Accounting I Essentials
By Duane Milano
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Accounting I Essentials - Duane Milano
ASSETS
CHAPTER 1
INTRODUCTION
1.1 DEFINITION OF ACCOUNTING
Accounting can be described as an information system that provides essential information about the financial activities of a business entity to various individuals or groups for their use in making informed decisions.
Accounting is primarily concerned with the design of the recordkeeping system, the preparation of summarized reports based on the recorded data, and the interpretation of those reports.
1.2 USERS OF ACCOUNTING INFORMATION
Users of accounting information can be quite varied, depending on the type of decision under consideration. Accounting information might be used for decisions involving investments, to impose income taxes, or for regulatory or managerial decisions. The process of using accounting to provide information to users is illustrated in Chart 1.2.1.
As shown in this diagram, the first step is to identify user needs. A properly designed accounting system can then generate summarized reports (using recorded transaction data) to meet those needs for accounting information. Users can then use those reports to make informed business decisions.
CHART 1.2.1
1.3 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
This broad range of potential users has brought about the evolution of Generally Accepted Accounting Principles (GAAP) used in preparation of financial statements. Many of these principles have been formally established by standard-setting bodies such as the Financial Accounting Standards Board (FASB). Others have simply gained acceptance through widespread use. Adherence to GAAP provides a measure of consistency in preparation of financial statements.
1.4 THE ACCOUNTING EQUATION
Assets are tangible or intangible properties owned by a business. The rights or claims to those assets are equities. Owners and creditors provide resources that enable a business to purchase assets and therefore are said to have equity in that business. For instance, an owner may start a business with $10,000 cash. This cash is used to buy equipment. The owner, who provided the funds for the equipment, has a claim to that equipment.
The relation between assets and equities is shown by the equation:
Assets = Equities
Equities can be subdivided into two categories: (1) Liabilities: rights of creditors represented by debts of the business, and (2) Owner’s Equity: rights of the owner or owners.
1.5 EXPANDING THE ACCOUNTING EQUATION
Expanding the original equation by using the two categories of equities shown in 1.4 yields the accounting equation:
Assets = Liabilities + Owner’s Equity
Creditors have preferential rights to the assets of a corporation. The residual claim of the owner or owners may be better understood by restating the accounting equation as:
Assets — Liabilities = Owner’s Equity
The dollar totals of both sides of the accounting equation are always equal, since they are simply two views of the same business property. The list of assets provides a description of the various business properties, while the list of liabilities and equity indicates the funding source for those assets.
1.6 TRANSACTIONS
A transaction can be defined as an occurrence or an event that must be recorded. Any business transaction can be stated in terms of the resulting change in the three basic elements of the accounting equation. The equality of the two sides of the accounting equation must be maintained upon completion of a transaction.
As an illustration, examine the result of a transaction to purchase land for $10,000 cash.
Assets (+$10,000 land — $10,000 cash) =
Liabilities + Owner’s Equity
In this case, assets would be increased by $10,000 to reflect the land purchase and decreased by $10,000 to reflect cash paid. The net effect on assets is zero, so the accounting equation remains valid.
As another example, modify the transaction above to reflect the purchase of land by borrowing $10,000 purchase price with a bank loan (also known as a note payable).
Assets (+$10,000 land) = Liabilities (+$10,000 note payable) + Owner’s Equity
In this case, assets and liabilities are each increased by $10,000. The accounting equation therefore remains