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Fundamental Financial Accounting Chapter 1

Fundamental Financial Accounting Chapter 1

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Chapter 1-1

Chapter 1

Accounting In Action
Financial Accounting, Sixth Edition
Chapter 1-2

Study Objectives
1. 2. 3. 4. 5. 6. 7. 8.
Chapter 1-3

Explain what accounting is. Identify the users and uses of accounting. Understand why ethics is a fundamental business concept. Explain generally accepted accounting principles and the cost principle. Explain the monetary unit assumption and the economic entity assumption. State the accounting equation, and define assets, liabilities, and stockholders· equity. Analyze the effects of business transactions on the accounting equation. Understand the four financial statements and how they are prepared.

Accounting in Action

What is Accounting?

The Building Blocks of Accounting Ethics in financial reporting Generally accepted accounting principles Assumptions

The Basic Accounting Equation Assets Liabilities Stockholders' equity

Using the Basic Accounting Equation Transaction analysis Summary of transactions

Financial Statements

Three activities Who uses accounting data

Income statement Statement of retained earnings Balance sheet Statement of cash flows

Chapter 1-4

What is Accounting?
The purpose of accounting is to:
(1) identify record and communicate the identify, record,

economic events of an
(2) organization to (3) interested users.

Chapter 1-5

SO 1 Explain what accounting is.

What is Accounting?
Three Activities
Illustration 1-1 Accounting process

The accounting process includes the bookkeeping function.
Chapter 1-6

SO 1 Explain what accounting is.

Who Uses Accounting Data?
Internal Users Human Resources Management IRS Investors Labor Unions Creditors Customers
Chapter 1-7

Finance

Common Questions

Marketing SEC

External Users

SO 2 Identify the users and uses of accounting.

Who Uses Accounting Data?
Common Questions Asked
1. Can we afford to give our employees a pay raise? 2. Did the company earn a satisfactory income? 3. Do we need to borrow in the near future? 4. Is cash sufficient to pay dividends to the stockholders? 5. What price for our product will maximize net income? 6. Will the company be able to pay its short-term debts?
Chapter 1-8

User Human Resources Investors Management Finance Marketing Creditors

SO 2 Identify the users and uses of accounting.

Who Uses Accounting Data?

Discussion Question
Q1. ´Accounting is ingrained in our society and it is vital to our economic system.µ Do you agree? Explain.

See notes page for discussion
Chapter 1-9

SO 3 Understand why ethics is a fundamental business concept.

The Building Blocks of Accounting
Ethics In Financial Reporting
Standards of conduct by which one·s actions are judged as right or wrong, honest or dishonest, fair or not fair, are Ethics. Recent financial scandals include: Enron, WorldCom, HealthSouth, AIG, and others. Congress passed Sarbanes-Oxley Act of 2002. Effective financial reporting depends on sound ethical behavior.
Chapter 1-10

SO 3 Understand why ethics is a fundamental business concept.

Ethics

Review Question
Ethics are the standards of conduct by which one's actions are judged as: a. right or wrong. b. honest or dishonest. c. fair or not fair. d. all of these options.

Chapter 1-11

SO 3 Understand why ethics is a fundamental business concept.

The Building Blocks of Accounting
Various users need financial information Financial Statements
Balance Sheet Income Statement Retained Earnings Statement Statement of Cash Flows Note Disclosure

The accounting profession has attempted to develop a set of standards that are generally accepted and universally practiced.

Generally Accepted Accepted Accounting Accounting Principles (GAAP)

Chapter 1-12

SO 4 Explain generally accepted accounting principles and the cost principle.

The Building Blocks of Accounting
Organizations Involved in Standard Setting:
Securities and Exchange Commission (SEC)
http://www.sec.gov/

Financial Accounting Standards Board (FASB)
http://www.fasb.org/

International Accounting Standards Board (IASB) http://www.iasb.org/
Chapter 1-13

SO 4 Explain generally accepted accounting principles and the cost principle.

The Building Blocks of Accounting
Cost Principle (Historical) ² dictates that companies
record assets at their cost. Issues: Reported at cost when purchased and also over the time the asset is held. Cost easily verified, whereas market value is often subjective. Fair value information may be more useful.

Chapter 1-14

SO 4 Explain generally accepted accounting principles and the cost principle.

Assumptions
Monetary Unit Assumption ² include in the
accounting records only transaction data that can be expressed in terms of money.

Economic Entity Assumption ² requires that
activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. Proprietorship. Partnership. Corporation.
Chapter 1-15

Forms of Business Ownership
SO 5 Explain the monetary unit assumption and the economic entity assumption.

Forms of Business Ownership
Proprietorship
Generally owned by one person. Often small serviceservice-type businesses Owner receives any profits, suffers any losses, and is personally liable for all debts.
Chapter 1-16

Partnership
Owned by two or more persons. Often retail and serviceservice-type businesses Generally unlimited personal liability Partnership agreement

Corporation
Ownership divided into shares of stock Separate legal entity organized under state corporation law Limited liability

SO 5 Explain the monetary unit assumption and the economic entity assumption.

Assumptions

Review Question
Combining the activities of Kellogg and General Mills would violate the a. cost principle. b. economic entity assumption. c. monetary unit assumption. d. ethics principle.

Chapter 1-17

SO 5 Explain the monetary unit assumption and the economic entity assumption.

Forms of Business Ownership

Review Question
A business organized as a separate legal entity under state law having ownership divided into shares of stock is a a. proprietorship. b. partnership. c. corporation. d. sole proprietorship.

Chapter 1-18

SO 5 Explain the monetary unit assumption and the economic entity assumption.

The Basic Accounting Equation
Assets Liabilities Stockholders· Equity

=

+

Provides the underlying framework for recording and summarizing economic events. Assets are claimed by either creditors or owners. Claims of creditors must be paid before ownership claims.

Chapter 1-19

SO 6 State the accounting equation, and define assets, liabilities, and stockholders· equity.

The Basic Accounting Equation
Assets Liabilities Stockholders· Equity

=

+

Provides the underlying framework for recording and summarizing economic events. Assets Resources a business owns. Provide future services or benefits. Cash, Supplies, Equipment, etc.
Chapter 1-20

SO 6 State the accounting equation, and define assets, liabilities, and stockholders· equity.

The Basic Accounting Equation
Assets Liabilities Stockholders· Equity

=

+

Provides the underlying framework for recording and summarizing economic events. Liabilities Claims against assets (debts and obligations). Creditors - party to whom money is owed. Accounts payable, Notes payable, etc.
Chapter 1-21

SO 6 State the accounting equation, and define assets, liabilities, and stockholders· equity.

The Basic Accounting Equation
Assets Liabilities Stockholders· Equity

=

+

Provides the underlying framework for recording and summarizing economic events. Stockholders· Equity Ownership claim on total assets. Referred to as residual equity. Paid-in Capital, Retained Earnings (Corporation).
Chapter 1-22

SO 6 State the accounting equation, and define assets, liabilities, and stockholders· equity.

Stockholders· Equity
Illustration 1-6

Revenues result from business activities entered into for the purpose of earning income. Common sources of revenue are: sales, fees, services, commissions, interest, dividends, royalties, and rent.
Chapter 1-23

SO 6 State the accounting equation, and define assets, liabilities, and stockholders· equity.

Stockholders· Equity
Illustration 1-6

Expenses are the cost of assets consumed or services used in the process of earning revenue. Common expenses are: salaries expense, rent expense, utilities expense, tax expense, etc.
Chapter 1-24

SO 6 State the accounting equation, and define assets, liabilities, and stockholders· equity.

Stockholders· Equity
Illustration 1-6

Dividends are the distribution of cash or other assets to stockholders. Dividends reduce retained earnings, however dividends are not an expense.
Chapter 1-25

SO 6 State the accounting equation, and define assets, liabilities, and stockholders· equity.

Using The Basic Accounting Equation
Transactions are a business·s economic events
recorded by accountants. May be external or internal. Not all activities represent transactions. Each transaction has a dual effect on the accounting equation.

Chapter 1-26

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions
Question: Are the following events recorded in the accounting records? Event
Supplies are purchased on account. An employee is hired. Dividends are paid to stockholders·.

Criterion

Is the financial position (assets, liabilities, or stockholders· equity) of the company changed?

Record/ Don·t Record
Chapter 1-27

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions

Discussion Question
Q18. In February 2008, Paula King invested an additional $10,000 in Hardy Company. Hardy·s accountant, Lance Jones, recorded this receipt as an increase in cash and revenues. Is this treatment appropriate? Why or why not?

See notes page for discussion
Chapter 1-28

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
P1P1-1A: Barone·s Repair Shop was started on May. Prepare a tabular analysis of the following transactions for the month of May. 1. Stockholders invested $10,000 cash to start the repair shop.
Assets Cash 1. +10,000 Liabilities Stockholders· Equity Accounts Accounts Common + Receivable + Equipment = Payable + Stock +10,000 Investment

Chapter 1-29

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
2. Purchased equipment for $5,000 cash.
Assets Cash 1. +10,000 2. -5,000 +5,000 Liabilities Stockholders· Equity Accounts Accounts Common + Receivable + Equipment = Payable + Stock +10,000 Investment

Chapter 1-30

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
3. Paid $400 cash for May office rent.
Assets Cash 1. +10,000 2. 3. -5,000 -400 +5,000 -400 Expense Liabilities Stockholders· Equity Accounts Accounts Common Retained + Receivable + Equipment = Payable + Stock + Earnings +10,000

Chapter 1-31

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
4. Received $5,100 from customers for repair service.
Assets Cash 1. +10,000 2. 3. 4. -5,000 -400 +5,100 +5,000 -400 +5,100 Revenue Liabilities Stockholders· Equity Accounts Accounts Common Retained + Receivable + Equipment = Payable + Stock + Earnings +10,000

Chapter 1-32

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
5. Paid dividends of $1,000 cash.
Assets Cash 1. +10,000 2. 3. 4. 5. -5,000 -400 +5,100 -1,000 +5,000 -400 +5,100 -1,000 Liabilities Stockholders· Equity Accounts Accounts Common Retained + Receivable + Equipment = Payable + Stock + Earnings +10,000

Chapter 1-33

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
6. Paid part-time employee salaries of $2,000.
Assets Cash 1. +10,000 2. 3. 4. 5. 6. -5,000 -400 +5,100 -1,000 -2,000 +5,000 -400 +5,100 -1,000 -2,000 Expense Liabilities Stockholders· Equity Accounts Accounts Common Retained + Receivable + Equipment = Payable + Stock + Earnings +10,000

Chapter 1-34

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
7. Incurred $250 of advertising costs, on account.
Assets Cash 1. +10,000 2. 3. 4. 5. 6. 7. -5,000 -400 +5,100 -1,000 -2,000 +250 +5,000 -400 +5,100 -1,000 -2,000 -250 Expense Liabilities Stockholders· Equity Accounts Accounts Common Retained + Receivable + Equipment = Payable + Stock + Earnings +10,000

Chapter 1-35

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
8. Provided repair services on account to customers $750.
Assets Cash 1. +10,000 2. 3. 4. 5. 6. 7. 8. -5,000 -400 +5,100 -1,000 -2,000 +250 +750 +5,000 -400 +5,100 -1,000 -2,000 -250 +750 Revenue
Chapter 1-36

Liabilities

Stockholders· Equity

Accounts Accounts Common Retained + Receivable + Equipment = Payable + Stock + Earnings +10,000

SO 7 Analyze the effects of business transactions on the accounting equation.

Transactions (Problem)
9. Collected $120 cash for services previously billed.
Assets Cash 1. +10,000 2. 3. 4. 5. 6. 7. 8. 9.
Chapter 1-37

Liabilities

Stockholders· Equity

Accounts Accounts Common Retained + Receivable + Equipment = Payable + Stock + Earnings +10,000 +5,000 -400 +5,100 -1,000 -2,000 +250 +750 -250 +750 10,000 + 2,200

-5,000 -400 +5,100 -1,000 -2,000

+120 6,820 +

-120 630 +

5,000 =

250 +

SO 7 Analyze the effects of business transactions on the accounting equation.

Financial Statements
Companies prepare four financial statements from the summarized accounting data:

Income Statement

Retained Earnings Statement

Balance Sheet

Statement of Cash Flows

Chapter 1-38

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements

Review Question
Net income will result during a time period when: a. assets exceed liabilities. b. assets exceed revenues. c. expenses exceed revenues. d. revenues exceed expenses.

Chapter 1-39

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements
Income Statement
Barone·s Repair Shop Income Statement For the Month Ended May 31, 2007 Revenues: ervice revenue Expenses: alar expense Rent expense dvertisin expense otal expenses Net income
Chapter 1-40

Reports the revenues and expenses for a specific period of time. Net income ² revenues exceed expenses. Net loss ² expenses exceed revenues.

$

3,200

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements
Income Statement
Barone·s Repair Shop Income Statement For the Month Ended May 31, 2007 Revenues: Service revenue Expenses: Salary expense Rent expense Advertising expense Total expenses Net income
Chapter 1-41

Retained Earnings Statement
Barone·s Repair Shop Retained Earnings Statement For the Month Ended May 31, 2007 Retained earnings, May 1 $ 3,200 (1,000) 2,200

$

5,850 2,000 400 250 2,650

Add: Net income Less: Dividends Retained earnings, May 31 $

$

3,200

Net income is needed to determine the ending balance in retained earnings.

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements
Retained Earnings Statement
Statement indicates the reasons why retained earnings has increased or decreased during the period.
Barone·s Repair Shop Retained Earnings Statement For the Month Ended May 31, 2007 Retained earnings, May 1 dd: et income Less: Di idends Retained earnings, May 31 (1 3,200 )

Chapter 1-42

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements
B l
B r B l ssets Cash s re eivable Equi Li ili i $ 250 10,000 00 $ 12,450 kh l r ' ui e $ 12,450 Total assets Accounts payable Common stock Retaine earnings Total liab. & equity
Chapter 1-43

h
R ir h 3 , 200 h

R t i r i g t t m t
B r R t i F r th R t i th r i g , R r i g ir h t t m t 3 , 200 3,200 (1,000) 3 $ 2,200

Add: Net income Less: Dividends R t i r i g ,

The ending balance in retained earnings is needed in preparing the balance sheet.

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements
Balance Sheet
B r e·s Repair Sh p B l Assets Cash Accounts receivable Equipment Total assets Li St ilities $ 250 10,000 2,200 $ 12,450 kh l ers' uit Accounts payable Common stock Retained earnings Total liab. & equity
Chapter 1-44

e Sheet

ay 3 , 200 $ , 20 0 5,000 $ 12,450

Reports the assets, liabilities, and stockholders· equity at a specific date. Assets listed at the top, followed by liabilities and stockholders· equity. Total assets must equal total liabilities and stockholders· equity.

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements
Balance Sheet
Barone·s Repair Shop Balance Sheet May 31, 2007 Assets Cash Accounts receivable Equipment Total assets Liabilities Accounts payable Stockholders' Equity Common stock Retained earnings Total liab. & equity
Chapter 1-45

Statement of Cash Flows
Barone·s Repair Shop Statement of Cash Flows For the Month Ended May 31, 2007 ash flow from Operations Cash receipts from customers Cash paid for expenses Cash provided by operations Cash flow from Investing Purchase of equipment Cash flow from Financing Investment by owners Drawings by owners Cash provided by financing Net increase in cash Cash balance, May 1 Cash balance, May 31 $ $ 5,220 (2,400) 2,820 (5,000) 10,000 (1,000) 9,000 6,820 6,820

$

6,820 630 5,000

$ 12,450 $ 250 10,000 2,200 $ 12,450

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements
Information for a specific period of time. Answers the following:
1. Where did cash come

Statement of Cash Flows
Barone·s Repair Shop Statement of Cash Flows For the Month Ended May 31, 2007 Cash flow from Operations Cash receipts from customers Cash paid for expenses Cash provided by operations Cash flow from Investing Purchase of equipment Cash flow from Financing Investment by owners Drawings by owners Cash provided by financing Net increase in cash Cash balance, May 1 Cash balance, May 31 $ $ 5,220 (2,400) 2,820 (5,000) 10,000 (1,000) 9,000 6,820 6,820

from?
2. What was cash used

for?
3. What was the change

in the cash balance?
Chapter 1-46

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements

Review Question
Which of the following financial statements is prepared as of a specific date? a. Balance sheet. b. Income statement. c. Statement of stockholders· equity. d. Statement of cash flows.

Chapter 1-47

SO 8 Understand the four financial statements and how they are prepared.

Financial Statements

Discussion Question
Q19. ´A company·s net income appears directly on the income statement and the retained earnings statement, and it is included indirectly in the company·s balance sheet.µ Do you agree? Explain.

See notes page for discussion
Chapter 1-48

SO 8 Understand the four financial statements and how they are prepared.

All About You
Ethics: Managing Personal Financial Reporting
When students need money for school, they often apply for financial aid. Why do the Department of Education and your school want this information? Bottom line: The worse off you look financially, the more likely you are to get money. Question: Should you intentionally make yourself look worse off than you are?

Chapter 1-49

All About You
Some Facts:
After adjusting for inflation, private-college tuition and fees have increased 37% over the past decade; public-college tuition has risen 54%. Two-thirds (65.6%) of undergraduate students graduate with some debt. Among graduating seniors, the average debt load is $19,202.

Chapter 1-50

All About You

Source: College Board, Princeton Review, as reported in ´College Admissions: Is Gate Open or Closed?,µ Wall Street Journal, March 25, 2006, p. A7.
Chapter 1-51

All About You
What Do You Think?
To increase your chances of receiving aid, should you use available cash to pay off your credit card bills, and therefore make yourself look ´worse offµ to the financial aid decision makers?
YES: You are simply restructuring your assets and liabilities to best conform with the preferences that are built into the federal aid formulas. NO: You are taking advantage of a loophole in the federal aid rules and potentially depriving someone who is actually worse off than you from receiving aid.

Chapter 1-52

Copyright
Copyright © 2008 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Chapter 1-53

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