Chapter 1

Accounting as a Form ofCommunication

What is Business?

Consists of activities necessary to provide members of society with goods and services

LO 1

Exhibit 1.1—Types of Businesses

Exhibit 1.2—Forms of Organization

LO 2

Business Entities

An organization operated to earn a profit Sole Proprietorships: organization with a single

owner Partnerships: business owned by two or more

individuals Often used by accounting firms and law firms

Corporations: entity organized under the laws of a particular state Ownership evidenced by shares of stock

Nonbusiness Entities

Organization operated for some purpose other than to earn a profit

Do not have an identifiable owner

Organizations and Social Responsibility

U.S. business entities recognize the societal aspects of their overall mission and have established programs to meet these responsibilities

Nature of Business Activity

Businesses engage in three types of activities:

LO 3

FinancingActivities

• Borrowing• Sale of stock

Investing Activities

• Purchase and sale of assets

OperatingActivities

• Sale of products/services

• Costs incurred to operate business

Exhibit 1.3—A Model of Business Activities

What is Accounting?

LO 4

Various UsersManagementStockholdersCreditorsFinancial analystsGovernment

Various UsersManagementStockholdersCreditorsFinancial analystsGovernment

EconomicInformation

Users of Accounting Information and Their Needs

Internal Users: Primarily the managers of a company Involved in the daily affairs of the business

External Users: Not directly involved in the operations of a business Need information that differs from that needed by

internal users Outsiders must rely on the information presented by

the company’s management

Management Accounting and Financial Accounting

Management accounting Branch of accounting concerned with providing

management with information to facilitate planning and control

Financial accounting Branch of accounting concerned with the

preparation of financial statements for outsider use

Exhibit 1.4—Users of Accounting Information

Financial Decision Framework

1. Formulate the question2. Gather information from the financial

statements and other sources3. Analyze the information gathered4. Make the decision5. Monitor your decision

The Accounting Equation

Assets = Liabilities + Owners’ Equity Left side: valuable economic resources and that

will provide future benefit to the company Right side: indicates who provided, or has a

claim to, the assets Stockholders’ equity or shareholders’ equity:

used to refer to the owners’ equity of a corporation

LO 5

Source of Stockholders’ Equity

Created when a company issues stock to an investor

Retained earnings Earnings accumulated or retained by the company Part of owners’ equity that represents the income

earned less dividends paid over the life of an entity

The Balance Sheet

Financial statement that summarizes the assets, liabilities, and owners’ equity at a specific point in time

At any point in time, assets must equal liabilities and owners’ equity

Example 1.4—Preparing a Balance Sheet

The Income Statement

Summarizes the revenues and expenses of a company for a period of time

EXHIBIT 1.5—The Relationship Between the Accounting Equation and the Balance Sheet

Example 1.5—Preparing an Income Statement

The Statement of Retained Earnings

Summarizes the income earned and dividends paid over the life of a business

Dividends: Distribution of the net income of a business to its owners

Example 1.6—Preparing a Statement of Retained Earnings

The Statement of Cash Flows

Summarizes a company’s cash receipts and cash payments during the period from operating, investing, and financing activities

Example 1.7—Preparing a Statement of Cash Flows

Exhibit 1.6—Relationships Among the Financial Statements

Financial Statement Assumptions

LO 6

EconomicEntity

Concept

CostPrinciple

GoingConcern

MonetaryUnit

TimePeriod

Assumption

Economic Entity Concept

Single, identifiable unit must be accounted for in all situations

Specific entity be the subject of a set of financial statements

Does not intermingle the personal assets and liabilities of the employees or any of the other stockholders

Cost Principle

Assets are recorded at the cost to acquire them Original cost or historical cost—until the company

disposes them More objective than market value

Going Concern

Assume an entity is not in the process of liquidation and that it will continue indefinitely

Justifies use of historical cost

Monetary Unit

Yardstick used to measure amounts in financial statements Example: U.S. dollar, Japanese yen, Mexican peso,

etc. Assumes monetary unit is relatively stable; no

adjustment for inflation made in financial statements

Time Period Assumption

Artificial segment on the calendar used as the basis for preparing financial statements

Accountants assume that it is possible to prepare an income statement that accurately reflects net income or earnings for a specific time period

Setting Accounting Standards

Generally accepted accounting principles (GAAP) Various methods, rules, practices, and other

procedures—preparing financial statements Securities and Exchange Commission (SEC)

Federal agency with ultimate authority to determine the rules for preparing statements

Financial Accounting Standards Board (FASB) Authority to set accounting standards

LO 7

Setting Accounting Standards (continued)

American Institute of Certified Public Accountants (AICPA) Professional organization of Certified Public

Accountants (CPA) Public Company Accounting Oversight Board

(PCAOB) Five-member body created by an act of Congress in

2002 to set auditing standards International Accounting Standards Board

(IASB) Develop worldwide accounting standards

Audit of Financial Statements

Most stockholders are not actively involved in the daily affairs of the business

Auditing: examining whether financial statements are fairly presented External auditor performs various tests and

procedures and render his opinion• Auditors’ report is an opinion, not a statement of fact

Ethics in Accounting

Ethics plays a critical role in providing useful financial information

Investors and other users must have confidence in a company, its accountants, and its outside auditors that the information presented in financial statements is relevant, complete, neutral, and free from error

Moral and social ethical behavior must be considered while decision making

LO 8

Exhibit 1.9—Ethics and Accounting: A Decision-Making Model

Sarbanes-Oxley Act

An attempt to bring about major reforms in corporate accountability and stewardship

Most important provisions in the act: Establishment of the Public Company Accounting

Oversight Board Requirement that the external auditors report directly

to the company’s audit committee Clause to prohibit public accounting firms from

providing any other services that could impair their ability to act independently in the course of their audit

End of Chapter 1