ACCOUNTING IN ACTION

LECTURE 1, 2,3

Maliha Rabeta
Lecturer
Department of Business Administration in
Finance and Banking
BUP

24,25,26 July 2022

WHAT IS ACCOUNTING?

▪ According to American Institute of Certified Public Accountants (AICPA), accounting is defined as

follows:

▪ Accounting is the art of identifying, recording, classifying and summarizing, in a significant

manner and in terms of money, transactions and events which are, in part at least, of a financial
character and interpreting the results thereof.

▪ The purpose of accounting: to identify, record, and communicate the economic events of an
organization to the interested users.
THREE ACTIVITIES OF ACCOUNTING
1. Identification 2. Recording 3. Communication

• Once identified, economic

• Selecting the economic • The recorded information is
events are recorded.
events i.e. transactions. communicated to interested
• A systematic,
• For example: sale of users through accounting
chronological diary of
products by a company. reports AKA Financial
events, measured in
Statements.
monetary units.
• Most common of these
reports are called financial
• Analysis : use of ratios, percentages, graphs, and charts to highlight statements
significant financial trends and relationships. • Analysing and interpreting
• Interpretation: explaining the uses, meaning, and limitations of reported for users.
data.
• The accounting process includes the bookkeeping function. Bookkeeping
refers to the recording of economic events & is a part of the accounting
process. In total, accounting involves the entire process of identifying,
recording, and communicating economic events
 USERS OF ACCOUNTING DATA
 Internal Users  External Users
 External users are individuals and organizations outside a
company who want financial information about the
 Internal users of accounting information are company.
managers who plan, organize, and run the  The two most common types of external users are
business. These include marketing managers, investors and creditors.
production supervisors, finance directors, and
company officers.  Investors (owners) use accounting information to decide
whether to buy, hold, or sell ownership shares of a
 Managerial accounting provides internal reports company.
to help users make decisions about their
 Creditors (such as suppliers and bankers) use accounting
companies
information to evaluate the risks of granting credit or
lending money
 Financial accounting provides economic and financial
information for investors, creditors, and other external
users (customers, labour unions, regulatory authority,
Taxing Authority)
COMMON QUESTIONS ASKED BY USERS OF ACCOUNTING DATA
1. Can we afford to give our employees a pay
raise? Human Resources

2. Did the company earn a satisfactory income?

Investors

3. Should any product lines be eliminated?

Management

4. Is cash sufficient to pay dividends to shareholders?

Finance

5. What price for our product will maximize net

income? Marketing

6. Will the company be able to pay its debts?

Creditors
 THE BUILDING BLOCKS OF ACCOUNTING
Ethics In Financial Reporting
Standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair,
are Ethics.

• Examples of Financial Scandals: Enron (USA), Parmalat (ITA), Satyam Computer Services (IND), AIG
(USA), and Aziz Halim Khair Choudhury (AHKC) & Crescent Group Scandal (BD)

• Effective financial reporting depends on sound ethical behavior.

SO 3 Understand why ethics is a fundamental business concept.

 THE BUILDING BLOCKS OF ACCOUNTING
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

 The accounting profession has developed standards that are generally accepted and universally practiced. This
common set of standards is called generally accepted accounting principles (GAAP). These standards indicate how
to report economic events.
 The primary accounting standard-setting body in the United States is the Financial Accounting Standards
Board (FASB). The Securities and Exchange Commission (SEC) is the agency of the U.S. government that
oversees U.S. financial markets and accounting standard-setting bodies. The SEC relies on the FASB to develop
accounting standards, which public companies must follow. Many countries outside of the United States have
adopted the accounting standards issued by the International Accounting Standards Board (IASB). These
standards are called International Financial Reporting Standards (IFRS).
 The Financial Reporting Standards prescribed by the Institute of Chartered Accountants in Bangladesh (ICAB) are
known as Bangladesh Financial Reporting Standards (BFRS, including Bangladesh Accounting Standards, BAS).
 THE BUILDING BLOCKS OF ACCOUNTING
Measurement Principles

Historical 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.
 THE BUILDING BLOCKS OF ACCOUNTING
Measurement Principles
Fair Value Principle – indicates that assets and liabilities should be reported at fair value (the price received to sell an
asset or settle a liability).

▪ In determining which measurement principle to use, companies weigh the factual nature of cost figures versus
the relevance of fair value.

▪ 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.

▪ In general, most companies choose to use cost.

▪ Only in situations where assets are actively traded, such as investment securities, is the fair value principle
applied.
THE BUILDING BLOCKS OF ACCOUNTING
Assumptions
Monetary Unit Assumption – include in the accounting records only transaction data that can be
expressed in terms of money.

Economic Entity Assumption – requires that activities of the entity be kept separate and distinct from the
activities of its owner and all other economic entities.

▪ Proprietorship.
Forms of Business
▪ Partnership.
Ownership
▪ Corporation.
THE BUILDING BLOCKS OF ACCOUNTING
Proprietorship Partnership Corporation

▪ Generally owned by one ▪ Owned by two or more ▪ Ownership divided into

person. persons. shares
▪ Often small service-type ▪ Often retail and service-type ▪ Separate legal entity
businesses businesses organized under state
Owner receives any profits, corporation law
▪ ▪ Generally unlimited personal
suffers any losses, and is liability ▪ Limited liability
personally liable for all
▪ Partnership agreement
debts.
THE BASIC ACCOUNTING EQUATION

Assets = Liabilities + Equity

▪ Provides the underlying framework for recording and summarizing economic events.

▪ Applies to all economic entities regardless of size.

▪ This relationship is the basic accounting equation. Assets must equal the sum of liabilities and owner’s equity.
Liabilities appear before owner’s equity in the basic accounting equation because they are paid first if a
business is liquidated.
THE BASIC ACCOUNTING EQUATION

Assets Liabilities + Equity

=

Provides the underlying framework for recording and summarizing economic events.

Assets
▪ Resources a business owns.
▪ The common characteristic possessed by all assets is the capacity to provide future services or benefits.
▪ Cash, Inventory, Equipment, etc.

SO 6 State the accounting equation, and define its components.

THE BASIC ACCOUNTING EQUATION

Assets Liabilities Equity

= +

Provides the underlying framework for recording and summarizing economic events.

Liabilities
▪ Claims against assets (debts and obligations).
▪ Creditors - party to whom money is owed.
▪ Accounts payable, Notes payable, etc.

SO 6 State the accounting equation, and define its components.

THE BASIC ACCOUNTING EQUATION

Assets = Liabilities Equity

+

Provides the underlying framework for recording and summarizing economic events.
Equity

▪ Ownership claim on total assets.

▪ Referred to as residual equity.
▪ Share capital and retained earnings.

SO 6 State the accounting equation, and define its components.

 THE BASIC ACCOUNTING EQUATION

INCREASES IN OWNER’S EQUITY

▪ Investments by owner are the assets the owner puts into the business. These investments increase
owner’s equity.They are recorded in a category called owner’s capital.
▪ Revenues are the gross increase in owner’s equity resulting from business activities entered into for the
purpose of earning income. Generally, revenues result from selling merchandise, performing services,
renting property, and lending money.
▪ Common sources of revenue are sales, fees, services, commissions, interest, dividends, royalties, and
rent.Generally results from selling merchandise, performing services, renting property, and lending
money. Revenues usually result in an increase in an asset.
THE BASIC ACCOUNTING EQUATION
DECREASES IN OWNER’S EQUITY

• Drawings An owner may withdraw cash or other assets for personal use. We use a separate classification
called drawings to determine the total withdrawals for each accounting period. Drawings decrease
owner’s equity. They are recorded in a category called owner’s drawings.

• Expenses are the cost of assets consumed or services used in the process of earning revenue.
• They are decreases in owner’s equity that result from operating the business.
• Common expenses are salaries expense, rent expense, utilities expense, tax expense etc.
 USING THE ACCOUNTING EQUATION

Transactions are a business’s economic events recorded by accountants.

▪ May be external or internal.

▪ External transactions involve economic events between the company and some outside enterprise.

▪ Internal transactions are economic events that occur entirely within one company.

▪ Not all activities represent transactions.

▪ Each transaction has a dual effect on the accounting equation.

SO 7 Analyze the effects of business transactions on the accounting equation.

 TRANSACTION IDENTIFICATION PROCESS

Illustration: Are the following events recorded in the accounting records?

Discuss product
Purchase design with
Event computer. customer. Pay rent.

Criterion Is the financial position (assets, liabilities, or equity) of the

company changed?

Record/ Don’t
Record
TRANSACTION ANALYSIS
Transaction (1). INVESTMENT BY OWNER. Ray Neal starts a smartphone app development
company which he names Softbyte. On September 1, 2017, he invests $15,000 cash in the business.
This transaction results in an equal increase in assets and owner’s equity.

Observe that the equality of the accounting equation has been maintained. Note that the investments by the owner do not represent
revenues, and they are excluded in determining net income. Therefore, it is necessary to make
clear that the increase is an investment (increasing Owner’s Capital) rather than revenue.
TRANSACTION (2). PURCHASE OF EQUIPMENT FOR CASH :
Softbyte purchases computer equipment for $7,000 cash. This transaction results in an equal increase and
decrease in total assets, though the composition of assets changes.

Solution on
notes page
TRANSACTION (3). PURCHASE OF SUPPLIES ON CREDIT Softbyte purchases for $1,600 from
Mobile Solutions headsets and other computer accessories expected to last several months. Mobile
Solutions agrees to allow Softbyte to pay this bill in October. This transaction is a purchase on account (a
credit purchase). Assets increase because of the expected future benefits of using the headsets and computer
accessories, and liabilities increase by the amount due to Mobile Solutions.
TRANSACTION (4). SERVICES PERFORMED FOR CASH Softbyte receives $1,200 cash from
customers for app development services it has performed. This transaction represents Softbyte’s principal
revenue-producing activity. Recall that revenue increases owner’s equity.

The two sides of the equation balance at $17,800. Service Revenue is included in determining Softbyte’s net income.
 TRANSACTION (5). PURCHASE OF ADVERTISING ON CREDIT Softbyte receives a bill for $250 from
the Daily News for advertising on its online website but postpones payment until a later date. This transaction results
in an increase in liabilities and a decrease in owner’s equity.

The two sides of the equation still balance at $17,800. Owner’s equity decreases when Softbyte incurs the expense. Expenses are not always paid in
cash at the time they are incurred. When Softbyte pays at a later date, the liability Accounts Payable will decrease, and the asset Cash will decrease.
The cost of advertising is an expense (rather than an asset) because the company has used the benefits. Advertising Expense is included in
determining net income.
TRANSACTION (6). SERVICES PERFORMED FOR CASH AND CREDIT Softbyte performs $3,500 of app
development services for customers. The company receives cash of $1,500 from customers, and it bills the balance of
$2,000 on account.This transaction results in an equal increase in assets and owner’s equity.

Softbyte recognizes $3,500 in revenue when it performs the service. In exchange for this service, it received $1,500 in Cash and
Accounts Receivable of $2,000. This Accounts Receivable represents customers’ promises to pay $2,000 to Softbyte in the future. When
it later receives collections on account, Softbyte will increase Cash and will decrease Accounts Receivable
TRANSACTION (7). PAYMENT OF EXPENSES Softbyte pays the following expenses in cash for September:
office rent $600, salaries and wages of employees $900, and utilities $200. These payments result in an equal decrease in
assets and owner’s equity.
TRANSACTION (8). PAYMENT OF ACCOUNTS PAYABLE Softbyte pays its $250 Daily News bill in cash. The
company previously [in Transaction (5)] recorded the bill as an increase in Accounts Payable and a decrease in owner’s
equity.

Observe that the payment of a liability related to an expense that has previously been recorded does not affect owner’s equity.
The company recorded this expense in Transaction (5) and should not record it again
TRANSACTION (9). RECEIPT OF CASH ON ACCOUNT Softbyte receives $600 in cash from customers who
had been billed for services [in Transaction (6)]. Transaction (9) does not change total assets, but it changes the
composition of those assets.

Note that the collection of an account receivable for services previously billed and recorded does not affect owner’s equity. Softbyte already
recorded this revenue in Transaction (6) and should not record it again.
TRANSACTION (10). WITHDRAWAL OF CASH BY OWNER Ray Neal withdraws $1,300 in cash from the
business for his personal use.This transaction results in an equal decrease in assets and owner’s equity.

Observe that the effect of a cash withdrawal by the owner is the opposite of the effect of an investment by the owner.
Owner’s drawings are not expenses. Expenses are incurred for the purpose of earning revenue. Drawings do not generate
revenue. They are a disinvestment. Like owner’s investment, the company excludes owner’s drawings in determining net
income.
Summary of Transactions
Companies prepare four financial statements from the summarized accounting data:
1. An income statement presents the revenues and expenses and resulting net income or net
loss for a specific period of time.
2. An owner’s equity statement summarizes the changes in owner’s equity for a specific period
of time.
3. A balance sheet reports the assets, liabilities, and owner’s equity at a specific date.
4. A statement of cash flows summarizes information about the cash inflows (receipts) and
outflows (payments) for a specific period of time.