Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities. Identifying business activities requires selecting transactions and events relevant to an organization. Recording business activities requires keeping a chronological log of transactions and events measured in dollars and classified and summarized in a useful format. Communicating business activities requires preparing accounting reports such as financial statements. It also requires analyzing and interpreting such reports.
Accountants prepare reports for both external and internal users. External users of accounting information are not directly involved in running the organization. Examples of external users are lenders, shareholders (investors), governments, consumer groups, customers, and the external auditors. Internal users of accounting information are those directly involved in managing and operating an organization. They use the information to help improve the efficiency and effectiveness of an organization. Examples of internal users are managers, officers/directors, internal auditors, sales staff, budget officers and controllers.
Financial accounting is the area of accounting aimed at serving external users by providing them with financial statements. Managerial accounting is the area of accounting that serves the decision-making needs of internal users.
Ethical behavior is the cornerstone of the accounting profession. Recently, we have seen many corporate scandals involving individuals who acted in an unethical, and often times, illegal, way. Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior.
Financial accounting is governed by a set of rules we call Generally Accepted Accounting Principles, or GAAP for short. Generally accepted accounting principles identify three major characteristics of information. First, the information must be relevant. Relevant information impacts the decision of the informed user for financial information. Second, the information must be reliable. Finally, the information must be comparable. Comparability helps us evaluate financial information from one period with that of the next period.
The Financial Accounting Standards Board is recognized as the group in the private sector that makes specific accounting principles. If an accountant departs from the principles established by the FASB, proper disclosure of the departure must be made. In the public sector, the Securities and Exchange Commission has the authority to establish accounting principles for companies reporting to the agency. Currently, the Securities and Exchange Commission has accepted all pronouncements of the FASB for use by public reporting companies. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards that identify preferred accounting practices to create harmony among accounting practices of different countries.
In today’s global economy, there is increased demand by external users for comparability in accounting reports. This demand often arises when companies wish to raise money from lenders and investors in different countries. If standards are harmonized, one company can potentially use a single set of financial statements in all financial markets. Differences between U.S. GAAP and IFRS are slowly fading as the FASB and IASB pursue a convergence process aimed to achieve a single set of accounting standards for global use.
There are three general forms of business operations. A sole proprietorship is a business owned by just one individual. A court can order an owner to sell personal belongings to pay a proprietorship’s debt. This unlimited liability of a proprietorship is a disadvantage. A partnership is owned by two or more individuals. Some partnerships have several thousand partners. A limited partnership (LP) includes a general partner(s) with unlimited liability and a limited partner(s) with liability restricted to the amount invested. A limited liability partnership (LLP) restricts partners’ liabilities to their own acts and the acts of individuals under their control. A limited liability company (LLC) offers the limited liability of a corporation and the tax treatment of a partnership (and proprietorship). Most proprietorships and partnerships are now organized as LLCs. A corporation is a business legally separate from its 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. A corporation acts through its managers, who are its legal agents. A corporation is owned by individuals who normally are not active in the day-to-day operations of that business. For example, you may become an owner of IBM by purchasing shares of stock on the New York Stock Exchange. While you are a part owner, you do not necessarily work for IBM nor are active in the operations of the company.
The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because in a general way it states that assets must be equal to the claims against those assets. If you have an asset we can have two broad categories of claims against that asset. First, we may have claims by creditors (liabilities). Finally, after all creditor claims are satisfied, the residual owners, and stockholders, have a claim on those assets.
Assets may be viewed as resources owned or controlled by an entity. They include such items as cash, accounts receivable (amounts owed to the company by customers), land, building and equipment, and supplies.
Liabilities represent the claims of creditors on the entity’s assets. Liabilities include accounts payable (amounts we owe to creditors for items purchased on account to operate the business), notes payable, taxes payable, and wages payable (amounts we owe to our employees at the end of the accounting period).
Equity is the owner’s claim on assets. Equity is equal to assets minus liabilities. This is the reason equity is also called net assets of residual equity. Net income occurs when revenues exceed expenses. Net income increases equity. A net loss occurs when expenses exceed revenues, which decreases equity.
Equity for a noncorporate entity, commonly called owner’s equity, increases with owner investments and revenues and decreases with owner withdrawals and expenses. Here is a breakdown of the equity section of the accounting equation to show the mathematical signs we will be using to keep track of investments, withdrawals, revenues and expenses.
During the process of recording business transactions, it is important that we always keep the accounting equation in balance. We can’t let our books get out of balance. You have probably heard this term before, but may not have been sure what we meant by keeping the books in balance.
End of Chapter 1.
Chapter 1 ACCOUNTING IN BUSINESS
IMPORTANCE OF ACCOUNTING Identifying Select transactions and events Recording Input, measure and classify Communicating Prepare, analyze and interpret Accounting C 1
USERS OF ACCOUNTING INFORMATION External Users <ul><li>Lenders </li></ul><ul><li>Shareholders </li></ul><ul><li>Governments </li></ul><ul><li>Consumer Groups </li></ul><ul><li>External Auditors </li></ul><ul><li>Customers </li></ul>Internal Users <ul><li>Managers </li></ul><ul><li>Officers/Directors </li></ul><ul><li>Internal Auditors </li></ul><ul><li>Sales Staff </li></ul><ul><li>Budget Officers </li></ul><ul><li>Controllers </li></ul>C 2
USERS OF ACCOUNTING INFORMATION External Users Financial accounting provides external users with financial statements. Internal Users Managerial accounting provides information needs for internal decision-makers. C 2
ETHICS - A KEY CONCEPT Beliefs that distinguish right from wrong Accepted standards of good and bad behavior C 3
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES Financial accounting practice is governed by concepts and rules known as generally accepted accounting principles (GAAP) . Relevant Information Affects the decision of its users. Reliable Information Is trusted by users. Comparable Information Is helpful in contrasting organizations. C 4
SETTING ACCOUNTING PRINCIPLES The Securities and Exchange Commission is the government agency that establishes reporting requirements for companies that issue stock to the public. Financial Accounting Standards Board is the private group that sets both broad and specific principles. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards that identify preferred accounting practices to create harmony among accounting practices of different countries. C 4
INTERNATIONAL STANDARDS The International Accounting Standards Board (IASB), an independent group (consisting of 16 individuals from many countries), issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. IASB C 4
FORMS OF BUSINESS ENTITIES C 4 Sole Proprietorship Partnership Corporation
TRANSACTION ANALYSIS AND THE ACCOUNTING EQUATION Assets = Liabilities + Equity Ecuación de Contabilidad A1
ASSETS Land Equipment Buildings Cash Vehicles Store Supplies Notes Receivable Accounts Receivable Recursos propios o controlados por la compañía. A1
LIABILITIES Taxes Payable Wages Payable Notes Payable Accounts Payable Reclamos de los acreedores sobre los activos . A1
EQUITY Igual a Activos Menos Pasivos (Activos Netos) Reclamos de los Dueños sobre los activos A