Accounting as a Form of

Communication

What is Business?
 Consists of activities necessary to provide members of society with goods and services

Exhibit 1.2—Forms of Organization

Business Entities
 An organization operated to earn a profit
 Sole Proprietorships: organization with a single owner
 Partnerships: business owned by two or more individuals
 Often used by accounting firms and law firms
 Corporations: entity organized under the laws of a particular state
 Ownership evidenced by shares of stock

Nonbusiness Entities
 Organization operated for some purpose other than to earn a profit
 Do not have an identifiable owner

Organizations and Social Responsibility

 U.S. business entities recognize the societal aspects of their overall mission and have
established programs to meet these responsibilities
Users of Accounting Information and Their Needs
 Internal Users:
 Primarily the managers of a company
 Involved in the daily affairs of the business
 External Users:
 Not directly involved in the operations of a business
 Need information that differs from that needed by internal users
 Outsiders must rely on the information presented by the company’s
management
Management Accounting and Financial Accounting
 Management accounting

 Branch of accounting concerned with providing management with information

to facilitate planning and control

 Financial accounting

 Branch of accounting concerned with the preparation of financial statements for

outsider use

Exhibit 1.4—Users of Accounting Information

Financial Decision Framework

1. Formulate the question
2. Gather information from the financial statements and other sources
3. Analyze the information gathered
4. Make the decision
5. Monitor your decision

The Accounting Equation

 Assets = Liabilities + Owners’ Equity
 Left side: valuable economic resources and that will provide future benefit to the
company
 Right side: indicates who provided, or has a claim to, the assets
 Stockholders’ equity or shareholders’ equity: used to refer to the owners’ equity of a
corporation

Source of Stockholders’ Equity

 Created when a company issues stock to an investor
  Retained earnings
 Earnings accumulated or retained by the company
 Part of owners’ equity that represents the income earned less dividends paid
over the life of an entity

The Balance Sheet

 Financial statement that summarizes the assets, liabilities, and owners’ equity at a
specific point in time
 At any point in time, assets must equal liabilities and owners’ equity
Example 1.4—Preparing a Balance Sheet

The Income Statement

 Summarizes the revenues and expenses of a company for a period of time

 Example 1.5—Preparing an Income Statement

The Statement of Retained Earnings

 Summarizes the income earned and dividends paid over the life of a business
 Dividends: Distribution of the net income of a business to its owners

The Statement of Cash Flows

 Summarizes a company’s cash receipts and cash payments during the period from
operating, investing, and financing activities
 Example 1.7—Preparing a Exhibit 1.6—Relationships Among
Statement of Cash Flows the Financial Statements

Financial Statement Assumptions

Economic Cost
Entity Principle
Concept
Time
Period
Assumption
Going Monetary
Concern Unit
Economic Entity Concept
 Single, identifiable unit must be accounted for in all situations
 Specific entity be the subject of a set of financial statements
 Does not intermingle the personal assets and liabilities of the employees or any of the
other stockholders

Cost Principle
 Assets are recorded at the cost to acquire them
 Original cost or historical cost—until the company disposes them
 More objective than market value

Going Concern
 Assume an entity is not in the process of liquidation and that it will continue indefinitely
 Justifies use of historical cost

Monetary Unit
 Yardstick used to measure amounts in financial statements
 Example: U.S. dollar, Japanese yen, Mexican peso, etc.
 Assumes monetary unit is relatively stable; no adjustment for inflation made in financial
statements

Time Period Assumption

 Artificial segment on the calendar used as the basis for preparing financial statements
 Accountants assume that it is possible to prepare an income statement that accurately
reflects net income or earnings for a specific time period

Setting Accounting Standards

 Generally accepted accounting principles (GAAP)
 Various methods, rules, practices, and other procedures—preparing financial
statements
 Securities and Exchange Commission (SEC)
 Federal agency with ultimate authority to determine the rules for preparing
statements
 Financial Accounting Standards Board (FASB)
 Authority to set accounting standards
Setting Accounting Standards (continued)
 American Institute of Certified Public Accountants (AICPA)
 Professional organization of Certified Public Accountants (CPA)
 Public Company Accounting Oversight Board (PCAOB)
 Five-member body created by an act of Congress in 2002 to set auditing
standards
 International Accounting Standards Board (IASB)
 Develop worldwide accounting standards

Audit of Financial Statements

 Most stockholders are not actively involved in the daily affairs of the business
 Auditing: examining whether financial statements are fairly presented
 External auditor performs various tests and procedures and render his opinion
• Auditors’ report is an opinion, not a statement of fact

Ethics in Accounting
 Ethics plays a critical role in providing useful financial information
 Investors and other users must have confidence in a company, its accountants, and its
outside auditors that the information presented in financial statements is relevant,
complete, neutral, and free from error
 Moral and social ethical behavior must be considered while decision making
 Exhibit 1.9—Ethics and Accounting: A Decision-Making Model

Sarbanes-Oxley Act
 An attempt to bring about major reforms in corporate accountability and stewardship
 Most important provisions in the act:
 Establishment of the Public Company Accounting Oversight Board
 Requirement that the external auditors report directly to the company’s audit
committee
 Clause to prohibit public accounting firms from providing any other services that
could impair their ability to act independently in the course of their audit