Chapter 1 Accounting in Business

Identify each of the following terms/phrases as either an accounting (a) principle, (b) assumption, or (c) constraint. 1._______ Materiality 2.______ Measurement 3.______ Business entity 4.______ Going concern 5.______ Full disclosure 6.______ Time period 7.______ Expense recognition 8.______ Revenue recognition

1. c 2. a 3. b 4. b 5. a 6. b 7. a 8. a

Business entity assumption

A business is accounted for separately from other business entities, including its owner.

Example of measurement principle

A company pays $500 for equipment. The cost principle requires it to be recorded at $500. It makes no difference if the owner thinks this equipment is worth $700.

S corporation

A corporation with special attributes, does not owe corporate income tax. Owners report their share of corporate income with their personal income.

General principles

Assumptions, concepts and guidelines for preparing financial statements. Consists of four basic principles, four assumptions and two constraints.

Partnership

Business owned by two or more people, called partners, who are jointly liable for tax and other obligations.

A lawn service bills a customer $800 on June 1 for two months of mowing (June and July). The customer pays the bill on July 1. When is revenue recorded?

It is recorded over time as it is earned; record $400 revenue for June and $400 for July.

What are the three types of partnerships that limit liability?

Limited partnership (LP), limited liability partnership (LLP) and limited liability company (LLC). The LLC form is most popular and offers limited liability of a corporation and the tax treatment of a partnership (and proprietorship).

What are the two basic constraints in financial reporting?

Materiality and benefit exceeds cost. Sometimes Conservatism and industry practices are also listed as constraints.

Two constraints of accounting principles

Materiality and cost-benefit constraints

Four principles of accounting principles

Measurement, Full disclosure, Revenue recognition and Expense recognition

Advantages and disadvantages of a partnership

Not legally separate from its owners. Each partner's share of profits is reported and taxed on that partner's tax return. Unlimited liability.

Accounting

Information and measurement system that identifies, records, and communicates information about an organization's business activities.

Objectivity

Information is supported by independent, unbiased evidence; it is more than an opinion.

Going-concern assumption

Accounting information reflects a presumption that the business will continue operating instead of being closed or sold. (Ex: property is reported at cost instead of, say, liquidation value, which assumes closure)

Building blocks for GAAP

Accounting principles and assumptions

Advantages and disadvantages of a corporation

Advantage: Limited liability. Disadvantage: Double taxation, meaning that (1) the corporation income is taxed and (2) any distribution of income to its owners through dividends is taxed as part of the owners' personal income, usually at the individual's income tax rate. (For "qualified" dividends, the tax rate is 0%, 15%, or 20%, depending on the individual's tax bracket.)

Advantages and disadvantages of a sole proprietorship

Advantages: Proprietorship's income is not subject to a business income tax but is instead reported and taxed on the owner's personal income tax return. Disadvantages: A proprietorship is not a separate legal entity from its owner. Unlimited liability. This means, for example, that a court can order an owner to sell personal belongings to pay a proprietor's debt.

Measurement principle

Also called the cost principle, prescribes that accounting information is based on actual cost (with possible later adjustment to market). Cash is measured on a cash or equal-to-cash basis. Emphasis is on reliability and verifiability, and information based on cost is considered objective.

Expense recognition principle

Also called the matching principle prescribes that a company record the expenses it incurred to generate the revenue reported.

Corporation

Also known as a C corporation, is a business legally separate from its owner or owners, meaning it is responsible for its own acts and its own debts. Separate legal status means that a corporation can conduct business with the rights, duties and responsibilities of a person. Acts through its managers, who are its legal agents. Its owners, called shareholders (or stockholders), are not personally liable for corporate acts and debts.

Sole proprietorship

Also known as proprietorship is a business owned by one person and accounted for separately.

Revenue sales

Amount received from selling products and services

Monetary unit assumption

Can express transactions and events in monetary, or money, units.

Accounting principles (and assumptions)

Composed of two types. General principles and specific principles.

Credit sales

Customer's promise to pay at a future date

Specific principles

Detailed rules used in reporting business transactions and events; often arise from rulings of authoritative groups and are described as we encounter them.

External users

Do not directly run the organization and have limited access to its accounting information.

Generally Accepted Accounting Principles (GAAP)

Financial accounting is governed by concepts and rules known as GAAP. GAAP aims to make information relevant, reliable and comparable. Relevant information affects decisions of users. Reliable information is trusted by users. Comparable information aids in contrasting organizations.

Four assumptions of accounting principles

Going concern, Monetary unit, Time period and Business entity

What are the four accounting assumptions?

Going concern, monetary unit, time period and business entity.

Securities and Exchange Commission (SEC)

Government agency in the United States that has the legal authority to set GAAP. Oversees proper use of GAAP by companies that raise money from the public through issuance of stock and debt.

Credit cards are used to pay $200 in gas for a lawn service during June and July. The cards are paid in August. When is expense recorded?

If revenue is earned over time, record $100 expense in June and $100 in July.

International Accounting Standards Board (IASB)

Independent group (consisting of individuals from many countries) issues IFRS that identify preferred practices.

Shares and stocks

Ownership of both corporation types is divided into these units

Full disclosure principle

Prescribes that a company report the details behind financial statements that would impact users' decisions. Those disclosures are usually footnotes to the statements.

Materiality constraint

Prescribes that only information that influences decisions (such as through importance and dollar amount) need to be disclosed.

Cost-benefit constraint

Prescribes that only information with benefits of disclosure greater than the costs of providing it need to be disclosed.

Time Period Assumption

Presumes that the life of the company can be divided into time periods, such as months and years, and that useful reports can be prepared for those periods.

What three legal forms can a business entity take?

Proprietorship, partnership or corporation

Revenue recognition principle

Revenue is recognized (1) when goods or services are provided to customers and (2) at the amount expected to be received from the customer.

Financial Accounting Standards Board (FASB)

SEC largely delegated the task of setting U.S. GAAP to the FASB. Private sector group that sets both broad and specific principles.

International Financial Reporting Standards (IFRS)

Standards are in many ways similar to, but sometimes different from, U.S. GAAP. Differences have been decreasing in recent years as the FASB and IASB pursued a process aimed at reducing inconsistencies.

Conceptual Framework

The FASB conceptual framework consists broadly of the following: Objectives - to provide information useful to investors, creditors and others, Qualitative Characteristics - to require relevant, reliable, and comparable information, Elements - to define items that financial statements can contain, and Recognition and Measurement - to set criteria for an item to be recognized as an element; and how to measure it.

Common stock (or capital stock)

When a corporation issues one type of stock

Complete the table with either a yes or no regarding the attributes of a partnership and a corporation Attribute present Partnership Corporation Business taxed....... a. __________ e. __________ Limited liability...... b. __________ f. __________ Legal entity............. c. __________ g. __________ Unlimited life.......... d. __________ h. __________

a. no, b. no, c. no, d. no, e. yes, f. yes, g. yes, h. yes