyze the trail balance and financial statements
Source Documents- identify and describe transactions and events entering the accounting system.
They can be in hard copy or electronic form. Examples are sales receipts, checks, purchase orders,
bills from suppliers, payroll records, and bank statements.
Account Underlying Financial Statements
An Account is a record of increases and decreases in a specific asset, liability, equity,
revenue, or expense.
General Ledger- or simply ledger is a record of all accounts and their balances. The ledger is
often in electronic form.
Accounts Organized by Accounting Equation: Assets= Liability (+) Equity
Assets Accounts:
Cash, Accounts Receivable, notes
Inventory, Prepaid accounts, supplies,
Equipment, Buildings, Land.
Liability Accounts:
Accounts Payable, Notes Payable,
Accrued Liabilities, Unearned Revenue
Equity Accounts:
Common Stock, Dividends,
Revenues, Expenses
Asset Accounts
Assets- are resources owned or controlled by a company. Resources have expected future
benefits.
Cash- account shows a company’s cash balance. All increases and decreases in cash are
recorded in the Cash account. It includes money and any funds that a bank accepts for
deposits.
Accounts Receivable- are held by a seller and are promises of payment from customers to
sellers. Accounts receivable are increased by credit sales or sales on credit. They are
decreased by customers payments.
Notes Receivable- or promissory note is a written promise of another entity to pay a specific
sum of money on a specific future date to the holder of the note; the holder has an asset
recorded in a notes receivable account.
Prepaid accounts- are assets from prepayments of future expenses (expenses expected to
be incurred in future accounting periods).
Supplies Accounts- are assets until they are used. When they are used up, their costs are
reported as expenses. Unused supplies are recorded in a supplies asset account.
Equipment Accounts- is an asset. Its cost is allocated over time to expense, called
depreciation. Equipment often is grouped by its purpose for example, office equipment and
store equipment.
Building Accounts- such as stores, offices, warehouses, and factories are assets. Cost of
buildings is allocated over time to expense, called depreciation. When several buildings are
owned, separate accounts are sometimes kept for each of them.
Land- is recorded in a land account. The cost of buildings located on the land is separately
recorded in building accounts.
Liability Accounts
Liabilities are obligations to transfer assets or provide products or services to others. They
are claims by creditors against assets.
Creditors- are individuals and organizations that have rights to receive payments from a
company.
Debtors- are those who owe money.
Accounts payable- are promise to pay later. Payable can come from purchases on credit or
on account of merchandise for resale, supplies, equipment, and services.
Notes Payable- is a written promissory note to pay a future amount. Notes payable are
different from accounts payable because they come from a formal contract called a
promissory note and usually require interest.
Unearned Revenue Accounts- is a liability that is recorded when customers pay in advance
for products or services.
Point: Two words that almost always identify liability accounts: payable, meaning
liabilities that must be paid and unearned, meaning liabilities that must be fulfilled.
Accrued liabilities- are amounts owed that are note yet paid. Examples are wages payable,
taxes payable, and interest payable.
Equity Accounts
Equity = Common Stock (-) Dividends (+) Revenues (-) Expense
Equity Accounts- The owner’s claim on a company’s assets. Stockholders’ equity, or
shareholders’ equity. Equity is the owner’s residual interest in the assets of a business after
subtracting liabilities.
Owner Investments (When an owner invests in a company it increases both assets and
equity. This is recorded in the “Common Stock.”
Owner Distributions (when a corporation distributes assets to its owners, it decreases both
company assets and total equity.) recorded in the Dividends
Revenue Accounts (revenue increases Equity)
Expense Accounts (Cost of providing products and services are recorded in expense
accounts, which decrease equity.
Ledger and Chart of Accounts
The Collection of all accounts and their balances is called a Ledger (General Ledger).
Chart of Accounts- is a list of all ledger accounts with an identification number assigned to
each account.
Double-Entry Accounting
Debits and Credits:
T-Account represents a ledger account and is used to show the effects of transactions. It’s
name comes from its shape like the letter T.
Account title
(left Side) (Right Side)
Debit Credit
The left side of the account is debit side or Dr. The right side is called the Credit Side, or CR.
Point: Debit or credit are accounting directions for left or right.
When total debits exceed total credits, the account has a debit balance. It has a credit
balance when the total credits exceed total debits. When total debits equal total credits, the
account has a zero balance.
Double entry accounting- demands the accounting equation remain in balance, which
means that for each transaction:
At least two accounts are involved, with at least one debit and one credit.
Total amount debited must equal total amount credited.
Point: Assets are on the left-hand side of the equation and thus increase on the left.
Liability and equity are on the right-hand side of the equation and thus increase on the
right.
The Left side is the normal balance side for assets and the right side is the normal balance
side for liability and equity.
Point: The ending balance is on the side with the larger dollar amount.
Analyzing and Processing Transactions
Four steps of processing transactions:
1. Transaction Analysis
2. Accounting equations
3. Is to record each transaction chronologically in a Journal.
Journal- is a complete record of each transaction in one place. It also shows debits and credits
for each transaction. Recording Transactions in a journal is called journalizing.
4. Is to transfer (or post) entries from the journal to the ledger. Transferring journal entry
information to the ledger is called posting.
Steps in processing Transactions:
1. Identify transactions and source documents
2. Analyze transactions using the accounting equation.
3. Record journal entry
4. Post entry to ledger
To record entries in a general Journal, apply these steps
A. Date the transaction on the first line of each journal entry.
B. Enter titles of accounts debited and then enter amounts in the debit column on the
same line. Account titles are taken from the chart accounts.
C. Enter titles of accounts credited and then enter amounts in the Credit column on the
same line. Account titles are from the chart of accounts and are intended to separate
them from debited accounts.
D. Enter a brief explanation of the transaction on the line below the entry
When a transaction is first recorded, the posting reference column is left blank. Later,
when posting entries to the ledger, the identification numbers of the individual ledger
accounts are entered in the PR column.
Point: posting is automatic with accounting software
Point: The fundamental concepts of a manual system are identical to those of a
computerized information system.
Trial Balance and Financial Statements
Trial Balance- is a list of all ledger accounts and their balances at a point in time. It is not
a financial statement but a tool for checking equality of debits and credits in the ledger.
Preparing a Trial Balance
Preparing a trial balance has three steps:
1. List each account title and its amount (from the ledger) in the trial balance.
2. Compute the total of debit balances and the total of credit balances.
3. Verify (prove) total debit balances equal total credit balances.
A one-year (annual) reporting period is common, as are semiannual, quarterly, and monthly
periods. The one-year reporting period is called the accounting, or fiscal year. Businesses whose
accounting year begins on January 1 and ends December 31 are called calendar-year
companies.
Point: An income statement is also called an earnings statement, a statement of operations,
or a P&L (Profit loss) statement. A balance sheet is also called a statement of financial
position.
Beginning Balance sheet is (Point in time)
Income Statement is (Period of time)
Ending Balance Sheet is (Point in time)
