Ch1 Accounting in Action PDF

2024 Fall BUSS 152: Principles of Accounting Chap.1 Accounting in Action Prof. Hyorim Lee 1 Chapter Outline Learning Objectives LO 1 Identify the Activities and Users Associ...

2024 Fall BUSS 152: Principles of Accounting Chap.1 Accounting in Action Prof. Hyorim Lee 1 Chapter Outline Learning Objectives LO 1 Identify the Activities and Users Associated with Accounting. LO 2 Basic Components of Accounting LO 3 State the Accounting Equation and Define its Components. LO 4 Analyze the Effects of Business Transactions on the Accounting Equation. LO 5 Describe the Five Financial Statements and How They are Prepared. Learning Objective 1 Identify the Activities and Users Associated with Accounting. Accounting Activities (3 steps) 1. Identify an economic event: What are economic events? 2. Record the transaction(bookkeeping): Standardized way (Financial statements) 3. Communicate with users 4  Accounting Users 1. Internal users: Managers within a company Used for internal management decisions (management accounting) Timeliness is key value to support informed decision-making. 2. External users: Shareholders, creditors, customers, regulator, tax authorities, etc. Used for financing(debt/equity), regulating, taxing, etc.(financial accounting) Financial statements are structured reports that present accounting information in accordance with these accounting standards and principles. Reliability is critical for transparent financial reporting. 5 Learning Objective 2 Basic Components of Accounting: Ethics, Principles, and Assumptions Basic Components of Accounting 1. Ethics (refer to chap. 7) Why is ethics important in accounting? How does the accounting scandal, such as Enron scandal(2001) affect accounting practices? ▪ Sarbanes-Oxley Act (SOX, 2002): To prevent accounting fraud and to protect investors - (Internal control) Requires for companies to assess and report on their internal controls - (Management) Enhanced responsibility for CEOs and CFOs - (Auditor) Strengthening auditor independence, the establishment of public company accounting oversight board (PCAOB) 7 Basic Components of Accounting 2. Accounting Standards Accountants report financial statements in accordance with accounting standards There are two main accounting standard-setting bodies. 1) International Accounting Standards Board (IASB) ▪ Determines International Financial Reporting Standards (IFRS): Principle-based ▪ Used in 130 countries including Korea. 2) Financial Accounting Standards Board (FASB) ▪ Determines Generally Accepted Accounting Principles (US-GAAP) : Rule-based ▪ Used in the U.S. Convergence between IFRS and US-GAAP: To reduce the differences between IFRS and US-GAAP (comparability) 8 Basic Components of Accounting 3. Measurement Principles Historical cost principle 1) Companies record assets at their cost. 2) Pros: Faithful representation (reliability) 3) Cons: Less relevance What kinds of assets are appropriate? Fair value principle 1) Assets and liabilities should be reported at fair value 2) Pros: Relevance (Financial information is capable of making a difference in a decision) 3) Cons: Less reliability What kinds of assets are appropriate? Trade-offs between relevance and faithful representation. 9 Basic Components of Accounting 4. Assumptions Monetary Unit Assumption ▪ Companies include in the accounting records only transaction data that can be expressed in money terms. Economic Entity Assumption ▪ Activities of the entity are kept separate and distinct from the activities of its owner and all other economic entities. ▪ Typical entity forms: proprietorship, partnership, corporation, etc. Going Concern Assumption ▪ A company will continue its business operations without going bankrupt as of the time the financial statements are prepared. 10 Basic Components of Accounting 4. Assumptions Time Period(Periodicity) Assumption (refer to chap.3) ▪ Companies divide the economic life of business into artificial time periods. ▪ Stakeholders want to know periodical operating performance (need to set accounting period) ▪ Quarterly/semi-annual/annual reporting ▪ Fiscal year vs. Calendar year Accrual basis accounting Assumption (refer to chap.3) ▪ Transactions are recorded in the periods in which the event occur cf. Cash basis accounting : Revenue are recorded when cash is received, and expenses are recorded when cash is paid out 11 Learning Objective 3 State the Accounting Equation and Define its Components. Accounting Equation Basic Accounting Equation Basic framework of accounting analysis when economic transactions occur Applicable to all economic entities regardless of their size. Always holds true 13 Accounting Equation Basic Accounting Equation Assets : ▪ Resources a business owns. ▪ Capacity to provide future services or benefits. ▪ Cash, inventories, property, plant, equipment, investments, etc. 14 Accounting Equation Basic Accounting Equation Liabilities: ▪ Claims against assets: Existing debts and obligations. ▪ When a company goes bankrupt, creditor claims are paid before ownership claims. ▪ Accounts payable, borrowings/loans, bond payable, etc. 15 Accounting Equation Basic Accounting Equation Equity : ▪ Ownership claim on a company’s total assets. ▪ Residual equity: The equity that’s “left over” after all creditors’ claims are paid. ▪ Share capital, retained earnings. ▪ Δ Retained earnings = Current Net income – Dividend 16 Accounting Equation How Assets, Liabilities, and Equity are presented in Statement of Financial Position Statement of Financial Position (or Balance Sheet) ASSETS LIABILITIES Accounts payable Cash Borrowings Accounts Receivable : Inventory Property(real estate) EQUITY Plant Equipment Share capital Retained earnings : Total = Total 17 always  Interrelationship between SFP and I/S SFP (B/S) I/S ASSETS LIABILITIES Revenue/Sales : EQUITY Share capital Expenses Retained earnings : Total = Total Net income always SFP reports assets, liabilities, and equity at a specific date (e.g. December 31) I/S presents revenues and expenses for a specific period of time (fiscal year) Balance of each account in SFP = Beginning balance + increase - decrease Retained earnings = Beginning balance of retained earnings + current net income - dividend (Ending balance) 18  Accounting Equation Equity Share capital—ordinary: ▪ The amounts paid in by shareholders for the ordinary shares they purchase. Dividends: ▪ Distribution of cash or other assets to shareholders from retained earnings. ▪ They are not an expense. Accounting Equation Equity Revenues: ▪ The gross increases in equity resulting from business activities e.g. Sales, Revenue from services, renting property, and lending money ▪ Revenues usually result in an increase in an asset. Expenses: ▪ The cost of assets consumed, or services used in the process of earning revenue. ▪ e.g. salaries, rent expenses, utilities, taxes, etc. Learning Objective 4 Analyze the Effects of Business Transactions on the Accounting Equation. Analyzing Business Transactions Accounting Information System: The system of collecting and processing transaction data and communicating financial information to decision-makers. The steps companies follow each period to record transactions and eventually prepare financial statements: Analyzing Business Transactions Identifying Accounting Transactions Transaction (1) Investment by Shareholders Assume: Ray and Barbara Neal decide to start a smartphone app development company that they incorporate as Softbyte SA. On September 1, 2020, they invest €15,000 cash in the business in exchange for €15,000 of ordinary shares. The ordinary shares indicates the ownership interest that the Neals have in Softbyte SA. Demonstrate: Basic and equation analysis of this transaction. Observe that the equality of the basic equation has been maintained. Note also that the source of the increase in equity (in this case, issued shares) is indicated. 24 Transaction(2) Purchase of Equipment for Cash Assume: Softbyte SA purchases computer equipment for €7,000 cash. Demonstrate: Basic and equation analysis of this transaction. This transaction results in an equal increase and decrease in total assets, though the composition of assets changes. 25  Transaction(3) Purchase of Supplies on Credit Assume: Softbyte SA purchases headsets (and other computer accessories expected to last several months) for €1,600 from Mobile Solutions. Mobile Solutions agrees to allow Softbyte to pay this bill in October. This transaction is a purchase on account (a credit purchase). Demonstrate: Basic and equation analysis of this transaction. Assets increase because of the expected future benefits of using the headsets and computer accessories, and liabilities increase by the amount due Mobile Solutions. 26  Transaction (4) Services Performed for Cash Assume: Softbyte SA receives €1,200 cash from customers for app development services it has performed. This transaction represents Softbyte’s principal revenue-producing activity. Recall that revenue increases equity. Demonstrate: Basic and equation analysis of this transaction. Recall that revenue increases equity. 27 Transaction (5) Purchase of Advertising on Credit Assume: Softbyte SA receives a bill for €250 from Programming News for advertising on its website but post pones payment until a later date. Demonstrate: Basic and equation analysis of this transaction. The two sides of the equation still balance at €17,800. Retained Earnings decreases when Softbyte incurs the expense. Expenses do not have to be paid in cash at the time they are incurred. When Softbyte pays at a later date, the liability Accounts Payable will decrease and the asset Cash will decrease [see Transaction (8)]. The cost of advertising is an expense (rather than an asset) because Softbyte has used the benefits. Advertising Expense is included in determining net income. Transaction (6) Services Performed for Cash & Credit Assume: Softbyte SA performs €3,500 of app development services for customers. The company receives cash of €1,500 from customers, and it bills the balance of €2,000 on account. Demonstrate: Basic and equation analysis of this transaction. This transaction results in an equal increase in assets and equity.  Transaction (7) Payment of Expenses Assume: Softbyte SA pays the following expenses in cash for September: office rent €600, salaries and wag es of employees €900, and utilities €200. Demonstrate: Basic and equation analysis of this transaction. This transaction results in an equal decrease in assets and equity. Transaction (8) Payment of Accounts Payable Assume: Softbyte SA pays its €250 Programming News bill in cash. The company previously [in Transaction (5)] recorded the bill as an increase in Accounts Payable and a decrease in equity. Demonstrate: Basic and equation analysis of this transaction. Observe that the payment of a liability related to an expense that has previously been recorded does not affect equity. Softbyte recorded the expense [in Transaction (5)] and should not record it again.  Transaction (9) Receipt of Cash on Account Assume: Softbyte SA receives €600 in cash from customers who had been billed for services [in Transaction (6)]. Demonstrate: Basic and equation analysis of this transaction. Transaction (9) does not change total assets, but it changes the composition of those assets. Note that the collection of an account receivable for services previously billed and recorded does not affect equity. Softbyte already recorded this revenue [in Transaction (6)] and should not record it again.  Transaction (10) Dividends Assume: The company pays a dividend of €1,300 in cash to Ray and Barbara Neal, the shareholders of Softbyte SA. This transaction results in an equal decrease in assets and equity. Demonstrate: Basic and equation analysis of this transaction. Note that the dividend reduces retained earnings, which is part of equity. Dividends are not expenses. Like shareholders’ investments, dividends are excluded in determining net income. Analyzing Business Transactions Softbyte SA: Tabular Analysis of Transactions Learning Objective 5 Describe the Five Financial Statements and How They are Prepared. Financial Statements: 1. Income Statement Presents the revenues and expenses and resulting net income or net loss for a specific period of time. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results. The income statement does not include investment and dividend transactions between shareholders and a company(→ Statement of changes in equity) Financial Statements: 2. Statement of Financial Position Reports the assets, liabilities, and equity of a company at a specific date. (Sometimes referred to as a balance sheet (US-GAAP)) The statement of financial position is like a snapshot of the company’s financial condition at a specific moment in time (usually month-end or year-end). Structure: ▪ Lists assets at the top, followed by equity and then liabilities. ▪ Total assets = Total liabilities + Total equity (always!) Financial Statements: 3. Statement of Changes in Equity Shows the changes in each equity account and in total equity during the year. When a statement of changes in equity is presented, retained earnings statement is not necessary. (considered one of the primary financial statements under IFRS, US-GAAP) cf. Retained earnings statement Summarizes the changes in retained earnings for a specific period of time. Can be a part of the statement of changes in equity or can be used as a supplementary statement providing additional details. Retained earnings(ending) = Retained earnings(beginning) + Current net income - Dividend Financial Statements: 4. Statement of Cash Flows Summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time. Structure: (1) the cash effects of a company’s operating activities during a period, (2) its investing activities, (3) its financing activities, (4) the net increase or decrease in cash during the period, and (5) the cash amount at the end of the period. Financial Statements: 5. Comprehensive Income Statement Presents other comprehensive income items that are not included in net income, but are considered important enough to be reported separately. May report both income statement and comprehensive income statement separately, or report one combined statement, statement of comprehensive income IFRS Alternative: ▪ IFRS allows an alternative statement format in which the information contained in the income statement and the comprehensive income statement are combined in a single statement, referred to as a statement of comprehensive income. (see Appendix A in textbook) Today’s Summary & Exercise 1. The historical cost principle dictates that companies record assets at their cost. However, in later period, the fair value of the asset must be used if fair value is higher than the cost. 2. Relevance means that financial information matches what really happened; the information is factual. 1. Service revenue 2. Dividend 1. The company purchased $2,000 of computer on credit 2. The company received $5,000 cash for products sale