Chapter 1 The Nature of Accounting 1© Paradigm Publishing, Inc

Chapter 1

The Nature of Accounting

1© Paradigm Publishing, Inc.

1. Define accounting and related terms.

2. Explain who uses accounting information.

3. Identify four forms of business organizations and three types of business operations.

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Learning Objectives

4. Define and describe the elements of accounting.

5. State the accounting equation.

6. Define business transaction.

7. Record business transactions in equation form.

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Learning Objectives

8. Identify four types of transactions that affect owner’s equity.

9. Define ethics and explain the importance of ethical behavior in modern business.

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Learning Objectives

Learning Objective 1

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Define accounting and related terms

What Is Accounting and Who Uses It?

Accounting is the process of recording, summarizing, analyzing, and interpreting financial activities to permit individuals and organizations to make informed judgments and decisions.

Accounting combines recording, summarizing, analyzing, and interpreting into a single process and applies this process to financial activities.

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Learning Objective 2

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Explain who uses accounting information

Users of Accounting Information

Individuals

Owners

Managers

Investors

Banks and other lending institutions

Governments

Tax authorities

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Users of Accounting Information

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Users Use of Accounting Information

Individuals Individuals, such as Janice Graham and Ray Clermont, must understand accounting to function personally within our society, which is very dependent on financial activities. They—and you—keep checkbooks and other bank records, receive paychecks, pay taxes, use charge cards, borrow money, and purchase a variety of products and services.

Owners Business owners, such as Drew Beedy and Lynn Bennett, must understand accounting to achieve success in their organizations. Very often, the owners do not actually run the business. In such cases, the owners rely on accounting information to determine how well their businesses are being managed.

Users of Accounting Information

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Users Use of Accounting Information

Managers Managers use accounting data extensively in deciding on alternatives, such as what to sell, how to price, and when to expand the product line.

Investors Investors use accounting data for insights on the financial condition of potential investments when deciding whether to invest in a business.

Banks and other lendinginstitutions

Lenders, such as banks, use accounting data in deciding whether to approve a loan.

Users of Accounting Information

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Users Use of Accounting Information

Governments Governmental units (federal, state, and local) also record, summarize, analyze, and interpret financial events to operate with limited resources.

Tax authorities Tax authorities use accounting data reported to the governmentin deciding whether a business is complying with tax rules andregulations. Since our country has an extensive taxing system, this is a major use of accounting data.

Identify four forms of business organizations and three types of

business operations

Learning Objective 3

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Forms of Business Organizations

Sole ProprietorshipA business owned by one person

PartnershipA business co-owned by two or more persons

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Forms of Business Organizations

CorporationA business that is owned by investors calledstockholders

Limited Liability Company (LLC)A business that combines features of a corporationand those of proprietorships and partnerships

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Types of Business Operations

Service BusinessPerforms services for customers to earn a profit

Merchandising Business Purchases goods produced by others and thensells these goods to customers

Manufacturing BusinessProduces a product to sell to its customers

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Learning Objective 4

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Define and describe the elements of accounting

The Elements of Accounting

AssetsAn item with money value that is owned by abusiness

LiabilityA debt owed by a business

Owner’s EquityThe excess of assets over liabilities

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Another name for owner’s equity is

Quick Check

a. note payable.

b. accounts receivable.

c. capital.

d. accounts payable.

e. notes receivable.

Learning Objective 5

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State the accounting equation

The Accounting Equation

For example, on December 31, 20X2, Jeanette Deese has business assets of $30,000, business liabilities of $10,000, and owner’s equity of $20,000. Her accounting equation is:

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Assets (A) = Liabilities (L) + Owner’s Equity (OE)

$30,000 = $10,000 + $20,000

or

$30,000 = $30,000

Assets=Liabilities+Owner’s Equity

Example

1. If assets are $30,000 and liabilities are $15,000, owner’s equity must be ____?

2. If owner’s equity is $9,000 and assets are $25,000, liabilities must be ____?

3. If liabilities are $5,500 and owner’s equity is $8,000, assets must be ____?

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Answer :1. $15,0002. $16,0003. $13,500

Review Quiz 1-1

Find the missing element in each of the following.

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A = L + OE

(a) $40,000 $25,000

(b) $38,000 $52,000

(c) $70,000 $48,000

(d) $75,000 $0

$15,000

$90,000

$22,000

$75,000

$?

$?

$?

$?

Learning Objective 6

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Define business transaction

Business Transactions

Any activity that changes the value of a firm’sassets, liabilities, or owner’s equity is called atransaction.

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Examples of Business Transactions

Purchase of equipment on credit

Cash payment to a creditor

Receipt of cash for services rendered to a customer

Purchase of supplies for cash

Payment of rent for the month

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Examples of Business Transactions

Payment of utility bill

Receipt of a bill to be paid later

Payment to employees for the payroll

Owner investment of cash in the business

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Understanding the Dual Effect of Business Transactions

Total assets must always equal liabilities plus owner’s equity.

To maintain this balance, transactions are recorded as having a dual effect on the basic accounting elements.

Every business transaction has at least two effects on the accounting equation.

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Learning Objective 7

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Record business transactions in equation form

Example

Susan Gilbert invests $30,000 to start Susan’s Gifts andCandies.How will this transaction affect the accounting equation?

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Example Answer

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Susan Gilbert invests $30,000 to start Susan’s Gifts andCandies.How will this transaction affect the accounting equation?

Assets = Liabilities + Owner’s Equity

Cash Equip. SuppliesAcc.

Payable

Susan Gilbert, Capital Revenue Expenses

=+$30,000 +$30,000

Example

Susan Gilbert purchases equipment costing $1,200 on account.How will this transaction affect the accounting equation?

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Example Answer

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Susan Gilbert purchases equipment costing $1,200 onaccount.How will this transaction affect the accounting equation?

Assets = Liabilities + Owner’s Equity

Cash Equip. SuppliesAcc.

Payable

Susan Gilbert, Capital Revenue Expenses

=+$1,200 +$1,200

Example

Susan Gilbert generates $500 of cash sales.How will this transaction affect the accounting equation?

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Assets = Liabilities + Owner’s Equity

Cash Equip. SuppliesAcc.

Payable

Susan Gilbert, Capital Revenue Expenses

=

Example Answer

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Susan Gilbert generates $500 of cash sales.How will this transaction affect the accounting equation?

+$500 +$500

Learning Objective 8

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Identify four types of transactions that affect owner’s equity

Four Types of Transactions that Affect Owner’s Equity

Owner investments increase owner’s equity.

Revenue increases owner’s equity.

Expenses decrease owner’s equity.

Owner withdrawals decrease owner’s equity.

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Review Quiz 1-2

Record the following transactions for Susan Wright in an expanded accounting equation with these headings:

Cash + Accounts Receivable + Supplies = Accounts Payable + Susan Wright, Capital + Revenue – Expenses.

Include a Description column. After recording the last transaction, prove that the equation is in balance.

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Review Quiz 1-2

(a) Susan invested $10,000 cash in the business.

(b) Invested supplies valued at $2,000 in the business.

(c) Paid rent for the month, $600.

(d) Performed services and received cash, $800.

(e) Purchased supplies on credit, $200.

(f) Performed services on credit, $625.

(g) Withdrew cash for personal use, $500.

(h) Received $250 cash as partial payment for services performed on account.

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Review Quiz 1-2

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A business owner generates $2,000 of revenue on account. This transaction

Quick Check

a. increases assets and decreases liabilities.

b. increases assets and increases owner’s equity.

c. increases liabilities and increases owner’s equity.

d. decreases assets and increases liabilities.

e. decreases assets and increases owner’s equity.

Learning Objective 9

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Define ethics and explain the importance of ethical behavior in

modern business

Ethics in Accounting

Sarbanes-Oxley Act of 2002A law, passed by Congress, requiring companies to certify the accuracy of their financial information

EthicsPrinciples of moral conduct that guide the behavior of individuals and businesses

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Do you agree with the U.S. government bailout of Fannie Mae and Freddie Mac?

Focus on Ethics

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Joining the Pieces The Expanded Accounting Equation