| Lecture III
Accounting:
The Language Of Business
The student will finish
the reading assignment on the textbook - as listed. After studying
the current lecture, the student will also prepare to complete the homework
– as assigned.
This course is organized around the practical applications of basic bookkeeping and accounting concepts by providing concise definitions and explanations in plain English and easily understood terms, which aims to develop the student's ability to understand and solve bookkeeping and accounting problems in the real world. The menu to the right provides links to the major topics of the lecture as well as to the assignment page for the current week. Usually, you need to scroll down to read the lecture notes and other materials presented for the current lecture.
What you need to know This course assumes the student has no background knowledge about bookkeeping and accounting. The basic concepts of the bookkeeping cycle will be covered first.
| Lecture Menu Objectives Understanding Accounting Decision Making Process Balance Sheet Components Business Transactions Summary Review Questions Required Readings |
| Learning Objectives After completing this lecture, you will be proficient in describing what accounting is about. Key aspects of this competency expectation include: Understand why accounting information is important in making business decisions. Describe the nature of a Balance Sheet. Explain the accounting meaning of assets, liabilities, and equity. Identify the components of a Balance Sheet. Analyze business transactions and relate them to changes on the Balance Sheet. |
| Understanding Accounting The purpose of accounting is to provide useful information in an effective, relevant, and reliable way for a wide variety of decisions. Anyone involved in making financial decisions of any kind – business or personal – should have a clear understanding of accounting theories and practices. An adequate understanding of the principles of bookkeeping and accounting is essential for anyone who is interested in a successful career in business of any kinds. The purpose of bookkeeping and accounting is to provide information concerning the finanical position of an on-going business. This information is needed by not only bookkeepers and accountants but also owners, managers, creditors, and governmental agencies. An individual person who earns a living by recording the financial activities of a business is known as a bookkeeper, while the process of classifying and summarizing business transactions and interpreting their effects is accomplished by the accoutants. The bookkeeper is concerned with techniques involving the recording of transactions, and the accountant's objective is the use of data for interpretation. Bookkeeping and accounting techniques will be discussed in order to fully understand the Bookkeeping Cycle.
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Accounting and Decision-Making Process
| A. The Nature of Accounting | | 1. Accounting is a process of identifying, recording, summarizing and reporting economic information to decision makers. | | 2. Financial accounting focuses on the specific needs of external (outside) decision makers, such as shareholders, suppliers, banks, and government agencies. | | 3. Financial statements, the output of the accounting process, are the result of the accountant’s ability to analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their financial effect on an organization. |
| B. Accounting as an Aid to Decision Making | | 1. Accounting information is useful to anyone who must make decisions that have economic consequences. Managers, owners, investors, and politicians all use accounting information to make decisions. | | 2. Accounting information may be used to help predict future effects of decisions, confirm or reject past predictions, and show where and when money has been spent and commitments have been made, by evaluating performances, and by indicating the financial implications of choosing one plan over another. |
| C. Financial and Management Accounting | | 1. Both financial accounting and managerial accounting use financial data related to a particular entity, and share many of the same accounting procedures. The difference between the two is their use by different types of decision makers. | | 2. Managerial accounting serves internal (inside) decision makers, such as top executives, department heads, and people at other management levels within an organization. | | 3. Accounting, through financial statements, performs a scorekeeping function. It answers the questions of: What is the financial picture of the organization on any given day? How well did it do during a given period? | | 4. There are three major financial statements:
4.1 The balance sheet focuses on the financial picture as of a given day.
4.2 The income statement and the statement of cash flows focus on performance over time. | | 5. The annual report is a document prepared by management and distributed to current and potential investors to inform them about the company’s past performance and future prospects. | |
Components of the Balance Sheet
| A. The Balance Sheet | | 1. A balance sheet is what accountants call a financial statement. Accountants prepare various kinds of statements that are equally important. The balance sheet shows the financial position of a business at a particular point in time. It is also known as the statement of financial position or statement of financial condition. A typical balance sheet might appear as in Figure 1.1:
Figure 1.1 - Balance Sheet Example | | 2. As you can see, the balance sheet has two counter-balancing sections, which form the accounting equation: Assets = Liabilities + Owners’ Equity In the financial literature, the owners' equity can also be referred to as Net Worth or Capital, whichis the interest of the owners in a business. 3. The financial condition or position of a business enterprise is represented by the relationship of assets to liabilities and owners' equity. Assets: properties that are owned and have money value - for instance, - cash
- inventory
- buildings
- equipment Liabilities: amounts owed to outsiders, such as - notes payable
- accounts payable
- bonds payable Owners' Equity: the interest of the owner(s) in an enterprise, also known as Capital or Net Worth. | | 4. The right side of the balance sheet equation represents outsider and owner claims against the total assets shown on the left side of the equation. | | 5. Assets are economic resources that are expected to increase or cause future cash inflows or reduce or prevent future cash outflows. | | 6. Liabilities are economic obligations of the organization to outsiders, or claims against its assets by outsiders. Notes payable are promissory notes that are evidence of a debt and state the terms of payment. | | 7. Owners’ equity is the residual interest in, or remaining claims against, the organization’s assets after deducting all liabilities. This may be expressed at: Owners’ Equity = Assets - Liabilities | These three basic elements are connected by a fundamental relationship called the accounting equation. This equation expresses the equality of the assets on one side with the claims of the creditors and owners on the other side. Equally true, this equation can be expressed just as above.
According to the accounting equation, a firm is assumed to posses its assets subject to the rights of the creditors and owners. Example
Consider the following business activities or events of a typical firm:
- the firm owned assets of $100,000
- the firm owed creditors $80,000
- the firm owed the owner $20,000
The accounting equation would be: Assets = Liabilities + Owners' Equity
$100,000 = $80,000 + $20,000 Suppose that $6,000 was used to reduce liabilities and the balance remained in assets side of the euqation. And then, as you would expect, the accounting equation would be changed: Assets = Liabilities + Owners' Equity
$94,000 = $74,000 + $20,000 We shall call any business event that changes the amount of assets, liabilities, or owners' equity a business transaction. |
Business Transactions and the Balance Sheet
| A. Balance Sheet Transactions | | 1. An entity is an organization or a section of an organization that stands apart from other organizations and individuals as a separate economic unit. | | 2. A transaction is any event that both affects the financial position of an entity and can be reliably recorded in terms of money. | | 3. Each transaction requires two counterbalancing entries so that the equality of the balance sheet equation is maintained. That is, total assets must always equal the total of liabilities and owners’ equity. |
| B. Transaction Analysis | | 1. An account is a summary record of the changes in a particular asset, liability, or owners’ equity. An account balance is the total of all entries to the account to date. | | 2. The analysis of transactions is the heart of accounting. For each transaction you must determine:
2.1 Which specific accounts are affected?
2.2 Whether the account balances are increased or decreased.
2.3 The amount of the change in each account balance. | | 3. Additional new terms introduced in this section.
3.1 Inventory is goods held by the company for the purpose of sale to the customers.
3.2 An open account means buying or selling on credit, usually by just an authorized signature of the buyer.
3.3 An account payable is a liability that results from a purchase of goods or services on open account.
3.4 A compound entry is a transaction that affects more than two accounts.
3.5 A creditor is one to whom money is owed.
3.6 A debtor is one who owes money. |
| C. Preparing the Balance Sheet | | 1. Remember that the balance sheet represents the financial impact of the accumulation of transactions at a specific point in time. Therefore, the totals of each account (account balances) are used to prepare the balance sheet. | | 2. A balance sheet could be prepared after each transaction, but this is unnecessary. Balance sheets are usually produced once a month. | |
| Summary All organizations rely on financial information in making decisions. This is not the only type of information that must be considered in making decisions, but it is certainly one of the most important. The accounting equation is the basis for the entrie accounting system:
Assets = Liabilities + Owners' Equity
Assets are future economic benefits. Liabilities are future sacrifices of economic benefits. Owners' equity is the residual interest that remains after deducting liabilities from assets. A balance sheet summarizes the financial position of a company at a specific point in time. An income statement reports on its revenues and expenses for a period of time.
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| Review Questions 1. Accounting is the major means of organizing and summarizing information about economic activities. This information is provided to decision makers in the form of _______________. 2. The accounting equation is: ___________ = ____________ + _____________ 3. Items owned by a business that have money value are known as ____________. 4. _____________ is the interest of the owners in a business. 5. Money owed to an outsider is a _________________. 6. An investment in the business increases ___________ and ___________.
Answers to Review Questions 1. A balance sheet
2. Assets = Liabilities + Capital
3. Assets
4. Owner's equity, also known as capital or net worth.
5. Liability
6. Assets and capital |
| Practical Test 1. Given any two known elements of the accounting equation, the third can be logically computed. Determine the missing amount in each of the accounting equations below. Assets = Liabilities + Owners' Equity
1) $7,200 = $2,800 + $______
2) $7,200 = $_____ + $4,400
3) $_____ = $2,800 + $4,400
4) $20,000 = $5,600 + $______
5) $18,000 = $_____ + $6,600
6) $_____ = $4,280 + $8,420 2. Classify each of the following as elements of the accounting equation using the following abbreviations: A = Assets; L = Liabilities; C = Capital. 1) Cash
2) Accounts payable
3) Owners' Investment
4) Accounts receivable
5) Supplies
6) Notes payable
7) Land
8) Equipment |
| Required Readings Textbook: Chapter 1, Pages 2-30 Kimmel, Weygandt & Kieso
Financial Accounting: Tools for Business Decision Making with Annual Reprots (2nd Edition)
Wiley, 2000
ISBN 0-471-34774-4 |
