Chapter 1

Accounting and
the Business
Environment

© 2016 Pearson Education, Ltd.

 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
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
© 2016 Pearson Education, Ltd. 1-2
Learning Objective 1

Explain why accounting

is important and list the
users of accounting
information

© 2016 Pearson Education, Ltd. 1-3

 Why Is Accounting Important?

• Accounting is the information system that:

– Measures business activities
– Processes the information into reports
– Communicates the results to decision makers

© 2016 Pearson Education, Ltd. 1-4

© 2016 Pearson Education, Ltd. 1-5
 Decision Makers: The Users of
Accounting Information
• Investors
• Creditors
• Suppliers
• Taxing authorities
• Managers
• Executive directors

© 2016 Pearson Education, Ltd. 1-6

 Decision Makers: The Users of
Accounting Information
• Financial accounting provides information
for external decision makers
• Managerial accounting provides
information to internal decision makers.
i.e. company managers

© 2016 Pearson Education, Ltd. 1-7

Comparing Managerial and Financial Accounting

© 2016 Pearson Education, Ltd.

LO 1
 The Accounting Profession

• Types of accountants:
– Certified Public Accountants (CPA) serve the general public.
To become a CPA you must meet educational and/or
experience requirements and pass a qualifying exam
– Certified Management Accountants (CMA) specialize in
accounting and financial management knowledge and work
for a single company.
• Accounting positions:
– Public
– Private
– Governmental
© 2016 Pearson Education, Ltd. 1-9
© 2016 Pearson Education, Ltd. 1-10
Learning Objective 2

Describe rules that govern

accounting

© 2016 Pearson Education, Ltd. 1-11

 What Are the Rules That Govern
Accounting?

Financial Statements
Various users 
 Balance
Balance Sheet
Sheet
need financial 


Income
Income Statement
Statement
 Statement
Statement of
of Stockholders’
Stockholders’ Equity
Equity
information 
 Statement
Statement of
of Cash
Cash Flows
Flows

 Note
Note Disclosure
Disclosure

The accounting profession

has attempted to develop a
Generally
Generally Accepted
Accepted
set of standards that are Accounting
Accounting Principles
Principles
generally accepted and (GAAP)
(GAAP)
universally practiced.

© 2016 Pearson Education, Ltd. LO 4

Rules That Govern Accounting

Economic entity Cost principle

assumption

GAAP

Going concern Monetary unit

assumption assumption

© 2016 Pearson Education, Ltd. 1-13

 Rules That Govern Accounting

• 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.
• Eg. Katy sold personal stock investment for $35,000. The proceed
is deposited in her personal bank account.
• Features of a corporation:
– A separate legal entity, separate from its owners.
– Continuous life and transferability of ownership
– No mutual agency
– Limited liability of stockholders
– Separation of ownership and management

© 2016 Pearson Education, Ltd. 1-14

Rules That Govern Accounting

© 2016 Pearson Education, Ltd. 1-15

 Rules That Govern Accounting

• Monetary Unit Assumption requires that companies

include in the accounting records only transaction data that
can be expressed in terms of money

• Going concern Assumption: This assumes that the entity

will remain in operation for the foreseeable future.

© 2016 Pearson Education, Ltd. 1-16

 Rules That Govern Accounting

Measurement Principles
Cost Principle (or historical cost principle) dictates that
companies record assets at their cost.

Fair Value Principle states that assets and liabilities should

be reported at fair value (the price received to sell an asset or
settle a liability).

Selection of which principle to follow

generally relates to trade-offs
between relevance and faithful
representation.
© 2016 Pearson Education, Ltd. LO 4
Learning Objective 3

Describe the accounting

equation and define assets,
liabilities, and equity

© 2016 Pearson Education, Ltd. 1-18

 The Accounting Equation

• The accounting equation is the basic tool of accounting,

measuring the resources of the business and the claims to
those resources.

Stockholder’s
Assets = Liabilities +
Equity

Notes:
- This equation applies to all economic entities at any time.
- Liabilities appear before equity in the equation because they are
paid first if a business is liquidated.

© 2016 Pearson Education, Ltd. 1-19

 Assets

• An asset is an economic resource that is expected to

benefit the business in the future.
• Examples:
– Cash
– Merchandise inventory
– Furniture
– Land

© 2016 Pearson Education, Ltd. 1-20

 Liabilities

• Liabilities are debts that are owed to creditors.

• Many liabilities have the word payable in their titles.
• Examples:
– Accounts payable
– Notes payable
– Salaries & wages payable
– Tax payable

© 2016 Pearson Education, Ltd. 1-21

 Equity
• The owners’ claims to the assets of the business are
called equity.
– Also called stockholders’ equity
• Two main components: Contributed capital &
Retained earnings
• Contributed capital:
– Also called paid-in capital, it is the amount invested in the
corporation by its owners, the stockholders.
– Common stock represents the basic ownership of every
corporation.

© 2016 Pearson Education, Ltd. 1-22

Example:
John established a clothes shop on 1 Jan, 20X8. At 1 Jan X8, John
contributed VND 60 millions in cash. During Jan, following
transactions have occurred:
1. Deposited VND 50 millions to bank.
2. Purchased some clothes for VND 40 millions by bank transfer
3. Borrowed VND 20 millions from some friends.
4. Purchased VND 15 millions equipment such as hangers,
wardrobes, etc by cash.
5. Pay VND 5 million for a friend.
Requirements: List all the assets, liabilities and equity of the shop
after each transaction.
© 2016 Pearson Education, Ltd. LO 6
 Equity

• Retained earnings: the accumulated equity earned by

profitable operations that is not distributed to stockholders.
Closing RE = Opening RE + RE of this period
Closing RE = Opening RE + Revenues – Expenses – Dividends
• Revenues are the gross increases in stockholders’ equity
result from business activities entered into for the purpose of
earning income.
Common sources of revenue are: sales, services, fees,
commissions, interest, dividends, royalties, and rent.

© 2016 Pearson Education, Ltd. 1-24

 Equity
• Expenses are the cost of assets consumed or services used in
the process of earning revenue, making a decrease in
stockholders’ equity.
Common expenses are: salaries expense, rent expense,
utilities expense, tax expense, etc.
• Profit/loss for the year = Revenues – Expenses
=> Income statements (I/S)

© 2016 Pearson Education, Ltd. 1-25

 Equity

© 2016 Pearson Education, Ltd. 1-26

On 1st Jan X8, Charles and Keith set up a clothes store. They
invested $5,000 USD in the store. During the 1 st quarter, the
store has conducted following transactions:
1. Purchased some clothes for $5,000 cash
2. Sold all the above clothes for $6,000 cash
3. Purchased some new clothes for $6,000 cash
4. The weather was hotter than last year, they sold the
purchased new clothes for $4,500 cash to get the money
back.
Requirement: List all the asset and capital of the store after
each transaction
© 2016 Pearson Education, Ltd. LO 6
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

3. Dividends Equity Decrease

4. Salaries and Wages
expense Expense Decrease

© 2016 Pearson Education, Ltd.

Advance slide in presentation mode to reveal answers. LO 6
Learning Objective 4

Use the accounting

equation to analyze
transactions

© 2016 Pearson Education, Ltd. 1-29

 How Do You Analyze a Transaction?

• A transaction is any event that affects the financial

position of the business and can be measured with
faithful representation.
• Transactions are recorded by accountants in books
of accounts.
• Not all activities represent transactions.

© 2016 Pearson Education, Ltd. 1-30

 How Do You Analyze a Transaction?

Illustration: Are the following events recorded in the accounting

records?
Discuss product
Purchase
Event design with Pay rent.
computer.
potential customer.

Criterion Is the financial position (assets, liabilities, or

stockholder’s equity) of the company changed?

Record/ Don’t
Record

© 2016 Pearson Education, Ltd. LO 7

Transaction Analysis
Transaction (1). Investment by Stockholders. Ray and Barbara
Neal decides to open a computer programming service which he
names Softbyte. On September 1, 2015, they invest $15,000 cash
in exchange for common stock. Illustration 1-9

© 2016 Pearson Education, Ltd.

Advance slide in presentation mode to reveal answers. LO 7
Transaction Analysis
Transaction (2). Purchase of Equipment for Cash. Softbyte
purchases computer equipment for $7,000 cash.

Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Transaction Analysis
Transaction (3). Purchase of Supplies on Credit. Softbyte
purchases for $1,600 from Acme Supply Company computer paper
and other supplies expected to last several months.
Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Transaction Analysis
Transaction (4). Services Provided for Cash. Softbyte receives
$1,200 cash from customers for programming services it has
provided.
Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Transaction Analysis
Transaction (5). Purchase of Advertising on Credit. Softbyte
receives a bill for $250 from the Daily News for advertising but
postpones payment until a later date.
Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Transaction Analysis
Transaction (6). Services Provided for Cash and Credit. Softbyte
provides $3,500 of programming services for customers. The
company receives cash of $1,500 from customers, and it bills the
balance of $2,000 on account. Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Transaction Analysis
Transaction (7). Payment of Expenses. Softbyte pays the
following expenses in cash for September: store rent $600, salaries
and wages of employees $900, and utilities $200.
Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Transaction Analysis
Transaction (8). Payment of Accounts Payable. Softbyte pays its
$250 Daily News bill in cash.

Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Transaction Analysis
Transaction (9). Receipt of Cash on Account. Softbyte receives
$600 in cash from customers who had been billed for services [in
Transaction (6)].
Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Transaction Analysis
Transaction (10). Dividends. The corporation pays a dividend of
$1,300 in cash.

Illustration 1-9

© 2016 Pearson Education, Ltd.

LO 7
Exercises
P1-40A Page 67
P1-45A Page 71
P1-53B Page 75

© 2016 Pearson Education, Ltd.

LO 7
Learning Objective 5

Prepare financial
statements

© 2016 Pearson Education, Ltd. 1-43

 How Do You Prepare Financial
Statements?
• Financial statements are business
documents that are used to communicate
information for decision making.

Statement
Statement
Income of Balance
of Cash
Statement Retained Sheet
Flows
Earnings

© 2016 Pearson Education, Ltd. 1-44

 How Do You Prepare Financial
Statements?
The income statement reports the net income or net loss of the
business for a specific period.

© 2016 Pearson Education, Ltd. 1-45

 How Do You Prepare Financial Statements?
The statement of retained earnings reports how the company’s
retained earnings balance changed from the beginning to the end
of the period.

© 2016 Pearson Education, Ltd. 1-46

 How Do You Prepare Financial Statements?
The balance sheet reports on the assets, liabilities, and
stockholders’ equity of the business as of a specific date.

© 2016 Pearson Education, Ltd. 1-47

 How Do You Prepare Financial Statements?
The statement of cash flows reports the change in cash during the
period. The SOCFs is divided into three sections: operating,
investing, and financing.

© 2016 Pearson Education, Ltd. 1-48

 Net income is needed to determine the
Financial Statements ending balance in retained earnings.

Illustration 1-10
Financial statements and
their interrelationships

© 2016 Pearson Education, Ltd. LO 8

 The ending balance in retained earnings
Financial Statements is needed in preparing the balance sheet.

Illustration 1-10

© 2016 Pearson Education, Ltd. LO 8

 Balance sheet and income statement are
Financial Statements needed to prepare statement of cash flows.

Illustration 1-10

© 2016 Pearson Education, Ltd. LO 8

How Do You Prepare Financial
Statements

© 2016 Pearson Education, Ltd. 1-52

Learning Objective 6

Use financial statements and

return on assets (ROA) to
evaluate business
performance

© 2016 Pearson Education, Ltd. 1-53

 Return on Assets

• Return on assets (ROA) measures how

profitably a company uses it assets.
– ROA is calculated by dividing net income by
average total assets.

© 2016 Pearson Education, Ltd. 1-54

 Homeworks

• Chapter 1 Exercises in the textbook

© 2016 Pearson Education, Ltd. 1-55