CHAPTER 1

Accounting:
The Language of Business

LEARNING OBJECTIVES
After studying this chapter you should be able to:
1.

Explain how accounting information assists in making decisions.

2.

Describe the components of the balance sheet.

3.

Analyze business transactions and relate them to changes in the balance sheet.

4.

Prepare a balance sheet from transactions data.

5.

Compare the features of sole proprietorships, partnerships, and corporations.

6.

Identify how the owners equity section in a corporate balance sheet differs from that in a sole
proprietorship or a partnership.

7.

Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.

8.

Describe auditing and how it enhances the value of financial information.

9.

Evaluate the role of ethics in the accounting process.

10.

Recognize career opportunities in accounting, and understand that accounting is important to both forprofit and nonprofit organizations.

Chapter 1 provides a glimpse of the entire field of accounting. It describes the nature of accounting and its
role in providing useful information for a wide variety of decisions. In addition, the balance sheet equation is
introduced: Assets = Liabilities + Ownersequity.
An introduction to the basic terms accountants usethe accounting vocabularyis an overall theme of
the chapter. Transaction analysis is introduced as well as the effect of a transaction on the balance sheet
equation. The chapter also looks at types of business organizations. The chapter concludes with a discussion
of the accounting profession, regulation, the auditing function, and professional ethics.

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Accounting is the language of business and is the process of identifying, recording, and
summarizing economic information to decision makers.
An organizations accounting system is the series of steps it uses to record financial data and
convert them into informative financial statements.

Learning Objective 1.

Explain how accounting information assists in making decisions.

Accounting information is useful to anyone making decisions that have economic consequences.
Financial accountingserves external decision makers (stockholders, suppliers, banks and
government agencies)whilemanagement accountingserves internal decision makers (top
executives, department heads, college deans, and hospital administrators).
A common source of financial information used by investors and others outside the company is
the annual report. It is prepared by management to inform current and potential investors about
the companys past performance and future prospects. It contains financial statements and other
information about the corporation, such as a letter from corporate management, a discussion and
analysis by management of recent economic events, footnotes to the financial statements,
auditors report, and statements by management and the authors on the companys internal
controls.
Financial statements also appear in Form 10-K, filed annually with the Securities and Exchange
Commission (SEC), the government agency responsible for regulating capital markets in theUnited
States. U.S. companies with publicly traded stock (companies that sell shares in their ownership to
the public) must file Form 10-K and other forms with the SEC.

DO MULTIPLE CHOICE 1, 2 and 3.

Learning Objective 2.

Describe the components of the balance sheet.

The balance sheet(also called the statement of financial position) shows the financial status of
an organization at a particular instant in time.
The balance sheet has two counterbalancing sections. One section lists the resources of the firm
and the other the claims against the resources. The two sections form the balance sheet
equation: Assets = Liabilities + Owners equity.
Assets are economic resources that the company expects to generate future cash inflows or
reduce or prevent future cash outflows. Examples are cash, inventory, and equipment.
Liabilities are economic obligations of the organization to outsiders, or claims against its
assets by outsiders such as a debt to the bank.Notes payable describe the existence of
promissory notes that are signed when a company takes out a bank loan.
Owners equity is the owners claims on the organizations assets and is equal to total
assets less total liabilities. The term net assets also refers to assets less liabilities.

DO MULTIPLE CHOICE 4 and 5.

DO EXERCISES 1 and 2.

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Learning Objective 3.

Analyze business transactions and relate them to changes in the

balance sheet (SeeEXHIBIT 1-2).

An entity is an organization or a section of an organization that stands apart from other

organizations and individuals as a separate economic unit. A transaction is any event that affects
the financial position of an entity and can be reliably recorded in monetary terms.
Every transaction affects the balance sheet. When accountants record transactions they always
make at least two entries(i.e., double-entry accounting system) so that the total assets always
equal the total liabilities and owners equity. The balance sheet equation always must remain in
balance.
Accountants record transactions in an organizations accounts. An account is a summary record
of the changes in a particular asset, liability, or owners equity category, and the account balance
is the total of all entries to the account up to a particular date.
Transaction analysis determines which specific accounts are affected, whether the account
balances are increased or decreased, andthe amount of the change in each account balance. For
example, if the company borrows money from the bank, an asset (cash) increases, and a liability
(notes payable) increases.
Inventory refers to goods held by the company for the purpose of sale to customers. An account
payable is a liability that results from a purchase of goods or services on open account (i.e., on
credit). When inventory is purchased on account, both assets and liabilities are increased (if
purchased for cash, one asset will increase and another asset will decrease). A compound entry
affects more than two balance sheet accounts. A creditor is one to whom the company owes
money.

DO MULTIPLE CHOICE 6 and 7.

Learning Objective 4.

Prepare a balance sheet from transactions data(See EXHIBIT 1-3)

Transactions data can be used to compute a cumulative total for each account at any date. Note
that a balance sheet represents the financial impact of all transactions up to a specific point in
time.
The account titles are listed with their respective balances on the specific date noted in the header
of the balance sheet. Each account is listed under the category that it belongs toassets, liabilities,
or owners equity. Examples of actual corporate balance sheets can be found in EXHIBIT 1-5.
Although a new balance sheet could be prepared after each transaction, companies usually produce
balance sheets only when needed by managers and at the end of each quarter for reporting to the
public.

Learning Objective 5.

Compare the features of sole proprietorships, partnerships, and

corporations.

A sole proprietorship is a business with a single owner. Sole proprietorships tend to be small
businesses such as local stores or restaurants.

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A partnership is aform of organization that joins two or more individuals together as co-owners.
Each partnership is an individual entity that is separate from the personal activities of each
partner.
Corporations are organizations created under state law in the United States with an unlimited
number of owners. Owners of a corporation have limited liability (i.e., corporation creditors
ordinarily have claims against the corporate assets only, not against the personal assets of the
owners).
A publicly owned corporation is one in which shares of ownershipare sold to the public.
Purchasers or shares are identified as shareholders or stockholders.
A privately owned (closely held, unlisted) corporation is owned by a family, a small
group of shareholders, or a single individual.
Advantages of the corporate form of ownership include ease of transfer of ownership (the
corporation issues stock certificates as formal evidence of ownership), ease of raising ownership
capital, and continuity of existence.
Tax laws may favor a sole proprietorship, a partnership, or a corporation, depending on the
personal tax situations of the owners.

Learning Objective 6.

Identify how the owners equity section in a corporate

balance sheet differs from that in a sole proprietorship or a
partnership.

All business entities account for assets and liabilities similarly (See EXHIBIT 1-8).
a.

Owners equities for proprietorships and partnerships are identified as capital.

b.

Owners equities for the corporation are called stockholders equity or shareholders
equity.

In a corporation, capital investment by the owners, known as paid-in capital,is recorded in two
parts: common stock at par value and paid-in capital in excess of par value.
Par value or stated value is the dollar amount printed on the stock certificates, and paid-in
capital in excess of par valueor additional paid-in capital is the difference
between the total amount received for the stock and the par value.
Common stock represents the par value purchased by the common stockholders of the
corporation. (See EXHIBIT 1-9). Common stockholders have a residual ownership in the
corporation.

DO MULTIPLE CHOICE 8 and 9.

In corporations, the ultimate responsibility for management is delegated by the stockholders to
the boardof directors. One of the duties of the board of directors is to appoint and monitor
managers. The chief executive officer (CEO) is the top manager in an organization and
sometimes serves as the chairman of the board.

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Learning Objective 7.

Explain the regulation of financial reporting, including differences

between U.S. GAAP and IFRS.

Generally accepted accounting principles (GAAP)consist of all the broad concepts and
detailed practices to be followed in preparing and distributing financial statements. Companies
reporting in more than 100 countries use International Financial Reporting Standards (IFRS)
while U.S. companies useFinancial Accounting Standards.
The Financial Accounting Standards Board is responsible for establishing U.S. GAAP. In
2009 it compiled all standards and other elements of U.S. GAAP into the FASB Accounting
Standards Codification.
The U. S. Congress has charged the Securities and Exchange Commission (SEC) with the
ultimate responsibility for authorizing GAAP for companies whose stock is held by the general
investing public. However, the SEC has informally delegated much rule-making power to the
FASB. Congress can, however, overrule both the SEC and the FASB.
The International Accounting Standards Board(IASB) was established to develop, in the
public interest, a single set of high quality, understandable, and enforceable global accounting
standards. The IASB sets International Financial Reporting Standards (IFRS). The IASB has 16
members who represent a diversity of geographic and professional backgrounds.

DO MULTIPLE CHOICE 10.

Learning Objective 8.

Describe auditing and how it enhances the value of financial

information.

The credibility of financial statements is the ultimate responsibility of the managers who are
entrusted with the resources of the entity under their command.
Third-party assurance about the credibility of financial statements gave rise to the CPA
profession. An auditor examines the information that managers use to prepare the financial
statements and provides assurances about the credibility of those statements.
The desire for third-party assurance about the credibility of financial statements created the
profession of public accountants accountants who offer services to the general public on a fee
basis. A certified public accountant (CPA) in the U.S. earns this designation by meeting
standards of knowledge and integrity set by a State Board of Accountancy.
To assess managements financial disclosures, CPAs conduct anaudit, an examination of a
companys transactions and the resulting financial statements.
The audit is conducted by an independent CPA to lend credibility to managements financial
statements and is described in the auditors opinion (see EXHIBIT 1-10). An auditors opinion
(also called an independent opinion) describes the scope and results of the audit, and companies
include the opinion with the financial statements in their annual reports and 10K filings.

DO MULTIPLE CHOICE 11.

Accountants who do not offer services to the general public are known as private accountants.
They work for businesses, governmental agencies, and other nonprofit organizations.

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The American Institute of Certified Public Accountants (AICPA) is the principal professional
association of CPAs. The International Auditing and Assurance Standards Board (IAASB),
established by the International Federation of Accountants, is working to standardize audit regulation
around the globe, but regulation of auditing continues to differ significantly across countries.
In 2002, the U.S. Congress passed the Sarbanes-Oxley Act, which gave the government a larger
role in regulating the audit profession. Among its regulations were:
a. the establishment of the Public Company Accounting Oversight Board(PCAOB)with
powers to regulate many aspects of public accounting and to set standards for audit
procedures,
b. prohibiting public accounting firms from providing to audit clients certain nonaudit
services, and
c. requiring rotation every five years of the lead audit or coordinating partner and the
reviewing partner on an audit.
All accounting firms that audit companies with publicly traded stock in the U.S. must register
with the PCAOB, and they are referred to as registered public accounting firms. Additionally,
the PCAOB issues Generally AcceptedAuditing Standards (GAAS) that prescribe the
minimum steps that an auditor must take in examining the transactions and financial statements
and issuing an auditors opinion.

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Learning Objective 9.

Evaluate the role of ethics in the accounting process.

Members of the AICPA, as well as members of the Institute of Management

Accountants and the Association of Government Accountants, must abide by codes
of professional conduct, which are especially concerned with integrity and
independence. Professional accounting organizations have procedures for reviewing
behavior alleged as not being consistent with the codes of professional conduct (see
EXHIBIT 1-11).

DO MULTIPLE CHOICE 12 and 13.

Learning Objective 10.

Recognize career opportunities in accounting, and

understand that accounting is important to both forprofit and nonprofit organizations.

Accounting is provides an excellent background for almost any manager and is especially
important for finance professionals.
Additionally, anyone who wants to move up in the management structure of a company
needs to know accounting.
Companies often rely on accountants to safeguard the ethics of a company. Therefore,
accountants have a special responsibility to ensure that managers act with integrity and
that information provided by the company is accurate.
Although this textbook focuses on profit-seeking organizations, accounting principles
also apply to nonprofit organizations such as hospitals, universities, and government
agencies.

Chapter 1 Quiz
Multiple Choice
1.

Financial accounting focuses on the specific needs of decision makers external to the
organization. Which of the following would not be an external user?
a.
b.
c.
d.

2.

Stockholders
Internal Revenue Service
Vice PresidentMarketing
Banks

The correct version of the accounting equation is

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a.
b.
c.
d.
3.

The annual report does not include

a.
b.
c.
d.

4.

an increase in one asset and a decrease in another.

an increase in owners equity and a decrease in an asset.
an increase in an asset and an increase in a liability.
none of the above

If the owners (stockholders) equity section of the balance sheet includes Additional
Paid-in-Capital, the type of organization is a
a.
b.
c.
d.

9.

increases assets and owners equity.

increases assets and liabilities.
increases liabilities and owners equity.
has no effect on total assets.

The purchase of inventory by paying cash causes

a.
b.
c.
d.

8.

at a particular point in time.

for a period of a month, quarter, or year.
from the beginning of a period to the end of the period.
only at the end of the year.

A loan from the bank

a.
b.
c.
d.

7.

assets.
liabilities.
net assets.
net liabilities.

The balance sheet shows the financial status of a company

a.
b.
c.
d.

6.

a report from the independent auditors.

footnotes.
statements on the companys internal controls.
a letter from the board of directors.

Another term for owners equity is

a.
b.
c.
d.

5.

assets = liabilities owners equity

assets = liabilities + owners equity
liabilities = assets + owners equity
owners equity = assets + liabilities

nonprofit.
partnership.
corporation.
governmental entity.

Which of the following is a disadvantage of the corporate form of ownership?

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a.
b.
c.
d.
e.
f.
10.

Which organization has the responsibility to establish U.S. GAAP?

a.
b.
c.
d.

11.

The FASB
The IASB
The SEC
Management

An audit opinion
a.
b.
c.
d.

12.

Separation of ownership and management

Continuity of existence
Unlimited liability
Ease of raising capital
Both c and d
None of the above

is provided by the audited companys president.

is provided by private accountants.
is provided by an independent CPA.
all of the above

A certified public accountant (CPA) in the U.S. earns certification through

a.
b.
c.
d.

being an accounting major in college.

having sufficient experience.
meeting Board of Accountancy standards of knowledge and integrity.
all of the above

13.
The overall concern of the AICPAs Code of Professional Conduct is which of the
following?
a.
b.
c.
d.

Whether the CPA is an officer in the corporation being audited

Whether the CPA owns stock in the corporation being audited
Whether the CPA is independent and acts with integrity and objectivity
Whether the CPAs father is the controller of the corporation being audited

Exercises
1.

If total assets are $85,000 and total liabilities are $45,000, what is total owners

equity?
2.

If a company purchases $50,000 of equipment on credit, how much did total owners

equity increase?

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Chapter 1 Quiz Solutions

Multiple Choice
1. c

6. b

11. c

2. b

7. a

12. f

3. d

8. c

13. c

4. c

9. f

5. a

10. a

Exercises
1.

The balance sheet equation holds that Total Assets equal Total Liabilities plus Total
Owners Equity. This means that $85,000 = $45,000 + x and x = $40,000, the Total
Owners Equity balance.

2.

0: Assets increase and liabilities increase.

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