Lecture Notes - 1

Chapter 1: Accounting in Business

Importance of Accounting
Accounting is an information and measurement system that identifies, records, and communicates relevant,
reliable, and comparable information about an organization’s business activities.
Identifying business activities requires that we select relevant transactions and events.
Recording business activities requires that we keep a chronological log of transactions and events measured
in Kwacha.
Communicating business activities includes preparing accounting reports such as financial statements,
which we analyze and interpret.
Users of Financial Information
Accounting is called the language of business because all organizations set up an accounting information
system to communicate data to help people make better decisions. Accounting serves many users who can
be divided into two groups: external users and internal users.
External users of accounting information are not directly involved in running the organization. They include
shareholders (investors), lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press.
External users have limited access to an organization’s information.
Internal users of accounting information are those directly involved in managing and operating an
organization. They use the information to help improve the efficiency and effectiveness of an organization.
Managerial accounting is the area of accounting that serves the decision-making needs of internal users.
Opportunities in Accounting
Accounting information is in all aspects of our lives. When we earn money, pay taxes, invest savings,
budget earnings, and plan for the future, we use accounting.
The majority of opportunities are in private accounting, which are employees working for businesses.
Public accounting offers the next largest number of opportunities, which involve services such as auditing
and tax advice. Still other opportunities exist in government and not-for-profit agencies, including business
regulation and investigation of law violations.
Accounting specialists are highly regarded. Their professional standing often is denoted by a certificate.
Certified public accountants (CPAs) must meet education and experience requirements, pass an
examination, and exhibit ethical character.
Ethics – A Key Concept
The goal of accounting is to provide useful information for decisions. For information to be useful, it must
be trusted. This demands ethics in accounting. Ethics are beliefs that distinguish right from wrong. They
are accepted standards of good and bad behavior.
When faced with an ethical concern, the first step is to recognize it as such. Next, we should analyze all of
our options (both good and bad). Finally, we must choose the best option after weighing all the
consequences.
Generally Accepted Accounting Principles (GAAP)
Financial accounting is governed by concepts and rules known as generally accepted accounting
principles (GAAP). GAAP aims to make information relevant, reliable, and comparable. Relevant
information affects decisions of users. Reliable information is trusted by users. Comparable information is
helpful in contrasting organizations.
Fraud Triangle
The fraud triangle is a model created by a criminologist that asserts the following three factors must exist
for a person to commit fraud: opportunity, pressure, and rationalization.
Opportunity is one side of the fraud triangle. A person must envision a way to commit fraud with a low
perceived risk of getting caught. Employers can directly reduce this risk. An example of some control on
opportunity is a pre-employment background check.
Pressure, or incentive, is another side of the fraud triangle. A person must have some pressure to commit
fraud. Examples are unpaid bills and addictions.
Rationalization, or attitude, is the third side of the fraud triangle. A person who rationalizes fails to see the
criminal nature of the fraud or justifies the action.
It is important to recognize that all three factors of the fraud triangle must usually exist for fraud to occur.
The absence of one or more factors suggests fraud is unlikely. The key to dealing with fraud is to focus on
prevention.
International Standards
In today’s global economy, there is increased demand by external users for comparability in accounting
reports. This demand often arises when companies wish to raise money from lenders and investors in
different countries. To that end, the International Accounting Standards Board (IASB), an independent
group (consisting of individuals from many countries), issues International Financial Reporting Standards
(IFRS) that identify preferred accounting practices.
Differences between U.S. GAAP and IFRS are decreasing as the FASB and IASB pursue a convergence
process aimed to achieve a single set of accounting standards for global use.
Conceptual Framework and Convergence
The FASB and IASB are attempting to converge and enhance the conceptual framework that guides
standard setting. The FASB framework consists broadly of the following:
● Objectives—to provide information useful to investors, creditors, and others.
● Qualitative Characteristics—to require information that is relevant, reliable, and comparable.
● Elements—to define items that financial statements can contain.
● Recognition and Measurement—to set criteria that an item must meet for it to be recognized as an
element; and how to measure that element.
Principles and Assumptions of Accounting
Accounting principles (and assumptions) are of two types. General principles are the basic assumptions,
concepts, and guidelines for preparing financial statements. Specific principles are detailed rules used in
reporting business transactions and events. General principles stem from long-used accounting practices.
Specific principles arise more often from the rulings of authoritative groups.
Accounting Principles
The measurement principle, also called the cost principle, usually means that accounting information is
based on actual cost (with a potential for subsequent adjustments to market). Cost is measured on a cash or
equal-to-cash basis. This means if cash is given for a service, its cost is measured as the amount of cash
paid.
Three concepts are important to the revenue recognition principle.
(1) Revenue is recognized when earned. The earnings process is normally complete when services are
performed or a seller transfers ownership of products to the buyer.
(2) Proceeds from selling products and services need not be in cash. A common noncash proceed
received by a seller is a customer’s promise to pay at a future date, called credit sales.
(3) Revenue is measured by the cash received plus the cash value of any other items received.
The expense recognition principle, also called the matching principle, prescribes that a company record
the expenses it incurred to generate the revenue reported. The principles of matching and revenue
recognition are key to modern accounting.
The full disclosure principle states that a company is required to report the details behind the financial
statements if the details so disclosed would impact the users’ decision-making process. Most of the details
are reported in the notes to the financial statements.
Accounting Assumptions
Now we will look at four fundamental assumptions of accounting.
The going-concern assumption states that, in the absence of information to the contrary, the business entity
is assumed to continue operations into the foreseeable future.
The monetary unit assumption tells us that we will only record accounting information that can be
expressed in monetary units, usually dollars in the United States.
The business entity assumption tells us that we must separate out the transaction of individual owners of
a business from those of the business.
Finally, the time period assumption presumes that the life of a company can be divided into time periods
such as months and years, and that useful reports can be prepared for those periods.
Business Entity Forms
A proprietorship, is a business owned by one person. No special legal requirements must be met to start a
proprietorship. It is a separate entity for accounting purposes, but it is not a separate legal entity from its
owner.
A partnership is a business owned by two or more people, called partners. Like a proprietorship, no special
legal requirements must be met in starting a partnership. The only requirement is an agreement between
partners to run a business together. The agreement can be either oral or written and usually indicates how
income and losses are to be shared. A partnership, like a proprietorship, is not legally separate from its
owners.
A corporation is a business legally separate from its owners, meaning it is responsible for its own acts and
its own debts. Separate legal status means that a corporation can conduct business with the rights, duties,
and responsibilities of a person. A corporation acts through its managers, who are its legal agents. Separate
legal status also means that its owners, who are called shareholders (or stockholders), are not personally
liable for corporate acts and debts. This limited liability is its main advantage.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed by Congress and
designed to:
1. promote accountability and transparency in the financial system,
2. put an end to the notion of “too big to fail,”
3. protect the taxpayer by ending bailouts, and
4. protect consumers from abusive financial services.

Accounting Equation
Assets = Liabilities + Equity
The accounting equation applies to all transactions and events, to all companies and forms of organization, and
to all points in time.
Assets are resources a company owns or controls. Examples are cash, supplies, equipment, and land,
where each carries expected benefits. The claims on a company’s assets—what it owes—are separated
into owner and nonowner claims.
Liabilities are what a company owes its nonowners (creditors) in future payments, products, or services.
Equity (also called owner’s equity or capital) refers to the claims of its owner(s). Together, liabilities and equity
are the source of funds to acquire assets. Examples are wage payable
The relation of assets, liabilities, and equity is reflected in the following accounting equation.

Transaction Analysis and the Accounting Equation

The accounting system reflects two basic aspects of a company: what it owns and what it owes. Assets are
resources a company owns or controls. Examples are cash, supplies, equipment, and land, where each
carries expected benefits. The claims on a company’s assets—what it owes—are separated into owner and
non-owner claims. Liabilities are what a company owes its non-owners (creditors) in future payments,
products, or services. Equity (also called owner’s equity or capital) refers to the claims of its owner(s).
Together, liabilities and equity are the source of funds to acquire assets.
Assets are resources a company owns or controls. These resources are expected to yield future benefits.
Examples are Web servers for an online services company, musical instruments for a rock band, and land
for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of
resources. A company that provides a service or product on credit is said to have an account receivable
from that customer.
Liabilities are creditors’ claims on assets. These claims reflect company obligations to provide assets,
products or services to others. The term payable refers to a liability that promises a future outflow of
resources. Examples are wages payable to workers, accounts payable to suppliers, notes payable to banks,
and taxes payable to the government.
Equity is the owner’s claim on assets, and is equal to assets minus liabilities. This is the reason equity is
also called net assets or residual equity.

Transaction Analysis

Let’s look at the identification and recording of business transactions for FastForward, a consulting business
owned by Chas Taylor that focuses on assessing the performance of footwear and accessories. On
December 1, Chas Taylor personally invests K30,000 cash in FastForward and deposits the cash in a bank
account opened under the name of FastForward.
First, we have to identify the assets, liability or equity accounts involved in this transaction. We can see
that the cash account will increase by K30,000 and the owner capital will increase by K30,000.
After this transaction, the cash (an asset) and the owner’s equity each equal K30,000. The source of increase
in equity is the owner’s investment, which is included in the column titled C. Taylor, Capital. (Owner
investments are always included under the title ‘Owner name,’ Capital.)

In transaction number 2, FastForward uses K2,500 of its cash to buy supplies of brand name footwear for
performance testing over the next few months.
This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It merely changes the
form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The
supplies of footwear are assets because of the expected future benefits from the test results of their
performance.

In transaction number 3, FastForward spends K26,000 to acquire equipment for testing footwear. This is
an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its
expected future benefits from testing footwear.
This purchase changes the makeup of assets but does not change the asset total.

In transaction number 4, FastForward decides more supplies of footwear and accessories are needed. These
additional supplies total K7,100, but as we see from the accounting equation, FastForward has only K1,500
in cash. Taylor arranges to purchase them on credit from CalTech Supply Company.
FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases
assets by K7,100 in supplies, and liabilities (called accounts payable to CalTech Supply) increase by the
same amount.
This purchase changes the makeup of assets but does not change the asset total.

In transaction number 5, FastForward provides consulting services to a powerwalking club and immediately
collects K4,200 cash.
The accounting equation reflects this increase in cash of K4,200 and in equity of K4,200. This increase in
equity is identified in the far right column under Revenues because the cash received is earned by providing
consulting services. It earns net income only if its revenues are greater than its expenses incurred in earning
them.
In transaction 6 and 7, FastForward pays K1,000 rent to the landlord of the building where its facilities are
located. Paying this amount allows FastForward to occupy the space for the month of December. In
addition, the company pays the biweekly K700 salary of the company’s only employee.
The costs of both rent and salary are expenses, as opposed to assets, because their benefits are used in
December (they have no future benefits after December). These transactions also use up an asset (cash). By
definition, increases in expenses yield decreases in equity. This can be seen in the accounting equation
chart because expenses are subtracted in the equity part of the equation. So, an increase in an expense
account yields the subtraction of a larger number, thus decreasing equity.

In transaction 8, FastForward provides consulting services of K1,600 and rents its test facilities for K300
to a podiatric services center. The center is billed for the K1,900 total. This transaction results in a new
asset, called accounts receivable, from this client. It also yields an increase in equity from the two revenue
components that total K1,900.

In transaction 9, the podiatric center pays K1,900 to FastForward 10 days after it is billed for consulting
services.
This transaction does not change the total amount of assets and does not affect liabilities or equity. It
converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was
recognized when FastForward rendered the services, not when the cash is received.

In transaction 10, FastForward pays CalTech Supply K900 cash as partial payment for its earlier K7,100
purchase of supplies, leaving K6,200 unpaid.
This transaction decreases FastForward’s cash by K900 and decreases its liability to CalTech Supply by
K900. Equity does not change. This event does not create an expense even though cash flows out of
FastForward (instead, the expense is recorded when FastForward derives the benefits from these supplies).

In transaction 11, the owner of FastForward withdraws K200 cash for personal use. FastForward’s cash
decreases. Chas Taylor, Withdrawals increases by K200, which by definition, yields a decrease in equity.
This relationship can be seen in the accounting equation on the slide by the subtraction of the withdrawals
account in the equity section. As the withdrawals account balance increases, total equity decreases.
Withdrawals (decreases in equity) are not reported as expenses because they are not part of the company’s
earnings process. Since withdrawals are not company expenses, they are not used in computing net income.

We have now completed transactions 1 through 11. This is a summary of all eleven of FastForward’s
transactions during the month of December. Why don’t you add all the assets and get a total. Compare the
total assets to the total of liabilities and equity. The books are still in balance after analyzing the eleven
transactions

Financial Statements

This section introduces us to how financial statements are prepared from the analysis of business
transactions. The four financial statements and their purposes are:
1. Income statement — describes a company’s revenues and expenses along with the resulting net
income or loss over a period of time due to earnings activities.
2. Statement of owner’s equity— explains changes in equity from net income (or loss) and from
any owner investments and withdrawals over a period of time.
3. Balance sheet — describes a company’s financial position (types and amounts of assets, liabilities,
and equity) at a point in time.
4. Statement of cash flows — identifies cash inflows (receipts) and cash outflows (payments) over
a period of time.
Income Statement

FastForward’s income statement for December shows revenues and expenses conveniently taken from the
equity columns of the transaction summary. Revenues are reported first on the income statement. They
include consulting revenues of K5,800 and rental revenue of K300. Expenses reflect the costs incurred to
generate the revenues reported. FastForward’s expenses include rent and salaries. Net income (or loss) is
reported at the bottom of the statement. FastForward has net income of K4,400 in December.

Statement of Owner’s Equity

The statement of owner’s equity reports information about how equity changes over the reporting period.
This statement shows beginning capital, events that increase it (owner investments and net income), and
events that decrease it (withdrawals and net loss).
FastForward was started this month, so the beginning balance in owner's equity was zero. Chas Taylor
invested K30,000 in the company at the beginning of the month. During December, net income of K4,400
was earned. Notice that the net income flows from the income statement to the statement of owner’s equity.
We must complete the income statement before we can begin work on the statement of owner’s equity. In
addition, K200 withdrawal was made by Chas Taylor, so the ending balance in owner's equity is K34,200.
After we complete this statement, we can prepare the balance sheet.

Balance Sheet

The balance sheet is a summary of assets, liabilities, and equity at the end of the month. Our total assets are
equal to K40,400. This includes cash of K4,800, supplies of K9,600, and equipment of K26,000.
Liabilities include accounts payable of K6,200. Equity is composed of C. Taylor, Capital of K34,200. The
account C.Taylor, Capital flows directly from the statement of owner’s equity. You can see that the books
are in balance because total assets are equal to total liabilities plus equity.
Creditors have claims against our assets of K6,200. The owner has claims to assets of K34,200.

Statement of Cash Flows

We will cover the statement of cash flows in detail in a later chapter. The statement of cash flows reconciles
to the ending cash balance and is divided into three major sections. The first section reports cash flows from
operating activities. It shows the K6,100 cash received from clients and the K5,100 cash paid for supplies,
rent, and employee salaries. Net cash provided by operating activities for December is K1,000. The second
section reports investing activities, which involve buying and selling assets such as land and equipment that
are held for long-term use . It includes K26,000 for the purchase of equipment. The third section shows
cash flows from financing activities, which include the long-term borrowing and repaying of cash from
lenders and the cash investments from, and withdrawals by, the owner.

Return on Assets

This chapter presents a profitability measure: return on assets. Return on assets is useful in evaluating
management, analyzing and forecasting profits, and planning activities. Dell has its marketing department
compute return on assets for every order. Return on assets (ROA), also called return on investment (ROI
), is defined as net income divided by total average assets. Total average assets is computed by adding the
beginning total assets to the ending total assets and divide the total by 2.
Dell shows a fairly stable pattern of good returns that reflect its productive use of assets. There is a decline
in its 2009 to 2010 ROA reflecting the recessionary period. Dell’s ROA compares favorably with the ROA
for the industry average.

Activity 1.1
You should read Chapter 1 from Text book, (Chapter 1: Page No. 2 to 25) and
You are advised to learn and practise the following Exercises and Problems of this chapter.
Questions Page No.
Demonstration Problem 23
Exercise 1-2 32
Exercise 1-6 33
Exercise 1-8 33
Exercise 1-10 34
Exercise 1-11 34
Exercise 1-19 35

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