Accounting Principles Chapter 1: Accounting in Action Study Guide

Overview of Accounting and the Accounting Process

• Definition and Scope of Accounting

  • Accounting is a system that identifies, records, and communicates economic events of an organization to interested users.
  • It is often called the "language of business."
  • Bookkeeping vs. Accounting:
    • Bookkeeping is a subset of accounting; it involves only the recording of economic events.
    • Accounting encompasses the entire process, including identifying, recording, classifying, summarizing, and interpreting financial data.

• Illustration 1-1: The Accounting Process

  • Identification: Selecting economic events that are considered transactions (e.g., an example from Gerald Trenholm at 7 MacCauly Drive, Fredericton, NB).
  • Recording: Maintaining a chronological log of events, which involves recording, classifying, and summarizing data.
  • Communication: Preparing accounting reports (such as annual reports) and analyzing/interpreting those reports for users.

Users of Accounting Information

• Internal Users (Illustration 1-2): Managers and other internal decision-makers ask questions such as:

  • Can we afford to give employees pay raises this year?
  • Is cash sufficient to pay bills?
  • What is the cost of manufacturing each unit of product?
  • Which product line is the most profitable?

• External Users (Illustration 1-3): Investors, creditors, and regulatory agencies ask questions such as:

  • Is the company earning satisfactory income?
  • How does the company compare in size and profitability with its competitors?
  • Will the company be able to pay its debts as they come due?

The Accounting Profession

• Public Accountants: Provide expertise to the general public through various services.
• Private Accountants: Employees of individual companies involved in cost accounting, tax accounting, systems design, and internal auditing.
• Not-for-profit Accounting: Includes reporting and control for government units, foundations, hospitals, labor unions, colleges, universities, and charities.

Ethics and Accounting Standards

• Ethics: Defined as standards of conduct. To solve an ethical dilemma (Illustration 1-4):

  1. Recognize the situation and the ethical issues involved.
  2. Identify and analyze the elements.
  3. Identify alternatives and weigh the effects on stakeholders.

• Generally Accepted Accounting Principles (GAAP):

  • Primarily established by the Canadian Institute of Chartered Accountants (CICA).
  • Cost Principle: Dictates that assets are recorded at their cost. Cost is the value exchanged at the time the asset is acquired. It is used because it is both relevant and reliable.

• Core Assumptions:

  1. Going Concern: Assumes the organization will continue to operate into the foreseeable future.
  2. Monetary Unit: Only transaction data that can be expressed in terms of money is included in accounting records.
  3. Economic Entity: Includes any organization or unit in society. The activities of the entity must be kept separate from the activities of the owner and all other economic entities.

Business Enterprises and Ownership

• Proprietorship: A business owned by one person. The ownership interest is referred to as owner’s equity.
• Partnership: A business owned by two or more persons associated as partners. The interest is referred to as partners’ equity.
• Corporation: A business organized as a separate legal entity under corporation law with ownership divided into transferable shares. The interest is referred to as shareholders’ equity.

The Basic Accounting Equation

• The relationship between assets, liabilities, and owner’s equity is expressed in the basic accounting equation:

  • $Assets = Liabilities + Owner's Equity$

• Building Blocks of the Equation:

  • Assets: Resources owned by a business ($things of value$) used in activities like production and exchange.
  • Liabilities: Claims against assets; they are existing debts and obligations.
  • Owner’s Equity: The ownership claim on total assets. Calculated as: $Owner's Equity = Assets - Liabilities$.

• Subdivisions of Owner’s Equity (Illustration 1-6):

  • Investments by Owner: Assets put into the business by the owner; these increase owner’s equity.
  • Revenues: Gross increases in owner's equity from business activities (sales, services, rental, interest) aimed at earning income; these increase owner's equity and usually result in an increase in assets.
  • Drawings: Withdrawals of cash or other assets by the owner for personal use; these decrease owner’s equity.
  • Expenses: Cost of assets consumed or services used in the process of earning revenue (e.g., utility, rent, supplies); these decrease owner’s equity.

Transaction Analysis: Softbyte Case Study

Marc Doucet opens a computer programming service named Softbyte. The following transactions occur in September:

• Transaction 1: Doucet invests $15,000$ cash.
  • Impact: Cash increases $15,000$; M. Doucet, Capital increases $15,000$.
• Transaction 2: Purchase of computer equipment for $7,000$ cash.
  • Impact: Cash decreases $7,000$; Equipment increases $7,000$.
• Transaction 3: Purchase of computer paper and supplies for $1,600$ on account from Chuah Supply Company.
  • Impact: Supplies increases $1,600$; Accounts Payable increases $1,600$.
• Transaction 4: Receives $1,200$ cash for services provided.
  • Impact: Cash increases $1,200$; M. Doucet, Capital increases $1,200$.
• Transaction 5: Receives advertising bill for $250$ (to be paid later).
  • Impact: Accounts Payable increases $250$; M. Doucet, Capital decreases $250$.
• Transaction 6: Provides services worth $3,500$; receives $1,500$ cash and $2,000$ on account.
  • Impact: Cash increases $1,500$; Accounts Receivable increases $2,000$; M. Doucet, Capital increases $3,500$.
• Transaction 7: Pays expenses in cash totaling $1,700$ (Rent $600$, Salaries $900$, Utilities $200$).
  • Impact: Cash decreases $1,700$; M. Doucet, Capital decreases $1,700$.
• Transaction 8: Pays the $250$ advertising bill (from Transaction 5) in cash.
  • Impact: Cash decreases $250$; Accounts Payable decreases $250$.
• Transaction 9: Receives $600$ cash from customers previously billed in Transaction 6.
  • Impact: Cash increases $600$; Accounts Receivable decreases $600$.
• Transaction 10: Doucet withdraws $1,300$ in cash for personal use.
  • Impact: Cash decreases $1,300$; M. Doucet, Capital decreases $1,300$.

Financial Statements and Their Interrelationships

There are four primary financial statements prepared in the following order:

1. Income Statement: Presents revenues and expenses to determine net income or net loss for a specific period.
   • In the example, net income is $2,750$.
2. Statement of Owner’s Equity: Summarizes changes in owner's equity for a specific period.
   • The net income ($2,750$) is added to the beginning capital.
   • Ending owner's capital in the example is $16,450$.
3. Balance Sheet: Reports assets, liabilities, and owner’s equity at a specific date.
   • The owner's capital ($16,450$) from the Statement of Owner’s Equity is recorded here.
   • Ending cash balance is reported as $8,050$.
4. Cash Flow Statement: Summarizes cash inflows (receipts) and outflows (payments) for a specific period.
   • The ending cash balance ($8,050$) must match the cash reported on the balance sheet.

Using Financial Information

• Annual Reports: Companies issue annual reports containing both financial and non-financial information.
• Notes: The notes are an integral part of the financial statements, providing necessary additional detail and context.