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c01AccountinginAction.indd Page 2 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop Chapter 1 Accounting in Action...

c01AccountinginAction.indd Page 2 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop Chapter 1 Accounting in Action Feature Story Knowing the marketing, production, management, or information systems. Numbers In business, accounting is the means for Many students who take this course communicating the numbers. If you do not plan to be accountants. If you don’t know how to read financial are in that group, you might be statements, you can’t really know your thinking, “If I’m not going to be an business. accountant, why do I need to know accounting?” In response, consider the Many companies spend significant quote from Harold Geneen, the former resources teaching their employees chairman of a major international basic accounting so that they can read company: “To be good at your financial statements and understand business, you have to know the how their actions affect the company’s numbers—cold.” financial results. Employers need Tetra Images/SUPERSTOCK managers in all areas of the company Success in any business comes back to to be “financially literate.” the numbers. You will rely on them to make decisions, and managers will use Taking this course will go a long way them to evaluate your performance. to making you financially literate. In That is true whether your job involves this book, you will learn how to read The Navigator is a learning system designed to prompt you to use the learning aids in the Learning Objectives give you a framework for learning the chapter and set priorities as you study. specific concepts covered in the chapter. ✔ The Navigator Learning Objectives Scan Learning Objectives After studying this chapter, you should be able to: Read Feature Story 1 Explain what accounting is. Read Preview 2 Identify the users and uses of accounting. 3 Understand why ethics is a fundamental business concept. Read text and answer DO IT! p. 11 p. 14 p. 21 p. 25 4 Explain accounting standards and the measurement principles. 5 Explain the monetary unit assumption and the economic Work Comprehensive DO IT! p. 26 entity assumption. Review Summary of Learning Objectives 6 State the accounting equation, and define its components. 7 Analyze the effects of business transactions on the Answer Self-Test Questions accounting equation. Complete Assignments 8 Understand the four financial statements and how they are prepared. Go to WileyPLUS for practice and tutorials ✔ The Navigator Read Another Perspective p. 47 2 c01AccountinginAction.indd Page 3 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop and prepare financial statements, and how to use basic tools encourage you to visit each company’s website where you can to evaluate financial results. view its complete annual report. In examining the financial reports of these three companies, you Appendices A, B, and C of this will see that the accounting practices textbook provide real financial of companies in specific countries that statements of three companies from follow IFRS sometimes differ with Tetra Images/SUPERSTOCK different countries that report under regard to particular details. However, International Financial Reporting more importantly, you will find that Standards (IFRS): Samsung Electronics the basic accounting principles are the Co., Ltd. (KOR), Nestlé S.A. (CHE), same. As a result, by learning these and Zetar plc (GBR). Throughout this basic principles, as presented in this textbook, we increase your familiarity textbook, you will be well equipped to with financial reporting by providing begin understanding the financial results of companies around numerous references, questions, and exercises that encourage the world. you to explore these financial statements. In addition, we ✔ The Navigator The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business. You will find references to the story throughout the chapter. Preview of Chapter 1 The Feature Story highlights the importance of having good financial information and knowing how to use it to make effective business decisions. Whatever your pursuits or occupation, the need for financial information is inescapable. You cannot earn a living, spend money, buy on credit, make an investment, or pay taxes without receiving, using, or dispensing financial information. Good decision-making depends on good information. The purpose of this chapter is to show you that accounting is the The Preview describes and outlines the system used to provide useful financial information. The content major topics and subtopics you will see and organization of Chapter 1 are as follows. in the chapter. ACCOUNTING IN ACTION The Building Blocks The Basic Accounting Using the Accounting What Is Accounting? of Accounting Equation Equation Financial Statements Three activities Ethics in financial Assets Transaction analysis Income statement Who uses reporting Liabilities Summary of Retained earnings accounting data? Accounting Equity transactions statement standards Statement of Measurement financial position principles Statement of cash Assumptions flows ✔ The Navigator 3 c01AccountinginAction.indd Page 4 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop 4 1 Accounting in Action What Is Accounting? LEARNING OBJECTIVE 1 What consistently ranks as one of the top career opportunities in business? What frequently rates among the most popular majors on campus? Accounting.1 Why Explain what do people choose accounting? They want to acquire the skills needed to under- accounting is. stand what is happening financially inside a company. Accounting is the financial information system that provides these insights. In short, to understand an orga- nization of any type, you have to know the numbers. Essential terms are Accounting consists of three basic activities—it identifies, records, and printed in blue when they communicates the economic events of an organization to interested users. Let’s first appear, and are defined in the end-of-chapter take a c loser look at these three activities. glossary. Three Activities As a starting point to the accounting process, a company identifies the economic events relevant to its business. Examples of economic events are the sale of food and snacks by Unilever (GBR and NLD), the providing of telephone services by Chunghwa Telecom (TWN), and the manufacture of motor vehicles by Tata Motors (IND). Once a company like Unilever identifies economic events, it records those events in order to provide a history of its financial activities. Recording con- sists of keeping a systematic, chronological diary of events, measured in monetary units. In recording, Unilever also classifies and summarizes economic events. Finally, Unilever communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. To make the reported financial information meaningful, Unilever reports the recorded data in a standardized way. It accumulates infor- mation resulting from similar transactions. For example, Unilever accumulates all sales transactions over a certain period of time and reports the data as one amount in the company’s financial statements. Such data are said to be reported in the aggregate. By presenting the recorded data in the aggregate, the account- ing process simplifies a multitude of transactions and makes a series of activities understandable and meaningful. A vital element in communicating economic events is the accountant’s ability to analyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Appendix A of this textbook shows the financial statements of Samsung Electronics (KOR). Appendix B illustrates the financial statements of Nestlé (CHE), and Appendix C includes the financial statements of Zetar (GBR). We refer to these statements at various places throughout the text- book. (In addition, in the Another Perspective section at the end of each chapter, the U.S. company Tootsie Roll Industries is analyzed.) At this point, these finan- cial statements probably strike you as complex and confusing. By the end of this course, you’ll be surprised at your ability to understand, analyze, and interpret them. Illustration 1-1 summarizes the activities of the accounting process. 1 The appendix to this chapter describes job opportunities for accounting majors and explains why accounting is such a popular major. c01AccountinginAction.indd Page 5 20/04/12 10:23 PM user-F392 /Users/user-F392/Desktop What Is Accounting? 5 Communication Identification Recording Prepare accounting reports Identify economic events (transactions) Record, classify, and summarize NOK KIAIAeppoortrt l RRe nuuaal An A Analyze and interpret for users Illustration 1-1 You should understand that the accounting process includes the bookkeeping The activities of the function. Bookkeeping usually involves only the recording of economic events. It accounting process is therefore just one part of the accounting process. In total, accounting involves the entire process of identifying, recording, and communicating economic events.2 Who Uses Accounting Data? The specific financial information that a user needs depends upon the kinds of LEARNING OBJECTIVE 2 decisions the user makes. There are two broad groups of users of financial infor- mation: internal users and external users. Identify the users and uses of accounting. INTERNAL USERS Internal users of accounting information are managers who plan, organize, and run the business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, internal users Illustration 1-2 must answer many important questions, as shown in Illustration 1-2. Questions that internal users ask Questions Asked by Internal Users ST ON ST RIK r RIK E fai es E Un ctic r a P playlist itunes Brien's L. H.C.B. In Sgt. Pepper's Comes My Ship Cowboy? When Do Wia Gonna What is A Life Want All I MENU Snack ack ck k cchi chips ch hi h Beve Beverages ev eve e ve errage rag age age g Shareholder Finance Marketing Human Resources Management Is cash sufficient to pay What price for a Nokia cell phone Can we afford to give Which PepsiCo product line is dividends to will maximize the company's Toyota employees the most profitable? Should any SAP shareholders? net income? pay raises this year? product lines be eliminated? 2 The origins of accounting are generally attributed to the work of Luca Pacioli, an Italian Renaissance mathematician. Pacioli was a close friend and tutor to Leonardo da Vinci and a contemporary of Christopher Columbus. In his 1494 text Summa de Arithmetica, Geometria, Proportione et Proportionalite, Pacioli described a system to ensure that financial information was recorded efficiently and accurately. c01AccountinginAction.indd Page 6 20/04/12 7:13 PM user-F392 /Users/user-F392/Desktop 6 1 Accounting in Action To answer these and other questions, internal users need detailed informa- tion on a timely basis. Managerial accounting provides internal reports to help users make decisions about their companies. Examples are financial compari- sons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. EXTERNAL USERS External users are individuals and organizations outside a company who want financial information about the company. The two most common types of exter- nal users are investors and creditors. Investors (owners) use accounting infor- mation to make decisions to buy, hold, or sell ownership shares of a company. Creditors (such as suppliers and bankers) use accounting information to evalu- Illustration 1-3 ate the risks of granting credit or lending money. Illustration 1-3 shows some Questions that external questions that investors and creditors may ask. users ask Questions Asked by External Users Yeah! What do we do if they catch us? BILL COLLECTOR Investors Investors Creditors Is Royal Dutch Shell earning How does Disney compare in size Will Singapore Airlines be able satisfactory income? and profitability with Time Warner? to pay its debts as they come due? Financial accounting answers these questions. It provides economic and finan- cial information for investors, creditors, and other external users. The information needs of external users vary considerably. Taxing authorities, such as the State Administration of Taxation in the People’s Republic of China (CHN), want to know whether the company complies with tax laws. Regulatory agencies, such as the Autorité des Marchés Financiers (FRA) or the Federal Trade Commission (USA), want to know whether the company is operating within prescribed rules. Customers are interested in whether a company like General Motors (USA) will continue to honor product warranties and support its product lines. Labor unions, such as the German Confederation of Trade Unions (DEU), want to know whether the compa- nies have the ability to pay increased wages and benefits to union members. The Building Blocks of Accounting A doctor follows certain standards in treating a patient’s illness. An architect follows certain standards in designing a building. An accountant follows certain standards in reporting financial information. For these standards to work, a fundamental business concept must be at work—ethical behavior. Ethics in Financial Reporting LEARNING OBJECTIVE 3 People won’t gamble in a casino if they think it is “rigged.” Similarly, people won’t play the securities market if they think share prices are rigged. In recent Understand why ethics is years, the financial press has been full of articles about financial scandals at a fundamental business Enron (USA), Parmalat (ITA), Satyam Computer Services (IND), AIG (USA), concept. and others. As the scandals came to light, mistrust of financial reporting in general grew. One article in the financial press noted that “repeated disclosures c01AccountinginAction.indd Page 7 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop The Building Blocks of Accounting 7 about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent share prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting. The standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are ethics. Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations in busi- ness and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this book: 1. A number of the Feature Stories and other parts of the textbook discuss the central importance of ethical behavior to financial reporting. 2. Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings. 3. Many of the People, Planet, and Profit Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. 4. At the end of the chapter, an Ethics Case simulates a business situation and asks you to put yourself in the position of a decision-maker in that case. When analyzing these various ethics cases, as well as experiences in your own Illustration 1-4 life, it is useful to apply the three steps outlined in Illustration 1-4. Steps in analyzing ethics cases and situations 1. Recognize an ethical 2. Identify and analyze 3. Identify the alternatives, situation and the ethical the principal elements and weigh the impact of issues involved. in the situation. each alternative on various Use your personal ethics to Identify the stakeholders— stakeholders. identify ethical situations and persons or groups who may Select the most ethical #1 #2 issues. Some businesses and professional organizations be harmed or benefited. Ask the question: What are the alternative, considering all the consequences. Sometimes there ALT ALT provide written codes of responsibilities and obligations will be one right answer. Other ethics for guidance in some of the parties involved? situations involve more than business situations. one right solution; these situations require an evaluation of each and a selection of the best alternative. Insights provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. ETHICS INSIGHT Gemunu Amarasinghe/©AP/Wide World Photos 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 for 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 organiza- tion is subject to waste or theft. The accounting challenges of some large international not- for-profits rival those of the world’s largest businesses. For example, after the Haitian earth- quake, the Haitian-born musician Wyclef Jean was criticized for the poor accounting controls in a relief fund that he founded. Since then, he has hired a new accountant and improved the transparency regarding funds raised and spent. What benefits does a sound accounting system provide to a not-for-profit ? organization? (See page 46.) c01AccountinginAction.indd Page 8 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop 8 1 Accounting in Action Accounting Standards LEARNING OBJECTIVE 4 In order to ensure high-quality financial reporting, accountants present financial statements in conformity with accounting standards that are issued by standard- Explain accounting setting bodies. Presently, there are two primary accounting standard-setting standards and the bodies—the International Accounting Standards Board (IASB) and the Finan- measurement principles. cial Accounting Standards Board (FASB). More than 130 countries follow stan- dards referred to as International Financial Reporting Standards (IFRS). IFRSs are determined by the IASB. The IASB is headquartered in London, with its 15 board members drawn from around the world. Most companies in the United States follow standards issued by the FASB, referred to as generally accepted accounting principles (GAAP). As markets become more global, it is often desirable to compare the results of companies from different countries that report using different accounting stan- dards. In order to increase comparability, in recent years the two standard-setting bodies have made efforts to reduce the differences between IFRS and U.S. GAAP. This process is referred to as convergence. As a result of these convergence efforts, it is likely that someday there will be a single set of high-quality accounting stan- dards that are used by companies around the world. Because convergence is such an important issue, we provide at the end of each chapter a section called Another Perspective, to provide a comparison with IFRS. Measurement Principles Helpful Hint IFRS generally uses one of two measurement principles, the historical cost prin- Relevance and faithful ciple or the fair value principle. Selection of which principle to follow generally representation are two relates to trade-offs between relevance and faithful representation. Relevance primary qualities that means that financial information is capable of making a difference in a deci- make accounting sion. Faithful representation means that the numbers and descriptions match information useful for what really existed or happened—they are factual. decision-making. Helpful Hints further clarify concepts being HISTORICAL COST PRINCIPLE discussed. The 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. For example, if Gazprom (RUS) purchases land for py 300,000, the company initially reports it in its accounting records at py 300,000. But what does Gazprom do if, by the end of the next year, the fair value of the land has increased to py 400,000? Under the historical cost principle, it continues to report the land at py 300,000. FAIR VALUE PRINCIPLE The 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). Fair value infor- mation may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market value information is usually readily available for these types of assets. In determining which measurement principle to use, companies weigh the factual nature of cost figures versus the relevance of fair value. In general, even though IFRS allows companies to revalue property, plant, and equipment and other long-lived assets to fair value, most companies choose to use cost. Only in situations where assets are actively traded, such as investment securities, do companies apply the fair value principle extensively. c01AccountinginAction.indd Page 9 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop The Building Blocks of Accounting 9 INTERNATIONAL INSIGHT The Korean Discount If you think that accounting standards don’t matter, consider recent events in South Korea. International investors expressed concerns that the financial reports of some South Korean companies were inaccurate. Accounting practices sometimes resulted in differences between stated revenues and actual revenues. Because investors did not have complete faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these compa- nies relative to shares of comparable companies in different countries. This difference in share price was referred to as the “Korean discount.” SeongJoon Cho/Bloomberg/Getty Images, Inc. In response, Korean regulators decided to require companies to comply with international accounting standards. This change was motivated by a desire to “make the country’s busi- nesses more transparent” in order to build investor confidence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the interna- tional standards. Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007). What is meant by the phrase “make the country’s businesses more transparent”? ? Why would increasing transparency spur economic growth? (See page 46.) Assumptions Assumptions provide a foundation for the accounting process. Two main assump- LEARNING OBJECTIVE 5 tions are the monetary unit assumption and the economic entity assumption. Explain the monetary MONETARY UNIT ASSUMPTION unit assumption and The monetary unit assumption requires that companies include in the account- the economic entity ing records only transaction data that can be expressed in money terms. assumption. This assumption enables accounting to quantify (measure) economic events. The monetary unit assumption is vital to applying the historical cost principle. This assumption prevents the inclusion of some relevant information in the accounting records. For example, the health of a company’s owner, the quality of service, and the morale of employees are not included. The reason: Compa- nies cannot quantify this information in money terms. Though this informa- tion is important, companies record only events that can be measured in money. Throughout this textbook, we use a variety of currencies in our examples and end-of-chapter materials. The currencies and the associated country or region are shown in Illustration 1-5. Illustration 1-5 Brazil, real R$ South Africa, rand R Currencies used in China, yuan renminbi ¥ South Korea, won W this textbook Europe, euro € Switzerland, Swiss franc CHF Hong Kong, dollar HK$ Taiwan, new dollar NT$ India, rupee Rs Turkey, lira Indonesia, rupia Rp United Kingdom, pound £ Japan, yen ¥ United States, dollar $ Russia, ruble py c01AccountinginAction.indd Page 10 01/05/12 9:22 AM user-F392 /Users/user-F392/Desktop 10 1 Accounting in Action Ethics Notes help sensitize ECONOMIC ENTITY ASSUMPTION you to some of the ethical An economic entity can be any organization or unit in society. It may be a issues in accounting. company [such as Telefónica (ESP)], a governmental unit (the city-state of Singapore), a municipality (Toronto, Canada), a school district (St. Louis District 48), or a church (Southern Baptist). The economic entity assump- Ethics Note tion requires that the activities of the entity be kept separate and distinct The importance of the economic from the activities of its owner and all other economic entities. To illus- entity assumption is illustrated by trate, Sally Rider, owner of Sally’s Boutique, must keep her personal living scandals involving Adelphia (USA). costs separate from the expenses of the boutique. Similarly, Metro (DEU) In this case, senior company em- and Coca-Cola (USA) are segregated into separate economic entities for ployees entered into transactions accounting purposes. that blurred the line between the employees’ financial interests and those of the company. For example, PROPRIETORSHIP A business owned by one person is generally a pro- Adelphia guaranteed over $2 billion prietorship. The owner is often the manager/operator of the business. of loans to the founding family. Small service-type businesses (plumbing companies, beauty salons, and auto repair shops), farms, and small retail stores (antique shops, clothing stores, and used-book stores) are often proprietorships. Usually only a relatively small amount of money (capital) is necessary to start in business as a pro- prietorship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable for all debts of the business. There is no legal distinc- tion between the business as an economic unit and the owner, but the accounting records of the business activities are kept separate from the personal records and activities of the owner. PARTNERSHIP A business owned by two or more persons associated as partners is a partnership. In most respects a partnership is like a proprietorship except that more than one owner is involved. Typically a partnership agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner. Each partner generally has unlimited personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes the part- nership transactions must be kept separate from the personal activities of the partners. Partnerships are often used to organize retail and service-type busi- nesses, including professional practices (lawyers, doctors, architects, and char- tered public accountants). CORPORATION A business organized as a separate legal entity under corpora- tion law and having ownership divided into transferable shares is a corpora- tion. The holders of the shares (shareholders) enjoy limited liability; that is, they are not personally liable for the debts of the corporate entity. Shareholders may transfer all or part of their ownership shares to other investors at any time (i.e., sell their shares). The ease with which ownership can change adds to the attractiveness of investing in a corporation. Because ownership can be trans- ferred without dissolving the corporation, the corporation enjoys an unlimited life. Although the combined number of proprietorships and partnerships in the world significantly exceeds the number of corporations, the revenue produced by corporations is much greater. Most of the largest companies in the world—for example, ING (NLD), Royal Dutch Shell (GBR and NLD), Wal-Mart Stores Inc. (USA), Fortis (BEL), and Toyota (JPN)—are corporations. c01AccountinginAction.indd Page 11 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop The Building Blocks of Accounting 11 > DO IT! Basic Concepts Indicate whether each of the five statements presented below is true or false. 1. The three steps in the accounting process are identification, recording, and communication. The DO IT! exercises ask 2. The two most common types of external users are investors and company officers. you to put newly acquired 3. Shareholders in a corporation enjoy limited legal liability as compared to partners in a knowledge to work. They partnership. outline the Action Plan necessary to complete the 4. The primary accounting standard-setting body outside the United States is the Inter- exercise, and they show a national Accounting Standards Board (IASB). Solution. 5. The historical cost principle dictates that companies record assets at their cost. In later periods, however, the fair value of the asset must be used if fair value is higher than its cost. Solution Action Plan 1. True 2. False. The two most common types of external users are investors and ✔ Review the basic concepts learned to creditors. 3. True. 4. True. 5. False. The historical cost principle dictates that com- date. panies record assets at their cost. Under the historical cost principle, the company ✔ Develop an under- must also use cost in later periods. standing of the key Related exercise material: E1-1, E1-2, E1-3, E1-4, and DO IT! 1-1. terms used. ✔ The Navigator ACCOUNTING ACROSS THE ORGANIZATION Spinning the Career Wheel One question that students frequently ask is, “How will the study of accounting help me?” It should help you a great deal because a working knowledge of accounting is desirable for virtu- ally every field of endeavor. Some examples of how accounting is used in other careers include: General management: Imagine running Volkswagen (DEU), Massachusetts General Hospital (USA), a Subway (USA) franchise, or a Fuji (JPN) bike shop. All general managers need to understand where the enterprise’s cash comes from and where it goes in order to make wise business decisions. Marketing: A marketing specialist at a company like Hyundai Motor (KOR) develops strate- gies to help the sales force be successful. But making a sale is meaningless unless it is a profit- able sale. Marketing people must be sensitive to costs and benefits, which accounting helps © Josef Volavka/iStockphoto them quantify and understand. Finance: Do you want to be a banker for Société Générale (FRA) or an investment analyst for Goldman Sachs (USA)? These fields rely heavily on accounting. In all of them, you will regu- larly examine and analyze financial statements. In fact, it is difficult to get a good finance job without two or three courses in accounting. Real estate: Are you interested in being a real estate broker for Prudential Real Estate (USA)? Because a third party—the bank—is almost always involved in financing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash flow from an industrial property justify the purchase price? What are the tax benefits of the purchase? How might accounting help you? (See page 47.) ? c01AccountinginAction.indd Page 12 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop 12 1 Accounting in Action The Basic Accounting Equation LEARNING OBJECTIVE 6 The two basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. For example, adidas (DEU) has total assets State the accounting of approximately €10.6 billion. Liabilities and owner’s equity are the rights or equation, and define its claims against these resources. Thus, adidas has €10.6 billion of claims against components. its €10.6 billion of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called equity. adidas has liabilities of €6.0 billion and equity of €4.6 billion. We can express the relationship of assets, liabilities, and equity as an equa- tion, as shown in Illustration 1-6. Illustration 1-6 The basic accounting equation Assets ⫽ Liabilities ⫹ Equity This relationship is the basic accounting equation. Assets must equal the sum of liabilities and equity. The accounting equation applies to all economic entities regardless of size, nature of business, or form of business organization. It applies to a small pro- prietorship such as a corner grocery store as well as to a giant corporation such as adidas. The equation provides the underlying framework for recording and summarizing economic events. Let’s look in more detail at the categories in the basic accounting equation. Assets As noted above, assets are resources a business owns. The business uses its assets in carrying out such activities as production and sales. The common characteristic possessed by all assets is the capacity to provide future services or benefits. In a business, that service potential or future economic benefit eventually results in cash inflows (receipts). For example, consider Campus Pizza, a local restaurant. It owns a delivery truck that provides economic benefits from delivering pizzas. Other assets of Campus Pizza are tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash. Liabilities Liabilities are claims against assets—that is, existing debts and obligations. Busi- nesses of all sizes usually borrow money and purchase merchandise on credit. These economic activities result in payables of various sorts: Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages on credit from suppliers. These obligations are called accounts payable. Campus Pizza also has a note payable to First National Bank for the money borrowed to purchase the delivery truck. Campus Pizza may also have salaries and wages payable to employees and sales and real estate taxes payable to the local government. All of these persons or entities to whom Campus Pizza owes money are its creditors. Creditors may legally force the liquidation of a business that does not pay its debts. In that case, the law requires that creditor claims be paid before ownership claims. c01AccountinginAction.indd Page 13 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop The Basic Accounting Equation 13 Equity The ownership claim on total assets is equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are claimed by either creditors or shareholders. To find out what belongs to shareholders, we subtract creditors’ claims (the liabilities) from the assets. The remainder is the shareholders’ claim on the assets—equity. It is often referred to as residual equity—that is, the equity “left over” after creditors’ claims are satisfied. Equity generally consists of (1) share capital—ordinary and (2) retained earnings. SHARE CAPITAL—ORDINARY A corporation may obtain funds by selling ordinary shares to investors. Share capital—ordinary is the term used to describe the amounts paid in by share- holders for the ordinary shares they purchase. RETAINED EARNINGS Retained earnings is determined by three items: revenues, expenses, and dividends. REVENUES Revenues are the gross increases in equity resulting from busi- Helpful Hint ness activities entered into for the purpose of earning income. Generally, The effect of revenues is revenues result from selling merchandise, performing services, renting property, positive—an increase in and lending money. equity coupled with an Revenues usually result in an increase in an asset. They may arise from increase in assets or a decrease in liabilities. different sources and are called various names depending on the nature of the business. Campus Pizza, for instance, has two categories of sales revenues— pizza sales and beverage sales. Other titles for and sources of revenue common to many businesses are sales, fees, services, commissions, interest, dividends, royalties, and rent. EXPENSES Expenses are the cost of assets consumed or services used in the Helpful Hint process of earning revenue. They are decreases in equity that result from The effect of expenses is operating the business. Like revenues, expenses take many forms and are called negative—a decrease in various names depending on the type of asset consumed or service used. For equity coupled with a example, Campus Pizza recognizes the following types of expenses: cost of decrease in assets or an increase in liabilities. ingredients (flour, cheese, tomato paste, meat, mushrooms, etc.); cost of beverages; wages expense; utilities expense (electric, gas, and water expense); telephone expense; delivery expense (gasoline, repairs, licenses, etc.); supplies expense (napkins, detergents, aprons, etc.); rent expense; interest expense; and property tax expense. DIVIDENDS Net income represents an increase in net assets which is then avail- able to distribute to shareholders. The distribution of cash or other assets to shareholders is called a dividend. Dividends reduce retained earnings. However, dividends are not an expense. A corporation first determines its revenues and expenses and then computes net income or net loss. If it has net income, and decides it has no better use for that income, a corporation may decide to distribute a dividend to its owners (the shareholders). 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. These relationships are shown in Illustration 1-7 (page 14). c01AccountinginAction.indd Page 14 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop 14 1 Accounting in Action Illustration 1-7 Increases and decreases in INCREASES DECREASES equity Investments by shareholders Dividends to shareholders Equity Revenues Expenses > DO IT! 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. (1) Rent Expense (3) Dividends Action Plan (2) Service Revenue (4) Salaries and Wages Expense ✔ Understand the sources of revenue. Solution ✔ Understand what causes expenses. 1. Rent Expense is an expense (E); it decreases equity. 2. Service Revenue is a ✔ Review the rules for revenue (R); it increases equity. 3. Dividends is a distribution to shareholders (D); changes in equity: it decreases equity. 4. Salaries and Wages Expense is an expense (E); it decreases Investments and rev- equity. enues increase equity. Expenses and divi- Related exercise material: BE1-1, BE1-2, BE1-3, BE1-4, BE1-5, BE1-8, BE1-9, E1-5, E1-6, E1-7, dends decrease equity. and DO IT! 1-2. ✔ Recognize that divi- dends are distributions ✔ The Navigator of cash or other assets to shareholders. Using the Accounting Equation LEARNING OBJECTIVE 7 Transactions (business transactions) are a business’s economic events recorded by accountants. Transactions may be external or internal. External transactions Analyze the effects of involve economic events between the company and some outside enterprise. For business transactions on example, Campus Pizza’s purchase of cooking equipment from a supplier, payment the accounting equation. of monthly rent to the landlord, and sale of pizzas to customers are external trans- actions. Internal transactions are economic events that occur entirely within one company. The use of cooking and cleaning supplies are internal transactions for Campus Pizza. Companies carry on many activities that do not represent business transac- tions. Examples are hiring employees, answering the telephone, talking with customers, and placing merchandise orders. Some of these activities may lead to business transactions: Employees will earn wages, and suppliers will deliver ordered merchandise. The company must analyze each event to find c01AccountinginAction.indd Page 15 23/04/12 10:49 AM user-F408 /Users/user-F408/Desktop Using the Accounting Equation 15 out if it affects the components of the accounting equation. If it does, the com- pany will record the transaction. Illustration 1-8 demonstrates the transaction- identification process. Bank Home Accounting Ballence Events Z Purchase computer Discuss product design with Pay rent potential customer Criterion Is the financial position (assets, liabilities, or equity) of the company changed? Yes No Yes Don't Record Record record Record/ Don’t Record Illustration 1-8 Transaction-identification process Each transaction must have a dual effect on the accounting equation. For exam- ple, if an asset is increased, there must be a corresponding (1) decrease in another asset, (2) increase in a specific liability, or (3) increase in equity. Two or more items could be affected. For example, as one asset is increased $10,000, another asset could decrease $6,000 and a liability could increase $4,000. Any change in a liability or ownership claim is subject to similar analysis. Transaction Analysis In order to analyze transactions, we will examine a computer programming business (Softbyte Inc.) during its first month of operations. As part of this analy- sis, we will expand the basic accounting equation. This will allow us to better illustrate the impact of transactions on equity. Recall that equity is comprised of two parts: share capital—ordinary and retained earnings. Share capital— ordinary is affected when the company issues new ordinary shares in exchange for cash. Retained earnings is affected when the company earns revenue, incurs expenses, or pays dividends. Illustration 1-9 (page 16) shows the expanded ac- counting equation. If you are tempted to skip ahead after you’ve read a few of the following transaction analyses, don’t do it. Each has something unique to teach, something you’ll need later. (We assure you that we’ve kept them to the minimum needed!) c01AccountinginAction.indd Page 16 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop 16 1 Accounting in Action Assets ⫽ Liabilities ⫹ Equity Share ⫹ Retained Earnings Capital—Ordinary Revenues ⫺ Expenses ⫺ Dividends Illustration 1-9 Expanded accounting equation Helpful Hint TRANSACTION 1. INVESTMENT BY SHAREHOLDERS Ray and Barbara Neal You will want to study decide to open a computer programming company that they incorporate as Softbyte these transactions until Inc. On September 1, 2014, they invest €15,000 cash in the business in exchange you are sure you under- for €15,000 of ordinary shares. The ordinary shares indicates the ownership stand them. They are not interest that the Neals have in Softbyte Inc. This transaction results in an equal difficult, but understanding them is important to your increase in both assets and equity.3 success in this course. The ability to analyze transactions in terms of Basic The asset Cash increases €15,000, and equity identified as Share Capital— the basic accounting equation is essential in Analysis Ordinary increases €15,000. accounting. Assets 5 Liabilities 1 Equity Equation Share Cash 5 Analysis Capital (1) 1€15,000 5 1€15,000 Issued Shares 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. Why does this matter? Because investments by shareholders do not represent revenues, and they are excluded in determining net income. Therefore, it is nec- essary to make clear that the increase is an investment rather than revenue from operations. Additional investments (i.e., investments made by shareholders after the corporation has been initially formed) have the same effect on equity as the initial investment. TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte Inc. pur- chases computer equipment for €7,000 cash. This transaction results in an equal increase and decrease in total assets, though the composition of assets changes. 3 For the illustrative equations that follow, we use the general account title “Share Capital” instead of “Share Capital—Ordinary” for space considerations. c01AccountinginAction.indd Page 17 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop Using the Accounting Equation 17 Basic Cash decreases €7,000, and the asset Equipment increases €7,000. Analysis Assets 5 Liabilities 1 Equity Cash 1 Equipment 5 Share Capital Equation €15,000 €15,000 Analysis (2) 27,000 1€7,000 ⎧€ 8,000 1 € 7,000 5 €15,000 ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎩ €15,000 Observe that total assets are still €15,000. Share Capital—Ordinary also remains at €15,000, the amount of the original investment. TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte Inc. purchases for €1,600 from Acme Supply Company computer paper and other supplies expected to last several months. Acme agrees to allow Softbyte to pay this bill in October. This transaction is a purchase on account (a credit purchase). Assets increase because of the expected future benefits of using the paper and supplies, and liabilities increase by the amount due Acme Company. Basic The asset Supplies increases €1,600, and the liability Accounts Payable increases by €1,600. Analysis Assets 5 Liabilities 1 Equity Accounts Share Cash 1 Supplies 1 Equipment 5 1 Payable Capital Equation €8,000 €7,000 €15,000 Analysis (3) 1€1,600 1€1,600 €8,000 1 € 1,600 1 €7,000 5 € 1,600 1 €15,000 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ €16,600 €16,600 Total assets are now €16,600. This total is matched by a €1,600 creditor’s claim and a €15,000 ownership claim. TRANSACTION 4. SERVICES PROVIDED FOR CASH Softbyte Inc. receives €1,200 cash from customers for programming services it has provided. This transaction represents Softbyte’s principal revenue-producing activity. Recall that revenue increases equity. Basic Cash increases €1,200, and revenues (specifically, Service Revenue) increase €1,200. Analysis Assets 5 Liabilities 1 Equity Accounts Share Retained Earnings Cash 1 Supplies 1 Equipment 5 Payable 1 1 Capital Rev. 2 Exp. 2 Div. Equation €8,000 €1,600 €7,000 €1,600 €15,000 Analysis (4) 11,200 1€1,200 Service Revenue €9,200 1 €1,600 1 €7,000 5 €1,600 1 €15,000 1 € 1,200 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ €17,800 €17,800 c01AccountinginAction.indd Page 18 20/04/12 9:46 AM user-F392 /Users/user-F392/Desktop 18 1 Accounting in Action The two sides of the equation balance at €17,800. Service Revenue is included in determining Softbyte’s net income. Note that we do not have room to give details for each individual revenue and expense account in this illustration. Thus, revenues (and expenses when we get to them) are summarized under one column heading for Revenues and one for Expenses. However, it is important to keep track of the category (account) titles affected (e.g., Service Revenue) as they will be needed when we prepare financial statements later in the chapter. TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT Softbyte receives a bill for €250 from the Daily News for advertising but postpones payment until a later date. This transaction results in an increase in liabilities and a decrease in equity. Basic Accounts Payable increases €250, and equity decreases €250 due to Advertising Expense. Analysis Assets 5 Liabilities 1 Equity Accounts Share Retained Earnings Cash 1 Supplies 1 Equipment 5 Payable 1 Capital 1 Rev. 2 Exp. 2 Div. Equation €9,200 €1,600 €7,000 €1,600 €1