Accounting in Action

Overview

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Unit Objectives
• After completing this unit, you’ll be able to:
• Explain what accounting is
• Identify the users and uses of accounting
• Understand why ethics is a fundamental business concept
• Explain accounting standards and measurement principles
• Explain the monetary unit assumption and the economic entity
assumption
• State the accounting equation, and define its components
• Analyze the effects of business transactions on the accounting
equation
• Understand the five financial statements and how they are prepared

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Contents
• What Is Accounting?
• The Building Blocks of Accounting
• The Basic Accounting Equation
• Using the Accounting Equation
• Financial Statements

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What Is Accounting?
Lesson Overview
• Why do people choose accounting?
• They want to acquire the skills needed to understand what is happening
financially inside a company
• Accounting is the financial information system that provides these
insights
• In short, to understand an organization of any type, you have to
know the numbers
• Accounting consists of three basic activities – it identifies, records,
and communicates the economic events of an organization to
interested users

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Lesson Objectives
• After completing this lesson, you’ll be able to:
• Explain what accounting is
• Identify the users and uses of accounting

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Question About Accounting …
• How do you start a business?
• How do you make it grow into a widely recongnized brand name?
• How do you determine whether your business is making or losing
money?
• When you need to expand your operations, where do you get
money to finance expansion – should you borrow, should you
issue stock, should you use your own funds?
• How do you convince lenders to lend you money or invetors to
buy your stock?

Success in business requires making countless decisions, and

decisions require financial information

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Business Example

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Business Example (Cont.)

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Type of Business
• Service Business
• Is a firm that provides service for customer
• Merchandising Business
• Is a company that sells product derived from other party to its customers
• Manufacturing Company
• Is a company that produces input (raw material) into output (finish
product) and sells it to individual customer

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Three Activities
• Accounting consists of three basic activities – it:
• identifies,
• records, and
• communicates
the economic events of an organization to interested users
• The accounting process includes the bookkeeping function

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The Activities of the Accounting
Process

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Who Uses Accounting Data?

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Lesson Summary
• You should now be able to:
• Explain what accounting is
• Identify the users and uses of accounting

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The Building Blocks of
Accounting
Lesson Overview
• A doctor follows certain protocols in treating a patient’s illness
• An architect follows certain structural guidelines in designing a
building
• Similarly, an accountant follows certain standards in reporting
financial information
• These standards are based on specific principles and assumptions
• For these standards to work, however, a fundamental business concept
must be at work – ethical behavior

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Lesson Objectives
• After completing this lesson, you’ll be able to:
• Understand why ethics is a fundamental business concept
• Explain accounting standards and measurement principles
• Explain the monetary unit assumption and the economic entity
assumption

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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
• Recent financial scandals include: Enron (USA), Parmalat (ITA), Satyam
Computer Services (IND), AIG (USA), and others
• Effective financial reporting depends on sound ethical behavior

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Steps in Analyzing Ethics Cases
and Situations

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Accounting Standards

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Accounting Standards
• More than 130 countries follow standards referred to as IFRS
• IFRSs are determined by the IASB
• Most companies in the United States follow standards issued by
the FASB, referred to as Generally Accepted Accounting Principles
(GAAP)
• As markets become more global, it is often desirable to compare
the results of companies from different countries that report
using different accounting standards
• In order to increase comparability, in recent years the two
standard-setting bodies made efforts to reduce the differences
between IFRS and U.S. GAAP
• This process is referred to as convergence

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Measurement Principles
• The historical cost principle (or cost principle) dictates that
companies record assets at their cost
• The 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)

Relevance and faithful representation are two primary

qualities that make accounting information useful for
decision-making

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Assumptions
• The monetary unit assumption requires that companies include
in the accounting records only transaction data that can be
expressed in money terms
• The economic entity assumption requires that the activities of
the entity be kept separate and distinct from the activities of its
owner and all other economic entities
• Forms of business ownership:
• Proprietorship
• Partnership
• Corporation

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Forms of Business Ownership
Proprietorship Partnership Corporation

• Owned by one • Owned by two or • Ownership divided

person more persons into shares
• Owner is often • Often retail and • Separate legal
manager/operator service-type entity organized
• Owner receives any businesses under corporation
profits, suffers any • Generally unlimited law
losses, and is personal liability • Limited liability
personally liable for • Partnership
all debts agreement

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Accounting Across the Organization
Spinning the Career Wheel
One question that students frequently ask is: “How will the study of accounting
help me?” A working knowledge of accounting is desirable for virtually every
field of endeavor. Some examples of how accounting is used in other careers
include:
• General management: Imagine running Unilever, Gudang Garam,
Indofood, or Astra. All general managers need to understand where the
company’s cash comes from and where it goes in order to make wise
business decisions.
• Marketing: Marketing specialists at a company like Hyundai Motor (KOR)
develop strategies to help the sales force be successful. But making a sale is
meaningless unless it is profitable. Marketing people must be sensitive to
costs and benefits, which accounting helps them quantify and understand.

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Accounting Across the Organization
(Cont.)
Spinning the Career Wheel
• Finance: Do you want to be a banker for Bank Central Asia or a financial
analyst for Bank Mandiri? These fields rely heavily on accounting. In all of
them, you will regularly examine and analyze financial statements. In fact, it
is difficult to get a good finance job without two or three courses in
accounting.
• Real estate: Are you interested in being a real estate broker for Wijaya
Karya (WIKA Realty)? Because a third party – the bank – is almost always
involved in financing a real estate transaction, brokers must understand the
numbers involved: Can the buyer afford to make the payments to the bank?
Does the cash flow from an industrial property justify the purchase price?
What are the tax benefits of the purchase?

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Lesson Summary
• You should now be able to:
• Understand why ethics is a fundamental business concept
• Explain accounting standards and measurement principles
• Explain the monetary unit assumption and the economic entity
assumption

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The Basic Accounting
Equation
Lesson Overview
• The two basic elements of a business are what it owns and what it
owes
• Assets are the resources a business owns
• Liabilities and equity are the rights or claims against these resources
• Claims of those to whom the company owes money (creditors) are called
liabilities
• Claims of owners are called equity
• The basic accounting equation is: Assets = Liabilities + Equity
• The accounting equation applies to all economic entities
regardless of size, nature of business, or form of business
organization
• It applies to a small proprietorship such as a corner grocery store as well
as to a giant corporation such as Adidas

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Lesson Objectives
• After completing this lesson, you’ll be able to:
• State the accounting equation, and define its components

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Basic Accounting Equation
• Basic accounting equation provides the underlying framework
for recording and summarizing economic events
• Assets must equal the sum of liabilities and equity

Assets = Liabilities + Equity

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Assets
• Assets are resources a business owns
• The common characteristic possessed by all assets is the capacity
to provide future services or benefits
• E.g.: Cash, Inventory, Equipment, etc.

Assets = Liabilities + Equity

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Liabilities
• Liabilities are claims against assets – that is, existing debts and
obligations
• Creditors are persons or entities to whom money is owed
• E.g.: Accounts Payable, Notes Payable, Salaries and Wages Payable,
etc.

Assets = Liabilities + Equity

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Equity
• Equity is the ownership claim on a company’s total assets
• Often referred to as residual equity
• E.g.: Share Capital – Ordinary and Retained Earnings

Assets = Liabilities + Equity

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Increases in Equity
• Investments by shareholders represent the total amount paid in by
shareholders for the ordinary shares they purchase

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Increases in Equity (Cont.)
• Revenues result from business activities entered into for the
purpose of earning income
• Common sources of revenue are sales, fees, services, commissions,
interest, dividends, royalties, and rent

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Decreases in Equity
• Expenses are the cost of assets consumed or services used in the
process of earning revenue
• Common expenses are salaries expense, rent expense, utilities
expense, property tax expense, etc.

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Decreases in Equity (Cont.)
• Dividends are the distribution of cash or other assets to
shareholders
• Dividends reduce retained earnings
• However, dividends are not expenses

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Do It!
• Classify the following items as issuance of shares, dividends,
revenues, or expenses. Then indicate whether each item increases
or decreases equity.
Items Classification Effect on Equity
1 Rent Expense
2 Service Revenue
3 Dividends
4 Salaries and Wages Expense

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Lesson Summary
• You should now be able to:
• State the accounting equation, and define its components

41
Using the Accounting
Equation
Lesson Overview
• Companies carry on many activities that do not represent
business transactions
• Examples are hiring employees, answering the telephone, talking with
customers, and placing merchandise orders
• Some of these activities may lead to business transactions
• Employees will earn wages, and suppliers will deliver ordered
merchandise
• The company must analyze each event to find out if it affects the
components of the accounting equation
• If it does, the company will record the transaction
• Each business transaction must have a dual effect on the
accounting equation
• For example, if an asset is increased, there must be a corresponding (1)
decrease in another asset, (2) increase in a specific liability, or (3)
increase in equity

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Lesson Objectives
• After completing this lesson, you’ll be able to:
• Analyze the effects of business transactions on the accounting equation

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Transactions
• Transactions (business transactions) are a business’s economic
events recorded by accountants
• Transactions may be external or internal
• Not all activities represent transactions
• Each transaction must have a dual effect on the accounting
equation

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Transaction-Identification Process
• Illustration: Are the following events recorded in the accounting
records?

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Expanded Accounting Equation

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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.

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Transaction Analysis (Cont.)
TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH
Softbyte SA purchases computer equipment for €7,000 cash.

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Transaction Analysis (Cont.)
TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT
Softbyte SA purchases for €1,600 headsets and other accessories
expected to last several months. The supplier allows Softbyte to pay
this bill in October.

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Transaction Analysis (Cont.)
TRANSACTION 4. SERVICES PERFORMED FOR CASH
Softbyte SA receives €1,200 cash from customers for app
development services it has performed.

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Transaction Analysis (Cont.)
TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT
Softbyte SA receives a bill for €250 from the Programming News for
advertising on its website but postpones payment until a later date.

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Transaction Analysis (Cont.)
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 bills the balance of €2,000 on
account.

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Transaction Analysis (Cont.)
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.

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Transaction Analysis (Cont.)
TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE
Softbyte SA pays its €250 Programming News bill in cash. The
company previously (in Transaction 5) recorded the bill as an
increase in Accounts Payable.

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Transaction Analysis (Cont.)
TRANSACTION 9. RECEIPT OF CASH ON ACCOUNT
Softbyte SA receives €600 in cash from customers who had been
billed for services (in Transaction 6).

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Transaction Analysis (Cont.)
TRANSACTION 10. DIVIDENDS
The corporation pays a dividend of €1,300 in cash to Ray and
Barbara Neal, the shareholders of Softbyte SA.

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Summary of Transactions
• Each transaction must be analyzed in terms of its effect on:
• (a) The three components of the basic accounting equation
• (b) Specific types (kinds) of items within each component
• The two sides of the equation must always be equal
• The Share Capital – Ordinary and Retained Earnings columns indicate
the causes of each change in the shareholders’ claim on assets

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Do It!
• Transactions made by Virmari & Co. SA, a public accounting firm,
for the month of August are shown below. Prepare a tabular
analysis which shows the effects of these transactions on the
expanded accounting equation.
• The company issued ordinary shares for €25,000 cash
• The company purchased €7,000 of office equipment on credit
• The company received €8,000 cash in exchange for services performed
• The company paid €850 for this month’s rent
• The company paid a dividend of €1,000 in cash to shareholders

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Do It!
TRANSACTION 1
The company issued ordinary shares for €25,000 cash.

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Do It!
TRANSACTION 2
The company purchased €7,000 of office equipment on credit.

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Do It!
TRANSACTION 3
The company received €8,000 cash in exchange for services
performed.

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Do It!
TRANSACTION 4
The company paid €850 for this month’s rent.

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Do It!
TRANSACTION 5
The company paid a dividend of €1,000 in cash to shareholders.

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Lesson Summary
• You should now be able to:
• Analyze the effects of business transactions on the accounting equation

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Financial Statements
Lesson Overview
• Companies prepare five financial statements from the
summarized accounting data: income statement, retained
earnings statement, statement of financial position, statement of
cash flows, and comprehensive income statement
• These statements provide relevant financial data for internal and
external users

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Lesson Objectives
• After completing this lesson, you’ll be able to:
• Understand the five financial statements and how they are prepared

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Financial Statements
• Companies prepare five financial statements:
Retained
Earnings Statement of
Income Statement/
Owner’s
Financial
Statement Position
Equity
Statement

Statement of Comprehensive
Cash Flows Income Statement

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Financial Statements and Their
Interrelationships

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Financial Statements and Their
Interrelationships (Cont.)

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Financial Statements and Their
Interrelationships (Cont.)

Balance sheet and

income statement
are needed to
prepare statement
of cash flows

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Income Statement
• Reports the success or profitability of the company’s operations
over a specific period of time
• Lists revenues first, followed by expenses
• Shows net income (or net loss)
• Does not include investment and dividend transactions between
the shareholders and the business

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Retained Earnings Statement
• Reports the changes in retained earnings for a specific period of
time
• The time period is the same as that covered by the income
statement
• Information provided indicates the reasons why retained earnings
increased or decreased during the period

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Statement of Financial Position
• Reports the assets, liabilities, and equity at a specific date
• Lists assets at the top, followed by equity and then liabilities
• Total assets must equal total equity and liabilities
• Is a snapshot of the company’s financial condition at a specific
moment in time (usually the month-end or year-end)

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Accounting Across the Organization
A Wise End Vodafone (GBR)
Not every company uses December 31 as the accounting year-end.
Some companies whose year-ends differ from December 31 are
Vodafone Group (GBR), March 31; Walt Disney Productions (USA),
September 30; and JJB Sports (GBR), the Sunday that falls before, but
closest to, January 31. Why do companies choose the particular year-
ends that they do? Many opt to end the accounting year when
inventory or operations are at a low. Compiling accounting information
requires much time and effort by managers, so companies would
rather do it when they aren’t as busy operating the business. Also,
inventory is easier and less costly to count when it is low.

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Statement of Cash Flows
• Information on the cash receipts and payments for a specific
period of time
• Answers the following:
• Where did cash come from?
• What was cash used for?
• What was the change in the cash balance?

HELPFUL HINT
Investing activities pertain to investments made by the
company, not investments made by the owners

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Comprehensive Income Statement
• Other comprehensive income items are not part of net income
• Reported either by:
• Combining with income statement, or
• Separate statement

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Do It!
Presented below is selected information related to Flanagan Group plc
at December 31, 2017. Flanagan reports financial information monthly.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
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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Do It!
Information related to Flanagan Group plc at December 31, 2017.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000
(a) Determine the total assets of Flanagan at December 31, 2017.

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Do It!
Information related to Flanagan Group plc at December 31, 2017.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000
(b) Determine the net income that Flanagan reported for December 2017.

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Do It!
Information related to Flanagan Group plc at December 31, 2017.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000
(c) Determine the equity of Flanagan at December 31, 2017.

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Lesson Summary
• You should now be able to:
• Understand the five financial statements and how they are prepared

83
Appendix: Accounting Career
Opportunities
Lesson Overview
• Accounting offers many different jobs in fields such as public and
private accounting, governmental, and forensic accounting
• Accounting is a popular major because there are many different
types of jobs, with unlimited potential for career advancement

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Accounting Career Opportunities

Public Accounting
Careers in auditing, taxation, and
management consulting serving the
general public

Governmental Accounting Private Accounting

Careers with the tax authorities, law Careers in industry working in cost
enforcement agencies, and accounting, budgeting, accounting
corporate regulators information systems, and taxation

Forensic Accounting
Uses accounting, auditing, and investigative skills to conduct investigations
into theft and fraud

86
Unit Summary
• You should now be able to:
• Explain what accounting is
• Identify the users and uses of accounting
• Understand why ethics is a fundamental business concept
• Explain accounting standards and measurement principles
• Explain the monetary unit assumption and the economic entity
assumption
• State the accounting equation, and define its components
• Analyze the effects of business transactions on the accounting
equation
• Understand the five financial statements and how they are prepared

87
Question & Answers