CHAPTER 1: INTRODUCTION TO ACCOUNTING AND BUSINESS

1.1 Definition of Accounting

What is accounting?
Accounting consists of three basic activities -i.e. it
 Identifies
 Records and the economic events of an organization to interested users.
 Communicates
Let’s take a closer look at these three activities.
a) Company identifies the economic events relevant to its business.
Examples of economic events are :
 Providing of telephone services
 The sale of goods and
 Payment of wages etc
b) Once a company identifies economic events, it records those events in order to provide a
history of its financial activities.
Recording consists of:
 Keeping a systematic, chronological diary of events, measured in dollars and
cents.
 In recording, any company also classifies and summarizes economic events.
Finally, a company communicates the collected information to interested users by means of
accounting reports.
The most common of these reports are called financial statements.
To make the reported financial information meaningful, the company
 Reports the recorded data in a standardized way.
1.2 Nature of a Business
A business is an organization in which basic resources (inputs), such as materials and labor
are assembled and processed to provide goods or services (outputs) to customers.
 E.g. Businesses come in all sizes, from a local coffee house to a car dealer, which
sells several billion dollars.
A business’s customers are
 Individuals or
 Other businesses that purchase goods or services in exchange for money or other
items of value.
The objective of most businesses is to maximize profits.
Some businesses operate with an objective other than to maximize profits.
The objective of such nonprofit businesses is to provide some benefit to society, such as
 Medical research or conservation of natural resources.
 In other cases, governmental units such as cities operate water works or sewage
treatment plants on a nonprofit basis.
a) Types of Businesses
There are three different types of businesses that are operated for profit:
 Manufacturing- change basic inputs into products that are sold to individual
customers.

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  Merchandising- sells products to customers. However, rather than making the
products, they purchase them from other businesses (such as manufacturers).
 Service businesses- provide services rather than products to customers.
NB: We will focus in this text on businesses operating to earn a profit. Keep in mind, though,
that many of the same concepts and principles apply to nonprofit businesses as well.
b) Types of Business Organizations
The common forms of business organization are:
 Proprietorship- is owned by one individual.
 Partnership- is owned by two or more individuals.
 Corporation, or Limited Liability Corporation- is organized under state or federal
statutes as a separate legal taxable entity.
1.3 The Role of Accounting in Business
What is the role of accounting in business?
Accounting provides information :
 For managers to use in operating the business and
 To other users in assessing the economic performance and condition of the business.
Thus, accounting can be defined as an information system that provides reports to users
about the economic activities and condition of a business.
You may think of accounting as the “language of business.”
This is because accounting is the means by which businesses’ financial information is
communicated to users.
The process by which accounting provides information to users is as follows:
 Identify users.
 Assess users’ information needs.
 Design the accounting information system to meet users’ needs.
 Record economic data about business activities and events.
 Prepare accounting reports for users.
users of accounting information can be divided into two groups:
A) Internal users and
B) External users.
A) Internal users of accounting information include:
Managers and employees.
These users are directly involved in managing and operating the business.
The area of accounting that provides internal users with information is:
Managerial accounting or management accounting.
The objective of managerial accounting is to provide relevant and timely information for
managers’ and employees’ decision-making needs.
Eg. Information about customers, prices, and plans to expand the business.
B) External users of accounting information include
Customers, creditors, and the government.
These users are not directly involved in managing and operating the business.
The area of accounting that provides external users with information is:
Financial accounting.
The objective of financial accounting is to provide relevant and timely information for the
decision-making needs of users outside of the business.

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 Eg. Financial reports on the operations and condition of the business are useful
for banks and other creditors in deciding whether to lend money to the
business.
General-purpose financial statements are one type of financial accounting report that is
distributed to external users.
1.4 Profession of Accounting
Accountants engage in either private accounting or public accounting.
Accountants employed by a business firm or a not-for-profit organization are said to be
engaged in private accounting.
Accountants and their staff who provide services on a fee basis are said to be employed in
public accounting.

1.4.1 Private Accounting.

An accountant may be an employee of a business enterprise.
In private accounting, you would be involved in one of the following activities:
Cost Accounting- determining the cost of producing specific products.
Budgeting- assisting management in quantifying goals concerning revenues, costs of
goods sold and operating expenses.
General Accounting- recording daily transactions and preparing financial statements
and related information.
Accounting information systems- designing both manual and computerized data
processing systems.
Tax Accounting- preparing tax returns (-forms to be filled by a company and returned to
a taxing authority) and engaging in tax planning for the company.
Internal Auditing-reviewing a company’s operations to determine compliance with
management policies and evaluating efficiency of operations.
1.4.2 Public Accounting.
In Public Accounting you would offer expert service to the general public in much the same
way that a doctor serves patients and a lawyer serves clients.
A major portion of public accounting practice is involved with Auditing.
In this area, a certified Public Accountant (CPA) examines the financial statements of
companies and expresses opinion as to the fairness of presentation.
When presentation is fair, users consider the statements to be reliable.
Management consulting is another area of public accounting.

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 That is, the accountant consults the management about the growth and development of the
business enterprise.

1.5 Accounting Principles and Practice

1.5.1 Accounting standard
The accounting profession has developed standards that are generally accepted and
universally practiced.
This common set of standards is called generally accepted accounting principles (GAAP).
These standards indicate how to report economic events.
The primary accounting standard-setting body in the United States is the Financial
Accounting Standards Board (FASB).
The Securities and Exchange Commission (SEC) is the agency of the U.S. government that
oversees U.S. financial markets and accounting standard-setting bodies.
Many countries outside of the United States have adopted the accounting standards issued by
the International Accounting Standards Board (IASB).
These standards are called International Financial Reporting Standards (IFRS).
As markets become more global, it is often desirable to compare the result of companies
from different countries that report using different accounting standards.
In order to increase comparability, in recent years the two standard-setting bodies have made
efforts to reduce the differences between U.S. GAAP and IFRS.
This process is referred to as convergence.
Most agree that there is a need for one set of international accounting standards. Here
is why:
Multinational corporations. Today’s companies view the entire world as their market.
Mergers and acquisitions.
Information technology.
Financial markets. Financial markets are of international significance today.
1.6 The Major Differences between GAAP and IFRS
GAAP is more detailed i.e.
It is more “rules-based.”

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 IFRS tends to be simpler in its accounting and disclosure requirements i.e.

 It is more “principles-based.”
A principle based approach
Represents a contrast to a rules-based approach
Attempts to limit additional accounting guidance
Is designed to encourage professional judgment and discourage over-reliance on
detailed rules
1.6.1 Measurement Principles
a) Cost Principle or Historical Cost Principle - dictates that companies record assets at
their cost.
b) Fair Value Principle – states that assets and liabilities should be reported at fair value
(the price received to sell an asset or settle a liability).
1.6.2 Assumptions
a) Monetary Unit – include in the accounting records only transaction data that can be
expressed in money terms.
b) Economic Entity – requires that activities of the entity be kept separate and distinct from
the activities of its owner and all other economic entities.
1.7 Accounting Equation and Elements of the Equation
1) The Basic Accounting Equation

Provides the underlying framework for recording and summarizing economic events.
Applies to all economic entities regardless of size.
Assets
A resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
Eg. Cash, Inventory, Equipment, etc
Liabilities
A present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic
benefits.
Eg. Accounts payable, Notes payable, etc.
Equity
A residual interest in the assets of the entity after deducting all its liabilities.

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1.7.1 Effects of Transactions on Shareholders’ Equity

Income
Increases in economic benefits that result in increases in equity (other than those related
to contributions from shareholders).
Income includes both revenues (resulting from ordinary activities) and gains.
Eg. Generally results from selling merchandise, performing services, renting property,
and lending money.
Expenses
Decreases in economic benefits that result in decreases in equity (other than those related
to distributions to shareholders).
Expenses include losses that are not the result of ordinary activities.
E.g Common expenses are salaries expense, rent expense, interest expense, property tax
expense, etc.

1.8 Business Transactions and the Accounting Equation

A business transaction is an economic event or condition that directly changes an entity’s
financial condition or directly affects its results of operations.
May be external or internal.
Not all activities represent transactions.
Each transaction has a dual effect on the accounting equation.

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Transaction Analysis
The following examples are business transactions for Ray Neal computer programming business
called Softbyte during its first month of operations On September 1, 2012.
a) Softbyte invests $15,000 cash in the business.
b) Softbyte purchases computer equipment for $7,000 cash.
c) Softbyte purchases for $1,600 from Acme Supply Company computer paper and other
supplies expected to last several months. Acme agrees to allow Softbyte to pay this bill
in October.
d) Softbyte receives $1,200 cash from customers for programming services it has provided.
This transaction represents Softbyte’s principal revenue-producing activity
e) Softbyte receives a bill for $250 from the Daily News for advertising but postpones
payment until a later date.
f) Softbyte provides $3,500 of programming services for customers. The company receives
cash of $1,500 from customers, and it bills the balance of $2,000 on account.
g) Softbyte pays the following expenses in cash for September: store rent $600, salaries
and wages of employees $900, and utilities $200.
h) Softbyte pays its $250 Daily News bill in cash.
i) Softbyte receives $600 in cash from customers who had been billed for services [in
Transaction (6)].
j) Ray Neal withdraws $1,300 in cash from the business for his personal use.
Required
a) Show the effect of transactions on the business equations.
Solution

From the above you should understand some significant facts, that is:
1. Each transaction is analyzed in terms of its effect on:
(a) The three components of the basic accounting equation.
(b) Specific items within each component.

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 2. The two sides of the equation must always be equal.
1.9 Financial Statements
The primary types of financial statements required by GAAP and IFRS are the same.
In practice, some format differences do exist in presentations commonly employed by
GAAP companies compared to IFRS companies.
Companies prepare four financial statements from the summarized accounting data:
1) An income statement: presents the revenues and expenses and resulting net income or net
loss for a specific period of time.
2) An owner’s equity statement: summarizes the changes in owner’s equity for a specific
period of time.
3) A balance sheet: reports the assets, liabilities, and owner’s equity at a specific date.
4) A statement of cash flows: summarizes information about the cash inflows (receipts) and
outflows (payments) for a specific period of time.
These statements provide relevant financial data for internal and external users.
The following are the financial statements of Softbyte.

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