NOTE: The accounting process includes the

CHAPTER 3
bookkeeping function.

ACCOUNTING IN ACTION USERS OF ACCOUNTING DATA

Learning Objectives:
INTERNAL USERS:
(1) Identify the activities and users
associated with accounting. ▪ FINANCE
(2) Explain the building blocks of
accounting: ethics, principles, and Is cash sufficient to pay dividends to Microsoft
assumptions. stockholders?
(3) Review the accounting equation, ▪ MARKETING
and define its components.
(4) Analyze the effects of business What price should Apple charge for an iPod to
transactions on the accounting maximize the company’s net income?
equation.
(5) Describe the five financial ▪ MANAGEMENT
statements and how they are
Which PepsiCo product line is the most
prepared.
profitable? Should any product lines be
eliminated?

Identify the activities and users associated ▪ HUMAN RESOURCES

with accounting.
Can General Motors afford to give its employees
Accounting consists of these basic activities–it pay raises this year?

▪ Identifies and records, economic

events (relevant to its business)
EXTERNAL USERS:
▪ Classifies;
▪ Summarizes; and ▪ INVESTORS
▪ Communicates/interprets –
o Prepare accounting reports Is General Electric earning satisfactory income?
o Analyze and interpret the
How does Disney compare in size and
reported information
profitability with Time Warner?
The economic events of an organization to
▪ CREDITORS
interested users.
Will United Airlines be able to pay its debts
as they come due?
ACCOUNTING PROCESS

IDENTIFICATION ACCOUNTING ACROSS THE

ORGANIZATION
→ Select economic events (transactions)

RECORDING, CLASSIFYING, AND

SUMMARIZING
→ Record, classify, and summarize
COMMUNICATION
→ Prepare accounting reports
→ Analyze and interpret for users
The Scoop on Accounting
Accounting can serve as a useful recruiting tool
even for the human resources department.
Rhino Foods, located in Burlington, Vermont, is
a manufacturer of specialty ice cream. Its
corporate website includes the following:
“Wouldn’t it be great to work where you were
part of a team? Where your input and hard work
made a difference? Where you weren’t kept in
the dark about what management was
thinking?... well–it’s not a dream! It’s the way
we do business… Rhino Foods believes in family,
honesty, and open communication–we really
care about and appreciate our employees–and
it shows. Operating results are posted and
monthly group meetings inform all employees
about what’s happening in the Company.
Employees also share in the Company’s profits,
in addition to having an excellent
comprehensive benefits package”.
EXERCISE 1
Indicate whether the following statements are
true or false.
1. The steps in the accounting process are
identification, recording, summarizing,
and communication. TRUE
2. Bookkeeping encompasses all steps in
the accounting process. FALSE
3. Accountants prepare, but do not
interpret, financial reports. FALSE
4. The two most common types of external
users are investors and company
officers. FALSE
5. Managerial accounting activities focus
on reports for internal users. TRUE
Explain the building blocks of accounting:
ethics, principles, and assumptions.
ETHICS IN FINANCIAL REPORTING
Some financial scandals include: Enron,
WorldCom, HealthSouth, AIG, and other
companies recently.
Regulators and law-makers concerned that
economy would suffer if investors lost
confidence in corporate accounting. Response,
• US Congress passed Sarbanes-Oxley
Act (SOX)
Effective financial reporting depends on sound
ethical behavior.
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.
EXERCISE 2
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 unfair
d. All of these options
ETHICS INSIGHT
The Numbers Behind Not-for-Profit
Organizations
Accounting plays an important role for a wide
range of business organizations worldwide. Just
as the integrity of the numbers matters for
business, it matters at least as much at not-for-
profit organizations. Proper control and
reporting help ensure that money is used the
way donors intended.
Donors are less inclined to give to an
organization if they think the organization is
subject to waste or theft. The accounting
challenges of some large international not-for-
profit rival those of the world’s largest
businesses. For example, after the Haitian
earthquake, the Haitian-born musician Wydef
Jean was criticized for the poor accounting
controls in a relief fund that he founded. In
response, he hired a new accountant and
improved the transparency regarding money
raised and spent.
GENERALLY ACCEPTED ACCOUNTING
PRINCIPLES (GAAP)
Various users need financial information
Financial Statements
▪ Balance Sheet
▪ Income Statement
▪ Statement of Owner’s Equity
▪ Statement of Cash Flows
▪ Note Disclosure
Generally Accepted Accounting
Principles (GAAP) / International
Financial Reporting Standards and
International Accounting Standards
The accounting profession has developed
standards that are generally accepted and
universally practiced.
Generally Accepted Accounting Principles
(GAAP) – are the International Financial
Reporting Standards and the International
Accounting Standards, that are generally
accepted and universally practiced. These
standards indicate how to report economic
events.
Standard-setting bodies:
➢ Financial Accounting Standards
Board (FASB)
➢ Securities and Exchange
Commission (SEC)
➢ International Accounting Standards
Board (IASB)
International Note: Over 100 countries are
International Financial Reporting
Standards (called IFRS). For example, all
companies in the European Union follow
international standards. The differences
between U.S. and international standards
are not generally significant.
MEASUREMENT PRINCIPLES
HISTORICAL COST PRINCIPLE (or Cost
Principle) dictates that companies record assets
at their cost.
FAIR VALUE PRINCIPLE states that assets
and liabilities should be reported at fair value
(the price received to sell an asset or settle a
liability).
Selection of which principle to follow generally
relates to trade-offs between relevance and
faithful representation.
Helpful Hint: Relevance and faithful
representation are two primary qualities
that make accounting information useful
for decision-making.
ASSUMPTIONS
MONETARY UNIT ASSUMPTION requires that
companies include in the accounting records
only transaction data that can be expressed in
terms of money.
ECONOMIC ENTITY ASSUMPTION requires
that activities of the entity be kept separate and
distinct from the activities of its owner and all
other economic entities.
 EXERCISE 3 4. Relevance means that financial
information matches what really
happened; the information is factual.
A business organized as a separate legal entity FALSE
under state law having ownership divided into 5. A business owner’s personal expenses
shares of stock is a must be separated from expenses of the
business to comply with accounting’s
a. Proprietorship economic entity assumption. TRUE
b. Partnership
c. Corporation
d. Sole proprietorship Review the accounting equation, and
define its components.
FORMS OF BUSINESS OWNERSHIP
ASSETS = LIABILITIES + OWNER’S
EQUITY
SINGLE PROPRIETORSHIP
BASIC ACCOUNTING EQUATION
▪ Owned by one person
▪ Owner is often manager/operator ▪ Provides the underlying
▪ Owner receives any profits, suffers any framework for recording and
losses, and is personally liable for all summarizing economic events.
debts ▪ Assets are claimed by either
creditors or owners.
PARTNERSHIP ▪ If a business is liquidated, claims
of creditors must be paid before
▪ Owned by two or more persons ownership claims.
▪ Often retail and service-type businesses
▪ Generally unlimited personal liability ASSETS
▪ Partnership agreement
▪ Resources a business owns.
CORPORATION ▪ Provide future services of
benefits.
▪ Ownership divided into shares of stock ▪ Cash, Supplies, Equipment, etc.
▪ Separate legal entity organized under
state corporation law LIABILITIES
▪ Limited liability
▪ Claims against assets (debts and
obligations).
EXERCISE 4: BUILDING BLOCKS OF ▪ Creditors (party to whom money
ACCOUNTING is owed).
▪ Accounts Payable, Notes Payable,
Salaries and Wages Payable, etc.
Indicate whether each of the following
OWNER’S EQUITY
statements presented below is true or false.
▪ Ownership claim on total assets.
1. US Congress passed the Sarbanes-
▪ Referred to as residual equity.
Oxley Act to reduce unethical behavior
▪ Investment by owners and
and decrease the likelihood of future
revenues (+)
corporate scandals. TRUE
▪ Drawings and expenses (-)
2. The primary accounting standard-
setting body is the Financial Accounting
Standards Board (FASB). TRUE
3. The historical cost principle dictates that
companies record assets at their cost. Assets = Liabilities +
Basic Equation
In later periods, however, the fair value Owner’s Equity
of the asset must be used if fair value is
higher than its cost. FALSE
 4. Salaries
Assets = Liabilities +
and
OE – Owner’s Expense Decrease
Expanded Equation Wages
Drawings + Revenues
Expense
- Expenses

Analyze the effects of business

INCREASE IN OWNER’S EQUITY transactions on the accounting equation.

▪ Investments by owners are the Transactions are a business’ economic events

assets the owner puts into the recorded by accountants.
business.
▪ Revenues result from business ▪ May be external or internal.
activities entered into for the ▪ Not all activities represent transactions.
purpose of earning income. ▪ Each transaction has a dual effect on the
o Common sources of revenue accounting equation.
are: sales, fees, services,
ACCOUNTING CYCLE:
commissions, interest,
dividends, royalties, and rent.
Analyze
DECREASE IN OWNER’S EQUITY Business
Journalize
▪ Drawings. An owner may Transactions
withdraw cash or other assets for
personal use.
▪ Expenses are the cost of assets
consumed or services used in the
Post Trial Balance
process of earning revenue.
o Common expenses are: salaries
expense, rent expense, utilities
expense, tax expense, etc.
Adjusted
Adjusting
Trial
EXERCISE 5: OWNER’S EQUITY EFFECTS Entries
Balance
Classify the following items as investment by
owner, owner’s drawings, revenue, or expenses.
Then indicate whether each item increases or
decreases owner’s equity. Financial Closing
Statements Entries
Effect on
Classification
Equity

1. Rent
Expense Decrease Post-
Expense
Closing Trial
2. Service Balance
Revenue Increase
Revenue

3. Drawings Drawings Decrease

TRANSACTION ANALYSIS

Are the following events recorded in the

accounting records?
 Purchase Discuss Pay b. Assets exceed revenues
Computer product rent c. Expenses exceed revenues
with d. Revenues exceed expenses
Event potential
customer
FINANCIAL STATEMENTS

• Net income is indeed to determine the

Did the financial position (assets, ending balance in owner’s equity.
Criterion liabilities, or owner’s equity) of • The ending balance in owner’s equity
the company changed? is needed in preparing the balance
sheet.
• Balance sheet and income statement
are needed to prepare statement of
Record/
Don’t YES NO YES cash flows.
Record
INCOME STATEMENT / STATEMENT OF
COMPREHENSIVE INCOME

SUMMARY OF TRANSACTIONS ▪ Reports the revenues and expenses for

a specific period of time.
▪ Lists revenues first, followed by
1. Each transaction is analyzed in terms of expenses.
its effect on: ▪ Shows net income (or net loss).
a. The three components of the ▪ Does not included investment and
basic accounting equation withdrawal transactions between the
(Assets, Liabilities, and owner and the business in measuring
Owner’s Equity) net income.
b. Specific of items within each
component. Alternative Terminology
2. The two sides of the equation must
The income statement is
always be equal.
sometimes referred to as the
3. The Owner’s Capital, Owner’s Drawings,
statement of operations, earnings
Revenues, and Expenses column
statement, or profit and loss
indicate the cause of each change in the
statement.
owner’s claim on assets.

Describe the five financial statements and

how they are prepared. STATEMENT OF OWNER’S EQUITY
Companies prepare five (5) financial
statements: ▪ Reports the changes in owner’s equity
for a specific period of time.
1. Income Statement / Statement of ▪ The time period is the same as that
Comprehensive Income covered by the income statement.
2. Statement of Owner’s Equity
3. Balance Sheet / Statement of Financial BALANCE SHEET / STATEMENT OF
Position FINANCIAL POSITION
4. Statement of Cash Flows
5. Notes to Financial Statements ▪ Reports the assets, liabilities, and
owner’s equity at a specific date.
QUESTION
▪ Lists assets at the top, followed by
Net income will result during a time period liabilities and owner’s equity. (Report
when: Form)
▪ Total assets must equal total liabilities
a. Assets exceed liabilities and owner’s equity.
 ▪ Is a snapshot of the company’s financial to society, as well as their financial results to
condition at a specific moment in time stockholders.
(usually the month-end or year-end).

STATEMENT OF CASH FLOWS APPENDIX 1A: Explain the career

opportunities in accounting.
▪ Information on the cash receipts and
payments for a specific period of time. PUBLI ACCOUNTING
▪ Answers the following:
o Where did cash come from Careers in auditing, taxation, and
during the period? management consulting serving the general
o What was cash used for during public.
the period?
PRIVATE ACCOUNTING
o What was the change in the
cash balance during the period? Careers in industry working in cost
accounting, budgeting, accounting information
QUESTION
systems, and taxation.
Which of the following financial statements is
GOVERNMENTAL ACCOUNTING
prepared as of a specific date?
Careers with the IRS (Internal Revenue
a. Balance Sheet
Service), the FBI (Federal Bureau of
b. Income Statement
Investigation), the SEC (Securities and
c. Owner’s Equity Statement
Exchange Commission), public colleges and
d. Statement of Cash Flows
universities, and in state and local
governments.
PEOPLE, PLANET, AND PROFIT
FORENSIC ACCOUNTING
INSIGHT

Beyond Financial Statements Uses accounting, auditing, and

investigative skills to conduct investigations into
Should we expand our financial theft and fraud.
statements beyond the income statement,
retained earnings statement, balance sheet,
and statement of cash flows? Some believe we
should take into account ecological and social
performance, in addition to financial results, in
evaluating a company. The argument is that a
company’s responsibility lies with anyone who is
influenced by its actions. In other words, a
company should be interested in benefitting
many different parties, instead of only
maximizing stockholder’s interests.

A socially responsible business does not

exploit or endanger any group of individuals. It
follows fair trade practices, provides safe
environments for workers, and bears
responsibility for environmental damage.
Granted, measurement of these factors is
difficult. How to report this information is also
controversial. But many interesting and useful
efforts are underway. Throughout this textbook,
we provide additional insights into how
companies are attempting to meet the challenge
of measuring and reporting their contributions