What Is Accounting?

What consistently ranks as one of the top career opportunities in business? What frequently rates among the most popular majors on campus? What was the undergraduate degree chosen by Nike founder Phil Knight, Home Depot co-founder Arthur Blank, former acting director of the Federal Bureau of Investigation (FBI) Thomas Pickard, and numerous members of Congress? Accounting.¹ Why did these people choose accounting? They wanted to understand what was happening financially to their organizations. Accounting is the financial information system that provides these insights. In short, to understand your organization, you have to know the numbers.

Accounting consists of three basic activities—it identifies, records, and communicates the economic events of an organization to interested users. Let's take a closer look at these three activities.

Three Activities

As a starting point to the accounting process, a company identifies the economic events relevant to its business. Examples of economic events are the sale of snack chips by PepsiCo, the provision of telephone services by AT&T, and the payment of wages by Ford Motor Company.

Once a company like PepsiCo identifies economic events, it records those events in order to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in dollars and cents. In recording, PepsiCo also classifies and summarizes economic events.

Finally, PepsiCo communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. To make the reported financial information meaningful, PepsiCo reports the recorded data in a standardized way. It accumulates information resulting from similar transactions. For example, PepsiCo accumulates all sales transactions over a certain period of time and reports the data as one amount in the company's financial statements. Such data are said to be reported in the aggregate. By presenting the recorded data in the aggregate, the accounting process simplifies a multitude of transactions and makes a series of activities understandable and meaningful.

A vital element in communicating economic events is the accountant's ability to analyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Appendices A–E show the financial statements of Apple Inc., PepsiCo Inc., The Coca-Cola Company, Amazon.com, Inc., and Wal-Mart Stores, Inc., respectively. (In addition, in the A Look at IFRS section at the end of each chapter, the U.K. company Zetar plc is analyzed.) We refer to these statements at various places throughout the textbook. At this point, these financial statements probably strike you as complex and confusing. By the end of this course, you'll be surprised at your ability to understand, analyze, and interpret them.

Illustration 1-1 summarizes the activities of the accounting process.

Illustration 1-1
The activities of the accounting process

You should understand that the accounting process includes the bookkeeping function. Bookkeeping usually involves only the recording of economic events. It is therefore just one part of the accounting process. In total, accounting involves the entire process of identifying, recording, and communicating economic events.²

Essential terms are printed in blue when they first appear, and are defined in the end-of-chapter glossary.

Who Uses Accounting Data

The financial information that users need depends upon the kinds of decisions they make. There are two broad groups of users of financial information: internal users and external users.

INTERNAL USERS

Internal users of accounting information are managers who plan, organize, and run the business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, internal users must answer many important questions, as shown in Illustration 1-2.

Illustration 1-2
Questions that internal users ask

To answer these and other questions, internal users need detailed information on a timely basis. Managerial accounting provides internal reports to help users make decisions about their companies. Examples are financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year.

Accounting Across the Organization boxes demonstrate applications of accounting information in various business functions.

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 shares of a company. Creditors (such as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money. Illustration 1-3 shows some questions that investors and creditors may ask.

Illustration 1-3
Questions that external users ask

Financial accounting answers these questions. It provides economic and financial information for investors, creditors, and other external users. The information needs of external users vary considerably. Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with tax laws. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. Customers are interested in whether a company like General Motors will continue to honor product warranties and support its product lines. Labor unions such as the Major League Baseball Players Association want to know whether the owners have the ability to pay increased wages and benefits.

The Building Blocks of Accounting

A doctor follows certain standards in treating a patient's illness. An architect follows certain standards in designing a building. An accountant follows certain standards in reporting financial information. For these standards to work, a fundamental business concept must be at work—ethical behavior.

Ethics in Financial Reporting

People won't gamble in a casino if they think it is “rigged.” Similarly, people won't play the stock market if they think stock prices are rigged. In recent years, the financial press has been 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. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting.

United States regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting. In response, Congress passed the Sarbanes-Oxley Act (SOX). Its intent is 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.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

The standards of conduct by which actions are judged as right or wrong, honest or dishonest, fair or not fair, are ethics. Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations in business and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this textbook:

1. A number of the Feature Stories and other parts of the textbook discuss the central importance of ethical behavior to financial reporting.

2. Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings.

3. Many of the People, Planet, and Profit Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues.

4. At the end of the chapter, an Ethics Case simulates a business situation and asks you to put yourself in the position of a decision-maker in that case.

When analyzing these various ethics cases, as well as experiences in your own life, it is useful to apply the three steps outlined in Illustration 1-4.

Illustration 1-4
Steps in analyzing ethics cases and situations

Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Guideline answers are provided near the end of the chapter.

Generally Accepted Accounting Principles

The accounting profession has developed standards that are generally accepted and universally practiced. This common set of standards is called generally accepted accounting principles (GAAP). These standards indicate how to report economic events.

The primary accounting standard-setting body in the United States is the Financial Accounting Standards Board (FASB). 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 relies on the FASB to develop accounting standards, which public companies must follow. Many countries outside of the United States have adopted the accounting standards issued by the International Accounting Standards Board (IASB). These standards are called International Financial Reporting Standards (IFRS).

As markets become more global, it is often desirable to compare the results of companies from different countries that report using different accounting standards. In order to increase comparability, in recent years the two standard-setting bodies have made efforts to reduce the differences between U.S. GAAP and IFRS. This process is referred to as convergence. As a result of these convergence efforts, it is likely that someday there will be a single set of high-quality accounting standards that are used by companies around the world. Because convergence is such an important issue, we highlight any major differences between GAAP and IFRS in International Notes (as shown in the margin here) and provide a more in-depth discussion in the A Look at IRFS section at the end of each chapter.

International Notes highlight differences between U.S. and international accounting standards.

Measurement Principles

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. Relevance means that financial information is capable of making a difference in a decision. Faithful representation means that the numbers and descriptions match what really existed or happened—they are factual.

Helpful Hint Relevance and faithful representation are two primary qualities that make accounting information useful for decision-making.

Helpful Hints further clarify concepts being discussed.

HISTORICAL COST PRINCIPLE

The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased, but also over the time the asset is held. For example, if Best Buy purchases land for $300,000, the company initially reports it in its accounting records at $300,000. But what does Best Buy do if, by the end of the next year, the fair value of the land has increased to $400,000? Under the historical cost principle, it continues to report the land at $300,000.

FAIR VALUE PRINCIPLE

The fair value principle states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is usually readily available for these types of assets. In determining which measurement principle to use, companies weigh the factual nature of cost figures versus the relevance of fair value. In general, most companies choose to use cost. Only in situations where assets are actively traded, such as investment securities, do companies apply the fair value principle extensively.

Assumptions

Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary unit assumption and the economic entity assumption.

MONETARY UNIT ASSUMPTION

The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in money terms. This assumption enables accounting to quantify (measure) economic events. The monetary unit assumption is vital to applying the historical cost principle.

This assumption prevents the inclusion of some relevant information in the accounting records. For example, the health of a company's owner, the quality of service, and the morale of employees are not included. The reason: Companies cannot quantify this information in money terms. Though this information is important, companies record only events that can be measured in money.

ECONOMIC ENTITY ASSUMPTION

An economic entity can be any organization or unit in society. It may be a company (such as Crocs, Inc.), a governmental unit (the state of Ohio), a municipality (Seattle), a school district (St. Louis District 48), or a church (Southern Baptist). The economic entity assumption requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. To illustrate, Sally Rider, owner of Sally's Boutique, must keep her personal living costs separate from the expenses of the business. Similarly, McDonald's, Coca-Cola, and Cadbury-Schweppes are segregated into separate economic entities for accounting purposes.

PROPRIETORSHIP A business owned by one person is generally a proprietorship. The owner is often the manager/operator of the business. Small service-type businesses (plumbing companies, beauty salons, and auto repair shops), farms, and small retail stores (antique shops, clothing stores, and used-book stores) are often proprietorships. Usually only a relatively small amount of money (capital) is necessary to start in business as a proprietor-ship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable for all debts of the business. There is no legal distinction between the business as an economic unit and the owner, but the accounting records of the business activities are kept separate from the personal records and activities of the owner.

PARTNERSHIP A business owned by two or more persons associated as partners is a partnership. In most respects a partnership is like a proprietorship except that more than one owner is involved. Typically a partnership agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner. Each partner generally has unlimited personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes the partnership transactions must be kept separate from the personal activities of the partners. Partnerships are often used to organize retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants).

CORPORATION A business organized as a separate legal entity under state corporation law and having ownership divided into transferable shares of stock is a corporation. The holders of the shares (stockholders) enjoy limited liability; that is, they are not personally liable for the debts of the corporate entity. Stockholders may transfer all or part of their ownership shares to other investors at any time (i.e., sell their shares). The ease with which ownership can change adds to the attractiveness of investing in a corporation. Because ownership can be transferred without dissolving the corporation, the corporation enjoys an unlimited life.

Although the combined number of proprietorships and partnerships in the United States is more than five times the number of corporations, the revenue produced by corporations is eight times greater. Most of the largest companies in the United States—for example, ExxonMobil, Ford, Wal-Mart Stores, Inc., Citigroup, and Apple—are corporations.

The DO IT! exercises ask you to put newly acquired knowledge to work. They outline the Action Plan necessary to complete the exercise, and they show a Solution.

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The Basic Accounting Equation

The two basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. For example, Google has total assets of approximately $40.5 billion. Liabilities and owner's equity are the rights or claims against these resources. Thus, Google has $40.5 billion of claims against its $40.5 billion of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called owner's equity. Google has liabilities of $4.5 billion and owners’ equity of $36 billion.

We can express the relationship of assets, liabilities, and owner's equity as an equation, as shown in Illustration 1-5.

Illustration 1-5
The basic accounting equation

This relationship is the basic accounting equation. Assets must equal the sum of liabilities and owner's equity. Liabilities appear before owner's equity in the basic accounting equation because they are paid first if a business is liquidated.

The accounting equation applies to all economic entities regardless of size, nature of business, or form of business organization. It applies to a small proprietorship such as a corner grocery store as well as to a giant corporation such as PepsiCo. The equation provides the underlying framework for recording and summarizing economic events.

Let's look in more detail at the categories in the basic accounting equation.

Assets

As noted above, assets are resources a business owns. The business uses its assets in carrying out such activities as production and sales. The common characteristic possessed by all assets is the capacity to provide future services or benefits. In a business, that service potential or future economic benefit eventually results in cash inflows (receipts). For example, consider Campus Pizza, a local restaurant. It owns a delivery truck that provides economic benefits from delivering pizzas. Other assets of Campus Pizza are tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash.

Liabilities

Liabilities are claims against assets—that is, existing debts and obligations. Businesses of all sizes usually borrow money and purchase merchandise on credit. These economic activities result in payables of various sorts:

• Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages on credit from suppliers. These obligations are called accounts payable.
• Campus Pizza also has a note payable to First National Bank for the money borrowed to purchase the delivery truck.
• Campus Pizza may also have salaries and wages payable to employees and sales and real estate taxes payable to the local government.

All of these persons or entities to whom Campus Pizza owes money are its creditors.

Creditors may legally force the liquidation of a business that does not pay its debts. In that case, the law requires that creditor claims be paid before ownership claims.

Owner's Equity

The ownership claim on total assets is owner's equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are claimed by either creditors or owners. To find out what belongs to owners, we subtract the creditors’ claims (the liabilities) from assets. The remainder is the owner's claim on the assets—the owner's equity. Since the claims of creditors must be paid before ownership claims, owner's equity is often referred to as residual equity.

Helpful Hint In some places, we use the term ”owner's equity” and in others we use ”owners’ equity.” Owner's (singular, possessive) refers to one owner (the case with a sole proprietorship). Owners’ (plural, possessive) refers to multiple owners (the case with partnerships or corporations).

INCREASES IN OWNER's EQUITY

In a proprietorship, owner's investments and revenues increase owner's equity.

INVESTMENTS BY OWNER Investments by owner are the assets the owner puts into the business. These investments increase owner's equity. They are recorded in a category called owner's capital.

REVENUES Revenues are the gross increase in owner's equity resulting from business activities entered into for the purpose of earning income. Generally, revenues result from selling merchandise, performing services, renting property, and lending money. Common sources of revenue are sales, fees, services, commissions, interest, dividends, royalties, and rent.

Revenues usually result in an increase in an asset. They may arise from different sources and are called various names depending on the nature of the business. Campus Pizza, for instance, has two categories of sales revenues—pizza sales and beverage sales.

DECREASES IN OWNER's EQUITY

In a proprietorship, owner's drawings and expenses decrease owner's equity.

DRAWINGS An owner may withdraw cash or other assets for personal use. We use a separate classification called drawings to determine the total withdrawals for each accounting period. Drawings decrease owner's equity. They are recorded in a category called owner's drawings.

EXPENSES Expenses are the cost of assets consumed or services used in the process of earning revenue. They are decreases in owner's equity that result from operating the business. For example, Campus Pizza recognizes the following expenses: cost of ingredients (meat, flour, cheese, tomato paste, mushrooms, etc.); cost of beverages; salaries and wages expense; utilities expense (electric, gas, and water expense); delivery expense (gasoline, repairs, licenses, etc.); supplies expense (napkins, detergents, aprons, etc.); rent expense; interest expense; and property tax expense.

In summary, owner's equity is increased by an owner's investments and by revenues from business operations. Owner's equity is decreased by an owner's withdrawals of assets and by expenses. Illustration 1-6 expands the basic accounting equation by showing the items that comprise owner's equity. This format is referred to as the expanded accounting equation.

Illustration 1-6
Expanded accounting equation

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Using the Accounting Equation

Transactions (business transactions) are a business's economic events recorded by accountants. Transactions may be external or internal. External transactions involve economic events between the company and some outside enterprise. For example, Campus Pizza's purchase of cooking equipment from a supplier, payment of monthly rent to the landlord, and sale of pizzas to customers are external transactions. Internal transactions are economic events that occur entirely within one company. The use of cooking and cleaning supplies are internal transactions for Campus Pizza.

Companies carry on many activities that do not represent business transactions. Examples are hiring employees, answering the telephone, talking with customers, and placing merchandise orders. Some of these activities may lead to business transactions: Employees will earn wages, and suppliers will deliver ordered merchandise. The company must analyze each event to find out if it affects the components of the accounting equation. If it does, the company will record the transaction. Illustration 1-7 demonstrates the transaction identification process.

Illustration 1-7
Transaction identification process

Each transaction must have a dual effect on the accounting equation. For example, if an asset is increased, there must be a corresponding (1) decrease in another asset, (2) increase in a specific liability, or (3) increase in owner's equity.

Two or more items could be affected. For example, as one asset is increased $10,000, another asset could decrease $6,000 and a liability could increase $4,000. Any change in a liability or ownership claim is subject to similar analysis.

Transaction Analysis

To demonstrate how to analyze transactions in terms of the accounting equation, we will review the business activities of Softbyte, a computer programming business. The following business transactions occur during Softbyte's first month of operations.

TRANSACTION (1). INVESTMENT BY OWNER Ray Neal decides to open a computer programming service which he names Softbyte. On September 1, 2014, he invests $15,000 cash in the business. This transaction results in an equal increase in assets and owner's equity.

Helpful Hint You will want to study these transactions until you are sure you understand them. They are not difficult, but understanding them is important to your success in this course. The ability to analyze transactions in terms of the basic accounting equation is essential in accounting.

Observe that the equality of the accounting equation has been maintained. Note that the investments by the owner do not represent revenues, and they are excluded in determining net income. Therefore, it is necessary to make clear that the increase is an investment (increasing Owner's Capital) rather than revenue.

TRANSACTION (2). PURCHASE OF EQUIPMENT FOR CASH Softbyte purchases computer equipment for $7,000 cash. This transaction results in an equal increase and decrease in total assets, though the composition of assets changes.

Observe that total assets are still $15,000. Owner's equity also remains at $15,000, the amount of Ray Neal's original investment.

TRANSACTION (3). PURCHASE OF SUPPLIES ON CREDIT Softbyte purchases for $1,600 from Acme Supply Company computer paper and other supplies expected to last several months. Acme agrees to allow Softbyte to pay this bill in October. This transaction is a purchase on account (a credit purchase). Assets increase because of the expected future benefits of using the paper and supplies, and liabilities increase by the amount due to Acme Company.

Total assets are now $16,600. This total is matched by a $1,600 creditor's claim and a $15,000 ownership claim.

TRANSACTION (4). SERVICES PERFORMED FOR CASH Softbyte receives $1,200 cash from customers for programming services it has performed. This transaction represents Softbyte's principal revenue-producing activity. Recall that revenue increases owner's equity.

The two sides of the equation balance at $17,800. Service Revenue is included in determining Softbyte's net income.

Note that we do not have room to give details for each individual revenue and expense account in this illustration. Thus, revenues (and expenses when we get to them) are summarized under one column heading for Revenues and one for Expenses. However, it is important to keep track of the category (account) titles affected (e.g., Service Revenue) as they will be needed when we prepare financial statements later in the chapter.

TRANSACTION (5). PURCHASE OF ADVERTISING ON CREDIT Softbyte receives a bill for $250 from the Daily News for advertising but postpones payment until a later date. This transaction results in an increase in liabilities and a decrease in owner's equity.

The two sides of the equation still balance at $17,800. Owner's equity decreases when Softbyte incurs the expense. Expenses are not always paid in cash at the time they are incurred. When Softbyte pays at a later date, the liability Accounts Payable will decrease, and the asset Cash will decrease [see Transaction (8)]. The cost of advertising is an expense (rather than an asset) because the company has used the benefits. Advertising Expense is included in determining net income.

TRANSACTION (6). SERVICES PERFORMED FOR CASH AND CREDIT Softbyte performs $3,500 of programming services for customers. The company receives cash of $1,500 from customers, and it bills the balance of $2,000 on account. This transaction results in an equal increase in assets and owner's equity.

Softbyte recognizes $3,500 in revenue when it performs the service. In exchange for this service, it received $1,500 in Cash and Accounts Receivable of $2,000. This Accounts Receivable represents customers’ promises to pay $2,000 to Softbyte in the future. When it later receives collections on account, Softbyte will increase Cash and will decrease Accounts Receivable [see Transaction (9)].

TRANSACTION (7). PAYMENT OF EXPENSES Softbyte pays the following expenses in cash for September: store rent $600, salaries and wages of employees $900, and utilities $200. These payments result in an equal decrease in assets and owner's equity.

The two sides of the equation now balance at $19,600. Three lines in the analysis indicate the different types of expenses that have been incurred.

TRANSACTION (8). PAYMENT OF ACCOUNTS PAYABLE Softbyte pays its $250 Daily News bill in cash. The company previously [in Transaction (5)] recorded the bill as an increase in Accounts Payable and a decrease in owner's equity.

Observe that the payment of a liability related to an expense that has previously been recorded does not affect owner's equity. The company recorded this expense in Transaction (5) and should not record it again.

TRANSACTION (9). RECEIPT OF CASH ON ACCOUNT Softbyte receives $600 in cash from customers who had been billed for services [in Transaction (6)]. Transaction (9) does not change total assets, but it changes the composition of those assets.

Note that the collection of an account receivable for services previously billed and recorded does not affect owner's equity. Softbyte already recorded this revenue in Transaction (6) and should not record it again.

TRANSACTION (10). WITHDRAWAL OF CASH BY OWNER Ray Neal withdraws $1,300 in cash from the business for his personal use. This transaction results in an equal decrease in assets and owner's equity.

Observe that the effect of a cash withdrawal by the owner is the opposite of the effect of an investment by the owner. Owner's drawings are not expenses. Expenses are incurred for the purpose of earning revenue. Drawings do not generate revenue. They are a disinvestment. Like owner's investment, the company excludes owner's drawings in determining net income.

Summary of Transactions

Illustration 1-8 summarizes the September transactions of Softbyte to show their cumulative effect on the basic accounting equation. It also indicates the transaction number and the specific effects of each transaction.

Illustration 1-8
Tabular summary of Softbyte transactions

Illustration 1-8 demonstrates some significant facts:

1. Each transaction is analyzed in terms of its effect on:

(a) The three components of the basic accounting equation.

(b) Specific items within each component.

2. The two sides of the equation must always be equal.

There! You made it through your first transaction analysis. If you feel a bit shaky on any of the transactions, it might be a good idea at this point to get up, take a short break, and come back again for a 10- to 15-minute review of the transactions, to make sure you understand them before you go on to the next section.

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Financial Statements

Companies prepare four financial statements from the summarized accounting data:

1. An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time.

2. An owner's equity statement summarizes the changes in owner's equity for a specific period of time.

3. A balance sheet reports the assets, liabilities, and owner's equity at a specific date.

4. A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.

These statements provide relevant financial data for internal and external users. Illustration 1-9 (page 22) shows the financial statements of Softbyte.

Illustration 1-9
Financial statements and their interrelationships

Helpful Hint The heading of each statement identifies the company, the type of statement, and the specific date or time period covered by the statement.

Helpful Hint Note that final sums are double-underlined, and negative amounts (in the statement of cash flows) are presented in parentheses.

Helpful Hint The arrows in this illustration show the interrelationships of the four financial statements.
1. Net income is computed first and is needed to determine the ending balance in owner's equity.
2. The ending balance in owner's equity is needed in preparing the balance sheet.
3. The cash shown on the balance sheet is needed in preparing the statement of cash flows.

Note that the statements shown in Illustration 1-9 are interrelated:

1. Net income of $2,750 on the income statement is added to the beginning balance of owner's capital in the owner's equity statement.

2. Owner's capital of $16,450 at the end of the reporting period shown in the owner's equity statement is reported on the balance sheet.

3. Cash of $8,050 on the balance sheet is reported on the statement of cash flows.

Also, explanatory notes and supporting schedules are an integral part of every set of financial statements. We illustrate these notes and schedules in later chapters of this textbook.

Be sure to carefully examine the format and content of each statement in Illustration 1-9. We describe the essential features of each in the following sections.

Helpful Hint The income statement, owner's equity statement, and statement of cash flows are all for a period of time, whereas the balance sheet is for a point in time.

Income Statement

The income statement reports the revenues and expenses for a specific period of time. (In Softbyte's case, this is “For the Month Ended September 30, 2014.”) Softbyte's income statement is prepared from the data appearing in the owner's equity columns of Illustration 1-8 (page 20).

The income statement lists revenues first, followed by expenses. Finally the statement shows net income (or net loss). Net income results when revenues exceed expenses. A net loss occurs when expenses exceed revenues.

Although practice varies, we have chosen in our illustrations and homework solutions to list expenses in order of magnitude. (We will consider alternative formats for the income statement in later chapters.)

Note that the income statement does not include investment and withdrawal transactions between the owner and the business in measuring net income. For example, as explained earlier, Ray Neal's withdrawal of cash from Softbyte was not regarded as a business expense.

Alternative Terminology The income statement is sometimes referred to as the statement of operations, earnings statement, or profit and loss statement.

Alternative Terminology notes introduce other terms you might hear or read.

Owner's Equity Statement

The owner's equity statement reports the changes in owner's equity for a specific period of time. The time period is the same as that covered by the income statement. Data for the preparation of the owner's equity statement come from the owner's equity columns of the tabular summary (Illustration 1-8) and from the income statement. The first line of the statement shows the beginning owner's equity amount (which was zero at the start of the business). Then come the owner's investments, net income (or loss), and the owner's drawings. This statement indicates why owner's equity has increased or decreased during the period.

What if Softbyte had reported a net loss in its first month? Let's assume that during the month of September 2014, Softbyte lost $10,000. Illustration 1-10 shows the presentation of a net loss in the owner's equity statement.

Illustration 1-10
Presentation of net loss

If the owner makes any additional investments, the company reports them in the owner's equity statement as investments.

Balance Sheet

Softbyte's balance sheet reports the assets, liabilities, and owner's equity at a specific date (in Softbyte's case, September 30, 2014). The company prepares the balance sheet from the column headings of the tabular summary (Illustration 1-8) and the month-end data shown in its last line.

Observe that the balance sheet lists assets at the top, followed by liabilities and owner's equity. Total assets must equal total liabilities and owner's equity. Softbyte reports only one liability—accounts payable—in its balance sheet. In most cases, there will be more than one liability. When two or more liabilities are involved, a customary way of listing is as follows.

Illustration 1-11
Presentation of liabilities

The balance sheet is a snapshot of the company's financial condition at a specific moment in time (usually the month-end or year-end).

Statement of Cash Flows

The statement of cash flows provides information on the cash receipts and payments for a specific period of time. The statement of cash flows reports (1) the cash effects of a company's operations during a period, (2) its investing activities, (3) its financing activities, (4) the net increase or decrease in cash during the period, and (5) the cash amount at the end of the period.

Reporting the sources, uses, and change in cash is useful because investors, creditors, and others want to know what is happening to a company's most liquid resource. The statement of cash flows provides answers to the following simple but important questions.

1. Where did cash come from during the period?

2. What was cash used for during the period?

3. What was the change in the cash balance during the period?

As shown in Softbyte's statement of cash flows, cash increased $8,050 during the period. Net cash provided by operating activities increased cash $1,350. Cash flow from investing activities decreased cash $7,000. And cash flow from financing activities increased cash $13,700. At this time, you need not be concerned with how these amounts are determined. Chapter 17 will examine the statement of cash flows in detail.

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Comprehensive DO IT!

SUMMARY OF LEARNING OBJECTIVES

1 Explain what accounting is. Accounting is an information system that identifies, records, and communicates the economic events of an organization to interested users.

2 Identify the users and uses of accounting. The major users and uses of accounting are as follows. (a) Management uses accounting information to plan, organize, and run the business. (b) Investors (owners) decide whether to buy, hold, or sell their financial interests on the basis of accounting data. (c) Creditors (suppliers and bankers) evaluate the risks of granting credit or lending money on the basis of accounting information. Other groups that use accounting information are taxing authorities, regulatory agencies, customers, and labor unions.

3 Understand why ethics is a fundamental business concept. Ethics are the standards of conduct by which actions are judged as right or wrong. Effective financial reporting depends on sound ethical behavior.

4 Explain generally accepted accounting principles. Generally accepted accounting principles are a common set of standards used by accountants.

5 Explain the monetary unit assumption and the economic entity assumption. The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption requires that the activities of each economic entity be kept separate from the activities of its owner(s) and other economic entities.

6 State the accounting equation, and define its components. The basic accounting equation is:

Assets = Liabilities + Owner's Equity

Assets are resources a business owns. Liabilities are creditorship claims on total assets. Owner's equity is the ownership claim on total assets.

     The expanded accounting equation is:

Owner's capital is assets the owner puts into the business. Owner's drawings are the assets the owner withdraws for personal use. Revenues are increases in assets resulting from income-earning activities. Expenses are the costs of assets consumed or services used in the process of earning revenue.

7 Analyze the effects of business transactions on the accounting equation. Each business transaction must have a dual effect on the accounting equation. For example, if an individual asset increases, there must be a corresponding (1) decrease in another asset, or (2) increase in a specific liability, or (3) increase in owner's equity.

8 Understand the four financial statements and how they are prepared. An income statement presents the revenues and expenses, and resulting net income or net loss, for a specific period of time. An owner's equity statement summarizes the changes in owner's equity for a specific period of time. A balance sheet reports the assets, liabilities, and owner's equity at a specific date. A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.

GLOSSARY

Accounting The information system that identifies, records, and communicates the economic events of an organization to interested users. (p. 4).

Assets Resources a business owns. (p. 13).

Balance sheet A financial statement that reports the assets, liabilities, and owner's equity at a specific date. (p. 21).

Basic accounting equation Assets = Liabilities + Owner's Equity. (p. 13).

Bookkeeping A part of accounting that involves only the recording of economic events. (p. 5).

Convergence The process of reducing the differences between U.S. GAAP and IFRS. (p. 9).

Corporation A business organized as a separate legal entity under state corporation law, having ownership divided into transferable shares of stock. (p. 11).

Drawings Withdrawal of cash or other assets from an unincorporated business for the personal use of the owner(s). (p. 14).

Economic entity assumption An assumption that requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. (p. 10).

Ethics The standards of conduct by which one's actions are judged as right or wrong, honest or dishonest, fair or not fair. (p. 7).

Expanded accounting equation Assets = Liabilities + Owner's Capital – Owner's Drawings + Revenues − Expenses. (p. 14).

Expenses The cost of assets consumed or services used in the process of earning revenue. (p. 14).

Fair value principle An accounting principle stating that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). (p. 9).

Faithful representation Numbers and descriptions match what really existed or happened—they are factual. (p. 9).

Financial accounting The field of accounting that provides economic and financial information for investors, creditors, and other external users. (p. 6).

Financial Accounting Standards Board (FASB) A private organization that establishes generally accepted accounting principles in the United States (GAAP). (p. 9).

Generally accepted accounting principles (GAAP) Common standards that indicate how to report economic events. (p. 8).

Historical cost principle An accounting principle that states that companies should record assets at their cost. (p. 9).

Income statement A financial statement that presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time. (p. 21).

International Accounting Standards Board (IASB) An accounting standard-setting body that issues standards adopted by many countries outside of the United States. (p. 9).

International Financial Reporting Standards (IFRS) International accounting standards set by the International Accounting Standards Board (IASB). (p. 9).

Investments by owner The assets an owner puts into the business. (p. 13).

Liabilities Creditor claims against total assets. (p. 13).

Managerial accounting The field of accounting that provides internal reports to help users make decisions about their companies. (p. 6).

Monetary unit assumption An assumption stating that companies include in the accounting records only transaction data that can be expressed in terms of money. (p. 10).

Net income The amount by which revenues exceed expenses. (p. 23).

Net loss The amount by which expenses exceed revenues. (p. 23).

Owner's equity The ownership claim on total assets. (p. 13).

Owner's equity statement A financial statement that summarizes the changes in owner's equity for a specific period of time. (p. 21).

Partnership A business owned by two or more persons associated as partners. (p. 11).

Proprietorship A business owned by one person. (p. 10).

Relevance Financial information that is capable of making a difference in a decision. (p. 9).

Revenues The gross increase in owner's equity resulting from business activities entered into for the purpose of earning income. (p. 13).

Sarbanes-Oxley Act (SOX) Law passed by Congress intended to reduce unethical corporate behavior. (p. 7).

Securities and Exchange Commission (SEC) A governmental agency that oversees U.S. financial markets and accounting standard-setting bodies. (p. 9).

Statement of cash flows A financial statement that summarizes information about the cash inflows (receipts) and cash outflows (payments) for a specific period of time. (p. 21).

Transactions The economic events of a business that are recorded by accountants. (p. 15).

APPENDIX 1A   Accounting Career Opportunities

Why is accounting such a popular major and career choice? First, there are a lot of jobs. In many cities in recent years, the demand for accountants exceeded the supply. Not only are there a lot of jobs, but there are a wide array of opportunities. As one accounting organization observed, “accounting is one degree with 360 degrees of opportunity.”

Accounting is also hot because it is obvious that accounting matters. Interest in accounting has increased, ironically, because of the attention caused by the accounting failures of companies such as Enron and WorldCom. These widely publicized scandals revealed the important role that accounting plays in society. Most people want to make a difference, and an accounting career provides many opportunities to contribute to society. Finally, the Sarbanes-Oxley Act (SOX) (see page 7) significantly increased the accounting and internal control requirements for corporations. This dramatically increased demand for professionals with accounting training.

Accountants are in such demand that it is not uncommon for accounting students to have accepted a job offer a year before graduation. As the following discussion reveals, the job options of people with accounting degrees are virtually unlimited.

Public Accounting

Individuals in public accounting offer expert service to the general public, in much the same way that doctors serve patients and lawyers serve clients. A major portion of public accounting involves auditing. In auditing, a certified public accountant (CPA) examines company financial statements and provides an opinion as to how accurately the financial statements present the company's results and financial position. Analysts, investors, and creditors rely heavily on these “audit opinions,” which CPAs have the exclusive authority to issue.

Taxation is another major area of public accounting. The work that tax specialists perform includes tax advice and planning, preparing tax returns, and representing clients before governmental agencies such as the Internal Revenue Service.

A third area in public accounting is management consulting. It ranges from installing basic accounting software or highly complex enterprise resource planning systems, to performing support services for major marketing projects and merger and acquisition activities.

Many CPAs are entrepreneurs. They form small- or medium-sized practices that frequently specialize in tax or consulting services.

Private Accounting

Instead of working in public accounting, you might choose to be an employee of a for-profit company such as Starbucks, Google, or PepsiCo. In private (or managerial) accounting, you would be involved in activities such as cost accounting (finding the cost of producing specific products), budgeting, accounting information system design and support, and tax planning and preparation. You might also be a member of your company's internal audit team. In response to SOX, the internal auditors’ job of reviewing the company's operations to ensure compliance with company policies and to increase efficiency has taken on increased importance.

Alternatively, many accountants work for not-for-profit organizations such as the Red Cross or the Bill and Melinda Gates Foundation, or for museums, libraries, or performing arts organizations.

Governmental Accounting

Another option is to pursue one of the many accounting opportunities in governmental agencies. For example, the Internal Revenue Service (IRS), Federal Bureau of Investigation (FBI), and the Securities and Exchange Commission (SEC) all employ accountants. The FBI has a stated goal that at least 15 percent of its new agents should be CPAs. There is also a very high demand for accounting educators at public colleges and universities and in state and local governments.

Forensic Accounting

Forensic accounting uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud. It is listed among the top 20 career paths of the future. The job of forensic accountants is to catch the perpetrators of the estimated $600 billion per year of theft and fraud occurring at U.S. companies. This includes tracing money-laundering and identity-theft activities as well as tax evasion. Insurance companies hire forensic accountants to detect frauds such as arson, and law offices employ forensic accountants to identify marital assets in divorces. Forensic accountants often have FBI, IRS, or similar government experience.

“Show Me the Money”

How much can a new accountant make? Take a look at the average salaries for college graduates in public and private accounting. Keep in mind if you also have a CPA license, you'll make 10–15% more when you start out.

Illustration 1A-1
Salary estimates for jobs in public and corporate accounting

Serious earning potential over time gives CPAs great job security. Here are some examples of upper-level salaries for managers in corporate accounting. Note that geographic region, experience, education, CPA certification, and company size each play a role in determining salary.

Illustration 1A-2
Upper-level management salaries in corporate accounting

For up-to-date salary estimates, as well as a wealth of additional information regarding accounting as a career, check out www.startheregoplaces.com.