1

CHAPTER

Introduction to Accounting
and Business
Nature of Business and Accounting

• A business is an organization in which basic

resources (inputs), such as materials and labor, are
assembled and processed to provide goods or services
(outputs) to customers.
• The objective of most businesses is to earn a profit.
• Profit is the difference between the amounts received
from customers for goods or services and the
amounts paid for the inputs used to provide the goods
or services.
Types of Businesses

• Three types of businesses operating for profit include

service, merchandising, and manufacturing
businesses.
o Service businesses provide service rather than products to
customers. Air France and the Walt Disney Company are
examples of service businesses.
o Merchandising businesses sell products they purchase
from other businesses to customers. Examples of
merchandising businesses include Amazon.com and Wal-
Mart.
o Manufacturing businesses convert basic inputs into
products that are sold to customers. Ford Motor Co. and
Dell Inc. are examples of manufacturing businesses.
Role of Accounting in Business

• Accounting can be defined as an information system

that provides reports to users about the economic
activities and condition of a business.
• The process by which accounting provides
information to users is as follows:
o Identify users.
o Assess users’ information needs.
o Design the accounting information system to meet users’
needs.
o Record economic data about business activities and events.
o Prepare accounting reports for users.
Managerial Accounting

• The area of accounting that provides internal users

with information is called managerial accounting, or
management accounting.
• Managerial accountants employed by a business are
employed in private accounting.
Financial Accounting

• The area of accounting that provides external users

with information is called financial accounting.
• The objective of financial accounting is to provide
relevant and timely information for the decision-
making needs of users outside of the business.
• General-purpose financial statements are one type
of financial accounting report that is distributed to
external users.
Role of Ethics in Accounting and Business

• The objective of accounting is to provide relevant,

timely information for user decision making.
• Accountants must behave in an ethical manner so that
the information they provide users will be trustworthy
and, thus, useful for decision making.
• Ethics are moral principles that guide the conduct of
individuals.
Role of Ethics in Accounting and Business
Opportunities for Accountants

• Accountants and their staff who provide services on a

fee basis are said to be employed in public
accounting.
• Accountants employed by a business firm,
government, or a not-for-profit organization are said
to be employed in private accounting.
• Public accountants who have met a state’s education,
experience, and examination requirements may
become Certified Public Accountants (CPAs).
Generally Accepted Accounting Principles

• Financial accountants follow generally accepted accounting

principles (GAAP) in preparing reports.
• Within the U.S., the Financial Accounting Standards Board
(FASB) has the primary responsibility for developing
accounting principles.
• The Securities and Exchange Commission (SEC), an agency
of the U.S. government, has authority over the accounting and
financial disclosures for companies whose shares of ownership
(stock) are traded and sold to the public.
• Many countries outside the U.S. use generally accepted
accounting principles adopted by the International
Accounting Standards Board (IASB).
Accounting Concepts

• Under the business entity concept, the activities of a

business are recorded separately from the activities of
its owners, creditors, or other businesses.
• Under the cost concept, amounts are initially
recorded in the accounting records at their cost or
purchase price.
• The objectivity concept requires that the amounts
recorded in the accounting records be based on
objective evidence.
• The unit of measure concept requires that economic
data be recorded in dollars.
Cost Concept: Example

On August 25, Gallatin Repair Service extended an

offer of $125,000 for land that has been priced for sale
at $150,000. On September 3, Gallatin Repair Service
accepted the seller’s counter offer of $137,000. On
October 20, the land was assessed at a value of $98,000
for property tax purposes. On December 4, Gallatin
Repair Service was offered $160,000 for the land by a
national retail chain. At what value should the land be
recorded in Gallatin Repair Service’s records?
Cost Concept: Example

Under the cost concept, the land should be recorded at

the cost to Gallatin Repair Service, that is $137,000.
The Accounting Equation

• The equation Assets = Liabilities + Owner’s Equity

is called the accounting equation.
Assets as a Building Block

• The resources owned by a business are its assets.

• They are things of value used in carrying out such
activities as production and exchange.
Liabilities as a Building Block

• Liabilities are claims against assets.

• They are existing debts and obligations.
Owner’s Equity as a Building Block

• Owner’s Equity is equal to total assets minus total

liabilities.
• Owner’s Equity represents the ownership claim on
total assets.
• Subdivisions of Owner’s Equity:
o Capital (Investments)
o Drawings
o Revenues
o Expenses
Owner’s Equity: Investments

• Investments by the owner are the assets put into the

business by the owner.
• These investments in the business increase the
owner’s equity.
Owner’s Equity: Drawings

• Drawings are withdrawals of cash or other assets by

the owner for personal use.
• Drawings decrease total owner’s equity.
Owner’s Equity: Revenue

• A business earns money by selling goods or services

to its customers. This amount is called revenue.
• Revenues may result from sales of merchandise,
performance of services, rental of property, or lending
of money.
• Revenues usually result in an increase in the owner’s
equity
Owner’s Equity: Expenses

• Assets used in the process of earning revenue are

called expenses.
• Expenses are the decreases in owner’s equity that
result from operating the business.
• Examples of expenses include utility expense, rent
expense, and supplies expense.
Increases and Decreases in Owner’s Equity

Owner’s Equity
The Accounting Equation: Example

John Joos is the owner and operator of You’re A Star, a

motivational consulting business. At the end of its
accounting period, December 31, 2015, You’re A Star
has assets of $800,000 and liabilities of $350,000.
Using the accounting equation, determine the following
amounts:
a- Owner’s equity as of December 31, 2015.
b- Owner’s equity as of December 31, 2016, assuming
that assets increased by $130,000 and liabilities
decreased by $25,000 during 2016.
The Accounting Equation: Example

a- Assets = Liabilities + Owner’s Equity

$800,000 = $350,000 + Owner’s Equity
Owner’s Equity = Assets – Liabilities = $450,000
b- Let find the change in owner’s equity during 2016:
ΔAssets = ΔLiabilities + ΔOwner’s Equity
Δ stands for the change
$130,000 = -$25,000 + ΔOwner’s Equity
ΔOwner’s Equity = $155,000
Owner’s Equity (Dec. 31, 2016) = $450,000 + $155,000
= $605,000
Business Transactions and
the Accounting Equation
(slide 1 of 2)

• A business transaction is an economic event or

condition that directly changes an entity’s financial
condition or its results of operations.
• The liability created by a purchase on account is
called an account payable.
• Items such as supplies that will be used in the
business in the future are called prepaid expenses,
which are assets.
Business Transactions and
the Accounting Equation
(slide 2 of 2)

• Revenue from providing services is recorded as fees

earned.
• Revenue from the sale of merchandise is recorded as
sales.
• Other examples of revenue include rent, which is
recorded as rent revenue, and interest, which is
recorded as interest revenue.
• An account receivable is a claim against a customer,
which is an asset.
Transaction Analysis

Marc Doucet decides to open a computer

programming service.
 Transaction 1

On September 1, he invests $15,000 cash in the

business, which he names Softbyte.

Trans. # Assets = Liabilities + Owner's Equity

Accounts M. Doucet,
Cash Supplies Equipment Payable Capital
(1) 15,000 = 15,000 Investment

There is an increase in the asset Cash, $15,000, and

an equal increase in the owner’s equity, M. Doucet,
Capital, $15,000.
Transaction 2

Softbyte purchases computer equipment for $7,000 cash.

Trans. # Assets = Liabilities + Owner's Equity

Accounts M. Doucet,
Cash Supplies Equipment Payable Capital
15,000 15,000 Investment
(2) (7,000) 7,000
Balance 8,000 + 7,000 = 15,000

Cash decreased by $7,000, and the asset

Equipment increased by $7,000.
 Transaction 3

Softbyte purchases computer paper and supplies expected to last

several months from Chuah Supply Company for $1,600 on
account.

Trans. # Assets = Liabilities + Owner's Equity

Accounts M. Doucet,
Cash Supplies Equipment Payable Capital
Balance 8,000 7,000 15,000
(3) 1,600 1,600
Balance 8,000 + 1,600 + 7,000 = 1,600 + 15,000

The asset Supplies increased by $1,600, and the liability

Accounts Payable increased by the same amount.
Transaction 4

Softbyte receives $1,200 cash from customers for

programming services it has provided.

Trans. # Assets = Liabilities + Owner's Equity

Accounts M. Doucet,
Cash Supplies Equipment Payable Capital
Balance 8,000 1,600 7,000 1,600 15,000
(4) 1,200 1,200 Service Revenue
Balance 9,200 + 1,600 + 7,000 = 1,600 + 16,200

Cash increased by $1,200, and

M. Doucet, Capital increased by $1,200.
Transaction 5

Softbyte receives a bill for $250 for advertising its business

but pays the bill on a later date.

Trans. # Assets = Liabilities + Owner's Equity

Accounts M. Doucet,
Cash Supplies Equipment Payable Capital
Balance 9,200 + 1,600 + 7,000 = 1,600 + 16,200
(5) 250 (250) Advertising Expense
Balance 9,200 1,600 7,000 1,850 15,950

Accounts Payable increased by $250, and

M. Doucet, Capital decreased by $250.
Transaction 6

Softbyte provides programming services of $3,500 for

customers and receives cash of $1,500, with the balance
payable on account.
Trans. # Assets = Liabilities + Owner's Equity
Account Accounts M. Doucet,
Cash Receivable Supplies Equipment Payable Capital
Balance 9,200 + 0 + 1,600 + 7,000 = 1,850 15,950
(6) 1,500 2,000 3,500 Service Revenue
Balance 10,700 2,000 1,600 7,000 1,850 19,450

Cash increased by $1,500; Accounts Receivable

increased by $2,000; and M. Doucet, Capital
increased by $3,500.
Transaction 7

Expenses paid in cash for September are store rent,

$600, salaries of employees, $900, and utilities, $200.

Trans. # Assets = Liabilities + Owner's Equity

Account Accounts M. Doucet,
Cash Receivable Supplies Equipment Payable Capital
Balance 10,700 2,000 1,600 7,000 1,850 19,450
(7) (600) (600) Rent Exp.
(900) (900) Salaries Exp.
(200) (200) Utilities Exp.
Balance 9,000 + 2,000 + 1,600 + 7,000 = 1,850 + 17,750

Cash decreased by $1,700 and M. Doucet,

Capital decreased by the same amount.
Transaction 8

Softbyte pays its advertising bill of $250 in cash.

Trans. # Assets = Liabilities + Owner's Equity

Account Accounts M. Doucet,
Cash Receivable Supplies Equipment Payable Capital
Balance 9,000 2,000 1,600 7,000 1,850 17,750
(8) (250) (250)
Balance 8,750 + 2,000 + 1,600 + 7,000 = 1,600 + 17,750

Cash decreased by $250 and Accounts

Payable decreased by the same amount.
Transaction 9

The sum of $600 in cash is received from customers who

have previously been billed for services in Transaction
6.
Trans. # Assets = Liabilities + Owner's Equity
Account Accounts M. Doucet,
Cash Receivable Supplies Equipment Payable Capital
Balance 8,750 2,000 1,600 7,000 1,600 17,750
(9) 600 (600)
Balance 9,350 + 1,400 + 1,600 + 7,000 = 1,600 + 17,750

Cash increased by $600 and Accounts

Receivable decreased by the same amount.
Transaction 10

Marc Doucet withdraws $1,300 in cash from

the business for his personal use.

Trans. # Assets = Liabilities + Owner's Equity

Account Accounts M. Doucet,
Cash Receivable Supplies Equipment Payable Capital
Balance 9,350 1,400 1,600 7,000 1,600 17,750
(10) (1,300) (1,300) Doucet, Drawings
Balance 8,050 + 1,400 + 1,600 + 7,000 = 1,600 + 16,450

Cash decreased by $1,300 and M. Doucet,

Capital decreased by the same amount.
Summary

• You should note the following:

o The effect of every transaction is an increase or a decrease
in one or more of the accounting equation elements.
o The two sides of the accounting equation are always equal.
o The owner’s equity is increased by amounts invested by the
owner and is decreased by withdrawals by the owner. In
addition, the owner’s equity is increased by revenues and is
decreased by expenses.
Financial Statements

• After transactions have been recorded and

summarized, reports are prepared for users. The
accounting reports providing this information are
called financial statements.
Income Statement

• The income statement reports the revenues and

expenses for a period of time, based on the matching
concept.
• The matching concept is applied by “matching” the
expenses incurred during a period with the revenue
that those expenses generated.
• The excess of the revenue over the expenses is called
net income, net profit, or earnings. If expenses
exceed revenue, the excess is a net loss.
Income Statement: Example

The revenues and expenses of Chickadee Travel Service

for the year ended April 30, 2016 follow:
Fees earned $263,200
Miscellaneous expense 12,950
Office expense 63,000
Wages expense 131,700
Prepare an income statement for the year ended April
30, 2016.
Income Statement: Example

Chickadee Travel Service

Income Statement
For the Year Ended April 30, 2016

Fees Earned ……………………….. $263,200

Expenses:
Wages Expense ………………… $131,700
Office Expense …………………. 63,000
Miscellaneous Expense ………….. 12,950
Total Expenses ……………… $207,650
Net Income ………………………… $55,550
Statement of Owner’s Equity

• The statement of owner’s equity reports the changes

in the owner’s equity for a period of time.
• It is prepared after the income statement because the
net income or net loss for the period must be reported
in this statement.
Statement of Owner’s Equity: Example

Using the income statement from the previous example,

prepare a statement of owner’s equity for the year ended
April 30, 2016. Adam Cellini, the owner, invested an
additional $50,000 in the business and withdrew cash of
$30,000 for personal use during the year. The capital of
Adam was $80,000 on May 1, 2015.
 Statement of Owner’s Equity: Example

Chickadee Travel Service

Statement of Owner’s Equity
For the Year Ended April 30, 2016

Adam Cellini, capital, May 1, 2015 …….... $80,000

Additional investment by owner ………….. $50,000
Net income for the year ………………….. 55,550
105,550
Less withdrawals …………………………. 30,000
Increase in owner’s equity ………………... 75,550
Adam Cellini, capital, April 30, 2016 …… $155,550
Balance Sheet

• A balance sheet is a list of the assets, liabilities, and

owner’s equity as of a specific date.
• The account form of a balance sheet lists the assets
on the left and the liabilities and owner’s equity on
the right. It resembles the basic format of the
accounting equation.
Balance Sheet: Example

Using the income statement and the statement of

owner’s equity from the previous example, prepare a
balance sheet as of April 30, 2016.
Accounts payable $12,200
Accounts receivable 31,350
Cash 53,050
Land 80,000
Supplies 3,350
 Balance Sheet: Example

Chickadee Travel Service

Balance Sheet
April 30,2016

Assets Liabilities
Cash …………………………… $53,050 Accounts Payable ……….. $12,200
Accounts Receivable ………… 31,350
Supplies ………………………. 3,350 Owner’s Equity
Land …………………………… 80,000 Adam Cellini, Capital ……. 155,550
Total Assets …………………… $167,750 Total Liab. & Owner’s eq. $167,750
Statement of Cash Flows
(slide 1 of 2)

• A statement of cash flows is a summary of the cash

receipts and cash payments for a specific period of
time.
o It consists of three sections:
1. operating activities
2. investing activities
3. financing activities
Statement of Cash Flows
(slide 2 of 2)

• The cash flows from operating activities section

reports a summary of cash receipts and cash
payments from operations.
• The cash flows from investing activities section
reports the cash transactions for the acquisition and
sale of relatively permanent assets.
• The cash flows from financing activities section
reports the cash transactions related to cash
investments by the owner, borrowings, and
withdrawals by the owner.
 Statement of Cash Flows: Example

A summary of cash flows for Chickadee Travel Service for

the year ended April 30, 2016, follows:
Cash receipts:
cash received from customers ……………. $251,000
cash received from additional investment .. 50,000
Cash payments:
cash paid for expenses …………………….. 210,000
cash paid for land …………………………. 80,000
cash paid to owner for personal use ……… 30,000

The cash balance as of May 1, 2015, was $72,050. Prepare

a statement of cash flows for Chickadee Travel Service for
the year ended April 30, 2016.
 Statement of Cash Flows: Example

Chickadee Travel Service

Statement of Cash Flows
For the Year Ended April 30, 2016

Cash flows from operating activities:

Cash received from customers …………………… $251,000
Deduct cash payments for expenses ……………. (210,000)
Net cash flows from operating activities …………. $41,000
Cash flows from investing activities:
Cash payment for purchase of land ………………. (80,000)
Cash flows from financing activities:
Cash received from owner as investment ………… $50,000
Deduct cash withdrawals by owner ……………….. (30,000)
Net cash flows from financing activities …………... 20,000
Net decrease in cash during year …………………….. (19,000)
Cash as of May 1, 2015 ……………………………….. 72,050
Cash as of April 30, 2016 ……………………………… $53,050
Financial Analysis and Interpretation:
Ratio of Liabilities to Owner’s Equity

• The ratio of liabilities to owner’s equity is useful in

analyzing the ability of a company to pay its creditors.
• The ratio of liabilities to owner’s equity is computed
as follows:

Ratio of Liabilities Total Liabilities

=
to Owner’s Equity Total Owner’s Equity (or Total
Stockholders’ Equity)
Ratio of Liabilities to Owner’s Equity: Example

The following data were taken from Hawthorne

Company’s balance sheet:

Dec. 31, 2016 Dec. 31, 2015

Total liabilities $120,000 $105,000
Total owner’s equity 80,000 75,000

a- Compute the ratio of liabilities to owner’s equity

b- Has the creditors’ risk increased or decreased from
December 31, 2015 to December 31, 2016?
Ratio of Liabilities to Owner’s Equity: Example

a- Dec. 31, 2016 Dec. 31, 2015

Total liabilities $120,000 $105,000
Total owner’s 80,000 75,000
equity
Ratio of liabilities 1.50 1.40
to owner’s equity (120,000/80,000) (105,000/75,000)
b- The creditors’ risk increased because the ratio of
liabilities to owner’s equity increased from Dec. 31, 2015
to Dec. 31, 2016.
Assignment

Marco Brolo is one of three partners who own and operate Silkroad Partners, a
global import–export business. Marco is the partner in charge of recording
partnership transactions in the accounts. On his way to work one day, Marco’s
car broke down. At the repair shop, Marco learned that his car’s engine had
significant damage, and it will cost over $2,000 to repair the damage. He does
not have enough money in his bank account to cover the cost of the repair, and
his credit cards are at their limit. This car is the only form of transportation that
Marco has to get to and from work every day. He does not use his car for any
business travel. After considering his options, Marco decides to take $2,000
from the partnership for the repair and record it as an expense of the partnership.
He believes that this is appropriate since he needs his car to get to work every
day.
1. Is Marco behaving ethically? Why or why not?
2. Who is affected by Marco’s decision?
3. What other alternatives might Marco consider?