CHAPTER 1

Accounting as a Form
of Communication
QUESTIONS

1. Business is concerned with all the activities necessary to provide the members of an
economic system with goods and services. Some businesses are organized to earn a
profit, whereas others are organized for some other purpose. Regardless, all busi-
nesses are organized to provide goods and/or services to their customers.
2. An asset is a future economic benefit to a business. Cash, accounts receivable, mer-
chandise inventories, and property and equipment are all examples of assets. They
are located on the left side of the accounting equation.
3. A liability is an obligation of a business. Assets and liabilities are related in that most
liabilities are satisfied by using assets, most often in the form of cash. They are located
on the right side of the equation along with owners’ equity.
4. The three forms of business entities are sole proprietorships, partnerships, and cor-
porations.
5. The types of activities in which companies engage are financing, investing, and
operating. To start a new business, such as renting bicycles and skis, requires initial
financing, such as initial contributions by the owners and loans by a bank. Next, the
business would need to invest in the assets it will rent—that is, bicycles and skis. Once
investments in assets are made, the business would earn revenue by renting out
bicycles and skis. The business would also incur various operating expenses, such as
wages, advertising, and taxes.
6. Accounting is a communication process. Its purpose is to provide economic infor-
mation about an organization that will be useful to those who need to make decisions
regarding that entity. For example, information provided by an accountant about an
entity is useful to a banker in reaching a decision about whether to loan money to a
business.
7. Financial accounting and management accounting differ with regard to the users of
the information provided by the two branches of the discipline. Management
accounting is the branch of accounting that provides management with information to
facilitate the planning and control functions. The information provided by a manage-
ment accounting system can be tailored to meet the needs of managers.

1-1
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1-2 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

Alternatively, financial accounting is concerned with the preparation of general-pur-

pose financial statements for use by both management and outsiders. Because the
information provided by financial accounting must meet the needs of many
different groups, it is necessary to rely on a set of generally accepted accounting prin-
ciples in preparing the financial statements.

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 CHAPTER 1 • ACCOUNTING AS A FORM OF COMMUNICATION 1-3

8. Many different groups rely on accounting information in making decisions. For

example, investors and potential investors rely on financial statements and related
disclosures in deciding whether to sell or buy stock in a company. This group is par-
ticularly concerned with the recent profitability of the company as shown on the
income statement. Bankers and other creditors need information to decide whether to
loan money to a company or whether to extend an existing loan. Many different gov-
ernment agencies have information needs that are specified by law. The Internal Rev-
enue Service needs to know about a company’s profitability in levying taxes on it. The
Securities and Exchange Commission, the Interstate Commerce Commission, and the
Federal Trade Commission also depend on the information provided by accountants
in making decisions. Labor unions need information about a company’s profitability
and financial position in negotiating contracts with the company for the employees.
Trade associations rely on the information provided in financial statements in compil-
ing information for use by their members.
9. Stockholders’ equity or owners’ equity is the difference between the assets of an entity
and its liabilities. Thus, it represents the claims of the owners to the assets of the
business. Therefore, it includes the contributions of the owners (e.g., capital stock)
and retained earnings.
10. The two distinct elements of owners’ equity in a corporation are contributed capital
and retained earnings. Contributed capital, as represented by capital stock, is the orig-
inal contribution to the company by the owners. Retained earnings represents the
claims of the owners to the assets of the business. These claims result from the earn-
ings of the company that have not been paid out in dividends.
11. The purpose of a balance sheet is to show the financial position of an entity as of a
particular point in time. It consists of three distinct elements: assets, liabilities, and
owners’ equity.
12. A balance sheet should be dated as of a particular day. It is a statement of financial
position and shows the assets, liabilities, and owners’ equity of a business at a partic-
ular point in time. Unlike an income statement, it is not a flow statement and therefore
is not dated for a particular period of time. Balance sheets are typically prepared to
coincide with the end of an accounting period, such as the end of the month or the
end of the year.
13. The cost principle is an accounting requirement to record an asset at the cost to ac-
quire it and report it on subsequent balance sheets at this amount.
14. The purpose of an income statement is to summarize the revenues and expenses of
a company for a period of time. It is an indicator of the profitability of an entity.
15. An income statement should be dated for a particular period of time: for example, for
the month of June or for the year ended December 31, 2014. The income statement
is a flow statement because it summarizes revenues and expenses for a period of
time. Unlike a balance sheet, it is not an indication of position at any one particular
point in time.

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 1-4 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

16. If Rogers has $55,000 in Retained Earnings to begin the year and net income for the
year of $27,000, the ending balance in Retained Earnings would be $82,000 if no
dividends were paid during the year. Because the ending balance in Retained Earn-
ings is $70,000, the company must have paid $12,000 in dividends.
17. Various groups are involved in determining the rules companies must follow in pre-
paring their financial statements. In the United States, the Securities and Exchange
Commission (SEC) has ultimate authority for companies whose securities are sold to
the general public. However, the SEC has relegated much of the standard setting to
the private sector in the form of the Financial Accounting Standards Board (FASB).
Standard setters in the United States continue to work closely with those in the inter-
national community. For instance, at one time, foreign companies that filed their finan-
cial statements with the SEC were required to adjust those statements to conform to
U.S. accounting standards. The SEC dropped this requirement, as long as foreign
companies follow the standards of the IASB. However, there are significant differ-
ences between U.S. and international standards; it may be some time before all dif-
ferences are eliminated.
18. In 2002, Congress passed the Sarbanes-Oxley Act. The act was a direct response to
corporate scandals and was an attempt to bring about major reforms in corporate ac-
countability and stewardship, given the vast numbers of stockholders, creditors, em-
ployees, and others affected in one way or another by these scandals. Among the
most important provisions in the act are the following: (1) the establishment of a new
Public Company Accounting Oversight Board, (2) a requirement that the external au-
ditors report directly to the company’s audit committee, and (3) a clause to prohibit
public accounting firms who audit a company from providing any other services that
could impair their ability to act independently in the course of their audit.
19. The auditors may be in an excellent position to evaluate a company, but not
because they have prepared the financial statements. The preparation of the state-
ments is the responsibility of management. The role of the auditor is to perform
various tests and procedures as a basis for rendering an opinion on the fairness of the
presentation of the statements.
20. We assume in the absence of evidence to the contrary that a business will continue
indefinitely. This assumption, known as the going concern assumption, helps to justify
the use of historical costs in the statements. For example, if we knew that a company
was in the process of liquidation, it would not be appropriate to use historical costs in
assigning an amount to such assets as land and buildings. Instead, the
current or market values of the assets would be more meaningful to a user of the
balance sheet. Because the normal assumption is that a business will continue
indefinitely, the objectivity of historical cost makes it more attractive as a basis for
valuation.

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 CHAPTER 1 • ACCOUNTING AS A FORM OF COMMUNICATION 1-5

21. Inflation, as evidenced by the changing value of the dollar, poses a problem for the
accountant. Accountants make the assumption in preparing a set of financial state-
ments that the dollar is a stable measuring unit. This assumption, called the monetary
unit assumption, may or may not be accurate, depending on the level of inflation in
the economy. The higher the rate of inflation, the less reliable is the dollar as a meas-
uring unit.
22. Any profession must have a set of standards that govern the practice of the profession.
In accounting, generally accepted accounting principles, or GAAP, are those methods,
rules, practices, and other procedures that have evolved over time and that govern
the preparation of financial statements. Two important points are worth noting about
GAAP. First, these principles are not static but rather change in response to changes
in the ways companies conduct business. Second, there is not a single, identifiable
source of GAAP. Both the private and public sectors have contributed to the develop-
ment of generally accepted accounting principles.
23. Although the Securities and Exchange Commission has the ultimate authority to de-
termine the rules in preparing financial statements, it has to a large extent allowed the
accounting profession, through the Financial Accounting Standards Board, to estab-
lish its own rules. The SEC has at times taken an active role in the setting of account-
ing standards. It has stepped in when it has believed that the profession has not acted
quickly enough or in the correct manner. Since its inception in 1934, the commission
has been more involved in the enforcement of GAAP as a means of protecting the
rights of investors than it has been in setting standards.

BRIEF EXERCISES

LO 1 BRIEF EXERCISE 1-1 TYPES OF BUSINESSES

Students will provide a number of different examples of real companies that are manu-
facturers, retailers, and service providers.

LO 2 BRIEF EXERCISE 1-2 FORMS OF ORGANIZATION

When you own a share of stock in a corporation, you are part owner of that business. In
contrast, if you own one of the corporation’s bonds, you have made a loan to the company
and you are one of its creditors.

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1-6 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

LO 3 BRIEF EXERCISE 1-3 BUSINESS ACTIVITIES

The first activity for a new business is to secure financing. Next, investing activities are
needed to secure the necessary assets to then begin operating the business. The order
of the activities is financing, investing, and operating.

LO 4 BRIEF EXERCISE 1-4 USERS OF ACCOUNTING INFORMATION

Stockholders, creditors (including banks, bondholders, and suppliers), and government

agencies are all examples of external users.

LO 5 BRIEF EXERCISE 1-5 THE ACCOUNTING EQUATION AND THE BALANCE SHEET

Assets = Liabilities + Stockholders’ Equity. The two parts that make up stockholders’ eq-
uity are capital stock and retained earnings.

LO 6 BRIEF EXERCISE 1-6 MONETARY UNIT

The dollar is the monetary unit used in the United States, and the yen is used in Japan.

LO 7 BRIEF EXERCISE 1-7 THE ROLE OF AUDITORS

The external auditors do not prepare the financial statements. Management of the com-
pany is responsible for preparation of the statements. The auditors provide an opinion as
to the fairness of the financial statements.

LO 8 BRIEF EXERCISE 1-8 MAKING ETHICAL DECISIONS

The four steps in the model presented in the chapter to help in making ethical decisions
are:
1. Recognize an ethical dilemma.
2. Analyze the key elements in the situation.
3. List alternatives and evaluate the impact of each on those affected.
4. Select the best alternative.

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 CHAPTER 1 • ACCOUNTING AS A FORM OF COMMUNICATION 1-7

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.