Chapter 1 - ACCOUNTING: The Language of Business

Learning Objectives (LO)
After studying this chapter, you should be able to
ACCOUNTING: The Language of Business
CHAPTER
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 transactional data 5. Compare the features of sole proprietorships, partnerships, and corporations
2010 Pearson Education Inc. Publishing as Prentice Hall
Introduction to Financial Accounting, 10/e
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Learning Objectives (LO)

After studying this chapter, you should be able to
6. Identify how the owners equity section in a corporate balance sheet differs from that in a sole proprietorship or partnership 7. Explain the regulation of financial reporting including differences between U.S. GAAP an IFRS 8. Describe auditing and how it enhances the value of financial information 9. Evaluate the role of ethics in the accounting profession
LO 1 - Accounting and Decision-Making

Accounting is the language of business. It is the process of identifying, recording, summarizing, and reporting economic information to decision makers. Accounting information helps decisions makers answer questions on various topics, such as:
Investment alternatives Product development Employee evaluations Loan levels, Cash needs, etc.
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Types of Accounting:
Managerial aimed for internal decision makers (budgets, planning, costing, pricing, managing product mix, etc.)

Principal Components of Annual Financial Reports
A letter from corporate management Managements discussion and analysis of past and possible future transactions, events, circumstances Financial statements Footnotes explaining many elements of the financial statements in more detail Independent auditors report A statement of managements responsibility for preparation of the financial statements Other corporate information
Financial aimed for external decision makers

(owners, creditors, suppliers, regulators, unions, etc.)
Financial Accounting answers the questions of financial strength and performance through the use of three major financial statements:
Balance Sheet Income Statement Statement of Cash Flows
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Characteristics of Financial Reports
Prepared by management Provided to outsiders quarterly and/or annually Primarily about past transactions and events Tell very little about future transactions, events, or circumstances

Accessing Financial Reports and Statements
Available to all via the Internet from companys website Formally sent or made available to owners by preparer Formally filed with the U.S. Government (Securities and Exchange Commission) (10-Q, 10-K, and numerous other forms) and subsequently accessible from the SECs EDGAR system
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LO 2 - The Balance Sheet

Assets
Left side of the balance sheet, Resources that the company owns or controls from past transactions/events, Resources that it expects to help generate future cash inflows or reduce/prevent future cash outflows.
LO 2 - The Balance Sheet Liabilities economic obligations of the

organization to outsiders, or claims against its assets by outsiders (debt to the bank, etc.). Accounts subdivision of the element Liabilities
Current Assets
Accounts subdivision of the element Assets

Cash and cash equivalents Accounts Receivable Inventories (Merchandise, Supplies, Parts) Prepaid Expenses (taxes, utilities, insurance) Property Plant Equipment
Accounts Payable Notes Payable Long-term debt
Long-term Assets
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LO 2 - The Balance Sheet Owners equity is the residual interest by the

owners in, or remaining claims against the organization's assets after deducting liabilities. Accounts subdivision of the element Equity
Sole Proprietorships - XX Capital Partnerships - YY Capital Corporations - Capital (Common) Stock - Paid in Capital in excess of par/stated value (See LO 6)
LO 2 - The Balance Sheet

The balance sheet (statement of financial position) shows the financial status of a company at a particular instant in time Reflects the basic accounting equation, which is Resources = Claims against those resources
Assets = Liabilities + Owners equity
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LO 3 - 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 for which the balance sheet is being prepared A transaction is any event that affects the financial position of that entity and that can be reliably recorded in money terms

Transaction 1: Initial Investment of $400,000
Assets Cash (1) + $400,000 = = Liabilities + Owners Equity Lopez, Capital +$400,000 (Owner Investment)
At least two accounts will be affected for every entry recorded (compound entry = > 2 accounts)
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Transaction 2: Loan of $100,000 from Bank
Assets Cash (1) (2) Bal. + $400,000 + $100,000 $500,000 $500,000 = = = + $100,000 $100,000 $500,000 $400,000 = Liabilities Note payable + Owners Equity Lopez, Capital +$400,000

Transaction 3: Acquire Store Equipment for Cash, $15,000
Assets Cash Store Equipment = Liabilities Note payable = $100,000 +15,000 15,000 = = 100,000 $500,000 400,000 + Owners Equity Lopez, Capital $400,000
Bal. $500,000 (3) Bal. 15,000 485,000
$500,000
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LO 4 Preparing the Balance Sheet
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LO 5 Comparative Ownership Features

Sole proprietorship a single owner Partnership two or more co-owners Corporation created under (U.S.) state laws
Publicly owned Owned by the public through the sale of shares; potentially thousands of owners Privately owned Owned by families or a small group of shareholders; shares are not sold or traded
LO 5 Comparative Ownership Features

Advantages of a Corporation
Limited liability (claims against corporate assets only not personal assets of managers) Ease of transfer of ownership Ease in raising ownership capital Continuity of existence Separation of ownership and management Prestige
Disadvantages of a Corporation
Unfavorable tax laws. Corporations and taxed as separate entity, i.e. double taxation on distributed earnings Regulation
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LO 6 Differences in Reporting Owners Equity

Proprietorships and Partnerships
Owners equities = Capital
LO 6 Differences in Reporting Owners Equity

Shareholders elect a board of directors to look out for their interests Board of Directors
Often include outsiders such as CEOs and presidents of other corporations, academics, attorneys, and community representatives Can also include insiders companys CEO, CFO, etc. Majority must be independent if stock is regulated Set strategic direction of the company
Corporations
Owners equities = Stockholders /Shareholders equity Total capital investment = Paid-in capital (e.g., $20) Common stock recorded at par/stated value Par/stated value = what is printed on the stock One share ? $5 par value = $5 Paid-in capital in excess of par value One share ? ($20 $5 par value) = $15
Senior Managers run day to day operations

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LO 7 Regulation of Financial Reporting

Generally Accepted Accounting Principles
Common set of measurement rules Common language to report information

Financial Accounting Standards Board (FASB)
Independent nonprofit entity established in 1973 Writes accounting/reporting standards for not-forprofit organizations Has delegated authority from SEC to create and amend financial accounting/reporting standards for for-profit organizations subject to control by the SEC Published 168 standards between 1973 and 2009 and put those into a single searchable database FASB Financial Standards Codification. Is working on convergence of US GAAP with IFRS
Two different languages in accounting

International Financial Reporting Standards (IFRS) Financial Accounting Standards/ US GAAP
Standard setting bodies

International Accounting Standards Board for IFRS Financial Accounting Standards Board for US GAAP
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International Accounting Standards Board (IASB)
Not a U.S. governmental agency United States is represented on the board Creates and amends financial accounting and reporting standards for European Union and many other countries (over 100 countries use IFRS) Selected current projects: Convergence with U.S. GAAP
LO 8 Auditing and Credibility of Financial Information

Principalagent problem Managers are prone to inflate the bottom-line
To send positive signals to stock market To be able to reward themselves They may be overoptimistic about own decisions
Auditors third-party assurance

Examine information managers use to compile financial statements Provide assurances about the credibility of those statements
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Audit examination of a companys transactions and the resulting financial statements Standard report includes the following topics:
Introduction what was audited? Scope how was the audit conducted? Opinion as to fairness of financial statements degree to which GAAP was followed Other topics (e.g., changes in principals, adequacy of managements review of internal controls)

The four largest international 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
CPA licensed public accountant entitled to issue official opinion on financial statements in the US
National, regional and local firms also exist Offer fee-based tax, consulting, auditing services
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LO 8 Auditing
1929 Stock Market Crash Senior managers
Rewarded in part by content of financial statements Prepare financial statements Potential for bias

Sarbanes Oxley Act 2002
Regulates accounting profession Established the Public Company Accounting Oversight Board (PCAOB) to set standards for audit procedures Prohibits public accounting firms from providing clients with certain non-audit services Requires rotation every 5 years of the lead audit or coordinating partner and the reviewing partner Regulates corporate governance Board of directors must have an audit committee composed only of independent directors Management must examine and certify the adequacy of internal controls used by its company (CEOs and SFOs sign the statements) Criminal penalties for knowingly misreporting financial information
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SEC Act of 1934 required public companies to

have their financial statements audited by independent outside auditors who are CPAs File results with the SEC
Shareholders audit report adds credibility to the financial statements they use when making decisions
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LO 9 Ethics
Auditors have a professional obligation to truthfully report their findings to the public as they are public accountants. Auditors code of conduct
Independence (from managements influence) Integrity Objectivity
Career Opportunities for Accountants

More CEOs started out in finance or accounting than any other area, Accounting provides an excellent training ground for future managers and executives Accountants have access to all financial information in the company and interact with all levels of management Accountants are well rewarded (starting salary in an accounting firm - $50,000 in 2009 and over $1MLN for the top partner)
Ethics is stressed in guidance from the following:

Professional societies (AICPA, IMA, state societies) Regulatory bodies (SEC, PCAOB, etc.) Accounting firms (international, national, regional, local) Publically traded firms (set the tone at the top)
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Learning Objectives (LO)

After studying this chapter, you should be able to

ACCOUNTING: The Language of Business

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

Learning Objectives (LO)

LO 1 - Accounting and Decision-Making

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 1 - Accounting and Decision-Making

LO 1 - Accounting and Decision-Making

Financial aimed for external decision makers

LO 1 - Accounting and Decision-Making

LO 1 - Accounting and Decision-Making

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 2 - The Balance Sheet

LO 2 - The Balance Sheet Liabilities economic obligations of the

Accounts subdivision of the element Assets

Accounts Payable Notes Payable Long-term debt

2010 Pearson Education Inc. Publishing as Prentice Hall

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 2 - The Balance Sheet Owners equity is the residual interest by the

LO 2 - The Balance Sheet

Assets = Liabilities + Owners equity

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 3 - Balance Sheet Transactions

LO 3 - Balance Sheet Transactions

LO 3 - Balance Sheet Transactions

LO 3 - Balance Sheet Transactions

Bal. $500,000 (3) Bal. 15,000 485,000

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 3 - Balance Sheet Transactions

LO 4 Preparing the Balance Sheet

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 5 Comparative Ownership Features

LO 5 Comparative Ownership Features

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 6 Differences in Reporting Owners Equity

LO 6 Differences in Reporting Owners Equity

Senior Managers run day to day operations

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 7 Regulation of Financial Reporting

LO 7 Regulation of Financial Reporting

Two different languages in accounting