Lecture Notes

Chapter 1 Lecture Notes

Accounting is used everyday in both our business and personal lives.

This chapter looks at what a business is, how it operates, and the role that accounting plays in that business.

This chapter deals with a lot of terms used in the accounting and business world. Be sure to read over these terms. There is a glossary in the textbook.

Nature of Business

There is a discussion of for-profit and nonprofit businesses. The book discusses the differences. However, even the nonprofit organization must be able to cover their costs. Nonprofit organizations that do well are generally run similar to for-profit organizations.

Business on Stage on page 3 discusses the factors of production. The factors of production common to all businesses are natural resources, labor, capital, and entrepreneurs.

Business on Stage on page 5 discusses the characteristics of an entrepreneur. What makes an entrepreneur successful?

There are three types of for-profit businesses and each has unique characteristics. These are listed on pages 2-3.

Manufacturing Businesses - produce the products

Merchandising Businesses - sells the product for the manufacturer

Service Businesses - provide services rather than products (note the comment in the "Real World" that roughly eight out of every ten workers in the U.S. are service providers).

There are three forms of business organizations:

Proprietorship - owned by one person

Partnership - owned by two or more individuals

Corporation - separate legal entity with ownership through the sale of stock

Proprietorship:

Primary advantage is the ease of formation. Generally anyone can start a business under this format.

Primary disadvantage is that the owner's personal belongings are not protected should the business go under.

There is one tax return for the owner who combines both the personal and business income and expenses.

Partnerships:

There are many variations of this format such as a Limited Liability Partnership or LLP.

The main advantage is that there is more availability of capital to start the business and someone to share the debts.

Depending on the type of partnership, the owners may still be held personally liable for the business debt.

Upon the death of a partner the business dissolves and a new one must be formed.

Income or Losses for the business are carried over to the owner's tax return using a Schedule K-1 Partnership Share of Income, Credits, and Deductions.

Corporation:

This form protects the owners from the business debt as long as he or she does not personally guarantee the business debt.

Can you imagine buying stock in Exxon Corporation if you were liable for the company's debt personally? No Way!!!!! This is why the corporation is a separate entity of it's own.

Gives the ability to obtain large amounts of resources (dollars) by issuing (selling) stock.

Another business form that the textbook does not talk about is a SubChapter S Corporation (S Corp). The S Corp combines the advantages of the partnership and corporation. It protects the owners from the business debt like a corporation but gives the owners the tax advantages of the partnership.

Business Stakeholders are the individuals who have an interest in the economic performance of the business.

Owners - they have invested resources in the business therefore they have an interest in seeing the business succeed.

Managers - the manager's income is generally based on how well the business is doing

Employees - they want to get paid; their job depends on the business doing well

Customers - they want to be able to return to the business in the future Creditors - they have invested resources in the business through loans, supplies, etc. They want to see the business do well so they can get paid.

Governments - they want to collect taxes from the businesses. Also they want to see businesses succeed so that the unemployment rate stays low.

Accounting provides information to the various stakeholders. It allows creditors, customers, and investors to assess the economic performance and condition of the business.

The Role of Ethics in Business

All types of businesses including accounting use business ethics.

Ethics is the moral principles that guide the conduct of individuals.

Look at the "Real World" example on page 5.

Moral and ethical behavior is good business. Even small lapses in ethics can be harmful. If you get by one time you might feel that you can continue the practice and not get caught.

The business must also consider its general reputation. Small lapses could hurt that reputation.

Look at the different companies in Exhibit 2 on page 4 that committed fraud and the outcomes.

The Role of Accounting in BusinessAccounting has been called the "language of business" since it is the means by which business information is communicated.

It is the information system that provides reports to the stakeholders about the economic activities and condition of the business.

Exhibit 1 on page 3 looks at the accounting information and stakeholders of a business.

Profession of Accounting

Accountants do more than prepare tax forms!

Financial Accounting - primarily concerned with the recording and reporting of economic data and activities of the business.

Managerial Accounting - uses financial accounting information and estimated managerial information to run the day-to-day operations and plan for future operations of the business.

Cost Accounting - accumulates the manufacturing costs for financial reporting and decision making

Accountants are as specialized as doctors and lawyers.

There are two basic types of accountants - private and public. (Look at Exhibit 4 on page 6)

Private Accounting is when a business firm employs the accountant. These individuals go by various names:

Management Accountants

Managerial Accountants

Cost Accountants - generally in manufacturing

Controller - chief accountant for a business

Internal Auditors - review the records of the business in order to detect fraud and errors

Private accountant's can sit for the Certified Management Accountant (CMA) exam.

If the accountant is involved in internal auditing or the review of accounting and operating procedures, they can sit for the Certified Internal Auditors (CIA) exam.

Public Accounting provides accounting services for a fee. These are generally the Certified Public Accountants or CPAs.

To become a CPA, the individual must have a college education in accounting with 150 semester hours of college credit. They also must sit for a two-day exam prepared by the American Institute of Certified Accountants (AICPA). Generally Accepted Accounting Principles (GAAP) are the guidelines established for the reporting of accounting data. Financial Accounting Standards Board (FASB) is the authoritative body that is responsible for developing the accounting principles.

Business Entity Concept - separation of business and personal accounting activities

The economic data in the accounting system of a business must be limited to data directly related to the activities of that business.

This concept is often violated in the proprietorship business because the owners deposit and pay the debts for both his personal and business activities from on checkbook.

Cost Concept - record financial data at what it cost originally not at the current value. Example: the business purchased a building for $200,000 last year, this year it is valued at $250,00. The accounting records still show cost or $200,000 and the difference or gain will be dealt with at the time the building is sold.

Look at Example Exercise 1-1 on page 8.

Objectivity Concept - accounting is based on objective evidence; there must be proof or evidence that the transaction actually occurred

Unit of Measure Concept - accounting uses a common unit of measure and the economic data must be recorded in dollars.

Look at the following examples: PE 1-1A and PE 1-1B

Accounting Equation and Basic Accounting Terms

These terms are very important to the basic understanding of accounting!

Assets - the resources owned by the business such as land, building, cash, and equipment. These have a positive value to the company's value or net worth.

Liabilities - the debts of the business. These have a negative value to the company's value or net worth. These are the rights of the creditors.

Owner's Equity - the business's debts owed to its owners. The owners investment or worth in the company. These are the rights of the owners.

Stockholders Equity Owners Equity in a Corporation.

Retained Earnings Net income that is retained or stays in the corporation. It is not paid out to the stockholders as dividends. Look at Exhibit 5 on page 14.

The accounting equation is the relationship between the rights of the creditors (liabilities) and the rights of the owners (owner's equity). It is stated as follows: Assets = Liabilities + Owner's Equity

Example:Business Assets$ 300,000

Liabilities

200,000

Owner's Equity 100,000

The equation must equal for the business's accounting records to be in balance.

Look at Example Exercise 1-2 on page 9 and Business Connection on page 10.

Business Transaction - an economic event or condition that directly changes an entity's financial position such as paying the utility bill.

All business transactions are stated in terms of changes in assets, liabilities, and owner's equity.

Let's look at some of the transactions starting on page 10. Be sure to notice that the accounting equation remains balanced in each of these transactions.

Transaction A - the business's assets increase through the deposit of the cash and the owner's equity or capital increases by him giving the business the cash.

Transaction B - the business's cash decreases and the land value increases. The equation remains equally since both are assets. There really is no change in the business's value.

Transaction C - The assets or supplies increase and the liabilities increase since they were bought on account. Accounts Payable are liabilities since they are purchases on account. Prepaid Expenses are assets since they are supplies that have been purchased but not used at this time. They will become an Expense when they are used.

Transaction D - discusses Revenues or money earned from the sale of goods or services. Other terms for revenues are Sales (merchandising), Fees Earned (services), Rent Revenue, and Interest Revenues. In this transaction we provided a service and received cash. The worth of the company increases through the increase in owner's equity or fees earned.

When a customer receives services or goods on credit it is known as an Accounts Receivable which is an asset account.

Transaction E deals with Expenses. Expenses are the dollars used in the process of earning revenues. Examples: supplies used, wages, rent, utilities, etc.

Look at the five key points starting at the bottom of page 13.

Look at the following example problems: PE 1-3A, Ex 1-9 through 1-13, and PR 1-1A.

Financial Statements

There are four basic accounting reports, which are shown in Exhibit 6 on page 17.

You must know how to do these reports in the correct format. The correct format includes the heading and body. They also should balance.

All of the forms tie together and must be done in order. (Notice the arrows linking each form together on page 17.)

The Heading should include the name of the company on the first line, the name of the statement on the second line, and the period the statement covers on the third line. The examples in the textbook are for the month ended but they can be for the year ended.

Income Statement is first. It shows all of the Revenues less the Expenses to give the companies Net Income or Loss for the period. The income statement is for a specific period of time such as a month, quarter, or year. At the end of each accounting year the figures in these accounts become zero and start over again. Sort of like your tax return - your W2 and expenses start over each year.

Look at Example Exercise 1-4 Retained Earnings Statement or Statement of Owner's Equity is next. This is a summary of the changes in the owner's investment in the company. The net income or loss on the Income Statement is used on this statement. Again the statement of owner's equity is for a specific period of time such as a month, quarter, or year.

Look at Example Exercise 1-5 Balance Sheet is third. It is a list of the assets, liabilities, and owner's equity of the company. This is based on the accounting equation. The date is always at the time the statement is prepared. It is considered to be continuous since the assets and liabilities do not go away each year.

Exhibit 6 on page 17 is the account form of preparing a Balance Sheet. There is an example of the report form on page 231. The Statement of Cash Flows is last. It is used to show where the company's cash is received from and used. There are three sections to this statement: Cash Flows from Operating Activities, Cash Flows from Investing Activities, and Cash Flows from Financing Activities. Management primarily uses this report.

In this chapter we will be preparing the first three statements. You will learn more about the Statement of Cash Flows in ACC 121.

Look at the following example problems: PE 1-4A & B through 1-7A & B. Ex 1-14 through 1-25. PR 1-2A and 1-3A.