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ACCOUNTING:

The Language
of Business

2006 Prentice Hall Business Publishing

CHAPTER

Introduction to Financial Accounting, 9/e

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

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Learning Objectives
After studying this chapter, you should be able to
5. Identify how the owners equity section in a
corporate balance sheet differs from that in a sole
proprietorship or partnership
6. Describe auditing and how it enhances the value of
financial information
7. Explain the regulation of financial reporting
8. Evaluate the role of ethics in the accounting
profession

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Nature of Accounting


Accounting is the process of identifying,
recording, summarizing, and reporting economic
information for decision makers
Accountants present this information in reports
called financial statements

Event

Accountants
Analysis and
Recording

2006 Prentice Hall Business Publishing

Financial
Statements

Introduction to Financial Accounting, 9/e

Users

Accounting as an Aid
to Decision Making
Accounting information is useful to anyone
making decisions that have economic
consequences
These decision makers include

Managers
Owners
Investors
Politicians

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Financial Accounting
Financial accounting serves external
decision makers:

Stockholders
Suppliers
Banks
Government agencies

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Management Accounting
Management accounting serves internal
decision makers:

Top executives
Department heads
College deans
Hospital administrators
Other managers within the organizations

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Annual Report


The annual report is prepared by management
and informs investors about the companys past
performance and future prospects

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Annual Report


The annual report includes
A letter from corporate management
Management discussion and analysis
Footnotes explaining many elements of the financial
statements in more detail
The report of the independent auditors
A statement of managements responsibility for
preparation of the financial statements
Other corporate information

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Annual Report


A companys financial statements can also be
found in Form 10-K, which it files annually with
the Securities and Exchange Commission
The three major financial statements are the
Balance sheet
Income statement
Statement of cash flows

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Annual Report


The balance sheet focuses on the financial
position of a company on a particular day
The income statement and cash flow statement
focus on the companys performance over time

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Balance Sheet


The balance sheet (also called the statement of
financial position) shows the financial status of a
company at a particular instant in time
The left side lists the resources of the firm
The right side lists the claims against those
resources
Assets= Liabilities + Owners equity

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Balance Sheet


Assets are economic resources that the
company expects to help generate future cash
inflows or reduce or prevent future cash outflows
Examples: Cash, inventories, equipment

Liabilities are economic obligations of the


organization to outsiders (creditors)
Example: A debt to a bank in the form of a note
payable

Owners equity is the owners claim on the


organizations assets
2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Balance Sheet


Open account the practice of making most
purchases on a credit basis instead of cash
basis
Accounts receivable are assets that result from
the sale of goods or services on open account
Accounts payable are liabilities that result from a
purchase of goods or services on open account
Inventories are assets held by the company for
the purpose of sale to customers
2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Balance Sheet Transactions


Every transaction of a company or entity affects
the balance sheet equation
An entity is 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 that can reliably recorded in
money terms

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Balance Sheet Transactions


An account is a summary record of the changes
in a particular asset, liability, or owners equity
item
The double-entry accounting system records
each transaction in at least two accounts
A compound entry affects more than two
balance sheet accounts

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Balance Sheet Transactions


Transaction 1: Initial Investment of $400,000
Assets

Liabilities

Owners Equity

Cash
(1)

+ $400,000

Lopez, Capital
=

2006 Prentice Hall Business Publishing

+$400,000
(Owner Investment)

Introduction to Financial Accounting, 9/e

Balance Sheet Transactions


Transaction 2: Loan of $100,000 from Bank
Assets

Cash

Liabilities

+ $400,000

(2)

+ $100,000

+ $100,000

$500,000

$100,000

$500,000

2006 Prentice Hall Business Publishing

Owners Equity

Note payable

(1)

Bal.

Lopez, Capital
+$400,000

$400,000
$500,000

Introduction to Financial Accounting, 9/e

Balance Sheet Transactions


Transaction 3: Acquire Store Equipment
for Cash, $15,000
Assets
Cash

=
Store Equipment

Bal. $500,000

Liabilities
Note payable

-15,000

+15,000

Bal.

485,000

15,000

$400,000

100,000

$500,000

400,000
$500,000

Introduction to Financial Accounting, 9/e

Owners Equity
Lopez, Capital

= $100,000

(3)

2006 Prentice Hall Business Publishing

Preparing the Balance Sheet


Biwheels Company
Balance Sheet January 3, 20X2

Assets
Cash
Store equipment
Total assets

Liabilities and Owners Equity


$485,000
15,000
$500,000

2006 Prentice Hall Business Publishing

Liabilities (note payable)


Lopez, capital
Total liabilities
and owners equity

Introduction to Financial Accounting, 9/e

$100,000
400,000
$500,000

Types of Ownership
Sole proprietorship a business with a single
owner
Partnership an organization that joins two or
more individuals who act as co-owners
Corporation a business organization created
under state laws in the Unites States

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Corporation
Publicly owned corporation A corporation owned by
the public through the sale of shares; it may have
thousands of owners
Privately owned corporation A corporation owned by
families or a small group of shareholders; shares are
not publicly sold
Corporation stockholders have limited liability
Creditors have claims against the corporation
assets only, not the personal assets of the owners

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Advantages and Disadvantages


of the Corporate Form
Advantages

Disadvantages

Limited liability
Easy transfer of
ownership
Ability to raise capital
from hundreds or
thousands of potential
stockholders
Continuity of existence
Prestige

2006 Prentice Hall Business Publishing

Unfavorable tax laws


Regulation

Introduction to Financial Accounting, 9/e

Accounting Differences Among


Legal Forms
Proprietorships and partnerships
Owners equities are labeled capital
Owners equities are recorded in the capital account

Corporations
Owners equities are labeled stockholders equity or
shareholders equity. Total capital investment is called
paid-in capital
Owners equity is recorded in two parts:
Common stock at par value
Paid-in capital in excess of par value

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Meaning of Par Value


Par value (or stated value) the dollar amount
printed on the stock certificate
Paid-in capital in excess of par value (or
additional paid-in capital) the difference
between the total amount the company receives
for the stock and the par value
Common stock is recorded at the par value
Common shareholders are owners who have a
residual ownership in the corporation through
the purchase of common stock
2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Stockholders and the


Board of Directors
Shareholders elect a board of directors to look
out for their interests
Members of a board often include CEOs and
presidents of other corporations; university
presidents and professors; attorneys; and
community representatives
The chairman of the board may also be the top
manager, the chief executive officer (CEO)

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Stockholders and the


Board of Directors
The boards duty is to ensure that managers act
in the interest of shareholders
When boards do their duty in monitoring
management, the corporate form of organization
is effective

Stockholders

2006 Prentice Hall Business Publishing

Board of Directors

Introduction to Financial Accounting, 9/e

Managers

Credibility and the Role of Auditing


The separation of owners and managers creates
potential problems in getting truthful information
about the performance of a company
Shareholders must rely on managers to tell the
truth
The auditor examines the information that
managers use to prepare the financial
statements and provides assurances about the
credibility of those statements
2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Certified Public Accountant and


the Auditors Opinion
Third party assurance about the credibility of
financial statements is provided by audit
professionals called Certified Public
Accountants (CPAs)
CPAs are public accountants who offer services
including auditing, preparing income taxes, and
management consulting to the general public on
a fee basis
Each state has a Board of Accountancy that sets
standards of both knowledge and integrity
2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Certified Public Accountant and


the Auditors Opinion
An audit is an examination of a companys
transactions and the resulting financial
statements
The auditors opinion describes the scope and
results of the audit and a judgment that the
financial statements prepared by management
are accurate

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

The Accounting Profession


Public accountants offer services to the general
public for a fee
Private accountants work for businesses,
government agencies, and other nonprofit
organizations

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Public Accounting Firms


The four largest public accounting firms are

Deloitte Touche Tohmatsu


Ernst & Young
KPMG International
PricewaterhouseCoopers

97% of the firms listed on the NYSE are clients


of these four firms

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Public Accounting Firms


Each firm has annual billings in excess of $1
billion
All firms must follow generally accepted
accounting principles (GAAP)
The broad concepts and detailed practices of
preparing and distributing financial statements

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Standard-Setting Bodies
The Financial Accounting Standards Board
(FASB) is responsible for establishing GAAP in
the United States by issuing FASB Statements
The Securities and Exchange Commission
(SEC) is responsible for authorizing the GAAP
for companies whose stock is held by the
general investing public
The FASB and SEC work closely together and
seldom have public disagreements
2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Standard-Setting Bodies
The International Accounting Board (IASB)
Is responsible for developing high quality,
understandable and enforceable global accounting
standards
Has 12 full-time and 2 part-time members
Standards will be adopted by the European Union for
financial statements prepared after 2005

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Standard-Setting Bodies
The American Institute of Certified Public
Accountants (AICPA) is the principal
professional association in the private sector that
regulates the quality of the public accounting
profession

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Sarbanes-Oxley Act
Established the Public Company Accounting
Oversight Board to regulate public accounting
and to set standards for audit procedures
through the issuance of generally accepted
auditing standards (GAAS)
Prohibits public accounting firms from providing
audit clients with certain non-audit services
Requires rotation every 5 years of the lead audit
or coordinating partner and the reviewing partner
on an audit
2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Sarbanes-Oxley Act
Provides regulation of corporate governance
Requiring boards to appoint an audit committee
composed only of independent directors
Requiring CEOs and chief financial officers (CFOs) to
personally sign a statement certifying the
appropriateness and fairness of their companies
financial statements
Increasing criminal penalties for knowingly
misreporting financial information

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Professional Ethics
Members of the AICPA must abide by a code of
professional conduct
The Institute of Management Accountants has a
code of ethics for management accounts
Auditors and management accountants have
professional responsibilities concerning
competence, confidentiality, integrity, and
objectivity

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Professional Ethics
Ethical standards are personal and depend on
the values of the individual
A successful manager must recognize the
ethical dimensions of a situation and act with
absolute integrity

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Professional Ethics
Despite the criticism of accounting ethics,
accountants were responsible for revealing the
problems in many of the recent corporate
scandals
Companies often rely on accountants to
safeguard the ethics of the company
WorldCom and Enron whistle-blowers became
two of the three 2002 Persons of the Year in
Time magazine
2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Career Opportunities
for Accountants
Accounting provides an excellent training ground
for future managers and executives
More CEOs started out in finance or accounting
than any other area

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Nonprofit Organizations
Fundamental accounting principles also apply to
nonprofit organizations
The Governmental Accounting Standards
Board (GASB) regulates disclosures for
governmental organizations
The FASB regulates financial reporting for other
nonprofit organizations

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e