CHAPTER 1: INTRODUCTION & FINANCIAL STATEMENTS

3 Business Types and Classifications

A business owned by one person is generally a proprietorship (also known as a sole proprietorship). A business owned by two or more people associated as partners is a partnership. A business organized as a separate legal entity under state corporation law and having ownership divided into transferable shares of stock is a corporation. Note that although the combined number of proprietorships and partnerships in the United States is more than five times the number of corporations, the amount earned by corporations is eight times greater.

THREE ACTIVITIES OF AN ACCOUNTING INFORMATION SYSTEM: IDENTIFY

As a starting point to the accounting process, a company identifies the economic events relevant to its business. EXAMPLE Economic events for Designer Dinners include the purchase of cooking supplies, the use of cell phone service by Dan Johnson, the preparation of meals, and the receipt of payment from Dan's customers.

Business Classifications: SERVICE COMPANY

As indicated, a service company performs a service for customers. Examples include professionals such as doctors, attorneys, and accountants; auto repair shops (Jiffy Lube); landscaping companies; spas (Red Door Spa); gyms (Gold's Gym); and personal chef services (Designer Dinners).

THREE ACTIVITIES OF AN ACCOUNTING INFORMATION SYSTEM: COMMUNICATE

Companies communicate the collected information to interested users through the preparation of financial statements. Often, we refer to the communication process as financial reporting. ` A vital element in communicating economic events is the ability of the accountant to analyze as well as interpret and explain the financial information. EXAMPLE Designer Dinners communicates the economic events it identifies and records by preparing financial statements.

Accounting Standards

Companies must follow certain standards in preparing financial statements. Let's learn about this common set of standards.

PARTNERSHIP (2 OR MORE)

Duties of each partner vary. A partnership agreement sets forth initial investment and withdrawal procedures. Tax advantages. Each partner shares in profits or losses and generally has unlimited personal liability for any company debts. A partnership agreement sets forth duties and division of net income (or net loss), and settlement. Owner transactions must be separate from business. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and CPAs). Dan Johnson has a college friend Chris who is a florist. Their skills would combine well for wedding planning services. Dan creates a partnership, so that now he and Chris are co-owners of the company. Chris will invest some money to help the company move in this new direction.

The Building Blocks of Accounting

ETHICS, PRINCIPLES, AND ASSUMPTIONS Companies must follow certain standards to identify, record, and communicate their financial information. These standards are based on specific principles and assumptions. For these standards to work, however, a fundamental business concept must be present—ethical behavior.

Ethics in Financial Reporting

Ethics are the standards of conduct by which actions are judged as right or wrong, honest or dishonest, fair or not fair. Effective financial reporting depends on sound ethical behavior. Creditors and investors will make funds available only if they trust the financial information provided by owners. EXAMPLE Designer Dinners needs a loan from the local bank to purchase additional cooking equipment. The bank will require credible financial information in order to determine if Designer Dinners qualifies for a loan. If Dan does not provide accurate information, the bank might lose money. Imagine if a large corporation such as PepsiCo provided inaccurate information. What impact would that have on the economy? You will be faced with ethical dilemmas involving your friends, your work, or other situations that arise in your life

EXTERNAL USERS

External users are individuals and organizations outside a company who want financial information about the company. The two most common types of external users are investors and creditors. Investors (owners) use accounting information to decide whether to buy, hold, or sell ownership interests of a company. Creditors (such as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money. External users need financial statements. Financial accounting is the field of accounting that provides economic and financial information for investors, creditors, and other external users. Have you ever taken out a loan? If yes, the bank probably requested information about your income and credit history. Companies provide their financial statements when they need to borrow money from a creditor, such as a bank.

FAITHFUL REPRESENTATION

Faithful representation means that the numbers and descriptions match what really existed or happened—they are factual.

Sarbanes-Oxley Act

In past years, the media was full of articles about financial scandals at Enron, WorldCom, HealthSouth, AIG, and other companies. As the scandals came to light, mistrust of financial reporting in general grew. United States regulators and lawmakers were concerned that if investors lost confidence in corporate accounting because of unethical financial reporting, the economy would suffer. In response, Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. As a result of SOX, top management must now certify the accuracy of financial information. In addition, penalties for fraudulent financial activity are much more severe. Also, SOX increased the independence requirements of the outside auditors who review the accuracy of corporate financial statements and increased the oversight role of boards of directors.

THREE ACTIVITIES OF AN ACCOUNTING INFORMATION SYSTEM: RECORD

Recording consists of keeping a systematic, chronological diary of economic events measured in dollars and cents. EXAMPLE Designer Dinners records all economic events in order to provide a history of its financial activities. In recording, Designer Dinners also classifies and summarizes these economic events.

RELEVANCE

Relevance means that financial information is capable of making a difference in a decision.

Who Uses Accounting Information?

The accounting information users need depends on the kinds of decisions they make. There are two broad groups of users of financial information—internal users and external users.

Generally Accepted Accounting Principles (GAAP)

The accounting profession has developed standards that are generally accepted and practiced in the United States. This common set of standards, called generally accepted accounting principles (GAAP), indicates how to report economic events. Simply put, these are the accounting rules.

Fair Value Principle

The fair value principle indicates that assets and liabilities should be reported at fair value—the price received to sell an asset or settle a liability. Liabilities are creditor claims against assets. Fair value information may be more useful than historical cost for certain types of assets and liabilities (see Q&A). For example, investment securities are reported at fair value because market price information is often readily available and verifiable.

Historical Cost Principle

The historical cost principle (or cost principle) dictates that companies record assets at their cost. Assets are resources that a company owns. Companies use the historical cost principle to value assets during the time period in which the company plans to use the assets. EXAMPLE Designer Dinners purchases a new blender for $400. As a result of the historical cost principle, Dan Johnson records the blender at $400 in his accounting records. If Dan keeps the blender for 3 years, his records would still show a cost of $400.

Standard-Setting Bodies

Within the United States, the accounting profession relies on two main standard-setting bodies: The primary accounting standard-setting body in the United States is the Financial Accounting Standards Board (FASB). The FASB is a private organization (not a government entity) that makes the U.S. accounting rules, or GAAP. The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies. The SEC enforces the U.S. accounting rules, or GAAP. The SEC relies on the FASB to develop accounting standards, which public companies must follow. A public company is one whose stock is traded on a national stock exchange. You are probably familiar with public companies such as PepsiCo and Facebook.

Are there other forms of business? LLC

Yes. An LLC (limited liability company) has the advantage of limited liability, like a corporation, but an LLC may choose to pay income tax as a proprietorship, partnership, or corporation. This allows for tax advantages over a corporation, which is double-taxed. PC stands for Professional Corporation. Alternatively, it can be called a Professional Service Corporation, abbreviated PSC. This form of business is similar to an LLC with the advantage of limited liability but is restricted to certain licensed professionals, such as accountants, lawyers, physicians, architects, and engineers.

BOOKKEEPING

You may hear the term bookkeeping in a discussion of accounting: Bookkeeping involves only recording activities, whereas accounting includes all three activities. Recording activities involves setting up and maintaining accounting records. The difference between a bookkeeper and an accountant is the ability to identify and communicate accounting results. An accountant must be able to analyze and interpret financial information. A bookkeeper simply records the information.

QUESTIONS ASKED BY EXTERNAL USERS

INVESTORS: IS THE COMPANY IN WHICH WE INVESTED MAKING MONEY? WHICH COMPANY DESERVES MORE INVESTMENT? CREDITORS: DOES THE COMPANY TO WHOM WE LOANED MONEY HAVE THE ABILITY TO PAY ITS BILLS?

ASSETS

ARE RESOURCES THE COMPANY OWNS

Accounting: The Language of Business

Accounting reports, called financial statements, provide the information necessary to make the right decisions. The information system that identifies, records, and communicates the economic events of an organization to interested users.

Steps in analyzing ethics cases and situations

1. Recognize an ethical situation and the ethical issues involved. Use your personal ethics to identify ethical situations and issues. Some businesses and professional organizations provide written codes of ethics for guidance in some business situations. 2. Identify and analyze the principal elements in the situation. Identify the stakeholders—persons or groups who may be harmed or benefited. Ask the question: What are the responsibilities and obligations of the parties involved? 3. Identify the alternatives and weigh the impact of each alternative on various stakeholders. Select the most ethical alternative, considering all the consequences. Sometimes there will be one right answer. Other situations involve more than one right solution; these situations require an evaluation of each and a selection of the best alternative.

Business Classifications: MANUFACTURING COMPANY

A manufacturing company converts raw materials into finished goods to sell to customers. Examples include The Hershey Company, Ford Motor Company, John Deere, and Intel.

Business Classifications: RETAIL OR MERCHANDISE COMPANY

A retail (merchandise) company purchases and sells merchandise directly to consumers. Examples include Target, Nordstrom, Abercrombie & Fitch, and The Home Depot.

Accounting in Various Fields of Business

General management: Managers at Ford Motors, Massachusetts General Hospital, California State University—Fullerton, a McDonald's franchise, and a Trek bike shop all need to understand accounting data in order to make effective business decisions. Marketing: Marketing specialists at Procter & Gamble must be sensitive to costs and revenues, which are measured in accounting numbers. Making a sale to or performing a service for a customer is meaningless unless it is profitable. Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, or a stockbroker for Merrill Lynch? These fields rely heavily on accounting knowledge to analyze financial statements. In fact, it is difficult to get a good job in a finance function without two or three courses in accounting. Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank—is almost always involved in financing a real-estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash flow from an industrial property justify the purchase price? What are the tax benefits of the purchase? Your own company: If you are interested in starting your own business, you may hire an accountant to help you. However, you still need to have a solid understanding of the accounting records of your company. Understanding the numbers will help you make better decisions.

INTERNAL USERS

Internal users of accounting information are managers who plan, organize, and run the business. Internal users include marketing managers, production supervisors, finance directors, and company officers. Internal users must answer many important questions QUESTIONS AS BY INTERNAL USERS FINANCE: DO WE HAVE ENOUGH MONEY TO PAY OUR BILLS? MARKETING: WHAT PRICE SHOULD WE CHARGE FOR OUR NEW PRODUCT TO MAKE THE MOST MONEY? HUMAN RESOURCES: CAN WE KEEP OUR EMPLOYEES HAPPY BY GIVING THEM RAISES? MANAGEMENT: WHICH PRODUCT LINE MAKES US THE MOST MONEY? internal users such as Dan Johnson, the owner of Designer Dinners, need detailed accounting information on a timely basis. Such detailed accounting information may help Dan Johnson compare operating alternatives, project revenues and costs, and forecast cash needs. Managerial accounting is the field of accounting that provides internal users with the information they need to make effective decisions about their companies Think about your current job. Are you responsible for any planning or organizing at your company? If yes, then you need accounting information. The more accurate and timely accounting information you have, the better decisions you can make. That's why accounting will be important to you!

Principles and Assumptions

Now that you know what GAAP is, let's see how businesses can interpret and apply GAAP based on some important principles and assumptions. Principles and assumptions provide a foundation for the accounting process. GAAP generally uses one of two measurement principles: the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.

PROPRIETORSHIP

Owner is the manager/operator. Only a relatively small amount of money (capital) is necessary. Tax advantages. Owner (proprietor) receives any profits, suffers any losses, and is personally liable for all company debts There is no legal distinction between the business as an economic unit and the owner. Owner transactions must be separate from business. Small service-type businesses, farms, and small retail stores. EXAMPLE Because Dan Johnson is the only owner of Designer Dinners, he forms his company as a proprietorship. The proprietorship form makes sense for Dan since only a small amount of money is necessary to start the business. However, Dan can grow his company from its current business form (as a proprietorship) to a partnership and then a corporation Dan Johnson operates his meal-preparation business as a proprietorship. Designer Dinners has only one owner, Dan, and he invests only a small amount of money (capital) to start this business.

CORPORATION (1 TO THOUSANDS)

Ownership is divided into transferable shares of stock. Stockholders may transfer their ownership shares to other investors at any time (i.e., sell their shares). Enjoys an unlimited life. Tax disadvantage: double-taxed. Holders of the shares (stockholders) enjoy limited liability; they are not personally liable for any company debts. Corporations are organized as separate legal entities under state corporation law. Owner transactions must be separate from business. Most of the largest companies in the United States—ExxonMobil, Ford, WalMart Stores, Inc., Citigroup, and Apple. As the business grows and becomes very successful doing corporate events all over the nation, Dan Johnson decides to incorporate. Dan and Chris will be the first to buy stock. The corporation can then offer stock to outside investors, allowing for further growth.

The origins of accounting

are generally attributed to the work of Luca Pacioli (1447-1517), an Italian Renaissance mathematician. In his 1494 text Summa de Arithmetica, Geometria, Proportione et Proportionalite, Pacioli described a system to ensure that financial information was recorded efficiently and accurately.