Introduction to Accounting and Business Study Notes

Chapter Objectives and Icebreaker

• Chapter Goal: To understand the nature of business, the role of accounting and ethics, generally accepted accounting principles (GAAP), the accounting equation, business transactions, and financial statements.
• Icebreaker Activity: Students organize into groups of $2$ to $5$ and select a large, well-known business regularly patronized to discuss how it uses accounting information for strategic decisions. Examples include:     * Tracking sales to determine product/service demand.     * Using demographic or regional data to adjust offerings.
• Key Skills to Acquire:     * Describe the nature of business, accounting, and ethics.     * Describe GAAP, including assumptions and principles.     * State the accounting equation: $\text{Assets} = \text{Liabilities} + \text{Owner's Equity}$.     * Illustrate how business transactions change the accounting equation.     * Describe and interrelate financial statements (Income Statement, Statement of Owner's Equity, Balance Sheet, Statement of Cash Flows).     * Calculate and use the ratio of liabilities to owner’s (stockholders’) equity.

Nature of Business and Accounting

• Definition of Business: An organization where basic resources (inputs), such as materials and labor, are assembled and processed to provide goods or services (outputs) to customers.
• Profit: The difference between the amounts received from customers for goods or services and the amounts paid for the inputs used to provide them.
• Types of For-Profit Businesses:     * Service Businesses: Provide services rather than products (e.g., Southwest Airlines).     * Retail Businesses: Sell products purchased from other businesses to customers (e.g., Walmart, Starbucks).     * Manufacturing Businesses: Change basic inputs into products sold to customers (e.g., Ford Motor Company).
• Definition of Accounting: An information system that provides reports to users about the economic activities and condition of a business. Its role is to provide information for managers to operate the business and for other users to assess economic performance.

Role of Ethics in Accounting and Business

• Definition of Ethics: Moral principles that guide the conduct of individuals. Information must be trustworthy to be useful for decision-making.
• Causes of Unethical Behavior:     * Failure of Individual Character: Pressure from supervisors to meet company or investor expectations despite being honest and fair.     * Culture of Greed and Ethical Indifference: Senior managers set a negative company culture through their behavior and attitude.
• Historical Accounting and Business Frauds (Exhibit 3):     * Countrywide: CEO misled investors. Result: CEO paid a $22.5\,\text{million}$ dollar penalty and received a permanent ban from serving as an officer/director of a public company.     * Enron: Fraudulently inflated financial results. Result: Bankruptcy, criminal convictions for senior executives, and over $60\,\text{billion}$ dollars in stock market losses.     * Goldman Sachs: Misstated and omitted key facts for investors. Result: Paid a $550\,\text{million}$ dollar fine and reformed business practices.     * Wells Fargo: Improperly opened customer accounts without permission. Result: CEO fined $17.5\,\text{million}$ dollars and banned for life from the banking industry.     * Xerox Corporation: Recognized $3\,\text{billion}$ dollars in sales before they should have been recorded. Result: $10\,\text{million}$ dollar fine to the SEC; six executives paid $22\,\text{million}$ dollars.

Accounting Career Paths and Salaries

• Private Accounting: Accountants employed by companies, government, or not-for-profit entities.     * Bookkeeper: Starting salary approximately $43,000$ dollars.     * Payroll Clerk: Starting salary approximately $42,000$ dollars; Certification: Certified Payroll Professional (CPP).     * General Accountant: Starting salary approximately $51,000$ dollars.     * Budget Analyst: Starting salary approximately $55,000$ dollars.     * Cost Accountant: Starting salary approximately $67,000$ dollars; Certification: Certified Management Accountant (CMA).     * Internal Auditor: Starting salary approximately $50,000$ dollars; Certification: Certified Internal Auditor (CIA).     * Information Technology Auditor: Starting salary approximately $56,000$ dollars; Certification: Certified Information Systems Auditor (CISA).
• Public Accounting: Accountants employed individually or within a firm in audit and tax services.     * Starting Salary: Approximately $50,000$ dollars (50th percentile).     * Certification: Certified Public Accountant (CPA).

Generally Accepted Accounting Principles (GAAP)

• Definition: A collection of accounting standards, principles, and assumptions defining how financial information is reported in the United States.
• Accounting Standards: Rules determining the accounting for individual business transactions.
• Accounting Principles and Assumptions: The framework providing the structure for standards.
• Regulatory Bodies:     * FASB (Financial Accounting Standards Board): Primary responsibility for developing U.S. standards. It maintains the Accounting Standards Codification, an electronic database of all GAAP standards. Changes are made via Accounting Standards Updates.     * SEC (Securities and Exchange Commission): U.S. government agency with authority over accounting and financial disclosures for companies whose stock is traded publicly.     * IASB (International Accounting Standards Board): Adopts standards used by most countries outside the United States.
• Characteristics of Financial Information:     1. Relevance: Potential to impact decision-making.     2. Faithful Representation: Accurately reflects economic activity/condition.
• Qualitative Enhancements:     * Comparability: Consistent reporting to identify similarities/differences.     * Verifiability: Allows users to agree on the meaning of items.     * Timeliness: Distributed in time to influence decisions.     * Understandability: Clear and concise reports for user interpretation.

Accounting Assumptions and Principles

• Primary Assumptions:     * Monetary Unit Assumption: Reports must be expressed in a single currency.     * Time Period Assumption: Reports economic activities on a regular basis for specific periods.         * Fiscal Year: The annual accounting period adopted by a company.         * Natural Business Year: A fiscal year ending when business activities are at the lowest point in the annual cycle.     * Business Entity Assumption: Limits data in reports to only that which is directly related to the business activities.     * Going Concern Assumption: Assumes the entity will continue operating into the future.
• Primary Principles:     * Measurement Principle: Determines the amount to be recorded/reported.     * Historical Cost Principle (or Cost Principle): Recording items at their initial transaction price.     * Revenue Recognition Principle: Determines when revenue (amounts earned from services or goods) is recorded.     * Expense Recognition Principle (or Matching Principle): Requires expenses (amounts used to generate revenue) to be recorded in the same period as the related revenue.
• Arm’s-Length Transactions: Transactions between two independent parties that provide objective and verifiable amounts.

Forms of Business Entities

1. Proprietorship:     * Owned by one individual.     * Comprises $70\%$ of U.S. business entities.     * Easy/inexpensive to organize but resources are limited to the owner.     * Example: A & B Painting.
2. Partnership:     * Owned by two or more individuals.     * Combines skills and resources of multiple people.     * Comprises $10\%$ of U.S. business organizations (with LLCs).     * Example: Jones & Smith, Architects.
3. Corporation:     * Organized under state or federal statutes as a separate legal taxable entity.     * Ownership divided into shares called stock.     * Generates $90\%$ of business revenues; represents $20\%$ of U.S. organizations.     * Example: Alphabet Inc. ($GOOG$), Apple Inc. ($AAPL$), Ford Motor Company ($F$).
4. Limited Liability Company (LLC):     * Combines attributes of partnership and corporation.     * Offers tax and legal liability advantages.     * Example: Boston Basketball Partners, LLC.

The Accounting Equation and Transactions

• The Equation: $Assets = Liabilities + Owner's Equity$     * Assets: Resources owned by the business.     * Liabilities: Rights of creditors; debts of the business. Shown first because creditors have first rights to assets.     * Owner’s Equity: Rights of the owners.
• Business Transaction: An economic event or condition that directly changes an entity's financial condition or results of operations.
• Transaction Examples (NetSolutions):     * a) Investment: Chris Clark deposits $25,000$ dollars in a bank account for NetSolutions. Assets ($Cash$) increase by $25,000$ dollars; Owner's Equity ($Chris Clark, Capital$) increases by $25,000$ dollars.     * b) Asset Exchange: Purchase of land for $20,000$ dollars cash. Cash decreases by $20,000$ dollars; Land (Asset) increases by $20,000$ dollars. Total assets remain unchanged.     * c) Purchase on Account: Purchased supplies for $1,350$ dollars on account. Assets ($Supplies$) increase by $1,350$ dollars; Liabilities ($Accounts Payable$) increase by $1,350$ dollars.     * d) Revenue Earned: Received $7,500$ dollars for services provided. Cash increases by $7,500$ dollars; Owner's Equity ($Fees Earned$) increases by $7,500$ dollars.     * e) Expenses: Paid wages ($2,125$ dollars), rent ($800$ dollars), utilities ($450$ dollars), and miscellaneous ($275$ dollars). Cash and Owner's Equity both decrease by the total expense amount of $3,650$ dollars.     * f) Payment of Liability: Paid $950$ dollars to creditors. Cash decreases by $950$ dollars; Accounts Payable decreases by $950$ dollars.     * g) Supplies Used: At month-end, supplies on hand are $550$ dollars. Since initial supplies were $1,350$ dollars, amount used is $1,350 - 550 = 800$ dollars. Supplies (Asset) decrease by $800$ dollars; Owner's Equity decreases by $800$ dollars (Supplies Expense).     * h) Withdrawal: Owner withdrew $2,000$ dollars for personal use. Cash decreases by $2,000$ dollars; Owner's Equity ($Chris Clark, Drawing$) decreases by $2,000$ dollars.

Financial Statements

1. Income Statement:     * Summary of revenue and expenses for a specific period.     * $\text{Revenue} > \text{Expenses} = \text{Net Income (Net Profit/Earnings)}$.     * $\text{Expenses} > \text{Revenue} = \text{Net Loss}$.
2. Statement of Owner’s Equity:     * Summary of changes in owner's equity for a specific period.     * The "connecting link" between the Income Statement and Balance Sheet.
3. Balance Sheet:     * List of assets, liabilities, and owner’s equity as of a specific date.     * Report Form: A vertical format presenting assets (in order of cash conversion/usage), then liabilities, then owner's equity.
4. Statement of Cash Flows:     * Summary of cash receipts and payments for a specific period.     * Sections:         * Operating Activities: Cash from operations (usually differs from net income).         * Investing Activities: Cash from acquisition/sale of permanent assets.         * Financing Activities: Cash from owner investments, borrowings, and withdrawals.

Interrelationship of Financial Statements

• Income Statement to Statement of Owner's Equity: Net income ($3,050$ dollars for NetSolutions) is added to the beginning capital ($0$ dollars in this case).
• Statement of Owner's Equity to Balance Sheet: End-of-period capital ($26,050$ dollars) is reported on the Balance Sheet.
• Balance Sheet to Statement of Cash Flows: Cash reported on the Balance Sheet ($5,900$ dollars) must match the end-of-period cash on the Statement of Cash Flows.

Analysis for Decision Making: Financial Ratios

• Ratio of Liabilities to Owner’s (Stockholders’) Equity: Used to evaluate a company's financial condition.
• Formula: $\text{Ratio of Liabilities to Stockholders' Equity} = \frac{\text{Total Liabilities}}{\text{Total Stockholders' Equity}}$
• Comparison Case Study (Twitter vs. Alphabet):     * Twitter (Year 2): $\frac{6,752}{7,307} = 0.92$     * Alphabet (Year 2): $\frac{107,633}{251,635} = 0.43$     * Analysis: A higher ratio indicates higher risk to creditors. In Year 2, Twitter had a higher ratio ($0.92$) compared to Alphabet ($0.43$), suggesting Alphabet was in a stronger position to manage debt relative to its equity.

Questions & Discussion

• Discussion Activity 1 (Business Entities):     * Scenario 1 (Three Dentists): Often select Partnership or LLC for legal liability protection.     * Scenario 2 (Graphic Artist): Often selects Sole Proprietorship for ease of organization.     * Scenario 3 (Hair Salon Chain): Corporation is best when multiple entrepreneurs are involved and shares may be issued.
• Discussion Activity 2 (Assets and Liabilities):     * Business Asset: Cash, Land, Supplies, Accounts Receivable.     * Individual Asset: Personal bank account, home, car.     * Business Liability: Accounts Payable, Loans.     * Individual Liability: Credit card debt, mortgage.     * Calculation: An individual can calculate Net Worth using the same equation: $\text{Net Worth} = \text{Assets} - \text{Liabilities}$.