Introduction to Accounting and Business Study Notes

Nature of Business and Accounting

• Definition of a Business: A business is a formal organization where basic resources, known as inputs (such as materials and labor), are assembled and processed to provide goods or services, known as outputs, to customers.

• Business Objective: The primary objective for most businesses is to earn a profit.

• Definition of Profit: Profit is calculated as the difference between the amounts received from customers for the goods or services provided and the amounts paid for the inputs required to provide those goods or services.

• Types of Businesses:

  • Service Businesses: These provide services rather than tangible products. Examples include:

    • Delta Air Lines: Provides transportation services.

    • The Walt Disney Company: Provides entertainment services.

  • Merchandising Businesses: These sell products they purchase from other businesses to customers. Examples include:

    • Walmart: Sells general merchandise.

    • Amazon.com: Sells internet-based books, music, and videos.

  • Manufacturing Businesses: These change basic inputs into finished products to be sold to customers. Examples include:

    • Ford Motor Co.: Produces cars, trucks, and vans.

    • Dell Inc.: Produces personal computers.

Role of Accounting in Business

• Definition of Accounting: Accounting is an information system that provides reports to users regarding the economic activities and condition of a business entity.

• The Accounting Process: The structured process by which accounting provides information includes five steps:

  1. Identify the users of the information.

  2. Assess the specific information needs of those users.

  3. Design the accounting information system (AIS) to meet the identified needs.

  4. Record economic data concerning business activities and events.

  5. Prepare accounting reports for the users.

• Managerial Accounting: This branch of accounting provides internal users (such as managers and employees) with information. Accountants in this field are said to be employed in private accounting.

• Financial Accounting: This branch provides information to external users (such as creditors, investors, and government agencies).

  • Objective: To provide relevant and timely information for the decision-making needs of users outside the business.

  • General-Purpose Financial Statements: A specific type of financial report distributed to external users.

Ethics in Accounting and Business

• Definition of Ethics: Ethics are moral principles that guide the conduct of individuals.

• Importance of Ethics: Accountants must behave ethically so the information provided is trustworthy and useful for decision-making. Unethical behavior undermines the reliability of financial reports.

• Factors Leading to Ethical Failures: Business and accounting frauds generally stem from two factors:

  1. Failure of individual character.

  2. A culture of greed and ethical indifference.

• Guidelines for Ethical Decision-Making:

  • Identify an ethical decision based on personal standards of honesty and fairness.

  • Identify the consequences of the decision and how it affects others.

  • Consider obligations and responsibilities to those affected.

  • Make a decision that is ethical and fair to all affected parties.

Opportunities and Career Paths for Accountants

• Public Accounting: Accountants and their staff who provide services (such as auditing or tax preparation) on a fee basis. Those meeting state education, experience, and exam requirements can become Certified Public Accountants (CPAs).

• Private Accounting: Accountants employed by a specific business firm, government entity, or not-for-profit organization.

Generally Accepted Accounting Principles (GAAP)

• Definition of GAAP: These are the standard rules followed by financial accountants when preparing reports to ensure consistency and comparability.

• Regulatory and Oversight Bodies:

  • Financial Accounting Standards Board (FASB): Holds the primary responsibility in the U.S. for developing accounting principles.

  • Securities and Exchange Commission (SEC): A U.S. government agency with authority over accounting and financial disclosures for companies whose stock is traded publicly.

  • International Accounting Standards Board (IASB): Sets principles used by many countries outside the U.S.

• Core Accounting Concepts:

  • Business Entity Concept: The activities of a business are recorded and reported separately from the activities of its owners, creditors, or other businesses.

  • Cost Concept: Amounts are initially recorded in accounting records at their cost or purchase price.

  • Objectivity Concept: Amounts recorded must be based on objective evidence. Only final, agreed-upon amounts are considered objective enough for entry.

  • Unit of Measure Concept: Economic data must be recorded in a common currency (e.g., dollars in the U.S.).

• Example Exercise: Cost Concept (Gallatin Repair Service):

  • Land priced at: $500,000$

  • Initial offer: $400,000$

  • Accepted counteroffer: $460,000$

  • Assessed value: $300,000$

  • Later offer: $525,000$

  • Recorded Value: Under the cost concept, the land is recorded at the accepted purchase price of $460,000$.

The Accounting Equation

• Definitions of Elements:

  • Assets: Resources owned by a business.

  • Liabilities: The rights of creditors; the debts of the business.

  • Owner’s Equity: The rights of the owners.

• The Equation: $Assets = Liabilities + Owner's Equity$

• Example Exercise (You’re A Star):

  • Data as of Dec 31, 2018: Assets = $800,000$; Liabilities = $350,000$.

  • Calculation (a): $Owner's Equity = 800,000 - 350,000 = 450,000$.

  • Calculation (b) for Dec 31, 2019: Assets increase by $130,000$ (Total $930,000$); Liabilities decrease by $25,000$ (Total $325,000$). New $Owner's Equity = 930,000 - 325,000 = 605,000$.

Business Transactions and Recording

• Business Transaction: An economic event or condition that directly changes an entity's financial condition or results of operations.

• NetSolutions Transaction Examples:

  • Transaction A: Chris Clark invests $25,000$ cash. (Cash increase $25,000$, Owner's Equity increase $25,000$).

  • Transaction B: Purchase of land for $20,000$ cash. (Cash decrease $20,000$, Land increase $20,000$).

  • Transaction C: Purchase supplies for $1,350$ on account. (Account Payable liability increase $1,350$, Supplies asset increase $1,350$). Supplies are considered prepaid expenses (assets).

  • Transaction D: Received $7,500$ for services provided. (Revenue increase; specifically Fees Earned). Increased Cash and Owner's Equity. Claims against customers are Accounts Receivable (assets).

  • Transaction E: Paid expenses: Wages ($2,125$), Rent ($800$), Utilities ($450$), Miscellaneous ($275$). Assets (Cash) decrease and Owner's Equity decreases.

  • Transaction F: Paid creditors on account $950$. (Cash decrease $950$, Account Payable decrease $950$).

  • Transaction G: Supplies used during the month. Starting supplies $1,350$, ending supplies $550$. Expense = $800$. (Supplies decrease $800$, Supplies Expense increase/OE decrease $800$).

  • Transaction H: Owner withdrawal of $2,000$ for personal use. (Cash decrease $2000$, Drawing increase/OE decrease $2,000$).

• Summary of Effects on Owner's Equity:

  • Increases: Owner Investments, Revenues.

  • Decreases: Owner Withdrawals, Expenses.

Financial Statements

• Order of Preparation:

  1. Income Statement: Reports revenues and expenses for a period. Based on the Matching Concept (matching expenses with the revenue they generated). $Revenue - Expenses = Net Income$ (or Net Loss).

  2. Statement of Owner's Equity: Reports changes in owner's equity over a period. Includes Net Income from the Income Statement.

  3. Balance Sheet: A list of assets, liabilities, and owner's equity as of a specific date.

     • Account Form: Assets on the left, Liabilities/OE on the right.

     • Report Form: Assets at the top, followed by Liabilities and OE.

  4. Statement of Cash Flows: A summary of cash receipts and payments for a period. It has three sections:

     • Operating Activities: Cash from core business operations.

     • Investing Activities: Cash from buying/selling permanent assets (e.g., land).

     • Financing Activities: Cash from owner investments, borrowings, and withdrawals.

Financial Analysis and Interpretation

• Ratio of Liabilities to Owner’s Equity: Used to analyze a company's ability to pay its creditors.

• Formula: $\text{Ratio of Liabilities to Owner's Equity} = \frac{\text{Total Liabilities}}{\text{Total Owner's Equity}}$

• NetSolutions Example: Current Liabilities = $400$, Owner's Equity = $26,050$. Ratio = $\frac{400}{26,050} = 0.015$.

• Example Exercise (Hawthorne Company):

  • Dec 31, 2019: Liab $182,000$, OE $140,000$. Ratio = $\frac{182,000}{140,000} = 1.3$

  • Dec 31, 2018: Liab $165,000$, OE $150,000$. Ratio = $\frac{165,000}{150,000} = 1.1$

  • Interpretation: Because the ratio increased from $1.1$ to $1.3$, the creditors' risk has increased.