ACC 111

CHAPTER 1 HANDOUT

INTRODUCTION TO
ACCOUNTING AND BUSINESS

Copyright protected, 2007: Janice Stoudemire, CPA

Certain material used with permission of Thomson/South-Western Publishing
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STUDYING SUGGESTIONS
Always READ the chapter! No exceptions. Be sure to review the At a Glance on page
224 and 25, which relates to key points of the chapter to the key learning outcomes to
specific examples and exercises. Review the list of key terms and go back to the page
reference listed for any that you have difficulty with.
Finally, attempt to complete the illustrative problem on
page 26 on your own. The solution is provided on in the
text on page 75.

Be sure to complete the assigned exercises and problems

(by the due date) in ThomsonNOW. Feel free to complete
additional exercises and problems if you feel you have not
mastered the material.

CHAPTER OVERVIEW
For many of you, Chapter 1 is your first taste of the business or accounting disciplines.
The challenge is to have you understand and accept the importance of learning
business and accounting concepts. Because this chapter will set the tone for the entire
course and your business career, avoid the temptation to rush through the material.
Budget sufficient time to learn the basics!

Chapter 1 begins with a discussion of the nature of a business and the different types
of businesses (service, merchandising, and manufacturing) and types of business
organizations (proprietorship, partnership, corporation, and limited liability
corporations). Next, the chapter describes different types of business stakeholders,
introduces business ethics, and discusses three factors of individual character, firm
culture, and laws and enforcement that affect ethics as well as accounting/business
fraud.

In addition, Generally Accepted Accounting Principles (GAAP), the business entity

concept, and the cost concept are presented. The accounting equation is introduced
then the discussion of how business transactions affect accounts in the accounting
equation begins. The chapter ends with examples of how to prepare all four financial
statements using the accounting equation information and with explanations of how
the four financial statements are interrelated. Following this, the text explains the
accounting equation and begins the discussion of recording business transactions in
accounts. Sounds like a lot of fun doesn’t it! Good luck. 
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CHAPTER OBJECTIVES

After studying the chapter, you should be able to:

1. Describe the nature of a business and the role of ethics and accounting in business.
2. Summarize the development of accounting principles and relate them to practice.
3. State the accounting equation and define each element of the equation.
4. Describe and illustrate how business transactions can be recorded in terms of the
resulting changes in the basic elements of the accounting equation.
5. Describe the financial statements of a proprietorship form of business and explain
how the statements interrelate.

Learning Objective 1: Describe the nature of a business and the

role of ethics and accounting in business.

NATURE OF BUSINESS AND ACCOUNTING:

KEY TERMS:
Accounting Manufacturing Business
Business Merchandising Business
Capital Market Stakeholders Partnership
Corporation Profit
Ethics Product or Service Market Stakeholders
Government Stakeholders Proprietorship
Internal Stakeholders Stakeholder
Limited Liability Corporation Service Business

NATURE OF BUSINESS AND ACCOUNTING:

• What is a business? Everyone has heard the term “business’ but

what is it?
1. “An organization in which basic resources (inputs), such
as materials and labor, are assembled and processed to
provide goods or services (outputs) to customers.”

2. An economic unit that sells goods and/or services to customers in order to

provide a return to its owners.
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• All businesses have similar goals:

1. Profitability – Difference between amounts received from customers and
amounts paid in order to provide goods/services.

2. Liquidity – Do you have enough cash on hand to pay your bills?

TYPES OF BUSINESSES:
1. SERVICE COMPANY - performs a service for a fee

2. MERCHANDISING COMPANY - buys goods and resells them to customers

3. MANUFACTURING COMPANY - buys materials, makes a product, and

sells the product to customers; We cover in ACC 102

BUSINESS ORGANIZATIONS

PROPRIETORSHIP:
• ONE owner; Owner usually runs the business;

• Legally, the business is the same economic unit as the owner – so the owner gets all
profits/losses and is PERSONALLY liable for all of the debts of the business;

• They make up the largest number of businesses, but are typically the smallest in
size.

NOTE: In the early chapters of the text, we will be learning

about accounting concepts related to service businesses
organized as proprietorships- I know you just can’t wait.

PARTNERSHIP:
• TWO OR MORE owners Partners usually run the business; Legally, the business is not
separate from partners – so the partners share profits/losses and at least one is
PERSONALLY liable for all of the debts of the business.
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• May be formed with verbal or written agreement;

• Partnership is dissolved if partner dies, withdraws, etc.

• We cover in ACC 102

CORPORATION:
• A business incorporated under the laws of a state; A separate legal entity – business
is legally separate from its owners (unlike proprietorships and partnerships);

• Issues shares of stock to its owners, who do NOT run the business day-to-day;

• Limited liability - stockholders are NOT personally liable

for the corporation's debts;

• Ownership of the business and management of it are

separate - stockholders elect board of directors, and the
board then appoints managers to run company;

• Make up the smallest number of businesses, but are typically the largest in size;

• We cover in ACC 115.

LIMITED LIABILITY CORPORATION (LLC:)

• Has the characteristics of both a partnership and a corporation! It is set up like a
corporation but is treated for TAX purposes as a partnership. We do not cover in this
course!

FUN FACTS:
1. More than 70% of the businesses in the United States are organized as
proprietorships.
2. About 10% of businesses are organized as partnerships.
3. About 20% of businesses are organized as corporations; however, they generate
over 90% of the total dollars of business receipts.
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WHO USES ACCOUNTING INFORMATION?

BUSINESS STAKEHOLDER:
• “a person or entity that has an interest in the economic
performance of the business”;

• Includes owners, managers, employees, customers, creditors,

and various government agencies;

• Use accounting data to gauge the economic performance of

businesses.

FOUR CATEGORIES OF BUSINESS STAKEHOLDERS:

1. Capital market stakeholders: provide major financing (i.e. banks, long-term

creditors)
2. Product or service market stakeholders: customers
3. Government stakeholders: local, state and federal
4. Internal stakeholders: employees, managers

MANAGEMENT:
• People responsible for operating the business: Their goals are to ensure that the
business is profitable and liquid! They need accounting information to help them
perform the following functions:
1. Finance the business
2. Invest the resources of the business
3. Produce goods and services
4. Market goods and services
5. Manage employees
6. Provide information to decision makers, both inside and outside the
company
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BUSINESS ETHICS

WHAT IS BUSINESS ETHICS?

• The difference between right and wrong!

• Moral principles that guide the conduct of individuals;

• Sometimes mangers/ employees can feel pressured into violating ethics!

• Normally develop a Conduct of Ethics

• Used to help accountants make difficult decisions.

THREE FACTORS THAT INFLUENCE ETHICAL BEHAVIOR:

1. Individual character: Does the person display characteristics of honesty, integrity

and fairness when under pressure? Who you “bend” or “break” rules when faced with
the threat of losing your job?

2. Firm culture: Does the behavior and attitude of senior

mangers of the company set the tone? Set example for others?

3. Laws and enforcement: Is there a lack of laws or

enforcement? We have new laws and procedures to help
address this.

PROFESSIONAL ETHICS:
• Accountants have obligation (to their employers and clients, as well as society as a
whole) to uphold the highest ethical standards.

• Codes of conduct apply to profession: these codes can be used to help accountants
make difficult decisions. Includes integrity, objectivity, independence, due care.

• Example of Codes:
American Institute of Certified Public Accountants Codes of
Professional Conduct
1. Exercise sensitive professional and moral judgment.
2. Act in a way that will serve the public interest, honor the public trust,
and demonstrate commitment to professionalism.
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3. Perform all professional responsibilities with the highest sense of integrity.

4. Maintain objectivity and be free of conflicts of interest.
5. Observe the profession's technical and ethical standards and continually
improve competency and quality of services.
6. Use ethical standards when determining the scope and nature of services
to be provided.

Institute of Management Accountants Standards of Ethical Conduct

1. Maintain an appropriate level of professional competence.
2. Refrain from disclosing confidential information.
3. Avoid conflicts of interest.
4. Communicate information fairly and objectively.

EXAMPLES:
For the following situations comment whether the person’s actions were
ethical or unethical considering the circumstances. Explain.

1. Lauren Smith is the controller for Sports

Central, a chain of sporting goods stores. She has
been asked to recommend a site for a new store.
Lauren has an uncle who owns a shopping plaza in
the area of town where the new store is to be
located, so she decides to contact her uncle about
leasing space in his plaza. Lauren also contacted
several other shopping plazas and malls, but her uncle's store turned out to be the
most economical place to lease. Therefore, Lauren recommended locating the new
store in her uncle's shopping plaza. In making her recommendation to management,
she did not disclose that her uncle owns the shopping plaza.
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2. John Jones is the chief accountant for the Southwest district office of
Security Life Insurance Company. While preparing the fourth-quarter sales report,
John overheard the company president say that he would close Security's Phoenix
office if it did not meet its fourth-quarter sales quota. John's best friend from college
works at the Phoenix office. Anxious to find out whether the office was in jeopardy,
John immediately finished the Phoenix office's report, only to find that it showed sales
25% below the quota. Later that afternoon, the company president called John for
Phoenix's sales results. John told the president that he had not finished preparing the
sales report for the Phoenix office. John wanted time to compile data that might
convince the president to continue operations in Phoenix, despite lagging sales.

3. Tech-Smart Computer Company recently discovered a defect in the hard

disks installed in its model R24 computer. The hard disk head in these units retracts
too violently whenever the computers are turned off. As a result, the hard disks are
destroyed after the computer is turned on and off approximately 500 times. Tech-
Smart has sold 4,000 model R24 computers nationwide.The marketing department at
Tech-Smart contacted most of the 4,000 owners of the model R24 computer and
discovered that 20% (or 800) use their computers in businesses that operate 24
hours per day. These customers never turn their computers off; therefore, the defect
should not damage their hard disk units.Judy Govan, Tech-Smart's controller, has
been asked to determine the cost to correct the hard disk problem and recommend a
course of action. After studying the marketing department's report, Judy decides to
recommend that Tech-Smart replace the hard drives only in the 3,200 units used by
customers who actually turn their computers off.
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4. Tom Brown, the controller for MicroTech Software Company, is responsible for
preparing the company's financial statements. He learns that sales for the first quarter
of the year have dropped so dramatically that the company is in danger of
bankruptcy. As a result, he applies for an accounting position with another software
company that competes with MicroTech. During his job interview, Tom is asked why
he wants to leave MicroTech. He replies truthfully, "The company's sales are down
another 10% this quarter. I fear they will go out of business." At that time, MicroTech
had not released its sales results to the public.

WHAT IS ACCOUNTING?
DEFINITION: “an information system that provides reports to stakeholders about the
economic activities and condition of a business.”

• Language of business

• An information system
1. MEASURES - by recording data about business activities
2. PROCESSES - by storing and preparing the data
3. COMMUNICATES - through reports called financial statements

WHAT IS THE PURPOSE OF ACCOUNTING?

• To provide information that can be used in making decisions; Accounting provides a
critical service to society

• Goal of accounting = Record + Report + Interpret

economic data for use by decision makers

• Process: Identify stakeholders, assess their information

needs, design accounting system to meet needs, record the
economic data, prepare useful reports

• Important: different accounting data are needed by different people and

organizations. For example, a banker evaluating an application for a short-term loan
and a public utility commission considering a rate increase would not consider the
same types of accounting information.
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EXAMPLE:
Provide a reason why the parties listed below would be interested in the economic data
in the chart.

Interested In Reason
1. Owner Sales
Profit
Cash

2. Investors/Stockholders Profit
Dividends

3. Bankers Debts

4. IRS Profit

5. Managers Expenses
Sales

6. Employees Profit

7. Customers Amount spent on

warranty claims

8. Competitors Amount spent on ads

STANDARDIZED ACCOUNTING PROCEDURES:

• Must realize that there is a need for standardized accounting procedures and for
recording business transactions and rules on how to determine profit if that
information is going to be useful to decision makers.

• There would be too much diversity in financial reporting that would occur without
accounting standards. The following example illustrates this!
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EXAMPLE: LEARNING ACTIVITY

Required: Can you compute the profit for the company based on the data given?

CLASSIC UPHOLSTERY SHOP

Tyler Smith has worked in an upholstery shop for 10 years. Last year, Tyler's wages
were $20,000. Lately, Tyler has been unhappy with the shop's owner. Convinced that
he could run an upholstery shop that did better work at a lower
cost, Tyler decided to go into business for himself and opened
CLASSIC UPHOLSTERY SHOP.

To get the business going, Tyler decided to invest heavily in

advertising. He spent $6,000 on advertising aimed at consumers
and another $2,000 on advertising aimed at getting work from
interior decorators and interior design stores. Tyler also purchased industrial sewing
machines costing $4,000 and other tools and equipment costing $3,000. He estimated
that the sewing machines can be used for about 5 years, before maintenance costs
will be too high and the machines will need to be replaced. The other tools and
equipment are not as durable and will have to be replaced in 3 years.

At the end of the first year of business, Tyler had received $80,000 in cash from
customers for upholstery work. Tyler was owed another $2,500 from customers who
are not required to pay cash, but are billed every 30 days.

A review of Tyler's checkbook shows he paid the following expenses (in addition to
those mentioned previously) during the first year of business:

Upholstery fabric $40,000

Other supplies 10,000
Wages–––part-time assistant 9,500
Rent 4,800
Insurance (2-year policy) 3,200
Utilities 2,500
Miscellaneous expenses 1,700

Tyler's utility bill for the last month of the year has not arrived. He estimated that the
bill would be approximately $320.

Tyler keeps some stock of upholstery fabric in popular colors on hand for customers
who do not want to wait for special-order fabric to arrive. At the end of the year,
about $14,000 of the fabric purchased during the year was in his store stock. In
addition, $2,300 in supplies had not been used.
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HOW MUCH PROFIT DID TYLER MAKE IN HIS FIRST YEAR OF BUSINESS? DO
YOU THINK IT WAS A GOOD IDEA TO OPEN THE UPHOLSTERY SHOP, OR
WOULD TYLER BE BETTER OFF WITH HIS OLD JOB?

Answer:

THE ACCOUNTING PROFESSION

NEWSFLASH:
• Accountants do more than just prepare tax forms! There
are the many employment alternatives available in
accounting- just look at the advertisements for
accounting positions from the newspaper. There is the
diversity in the accounting profession and we need to
move away from the “bean-counter” image.

• In fact there are some nontraditional accounting careers.

Two government organizations who hire accountants to
help with investigations of fraud and criminal activities
are the FBI and the IRS.

PRIVATE ACCOUNTING:
• Management accountants: provide accounting services for a single business - their
employer! Goal – to give management the information it needs to make wise
decisions; Includes controller (chief accountant), treasurer, internal auditor, financial
accountant, cost accountant

• Professional Certifications: Certified Management Accountant (CMA) and Certified

Internal Auditor (CIA)
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PUBLIC ACCOUNTING:
• Offer professional accounting services to many clients

• Certified Public Accountants (CPA): Licensed by the state to protect the public;
Requirements include education, exam, experience

• Primary Activities are:

1. AUDITING - examine client's financial statements to see if they comply with GAAP:
Purpose - to lend credibility to the client's financial statements; Auditor is
INDEPENDENT of the client - must have no financial, employment, or other
compromising ties to the client
2. TAX SERVICES - planning and preparation
3. MANAGEMENT ADVISORY SERVICES - consulting, system design, etc.
4. SMALL BUSINESS SERVICES - bookkeeping, advising, etc.

SPECIALIZED ACCOUNTING:
• Financial Accounting ––– preparing reports that show the profits and financial health of
the company using the rules of accounting, known as generally accepted accounting
principles (GAAP)

• Auditing ––– evaluating financial records and reports to determine whether they present
the results of a company's operations fairly

• Management Accounting ––– providing data to management to assist in running day-

to-day operations

• Cost Accounting ––– tracking costs, particularly those to

manufacture a product

• Tax Accounting ––– preparing tax returns and helping

companies and individuals reduce the amount of taxes paid by
carefully planning their business activities

• Accounting Systems ––– designing accounting systems that collect accurate data and
protect a company's assets (cash, inventory, etc.) from misuse or theft; since most
accounting systems today are maintained on a computer, this area requires computer
hardware and software knowledge

• International Accounting ––– focusing on issues related to international trade; for

example, buying or selling goods in a foreign currency

• Not-for-Profit Accounting ––– reporting on the operations of nonprofit organizations

(such as churches, charities, educational institutions, and governmental agencies)
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• Social Accounting ––– measuring the social costs and benefits of various actions

• Accounting Instruction ––– teaching accounting to students

FINANCIAL ACCOUNTING VERSUS MANAGERIAL ACCOUNTING

• FINANCIAL – accounting that is primarily for EXTERNAL users (owners, creditors,
employees, government, etc.); Purpose - to provide financial statements (Report sent to
external users are called financial statements) and other accounting info to third parties

• MANAGERIAL – accounting that is primarily for INTERNAL use by management; To help

them achieve their goals of profitability and liquidity by giving them information about their
financing, investing, and operating activities

Learning Objective 2: Summarize the development of

accounting principles and relate them to practice.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

KEY TERMS:
Business Entity Concept
Objectivity Concept
Cost Concept
Unit of Measure Concept
Financial Accounting Standards Board (FASB)
Generally Accepted Accounting Principles (GAAP)

WHAT ARE GENERALLY ACCEPTED ACCOUNTING PRINCIPLES?

• Guidelines accountants follow in preparing financial statements.They are not "empirical
truths" or "laws of nature", but they are constantly being changed as better methods are
developed or circumstances change

• Everyone must follow the same set of rules; otherwise, financial statements would be
meaningless because we couldn't compare them!
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WHO HAS HAD A PART IN ESTABLISHING GAAP?

• FINANCIAL ACCOUNTING STANDARDS BOARD (FASB): The primary source of GAAP
since 1973

• Issues accounting standards that are to be followed in the recording, reporting and
presentation of financial transactions (the “laws, rules, guidelines of accounting”)

OTHERS THAT INFLUENCE GAAP:

• American Institute Of Certified Public Accountants (AICPA): Professional organization
of CPA's that set financial accounting standards through 1973

• Securities And Exchange Commission (SEC): Government agency that has the legal
authority to set standards but it has historically let the private sector (through
FASB now) set GAAP

• Internal Revenue Service (IRS): Sets rules for determining taxable income (but not
GAAP!)

• Governmental Accounting Standards Board (GASB): Sets standards for governmental

accounting

BASIC “CONCEPTS”

WHAT ARE THEY?

• Four principles that govern how accounting data are accumulated!
1. Business Entity Concept
2. Cost Concept
3. Objectivity Concept
4. Unit of Measure Concept

Remember that accounting data would be inconsistent from company to

company if standardized procedures were not followed (as demonstrated
in the Classic Upholstery Shop example earlier).
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BUSINESS ENTITY CONCEPT:

• Sometimes called Separate Entity Concept

• For accounting purposes, business is separate and distinct from its owners, creditors,
and customers. So it keeps a separate set of records, reports, etc. Business keeps its
records separate from those of any other business and also separate from its owners’
personal records

• If an individual owned a dry cleaner, a video store, and a gas station, how would the
owner know the profitability of each? Answer: by keeping separate accounting
records.

COST CONCEPT:
• For accounting purposes we need a “basis” for valuing and recording transactions

• What amount do we use? The “cost” of the item in the transaction, but what is the
“cost”? Normally the amount we incur!

OBJECTIVITY CONCEPT:
Requires that the accounting records be based on objective evidence; this ensures
reliability (You can’t just go make up amounts!!)

UNIT OF MEASURE CONCEPT

Sometimes called the Money Measurement Concept

This concept prescribes that all economic data should be

recorded in dollars. Why? We measure, record and report
transactions in terms of money and in the USA, we measure
them in terms of dollars.

EXAMPLES:

1. Sally Vertrees purchased a personal computer for use at home. Sally owns a dental
practice. She occasionally uses the computer for a task related to her dental
practice; however, the computer is used primarily by Sally's children. Can the
computer be recorded as an asset in the accounting records of Sally's dental office?
Why or why not?
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2. Jason Thompson purchased an office building 10 years ago for $780,000. The
building was just appraised at $1.25 million. What value should be used for the
building in Jason's accounting records? Support your answer.

Learning objective 3: State the accounting equation and

define each element of the equation.

ASSETS, LIABILITIES AND OWNER’S EQUITY

KEY TERMS:
Accounting Equation Expenses
Assets Liabilities
Capital Owner’s Equity
Drawing Revenue Accounts

WHAT ARE THESE FUNNY SOUNDING TERMS?

Part of the language of accounting! You need to understand what each term means
and be able to identify accounts as assets, liabilities or owner’s equity.

WHAT ARE ASSETS?

• Resources owned by a business: what are resources? Things of
value! Resources that will benefit us in the future

• Examples:
1. CASH - coins, currency on hand and in bank
2. ACCOUNTS RECEIVABLE (AR) - amounts owed to us by others
who have promised to pay us (but did NOT give us a promissory note)
3. A RECEIVABLE to us because we will RECEIVE payment later!
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4. NOTES RECEIVABLE (NR) - amounts owed to us by others who HAVE given us a

promissory note as a promise to pay us
5. INVENTORY - goods we hold to resell to customers
6. PREPAID EXPENSES - goods or services we have paid for in advance but not yet used
up (prepaid insurance, prepaid rent, office supplies, etc.)
7. LAND, BUILDING, EQUIPMENT, FURNITURE, etc.

WHAT ARE LIABILITIES?

• Rights or claims to the resources by CREDITORS; Liabilities
are our DEBTS, the amounts we OWE

• Examples:
1. ACCOUNTS PAYABLE (AP) - amounts we owe to
others for purchases we made on account (but we
have NOT issued a promissory note, we just
promised to pay)
2. A PAYABLE to us because we must PAY it later!
3. A RECEIVABLE to the lender is a PAYABLE to the
borrower!!!
4. NOTES PAYABLE (NP) - amounts we owe to others for which we HAVE
issued a promissory note as a promise to pay
5. WAGES PAYABLE, TAXES PAYABLE, MORTGAGE PAYABLE, etc.

WHAT IS OWNER'S EQUITY?

• Rights or claims to the resources by OWNERS; what is left after the assets were
used to pay off all the business's debts. Theoretically, owner’s equity represents how
much of business the owner owns outright, meaning how much the owner would get out
of the business if it were to go out of business, selling off all assets and paying all debts.

• For example: let’s compare it to the "equity" that a homeowner has in

his or her home. A homeowner's equity is that portion of his or her home's value that
would be received if the home were sold–––it's what would be left after paying off the
mortgage. In the same way, the owner's equity in a business is that owner's residual
interest–––what would be left if the assets were used to pay off all the business's debts.

• Owner contributions make owner’s equity go UP and owner

withdrawals make it go DOWN!

• Examples: Good news, there is only ONE type of Owner’s Equity

account! It is called Capital. We normally write the “Name of the owner, Capital”.
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ACCOUNTING EQUATION

Note: This equation is very important! It is the foundation of

ALL accounting. Be sure you have a solid understanding of
the equation!!

WHAT IS IT?
• Special Relationship: There is a special relationship
between Assets, Liabilities and Owner’s Equity.

• This relationship is true for ALL businesses!

• Foundation of accounting transactions!

The Cost of Items Used in Where the Funds Came From, Either to
Running a Business = Buy Those Items or from Creditors or Owner

ACCOUNTING EQUATION:
• Also called the Balance Sheet equation- MEMORIZE THIS!!!

ASSETS = LIABILITIES + OWNER'S EQUITY

• Note: You can “rewrite” this equation many ways, but it will also be
balanced; For example:
1. Assets – Liabilities = Owner’s Equity
2. Assets- Owner’s Equity = Liabilities

WHAT DOES THIS REALLY MEAN?

• What you OWN minus what you OWE equal what you are WORTH! Assets always
EQUAL the claims to creditors and the owners. After all, who is entitled to the assets of a
business?

1. First the people you OWE

2. Second, the reminder goes to the owner of the business.
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EXAMPLE:
How does the equation work? Let’s try some examples.

ASSETS = LIABILITIES + OWNER'S EQUITY

1. A business buys a $20,000 delivery van by using $5,000 of

the owner's money as a down payment and financing
the rest.

2. If you have Assets of $20,000 and Liabilities of $3,000, what is the Owner’s
Equity?

3. If you have Liabilities of $16,000 and Owner’s Equity of $10,000, what do the
Assets equal?

4. If you have Owner’s Equity of $5,000 and Assets of $12,000, what do the
Liabilities equal?

5. If Assets increase $7,000 and Liabilities decreased $5,000, what was the change on
Owner’s Equity?
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Learning objective 4: Describe and illustrate how business

transactions can be recorded in terms of the resulting
changes in the basic elements of the accounting equation.

BUSINESS TRANSACTIONS AND

THE ACCOUNTING EQUATION

KEY TERMS:
Account Payable Prepaid Expenses
Account Receivable Revenue
Business Transaction Supplies
Expenses

WHAT DO WE MEASURE?
• BUSINESS TRANSACTIONS – “Economic events or
condition that directly changes the entity's financial
position or directly affects its results of operations."

• Record business transactions within the framework of the

accounting equation. This means that AFTER recording
every transaction, Assets must equal Liabilities plus
Owner’s Equity. NO EXCEPTIONS!

EVENTS/CONDITIONS RECORDED IN ACCOUNTING RECORDS

1. Receipt of cash
2. Payment of cash
3. Events that create a legal obligation to pay out cash (or other assets) in the future
4. Events that obligate another party to pay you cash (or other assets) in the future
5. Sale of a product or completion of a service for a customer––this is known as
earning revenue
6. The use of products or services in running your business––this is known as
incurring an expense.
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NEED TO LEARN A NEW LANGUAGE: THE LANGUAGE OF

BUSINESS: Before we can start recording business
transactions, we need to discuss some additional terms.

REVENUES:
• What we earn by selling a product or performing a service! The price charged for the
sale of goods or services.

• Sometimes we are paid in cash, and other times people promise to pay us later
(called Accounts Receivable). Either way, when we "do the work", we have earned
the revenue (whether or not we are paid in cash then is irrelevant – we record all
revenue when we “do the work”)

• Earning revenue makes the business worth MORE!

• Other words used for revenue include "income" or "earned". Examples of revenues:
Rent Revenue, Fees earned, Interest Income, Services Earned, Advertising Revenue,
Advertising Fees earned etc! The type of business you are in will determine the name
of your revenue. A company can have revenue from MORE than one source!

• Important Note:
 Receiving investments from the owner (owner contributions) are NOT revenue;
instead they increase the Owner’s Equity.
 Borrowing by the business, such as a bank loan, is NOT revenue because we
have not done any work!

EXPENSES:
• Costs we incur to produce revenue; The costs of doing business (i.e.,
using up goods and services in the process of producing revenue.)

• Sometimes we pay them in cash, and other times we promise to pay

them later (called Accounts Payable)

• Either way, when we “use up” the goods/services to produce revenue,

we have incurred the expense (whether or not we pay it in cash then is
irrelevant – we must record all expenses when they are INCURRED).

• Incurring expenses makes the business worth LESS. Examples of

Expenses: Wage Expense, Supply Expense, Insurance Expense, Advertising
Expense, Rent Expense, Tax Expense, Utility Expense, etc.
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• Important Note: Withdrawals by the owner are NOT expenses

(because they do not generate revenue; owner withdrawals decrease the
equity (capital account)

DON'T GET CONFUSED IN THESE AREAS!

• DON'T GET CONFUSED BETWEEN ASSETS AND EXPENSES.

• Assets are items we have NOT yet used up; Assets become
expenses to us only when we USE THEM UP!

•DON'T GET CONFUSED BETWEEN REVENUES AND ASSETS.

We like them both - but they are completely different! Think of
REVENUE as the ACTIVITY – a measure of the work we do; It is
intangible. Earning revenue typically results in us receiving an
asset -- either Cash or Accounts Receivable.

• Think of ASSETS as the BY-PRODUCT (RESULT) of earning revenue; Assets are

tangible items (Cash, Accounts Receivable, etc.) that revenue produces But we may
also receive an asset WITHOUT earning revenue (i.e., without doing work -- for
example, receiving an investment from the owner or borrowing money increases our
assets without us having “done any work”)

• DON'T GET CONFUSED BETWEEN EXPENSES AND LIABILITIES.

• We don't like either one - but they are completely different! Think of expenses as
the
COSTS OF THE ACTIVITIES UNDERTAKEN to generate revenue; They are intangible.

• Sometimes we pay expenses in cash immediately as they are incurred; only if we do

NOT pay them immediately do they become a LIABILITY (unpaid debt) to us.

• Think of liabilities as the BY-PRODUCT (RESULT) of incurring expenses if we do not

pay them immediately! Liabilities are tangible items (Accounts Payable, Notes
Payable, etc.) that expenses produce - they go on the Balance Sheet. But we may
also incur a liability WITHOUT having an expense (for example, borrowing money
increases our liabilities but also increases our assets)
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ANALYZING BUSINESS TRANSACTIONS USING THE

ACCOUNTING EQUATION

ACCOUNTING EQUATION (BALANCE SHEET EQUATION)

• REMEMBER: ASSETS = LIABILITIES + OWNER'S EQUITY

• All transactions can be recorded so that they fit into this equation!! It must be
balanced after each transaction.

• Ask this question - "What do I have MORE of?" or "What do I have LESS of?"

• The accounting equation must always stay in balance. Transactions may require
additions to both sides, subtractions from either sides, or an addition and
subtraction on the same side, but the equation must always balance.

• Revenue represents the receipt of assets for goods sold or services rendered.
Revenues are recognized when services are rendered, not when the cash is
received.
• The receipt of assets from the owner is an investment.

• Expenses are costs incurred in generating revenues.

• Purchases of assets, payments of liabilities, and owner's withdrawals are not

recorded as expenses.

LET’S PRACTICE:
It is important to be able to analyze a transaction and determine the type of accounts
that are affected or involved. Once we do that, we can then apply the accounting
equation to it. So we will first practice with identifying accounts!
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EXAMPLE:
For the transactions below for Frank Flintstone Lawn Care Company,
determine the accounts affected. Do not worry about increases and
decreases or the accounting equation!

1. Frank began a lawn care business in May by depositing $800 in a business bank
account.

2. Purchased lawnmowers and other lawn equipment on account, $1,000.

3. Paid cash for supplies, $50.

4. Performed lawn care services for credit customers and billed them $700.

5. Received $700 cash from the customers billed in #4.

6. Paid $1,000 cash for the lawn equipment purchased in #2.

7. Paid for an advertisement in a local newspaper, $150.

8. Performed lawn care services for cash customers and immediately received $420.

9. Paid wages to a part-time assistant, $85.

10. Performed lawn care services for credit customers and billed them $600.

11. Received an invoice from Gas-n-Go for gasoline purchased on account during May,
$110. The invoice will not be paid until next month.
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12. At the end of May, Frank withdrew $100 from the business for personal use.

EXAMPLE:
For the transactions below for Frank’s Lawn Care Company, above, let’s
apply increases and decreases and the accounting equation. Use the chart
below.

ASSETS = LIABILITIES + OWNER’S EQUITY

TRANSACTION CASH ACCTS SUPPLIES LAWN ACCTS FRANK TYPE
REC. EQUIP. PAYABLE FLINTSTONE
CAPITAL

Frank Flintstone
began a lawn
care business in
May by
depositing $800
in a business
bank account.

Purchased
lawnmowers and
other lawn
equipment on
account, $1,000.

Paid cash for

supplies, $50.

Performed lawn
care services for
credit customers
and billed them
$700.

Received $700
cash from the
customers billed.

Paid $1,000 cash

for the lawn
equipment
purchased earlier.

Paid for this

week’s
advertisement in
the newspaper,
$150.
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TRANSACTION CASH ACCTS SUPPLIES LAWN ACCTS FRANK TYPE

REC. EQUIP. PAYABLE FLINTSTONE
CAPITAL

Performed lawn
care services for
cash customers
and immediately
received $420.

Paid wages to a
part-time
assistant, $85.

Performed lawn
care services for
credit customers
and billed them
$600.

Received an
invoice from Gas-
n-Go for gasoline
purchased on
account during
May, $110. The
invoice will not be
paid until next
month.

Frank withdrew
$100 from the
business for
personal use.

TOTALS

EXAMPLE:
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We are recording the transactions For Bugs Bunny’s advertising company for the month
of August.

ASSETS = LIABILITIES + OWNER’S EQUITY

BUGS
TRANSACTION CASH ACCTS EQUIP. ACCTS BUNNY, TYPE
REC. PAYABLE CAPITAL

Bugs Bunny
contributed
$9,000
cash to start
business.
Buy camera for
$2,000 cash

Create ads for

Ralphie, who
pays us $600
cash
Purchase
$3,000
computer,
promising to pay
later
Pay $900 for the
monthly
rent on our office
Create ads for
Liz, who
promises to pay
us $1,900 soon

Pay $800 salary

to our helper,
Arnold

Pay half owed

on computer

Receive (but
don’t pay) a
$300 bill for
electricity used
this
month

Bugs Bunny
takes $1,200
from business
for personal use
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TOTALS

Learning Objective 5: Describe the financial statements of a

proprietorship form of business and explain how the
statements interrelate.

FINANCIAL STATEMENTS

WHAT ARE FINANCIAL STATEMENTS?

• After we record and summarize the transactions, we need to prepare “reports”
• They help communicate information, so everyone prepares the reports the same
• The reports are called Financial Statements

FOUR BASIC FINANCIAL STATEMENTS:

1. INCOME STATEMENT - shows how PROFITABLE a
business was during a period of time; it matches the
revenue earned against the expenses incurred to
determne the profit or loss for the period.

2. STATEMENT OF OWNER'S EQUITY - shows changes

in a business' NET WORTH during a period of time

3. BALANCE SHEET - shows the FINANCIAL POSITION of

a business at a point in time

4. STATEMENT OF CASH FLOWS – Summary of cash receipts and cash payments;

covered in ACC 102

INTERRELATIONSHIPS OF THE FOUR FINANCIAL STATEMENTS:

• All four financial statements are interrelated; Each one ties into one of the other
statements. For example the Income Statement provides a key figure for the
Statement of Owner’s equity, which provides a key figure for the balance Sheet. The
Statement of Cash Flow derives its accounts from both the Income Statement and
the Balance Sheet!

• See example on page 20 in the textbook.

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HEADINGS OF ALL FINANCIAL STATEMENTS

• Need to provide the “who, what, where and when!”

• Every statement has the following 3-line heading-No exceptions!

1. FIRST LINE - company name
2. SECOND LINE - name of the statement (Income Statement, Balance Sheet, etc.)
3. THIRD LINE - either a specific date (for the Balance Sheet) or a period of time
(for the Income Statement, Statement of Owner’s Equity, and Statement of Cash
Flows)

Examples of specific dates: “December 31, 2007”; “As of July 31, 2008”
Examples of periods of time: “For the month ended June 30, 2008”; “For the year
Ended December 31, 2007”; “For the Quarter Ended March 31, 2008”

INCOME STATEMENT

WHAT DOES IT TELLS US ABOUT THE BUSINESS?

• Shows how profitable a business was during a period of time; Also called “Profit
and Loss (P&L) Statement”

• Contains only revenues and expense for the business; NO other accounts!!!

• The third line of the heading is for a PERIOD of time (month, quarter, year, etc.)
• For example: For the Month Ended May 31, 2007 or For the Quarter Ended June 30,
2008

INCOME STATEMENT FORMULA (MEMORIZE THIS!!!):

REVENUES
- EXPENSES
= NET INCOME ( or LOSS)

 If Revenues > Expenses, then the result

is Net Income
 If Revenues < Expenses, then the result is Net Loss

• How do you remember what accounts go on Income Statement?

Real Easy
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Revenues Expenses

INCOME STATEMENT FORMAT (MEMORIZE THIS!!!):

Name of Company
Income Statement
For the Year ended 12/31/08
REVENUES:
Rent Revenue xx
Interest Income xx
Total Revenues xxx

EXPENSES:
Wage Expense xx
Tax Expense xx
Supply Expense xx
Total Expenses xxx

NET INCOME xxx

• Helpful hints:
1. List ALL types of revenues and expense under
each heading.

2. Subtotal revenues and expense; the difference

is Net income (or Net loss if a negative
number). If a net loss we do NOT use negative
signs-instead you put the amount in brackets.

3. Double line underscore Net Income or Net Loss amount

STATEMENT OF OWNER’S EQUITY

WHAT DOES IT TELLS US ABOUT THE BUSINESS?

• Connects the Income Statement and Balance Sheet

• It shows the changes that have occurred in capital (the business' net worth) during a
period of time
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• What affects the net worth of a business? Remember “wire”

 Withdrawals from the business by the owner make the business
worth less
 Investments (contributions) into the business by the owner
make the business worth more
 Earning Revenues make the business worth more
 Incurring Expenses make the business worth less

• HEADING IS FOR A PERIOD OF TIME (month, quarter, year, etc.); It is the SAME
period of time that the Income Statement covered!

STATEMENT OF OWNER’S EQUITY FORMULA (MEMORIZE THIS!!!):

• FORMULA (BINWE) Just use the acronym BINWE to help remember what goes on the
statement!

Beginning Capital
+ Investments by Owner
± Net Income/Net Loss (+ Net Income OR - Net Loss)
- Withdrawals
= Ending Capital

• Note: We said above that revenues and expenses both affect the net worth of a
business, but these are NOT reported separate on the Statement of Owner’s Equity;
instead, the net difference between the two (Net Income/Loss) is reported instead!

STATEMENT OF OWNER’S EQUITY FORMAT (MEMORIZE THIS!!!):

Name of Company
Statement of Owner’s equity
For the Year ended 12/31/08

Name of Owner, Capital, Beginning of period xxx

ADD:
Investments by Owner xx
Net Income xx
LESS:
Net Loss
Withdrawals xx
Increase or decrease in owner’s equity xxx
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Name of Owner, Capital, End of period xxx

• Helpful Hints:
1. For example, don’t just write “Beginning Capital”, but instead write the
owner’s name, then the word “Capital,”, then the beginning date of the
period; Do the same for Ending Capital – but use the ending date for the
period instead!

2. You can’t have BOTH net Income and Net Loss; It has to be one or the other!
Remember, you use the Net income/Net loss you generated from the Income
Statement!

3. If the owner didn’t make any contributions and/or any withdrawals, just leave
it off the statement

BALANCE SHEET

WHAT DOES IT TELLS US ABOUT THE BUSINESS?

• Shows the financial position of a business at a particular point in time

• What is “financial position”? The amount of Assets,

Liabilities and Owner’s Equity at any given point in
time. Remember, these amounts change daily so the
statement is always at a point in time and not for a
period of time.

• Third line of heading is as of a PARTICULAR DATE

(not covering period of time); It is the last day of the
period covered by the Income Statement

• For example: March 31, 2006 or December 31, 2006

• CAPITAL - personal resources the owner has invested in the business; Terms
"owner's equity" and "capital" used interchangeably

• WITHDRAWALS – when the owner takes assets (usually cash) out of the business
for personal use; This is NOT an expense and it is NOT shown on Income Statement;
Not on Balance Sheet; it goes on Statement of Owner’s Equity

• To Summarize The Balance Sheet

 LEFT side = resources of the business (assets)
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 RIGHT side = who provided these resources: creditors (liabilities) and owners
(capital)

BALANCE SHEET FORMULA (MEMORIZE THIS!!!):

• The formula is easy; we already learned it! It is the Accounting Equation (remember it
is also called the Balance Sheet equation).

• Only Assets, Liabilities and Owner’s Equity account go the Balance Sheet. Since we
only have ONE Owner’s Equity account (Capital) you can remember the formula by
using these acronyms:

Aliens Live On Earth or Aliens Love Cake

Assets Liabilities Owner’s Equity Assets Liabilities Capital

BALANCE SHEET FORMAT (MEMORIZE THIS!!!):

Name of Company
Balance Sheet
12/31/08

ASSETS: LIABILITIES:
Cash Accounts Payable
Accounts Receivable Taxes Payable
Land Total Liabilities
Building
Total Assets OWNER’S EQUITY:
Name of Owner, Capital

Total Liabilities and Owner’s Equity

Helpful hints:
1. The Capital Account amount is from the Statement of Owner’s Equity
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2. Total Assets MUST equal Total Liabilities plus Owner’s Equity

(Remember the Accounting Equation)

3. Assets can be listed on the left, with Liabilities and Owner's Equity on
right (Know as the “Account form”)OR Assets can be listed on top,
with Liabilities and Owner's Equity below (know as the “report form”)

4. If you only have ONE liability, then you do NOT need a line called
Total liabilities.

5. The Assets have a special order for listing the accounts; it is know as
the order of liquidity- cash first then A/R, Inventory, prepaids, Land,
Building , Equipment! We will work on the order more in the next two
chapters!

IN WHAT ORDER DO WE PREPARE FINANCIAL STATEMENTS?

• Because of the interrelationships that exist among the financial statement, we prepare
them in the following order:

• INCOME STATEMENT FIRST: Why? We need to know net income/loss to go on the

Statement of Owner's Equity

• STATEMENT OF OWNER'S EQUITY SECOND: Why? We need to know the ending

capital balance to go on the Balance Sheet

• BALANCE SHEET is completed last! (Remember we do not cover the Statement of

Cash Flows in this course, therefore, the Balance Sheet is the last statement)

TIPS ON PRESENTATION
• ADDING TWO NUMBERS TOGETHER? Put them in the same
column and draw a single line under the last number

• SUBTRACTING ONE NUMBER FROM ANOTHER? Put them in the

same column and draw a single line under the last number
HELPFUL
• IS THIS NUMBER THE FINAL TOTAL on the statement (i.e., Net
Income, Ending Capital, Total Assets)? Draw a double line
TIPS
under it to show it has been checked
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• WHERE DO DOLLAR SIGNS GO? Before the first amount in each column AND before
the first amount after each ruled line

• DO YOU ONLY HAVE ONE OF AN ITEM (like only one expense)? Don’t have to show a
total for it also if there is only one

EXAMPLE - PREPARING FINANCIAL STATEMENTS

Let’s prepare the three financial statements for Bugs Bunny’s business and Frank
Flintstone’s business. We will use the data from our earlier summary of transactions.

INCOME STATEMENT

STATEMENT OF OWNER’S EQUITY

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BALANCE SHEET

INCOME STATEMENT
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STATEMENT OF OWNER’S EQUITY

BALANCE SHEET