Chapter 1 – Accounting as a Form of Communication

What is Business
• Business: All of the activities necessary to provide the members of an economic system with goods
and services.
• Two major types of companies: Product Companies and Service Companies
• Types of Product Companies: Suppliers, Manufacturers/Producers, Distributors/Wholesalers and
Retailers.

Forms of Organization
• Two basic categories of organization:
1. Businesses that are organized to earn money – business entities
2. Businesses that are organized for some other purpose than earning money – non-business
entities.
• Business entity: an organization operated to earn a profit.
• Business entities: sole proprietorships, partnerships, or corporations.
• Non-business entities: government entities such as local, state, and federal governments and
private organizations such as hospitals and universities.

Sole Proprietorship
• A form of organization with a single owner (most small businesses).
• Often owned and operated by the same person.
 To avoid any biased decisions when it comes to the business, the economic entity principle
comes into play.
• Economic Entity Principle: The assumption that a single, identifiable unit must be accounted for in
all situations (affairs of the business and the owner must be kept separate).
• A sole proprietorship is not a taxable entity; the business’s profits are taxed on the individual’s
return.

Partnership
• A business owned by two or more individuals (sometimes even thousands of partners); the
organization form often used by accounting firms and law firms.
• When two or more partners start out, they need some sort of agreement as to how much each
will contribute to the business and how they will divide any profits.
 Usually an oral understanding between partners in small businesses.
 Formalized in a written document for large businesses.
• Like a sole proprietorship, a partnership is not a taxable entity. Individual partners pay taxes on
their proportionate shares of the business’s profits.

Corporation
• An entity organized under the laws of a particular state; ownership evidenced by shares of stock.
• A share of stock is a certificate that acts as evidence of ownership in a corporation.
• To start a corporation, one must fi le articles of incorporation with the state. If the articles are
approved by the state, a corporate charter is issued, and the corporation can begin to issue stock.
• Stocks of many corporations are traded on organized stock exchanges.
Advantages of Incorporation
1. The ability to raise large amounts of money in a relatively brief period of time.
2. The ease of transfer of ownership.
3. Limited liability of the stockholder – a stockholder is liable only for the amount contributed to the
business.
• A bond is a certificate that represents a corporation’s promise to repay a certain amount of money
and interest in the future.

Non-Business Entities
• An organization operated for some purpose other than to earn a profit.
 Exist to serve the needs of various segments of society.
• The lack of an identifiable owner in non-business entities and of the profit motive changes to some
extent the type of accounting used by nonbusiness entities – this type of accounting is called fund
accounting.

Organizations and Social Responsibility

• Although nonbusiness entities are organized specifically to serve members of society, business
entities have become more sensitive to their broader social responsibilities.
• Most large corporations recognize the societal aspects of their overall mission and have
established programs to meet their social responsibilities.
• Some companies focus on local charities, while others donate to national or international causes.

Nature of Business Activity

• Corporations engage in three types of activities – financing, investing and operating.

Financing Activities
• All businesses start with financing – money is needed to start a business.
• Most companies not only sell stock to raise money but also borrow from various sources to finance
their operations.
• Liability – an obligation of a business.
 When a company borrows money at a bank: note payable.
 When a company sells bonds: bonds payable.
 Amounts owed to the government for taxes: taxes payable.
• Capital stock – indicates the owners’ contributions to a corporation (dollar amount of stock sold
to the public).
• Stockholder/Shareholder – one of the owners of a corporation (permanent form of financing for
the firm).
• Creditor/Lender – someone to whom a company or person has a debt (not a permanent form of
financing; has to be repaid, usually with interest).

Investing Activities
• Natural progression from financing activities to investing activities: once funds are generated from
creditors and stockholders, money is available to invest.
• An asset is a future economic benefit to a business (cash, equipment, buildings, patents, etc.; not
all assets are tangible).
• Most liabilities are settled by transferring assets. The asset most often used to settle a liability is
cash.
Operating Activities
• Revenue – inflow of assets resulting from the sale of products and services.
• When a company makes a cash sale, the asset it receives is cash. When a sale is made on credit,
the asset received is an account receivable.
 Revenue represents the dollar amount of sales of products and services for a specific period of
time.
• An expense is the outflow of assets resulting from the sale of goods and services.

What Is Accounting, and What Information Do Users of

Accounting Reports Need?
• Accounting – the process of identifying, measuring, and communicating economic information to
various users.
• Internal users, primarily the managers of a company, are involved in the daily affairs of the
business. All other groups are external users.

Internal Users
• The management of an organization obtain financial information to make decisions that best suit
the needs of the organization.
• Management Accounting – The branch of accounting concerned with providing management with
information to facilitate planning and control.
• Ability to produce management accounting reports is limited only by the extent of the data
available and the cost involved in generating the relevant information.

External Users
• External users, those not directly involved in the operations of a business, need information that
differs from that needed by internal users.
• Their ability to obtain financial information is more limited than that of internal users.
• Certain external users such as the IRS require that information be presented in a very specific
manner, and they have the authority of the law to ensure that they get the required information.
• A supplier of raw material needs to know the creditworthiness of a company before selling it a
product on credit.
• Financial accounting – branch of accounting concerned with communication with outsiders
through financial statements.

1. Stockholders & Potential Stockholders

• If you currently own stock in Kellogg’s, you need information that will aid in your decision
either to continue to hold the stock or to sell it.
• If you are considering buying stock, you need financial information that will help in choosing
among competing alternative investments.

2. Bondholders, Bankers & Other Creditors

• Before buying a bond in a company, you need assurance that the company will be able to
pay you the amount owed at maturity and the periodic interest payments.
 Financial statements can help you to decide whether to purchase a bond.
• Before lending money, a bank needs information that will help it determine the company’s
ability to repay both the amount of the loan and interest.
• Financial statements are a key ingredient in a loan proposal.
 3. Government Agencies
• Numerous government agencies have information needs specified by law.
• Examples of such agencies include IRS, SEC, etc.
• Global companies must consider the reporting requirements in foreign countries where
they operate.

The Accounting Equation

• Assets (cash, accounts receivable, land) = Liabilities (accounts payable, notes payable) + Owners’
Equity (capital stock, retained earnings)
• The left side of the accounting equation refers to the assets of the company, whereas the right
side of the equation indicates who provided, or has a claim to, those assets.
• Owners’ equity – the owners’ claims on the assets of an entity.
• Stockholders’ equity – the owners’ equity in a corporation.
• Stockholders’ equity arises in two distinct ways:
1. It is created when a company issues stock to an investor. Stock ownership certificate represents
the amounts contributed by the owners to the company.
2. As owners of shares in a corporation, stockholders have a claim on the assets of a business
when it is profitable. Retained earnings represents the owners’ claims to the company’s assets
that result from its earnings that have not been paid out in dividends. It is the earnings
accumulated or retained by the company.

The Balance Sheet

• Balance sheet – statement that summarizes the assets, liabilities, and owners’ equity at a specific
point in time (also called statement of financial position).
• A balance sheet can be prepared on any day of the year, although it is most commonly prepared
on the last day of a month, quarter, or year.

The Income Statement

• Income statement – statement that summarizes revenues and expenses.
• It summarizes the flow of revenues and expenses for the year.
• Net income – the excess of revenues over expenses (also called profits or earnings).

The Statement of Retained Earnings

• Dividends – a distribution of the net income of a business to its owners.
• Statement of retained earnings summarizes the income earned and dividends paid over the life of
a business.
• Dividends are not an expense and thus are not a component of net income, as are expenses.

The Statement of Cash Flows

• Statement of cash flows summarizes a company’s cash receipts and cash payments during the
period from operating, investing, and financing activities.
• It shows where a company got cash during the year and how it used that cash.
Conceptual Framework for Accounting
Economic Entity Concept
• This assumption requires that an identifiable, specific entity be the subject of a set of financial
statements.
• The personal affairs must be kept separate from the business affairs.
• The financial position of an entity does not intermingle the personal assets and liabilities of the
employees or any of the other stockholders.

Asset Valuation: Cost or Fair Value?

• Cost principle: all assets are initially recorded at the cost to acquire them.
• How should these assets be valued on subsequent balance sheets?
1. Continue to report assets at their original cost. Accountants use the term historical cost to refer
to the original cost of an asset.
2. Certain assets are valued on subsequent balance sheets at market value than historical cost.
• A recent accounting rule requires a company to determine the amount an asset could be sold for,
rather than the amount it could be bought for, when market prices are used to value assets on the
balance sheet.

Going Concern
• Accountants assume that the entity being accounted for is a going concern – that it is not in the
process of liquidation and that it will continue indefinitely into the future.
• When we assume that a business is not a going concern, we assume that it is in the process of
liquidation – here asset valuation using market value might be more relevant than cost as a basis
for recognizing the assets.
• Monetary unit: the yardstick used to measure amounts in financial statements; the dollar in the
United States.
• Inflation: general rise in the level of prices in an economy. The financial statements of corporations
are prepared under the assumption that the monetary unit is relatively stable (sometimes a
reasonable assumption and at other times not so reasonable).

Time Period Assumption

• Under this assumption, it is possible to prepare an income statement that accurately reflects net
income or earnings for a specific time period.
• It is somewhat artificial to measure the earnings of a business for a period of time.
• The most accurate point in time to measure the earnings of a business is at the end of its life.
• Accountants prepare periodic statements, however, because the users of the statements demand
information about the entity on a regular basis.

Generally Accepted Accounting Principles (GAAP)

• Financial statements prepared by accountants must conform to generally accepted accounting
principles (GAAP).
• Refers to the various methods, rules, practices, and other procedures that have evolved over time
in response to the need for some form of regulation over the preparation of financial statements.
Setting Accounting Standards
Who determines the rules of the game?
No one group is totally responsible for setting the standards or principles to be followed in
preparing financial statements. The process is a joint effort among the following groups.

1. Securities and Exchange Commission (SEC)

• The federal agency with ultimate authority to determine the rules for preparing statements
for companies whose stock is sold to the public.
• The SEC has allowed the accounting profession to establish its own rules.

2. Financial Accounting Standards Board (FASB)

• The group in the private sector with authority to set accounting standards.
• The board has issued more than 150 financial accounting standards and seven statements of
financial accounting concepts since its creation in the early 1970s.

3. American Institute of Certified Public Accountants (AICPA)

• The professional organization of certified public accountants.
• Certified Public Accountant (CPA): The designation for an individual who has passed a uniform
exam administered by the AICPA and has met other requirements as determined by individual
states.
• AICPA advises the FASB and in the past was involved in setting the auditing standards to be
followed by public accounting firms.
• Public Company Accounting Oversight Board (PCAOB) was created by an act of Congress in
2002, and this 5-member body now has the authority to set the standards for conducting
audits.

4. International Accounting Standards Board (IASB)

• The organization formed to develop worldwide accounting standards.
• Organizations from many different countries, including the FASB in this country, participate
in the IASB’s efforts to develop international reporting standards.

The Audit of Financial Statements

• Auditing: the process of examining the financial statements and the underlying records of a
company to render an opinion as to whether the statements are fairly presented.
• Financial statements are prepared by a company’s accountants and are the responsibility of the
company’s management.
• The external auditor performs various tests and procedures to be able to render an opinion.
• The auditors’ report is an opinion, not a statement of fact.
• The primary objective of an audit is to assure stockholders and other users that the statements
are fairly presented.
Why should Accountants be concerned with Ethics?
• As a decision maker outside a company, you should be aware of the potential for ethical conflicts
that arise within organizations. Ask questions, do research, and don’t just accept everything as
fact.
• If you are a decision maker inside a company, you should stay alert for potential pressures on you
or others to make choices that are not in the best interest of the company, its owners, and its
employees as a whole.
• Companies may use aggressive accounting practices to misrepresent their earnings; executives
may misuse their companies’ funds.
• As a decision maker, you may analyze business information to project capital expansion, to open
markets for new products, or to anticipate tax liabilities. You may be responsible for making
financial reporting decisions that will affect others inside or outside the organization.
 Knowledge of the professional standards of accounting procedures will be critical for your
decision-making process. It will also help you recognize when information is not consistent with
the standards and needs to be questioned.
• At times, GAAP may not be able to help resolve particular accounting issues because there are
several conflicting rules, because no specific GAAP rules seem applicable, or because of fraud. In
such situations, an ethical dilemma is likely to exist, resolving which may involve one or more
decision makers. In most instances, an accountant plays a significant role in the process.
• Financial reporting should provide information that is useful to present and potential investors
and creditors and other users in making rational investment, credit, and similar decisions.
• For an accountant, if the information is both relevant and reliable, its quality is good.
• Relevant information is information that is useful to the decision-making process – it should be
clear about past financial events; should be helpful for predicting the future; should be available
at the time the decision is being made.
• Reliable information refers to information that accurately represents what it claims to represent.
Reliability includes verifiability; thus, there is documentation from one or more independent
parties that supports the accuracy of the information. It also includes neutrality, which means the
presentation of information is free from bias toward a particular result.
• Whatever the circumstances, dilemmas should be resolved by questioning and analyzing the
situation.
• The process of determining the most ethical choice involves identifying the most significant facts
of the situation.
• Corporate scandals have led to some of the largest bankruptcies in the history of business. The
involvement of the auditors in one of these scandals resulted in the demise of one of the oldest
and most respected public accounting firms in the world.
• Sarbanes-Oxley Act: an act of Congress in 2002 intended to bring reform to corporate
accountability and stewardship in the wake of a number of major corporate scandals; it includes:
1. The establishment of a new Public Company Accounting Oversight Board.
2. A requirement that the external auditors report directly to the company’s audit committee.
3. A clause to prohibit public accounting firms that audit a company from providing any other
services that could impair their ability to act independently in the course of their audit.
• In addition to corporate scandals, the ongoing global economic crisis continues to present
challenges for accountants.