ACCOUNTING: 
The Language 
of Business

CHAPTER 
1
Learning Objectives
After studying this chapter, you should be able to
•	Explain how accounting information assists in making decisions
•	Describe the components of the balance sheet
•	Analyze business transactions and relate them to changes in the balance sheet
•	Compare the features of sole proprietorships, partnerships, and corporations
Learning Objectives
After studying this chapter, you should be able to
•	Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole proprietorship or partnership
•	Describe auditing and how it enhances the value of financial information
•	Explain the regulation of financial reporting
•	Evaluate the role of ethics in the accounting profession
The Nature of Accounting
•	Accounting is the process of identifying, recording, summarizing, and reporting economic information for decision makers
•	Accountants present this information in reports called financial statements

Accounting as an Aid 
to Decision Making
•	Accounting information is useful to anyone making decisions that have economic consequences
•	These decision makers include
–	Managers
–	Owners
–	Investors
–	Politicians

Financial Accounting
•	Financial accounting serves external decision makers:
–	Stockholders
–	Suppliers
–	Banks
–	Government agencies
Management Accounting
•	Management accounting serves internal decision makers:
–	Top executives
–	Department heads
–	College deans
–	Hospital administrators
–	Other managers within the organizations
The Annual Report
•	The annual report is prepared by management and informs investors about the company’s past performance and future prospects
The Annual Report
•	The annual report includes
–	A letter from corporate management
–	Management discussion and analysis
–	Footnotes explaining many elements of the financial statements in more detail
–	The report of the independent auditors
–	A statement of management’s responsibility for preparation of the financial statements
–	Other corporate information
The Annual Report
•	A company’s financial statements can also be found in Form 10-K, which it files annually with the Securities and Exchange Commission
•	The three major financial statements are the
–	Balance sheet
–	Income statement
–	Statement of cash flows

The Annual Report
•	The balance sheet focuses on the financial position of a company on a particular day
•	The income statement and cash flow statement focus on the company’s performance over time
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
•	The left side lists the resources of the firm
•	The right side lists the claims against those resources
The Balance Sheet
•	Assets are economic resources that the company expects to help generate future cash inflows or reduce or prevent future cash outflows
–	Examples: Cash, inventories, equipment
•	Liabilities are economic obligations of the organization to outsiders (creditors)
–	 Example: A debt to a bank in the form of a note payable
•	Owners’ equity is the owners’ claim on the organization’s assets

The Balance Sheet
•	Open account – the practice of making most purchases on a credit basis instead of cash basis
•	Accounts receivable are assets that result from the sale of goods or services on open account
•	Accounts payable are liabilities that result from a purchase of goods or services on open account 
•	Inventories are assets held by the company for the purpose of sale to customers
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
–	A transaction is any event that affects the financial position of an entity and that can reliably recorded in money terms
Balance Sheet Transactions
•	An account is a summary record of the changes in a particular asset, liability, or owners’ equity item
•	The double-entry accounting system records each transaction in at least two accounts
•	A compound entry affects more than two balance sheet accounts
Balance Sheet Transactions
Balance Sheet Transactions
Balance Sheet Transactions
Preparing the Balance Sheet
Types of Ownership
•	Sole proprietorship – a business with a single owner
•	Partnership – an organization that joins two or more individuals who act as co-owners
•	Corporation – a business organization created under state laws in the Unites States

Corporation
–	Publicly owned corporation – A corporation owned by the public through the sale of shares; it may have thousands of owners
–	Privately owned corporation – A corporation owned by families or a small group of shareholders; shares are not publicly sold
–	Corporation stockholders have limited liability
•	Creditors have claims against the corporation assets only, not the personal assets of the owners

Advantages and Disadvantages 
of the Corporate Form
•	Advantages
–	Limited liability
–	Easy transfer of ownership
–	Ability to raise capital from hundreds or thousands of potential stockholders
–	Continuity of existence
–	Prestige
•	Disadvantages
–	Unfavorable tax laws
–	Regulation
Accounting Differences Among Legal Forms
•	Proprietorships and partnerships
–	Owners’ equities are labeled capital
–	Owners’ equities are recorded in the capital account
•	Corporations
–	Owners’ equities are labeled stockholders’ equity or shareholders’ equity.  Total capital investment is called paid-in capital
–	Owners’ equity is recorded in two parts:
•	Common stock at par value
•	Paid-in capital in excess of par value

The Meaning of Par Value
•	Par value (or stated value) – the dollar amount printed on the stock certificate
•	Paid-in capital in excess of par value (or additional paid-in capital) – the difference between the total amount the company receives for the stock and the par value
•	Common stock is recorded at the par value 
•	Common shareholders are owners who have a “residual” ownership in the corporation through the purchase of common stock
Stockholders and the 
Board of Directors
•	Shareholders elect a board of directors to look out for their interests
•	Members of a board often include CEOs and presidents of other corporations; university presidents and professors; attorneys; and community representatives 
•	The chairman of the board may also be the top manager, the chief executive officer (CEO)
Stockholders and the 
Board of Directors
•	The board’s duty is to ensure that managers act in the interest of shareholders
•	When boards do their duty in monitoring management, the corporate form of organization is effective
Credibility and the Role of Auditing
•	The separation of owners and managers creates potential problems in getting truthful information about the performance of a company
•	Shareholders must rely on managers to tell the truth
•	The auditor examines the information that managers use to prepare the financial statements and provides assurances about the credibility of those statements
The Certified Public Accountant and the Auditor’s Opinion
•	Third party assurance about the credibility of financial statements is provided by audit professionals called Certified Public Accountants (CPAs)
•	CPAs are public accountants who offer services including auditing, preparing income taxes, and management consulting to the general public on a fee basis
•	Each state has a Board of Accountancy that sets standards of both knowledge and integrity 
The Certified Public Accountant and the Auditor’s Opinion
•	An audit is an examination of a company’s transactions and the resulting financial statements
•	The auditor’s opinion describes the scope and results of the audit and a judgment that the financial statements prepared by management are accurate

The Accounting Profession
•	Public accountants offer services to the general public for a fee
•	Private accountants work for businesses, government agencies, and other nonprofit organizations
Public Accounting Firms
•	The four largest 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
Public Accounting Firms
•	Each firm has annual billings in excess of $1 billion
•	All firms must follow generally accepted accounting principles (GAAP)
–	The broad concepts and detailed practices of preparing and distributing financial statements
Standard-Setting Bodies
•	The Financial Accounting Standards Board (FASB) is responsible for establishing GAAP in the United States by issuing FASB Statements
•	The Securities and Exchange Commission (SEC) is responsible for authorizing the GAAP for companies whose stock is held by the general investing public
•	The FASB and SEC work closely together and seldom have public disagreements

Standard-Setting Bodies
•	The International Accounting Board (IASB) 
–	Is responsible for developing high quality, understandable and enforceable global accounting standards
–	Has 12 full-time and 2 part-time members
–	Standards will be adopted by the European Union for financial statements prepared after 2005
Standard-Setting Bodies
•	The American Institute of Certified Public Accountants (AICPA) is the principal professional association in the private sector that regulates the quality of the public accounting profession
Sarbanes-Oxley Act
•	Established the Public Company Accounting Oversight Board to regulate public accounting and to set standards for audit procedures through the issuance of generally accepted auditing standards (GAAS)
•	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 on an audit 
Sarbanes-Oxley Act
•	Provides regulation of corporate governance
–	Requiring boards to appoint an audit committee composed only of “independent” directors
–	Requiring CEOs and chief financial officers (CFOs) to personally sign a statement certifying the appropriateness and fairness of their companies’ financial statements
–	Increasing criminal penalties for knowingly misreporting financial information
Professional Ethics
•	Members of the AICPA must abide by a code of professional conduct
•	The Institute of Management Accountants has a code of ethics for management accounts
•	Auditors and management accountants have professional responsibilities concerning competence, confidentiality, integrity, and objectivity
Professional Ethics
•	Ethical standards are personal and depend on the values of the individual
•	A successful manager must recognize the ethical dimensions of a situation and act with absolute integrity
Professional Ethics
•	Despite the criticism of accounting ethics, accountants were responsible for revealing the problems in many of the recent corporate scandals
•	Companies often rely on accountants to safeguard the ethics of the company
•	WorldCom and Enron whistle-blowers became two of the three 2002 Persons of the Year in Time magazine 

Career Opportunities 
for Accountants
•	Accounting provides an excellent training ground for future managers and executives
•	More CEOs started out in finance or accounting than any other area
Nonprofit Organizations
•	Fundamental accounting principles also apply to nonprofit organizations
•	The Governmental Accounting Standards Board (GASB) regulates disclosures for governmental organizations
•	The FASB regulates financial reporting for other nonprofit organizations