Chapter 1 Notes: Introduction to Accounting and Business

Chapter 1: Introduction to Accounting and Business

Icebreaker: How Businesses Use Accounting Information

• Small groups select a well-known business.

• Discuss how the business uses accounting information for strategic decisions (e.g., tracking sales to determine products/services to sell based on demographics/regions).

• Each group shares their findings with the class.

Chapter Objectives

• Obj. 1: Describe the nature of business and the role of accounting and ethics.

• Obj. 2: Describe Generally Accepted Accounting Principles (GAAP).

• Obj. 3: State the accounting equation and define its elements.

• Obj. 4: Describe how business transactions change the accounting equation elements.

• Obj. 5: Describe financial statements of a proprietorship and their interrelation.

• Obj. 6: Describe the ratio of liabilities to owner’s equity in evaluating financial condition.

Nature of Business and Accounting (Learning Objective 1)

• A business assembles resources (inputs) to provide goods/services (outputs) to customers.

• Profit is the difference between revenue from customers and the cost of inputs.

Types of Businesses

• Three types of for-profit businesses:

  • Service: Provides services (e.g., Southwest Airlines).

  • Retail: Sells products purchased from other businesses (e.g., Walmart, Starbucks).

  • Manufacturing: Changes basic inputs into products for sale (e.g., Ford Motor Company).

Role of Accounting in Business

• Accounting provides information for managers to operate the business.

• It also provides data to external users for assessing economic performance.

• Accounting is an information system providing reports on economic activities and condition.

Role of Ethics in Accounting and Business

• Accountants must be ethical to ensure trustworthy information for decision-making.

• Ethics are moral principles guiding individual conduct.

• Unethical behavior occurs due to:

  • Failure of Individual Character: Dishonesty, unfairness, pressure to meet expectations.

  • Culture of Greed and Ethical Indifference: Senior managers setting a poor example.

Examples of Accounting and Business Frauds (Exhibit 3)

• Countrywide: CEO misled investors; CEO paid $22.5$ million penalty.

• Enron: Inflated financial results; bankruptcy; senior executives criminally convicted; more than $60$ billion in stock market losses.

• Goldman Sachs: Misstated and omitted key facts from investors; Company agreed to pay $550$ million fine.

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

• Xerox Corporation: Recognized $3$ billion in sales prematurely; $10$ million fine to SEC, six execs forced to pay $22$ million.

Accounting Career Paths and Salaries (Exhibit 4)

• Private Accounting:

  • Roles: Bookkeeper, Payroll Clerk, General Accountant, Budget Analyst, Cost Accountant, Internal Auditor, IT Auditor.

  • Certifications: CPP, CMA, CIA, CISA.

  • Starting Salaries: Vary from $42,000$ to $67,000$ depending on the role and certifications.

• Public Accounting:

  • Role: Accountant in audit and tax services.

  • Certification: CPA.

  • Starting Salary: Around $50,000$.

  • Salaries may vary by company size and location.

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

• GAAP is the foundation for financial reporting in the U.S.

• It includes accounting standards, principles, and assumptions.

• Accounting standards are the rules for specific transactions.

• Principles and assumptions are the framework for these standards.

• Financial Accounting Standards Board (FASB) develops accounting standards in the U.S.

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

• Changes to the Codification are made via Accounting Standards Updates.

• The Securities and Exchange Commission (SEC) oversees financial disclosures of publicly traded companies.

• International Accounting Standards Board (IASB) sets standards used outside the U.S.

Characteristics of Financial Information

• Relevance: Information must potentially impact decision-making.

• Faithful Representation: Information accurately reflects economic activity.

• These are enhanced by:

  • Comparability: Consistent reporting allows users to identify similarities and differences.

  • Verifiability: Users agree on the meaning of reported items.

  • Timeliness: Reports are available in time to influence decisions.

  • Understandability: Clear, concise reports facilitate interpretation and analysis.

Assumptions

• Monetary Unit: Reports are expressed in a single currency.

• Time Period: Business activities are reported regularly for specific periods.

  • Annual period is the fiscal year.

  • Natural business year ends when activities are at their lowest point.

• Business Entity: Financial reports include only data related to the business’s activities.

• Going Concern: Reports assume the entity will continue operating in the future.

Forms of Business Entities (Exhibit 5)

• Proprietorship:

  • Owned by one individual.

  • Easy and inexpensive to organize.

  • Resources are limited to the owner’s.

  • Examples: A & B Painting.

  • 70% of business entities in the U.S.

• Partnership:

  • Owned by two or more individuals.

  • Combines skills and resources of multiple people.

  • Examples: Jones & Smith, Architects.

  • 10% of business organizations in the U.S.

• Corporation:

  • Organized under state/federal statutes as a separate legal/taxable entity.

  • Ownership divided into stock.

  • Can raise large funds by issuing stock.

  • Examples: Alphabet Inc. (GOOG), Apple Inc. (AAPL), Ford Motor Company (F).

  • 20% of the business organizations in the U.S.

  • Generates 90% of business revenues.

• Limited Liability Company (LLC):

  • Combines partnership and corporation attributes.

  • Offers tax and liability advantages to owners.

  • Examples: Boston Basketball Partners, LLC.

  • 10% of business organizations in the U.S.

Principles

• Measurement: Determines the amount recorded and reported.

• Historical Cost: Recording items at their initial transaction price.

• Revenue Recognition: Determines when revenue is recorded.

• Expense Recognition: Requires expenses to be recorded in the same period as related revenue (matching principle).

• Transactions should be arm’s-length transactions which occur between two independent parties.

The Accounting Equation (Learning Objective 3)

• Assets = Liabilities + Owner’s Equity

Business Transactions and the Accounting Equation (Learning Objective 4)

• Business transaction: An economic event that changes an entity’s financial condition.

• All transactions can be stated in terms of changes in the accounting equation.

• Transaction a: Investment by Owner

  • Increases cash (asset) and owner's equity.

• Transaction b: Purchase of Land for Cash

  • Changes asset composition but not total assets.

• Transaction c: Purchase of Supplies on Account

  • Increases supplies (asset) and accounts payable (liability).

  • Items such as supplies that will be used in the business in the future are called prepaid expenses, which are assets.

• Transaction d: Receipt of Cash for Providing Services

  • Increases cash (asset) and owner's equity (fees earned or sales revenue).

  • Revenue from providing services is recorded as fees earned.

  • Revenue from the sale of merchandise is recorded as sales.

  • Instead of receiving cash at the time services are provided or goods are sold, a business may accept payment at a later date.

  • Such revenues are described as fees earned on account or sales on account; the business has an asset called an account receivable.

• Transaction e: Payment of Expenses

  • Decreases cash (asset) and owner's equity.

  • Assets used in the process of earning revenue are called expenses.

• Transaction f: Payment of Accounts Payable

  • Decreases cash (asset) and accounts payable (liability).

• Transaction g: Supplies Used

  • Decreases supplies (asset) and increases expenses (decreasing equity).

• Transaction h: Owner Withdrawal

  • Decreases cash (asset) and owner's equity (drawing).

Types of Transactions Affecting Owner’s Equity (Exhibit 7)

• Increases:

  • Owner Investment

  • Revenues

• Decreases:

  • Expenses

  • Owner Withdrawals

Financial Statements (Learning Objective 5)

• Reports prepared after transactions are recorded and summarized.

• Primary financial statements for a proprietorship:

  1. Income Statement

  2. Statement of Owner’s Equity

  3. Balance Sheet

  4. Statement of Cash Flows

Financial Statements (Exhibit 8)

• Income statement: Revenue and expenses for a period - prepared 1st.

• Statement of owner’s equity: Changes in owner’s equity for a period - prepared 2nd.

• Balance sheet: Assets, liabilities, and owner’s equity at a specific date - prepared 3rd.

• Statement of cash flows: Cash receipts and payments for a period - prepared 4th.

Income Statement

• Reports revenues and expenses for a period.

• Matches revenues and related expenses in the same period.

• Net income (profit or earnings) is the excess of revenue over expenses.

• Net loss is the excess of expenses over revenue.

Statement of Owner’s Equity

• Reports changes in owner’s equity for a period.

• Prepared after the income statement (uses net income/loss).

• Prepared before the balance sheet (owner’s equity at the end of the period is reported on the balance sheet).

• Connecting link between the income statement and balance sheet.

Balance Sheet

• Reports assets, liabilities, and owner’s equity at a specific point in time.

• Assets are presented in order of liquidity (how quickly they can be converted to cash).

Statement of Cash Flows

• Three sections:

  1. Operating Activities: Cash receipts and payments from operations.

  2. Investing Activities: Cash transactions for acquiring and selling long-term assets.

  3. Financing Activities: Cash transactions related to owner investments, borrowings, and withdrawals.

Financial Statement Interrelationships (Exhibit 10)

• Net income from the income statement is used in the statement of owner’s equity.

• Ending owner's equity from the statement of owner’s equity is used in the balance sheet.

• Cash balance from the balance sheet is reported on the statement of cash flows.

Analysis for Decision Making: Ratio of Liabilities to Owner’s (Stockholders’) Equity (Learning Objective 6)

• Formula: $\text{Ratio of Liabilities to Owner's Equity} = \frac{\text{Total Liabilities}}{\text{Total Owner's (Stockholders') Equity}}$

• Indicates the proportion of debt financing relative to equity financing.

• Example:

  • Twitter (TWTR)

    • End of Year 1: $\frac{5409}{7970} = 0.68$

    • End of Year 2: $\frac{6752}{7307} = 0.92$

  • Alphabet (GOOG)

    • End of Year 1: $\frac{97072}{222544} = 0.44$

    • End of Year 2: $\frac{107633}{251635} = 0.43$