Accrual Accounting and Financial Statements - 1

ACCOUNTING: CHAPTER
The Language
of Business
1
© 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting,
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Learning Objectives (LO)
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 transactional data
5. Compare the features of sole proprietorships,
partnerships, and corporations
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Learning Objectives (LO)
After studying this chapter, you should be able to

6. Identify how the owners’ equity section in a
corporate balance sheet differs from that in a sole
proprietorship or partnership
7. Explain the regulation of financial reporting including
differences between U.S. GAAP an IFRS
8. Describe auditing and how it enhances the value of
financial information
9. Evaluate the role of ethics in the accounting
profession
© 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e
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LO 1 - Accounting and Decision-Making
• Accounting – the process of identifying,
recording, summarizing, and reporting economic
information to decision makers
• Types of Accounting:
– Tax – primarily used by the government
– Non-Profit (donors, governments)
– Managerial – insiders (budgets, planning, costing,
pricing, managing product mix, etc.)
– Financial – outsiders (owners, creditors,
suppliers, regulators, unions, others)
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• Principal Components of Annual Financial Reports

– A letter from corporate management
– Management’s discussion and analysis of past and
possible future transactions, events, circumstances
– Financial statements
– Footnotes explaining many elements of the
financial statements in more detail
– Independent auditor’s report
– A statement of management’s responsibility for
preparation of the financial statements
– Other corporate information
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• Sequence of Events Leading to Financial

Statements Found in Those Reports
1. Measurable economic event occurs
2. Private (work for the reporting entity)
bookkeepers/accountants analyze event to
determine what elements/accounts are affected,
then record the event into records
3. Records are summarized into financial statements
4. Financial reports that include the statements are
provided to users who make decisions
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• Characteristics of Financial Reports

– Prepared by management
– Provided to outsiders quarterly and annually
– Primarily about past transactions and events
– Tell very little about future transactions, events, or
circumstances
• Financial Statements (part of those reports)
– Balance Sheet
– Income Statement
– Statement of Cash Flows
– Statement of Stockholders’ Equity
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• Accessing Financial Reports and Statements

– Available to all via the Internet from company’s
website
– Formally sent or made available to owners by
preparer
– Formally filed with the U.S. Government (Securities
and Exchange Commission) (10-Q, 10-K, and
numerous other forms) and subsequently accessible
from the SEC’s EDGAR system
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LO 2 - The Balance Sheet
• The balance sheet (also called the statement of

financial position) shows the financial status of a
company at a particular instant in time
• Reflects the basic accounting equation, which is
Resources = Claims against those resources
Assets = Liabilities + Owners’ equity
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Assets – economic resources that the company

owns or controls from past transactions/events
that it expects to help generate future benefits
• Accounts – subdivision of the element Assets
– Cash and cash equivalents
– Accounts Receivable (Customer bought it on credit) Current
– Inventories (Merchandise, Supplies, Parts) Assets
– Prepaid Expenses (taxes, utilities, insurance)
– Property
Long-term
– Plant
Assets
– Equipment
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Liabilities – economic obligations of the

organization to outsiders from past
transactions /events that it expects to pay in the
future
• Accounts – subdivision of the element Liabilities
– Accounts Payable (We bought it on credit)
– Notes Payable
– Long-term debt
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Owners’ equity is the owners’ claim on the

organization’s assets, i.e., assets minus liabilities
• Accounts – subdivision of the element Equity
– Sole Proprietorships - XX Capital
– Partnerships - YY Capital
– Corporations - Capital (Common) Stock

- Paid in Capital in excess of
par/stated value (See LO 6)
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LO 3 - Balance Sheet Transactions
• Every transaction of a company or entity affects

the balance sheet equation
– An entity is an organization that stands apart from other
organizations and individuals as a separate economic
unit for which the balance sheet is being prepared
– A transaction is any event that affects the financial
position of that entity and that can be reliably recorded
in money terms
• At least two accounts will be affected for every
entry recorded (compound entry = > 2 accounts)
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Transaction 1: Initial Investment of $400,000

Assets = Liabilities + Owners’ Equity
Cash Lopez, Capital
(1) + $400,000 = +$400,000

(Owner Investment)
Transaction 2: Loan of $100,000 from Bank

Cash Note payable Lopez, Capital
(1) + $400,000 = +$400,000

(2) + $100,000 = + $100,000
Bal. $500,000 = $100,000 $400,000
$500,000 $500,000
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Transaction 3: Acquire Store Equipment

for Cash, $15,000
Cash Store Equipment Note payable Lopez, Capital
Bal. $500,000 = $100,000 $400,000

(3) –15,000 +15,000 =
Bal. 485,000 15,000 = 100,000 400,000
$500,000 $500,000
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LO 4 – Preparing the Balance Sheet
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LO 5 – Comparative Ownership Features
• Sole proprietorship – a single owner

• Partnership – two or more co-owners
• Corporation – created under (U.S.) state laws
– Publicly owned – Owned by the public through the
sale of shares; potentially thousands of owners
– Privately owned – Owned by families or a small

group of shareholders; shares are not sold or traded
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LO 5 – Comparative Ownership Features
• Advantages of a Corporation
– Limited liability (claims against corporate assets only
– not personal assets of managers)
– Easy transfer of ownership
– Ability to raise capital from thousands
– Continuity of existence
– Prestige
• Disadvantages of a Corporation
– Unfavorable tax laws (double taxation on distributed
earnings)
– Regulation
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LO – 6 Differences in Reporting Owners’
Equity
• Proprietorships and Partnerships
– Owners’ equities = “Capital”
– Owners’ equities are recorded in the capital account
• Corporations
– Owners’ equities (Residual interests in the company)
also called Stockholders’/Shareholders’ equity
– Total capital investment = Paid-in capital (e.g., $20)
• Common stock recorded at par/stated value
– Par/stated value = what is printed on the stock
– One share × $5 par value = $5
• Paid-in capital in excess of par value
– One share × ($20 – $5 par value) = $15
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LO – 6 Differences in Reporting Owners’
Equity
• Shareholders elect a board of directors to look out
for their interests
• Board of Directors
– Often include outsiders such as CEOs and presidents of
other corporations, academics, attorneys, and
community representatives
– Can also include insiders – company’s CEO, CFO, etc.
– Majority must be independent if stock is regulated
– Set strategic direction of the company
• Senior Managers – run day to day operations
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LO – 7 Regulation of Financial Reporting
• Federal Government
– Legislative (Congress) passes laws and funding for
federal agencies
– Judicial – enforces laws
– Executive – Proposes, signs, administers budgets and
laws (see SEC below)
• SEC – Has statutory authority to
– regulate investment management activities
– regulate stock market activities
– investigate violations of security laws
– control financial reports and their preparers
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• Financial Accounting Standards Board

(FASB)
– Independent nonprofit organization
– Writes accounting/reporting standards for not-for-
profit organizations
– Has delegated authority from SEC to create and
amend financial accounting/reporting standards for
for-profit organizations subject to control by the SEC
– Authority may be rescinded at any time
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• FASB (continued)
– Does not have investigatory or enforcement authority
– Published over 160 separate opinions that include
Generally Accepted Accounting Principals (GAAP)
– Selected recent/current projects
• Codification (now only one set of guidance)
• Convergence with the IFRS
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• International Accounting Standards Board

(IASB)
– Not a U.S. governmental agency
– United States is represented on the board
– Creates and amends financial accounting and
reporting standards for European Union and many
other countries
– Selected current projects:
• Convergence with U.S. GAAP
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• Sarbanes Oxley Act – 2002

– Board of directors must have an audit committee
composed only of “independent” directors
– Management must examine and certify the adequacy
of internal controls used by its company
– Prohibits public accounting firms from providing audit
clients with certain non-audit services
– Requires rotation every 5 years of the lead audit or
coordinating partner and the reviewing partner
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• Sarbanes Oxley Act – 2002 (continued)

– Established the Public Company Accounting Oversight
Board (PCAOB)
• Subordinate to the SEC
• Writes Generally Accepted Auditing Standards
(GAAS) that external auditors must follow when
conducting an audit
• Writes policies directed toward management
regarding internal controls of the companies
• Investigates audit and management compliance
• SEC approves recommended disciplinary actions
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• American Institute of Certified Public

Accountants (AICPA)
– National voluntary membership association of CPAs
– Sets strategic direction for the profession
– Members must abide by a code of conduct
– Writes/grades/updates the Uniform CPA Examination
• XXX Society of CPAs
– Each state has its own society
– Advocate for the profession within the state
– Provides multiple goods and services to members
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• State Boards of Accountancy (SBA)

– Sets knowledge, integrity, and ethics policies
– Uses the Uniform CPA Exam, written and graded by
the AICPA, as part of the licensing process
– Licenses and disciplines CPAs
– Requires certain number of professional-subject
courses (continuing professional education [CPE]) to
be taken within a period of time to maintain license
– Works with other SBA on reciprocity of CPA licenses
between states
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LO – 8 Auditing
• 1929 Stock Market Crash – Senior managers
– Rewarded in part by content of financial statements
– Prepare financial statements
– Potential for bias
• SEC Act of 1934 required public companies to
– have their financial statements audited by independent
outside auditors who are CPAs
– File results with the SEC
• Shareholders – audit report adds credibility to the
financial statements they use when making
decisions
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LO – 8 Auditing
• The four largest international public accounting

firms are
– Deloitte Touche Tohmatsu
– Ernst & Young
– KPMG International
– PricewaterhouseCoopers
• 97% of the firms listed on the NYSE are clients of
these four firms
• National, regional and local firms also exist
• Offer fee-based tax, consulting, auditing services
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LO – 8 Auditing
• Audit – examination of a company’s transactions and the resulting
financial statements
• Standard report includes the following topics:
– Introduction – what was audited?
– Scope – how was the audit conducted?
– Opinion as to
• fairness of financial statements
• degree to which GAAP was followed
– Other topics (e.g., changes in principals, adequacy of management’s review of
internal controls)
• (
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LO – 9 Ethics
• Ethics – doing what is right for all stakeholders

• Ethics are an integral part of the accounting
profession and are stressed in guidance from the
following:
– Professional societies (AICPA, IMA, state societies)
– Regulatory bodies (SEC, PCAOB, SBA)
– Accounting firms (international, national, regional, local)
– Publically traded firms (set the “tone at the top”)
• Nevertheless – greed often trumps ethics
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Miscellaneous
• The Governmental Accounting Standards

Board (GASB) regulates disclosures for
nonfederal governmental organizations (states
and below, organizations, etc.)
• More CEOs started out in finance or accounting
than any other area, i.e.,
• Accounting provides an excellent training ground
for future managers and executives
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ACCOUNTING: CHAPTER

After studying this chapter, you should be able to

After studying this chapter, you should be able to

• Principal Components of Annual Financial Reports

• Sequence of Events Leading to Financial

• Characteristics of Financial Reports

• Accessing Financial Reports and Statements

• The balance sheet (also called the statement of

Assets = Liabilities + Owners’ equity

Assets – economic resources that the company

Liabilities – economic obligations of the

Owners’ equity is the owners’ claim on the

– Corporations - Capital (Common) Stock

• Every transaction of a company or entity affects

Transaction 1: Initial Investment of $400,000

Cash Lopez, Capital

(1) + $400,000 = +$400,000

Transaction 2: Loan of $100,000 from Bank

Cash Note payable Lopez, Capital

(1) + $400,000 = +$400,000

Transaction 3: Acquire Store Equipment

Cash Store Equipment Note payable Lopez, Capital

Bal. $500,000 = $100,000 $400,000

• Sole proprietorship – a single owner

– Privately owned – Owned by families or a small

• Financial Accounting Standards Board

• International Accounting Standards Board

• Sarbanes Oxley Act – 2002

• Sarbanes Oxley Act – 2002 (continued)

• American Institute of Certified Public

• State Boards of Accountancy (SBA)

• The four largest international public accounting

• Ethics – doing what is right for all stakeholders

• The Governmental Accounting Standards

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