CHAPTER

1 Accounting in Action
LEARNING OBJECTIVES
After studying this chapter, you should be able to:

CHAPTER 1 1 Explain what accounting is.

2 Identify the users and uses of accounting.
3 Understand why ethics is a fundamental business concept.
4 Explain accounting standards and measurement principles.
5 Explain the monetary unit assumption and the economic entity assumption.
6 State the accounting equation, and define its components.
7 Analyze the effects of business transactions on the accounting equation.
8 Understand the five financial statements and how they are prepared.

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What is Accounting?
PREVIEW OF CHAPTER 1 Learning
Accounting consists of three basic Objective 1
Explain what
activities—it accounting is.

 identifies,

 records, and

 communicates

the economic events of an organization to interested users.

Financial Accounting
IFRS 3rd Edition
Weygandt ● Kimmel ● Kieso
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 Three Activities Assumptions
Illustration 1-1
The activities of the accounting process Review Question
Which of the following is not a step in the accounting process?
a. Identification.
b. Recording.
c. Economic entity.
d. Communication

The accounting process includes

the bookkeeping function.

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Who Uses Accounting Data? Who Uses Accounting Data?

Learning
Objective 2
INTERNAL EXTERNALUS Identify the
USERS ERS users and uses
of accounting.

Illustration 1-2
Questions that internal
users ask

Illustration 1-3
Questions that external users ask
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 > DO IT! The Building Blocks of Accounting
Learning
Indicate whether the following statements are true or false. Ethics in Financial Reporting Objective 3
Understand why
1. The three steps in the accounting process are identification, recording, Standards of conduct by which one’s actions are ethics is a
fundamental
and communication. business concept.
judged as right or wrong, honest or dishonest,
2. Bookkeeping encompasses all steps in the accounting process. fair or not fair, are ethics.
3. Accountants prepare, but do not interpret, financial reports.  Recent financial scandals include: Enron (USA), Parmalat
4. The two most common types of external users are investors and (ITA), Satyam Computer Services (IND), AIG (USA), and others.
company officers.
 Effective financial reporting depends on sound ethical
5. Managerial accounting activities focus on reports for internal users. behavior.

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Accounting Standards Measurement Principles

Learning
Objective 4
International Accounting Standards Board (IASB) Explain accounting
http://www.iasb.org/ standards and the
measurement
Measurement
principles. principles
International Financial
Reporting Standards

Financial Accounting Standards Board (FASB)

http://www.fasb.org/
Historical cost Fair value
Generally Accepted Accounting Principles (GAAP)
principle principle

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 Measurement Principles Assumptions

HISTORICAL COST PRINCIPLE (or cost principle) dictates that

companies record assets at their cost.

FAIR VALUE PRINCIPLE states that assets and liabilities should Assumptions
be reported at fair value (the price received to sell an asset or
settle a liability).

Monetary Economic
unit entity
assumption assumption
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Assumptions Forms of Business Ownership

Learning
MONETARY UNIT ASSUMPTION Objective 5
Proprietorship Partnership Corporation
Explain the
requires that companies include in the monetary unit
assumption and the
accounting records only transaction data that economic entity  Owned by one person  Owned by two or  Ownership divided
assumption. more persons into shares
can be expressed in terms of money.  Owner is often
manager/operator  Often retail and  Separate legal
ECONOMIC ENTITY ASSUMPTION requires that activities of the  Owner receives any service-type entity organized
entity be kept separate and distinct from the activities of its profits, suffers any businesses under corporation
losses, and is law
owner and all other economic entities.  Generally unlimited
personally liable for personal liability  Limited liability
 Proprietorship all debts
 Partnership
Forms of Business agreement
 Partnership
Ownership
 Corporation
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 Assumptions > DO IT!

Review Question Indicate whether each of the following statements presented below is
true or false.
The historical cost principle states that:
1. Convergence refers to efforts to reduce differences
a. assets should be initially recorded at cost and adjusted between IFRS and U.S. GAAP.
when the fair value changes.
2. The primary accounting standard-setting body
b. activities of an entity are to be kept separate and headquartered in London is the International
distinct from its owner. Accounting Standards Board (IASB).

c. assets should be recorded at their cost. 3. The historical cost principle dictates that companies
d. only transaction data capable of being expressed in record assets at their cost. In later periods, however,
the fair value of the asset must be used if fair value
terms of money be included in the accounting records.
is higher than its cost.

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> DO IT! The Basic Accounting Equation

Learning
Indicate whether each of the following statements presented below is Basic Accounting Equation Objective 6
State the
true or false.
accounting
 Provides the underlying framework for equation, and
4. Relevance means that financial information matches define its
recording and summarizing economic events. components.
what really happened; the information is factual.
 Assets must equal the sum of liabilities and
5. A business owner’s personal expenses must be
equity.
separated from expenses of the business to comply
with accounting’s economic entity assumption.

Assets = Liabilities + Equity

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 Basic Accounting Equation Basic Accounting Equation

Assets = Liabilities + Equity Assets = Liabilities + Equity

Assets Liabilities
 Resources a business owns.  Claims against assets (debts and obligations).

 Provide future services or benefits.  Creditors (party to whom money is owed).

 Cash, Inventory, Equipment, etc.  Accounts Payable, Notes Payable, Salaries and Wages
Payable, etc.

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Basic Accounting Equation Equity Illustration 1-7

Increases and
decreases in equity

Assets = Liabilities + Equity

Equity
 Ownership claim on total assets.

 Referred to as residual equity. Investments by shareholders represent the total amount paid in by
 Share Capital—Ordinary and Retained Earnings. shareholders for the ordinary shares they purchase.

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 Stockholders’ Equity Illustration 1-7
Stockholders’ Equity Illustration 1-7
Increases and Increases and
decreases in equity decreases in equity

Revenues result from business activities entered into for the purpose Expenses are the cost of assets consumed or services used in the
of earning income. process of earning revenue.
Common sources of revenue are: sales, fees, services, commissions, Common expenses are: salaries expense, rent expense, utilities
interest, dividends, royalties, and rent. expense, property tax expense, etc.

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Stockholders’ Equity Illustration 1-7

> DO IT!
Increases and
decreases in equity

Classify the following items as issuance of stock, dividends,

revenues, or expenses. Then indicate whether each item increases or
decreases stockholders’ equity.

Classification Effect on Equity

1. Rent Expense Expense Decrease

2. Service Revenue Revenue Increase

Dividends are the distribution of cash or other assets to shareholders.
3. Dividends Dividends Decrease
Dividends reduce retained earnings. However, dividends are not
expenses. 4. Salaries and Wages
Expense Decrease
Expense

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 The Basic Accounting Equation Transaction Analysis
Learning
Transactions are a business’s economic Objective 7 Illustration: Are the following events recorded in the accounting
Analyze the records?
events recorded by accountants. effects of
Discuss product
business Purchase
 May be external or internal. transactions on Event design with Pay rent
the accounting
computer
potential customer
equation.
 Not all activities represent transactions.

 Each transaction has a dual effect on the accounting equation. Criterion Is the financial position (assets, liabilities, or
stockholder’s equity) of the company changed?

Record/
Don’t Record
Illustration 1-8
Transaction-identification
process
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Transaction Analysis Transaction Analysis

TRANSACTION 1. INVESTMENT BY STOCKHOLDERS Ray and Barbara Neal
decide to start a smartphone app development company that they incorporate
as Softbyte SA. On September 1, 2017, they invest €15,000 cash in the
business in exchange for €15,000 of ordinary shares. The ordinary shares
indicates the ownership interest that the Neals have in Softbyte SA. This
transaction results in an equal increase in both assets and equity.
TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte SA purchases
computer equipment for €7,000 cash.
TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte SA purchases
Illustration 1-9 for €1,600 headsets and other accessories expected to last several months.
Expanded accounting equation
The supplier allows Softbyte to pay this bill in October.

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 TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE Softbyte SA pays its
TRANSACTION 4. SERVICES PERFORMED FOR CASH Softbyte SA receives €1,200
€250 Programming News bill in cash. The company previously (in
cash from customers for app development services it has performed.
Transaction 5) recorded the bill as an increase in Accounts Payable.
TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT Softbyte SA receives a
TRANSACTION 9. RECEIPT OF CASH ON ACCOUNT Softbyte SA receives
bill for €250 from the Programming News for advertising on its website but
€600 in cash from customers who had been billed for services (in
postpones payment until a later date.
Transaction 6).
TRANSACTION 6. SERVICES PROVIDED FOR CASH AND CREDIT. Softbyte provides
€3,500 of services. The company receives cash of €1,500 from customers, and it TRANSACTION 10. DIVIDENDS The corporation pays a dividend of €1,300 in
bills the balance of €2,000 on account. cash to Ray and Barbara Neal, the shareholders of Softbyte SA.

TRANSACTION 7. PAYMENT OF EXPENSES Softbyte SA pays the following

expenses in cash for September: office rent €600, salaries and wages of
employees €900, and utilities €200.
10. -1,300 -1,300
$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300 $8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 - $1,300
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Summary of Transactions
Illustration 1-10
Assets = Liabilities + Equity
1. Each transaction must be analyzed in terms of its effect
Trans- Accounts Accounts Share Retained Earnings
Cash + + Supplies + Equipment = + +
action Receivable Payable Capital Rev. – Exp. – Div. on:
1.
2. a. The three components of the basic accounting
3. equation.
4.
5. b. Specific types (kinds) of items within each component.
6.
7. 2. The two sides of the equation must always be equal.
3. The Share Capital—Ordinary and Retained Earnings columns
8. indicate the causes of each change in the shareholders’
9.
10.
claim on assets.
€8,050 + €1,400 + €1,600 + €7,000 = €1,600 + €15,000 + €4,700 - €1,950 - €1,300

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 > DO IT! > DO IT!

Transactions made by Virmari & Co. SA, a public accounting firm, for the
Assets = Liabilities + Equity
month of August are shown below. Prepare a tabular analysis which shows
Trans- Accounts Retained Earnings
Cash + Equipment = + Share Capital+
the effects of these transactions on the expanded accounting equation, action Payable Rev. – Exp. – Div.
similar to that shown in Illustration 1-10. 1.

1. The company issued ordinary shares for €25,000 cash. 2.

3.
2. The company purchased €7,000 of office equipment on credit.
4.
3. The company received €8,000 cash in exchange for services performed.
5.
4. The company paid €850 for this month’s rent.
+ = + + - -
5. The company paid a dividend of €1,000 in cash to shareholders.

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The Basic Accounting Equation

Learning
Companies prepare five financial Objective 8
Understand the
statements : five financial
statements and
how they are
prepared. Illustration 1-10
Retained Statement Financial statements and
Income their interrelationships
Earnings of Financial
Statement
Statement Position

Statement
Comprehensive
of Cash
Income Statement
Flows
Illustration 1-11
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Financial statements and their interrelationships
LO 8
 Balance sheet and
income statement are
needed to prepare
statement of cash
flows.

Illustration 1-11
Financial statements
and their
interrelationships

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Illustration 1-11 LO 8

Income Statement Financial Statements

 Reports the profitability of the company’s operations over Review Question

a specific period of time.
Net income will result during a time period when:
 Lists revenues first, followed by expenses.
a. assets exceed liabilities.
 Shows net income (or net loss).
b. assets exceed revenues.
 Does not include investment and dividend transactions
c. expenses exceed revenues.
between the shareholders and the business.
d. revenues exceed expenses.

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 Retained Earnings Statement Statement of Financial Position

 Reports the changes in retained earnings for a specific  Reports the assets, liabilities, and equity at a specific
period of time. date.

 The time period is the same as that covered by the income  Lists assets at the top, followed by liabilities and equity.
statement.
 Total assets must equal total liabilities and equity.
 Information provided indicates the reasons why retained
 Is a snapshot of the company’s financial condition at a
earnings increased or decreased during the period.
specific moment in time (usually the month-end or year-
end).

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Financial Statements Statement of Cash Flows

Review Question  Information on the cash receipts and payments for a

specific period of time.
The financial statement that reports assets, liabilities, and
equity is the:  Answers the following:
HELPFUL HINT
a. income statement. ► Where did cash come from? Investing activities pertain
to investments made by
► What was cash used for? the company, not
b. retained earnings statement.
investments made by the
► What was the change in the owners.
c. statement of financial position.
cash balance?
d. statement of cash flows.

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 Comprehensive Income Statement > DO IT!

 Other comprehensive income items are not part of net Presented below is selected information related to Flanagan Group plc at
income. December 31, 2017. Flanagan reports financial information monthly.
Equipment £10,000 Utilities Expense £ 4,000
 Reported either by
Cash 8,000 Accounts Receivable 9,000
► Combining with income statement, or Service Revenue 36,000 Salaries and Wages Expense 7,000
► Separate statement. Illustration 1-13 Rent Expense 11,000 Notes Payable 16,500
Comprehensive
income statement Accounts Payable 2,000 Dividends 5,000
(a) Determine the total assets of Flanagan at December 31, 2017.
(b) Determine the net income that Flanagan reported for December 2017.
(c) Determine the equity of Flanagan at December 31, 2017.

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THIS IS THE END OF

CHAPTER 1

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