Financial Accounting, 4e

Weygandt, Kieso, & Kimmel

CHAPTER 1 - ACCOUNTING IN ACTION
After studying this chapter, you should be able to:
1. Explain the meaning of accounting.
2. Identify the users and uses of accounting.
3. Understand why ethics is a fundamental business concept.
4. Explain the meaning of generally accepted accounting principles and the cost
principle.
5. Explain the meaning of the monetary unit assumption and the economic entity
assumption.
6. State the basic accounting equation and explain the meaning of assets, liabilities, and
stockholder’s equity.
7. Analyze the effect of business transactions on the basic accounting equation.
8. Understand what the four financial statements are and how they are prepared.
 What is accounting?
Accounting is a process of three activities:

1. Identifying
2. Recording
3. Communicating

QUESTIONS ASKED BY INTERNAL USERS

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

QUESTIONS ASKED BY EXTERNAL USERS

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

BOOKKEEPING DISTINGUISHED FROM ACCOUNTING

Accounting

1. Includes bookkeeping
2. Also includes much more

Bookkeeping

1. Involves only the recording of economic events

2. Is just one part of accounting
 THE BUILDING BLOCKS OF ACCOUNTING
 Ethics - Standards of conduct by which one’s actions are judged as right or wrong, honest or
dishonest.
 Generally Accepted Accounting Principles - Primarily established by the Financial
Accounting Standards Board and the Securities and Exchange Commission.
 Assumptions:
1. Monetary unit - only transaction data that can be expressed in terms of money is
included in the accounting records.
2. Economic entity - includes any organization or unit in society.

ILLUSTRATION 1-4 STEPS IN ANALYZING ETHICS CASES

SOLVING AN ETHICAL DILEMMA
1. Recognize an ethical situation and the ethical issues involved.
Use your personal ethics to identify ethical situations and issues. Some businesses and
professional organizations provide written codes of ethics for guidance in some business
situations
2. Identify and analyze the principal elements in the situation.
Identify the stakeholders - persons or groups who may be harmed or benefited. Ask the
question: What are the responsibilities and obligations of the parties involved?
3. Identify the alternatives and weigh the impact of each alternative on various stakeholders.
Select the most ethical alternative, considering all the consequences. Sometimes there will
be one right answer. Other situations involve more than one right solution; these situations
require an evaluation of each and a selection of the best alternative.

BUSINESS ENTERPRISES
 A business owned by one person is generally a proprietorship.
 A business owned by two or more persons associated as partners is a partnership.
 A business organized as a separate legal entity under state corporation law and having
ownership divided into transferable shares of stock is called a corporation.

ILLUSTRATION 1-5 THE BASIC ACCOUNTING EQUATION

The Basic Accounting Equation

Assets = Liabilities + Stockholders’ Equity

ASSETS AS A BUILDING BLOCK

 Assets are resources owned by a business.
 They are things of value used in carrying out such activities as production, consumption and
exchange.
 The common characteristics possessed by all assets is the capacity to provide future services
or benefits to the entities that use them.
LIABILITIES AS A BUILDING BLOCK
 Liabilities are claims against assets.
 They are existing debts and obligations.
 Most claims of creditors attach to total enterprise assets rather than to the specific assets
provided by the creditor.

STOCKHOLDER’S EQUITY AS A BUILDING BLOCK

 The ownership claim on total assets is known as stockholder’s equity.
 It is equal to total assets minus total liabilities.
 The stockholders’ equity section of a corporation’s balance sheet consists of:
paid-in (contributed) capital & retained earnings.

PAID-IN CAPITAL AS A BUILDING BLOCK

 Paid-in capital is the term used to describe the total amount paid in by stockholders.
 The principal source of paid-in-capital is the investment of cash and other assets in the
corporation by stockholders in exchange for capital stock.

RETAINED EARNINGS AS A BUILDING BLOCK

The retained earnings section of the balance sheet is determined by three items:

1. Revenues
2. Expenses
3. Dividends

REVENUES AS A BUILDING BLOCK

 Revenues are the gross increases in stockholder’s equity that result from operating the
business.
 Generally, revenues result from the sale of merchandise, the performance of services, the
rental of property, or the lending of money.
 Revenues usually result in an increase in an asset.

EXPENSES AS A BUILDING BLOCK

 Expenses are the decreases in stockholders’ equity that result from operating the business.
 They are the cost of assets consumed or services used in the process of earning revenue.
 Examples of expenses include utility expense, rent expense, supplies expense, and tax
expense.
 When revenues exceed expenses, net income results.
 When expenses exceed revenues, a net loss results.

DIVIDENDS
 Net income represents an increase in net assets which then become available for
distribution to stockholders.
 Cash or other assets that are distributed to stockholders are called dividends.
 Dividends reduce retained earnings but are not corporate expenses.
 A corporation decides whether or not to distribute a dividend after determining its net
income or net loss.
USING THE BUILDING BLOCKS TRANSACTION ANALYSIS
 Transactions are the economic events of the enterprise.
 They may be identified as external or internal.
1. External transactions involve economic events between the company and some
outside enterprise or party.
2. Internal transactions are economic events that occur entirely within one company.

TRANSACTION ANALYSIS TRANSACTION 1

Ray and Barbara Neal decide to open a computer programming company to be incorporated as
Softbyte, Inc. They invest $15,000 cash in exchange for $15,000 of common stock.

Solution:
TRANSACTION ANALYSIS TRANSACTION 2
Softbyte purchases computer equipment for $7,000 cash.

Solution:

*Cas
h is decreased $7,000 and the asset Equipment is
increased $7,000.

TRANSACTION ANALYSIS TRANSACTION 3

Softbyte purchases computer paper and other supplies expected to last several months from Acme
Supply Company for $1,600. Acme Supply Company agrees to allow Softbyte to pay this bill in
October, a month later. This transaction is often referred to as a purchase on account or a credit
purchase.

Solution:

*The asset Supplies is increased $1,600 and the liability. Accounts Payable is increased by the same
amount.
TRANSACTION ANALYSIS TRANSACTION 4
Softbyte receives $1,200 cash from customers for programming services it has provided. This
transaction represents the principal revenue-producing activity of Softbyte.

Solution

*Cash is increased $1,200 and Retained Earnings is increased $1,200.

TRANSACTION ANALYSIS TRANSACTION 5

Softbyte receives a bill for $250 from the Daily News for advertising the opening of its business but
postpones payment of the bill until a later date.

Solution:

*Accounts Payable is increased $250, and Retained Earnings is decreased $250.

TRANSACTION ANALYSIS
TRANSACTION 6
Softbyte provides programming services of
$3,500 for customers. Cash amounting to
$1,500 is received from customers, and the
balance of $2,000 is billed to customers on account.

Solution:

*Cash is increased $1,500; Accounts Receivable is increased $2,000; and Retained Earnings is
increased $3,500.

TRANSACTION ANALYSIS TRANSACTION 7

Expenses paid in cash for September are store
rent, $600, salaries of employees, $900, and
utilities, $200.

*Cash is decreased $1,700 and Retained Earnings is decreased by $1,700.

TRANSACTION ANALYSIS
TRANSACTION 8
Softbyte pays its Daily News advertising bill
of $250 in cash.

Solution:
*Cash is decreased $250 and Accounts Payable is decreased by $250.
TRANSACTION ANALYSIS TRANSACTION 9
The sum of $600 in cash is received from customers who have previously been billed for services in
Transaction 6.

Solution:

* Cash is increased $600 and Accounts Receivable is decreased by the same amount.

TRANSACTION ANALYSIS TRANSACTION 10

The corporation pays a dividend of $1,300 in cash to Ray and Barbara Neal, the stockholders of
Softbyte, Inc.

Solution:

* Cash is decreased $1,300 and Stockholders’ Equity is decreased by the same amount.
 FINANCIAL STATEMENTS

After transactions are identified, recorded, and summarized, four financial statements are prepared
from the summarized accounting data:

1. An income statement presents the revenues and expenses and resulting net income or net
loss of a company for a specific period of time.
2. A retained earnings statement summarizes the changes in retained earnings for a specific
period of time.
3. A balance sheet reports the assets, liabilities, and stockholders’ equity of a business
enterprise at a specific date.
4. A statement of cash flows summarizes information concerning the cash inflows (receipts)
and outflows (payments) for a specific period of time.

ILLUSTRATION 1-9 FINANCIAL STATEMENTS AND THEIR

INTERRELATIONSHIPS
 APPENDIX A
THE ACCOUNTING PROFESSION
 In public accounting, you would offer expert service to the general public.
 Areas of public accounting:
- Auditing
- Taxation
- Management consulting
 In private (managerial) accounting, you would be involved in one of the following activities:
- General accounting
- Cost accounting
- Budgeting
- Accounting information systems
- Tax accounting
- Internal auditing
 Not-for profit organizations also need sound financial reporting and control.
 Donors want information about how well the organization has met its objectives and
whether continued support is justified.
 Hospitals and colleges must make decisions about the allocation of funds.
 Governmental units must provide information to citizens, employees, creditors and
legislators.