CHAPTER 1

WHAT IS ACCOUNTING?
accounting is the process of:

bookkeeping — collecting financial information, learn the effects, learn implications and being able to read financial informations

Analyzing it to determine what information is relevant, in order to help investors and creditors

presenting the relevant information in a meaningful form to the user,

assisting the user in interpreting the information and applying it in the decision making process, applying judgement, as an

added value, to decide how to report a transaction in financial statements

WHY IS ACCOUNTING IMPORTANT?

measures business activities

processes the information into reports

communicates the result to decision makers


FINANCIAL INFORMATION AND DECISION MAKING

its important to help a business, to help the decision makers evaluate the potential for success of their decision.

the primary purpose of accounting is to provide decision makers with certain types of financial information.

it has its own language, the language of business

it is essential that all parties involved in the business understand the language used to communicate financial information.

with the right

information you
discover the truth

DECISION MAKERS
they’re divided between financial accounting and managerial accounting

Financial accounting Managerial accounting

Provides information for external decision Provides informations to internal decision
makers makers
Investors who have a portion of the Managers
business
Creditor to whom the business owes Employees
money
Taxing authorities Individuals

there are different types of accountants:

 Certified public accountants, CPAs, those who serve the general public as
licensed professionals
 Financial accountants deal with preparing financial statements in private
and public firms
 Certified management accountants, CMAs, those who specialize in
accounting and financial management knowledge and often work for a
single company
 Auditors are independent experts who verify the conformity of financial
statements to accounting standards, make sure numbers are correct
accountants have to understand how technology is used and how to interpret
data.

WHAT ARE THE ORGANIZATIONS AND RULES THAT GOVERN

ACCOUNTING?
 international accounting standards board, IASB:
 EU commission and individual Member State
 National standard setters, ex. OIC
 market regulators

The guidelines for accounting are called GAAP, generally accepted accounting
principles. its important to prepare financial statements and so we have to
understand it.
ECONOMIC ENTITY ASSUMPTION
the economic entity is an organization that is separated form its owners
(economic unit).
the economic entity can be:
 sole proprietorship: the owner is the only one responsible for the business,
if the bills are not paid the creditors can take away some of the owners
properties. the owner is personally liable, he pays the taxes on the
business income. this are typically small businesses
 partnership: two or more people are owners of the business, not organized
as a corporation. its very similar to the sole proprietorship, just with more
people as owners. the partners are personally liable. the partnership is not
taxed but the partners pay the taxes on their share of earnings
 corporation: business organized under state law that is a separate legal
entity. more than one owner, called stockholders, hold the stock of the
business. the corporations survive even after the death of their funding
fathers. stockholders are not personally liable, if you own a stock you’re
not personally liable for the corporation, they can’t ask you to pay if
they’re in debt. risk of double taxation.
 limited-liability company

THE CORPORATION
it’s a legally separated entity, life is continuous and can be transferred
owners cannot involve corporation in their business —> no mutual agency, if you
own one share you can’t speak on behalf of the business
limited liability of stockholders: the most that the stockholder can lose is the
amount they originally paid the stock
corporations are separate taxable entities: rules and law that regulate
corporation to make sure they are to be trusted

how corporation are organized?

the creation of a corporation begins when the organizers obtain a charter from
the state, that include authorization for a certain number of stock.
the incorporators agree to a set of bylaws, “constitution” of the corporation.
When the first share of stock is issued, the corporation starts existing
the control of the corporation lays with the stockholders, who receive one vote
for each share they own.
they elect members for the board of directors. the board then elect a
chairperson, usually the most powerful person in the corporation CEO. the board
also designates the president, COO, he manages the operation day-to-day.
some corporations also have vice presidents in charge of specific things

THE MAIN ASSUMPIONTS IN ACCOUNTING

COST PRINCIPLE
is a principle that states that the assets are recorders at their actual cost
(historical cost). the accounting reports also should continue to report the
historical cost of the asset and not their useful life value because cost is a
reliable measure.

GOING CONCERN ASSUMPTION

with this we assume that the company in going to continue in the future to use
existing resources for their intended purpose
 THE MONETARY UNIT ASSUMPTION
in the US we record transactions in dollars. The value of the dollar changes over
time (inflation). accountants assume that the dollar’s value is stable so we can
measure the financial statements in monetary unit
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. It’s made up of three
parts: assets, liabilities and equity, all related to each other
ASSET= LIABILITY+ EQUITY

ASSETS
is an economic resource that is expected to:
 Benefit the business in the future
 owners have control over them
 reliable measurements
if a resources meets all these three, then it’s an asset. examples: cash,
inventory, furniture, land

LIABILITY
Are debts, claims, owed to creditors. a creditor who has loaned money has a
CLAIM to some of the business’s assets until the business pays the debt. Many
liabilities have the word payable in their titles.

EQUITY
Represents the amount of assets that are left over after the company has paid
its liabilities. It’s the company net worth.
Equity increases with contributions and revenues.
Owners contributions are referred to as contributed capital, that can be
cash or other assets to the business and in exchange receive capita.
Revenues are earnings that result from delivering goods or services to
customers.
Equity decreases with expenses and distributions to owners.
Expenses are the cost of selling goods or services, they’re the opposite of
revenues. examples are rent, salaries…
Distributions to stockholders are called dividends, paid in cash, stock or
other. they are not expenses and decrease equity
Equity consists of two main components: contributed capital and retained
earnings.
Contributed capital is the amount invested in the business by its owners
Retained earining is the equity earned by profitable operations that is not
distributed. Three events that affects the retained earnings: revenues, expenses
and dividends.
The accounting equation can be expanded to show the components of equity.
When revenues are greater than expenses, the result is a profit —> NET INCOME
When expenses are greater than revenues,the result is a loss —> NET LOSS

The Net income is the net increase or net decrease in owner’s equity over a
period of time, with the exclusions of changes in equity related to contributions
or distributions to owners.

The equity might increase because the owner puts more money into the
business, but its not generated by the business. If the owner withdraws money,
the company has less equity but the loss is not from the business.

THE RELANTIONSHIP BETWEEN THE BALANCE SHEETS OF TWO DIFFERENT DATES

To calculate the difference between two balance sheets we have to use the
accounting equation.
But to calculate the equity of the second balance sheet we have to:
 Equity 1= equity 0 + Income+ Contributions - Distributions

LINK BETWEEN NET INCOME AND THE ACCOUNTING EQUATION

REVENUES are increases in economic benefits during the accounting period in

the form of inflow or enhancements of assets (cash) or decreases of liabilities
that result in increases in equity, other than those relating to contributions from
equity participants.
Not all transactions affect the assets
EXPENSES are decreases in economic benefits during the accounting period in
form of outflows or depletions of assets (pay something) or incurrences of
liabilities (hiring someone) that result in decreases in equity, other than those
relating to distributions to equity participants.

ACCRUAL VS. CASH ACCOUNTING

 Accrual accounting:
o Impact a business transactions are recorded when the transaction
occurs
o Trvenues are recognized when earned
o Expenses are recognized when incurred
 Cash accounting
o Transactions are recorded when cash is received or paid
o Revenues are recorded when cash is received
o Expenses are recorded when cash is paid
With accrual accounting cash transactions are recorded as well as non cash
transactions such as: purchases of inventory on account (asset, liability), sales
on account (not paid yet), usage of prepaid rent, insurance….

When we should record a revenue in a transaction between businesses?

 customer collects the order Too early, could still be cancelled or
you have to cancel cause you don’t have the item
 Good are delivered. This is when we recognize the sale!!
 Customer pays. This could occur within 30-120 days

You fulfill the obligation

and recognize the
revenue when you
deliver or the service is
completed
THE MATCHING PRINCIPLE
- Expenses are costs of assets used up and of liabilities crested in earning
revenues
 Matching involves two steps:
o Identify all expenses incurred during the period
o Measure the expenses and match the expenses against revenues
earned
 Expenses may
o Be paid in cash
o Result from using up an asset such as supplies
o Result from creating a liability (payable)
The transaction appear in the same time so you have the expenses that
generated the revenues

Why do we use the accrual accounting?

If we buy an item for 10$, then we sell it for 12$ but this price will be collected in

the future

When you want to make prediction of earning power, what do you use?
Cash -10 is the cash spent today
Cash + 2 is the cash we will have in the future so its more useful for the
prediction

HOW TO ANALYZE A TRANSACTION?

Accounting is based on actual transactions.
A transaction is any event that affects the financial position of the business and
can be measured with faithful representation. They affect what the company has,
owns or its net worth.
It is important to know what transactions are important to record. Accountants
do not record everything: they record only events that have dollar amounts that
can be measured realibly (purchase of buildings, sale of merchandise, rent
payment).

EXAMPLE OF A TRANSACTION
Transaction 1
Sheena Bright contributes $30.000 cash to Smart Touch Learning, a corporation,
in exchange for stock.
The business receives $30.000 cash and issues (distributes) common stock to
her.

Step 1) Each transaction must have at least two accounts involved

Step 2) We have to view this from the business’s perspective. The
business has more cash than it had before. The business received cash
and issued stock (common stock increase)
Step 3) At the end of the transaction the left side of the equation must
equal to the amount on the right side.

The equity increased but not from profits in the performance but just for
contributions from the stockholder.

Transaction 2
The business purchase land for offices paying $20.000 cash. This transaction
affects the equation.

Step 1) Two accounts are involved

Step 2) The business paid cash
(cash decreases). The business has
land (land increases)
Step 3) Assets:
10.000+20.000=30.000

Land is a long term asset

Transaction 3
The business purchase office supplies on account (they pay after), agreeing to
pay $500 within 30 days. This transaction increases both assets and liabilities.

Step 1) Two accounts involved:

office supplies (asset) and account
payable (liability). Office supplies is
an asset cause they will buy used in the future. The liability is an accounts
payable, which will be paid in the future. A payable is a liability
Step 3) 10.000+500+20.000=500+30.000

The steps help us analyze the transactions.

Transaction 4
The business earns service revenue by providing services for clients. The
business earns $5.500 of revenue and collects the same amount in cash.
Step 1) The accounts
involved are cash (asset)
and retained earnings
(equity)
Step 2) Cash increases
and retained earnings
increases, the business
has revenues.
Step 3) The equation is
balanced

Transaction 5
The business performs a service for clients who do not pay
immediately(account).
The client promises to pay $3.000 within one month.

Step 1) The accounts

involved are Accounts
Receivable (asset) and
Retained Earning (equity).
Step 2) Accounts
receivable increases and
retained earnings
increases
Step 3) The equation is
balanced

This transaction has to be register when it happens, not when we receive the
money. Once we receive the money, then the account receivable decreases

Transaction 6
The business pays $3.200 in cash expenses: $2.000 for office rent and $ 1.200
for employee salaries.

Step 1) The accounts

involved are cash and
expenses.
Step 2) Cash decreases
and so does the equity
since there are
expenses
Step 3) The equation is balanced

Expenses are the opposite of revenues, they shrink the business.

Each expense is recorded separately

Transaction 7
The business pays $300 to the store of office supplies (Trans.3). In accounting we
say they the business pays $300 on account.

Step 1) The accounts

involved are cash
and accounts
payable.
Step 2) Cash
decreases and also
the accounts payable
decreases
Step 3) The equation is balanced

The payment on account has no effects in the amount of Office supplies. The
business is paying off a liability with cash (both decreased) .

Transaction 8
In transaction 5 the business performed a service on account for a client. Now
they collect $2.000 from the client. The business already recorded the revenue
but they will decrease the Accounts Receivable and increase Cash.

Step 1) The
accounts involved
are cash and
accounts receivable
Step 2) Cash
increases and
Account receivable
decreases
Step 3) The equation is balanced

As long as we record an increase and decrease of the same amount on one side
of the accounting equation, the equation remains in balance.

Transaction 9
The business distributes a $5.000 cash dividend to the stockholder.

Step 1) The accounts involved are

Cash and Dividends.
Step 2) Cash
decreases and
Dividends
decreases
Step 3) The
equation is still
balanced
 SUMMARY OF ALL NINE TRANSACTIONS FOR SMART TOUCH LEARNING

Now that we recorded the transactions and summarized, we need financial

statements: business documents used to communicate information needed to
make business decisions.

THE FOUR MAIN FINANCIAL STATEMENTS

statements designed to provide a picture of the overall financial position and
performance of the business:
 the balance sheet
 the income statement
 the cash flow statement
 Statement of Retained earnings

The income statement presents a summary of a business entity’s revenues and

expenses for a period of time (month, year); it also tell us if the business enjoyed
net income or suffered a net loss.
The only two types of accounts recorded in the income statements are revenues
and expenses.
 The statement of
retained earnings
shows the changes in retained earnings for a business entity during a period of
time.

The balance sheet lists the business assets, liabilities and equity as of a specific
date.
The balance sheet is a snapshot of the entity. Thanks to this document an
investor or creditor can quickly asses the overall health of a business by viewing
the balance sheet.
The statement of cash flows reports the
cash coming in and going out during a
period, it only reports transactions that
involve cash. If a transaction does not
involve cash, such as the purchase of
land with a mortgage, it will not be
reported on the statement of cash flow.
Divided into three: operating, investing
and financing. Operating activities
involve cash receipts for services and
payments. Investing activities include the
purchase and sale of land.

HOW DO YOU USE FINANCIAL STATEMENTS TO EVALUATE BUSINESS

PERFORMANCE?
One tool that's used to determine how well a company 's performing is the return
on assets (ROA).
They measure how profitably a company is using their assets.
Return on assets = Net income/Average total assets