Chapter 1 of your text is a huge chapter, both in terms of the number of pages, and in the amount of accounting you will learn. Believe it or not, Chapter 1 of your text will include some transaction analysis, accounting theory, and preparation of financial statements. Your time and patient study of this opening lesson will reap big rewards in future chapters. So, take your time and enjoy it.
The first part of Chapter 1 concerns itself with a number of general issues in accounting, such as:
What is accounting?
Who uses accounting information?
What types of activities are performed by accountants?
What are some "Generally Accepted Accounting Principles?" and who determines what those principles are?
What is the accounting equation, and how do various transactions affect that equation?
What are the four financial statements, and what does each one tell us?
You should read the first part of Chapter 1 with the questions above in mind.
Chapter 1 also contains a number of fundamental definitions that provide the structure of accounting. Let us start with a definition of accounting itself.
Accounting is the process of analyzing, recording, classifying, summarizing and communicating the results of the economic events of an organization. The economic events must be measurable in dollars, and are called transactions. During a time period such as one year, accountants execute a set of well-defined steps, called the accounting cycle. The steps are summarized below.
1. Analyze each transaction.
2. Record each transaction in a journal (ordered by date).
3. Transfer each transaction to the accounts affected in the ledger.
(The ledger is a set of accounts ordered by account number.)
4. Summarize the transactions in the form of financial statements:
a. Income Statement: Shows the net income (profit) of the company.
b. Owner's Equity Statement: Shows the owner's claim in the business.
c. Balance Sheet: Shows the financial position of the company.
d. Cash Flow Statement: Shows where cash came from and where it went during the period.
There are five main groups of accounts that must be understood. These are Assets, Liabilities, Owner's Equity, Revenues and Expenses. We start with the "balance sheet accounts" which consist of Assets, Liabilities, and Owner's Equity.
ASSETS: Economic resources owned by a business that are used for the purpose of generating revenue. Examples: Cash, Accounts Receivable, Equipment, Supplies.
LIABILITIES: Debts owed by a business. Examples: Accounts Payable, Notes Payable
OWNER'S EQUITY: The owner's claim in the business. For the time being, we'll focus on the Owner's Capital account, which holds the Owner's investments, drawings, revenues and expenses.
There is an important mathematical relationship among the three Balance Sheet elements:
ASSETS = LIABILITIES + OWNER'S EQUITY
This formula is called the Balance Sheet Equation, and is always true. Another way of stating this equation is to say that the total resources owned by the business are equal to the debts owed by the business + the owner's claim in the business. This may not seem obvious at first, but when we attempt some transactions shortly, you'll see that the equation always works.
A transaction is an economic event that is measurable in dollars. As a first approximation, you might consider that many transactions involve an exchange. For example, a business might purchase a piece of land and pay cash. You can visualize the cash flowing in one direction, and land in the other.
To go a step further, if you are the buyer of the land, you would be interested in knowing the cost of the land you are purchasing, as well as the amount of cash you are giving up. And, in this case, the purchase of the land would cause an increase in land, but a simultaneous decrease in cash. We will focus on such increases and decreases in our analysis of transactions.
To get you started, let us start with a small set of accounts and I'll demonstrate a few transactions. Let us assume that J. Thomas is beginning a small consulting business called Thomas Consulting. Let us further assume that the business is started on January 1 of 1999.
I have placed the accounts across the top in this transaction table, with Assets on the left (Cash, Accounts Receivable, and Equipment). There's one liability account (Accounts Payable), and one Owner's Equity account, Thomas, Capital.
In this first transaction (refer to the diagram above), Thomas creates a new business entity by investing $25,000 of his personal funds. Notice that, from the viewpoint of this new business, cash is received in the amount of $25,000. The source of this cash is the owner, Thomas. The implication is that money can come into a business from investments by the owner. But, as you will come to learn, money can also be acquired from creditors. A creditor is someone you owe money to, such as a bank.
In the diagram above, you'll note that I've shown the totals for the accounts. After this one transaction, you can prove to yourself that Assets (Cash of $25,000) are equal to Liabilities ($0) + Owner's Equity (Capital of $25,000).
Notice that, in transaction 2, one asset (Equipment) increases, while another asset (Cash) decreases. Do the Assets = Liabilities + Owner's Equity? Yes, they do.
Notice that in transaction 3, the company purchases Supplies. I have added a column for this new asset in the diagram. The Supplies vendor is allowing Thomas to pay for the Supplies at a later time. This transaction represents an increase in an asset, Supplies, and an increase in a liability, Accounts Payable. Do Total Assets = Total Liabilities + Total Owner's Equity? As always, the answer is yes.
The payment of an Account Payable ("payment on account") reduces both the liability (Accounts Payable) and Cash. Do Assets = Liabilities after this transaction? Yes.
Now, the purpose of starting a business is to provide a product or service, and the owner hopes to make a profit doing so. In Accounting, we usually do not use the word profit; a better term is net income.
Net Income = Revenues - Expenses
A Revenue is an increase in Owner's Equity brought about by operating the business. A dentist operates by fixing teeth; an architect earns revenue by drawing house plans. For a consulting business, revenue is earned when consulting services are provided to a client. In our example, we will call the revenue account Service Revenue.
An Expense is a cost incurred in the pursuit of Revenue. A company might purchase advertising, a cost which, we hope, will generate revenue. We would record Advertising Expense for this cost. Employees may be hired, resulting in Salaries Expense, in order to accomplish the company's goals. The company might rent an office for conducting its business, resulting in Rent Expense.
It is important to note that:
Revenues increase Owner's Equity
Expenses decrease Owner's Equity.
Notice that the earning of a Revenue increases Owner's Equity, and also increases Accounts Receivable, an asset. Thomas earns money for the business by performing consulting services. Thomas hopes that the revenue earned will be greater than the expenses incurred by the business. The earning of a revenue always increases owner's equity, and is usually evidenced by an increase in an asset, such as Cash or Accounts Receivable.
Notice that Rent Expense is an owner's equity account. An expense
always reduces owner's equity, and is often (but not always) associated
with a decrease in cash. Examine the Totals line to verify
that Assets = Liabilities + Owner's Equity.
Notice that when the owner withdraws cash from the business, this represents a decrease in owner's equity--but keep in mind that Drawings are not considered an expense. The reason for this is that expenses are incurred for the purpose of generating revenue. A drawing, on the other hand, is simply a disinvestment by the owner, and will likely not increase revenue in the future.
We have processed seven transactions, and look how much work it required! Our task now is to prepare three financial statements: an Income Statement, an Owner's Equity Statement, and a Balance Sheet. Normally, these financial statements are prepared at the end of the accounting period. In this example, we will consider the accounting period to be one month, so the financial statements would be prepared on January 31.
The formula for the Income Statement is: Revenues - Expenses = Net Income. The Income Statement covers a period of time, and in this case, we'll assume that the seven transactions shown above represent all of the transactions for January 1999. The Revenues and Expenses can be found in the far right column. The Income Statement would be constructed as follows:
If you look down the far right column of the transaction table, you will see every change that affected the Owner's Capital account. The Owner's Equity Statement reconciles the beginning and ending balance of the Capital account. In our example, the owner invested $25,000; the net income for January was $500; and the owner withdrew $300. These effects are summarized below.
Notice that both the Income Statement and the Owner's Equity Statement cover a period of time-- "the month ended January 31,1999."
The third statement is called the Balance Sheet. It shows the total Assets, Liabilities, and the Owner's Capital. You can look across the bottom line of the transaction table to find the accounts used for the Balance Sheet.
Notice that the Balance Sheet shows the financial position of the company as of one date in time, January 31, 1999.