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Lecture #1: Accounting: An Introduction to Its Concepts

What is accounting?

Accounting is a service activity. It provides quantitative information about economic entities. This information is used in making decisions.

Most people think that accounting and bookkeeping are the same. Actually bookkeeping is a small part of accounting. Accountants design accounting systems, analyze complex transactions, and interpret accounting information.

Accounting as a Profession:

Accounting has attained a stature comparable with law and medicine. To be an accountant, you have to possess a license from the state, just like doctors and lawyers.

The license helps ensure a high standard of professional service.
F A licensed accountant is called a certified public account (CPA)

The Work of an Accountant

Accountants are employed in three major fields.

1. Public Accounting.

(i) Auditing - Companies are audited for two reasons by independent CPA firm. First, banks want an audit of a company that applied for a bank loan. The banks want to know the financial strength of the company. Second, if the company issues securities to the public, then the public has the right to know about the financial position of the company.

(ii) Management Advisory Services - CPAs design, install, and improve the client’s general accounting system, including the installation of the computer systems. These services may include financial planning, forecasting, and inventory control.

(iii) Tax Services - Usually tax laws are very complex, so CPAs can advise clients the best way of preparing tax returns, so the client pays the smallest taxes.

2. Private Accounting - Accountants employed by a single enterprise.

(i) General Accounting - The task of recording transactions, processing the data, and preparing the financial statements for the management, public, government, and creditors.

(ii) Cost Accounting - Accounting and controlling the cost of producing a product or service, even assessing the performance of managers, who are responsible for these costs.

(iii) Budgeting - The process of developing formal plans for future business activities. This gives management a clear understanding of what must be done to accomplish these future plans.

(iv) Internal Auditing - Checking the records and operating procedures of each department. They make sure company policies are followed and determine the efficiency of each department.

F Private accountants do not have to be licensed CPAs to work in corporations.

3 Government Accounting.

(i) Elected and appointed officials must use accounting data to complete their administrative duties.

(ii) Accountants also audit the tax statements of people and businesses.

(iii) Criminal investigation agencies, such as the Federal Bureau of Investigation (FBI) use accountants in detecting certain crimes, such as fraud.

Generally Accepted Accounting Principles (GAAP)

The principles are the broad rules adopted by the accounting profession as guides in measuring, recording, and reporting the financial affairs and activities of a business.

The main agency that imposes accounting rules to the public is the Securities and Exchange Commission (SEC).

- This is an independent agency of the U.S. federal government.
- It monitors the distribution and sale of securities, i.e. corporate stock and bonds
- Before the securities are sold, the business must be registered with the SEC.
- The SEC requires the filing of audited financial statements prepared by the rules of the SEC each year.

1. Business Entity Concept.- Every business is perceived and treated as if it is a separate legal entity that is distinct from its owners and from every other business.

2. The Cost Principle - All goods and services purchased are recorded at cost.

3. The Objectivity Principle.

- Why are assets and goods recorded at cost rather than some other amount, such as estimated market value? The Objectivity Principle requires that accounting records be based on verifiable records. Accounting information must be based on objective data.

4. The Continuing-Concern Concept - When a business purchases and holds assets for use in its operations, the market values of those assets will change over time. Nevertheless, accounting records are not adjusted to reflect market value changes, because of the continuing concern concept.

5. The Stable-Dollar Concept - In the U.S., all accounting transactions are measured, recorded, and reported in terms of dollars. So the dollar is treated as a stable unit of measure, such as the meter, kilogram, etc.

Business Organizations.

1. Single Proprietorships - The business is owned by one person, and by law, the business is not a separate legal entity (i.e. not a corporation).

2. Partnerships - When a business is owned by two or more people and it is not a separate legal entity.

3. Corporations.-A corporation is a separate legal entity.

  • The owners of a corporation are called stockholders, because the ownership of the corporation is divided into units that are called shares of stock.
  • Most important characteristic of a corporation is its status as a separate legal entity. The corporation is responsible for its own acts and its debts. It can buy, own, and sell property in its own name.
  • The corporation is created by securing a charter from the state.
  • Even though the proprietorship is more numerous, the corporations are the dominant form of in the U.S.
Two Reasons
  • Shareholders are not responsible for the corporation’s debt.
  • The corporation’s stock can easily be bought and sold without affecting the daily operation of the business.

Financial Statements

Financial statements are used to communicate accounting information.

1. The Income Statement - The most important financial statement. Did the business earn a profit of a loss (profit is also called net income).

  • Revenues: Are inflows of assets received in exchange for goods and services, which the business produces.
  • Expenses: Are outflows of assets as a result of the major operations of a business.

Jerry Dow, Attorney
Income Statement
For Month Ended December 31, 1990

Legal fees earned $3,900
Operating Expenses:
ffice rent expense $1,000
Salaries expense 700
Total Operating Expenses $1,700
Net Income $2,200

2. The Balance Sheet.- This shows the financial position of a business on a specific date. This shows the business’s assets, liabilities, and equity.

  • Assets: Property or property rights.
  • Liabilities: Debts.
  • Equity: The residual claim of the business’s owner or owners.

Jerry Dow, Attorney
Balance Sheet
December 31, 1990

Assets: Liabilities
Cash $1,100 Accounts Payable $760
Law library 2,880
Office equipment 6,880 Owner’s Equity:
Jerry Dow, capital 10,100
Total Assets $10,860 Total Liabilities and Owner’s Equity $10,860

Assets - Economic resources owned by a business.

  • Cash.
  • Money owed to the business by its customers for goods and services sold to him on credit, which is called accounts receivable.
  • Equipment
  • Buildings and land
  • Patents and copyrights

Liabilities - These are the debts of the business.

  • Amounts owed to creditors for goods and services bought on credit, called accounts payable.
  • Salaries owed to workers.
  • Taxes payable.
  • Interest payable.

Equity (i.e. Net Assets) = Total assets - total liabilities

F If a business does not pay its debts, the creditors can legally force the business to sell its assets to pay off the debt. The creditors can take the owner’s equity to pay off debts, if the value of the assets are lower than the recorded amount. Owner’s equity is very important for the creditors. They want to know how much capital the person contributed.

Jerry Dow, Attorney
Balance Sheet
December 10, 1990

Assets: Liabilities:
Cash $800 Accounts Payable $1,660
Law library 2,880
Office equipment 6,880 Owner’s Equity
Jerry Dow, capital 8,900
Total Assets $10,560 Total Liabilities and Owner’s Equity $10,560

Realization Principle - Revenue is recognized when the service is rendered. In Jerry Dow’s case, he received cash for legal services. What if the client did not pay him yet for this service, then Jerry still has to recognize this as revenue, but you use a different account.

The accounting system you are studying is a double-entry system. For each transaction, there are two entries. If the balance sheet does not balance, then you know a mistake occurred.

3. The Statement of Changes in Owner’s Equity - This financial statement shows changes in owner’s equity along with his investments and withdrawals.

Jerry Dow, Attorney
Statement of Changes in Owner’s Equity
For Month Ended December 31, 1990

Jerry Dow, capital, November 30, 1990 $0
Plus: Investments by owner $9,000
Net income $2,200
Less: Withdrawals by owner $1,100
Jerry Dow, capital December 31, 1990 $10,100

4. Statement of Cash Flows - This financial statement shows the cash inflows and outflows of a business. This statement is important, because a business needs adequate cash to operate such as paying workers, taxes, rent, and interest payments.

Jerry Dow, Attorney
Statement of Cash Flows
For Month Ended December 31, 1990

Cash flows from operations
Cash received from customers +$3,900
Cash paid for rent -$1,000
Cash paid to employee -$700
Net cash provided by operating activities +$2,200
Cash flows from investing activities
Purchase of office equipment -$5,600
Purchase of law library -$2,500
Net cash by investing activities -$8,100
Cash flows from financing activities
Investments by owner +$9,000
Withdrawals by owner -$1,100
Repayment of debt -$900
Net cash provided by financing activities +$7,000
Net increase in cash $1,100
Cash balance, November 30, 1990 $0
Cash balance, December 31, 1990 $1,100

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