WHAT IS ACCOUNTING?

Accounting is a process of three activities:

1 Identifying
2 Recording
3 Communicating
 ILLUSTRATION 1-1
ACCOUNTING PROCESS
Communication
Accounting

Identification
Reports
Recording

Prepare accounting
reports

SOFTBYTE
Select economic events Record, classify Annual Report

(transactions) and summarize

Analyze and interpret

for users
QUESTIONS ASKED BY
INTERNAL USERS

• Is cash sufficient to pay bills?

• Can we afford to give
employee pay raises this year?
• What is the cost of
manufacturing each unit of
product?
• Which product line is the
most profitable?
QUESTIONS ASKED BY
EXTERNAL USERS

• Is the company earning

satisfactory income?
• Will the company be able to
pay its debts as they come
due?
• How does the company
compare in size and
profitability with
competitors?
 BOOKKEEPING DISTINGUISHED
FROM ACCOUNTING
Accounting
1 Includes bookkeeping
2 Also includes much more

Bookkeeping
1 Involves only the recording of economic events
2 Is just one part of accounting
 BUSINESS ENTERPRISES
 A business owned by one person is generally a
proprietorship.
 A business owned by two or more persons
associated as partners is a partnership.
 A business organized as a separate legal entity
under state corporation law and having
ownership divided into transferable shares of
stock is called a corporation.
 ILLUSTRATION 1-5
THE BASIC ACCOUNTING EQUATION

The Basic Accounting Equation

Assets = Liabilities + Stockholders’ Equity

 ASSETS AS A
BUILDING BLOCK
 Assets are resources owned by a business.
 They are things of value used in carrying out
such activities as production, consumption and
exchange.
 The common characteristics possessed by all
assets is the capacity to provide future services
or benefits to the entities that use them.
 LIABILITIES AS A
BUILDING BLOCK
 Liabilities are claims against assets.
 They are existing debts and obligations.
 Most claims of creditors attach to total
enterprise assets rather than to the
specific assets provided by the creditor.
 STOCKHOLDER’S EQUITY
AS A BUILDING BLOCK
 The ownership claim on total assets is
known as stockholder’s equity.
 It is equal to total assets minus total
liabilities.
 The stockholders’ equity section of a
corporation’s balance sheet consists of:
1 Paid-in (contributed) capital
2 Retained earnings
 PAID-IN CAPITAL AS
A BUILDING BLOCK

 Paid-in capital is the term used to describe

the total amount paid in by stockholders.
 The principal source of paid-in-capital is
the investment of cash and other assets in
the corporation by stockholders in
exchange for capital stock.
 RETAINED EARNINGS AS
A BUILDING BLOCK
The retained earnings section of the balance
sheet is determined by three items:
1 Revenues
2 Expenses
3 Dividends
 REVENUES AS A
BUILDING BLOCK
 Revenues are the gross increases in
stockholder’s equity that result from
operating the business.
 Generally, revenues result from the sale of
merchandise, the performance of services,
the rental of property, or the lending of
money.
 Revenues usually result in an increase in
an asset.
 EXPENSES AS A
BUILDING BLOCK
 Expenses are the decreases in stockholders’
equity that result from operating the business.
 They are the cost of assets consumed or
services used in the process of earning revenue.
 Examples of expenses include utility expense,
rent expense, supplies expense, and tax
expense.
 When revenues exceed expenses, net income
results.
 When expenses exceed revenues, a net loss
results.
 DIVIDENDS
 Net income represents an increase in net
assets which then become available for
distribution to stockholders.
 Cash or other assets that are distributed to
stockholders are called dividends.
 Dividends reduce retained earnings but
are not corporate expenses.
 A corporation decides whether or not to
distribute a dividend after determining its
net income or net loss.
 ILLUSTRATION 1-6
INCREASES AND DECREASES IN
STOCKHOLDERS’ EQUITY

INCREASE DECREASE
Investments by Dividends to
Stockholders Stockholders
Stockholders’
Equity
Revenues Expenses
 USING THE BUILDING BLOCKS
TRANSACTION ANALYSIS
 Transactions are the economic events of the enterprise.
 They may be identified as external or internal.
1 External transactions involve economic events
between the company and some outside enterprise or
party.
2 Internal transactions are economic events that
occur entirely within one company.

My division
We need ten
needs 2,500
cases by
pounds from
Friday
your division
 TRANSACTION ANALYSIS
TRANSACTION 1

 Ray and Barbara Neal decide to open a computer

programming company to be incorporated as
Softbyte, Inc.
 They invest $15,000 cash in exchange for $15,000
of common stock.
 TRANSACTION ANALYSIS
TRANSACTION 1 SOLUTION

Assets = Liabilities + Stockholders’ Equity

Common
Cash Stock
(1) +15,000 = +15,000 Investment

There is an increase in the asset Cash, $15,000,

and an equal increase in the stockholders’
equity, Common Stock, $15,000.
 TRANSACTION ANALYSIS
TRANSACTION 2

Softbyte purchases computer equipment for $7,000 cash.

 TRANSACTION ANALYSIS
TRANSACTION 2 SOLUTION

Stockholders’
Assets = Liabilities + Equity
Common
Cash + Equipment = Stock
Old Bal. $15,000 $15,000
(2) -7,000 +$7,000
New Bal. $ 8,000 + $7,000 = $15,000

$15,000

Cash is decreased $7,000 and the asset

Equipment is increased $7,000.
 TRANSACTION ANALYSIS
TRANSACTION 3

 Softbyte purchases computer paper and other

supplies expected to last several months from
Acme Supply Company for $1,600.
 Acme Supply Company agrees to allow Softbyte
to pay this bill in October, a month later.
 This transaction is often referred to as a purchase
on account or a credit purchase.
Acme Supply Company

Softbyte, Inc.
 TRANSACTION ANALYSIS
TRANSACTION 3 SOLUTION

Stockholders’
Assets = Liabilities + Equity
Accounts Common
Cash + Supplies + Equipment = Payable + Stock
Old Bal. $8,000 $7,000 $15,000
(3) +$1,600 +$1,600
New Bal. $8,000 + $1,600 + $7,000 = $1,600 + $15,000

$16,600 $16,600

The asset Supplies is increased $1,600 and the liability

Accounts Payable is increased by the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 4

 Softbyte receives $1,200 cash from customers for

programming services it has provided.
 This transaction represents the principal
revenue-producing activity of Softbyte.

Softbyte, Inc.
 TRANSACTION ANALYSIS
TRANSACTION 4 SOLUTION

Assets = Liabilities + Stockholders’ Equity

Accounts Common Retained
Cash + Supplies + Equipment = Payable + Stock Earnings
Old Bal. $8,000 $1,600 $7,000 $1,600 $15,000
(4) +1,200 +1,200 Service
Revenue
New Bal. $9,200 + $1,600 + $7,000 = $1,600 + $15,000 $1,200

$17,800 $17,800

Cash is increased $1,200 and Retained

Earnings is increased $1,200.
 TRANSACTION ANALYSIS
TRANSACTION 5

Softbyte receives a bill for $250 from the Daily News

for advertising the opening of its business but
postpones payment of the bill until a later date.

Softbyte, Inc. Bill

Dail News
y
 TRANSACTION ANALYSIS
TRANSACTION 5 SOLUTION

Assets = Liabilities + Stockholders’ Equity

Accounts Common Retained
Cash + Supplies + Equipment = Payable + Stock Earnings
Old Bal. $9,200 $1,600 $7,000 $1,600 $15,000 $1,200
(5) +250 -250 Advertising
Expense
New Bal. $9,200 + $1,600 + $7,000 = $1,850 + $15,000 $ 950

$17,800 $17,800

Accounts Payable is increased $250, and

Retained Earnings is decreased $250.
 TRANSACTION ANALYSIS
TRANSACTION 6

 Softbyte provides programming services of $3,500

for customers.
 Cash amounting to $1,500 is received from
customers, and the balance of $2,000 is billed to
customers on account.

Softbyte, Inc.
Bill
 TRANSACTION ANALYSIS
TRANSACTION 6 SOLUTION

Assets = Liabilities + Stockholders’ Equity

(6) +1,500 +2,000 +3,500 Service

Revenue

$21,300 $21,300

Cash is increased $1,500; Accounts Receivable is increased

$2,000; and Retained Earnings is increased $3,500.
 TRANSACTION ANALYSIS
TRANSACTION 7

Expenses paid in cash for September are store rent,

$600, salaries of employees, $900, and utilities, $200.

$600

$900
Softbyte, Inc.

$200
 TRANSACTION ANALYSIS
TRANSACTION 7 SOLUTION

Assets = Liabilities + Stockholders’ Equity

(7) -1,700 -600 Rent

-900 Salaries
-200 Utilities

$19,600 $19,600

Cash is decreased $1,700 and Retained Earnings is

decreased by $1,700.
 TRANSACTION ANALYSIS
TRANSACTION 8

Softbyte pays its Daily News advertising bill of $250

in cash.

Softbyte, Inc.

Daily News
 TRANSACTION ANALYSIS
TRANSACTION 8 SOLUTION

Assets = Liabilities + Stockholders’ Equity

(8) -250 -250

$19,350 $19,350

Cash is decreased $250 and Accounts Payable is decreased by

$250.
 TRANSACTION ANALYSIS
TRANSACTION 9

The sum of $600 in cash is received from customers

who have previously been billed for services in
Transaction 6.

Softbyte, Inc.
 TRANSACTION ANALYSIS
TRANSACTION 9 SOLUTION

Assets = Liabilities + Stockholders’ Equity

(9) +600 -600

$19,350 $19,350

Cash is increased $600 and Accounts Receivable is

decreased by the same amount.
 TRANSACTION ANALYSIS
TRANSACTION 10

The corporation pays a dividend of $1,300 in

cash to Ray and Barbara Neal, the stockholders
of Softbyte, Inc.

$1,300
Softbyte, Inc.
 TRANSACTION ANALYSIS
TRANSACTION 10 SOLUTION

Assets = Liabilities + Stockholders’ Equity

(10) -1,300 -1,300 Dividends

$18,050 $18,050

Cash is decreased $1,300 and Stockholders’ Equity is

decreased by the same amount.
 FINANCIAL STATEMENTS
After transactions are identified, recorded, and summarized,
four financial statements are prepared from the
summarized accounting data:
1 An income statement presents the revenues and expenses
and resulting net income or net loss of a company for a
specific period of time.
2 A retained earnings statement summarizes the changes in
retained earnings for a specific period of time.
3 A balance sheet reports the assets, liabilities, and
stockholders’equity of a business enterprise at a
specific date.
4 A statement of cash flows summarizes information
concerning the cash inflows (receipts) and outflows
(payments) for a specific period of time.
 ILLUSTRATION 1-9
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

Net SOFTBYTE, INC.

income of Income Statement Net income
$2,750 For the Month Ended September 30, 2002 of $2,750 is
Revenues
shown on Service revenue $ 4,700 determined
the Expenses
from the
Salaries expense $ 900
income Rent expense 600 information
statement Advertising expense 250
in the
Utilities expense 200
is added Total expenses 1,950 retained
to the Net income $ 2,750 earnings
beginning column of
balance of SOFTBYTE, INC.
Retained Earnings Statement the
retained For the Month Ended September 30, 2002 Summary of
earnings Retained earnings, September 1 $ –0– Transactions
Add: Net income
in the 2,750
2,750 (Illustration
retained Less: Dividends 1,300 1-8).
earnings Retained earnings, September 30 $ 1,450

statement.
 ILLUSTRATION 1-9
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE, INC.
Retained Earnings Statement
For the Month Ended September 30, 2002
Retained earnings, September 1 $ –0–
Add: Net income 2,750
Retained 2,750 The retained
earnings of Less: Dividends 1,300
earnings of
Retained earnings, September 30 $ 1,450
$1,450 at the $1,450 at the
end of the SOFTBYTE, INC. end of the
reporting Balance Sheet reporting period
period September 30, 2002 is shown as the
Assets final total of the
shown in the Cash $ 8,050
retained Accounts receivable 1,400 retained
Supplies 1,600 earnings column
earnings Equipment 7,000 of the Summary
statement is Total assets $ 18,050
of Transactions
shown on Liabilities and Stockholders’ Equity
(Illustration
Liabilities
the balance Accounts payable $ 1,600 1-8).
sheet. Stockholders’ equity
Common stock $ 15,000
Retained earnings 1,450 16,450
Total liabilities and stockholders’ equity $ 18,050
 ILLUSTRATION 1-9
FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE, INC.
Balance Sheet
September 30, 2002
Assets
Cash $ 8,050
Accounts receivable 1,400
Supplies 1,600
Equipment 7,000
Total assets
Liabilities and Stockholders’ Equity
$ 18,050
Cash of $8,050
Liabilities on the balance
Accounts payable $ 1,600
Stockholders’ equity sheet and
Cash of $8,050 on Common stock $ 15,000
statement of cash
Retained earnings 1,450 16,450
the balance sheet Total liabilities and stockholders’ equity $ 18,050 flows is shown as
is reported on the SOFTBYTE, INC. the final total of
statement of cash Statement of Cash Flows the cash column
For the Month Ended September 30, 2002
flows. Cash flows from operating activities of the Summary
Cash receipts from revenues
Cash payments for expenses
$ 3,300
(1,950)
of Transactions
Net cash provided by operating activities 1,350 (Illustration 1-8).
Cash flows from investing activities
Purchase of equipment (7,000)
Cash flows from financing activities
Sale of common stock $ 15,000
Payment of cash dividends (1,300) 13,700
Net increase in cash 8,050
Cash at the beginning of the period –0–
Cash at the end of the period $8,050