Chapter 1. Accounting In Action PDF

Chapter1. Accounting in Action This slide deck contains animations. Please disable animations if they cause issues with your device. Copyright © John Wiley & Sons, Inc. Chapter Outline Copyright © John Wiley & Sons, Inc. Learning Objective 1 Iden...

Chapter1. Accounting in Action This slide deck contains animations. Please disable animations if they cause issues with your device. Copyright © John Wiley & Sons, Inc. Chapter Outline Copyright © John Wiley & Sons, Inc. Learning Objective 1 Identify the activities and users associated with accounting. Copyright © John Wiley & Sons, Inc. LO 1 Accounting Activities Three Activities Illustration 1.1: The activities of the accounting process. Copyright © John Wiley & Sons, Inc. LO 1 Financial Information User Groups Internal: Managers who plan, organize, and run the business. o Rely on managerial accounting for decision-making. o Examples: Marketing, production, finance managers. External: Users outside of the organization. o Rely on financial accounting for decision-making. o Examples: Investors and creditors. Copyright © John Wiley & Sons, Inc. LO 1  Internal Users Illustration 1.2: Questions that internal users ask. ▪ To answer these questions Detailed information is needed on a timely basis Examples: financial comparison of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year Copyright © John Wiley & Sons, Inc. LO 1  External Users Illustration 1.3: Questions that external users ask. Copyright © John Wiley & Sons, Inc. LO 1 Additional External Users Taxing authorities: Does the company comply with the tax laws? Regulatory agencies: Is the company operating within prescribed rules? Customers: Will the company continue to honor product warranties and support its product lines? Labor unions: Does the company have the ability to pay increased wages and benefits to union members? Copyright © John Wiley & Sons, Inc. LO 1 DO IT! 1: Basic Concepts Copyright © John Wiley & Sons, Inc. LO 1  DO IT! 1: Basic Concepts Solution 1. True. 2. False. Bookkeeping involves only the recording step. 3. False. Accountants analyze and interpret information in reports as part of the communication step. 4. False. The two most common types of external users are investors and creditors. 5. True. Copyright © John Wiley & Sons, Inc. LO 1 Learning Objective 2 Explain the building blocks of accounting: ethics, principles, and assumptions. Copyright © John Wiley & Sons, Inc. LO 2  Ethics in Financial Reporting Illustration 1.5: Steps in analyzing ethics cases and situations. ▪ Effective financial reporting depends on sound ethical behavior. Copyright © John Wiley & Sons, Inc. LO 2 Accounting Standards Ensure high-quality financial reporting, , financial statements must adhere to accounting standards issued by standard-setting bodies. Primary accounting standard-setting bodies: International Accounting Standards Board (IASB) o Determines International Financial Reporting Standards (IFRS) o Used in more than 150 countries Financial Accounting Standards Board (FASB) o Determines generally accepted accounting principles (GAAP) o Used by most companies in the U.S. Copyright © John Wiley & Sons, Inc. LO 2 Measurement Principles IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. Historical cost principle (or cost principle): dictates that companies record assets at their cost. This is true not only at the time the asset is purchased, but also over the time the asset is held. 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), value in use (present value of future cash flows), or current cost (replacement cost). Copyright © John Wiley & Sons, Inc. LO 2 Selecting Measurement Principles Selection of which principle to follow generally relates to trade- offs between relevance and faithful representation. Relevance means that financial information is capable of making a difference in a decision. Faithful representation means that the numbers and descriptions match what really existed or happened—they are factual. Copyright © John Wiley & Sons, Inc. LO 2 Assumptions Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary unit assumption and the economic entity assumption. o Monetary unit assumption: requires that companies include in the accounting records only transaction data that can be expressed in money terms. o Economic Entity Assumption: requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. ▪ Typical entity forms are proprietorship, partnership, corporation. Copyright © John Wiley & Sons, Inc. LO 2 DO IT! 2: Building Blocks of Accounting Copyright © John Wiley & Sons, Inc. LO 2  DO IT! 2: Building Blocks of Accounting Solution 1. True. 2. True. 3. False. The historical cost principle dictates that companies record assets at their cost. Under the historical cost principle, the company must also use cost in later periods. 4. False. Faithful representation means that financial information matches what really happened; the information is factual. 5. True. Copyright © John Wiley & Sons, Inc. LO 2 Learning Objective 3 State the accounting equation, and define its components. Copyright © John Wiley & Sons, Inc. LO 3 The Accounting Equation The Basic Accounting Equation Assets = Liabilities + Equity Illustration 1.6: The basic accounting equation. Assets: resources a business owns. Liabilities: claims against assets, i.e. existing debts and obligations. Equity: the ownership claim on a company’s total assets. Copyright © John Wiley & Sons, Inc. LO 3  Equity Illustration 1.7: Increases and decreases in equity. Share capital—ordinary: describes the amounts paid in by shareholders for the ordinary shares they purchase. Revenues: are the gross increases in equity resulting from business activities entered into for the purpose of earning income. Revenues usually result in an increase in an asset. Expenses: are the cost of assets consumed or services used in the process of earning revenue. Dividends: are distribution of cash or other assets to shareholders. They are not an expense. Copyright © John Wiley & Sons, Inc. LO 3 DO IT! 3: Equity Effects Classify the following items as issuance of shares (I), dividends (D), revenues (R), or expenses (E). Then indicate whether each item increases or decreases equity. a. Rent Expense b. Service Revenue c. Dividends d. Salaries and Wage Expense Copyright © John Wiley & Sons, Inc. LO 3 Learning Objective 4 Analyze the effects of business transactions on the accounting equation. Copyright © John Wiley & Sons, Inc. LO 4 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: Copyright © John Wiley & Sons, Inc. LO 4 Accounting Transactions Illustration 1.8: The transaction identification process. Copyright © John Wiley & Sons, Inc. LO 4 Transaction Analysis Illustration 1.9: Expanded accounting equation. Copyright © John Wiley & Sons, Inc. LO 4 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, 2025, 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. Copyright © John Wiley & Sons, Inc. LO 4 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. Copyright © John Wiley & Sons, Inc. LO 4 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. Copyright © John Wiley & Sons, Inc. LO 4 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. Copyright © John Wiley & Sons, Inc. LO 4 Transaction (5). Purchase of Advertising on Credit. Assume: Softbyte SA receives a bill for €250 from Programming News for advertising on its website but postpones 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. The cost of advertising is an expense because Softbyte has used the benefits. Advertising Expense is included in determining net income. Copyright © John Wiley & Sons, Inc. LO 4 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. Copyright © John Wiley & Sons, Inc. LO 4 Transaction (7). Payment of Expenses. Assume: Softbyte SA pays the following expenses in cash for September: office rent €600, salaries and wages 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. Copyright © John Wiley & Sons, Inc. LO 4 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. Copyright © John Wiley & Sons, Inc. LO 4 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. Copyright © John Wiley & Sons, Inc. LO 4 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. Total assets did not change, but the composition of those assets did. 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. Copyright © John Wiley & Sons, Inc. LO 4 Tabular Summary Illustration 1.10: Tabular summary of Softbyte SA transactions Copyright © John Wiley & Sons, Inc. LO 4 Summarizing Transactions Key Points 1. Each transaction must be analyzed in terms of its effect on: a. The three components of the basic accounting equation. b. Specific types (kinds) 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. Copyright © John Wiley & Sons, Inc. LO 4 DO IT! 4: Tabular Analysis Transactions made by Virmari & Co., a public accounting firm in France, for the month of August are shown below. Prepare a tabular analysis which shows the effects of these transactions on the expanded accounting equation, similar to that shown in Illustration 1.10. 1. The company issued ordinary shares for €25,000 cash. 2. The company purchased €7,000 of office equipment on credit. 3. The company received €8,000 cash in exchange for services performed. 4. The company paid €850 for this month’s rent. 5. The company paid a dividend of €1,000 in cash to shareholders. Copyright © John Wiley & Sons, Inc. LO 4 DO IT! 4: Tabular Analysis – Solution Copyright © John Wiley & Sons, Inc. LO 4 Learning Objective 5 Describe the five financial statements and how they are prepared. Copyright © John Wiley & Sons, Inc. LO 5 Financial Statements 1. Income statement: presents the revenues and expenses and resulting net income or net loss for a specific period of time. 2. Retained earnings statement: summarizes the changes in retained earnings for a specific period of time. 3. Statement of financial position: reports the assets, liabilities, and equity of a company at a specific date. (Sometimes referred to as a balance sheet.) 4. Statement of cash flows: summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time. 5. Comprehensive income statement: presents other comprehensive income items that are not included in the determination of net income in 1. Copyright © John Wiley & Sons, Inc. LO 5  Financial Statement Connections Income Statement Net income is computed first Retained Earnings Statement and is needed to determine the ending balance in retained earnings. Statement of Financial Position The ending balance in retained earnings is needed in preparing the statement of financial position. The cash shown on the Statement of Cash Flows statement of financial position is needed in preparing the Illustration 1.11: Financial statement of cash flows. statements and their interrelationships Copyright © John Wiley & Sons, Inc. LO 5 Income Statement The income statement lists revenues first, followed by expenses. Then, the statement shows net income (or net loss). Structure: The income statement lists revenues first, followed by expenses. Then, the statement shows net income (or net loss). 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 the shareholders and the business in measuring net income. Copyright © John Wiley & Sons, Inc. LO 5 Net Income 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. Copyright © John Wiley & Sons, Inc. LO 5 Retained Earnings Statement The information provided by this statement indicates the reasons why retained earnings increased or decreased during the period. If there is a net loss, it is deducted with dividends in the retained earnings statement. Structure: The first line of the statement shows the beginning retained earnings amount. Then add net income (or subtract net loss) and subtract dividends. The retained earnings ending balance is the final amount on the statement. Copyright © John Wiley & Sons, Inc. LO 5 Statement of Financial Position The statement of financial position is like a snapshot of the company’s financial condition at a specific moment in time (usually the month-end or year-end). Structure: Lists assets at the top, followed by equity and then liabilities. Total assets must equal total equity and liabilities. When two or more liabilities are involved, a customary way of listing is as shown in Illustration 1.12: Illustration 1.12: Presentation of liabilities. Copyright © John Wiley & Sons, Inc. LO 5 Statement of Cash Flows The statement of cash flows provides information on the cash receipts and payments for a specific period of time. Structure: The statement of cash flows reports 1) the cash effects of a company’s operations 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. Copyright © John Wiley & Sons, Inc. LO 5 Comprehensive Income Statement Other comprehensive income items are not part of net income but are considered important enough to be reported separately. This statement immediately follows the income statement. Illustration 1.13: Comprehensive income statement 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. Copyright © John Wiley & Sons, Inc. LO 5 DO IT! 5: Financial Statement Items Copyright © John Wiley & Sons, Inc. LO 5 DO IT! 5: Financial Statement Items – Solution Solution Copyright © John Wiley & Sons, Inc. LO 5