CHAPTER 1. Accounting Principles Weygandt, Kieso, Trenholm 1-1 CHAPTER 1 ACCOUNTING IN ACTION ACCOUNTING IN ACTION

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1 CHAPTER 1 ACCOUNTING IN ACTION Accounting Principles Weygandt, Kieso, Trenholm Prepared by Barbara Trenholm University of New Brunswick 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 going concern, monetary unit, and economic entity assumptions. CHAPTER 1 ACCOUNTING IN ACTION After studying this chapter, you should be able to: 6 State the basic accounting equation and explain the meaning of assets, liabilities, and owner s equity. 7 Analyse the effect of business transactions on the basic accounting equation. 8 Distinguish between an income statement, statement of owner s equity, balance sheet, and statement of cash flows. 1-1

2 Chapter 1 Accounting In Action PREVIEW OF CHAPTER 1 Accounting In Action What is Accounting? Who uses accounting info? Brief history of accounting Bookkeeping and accounting Accounting and you The accounting profession PREVIEW OF CHAPTER 1 Accounting In Action The Building Blocks of Accounting Ethics - a fundamental business concept Generally accepted accounting principles Assumptions Basic accounting equation PREVIEW OF CHAPTER 1 Accounting In Action Using the Building Blocks Transaction analysis Summary of transactions Financial statements Using the information in the financial statements 1-2

3 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition PREVIEW OF CHAPTER 1 Accounting In Action Financial Statements Income Statement Statement of Owner s Equity Balance Sheet Statement of Cash Flows STUDY OBJECTIVE 1 Explain the meaning of accounting. WHAT IS ACCOUNTING? Accounting is a process of three activities: 1 Identifying 2 Recording 3 Communicating 1-3

4 Chapter 1 Accounting In Action ILLUSTRATION 1-1 THE ACCOUNTING PROCESS Identification Recording Communication Accounting Reports Gerald Trenholm 7 MacCauly Drive Fredericton NB 2000 Prepare accounting reports Select economic events (transactions) Record, classify and summarize SOFTBYTE Annual Report Analyse and interpret for users STUDY OBJECTIVE 2 Identify the users and uses of accounting. ILLUSTRATION 1-2 QUESTIONS ASKED BY INTERNAL USERS Is cash sufficient to pay bills? What is the cost of manufacturing each unit of product? Can we afford to give employees pay raises this year? Which product line is the most profitable? 1-4

5 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition ILLUSTRATION 1-2 QUESTIONS ASKED BY EXTERNAL USERS Is the company earning satisfactory income? How does the company compare in size and profitability with its competitors? What do we do if they catch us? Will the company be able to pay its debts as they come due? 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 ACCOUNTING PROFESSION Public accountants offer expert service to the general public through the services they perform. Private accountants are employees of individual companies and are involved in a number of activities including cost and tax accounting, systems, and internal auditing. Not-for-profit accounting includes reporting and control for government units, foundations, hospitals, labour unions, colleges/universities, and charities. 1-5

6 Chapter 1 Accounting In Action ACCOUNTING CAREER LADDER Private Accounting VP Finance and CFO Comptroller Manager Accountant 10+ years 6 to 8 years 2 to 4+ years Entry level Public Accounting Partner Senior Manager Manager Staff Accountant STUDY OBJECTIVE 3 Understand why ethics is a fundamental business concept. ETHICS Ethics - standards of conduct To Solve Ethical Dilemma 1 Recognize situation and ethical issues involved 2 Identify and analyse elements 3 Identify alternatives and weigh impacts on stakeholders 1-6

7 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition STUDY OBJECTIVE 4 Explain the meaning of generally accepted accounting principles and the cost principle. GAAP Generally Accepted Accounting Principles - primarily established by the Canadian Institute of Chartered Accountants Cost Principle The cost principle dictates that assets are recorded at their cost. Cost is the value exchanged at the time something is acquired. Cost is used because it is both relevant and reliable. STUDY OBJECTIVE 5 Explain the meaning of the going concern, monetary unit, and economic entity assumptions. 1-7

8 Chapter 1 Accounting In Action ASSUMPTIONS 1 Going Concern - assumes organization will continue into foreseeable future. 2 Monetary Unit - only transaction data that can be expressed in terms of money is included in the accounting records. 3 Economic Entity - includes any organization or unit in society. BUSINESS ENTERPRISES A business owned by one person is generally a proprietorship (owner s equity). A business owned by two or more persons associated as partners is a partnership (partners equity). A business organized as a separate legal entity under corporation law and having ownership divided into transferable shares of stock is called a corporation (shareholders equity). ILLUSTRATION 1-7 EQUITY FORMATS Proprietorship Owner s equity: Bure, capital $50,000 Partnership Partners equity: Wu, capital $ 75,000 Scholten, capital 75,000 Total partners equity $150,

9 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition ILLUSTRATION 1-7 EQUITY FORMATS Corporation Shareholders equity: Capital stock $500,000 Retained earnings 350,000 Total shareholders equity $850,000 STUDY OBJECTIVE 6 State the basic accounting equation and explain the meaning of assets, liabilities, and owner s equity. ILLUSTRATION 1-5 BASIC ACCOUNTING EQUATION The Basic Accounting Equation Assets = Liabilities + Owner s Equity 1-9

10 Chapter 1 Accounting In Action 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 and exchange. LIABILITIES AS A BUILDING BLOCK Liabilities are claims against assets. They are existing debts and obligations. OWNER S EQUITY AS A BUILDING BLOCK Owner s Equity is equal to total assets minus total liabilities. Owner s Equity represents the ownership claim on total assets. Subdivisions of Owner s Equity: 1 Capital 2 Drawings 3 Revenues 4 Expenses 1-10

11 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition INVESTMENTS BY OWNERS AS A BUILDING BLOCK Investments by owner are the assets put in the business by the owner. These investments in the business increase owner s equity. DRAWINGS AS A BUILDING BLOCK Drawings are withdrawals of cash or other assets by the owner for personal use. Drawings decrease total owner s equity. REVENUES AS A BUILDING BLOCK Revenues are the gross increases in owner s equity resulting from business activities entered into for the purpose of earning income. Revenues may result from sale of merchandise, performance of services, rental of property, or lending of money. Revenues usually result in an increase in an asset. 1-11

12 Chapter 1 Accounting In Action EXPENSES AS A BUILDING BLOCK Expenses are the decreases in owner s equity that result from operating the business. Expenses are the cost of assets consumed or services used in the process of earning revenue. Examples of expenses may be utility expense, rent expense, supplies expense, and income tax expense. ILLUSTRATION 1-6 INCREASES AND DECREASES IN OWNER S EQUITY INCREASES Investments by Owner Revenues Owner s Equity DECREASES Withdrawals by Owner Expenses STUDY OBJECTIVE 7 Analyse the effect of business transactions on the basic accounting equation. 1-12

13 Royal Imperial Dominion Bank of Montreal Everywhere, Canada Weygandt Kieso Trenholm Accounting Principles, Canadian Edition TRANSACTION IDENTIFICATION PROCESS Gerald Trenholm 7 MacCauly Drive Fredericton NB 2000 Purchase computer Answer telephone Pay rent Is the financial position (assets, liabilities, and owner s equity) of the company changed? Yes No Yes Record Don t Record Record TRANSACTION 1 Marc Doucet decides to open a computer programming service. On September 1, he invests $15,000 cash in the business, which he names Softbyte. BANK Softbyte TRANSACTION 1 SOLUTION Assets = Liabilities + Owner s Equity Doucet, Cash Capital (1) +$15,000 = +$15,000 Investment There is an increase in the asset Cash, $15,000, and an equal increase in the owner s equity, Doucet, Capital, $15,

14 Chapter 1 Accounting In Action TRANSACTION 2 Softbyte purchases computer equipment for $7,000 cash. TRANSACTION 2 SOLUTION Assets = Liabilities + Owner s Equity Doucet, Cash + Equipment = Capital Old Bal. $15,000 $15,000 (2) -7,000 +$7,000 New Bal. $ 8,000 + $7,000 = $15,000 $15,000 Cash is decreased $7,000, and the asset Equipment is increased $7,000. TRANSACTION 3 Softbyte purchases computer paper and other supplies expected to last several months from Chuah Supply Company for $1,600. Chuah 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. Chuah Supply Company Softbyte 1-14

15 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition TRANSACTION 3 SOLUTION Assets = Liabilities + Owner s Equity Accounts Doucet, Cash + Supplies + Equipment = Payable + Capital Old Bal. $8,000 $7,000 $15,000 (3) +$1,600 +$1,600 New Bal. $8,000 + $1,600 + $7,000 = $1,600 + $15,000 $16,600 $16,600 The asset Supplies is increased $1,600, and the liability Accounts Payable is increased by the same amount. 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. Softbyte TRANSACTION 4 SOLUTION Assets = Liabilities + Owner s Equity Accounts Doucet, Cash + Supplies + Equipment = Payable + Capital Old Bal. $8,000 $1,600 $7,000 $1,600 $15,000 (4) +1,200 +1,200 Service Revenue New Bal. $9,200 + $1,600 + $7,000 = $1,600 + $16,200 $17,800 $17,800 Cash is increased $1,200, and Doucet, Capital is increased $1,

16 Chapter 1 Accounting In Action TRANSACTION 5 Softbyte receives a bill for $250 from the Financial Post for advertising the opening of its business but postpones payment of the bill until a later date. Softbyte Bill Daily News TRANSACTION 5 SOLUTION Assets = Liabilities + Owner s Equity Accounts Doucet, Cash + Supplies + Equipment = Payable + Capital Old Bal. $9,200 $1,600 $7,000 $1,600 $16,200 (5) Advertising Expense New Bal. $9,200 + $1,600 + $7,000 = $1,850 + $15,950 $17,800 $17,800 Accounts Payable is increased $250, and Doucet, Capital is decreased $250. 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. Softbyte Bill 1-16

17 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition TRANSACTION 6 SOLUTION Assets = Liabilities + Owner s Equity Accounts Accounts Doucet, Cash + Receivable + Supplies + Equipment = Payable + Capital Old Bal. $ 9,200 $1,600 $7,000 $1,850 $15,950 (6) +1,500 +2,000 +3,500 Service New Bal. $10,700 + $2,000 + $1,600 + $7,000 = $1,850 + $19,450Revenue $21,300 $21,300 Cash is increased $1,500; Accounts Receivable is increased $2,000; and Doucet, Capital is increased $3,500. TRANSACTION 7 Expenses paid in cash for September are store rent, $600, salaries of employees, $900, and utilities, $200. $600 Softbyte $900 $200 TRANSACTION 7 SOLUTION Assets = Liabilities + Owner s Equity Accounts Accounts Doucet, Cash + Receivable + Supplies + Equipment = Payable + Capital Old Bal. $10,700 $2,000 $1,600 $7,000 $1,850 $19,450 (7) -1, Rent Exp Salaries Exp Utilities Exp. New Bal. $ 9,000 + $2,000 + $1,600 + $7,000 = $1,850 + $17,750 $19,600 $19,600 Cash is decreased $1,700 and Doucet, Capital is decreased the same amount. 1-17

18 Chapter 1 Accounting In Action TRANSACTION 8 Softbyte pays its Financial Post advertising bill of $250 in cash. Softbyte Daily News TRANSACTION 8 SOLUTION Assets = Liabilities + Owner s Equity Accounts Accounts Doucet, Cash + Receivable + Supplies + Equipment = Payable + Capital Old Bal. $9,000 $2,000 $1,600 $7,000 $1,850 $17,750 (8) New Bal. $8,750 + $2,000 + $1,600 + $7,000 = $1,600 + $17,750 $19,350 $19,350 Cash is decreased $250 and Accounts Payable is decreased the same amount. TRANSACTION 9 The sum of $600 in cash is received from customers who have previously been billed for services in Transaction 6. Softbyte 1-18

19 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition TRANSACTION 9 SOLUTION Assets = Liabilities + Owner s Equity Accounts Accounts Doucet, Cash + Receivable + Supplies + Equipment = Payable + Capital Old Bal. $8,750 $2,000 $1,600 $7,000 $1,600 $17,750 (9) New Bal. $9,350 + $1,400 + $1,600 + $7,000 = $1,600 + $17,750 $19,350 $19,350 Cash is increased $600 and Accounts Receivable is decreased by the same amount. TRANSACTION 10 Marc Doucet withdraws $1,300 in cash from the business for his personal use. Softbyte $1,300 TRANSACTION 10 SOLUTION Assets = Liabilities + Owner s Equity Accounts Accounts Doucet, Cash + Receivable + Supplies + Equipment = Payable + Capital Old Bal. $9,350 $1,400 $1,600 $7,000 $1,600 $17,750 (10) -1,300-1,300 Drawings New Bal. $8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $16,450 $18,050 $18,050 Cash is decreased $1,300 and Doucet, Capital is decreased by the same amount. 1-19

20 Chapter 1 Accounting In Action STUDY OBJECTIVE 8 Distinguish between an income statement, statement of owner s equity, balance sheet, and statement of cash flows. 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 statement of owner s equity summarizes the changes in owner s equity for a specific period of time. FINANCIAL STATEMENTS In addition to the income statement, and statement of owner s equity, the remaining statements include: 3 A balance sheet reports the assets, liabilities, andequity 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. The notes are an integral part of the financial statements. 1-20

21 Weygandt Kieso Trenholm Accounting Principles, Canadian Edition ILLUSTRATION 1-9 FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS SOFTBYTE, INC. Income Statement For the Month Ended September 30, 1999 Revenues Service revenue $ 4,700 Expenses Salaries expense $ 900 Rent expense 600 Advertising expense 250 Utilities expense 200 Total expenses 1,950 Net income $2,750 Net income of $2,750 shown on the income statement is added to the beginning balance of owner s capital in the statement of owner s equity. ILLUSTRATION 1-9 FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS SOFTBYTE, INC. Statement of Owner s Equity For the Month Ended September 30, 1999 M. Doucet, Capital, September 1 $ 0 Add: Investments $ 15,000 Net income 2,750 17,750 17,750 Less: Drawings 1,300 M. Doucet, Capital, September 30 $16,450 Net income of $2,750 is carried forward from the income statement to the statement of owner s equity. The owner s capital of $16,450 at the end of the reporting period is shown as the final total of the owner s equity column of the Summary of Transactions (Illustration 1-8). ILLUSTRATION 1-9 FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS SOFTBYTE, INC. Balance Sheet September 30, 1999 Assets Cash $ 8,050 Accounts receivable 1,400 Supplies 1,600 Equipment 7,000 Total assets $ 18,050 Liabilities and Owner s Equity Liabilities Accounts payable $ 1,600 Owner s equity M. Doucet, capital 16,450 Total liabilities and owner s equity $ 18,050 Owner s capital of $16,450 at the end of the reporting period shown in the statement of owner s equity is shown on the balance sheet. Cash of $8,050 on the balance sheet is reported on the statement of cash flows. 1-21

22 Chapter 1 Accounting In Action ILLUSTRATION 1-9 FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS SOFTBYTE, INC. Statement of Cash Flows For the Month Ended September 30, 1999 Cash flows from operating activities Cash receipts from customers $ 3,300 Cash payments to suppliers and employees (1,950) Net cash provided by operating activities 1,350 Cash flows from investing activities Purchase of equipment (7,000) Cash flows from financing activities Investments by owner $ 15,000 Drawings by owner (1,300) Net cash provided by financing activities 13,700 Net increase in cash 8,050 Cash at the beginning of the period 0 Cash at the end of the period $ 8,050 Cash of $8,050 on the balance sheet and statement of cash flows is shown as the final total of the cash column of the Summary of Transactions (Illustration 1-8). USING THE INFORMATION IN THE FINANCIAL STATEMENTS Annual Reports Non-financial information Financial information 1-22