Chapter 1. Accounting in action.

What’s accounting?
Accounting consists of three basic activities – it identifies, records, and communicates the
economic events of an organization to interested users.
Three activities:
As a starting point, accountants identify the economic events relevant to its business, known
as transactions. Once those events are identified, it records those events in order to provide a
history of its financial activities. That’s it, it consists of keeping a systematic and chronological
diary of events (Recording also includes the bookkeeping function). Finally, the company
communicates the collected information to interested users by means of accounting reports in
a standardized way. A vital element in communicating economic events is the accountant’s
ability to analyse and interpret the reported information. Therefore, interpretation means to
explain the uses, the meaning and the limitations of the reported data.

Who uses accounting data?

Internal users. Those ones who are inside an organization. They need detailed accounting
information: managerial accounting provides internal reports to help users make decisions
about their companies.
External users. Those individuals and organizations outside a company who want financial
information about the company. Financial accounting provides economic and financial
information for these external users.

Accounting standards.
In order to ensure high-quality financial reporting, accountants present financial statements in
conformity with accounting standards that are issued by standard-setting bodies. There are
two primary ones the International Accounting Standards Board (IASB) and the Financial
Accounting Standards Board (FASB). Most countries follow the standards which are referred
as International Financial Reporting Standards (IFRS). Due to globalization, more and more
firms have the necessity to compare their data, so in order to increase comparability,
differences have been reduced. It is known as convergence.
Measurement principles of IFRS.
Historical cost principle. It dictates that the companies record assets at their cost. This is
applied not only at the moment of the purchase of the asset, but also over the time the asset is
hold.
Fair value principle. It states that the assets and liabilities should be reported at the price
received to sell an asset or settle liability.
Assumptions.
Assumptions provide a base for the accounting process.
Monetary unit assumption. It requires that the companies include in the accounting records
only the transaction data that can be expressed in money terms (related with the historical
cost principle). This assumption allows to quantify economic events.
Economic entry assumption. The activities of the entity are kept separately and are distinct
from the activities of its owner and all other economic entities.

Proprietorship Partnership Corporation

 -Owned by one person. -Owned by two or more -Ownership divided into
-Owner is often the persons. shares.
manager. -Owner receives -Often retail and service- -Separate legal entity
any profits, suffers any type businesses. organized under corporation
losses, and is personally -Unlimited personal liability. law.
liable for all debts. -Partnership agreement. -Limited liability.
The basic accounting equation.
Assets = Liabilities + Equity.
The accounting equation applies to all economic entities regardless of size and form of
business organization. It provides the underlying framework for recording and summarizing
economic events.
Assets. Assets are resources a business owns. They have the capacity to provide future services
or benefits.
Liabilities. These are claims against assets – that is, debts and obligations. Mainly are owed to
creditors
Equity. The ownership claim on a company’s total assets is equity. It’s equal to total assets
minus total liabilities. This is often referred to as residual equity – that is, the equity “left over”
after creditors’ claims are satisfied. Equity consists of share capital ( amounts paid in by
shareholders for the ordinary shares they purchase), and retained earnings ( revenues,
expenses and dividends).
It increases equity1:
Investments by shareholders and revenues (result from business activities entered into for the
purpose of earning income)
It decreases equity:
Expenses (cost of assets consumed or services used in the process of earning revenue) and
dividends to shareholders (distribution of cash or other assets to shareholders).

Using the accounting equation

Business transactions are a business’s economic events recorded by accountants.
-Might be external (outside the enterprise) or internal (indoors the company).
-Not all the activities represent transactions; example, discuss product design with potential
customers, appointment with suppliers….
-Each transaction has a dual effect on the accounting.
Expanded accounting equation:

Summary.
1-Each transaction must be analyzed in terms of its effect on:
-The three components of the basic accounting equation.

1
In summary, the principal sources (increases) of equity are investments by shareholders and revenues from business operations.
In contrast, reductions (decreases) in equity result from expenses and dividends.
 -Specific types of items within each component.
2-The two sides of the equation must always be equal.
3-The Share Capital –Ordinary and Retained Earnings columns indicate the causes of each change in the
shareholders’ claim on assets.

Financial statements
Companies prepare 5 financial statements from the summarized accounting data:
1-An income statement presents the revenues and expenses and resulting net income or net loss for a
specific period of time.
-Reports the profitability of the company’s operations over a specific period of time.
-Lists revenues first, followed by expenses.
-Shows net income (or net loss).
-It doesn’t include investment and dividend transactions between the shareholders and the business.
2-A retained earnings statement summarizes the changes in returned earnings for a specific period of
time.
-The time period is the same as that covered by the income statement.
-Information provided indicates the reasons why retained earnings increased or decreased during the
period.
3-A statement of financial statement (balance sheet) reports the assets, liabilities, and equity of a
company at a specific date.
-Lists asserts at the top, followed by liabilities and equity.
-Total assets must equal total liabilities and equity.4
-It’s a snapshot of the company’s financial condition at a specific moment of time (usually the month-end
or year-end).
4-A statement of cash flows summarizes information about the cash inflows (receipts) and the outflows
(payments) for a specific period of time (where did cash come from? what was cash used for? what was
the change in the cash balance?)
5-A comprehensive income statement presents other comprehensive income items that are not included
in the determination of the net income. It’s reported either by combining with income statement, or
separate statement.