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LEARNING OBJECTIVES

Define accounting and identify its objectives.

Distinguish among the three major types of accounting.

List the three primary financial statements and briefly summarize the informationcontained in each.

Identify financial statement users and the decisions they make.

Define generally accepted accounting principles and explain how they aredetermined.

Describe the role of auditing.

List the economic consequences of accounting principle choice.

Assess the importance of ethics in accounting.

INTRODUCTION

Jane Johnson is considering selling T-shirts in the parking lot during her university’sfootball games. Jane, of course, will do this only if she expects to make a profit. To es-timate her profits, Jane needs certain pieces of information, such as the cost of a shirt,the university’s charge for the right to conduct business on its property, the expectedselling price, and the expected sales volume. Suppose Jane has developed the follow-ing estimates:

Sales price per shirt$ 12Cost per shirt$ 7Number of shirts sold per game day50University fee per game day$100

Although developing estimates is tricky, let’s take these estimates as given. Basedon the estimates, Jane would earn a profit of $150 per game day.

Sales ($12



50)$600Less expenses:Cost of merchandise ($7



50)$350University fee100Total expenses450Net income$150

c h a p t e r

Financial Accounting and Its Environment

Since this looks like a reasonable profit, Jane puts her plan into action. After her first game day, Jane needs to assess her success (or failure). Based on her actual results, Jane prepares the following information:

Sales ($12



40)$480Less expenses:Cost of merchandise ($7



40)$280University fee100Total expenses380Net income$100

Jane’s business was profitable, but not as profitable as she planned. This is because Jane sold fewer shirts than she hoped, but Jane is confident that she can sell any re-maining shirts on the next game day.The preceding illustration shows two ways in which accounting can be used.First, Jane used accounting to help plan her business. That is, she used accounting toproject her expected profit. Second, after Jane operated her business for a day, sheused accounting to determine if, in fact, she had made a profit. In general, accountingis used during all phases of planning and operating a business.

ACCOUNTING

Accounting

is the systematic process of measuring the economic activity of a busi-ness to provide useful information to those who make economic decisions. Account-ing information is used in many different situations. The illustration in the introduc-tory section shows how a business owner (Jane) can use accounting information.Bankers use accounting information when deciding whether or not to make a loan.Stockbrokers and other financial advisers base investment recommendations on ac-counting information, while government regulators use accounting information to de-termine if firms are complying with various laws and regulations.

TYPES OF ACCOUNTING

The examples mentioned in the last section explained how accounting informationcan be helpful in a number of situations. In fact, the field of accounting consists of sev-eral specialty areas that are based on the nature of the decision. The following sectionsdescribe the three major types of accounting, which are summarized in Exhibit 1-1.

Financial Accounting

Financial accounting

provides information to decision makers who are externalto the business. To understand the role of financial accounting, consider a large cor-poration such as IBM. The owners of corporations are called shareholders, and IBMhas more than 600,000 shareholders. Obviously, each shareholder cannot partici-pate directly in the running of IBM, and because IBM needs to maintain various tradesecrets, its many thousands of shareholders are not permitted access to much of thefirm’s information. Because of this, shareholders delegate most of their decision-making power to the corporation’s board of directors and officers. Exhibit 1-2 con-tains an organizational chart for a typical corporation. Shareholders, however, needinformation to evaluate (1) the performance of the business and (2) the advisability of retaining their investment in the business. Financial accounting provides some of the information for this purpose; such information is also used by potential share-holders who are considering an investment in the business.

CHAPTER 1

Financial Accounting and Its Environment