Chapter 1: Introduction to Accounting and Business (Vocabulary flashcards)

Nature of Business and Accounting (Learning Objective 1)

• A business is an organization in which basic resources (inputs), such as materials and labor, are assembled and processed to provide goods or services (outputs) to customers.

• Profit is the difference between the amounts received from customers for goods or services and the amounts paid for the inputs used to provide the goods or services.

Types of Businesses

• Service businesses: provide services rather than products to customers.

• Retail businesses: sell products purchased from other businesses to customers.

• Manufacturing businesses: change basic inputs into products that are sold to customers.

Knowledge Check Activity 1

• Question: Which of the following businesses would be considered a service business?

  • a. Walmart

  • b. Southwest Airlines

  • c. Ford Motor Company

  • d. Starbucks

• Answer: b. Southwest Airlines. Explanation: Southwest is a service provider; Walmart and Starbucks are retail; Ford is a manufacturer.

Role of Accounting in Business

• The role of accounting is to provide information for managers to use in operating the business.

• Accounting provides information to other users in assessing the economic performance and condition of the business.

• Accounting can be defined as an information system that provides reports to users about the economic activities and condition of a business.

Financial vs Managerial Accounting

• Financial Accounting: provides external users with information. Objective is to provide relevant and timely information for the decision-making needs of users outside of the business. Governed by GAAP.

• Managerial Accounting: provides internal users with information for internal managers and employees’ decision-making needs. Governed by internal management and not bound to GAAP.

Role of Ethics in Accounting and Business

• Accountants must behave ethically so that information provided to users is trustworthy and useful for decision making.

• Ethics are moral principles guiding conduct.

• Challenges include: Failure of Individual Character (temptations to be dishonest under pressure) and Culture of Greed and Ethical Indifference (senior management shaping company culture).

Exhibits: Accounting and Business Frauds (Exhibit 3)

• Countrywide: CEO misled investors; CEO paid $22.5 million and was banned from serving as an officer or director of a public company.

• Enron: Fraudulent inflation of financial results; bankruptcy; senior executives criminally convicted; large stock market losses (~$60B+).

• Goldman Sachs: Misstated and omitted key facts from investors; fine of $550 million and reforms.

• Wells Fargo: Improperly opened customer accounts; CEO fined $17.5 million and banned from banking industry for life.

• Xerox: Recognized $3 billion in sales earlier than recorded; $10 million SEC fine; six executives paid $22 million.

Exhibits: Accounting Career Paths and Salaries (Exhibit 4)

• Private Accounting:

  • Description: Accountants employed by companies, government, and not-for-profit entities.

  • Career options: Bookkeeper, Payroll clerk, General accountant, Budget analyst, Cost accountant, Internal auditor, IT auditor.

  • Typical starting salaries (approximate): $40k–$65k depending on role.

  • Certifications: CPP, CMA, CIA, CISA (examples listed).

• Public Accounting:

  • Description: Accountants employed in audit and tax services within a public accounting firm.

  • Typical starting salaries: around $49k or higher depending on firm and region.

  • Certifications: CPA (and others listed).

Generally Accepted Accounting Principles (GAAP) (Learning Objective 2)

• GAAP is a collection of accounting standards, principles, and assumptions that define how financial information is reported.

• Accounting standards are rules for individual transactions; Principles and assumptions provide the framework for standards.

• In the United States, the Financial Accounting Standards Board (FASB) is the primary body developing accounting standards.

GAAP Codification and Regulation

• The FASB maintains the Accounting Standards Codification, an electronic database of GAAP.

• Changes are made via Accounting Standards Updates (ASUs).

• The U.S. Securities and Exchange Commission (SEC) has authority over accounting and disclosures for public companies, delegated to FASB.

• Outside the United States, many countries use standards adopted by the International Accounting Standards Board (IASB).

Characteristics of Financial Information

• Financial information should have two key characteristics: relevance and faithful representation.

• Relevance: information has the potential to influence decision making.

• Faithful representation: information faithfully reflects the economic activity or condition.

• Enhancing characteristics:

  • Comparability: consistent reporting across periods to identify similarities and differences.

  • Verifiability: users can agree on the meaning of reported items.

  • Timeliness: information is available when decision making occurs.

  • Understandability: information is clear and concise.

Assumptions (1 of 2)

• Monetary unit assumption: financial reports are expressed in a single money unit or currency.

• Time period assumption: economic activities are reported for a regular period of time.

• Business entity assumption: economic data are limited to activities of the business itself.

• Going concern assumption: financial reports assume the entity will continue operating into the future.

Assumptions (2 of 2)

• Fiscal year vs natural business year:

  • A fiscal year is the annual accounting period.

  • A natural business year ends when business activities reach the lowest point in the annual operating cycle.

• The going concern assumption (re-stated) and the business entity assumption are reiterated for emphasis.

Exhibit 5 – Forms of Business Entities (1 of 2)

• Proprietorship: owned by one individual; about 70% of U.S. entities; easy and inexpensive to organize; limited resources to owner; used by small businesses.

• Partnership: owned by two or more individuals; about 10% of U.S. entities (often combined with LLCs); combines skills/resources of multiple people.

• Examples provided for each form (e.g., A & B Painting for proprietorship; Jones & Smith Architects for partnership).

Exhibit 5 – Forms of Business Entities (2 of 2)

• Corporation: organized as a separate legal taxable entity; generates about 90% of business revenues; about 20% of U.S. entities; ownership divided into shares; can obtain large resources by issuing stock; used by large businesses; examples: Alphabet, Apple, Ford.

• Limited Liability Company (LLC): combines attributes of partnership and corporation; tax and liability advantages; examples: Boston Basketball Partners, LLC.

Principles (1 of 2)

• Measurement principle: determines the amount to be recorded and reported.

• Historical cost principle: recording an item at its initial transaction price; independent party confirmation via arm's-length transactions provides objectivity and verifiability.

• Revenue recognition principle: revenue is the amount earned from providing goods or services.

• Expense recognition principle (matching principle): expenses are recorded in the same period as the related revenue.

Principles (2 of 2)

• Additional details:

  • The four main principles include measurement, historical cost, revenue recognition, and expense recognition.

  • Arm's-length transactions provide objective evidence of value.

  • The matching principle ties expenses to the revenues they help generate.

The Accounting Equation (Learning Objective 3)

• Fundamental relationship among assets, liabilities, and equity:

  • $Assets = Liabilities + Equity$

• Meaning:

  • Assets are resources owned by the business.

  • Liabilities are claims by creditors on assets.

  • Equity is the residual interest of the owners, including the impact of revenues and expenses on retained earnings.

• This equation is the basis for recording all business transactions.

Exhibit 7 – Effects of Transactions on Stockholders’ Equity

• Retained earnings is the stockholders’ equity created from business operations through revenue and expense transactions.

Business Transactions and the Accounting Equation (Learning Objective 4)

• A business transaction is an economic event that directly changes a company’s financial condition or results of operations.

• All business transactions can be stated as changes in the elements of the accounting equation.

Transaction a (Nov 1, 20Y3)

• NetSolutions issued common stock and received $25,000 cash.

• Effect: Cash (Asset) increases by $25,000; Common Stock (Stockholders’ Equity) increases by $25,000.

Transaction b (Nov 5, 20Y3)

• NetSolutions paid $20,000 for land as a future building site.

• Effect: total assets unchanged; Cash decreases by $20,000; Land increases by $20,000.

Transaction c (Nov 10, 20Y3)

• NetSolutions purchased supplies for $1,350 on account.

• Liability created: Accounts Payable +$1,350.

• Assets: Supplies +$1,350.

• Notes: Prepaid expenses are assets; this is a normal payable transaction.

Transaction d (Nov 18, 20Y3)

• NetSolutions received cash of $7,500 for providing services to customers.

• Effect: Cash increases by $7,500; Stockholders’ Equity (fees/income) increases by $7,500.

Transaction e (Nov 30, 20Y3)

• Expenses during the month: wages $2,125; rent $800; utilities $450; miscellaneous $275.

• Effect: Expenses reduce assets and reduce stockholders’ equity by total $3,650 (via retained earnings).

Transaction f (Nov 30, 20Y3)

• NetSolutions paid creditors on account $950.

• Effect: Assets decrease by $950; Liabilities decrease by $950.

Transaction g (Nov 30, 20Y3)

• Cost of supplies on hand at end of month is $550; used supplies cost is $800 ($1,350 − $550).

• Effect: Supplies asset decreases by $800; corresponding expense recognized reduces retained earnings.

Transaction h (Nov 30, 20Y3)

• Paid dividends $2,000.

• Effect: Cash decreases; Stockholders’ Equity decreases by $2,000 (dividends reduce retained earnings).

Exhibit 6 – Summary of Transactions for NetSolutions

• A consolidated view of a sequence of transactions showing how each transaction affects assets, liabilities, and stockholders’ equity.

Knowledge Check Activity 2

• Hampshire Havens buys adjoining land, pays $89,000 in cash.

• Accounting equation effect: Cash decreases by 89,000; Land increases by 89,000.

• Answer: b. Cash -89,000, Land +89,000.

Financial Statements (Learning Objective 5)

• Primary financial statements of a corporation:

  • Income statement

  • Statement of stockholders’ equity

  • Balance sheet

  • Statement of cash flows

Exhibit 8 – Financial Statements Order Prepared

• 1. Income statement: revenue and expenses for a specific period.

• 2. Statement of stockholders’ equity: changes in stockholders’ equity during a period; net income or loss affects Retained Earnings.

• 3. Balance sheet: assets, liabilities, and stockholders’ equity as of a date; usually last day of the period; report form.

• 4. Statement of cash flows: cash receipts and payments for a period; three activities: operating, investing, financing.

Income Statement – Prepared 1st

• Reports revenues and expenses for a period; based on revenue and expense recognition principles.

• Matches revenues with related expenses so they are reported in the same period.

• Net income = revenues − expenses; Net income is also called net profit or earnings.

• If expenses exceed revenues, net loss.

• Net income or loss is closed to the Statement of Stockholders’ Equity.

Statement of Stockholders’ Equity – Prepared 2nd

• Reports changes in stockholders’ equity for a period.

• Net income or net loss from the income statement is reported in Retained Earnings.

• Prepared after the income statement because net income or loss affects Retained Earnings.

• Prepared before the balance sheet because end-of-period common stock and retained earnings are reported on the balance sheet.

Balance Sheet – Prepared 3rd

• Reports amounts of assets, liabilities, and stockholders’ equity in a vertical format as of a specific date.

• Commonly used form is the report form.

Statement of Cash Flows – Prepared Last

• Summarizes cash receipts and payments by period, based on three activities:

  • Operating Activities: cash from operations; often differs from net income due to accrual accounting.

  • Investing Activities: purchases and sales of long-term assets.

  • Financing Activities: cash inflows/outflows from financing with owners and lenders, including dividends.

Financial Statement Flow - Summary From Income Statement and Balance Sheet (1)-(4)

• Describes how income statement and balance sheet flows provide information for the statements that follow.

Financial Statement Flow - Details (1 of 2) and (2 of 2)

• Details on how items flow between income statement, statement of stockholders’ equity, balance sheet, and cash flow statement.

Financial Statements Flow – In Words (1 of 2)

• Interrelationship example: NetSolutions shows that net income from the income statement increases retained earnings on the statement of stockholders’ equity.

• Net income or net loss for the period is carried into retained earnings and then into the balance sheet as part of stockholders’ equity.

• The balance sheet shows ending balances of common stock and retained earnings, which tie to the statement of stockholders’ equity.

NetSolutions Example (Exhibit 9)

• Net income for November = $3,050; Beginning retained earnings = $0 on November 1, 20Y3.

• Retained earnings on November 30, 20Y3 = $1,050.

• Common stock = $25,000; Total stockholders’ equity = $26,050.

• Balance sheet shows ending cash of $5,900.

• These items appear across the income statement, statement of stockholders’ equity, and balance sheet to illustrate interconnections.

Balance Sheet and Statement of Cash Flows cross-reference

• Balance sheet cash equals the ending cash on the statement of cash flows.

• The three statements are interrelated and collectively reflect the company’s financial position and performance.

Knowledge Check Activity 3

• Question: Which financial statement would a stockholder want to review if they are interested in the company’s sales and expenses?

  • a. Balance Sheet

  • b. Statement of Cash Flows

  • c. Income Statement

  • d. Statement of Shareholders’ Equity

• Answer: c. Income Statement. Explanation: It lists revenue (sales) and expenses, yielding net income or loss.

Ratio of Liabilities to Stockholders’ Equity (Learning Objective 6)

• This ratio helps bankers, creditors, stockholders, and others analyze a company’s financial condition.

• Formula: $ext{Liabilities to Equity Ratio} = rac{ ext{Total Liabilities}}{ ext{Total Stockholders' Equity}}$

• Example data (in millions):

  • Twitter (TWTR)

  • End of Year 1: Liabilities = 2{,}365; Stockholders’ Equity = 5{,}047

  • End of Year 2: Liabilities = 3{,}357; Stockholders’ Equity = 6{,}806

  • Alphabet (GOOG)

  • End of Year 1: Liabilities = 44{,}793; Stockholders’ Equity = 152{,}502

  • End of Year 2: Liabilities = 55{,}164; Stockholders’ Equity = 177{,}628

• Calculated ratios:

  • Twitter Year 1: $rac{2{,}365}{5{,}047} \approx 0.469$

  • Twitter Year 2: $rac{3{,}357}{6{,}806} \approx 0.493$

  • Alphabet Year 1: $rac{44{,}793}{152{,}502} \approx 0.293$

  • Alphabet Year 2: $rac{55{,}164}{177{,}628} \approx 0.310$

• Interpretation: Higher ratios indicate greater reliance on liabilities relative to equity; different industries have different typical ranges.

Icebreaker: How does a business use accounting information?

• Students group to discuss how a well-known business uses accounting information to make strategic decisions.

• Examples include tracking sales, determining product/service offerings by demographics or regions, and applying findings to strategic plans.

Summary

• By the end of this chapter, you should be able to:

  • Describe the nature of business and the role of accounting and ethics in business.

  • Describe GAAP including assumptions and principles.

  • State the accounting equation and define each element.

  • Describe how business transactions change the accounting equation.

  • Describe the financial statements of a corporation and how they interrelate.

  • Describe and illustrate the use of the ratio of liabilities to stockholders’ equity in evaluating a company’s financial condition.