The Language of Business

CHAPTER 1

Accounting:

The Language of Business

Learning objectives

After studying this chapter you should be able to:

1. Explain how accounting information assists in making decisions.

2. Describe the components of the balance sheet.

3. Analyze business transactions and relate them to changes in the balance sheet.

4. Prepare a balance sheet from transactions data.

5. Compare the features of sole proprietorships, partnerships, and corporations.

6. Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole proprietorship or a partnership.

7. Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.

8. Describe auditing and how it enhances the value of financial information.

9. Evaluate the role of ethics in the accounting process.

10. Recognize career opportunities in accounting, and understand that accounting is important to both for-profit and nonprofit organizations.

Chapter 1 provides a glimpse of the entire field of accounting. It describes the nature of accounting and its role in providing useful information for a wide variety of decisions. In addition, the balance sheet equation is introduced: Assets = Liabilities + Owners’equity.

An introduction to the basic terms accountants use—the accounting vocabulary—is an overall theme of the chapter. Transaction analysis is introduced as well as the effect of a transaction on the balance sheet equation. The chapter also looks at types of business organizations. The chapter concludes with a discussion of the accounting profession, regulation, the auditing function, and professional ethics.

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Accounting is the language of business and is the process of identifying, recording, and summarizing economic information to decision makers.

An organization’s accounting system is the series of steps it uses to record financial data and convert them into informative financial statements.

Learning Objective 1. Explain how accounting information assists in making decisions.

Accounting information is useful to anyone making decisions that have economic consequences.

Financial accountingserves external decision makers (stockholders, suppliers, banks and government agencies)whilemanagement accountingserves internal decision makers (top executives, department heads, college deans, and hospital administrators).

A common source of financial information used by investors and others outside the company is the annual report. It is prepared by management to inform current and potential investors about the company’s past performance and future prospects. It contains financial statements and other information about the corporation, such as a letter from corporate management, a discussion and analysis by management of recent economic events, footnotes to the financial statements, auditor’s report, and statements by management and the authors on the company’s internal controls.

Financial statements also appear in Form 10-K, filed annually with the Securities and Exchange Commission (SEC), the government agency responsible for regulating capital markets in theUnited States. U.S. companies with publicly traded stock (companies that sell shares in their ownership to the public) must file Form 10-K and other forms with the SEC.

DO MULTIPLE CHOICE 1, 2 and 3.

Learning Objective 2. Describe the components of the balance sheet.

The balance sheet(also called the statement of financial position) shows the financial status of an organization at a particular instant in time.

The balance sheet has two counterbalancing sections. One section lists the resources of the firm and the other the claims against the resources. The two sections form the balance sheet equation: Assets = Liabilities + Owners’ equity.

Assets are economic resources that the company expects to generate future cash inflows or reduce or prevent future cash outflows. Examples are cash, inventory, and equipment.

Liabilities are economic obligations of the organization to outsiders, or claims against its

assets by outsiders such as a debt to the bank.Notes payable describe the existence of

promissory notes that are signed when a company takes out a bank loan.

Owners’ equity is the owners’ claims on the organization’s assets and is equal to total

assets less total liabilities. The term net assets also refers to assets less liabilities.

DO MULTIPLE CHOICE 4 and 5.

DO EXERCISES 1 and 2.

Learning Objective 3. Analyze business transactions and relate them to changes in the balance sheet (SeeEXHIBIT 1-2).

An entity is an organization or a section of an organization that stands apart from other organizations and individuals as a separate economic unit. A transaction is any event that affects the financial position of an entity and can be reliably recorded in monetary terms.

Every transaction affects the balance sheet. When accountants record transactions they always make at least two entries(i.e., double-entry accounting system) so that the total assets always equal the total liabilities and owners’ equity. The balance sheet equation always must remain in balance.

Accountants record transactions in an organization’s accounts. An account is a summary record of the changes in a particular asset, liability, or owners’ equity category, and the account balance is the total of all entries to the account up to a particular date.

Transaction analysis determines which specific accounts are affected, whether the account balances are increased or decreased, andthe amount of the change in each account balance. For example, if the company borrows money from the bank, an asset (cash) increases, and a liability (notes payable) increases.

Inventory refers to goods held by the company for the purpose of sale to customers. An account payable is a liability that results from a purchase of goods or services on open account (i.e., on credit). When inventory is purchased on account, both assets and liabilities are increased (if purchased for cash, one asset will increase and another asset will decrease). A compound entry affects more than two balance sheet accounts. A creditor is one to whom the company owes money.

DO MULTIPLE CHOICE 6 and 7.

Learning Objective 4. Prepare a balance sheet from transactions data(See EXHIBIT 1-3)

Transactions data can be used to compute a cumulative total for each account at any date. Note that a balance sheet represents the financial impact of all transactions up to a specific point in time.

The account titles are listed with their respective balances on the specific date noted in the header of the balance sheet. Each account is listed under the category that it belongs to—assets, liabilities, or owner’s equity. Examples of actual corporate balance sheets can be found in EXHIBIT 1-5.

Although a new balance sheet could be prepared after each transaction, companies usually produce balance sheets only when needed by managers and at the end of each quarter for reporting to the public.

Learning Objective 5. Compare the features of sole proprietorships, partnerships, and corporations.

A sole proprietorship is a business with a single owner. Sole proprietorships tend to be small businesses such as local stores or restaurants.

A partnership is aform of organization that joins two or more individuals together as co-owners. Each partnership is an individual entity that is separate from the personal activities of each partner.

Corporations are organizations created under state law in the United States with an unlimited number of owners. Owners of a corporation have limited liability (i.e., corporation creditors ordinarily have claims against the corporate assets only, not against the personal assets of the owners).

A publicly owned corporation is one in which shares of ownershipare sold to the public. Purchasers or shares are identified as shareholders or stockholders.

A privately owned (closely held, unlisted) corporation is owned by a family, a small group of shareholders, or a single individual.

Advantages of the corporate form of ownership include ease of transfer of ownership (the corporation issues stock certificates as formal evidence of ownership), ease of raising ownership capital, and continuity of existence.

Tax laws may favor a sole proprietorship, a partnership, or a corporation, depending on the personal tax situations of the owners.

Learning Objective 6. Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole proprietorship or a partnership.

All business entities account for assets and liabilities similarly (See EXHIBIT 1-8).

a. Owners’ equities for proprietorships and partnerships are identified as capital.

b. Owners’ equities for the corporation are called stockholders’ equity or shareholders’ equity.

In a corporation, capital investment by the owners, known as paid-in capital,is recorded in two

parts: common stock at par value and paid-in capital in excess of par value.

Par value or stated value is the dollar amount printed on the stock certificates, and paid-in capital in excess of par valueor additional paid-in capital is the difference

between the total amount received for the stock and the par value.

Common stock represents the par value purchased by the common stockholders of the corporation. (See EXHIBIT 1-9). Common stockholders have a “residual” ownership in the corporation.

DO MULTIPLE CHOICE 8 and 9.

In corporations, the ultimate responsibility for management is delegated by the stockholders to the boardof directors. One of the duties of the board of directors is to appoint and monitor managers. The chief executive officer (CEO) is the top manager in an organization and sometimes serves as the chairman of the board.

Learning Objective 7. Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.

Generally accepted accounting principles (GAAP)consist of all the broad concepts and detailed practices to be followed in preparing and distributing financial statements. Companies reporting in more than 100 countries use International Financial Reporting Standards (IFRS) while U.S. companies useFinancial Accounting Standards.

The Financial Accounting Standards Board is responsible for establishing U.S. GAAP. In 2009 it compiled all standards and other elements of U.S. GAAP into the FASB Accounting Standards Codification.

The U. S. Congress has charged the Securities and Exchange Commission (SEC) with the ultimate responsibility for authorizing GAAP for companies whose stock is held by the general investing public. However, the SEC has informally delegated much rule-making power to the FASB. Congress can, however, overrule both the SEC and the FASB.

The International Accounting Standards Board(IASB) was established to “develop, in the public interest, a single set of high quality, understandable, and enforceable global accounting standards.” The IASB sets International Financial Reporting Standards (IFRS). The IASB has 16 members who represent a diversity of geographic and professional backgrounds.

DO MULTIPLE CHOICE 10.

Learning Objective 8. Describe auditing and how it enhances the value of financial information.

The credibility of financial statements is the ultimate responsibility of the managers who are entrusted with the resources of the entity under their command.

Third-party assurance about the credibility of financial statements gave rise to the CPA profession. An auditor examines the information that managers use to prepare the financial statements and provides assurances about the credibility of those statements.

The desire for third-party assurance about the credibility of financial statements created the profession of public accountants – accountants who offer services to the general public on a fee basis. A certified public accountant (CPA) in the U.S. earns this designation by meeting standards of knowledge and integrity set by a State Board of Accountancy.

To assess management’s financial disclosures, CPAs conduct anaudit, an examination of a company’s transactions and the resulting financial statements.

The audit is conducted by an independent CPA to lend credibility to management’s financial statements and is described in the auditor’s opinion (see EXHIBIT 1-10). An auditor’s opinion (also called an independent opinion) describes the scope and results of the audit, and companies include the opinion with the financial statements in their annual reports and 10K filings.

DO MULTIPLE CHOICE 11.

Accountants who do not offer services to the general public are known as private accountants. They work for businesses, governmental agencies, and other nonprofit organizations.

The American Institute of Certified Public Accountants (AICPA) is the principal professional

association of CPAs. The International Auditing and Assurance Standards Board (IAASB),

established by the International Federation of Accountants, is working to standardize audit regulation

around the globe, but regulation of auditing continues to differ significantly across countries.

In 2002, the U.S. Congress passed the Sarbanes-Oxley Act, which gave the government a larger role in regulating the audit profession. Among its regulations were:

a. the establishment of the Public Company Accounting Oversight Board(PCAOB)with powers to regulate many aspects of public accounting and to set standards for audit procedures,

b. prohibiting public accounting firms from providing to audit clients certain nonaudit services, and

c. requiring rotation every five years of the lead audit or coordinating partner and the reviewing partner on an audit.

All accounting firms that audit companies with publicly traded stock in the U.S. must register with the PCAOB, and they are referred to as registered public accounting firms. Additionally, the PCAOB issues Generally AcceptedAuditing Standards (GAAS) that prescribe the minimum steps that an auditor must take in examining the transactions and financial statements and issuing an auditor’s opinion.

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Learning Objective 9. Evaluate the role of ethics in the accounting process.

Members of the AICPA, as well as members of the Institute of Management Accountants and the Association of Government Accountants, must abide by codes of professional conduct, which are especially concerned with integrity and independence. Professional accounting organizations have procedures for reviewing behavior alleged as not being consistent with the codes of professional conduct (see EXHIBIT 1-11).

DO MULTIPLE CHOICE 12 and 13.

Learning Objective 10. Recognize career opportunities in accounting, and understand that accounting is important to both for-profit and nonprofit organizations.

Accounting is provides an excellent background for almost any manager and is especially important for finance professionals.

Additionally, anyone who wants to move up in the management structure of a company needs to know accounting.

Companies often rely on accountants to safeguard the ethics of a company. Therefore, accountants have a special responsibility to ensure that managers act with integrity and that information provided by the company is accurate.

Although this textbook focuses on profit-seeking organizations, accounting principles also apply to nonprofit organizations such as hospitals, universities, and government agencies.

Chapter 1 Quiz

Multiple Choice

1. Financial accounting focuses on the specific needs of decision makers external to the organization. Which of the following would not be an external user?