Lesson 1: Introduction to Accounting

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.

Overview of Chapter 1

The first part of Chapter 1 concerns itself with a number of general issues in accounting, such as:

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.

Definition: Accounting

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.

A Summary of the Accounting Cycle

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.

The Balance Sheet Accounts

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.

Transaction Examples

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.

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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.

Transaction 1: Owner's Investment in the Business

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).

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Transaction 2: Purchase of an Asset for Cash

Notice that, in transaction 2, one asset (Equipment) increases, while another asset (Cash) decreases. Do the Assets = Liabilities + Owner's Equity? Yes, they do.

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Transaction 3: Purchase of an Asset on Account

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.

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Transaction 4: Payment of Cash on Account

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 wordprofit; a better term is net income.

Net Income = Revenues - Expenses

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.

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Transaction 5: Revenue is Earned on Account

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.

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Transaction 6: Incurring of Rent Expense

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. 
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Transaction 7: Owner Withdraws Cash from the Business

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 Income Statement

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:

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The Owner's Equity Statement

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.

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Notice that both the Income Statement and the Owner's Equity Statement cover a period of time-- "the month ended January 31,1999."

The Balance Sheet

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.

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Notice that the Balance Sheet shows the financial position of the company as of one date in time, January 31, 1999.

Service, Merchandising and Manufacturing Businesses

In the example shown above, the company earned revenue by providing a service, in this case, consulting. A medical office, a shirt laundry, and a shoe repair are all examples of service businesses.

Another strategy for earning revenue is by selling a product. Safeway, Nordstrom and a tire store earn revenue by selling products. The business purchases the inventory at a cost, and then sells the merchandise for a higher price. These are called merchandising business.

A third possibility is that a company may manufacture a product and sell it. Examples of this revenue-earning strategy are the Boeing Company, Ford and a home-construction company.

Accounting Careers

There are two broad areas of accounting described in your textbook, financial accounting and managerial accounting. ACCT 201 and ACCT 202 are financial, and ACCT 203 is managerial. Financial accounting is concerned with record-keeping, account management, and production of financial statements. Managerial accounting is devoted to finding ways to increase profitability, create and manage budgets, and for long term planning activities. Beyond these two classifications, there are various branches of accounting such as income tax accounting, forensic accounting, and governmental accounting, all of which would likely require a university degree with specialized coursework, as well as experience in the accounting profession.

There are a couple of professional certifications that one might pursue in accounting, the CPA and the CMA. To become certified, the candidate would complete an accounting degree, and then take extra courses to prepare for a standardized examination. For the CPA certification, a university degree plus 150 hours of additional accounting training are required. The CPA is oriented toward financial accounting and the CMA toward managerial accounting. Both certifications may also involve actual accounting experience, which varies by state.

Many CPAs are involved in auditing, which is a process of examining accounting records to determine if the company has complied with the rules. An important aspect of the audit is to evaluate the company internal controls, to make sure that cash and other assets are managed carefully. A company must create policies and procedures to ensure that employees of the company handle transactions fairly, and apply diligence to protect the assets from theft. There have been many cases (some referred to in your text) of employees, and even managers conspiring to steal company resources. Strong internal controls help to reduce theft and thus enhance the validity of accounting reports.

The Rules of Accounting

Prior to the 1950s, the rules of accounting were somewhat informal in that accountants adhered to what was called Generally Accepted Accounting Principles (GAAP). These principles were agreed to by members of the profession. As time went on, the need for written rules became critical, and a group called the Accounting Principles Board was formed. This group, the APB, came up with some basic principles that we still use today.

Later, as accounting transactions became more complex, due to unforeseen types of transactions, along with international trade and technology influences, a new group called the Financial Accounting Standards Board took over responsibility to make the rules in the United States. That group, the FASB, still exists today.

In the past two decades, an international board called the IASB has made great strides in formulating rules that are global in scope. The IASB hopes to coordinate the rules of all countries so that the financial reports are consistent worldwide.

It is important to realize that accounting principles are made by human beings, and undergo change over time. And, these principles are not considered laws. However, in the area of tax accounting, the rules made by national and local bodies are considered laws. For example, if you earn income in the United States, you must follow federal tax laws.

A Few Basic Accounting Principles

A few basic accounting principles are described in the following paragraphs.

The cost principle says that all assets are recorded at the amount we paid for them, and that cost amount is not changed to reflect market value. Example: we purchase a small office building in Seattle for $100,000. That building would be entered in the accounts at the cost of $100,000. But what if the market value of the building increases by $10,000? We do not record the increase in value. We continue to show the building at the cost of $100,000.

The revenue recognition principle provides a way for us to determine when we have earned revenue. The principle says that we record revenue at the moment we have provided a service or a product to the customer. For example, if you purchase a shirt at Nordstrom, the revenue is earned when the shirt is conveyed to you. Delivery of the product to the customer indicates that revenue has now been earned. Another example: a landscape company builds a deck in your yard. As soon as the deck is complete, the landscaper earns the revenue.

It is important to note that the receipt of cash by the service provider does not necessarily prove that revenue was earned. In the Nordstrom example, perhaps you used your credit card to make the purchase. Even though Nordstrom did not receive cash from you, the revenue is considered earned, because the product was conveyed to you.

The monetary unit assumption requires that all transactions be recorded in dollars. Every transaction must be evaluated using the appropriate currency. However, accountants do not weigh the value of the currency. If inflation is occurring in the economy, accountants generally do not impute the inflationary effects into the financial statements.

The entity theory says that we must consider the limits of the entity when analyzing economic events. Every person is theoretically an entity. The person earns money, engages in purchases of assets, assumes debts, and pays taxes. If that person also starts a business, the business is considered a separate entity. That business entity has its own assets, liabilities, revenues and expenses, separate from those of the owner. The accountant must recognize which entity is under scrutiny and include only the transactions for that entity.