Chapter 1 Accounting and the Business Environment

Transcription

1 Use accounting vocabulary: Chapter 1 Accounting and the Business Environment Business, as a general system, has a number of systems (purchasing, production, marketing, human resource, accounting, and so on). The accounting system is just one of the systems within a business, all of which must work together in an active and efficient way. An Information system is a set of interrelated subsystems that work together to collect, process, store, transform, and distribute information for planning, decision making, and control. Accounting information system: is a collection of resources, such as people and equipment, design to transform financial and other data into information. This information is communicated to a wide range of decision makers. - It collects and stores data about activities and transactions. - It processes data into information that is useful for making decisions. - It provides adequate controls to safeguard the organization s assets. Accounting can be defined as an information system that provides reports to stakeholders about the economic activities and conditions of a business. Accounting is the information system that; measures business activity, Processes the information into reports, and communicates the results to decision makers. It also called the language of business that helps decision making. The primary role of accounting is to evaluate the performance of business and convey this information to users. Objectives of financial reporting: It Provides; - Information about economic resources, claims to resources, and changes in resources and claims. - Information useful in assessing amount, timing and uncertainty of future cash flows. - Information useful in making investment and credit decisions. Financial reporting is not an end in itself but is intended to provide information that is useful in making business and economic decisions. Decision Makers: The Users of Accounting Information (stakeholders); - External users: make decisions concerning their relationship to the entity (investors, creditors, customers, suppliers, Taxing Authorities, public); - Internal users: make decisions that directly affect the internal operations of the entity (investors owners, managers, and employees). Decision makers need information. The bigger the decision, the greater the need. Bookkeeping and Accounting: - Bookkeeping: Involves only the recording of monetary economic transactions or events. Is just one part of accounting. - Accounting: Includes bookkeeping. Also includes much more. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 1

2 Fields of Accounting: - Financial accounting: is primarily concerned with the recording and reporting of economic data and activities for a business. It provides information for people outside the company, such as investors and creditors. - Managerial accounting: focuses on information for internal decision making by the company s managers. It focuses on information for internal decision makers, such as mangers of the company. Governing Organizations: In US, the following organizations relate to the regulation of accounting. - FASB (Financial Accounting Standards Board): formulates accounting standards ( Develops acceptable accounting practices and issues pronouncements that firms must follow to be in compliance with GAAP. - SEC (The Securities and Exchange Commission): regulate security markets ( - AICPA (The American Institute of Certified Public Accountants): regulate Certified Public Accountants ( - CPA (Certified Public Accountant): a professional accountant who is licensed to serve the general public. - CMA (Certified Management Accountant): is licensed professional who work for a single company. - IMA (Institute of Management Accountants). The rules that govern public accounting information are called Generally Accepted accounting Principles (GAAP). Rules of financial accounting established by the FASB. Designed to protect the public from harm caused by false and misleading statements about the performance, cash flows and financial position of a firm. Ethics in Accounting and Business: - Audit: Examination of company s financial situation. Performed by independent accountants. - Investors and creditors need relevant and reliable information about a company. - But is the accounting information of the company reliable? - Some famous accounting scandals: Enron Corp. (report fewer debts). WorldCom. (record assets as expenses). Xerox (manipulating reported profits). - Reliability is a function of representational faithfulness, verifiability and neutrality. The building block of accounting: - Ethics: standards of conduct by which one s actions are judged as right or wrong, honest or dishonest. - Most individuals in business are ethical. Their actions are both legal and responsible. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 2

3 Types of Business Organizations: A business can be organized as: Proprietorships, Partnerships, Corporations, and Limited-Liability Partnerships (LLPs) and Limited Liability Companies (LLCs). 1- Proprietorships: - Owned by one individual (single owner). - Small local business such as hardware store, repair shops, laundries. - From accounting viewpoint, each proprietorship is distinct from its proprietor. - From legal perspective, the business is the proprietor. 2- Partnership: - Owned by two or more individuals. - Each owner is called partner. - Small or medium-sized business such as automotive repair shops, music stores, beauty shops. - Specifically, Professional organizations such as legal firms (Big 4). - Accounting treats partnership as a separate organization, distinct from partners. - From legal perspective,a partnership is the partners. 3- Corporations: - Organized as a separate legal entity. - Ownership divided into shares of stock. - Therefore owned by shareholders. - A business becomes a corporation when the state approves its articles of incorporation. - Continuous life and transferability of ownership. - No mutual agency. - Limited liability of stakeholders. - Separation of ownership and management. 4- Limited-Liability Partnerships (LLPs) and Limited Liability Companies (LLCs): - A Limited-Liability Partnerships is one in which a wayward partner cannot create a large liability for the other partner. Each partner is liable only for his or her own actions and those under his or her control. Similarly, a business can be organized as a Limited Liability Companies. In an LLC the business, and not the members of the LLC, is liable for the company's debts. Comparison of the Four Forms of Business Organization: Owner(s) Proprietorship - only one owner Life of the organization Personal liability of the owner(s) for the business's debts Proprietorship Partnership Corporation LLC Limited by the owner's choice, or death Proprietor is personally liable *Unless it is a Limited-Liability Partnership (LLP) Partners - two or more owners Limited by the owner's choice, or death Partners are personally liable* Stockholders - generally many owners Indefinite Stockholders are not personally liable Members Indefinite Members are not personally liable Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 3

4 Accounting Concepts and Principles Generally Accepted Accounting Principles (GAAP) - GAAP rests on a conceptual framework. - FASB: objective of financial reporting is to provide information useful for making investment and lending decisions. - Basic objective of financial reporting is to provide information that is: Useful to those making investment and credit decisions. To be useful, information must be: 1- Relevance: To be useful, the accounting information must be relevant to the needs of decision makers. Relevant accounting information is capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations. Relevance is a function of predictive value, feedback value and timelines. 2- Reliability (objectivity): To be useful, information must also be reliable. Reliability of information means that the information is free of error and bias, it can be depended on. Reliability is a function of Verifiability, representational faithfulness, and neutrality. Qualitative Characteristics of Accounting Information 1. The Entity Concept: An accounting entity: an organization or a section of an organization that stands apart as a separate economic unit. Entity decides boundary of accounting. The entity concept applies to any economic unit that needs to be evaluated separately. 2. The Cost Principle: Assets and services acquired should be recorded at their actual cost (historical cost). Historical cost represents the amount of cash or cash equivalents paid in acquiring an asset, this is sometimes called original acquisition cost. This is objective because it is based on actual invoices and other documents. Depreciated cost is determined based on original acquisition cost. Historical cost is the most objective measure of the value of an asset. However, it cannot reflect the current value of an asset. This principle also holds that accounting records should maintain the historical cost of an asset over its useful life. 3. The Going Concern Concept: Assume the entity will continue to operate in the future. This concept implies that the business will continue to operate for the foreseeable future. This concept is another reason for measuring assets at historical cost. 4. The Stable-Monetary-Unit Concept: The dollar s purchasing power is relatively stable. This allows us to add and subtract dollar amounts as each dollar has the same purchasing power as any other dollar at any time. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 4

5 The Accounting Equation: The algebraic relationship in the fundamental accounting model. Accounting data is represented by the following relationship among the assets, liabilities and owners equity of a business: Economic Resources = Claims to Economic Resources - Assets: Definition: Economic resources that are expected to bring benefits in the future. Examples:, Land, Building, Equipment, patent, Merchandise inventory, and Goodwill. Tangible assets (Ex., Land, Building, Equipment). Intangible assets (Ex. patent, Goodwill, and Trademark). - Liability: Definition: Outsider claims debt that is payable to outsider. Examples: Accounts payable, Notes payable, Salary payable and Bank loan. - Owner s equity: Also called shareholder s funds or stockholder s funds. It is what s left of the assets after liabilities have been deducted. Equals net assets in balance sheet. The insider-owner s claim on the entity s assets. The purpose of business is to increase owner s equity through revenues (income) i.e. maximize shareholder s value. Owner withdrawals and expenses decrease owner s equity. - Stockholder s Equity: The equity section of a corporation s balance sheet consists of: 1- Paid-in (contributed) capital: is the term used to describe the total amount paid in by stockholders. 2- Retained earnings: 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: The retained earnings section of the balance sheet is determined by three items: 1- Revenues. 2- Expenses. 3- Dividends. Retained earnings = Revenues Expenses Dividends Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 5

6 1- Revenue (income): - Definition: amounts received or to be received from customers for sales of products or services provided during a specific period, usually result in an increase in an asset. - Examples: Sales revenue, Service revenue, Interest revenue and Dividend revenue. 2- Expenses: - Definition: The economic costs that a business incurs through its operations to earn revenue. - Examples: Salaries and Wages, Tax, Insurance, Advertising, Factory leases, Utilities, Interest, Rent and Depreciation. 3- Dividends: - Net income represents an increase in net assets which then become available for distribution to stockholders. - 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. Owner s Equity Structure: Increase Owner s equity Decreas e Revenue Expense Investment Dividends The Accounting Equation: The Principle of The balance Sheet: Assets Liabilities owner s equity Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 6

7 Accounting for Business Transactions: Transaction Analysis: - Transaction: An event that affects the financial position of a particular entity and can be recorded reliably. Or exchanges of economic consideration between two parties. Example: - Pay monthly telephone bill of $ Purchasing land for $ 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. Example 1: Sheena Bright, INC. Sheena Bright starts her new business as a corporation named Smart Touch Learning, Inc. The Inc. in the company name abbreviates Incorporated, which lets people know the business is a corporation: Transaction 1: Starting the Business The e-learning agency received $30,000 cash from the President, Sheena Bright, and issued common stock to her. () Increase by 30,000 Increase by 30,000 There is an increase in the asset, $30,000, and an equal increase in the stockholders equity, Common Stock by $30,000. (1) Issued Stock Common = Stock $30,000 = 0 $30,000 Balance 30,000 = 30,000 Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 7

8 Transaction 2: Purchase of Land The business purchased land for an office location, paying cash of $20,000. Land increase by 20,000 There is a decrease in the asset by $20,000 and an equal increase in asset - Land for the same amount, by $20,000. Common Stock Old Balance 30,000 = 0 30,000 (2) Purchase Land - 20,000 20,000 New Balance () decrease by 20,000 10,000 20,000 = 0 30,000 30,000 = 30,000 Transaction 3: Purchase of Office Supplies The e-learning agency bought stationery and other office supplies, agreeing to pay $500 within 30 days. - This transaction is often referred to as a purchase on account or a credit purchase. (Office Supplies) Increase by 500 (Accounts payable) increase by 500 There is an increase in the asset Office Supplies by $500 and an equal increase in - Accounts Payable (to suppliers) for the same amount, by $500. Office Accounts Common Supplies Payable Stock Old Balance 10,000 20,000 = 0 30,000 (3) Purchase Office Supplies New Balance 10, ,000 = ,000 30,500 = 30,500 Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 8

9 Transaction 4: Earning of Service Revenue Smart Touch Learning earned service revenue by providing travel service for clients. The business earned $5,500 revenue and collected this amount in cash. - This transaction represents the principal revenue-producing activity of the business. () Increase by 5,500 (Retained Earning) increase by 5,500 is increased by $5,500 and Retained Earnings is increased by $5,500. Revenue will be recognized in the income statement and increase the retained earnings figure in the balance sheet as a result. Old Balance (4) Service Revenue New Balance Office Accounts Common Retained Supplies Payable Stock Earning 10, ,000 = ,000 5,500 5,500 15, ,000 = ,000 5,500 36,000 = 36,000 Transaction 5: Earning of Service on Account Smart Touch performed service for clients who do not pay immediately. The business received the clients promises to pay $3,000 within one month. (Accounts Receivable) Increase by 3,000 (Retained Earning) increase by 3,000 - Accounts Receivable (Assets) is increased by $3,000, and Retained Earnings is increased by the same amount, $3, Revenue service will be recognized in the income statement. Accounts Office Accounts Common Retained Receivable Supplies Payable Stock Earning Old Balance 15, ,000 = ,000 5,500 (5) Service 3,000 3,000 Revenue 15,500 3, ,000 = ,000 8,500 New Balance 39,000 = 39,000 Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 9

10 Transaction 6: Payment of Expenses During the month, the business paid $3,300 in cash expenses: rent expense on a computer, $600; office rent, $1,100; employee salary, $1,200; and utilities, $400. () decrease by 3,300 (Retained Earning) decrease by 3,300 Expenses have the opposite effect of revenue. Expenses paid in cash are: $600 $1,100 $1,200 $400 = $3,300 is decreased by $3,300 and Retained Earnings is decreased by $3,300. Rent expense on a computer; office rent; employee salary; and utilities will be recognized as expenses in the income statement and decrease the retained earning figure and cash in the balance sheet as a result. (If actual payment is made). Accounts Office Accounts Common Retained Receivable Supplies Payable Stock Earning Old Balance 15,500 3, ,000 = ,000 8,500 (6) Pay Expenses - 3,300-3,300 New Balance 12,200 3, ,000 = ,000 5,200 35,700 = 35,700 Transaction 7: Payment of Account The business paid $300 to the store from which she purchased supplies in transaction 3. () decrease by 300 (Accounts payable) decrease by is decreased $300 and Accounts Payable is decreased by $300. Accounts Office Accounts Common Retained Receivable Supplies Payable Stock Earning Old Balance 12,200 3, ,000 = ,000 5,200 (7) Pay on Account New Balance 11,900 3, ,000 = ,000 5,200 35,400 = 35,400 Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 10

11 Transaction 8: Personal Transaction Sheena Bright remodeled her home at a cost of $40,000, paying cash from personal funds. - This transaction is not a transaction of Sheena Bright. It has no effect on the travel agency and, therefore, is not recorded by the business. It is a transaction of the Sheena Bright personal entity, not the business. This transaction illustrates the entity concept. Transaction 9: Collection on Account The business collected $1,000 from the client (in transaction 5). Assets = Liabilities Stockholders Equity () Increase by 1,000 (Accounts Receivable) decrease by 1,000 is increased by $1,000 and Accounts Receivable is decreased by the same amount. Accounts Office Accounts Common Retained Receivable Supplies Payable Stock Earning Old Balance 11,900 3, ,000 = ,000 5,200 (9) Collection on Account 1,000-1,000 New Balance 12,900 2, ,000 = ,000 5,200 35,400 = 35,400 Transaction 10: Sale of Land The business sold some of land by the travel agency. The sale price of $9,000 is equal to the cost of the land. The business received $9,000 cash. () Increase by 9,000 (Land) decrease by 9,000 - is increased by $9,000 and Land is decreased by the same amount. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 11

12 Accounts Office Accounts Common Retained Receivable Supplies Payable Stock Earning Old Balance 12,900 2, ,000 = ,000 5,200 (10) Sale of Land 9,000-9,000 New Balance 21,900 2, ,000 = ,000 5,200 35,400 = 35,400 Transaction 11: Payment of Dividend The business declared and paid Sheena Bright a $2,000 cash dividend. () decrease by 2,000 Retained Earnings decrease by Dividends (2,000) - is decreased by $2,000 and Stockholders Equity is decreased by $2,000. Payment of dividends will decrease the retained earnings figure in the income statement. Accounts Office Accounts Common Retained Receivable Supplies Payable Stock Earning Old Balance 21,900 2, ,000 = ,000 5,200 (11) Dividend - 2,000-2,000 New Balance 19,900 2, ,000 = ,000 3,200 33,400 = 33,400 Summary of all transactions: Accounts Office Accounts Common Retained Receivable Supplies Payable Stock Earning (1) Issued Stock $30,000 $30,000 (2) Purchase Land - 20,000 20,000 (3) Purchase Office Supplies (4) Service 5,500 5,500 Revenue (5) Service 3,000 3,000 Revenue (6) Pay Expenses - 3,300-3,300 (7) Pay on Account (9) Collection on 1,000-1,000 Account (10) Sale of Land 9,000-9,000 (11) Dividend - 2,000-2,000 Balance 19,900 2, ,000 = ,000 3,200 Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 12

13 Prepare Financial Statements: - Daily business transactions are recorded in order to prepare financial statements for shareholders. - After transactions are identified, recorded, and summarized financial information about the company can be reflected in financial statements to stakeholders of the company and any parties who are interested. - Financial statements are the final product of the whole accounting process which starts at the business transaction recording phase. Financial statements report on a business in monetary terms. - Tells how the business is performing and where it stands. - Usually published by listed company at the end of a fiscal year or season. Major financial statements include: 1. Income statement: - A statement showing revenues and expenses for a specific period of time. Income statement or profit and loss statement reflecting financial performance (profitability). Summary of an entity s revenues, expenses, and net income or net loss for a specific period. - The income statement is more like a video of the firm s operations for a specified period of time, rather than having been prepared at a point of time. - Income - expenses = net income (profit or loss). Net Income: Revenues > Expenses Net Loss: Revenues < Expenses 2. Retained earnings statement: - Summarizes the changes in retained earnings for a specific period of time. 3. Balance sheet: - A statement showing the resources of a company (the assets), the company s obligations (the liabilities), and the equity of the owners at a certain point in time. The balance sheet is a snapshot of the entity s assets and liabilities at a given point in time. - Reports the assets, liabilities, and stockholders equity of a business enterprise at a specific date. - The balance sheet is a snapshot of the entity s assets and liabilities at a given point in time. - It is produced based on the accounting equation: Asset liabilities = owner s equity Asset = owner s equity liabilities 4. flow statement: - Reports cash receipts and cash payments during a period (covered in subsequent chapter). Summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time. - The statement classifies the various cash flows into three categories: operating, investing, and financing; and relates these categories to the beginning and ending cash balances. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 13

14 Relationships among the Four Basic Financial Statements: SMART TOUCH LEARNING, INC. Income Statement For the Month Ended April 30, 2010 Revenues: Service revenue $ 8,500 Expenses: Salary expense $1,200 Rent expense, office 1,100 Rent expense, computer 600 Utilities expense 400 Total expenses 3,300 Net income $ 5,200 SMART TOUCH LEARNING, INC. Retained Earnings Statement For the Month Ended April 30, 2010 Retained earnings, April 1, 2010 $ Add: Net income (From the Income Statement) 5,200 5,200 Less: Dividends (2,000) Retained earnings, April 30, 2010 $ 3,200 - Note the headings for both of these statements Name of company. Name of financial statement For the period ended. - Both of these statements report activity over a period of time. - Final sums are double-underlined. - Negative amounts are presented in parentheses - Net income is computed first because you need that number to complete the ending balance in owner s equity. - When preparing a financial statement, clearly label each line in the statement. - If you are using columnar paper, always start your number columns in the far right-hand column. - Numbers that are added or subtracted from each other should be in the same column. Assets SMART TOUCH LEARNING, INC. Balance Sheet At April 30, 2010 Liabilities & Stockholders Equity $19,900 Liabilities: Accounts receivable 2,000 Accounts payable $200 Office supplies 500 Stockholders equity: Land 11,000 Common stock 30,000 Retained earnings 3,200 Total stockholders equity 33,200 Total assets $33,400 Total liabilities and stockholders equity $33,400 - Note the heading for the balance sheet is different from the other statements: Name of company Name of financial statement Date - This statement reports what the company owns and who has claims to the assets at a specific point in time. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 14

15 SMART TOUCH LEARNING, INC. Statement of Flows For the Month Ended April 30, 2010 flows from operating activities: receipts from customers (5, ) $6,500 payments to suppliers (6,00 1, ) (2,400) payments to employees (1,200) Net cash provided by operating activities 2,900 flows from investing activities: Acquisition of land (20,000) Sale of land 9,000 Net cash provided by investing activities (11,000) flows from financing activities: Issuance of stock $30,000 Payment of cash dividends (2,000) Net cash provided by financing activities 28,000 Net increase in cash 19,900 at the beginning of the period at the end of the period $19,900 Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 15