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? Accounting.¹ Why do people choose accounting? They want to acquire the skills needed to understand what is happening financially inside a company. Accounting is the financial information system that provides these insights. In short, to understand an organization of any type, you have to know the numbers.

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

Accounting consists of three basic activities—it identifies, records, and communicates the economic events of an organization to interested users. Let's take a c loser 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 food and snacks by Unilever (GBR and NLD), the providing of telephone services by Chunghwa Telecom (TWN), and the manufacture of motor vehicles by Tata Motors (IND).

Once a company like Unilever 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 monetary units. In recording, Unilever also classifies and summarizes economic events.

Finally, Unilever 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, Unilever reports the recorded data in a standardized way. It accumulates information resulting from similar transactions. For example, Unilever 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. Appendix A of this textbook shows the financial statements of Samsung Electronics (KOR). Appendix B illustrates the financial statements of Nestlé (CHE), and Appendix C includes the financial statements of Zetar (GBR). We refer to these statements at various places throughout the textbook. (In addition, in the Another Perspective section at the end of each chapter, the U.S. company Tootsie Roll Industries is analyzed.) 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

Who Uses Accounting Data?

The specific financial information that a user needs depends upon the kinds of decisions the user makes. 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.

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 make decisions 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 State Administration of Taxation in the People's Republic of China (CHN), want to know whether the company complies with tax laws. Regulatory agencies, such as the Autorité des Marchés Financiers (FRA) or the Federal Trade Commission (USA), want to know whether the company is operating within prescribed rules. Customers are interested in whether a company like General Motors (USA) will continue to honor product warranties and support its product lines. Labor unions, such as the German Confederation of Trade Unions (DEU), want to know whether the companies have the ability to pay increased wages and benefits to union members.

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 securities market if they think share prices are rigged. In recent years, the financial press has been full of articles about financial scandals at Enron (USA), Parmalat (ITA), Satyam Computer Services (IND), AIG (USA), and others. As the scandals came to light, mistrust of financial reporting in general grew. One article in the financial press noted that “repeated disclosures about questionable accounting practices have bruised investors' faith in the reliability of earnings reports, which in turn has sent share 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.

The standards of conduct by which one's 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 book:

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

Insights provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility.

Accounting Standards

In order to ensure high-quality financial reporting, accountants present financial statements in conformity with accounting standards that are issued by standard-setting bodies. Presently, there are two primary accounting standard-setting bodies—the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). More than 130 countries follow standards referred to as International Financial Reporting Standards (IFRS). IFRSs are determined by the IASB. The IASB is headquartered in London, with its 15 board members drawn from around the world. Most companies in the United States follow standards issued by the FASB, referred to as generally accepted accounting principles (GAAP).

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 IFRS and U.S. GAAP. 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 provide at the end of each chapter a section called Another Perspective, to provide a comparison with IFRS.

Measurement Principles

IFRS 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 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 Gazprom (RUS) purchases land for 300,000, the company initially reports it in its accounting records at 300,000. But what does Gazprom 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 value 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, even though IFRS allows companies to revalue property, plant, and equipment and other long-lived assets to fair value, 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. Throughout this textbook, we use a variety of currencies in our examples and end-of-chapter materials. The currencies and the associated country or region are shown in Illustration 1-5.

Illustration 1-5 Currencies used in this textbook

ECONOMIC ENTITY ASSUMPTION

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

An economic entity can be any organization or unit in society. It may be a company [such as Telefónica (ESP)], a governmental unit (the city-state of Singapore), a municipality (Toronto, Canada), 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 boutique. Similarly, Metro (DEU) and Coca-Cola (USA) 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 proprietorship. 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 chartered public accountants).

CORPORATION A business organized as a separate legal entity under corporation law and having ownership divided into transferable shares is a corporation. The holders of the shares (shareholders) enjoy limited liability; that is, they are not personally liable for the debts of the corporate entity. Shareholders 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 world significantly exceeds the number of corporations, the revenue produced by corporations is much greater. Most of the largest companies in the world—for example, ING (NLD), Royal Dutch Shell (GBR and NLD), Wal-Mart Stores Inc. (USA), Fortis (BEL), and Toyota (JPN)—are corporations.

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, adidas (DEU) has total assets of approximately €10.6 billion. Liabilities and owner's equity are the rights or claims against these resources. Thus, adidas has €10.6 billion of claims against its €10.6 billion of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called equity. adidas has liabilities of €6.0 billion and equity of €4.6 billion.

We can express the relationship of assets, liabilities, and equity as an equation, as shown in Illustration 1-6.

Illustration 1-6 The basic accounting equation

This relationship is the basic accounting equation. Assets must equal the sum of liabilities and equity.

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 adidas. 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.

Equity

The ownership claim on total assets is equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are claimed by either creditors or shareholders. To find out what belongs to shareholders, we subtract creditors' claims (the liabilities) from the assets. The remainder is the shareholders' claim on the assets—equity. It is often referred to as residual equity—that is, the equity “left over” after creditors' claims are satisfied.

Equity generally consists of (1) share capital—ordinary and (2) retained earnings.

SHARE CAPITAL—ORDINARY

A corporation may obtain funds by selling ordinary shares to investors. Share capital—ordinary is the term used to describe the amounts paid in by shareholders for the ordinary shares they purchase.

RETAINED EARNINGS

Retained earnings is determined by three items: revenues, expenses, and dividends.

REVENUES Revenues are the gross increases in 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.

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. Other titles for and sources of revenue common to many businesses are sales, fees, services, commissions, interest, dividends, royalties, and rent.

EXPENSES Expenses are the cost of assets consumed or services used in the process of earning revenue. They are decreases in equity that result from operating the business. Like revenues, expenses take many forms and are called various names depending on the type of asset consumed or service used. For example, Campus Pizza recognizes the following types of expenses: cost of ingredients (flour, cheese, tomato paste, meat, mushrooms, etc.); cost of beverages; wages expense; utilities expense (electric, gas, and water expense); telephone expense; delivery expense (gasoline, repairs, licenses, etc.); supplies expense (napkins, detergents, aprons, etc.); rent expense; interest expense; and property tax expense.

DIVIDENDS Net income represents an increase in net assets which is then available to distribute to shareholders. The distribution of cash or other assets to shareholders is called a dividend. Dividends reduce retained earnings. However, dividends are not an expense. A corporation first determines its revenues and expenses and then computes net income or net loss. If it has net income, and decides it has no better use for that income, a corporation may decide to distribute a dividend to its owners (the shareholders).

In summary, the principal sources (increases) of equity are investments by shareholders and revenues from business operations. In contrast, reductions (decreases) in equity result from expenses and dividends. These relationships are shown in Illustration 1-7 (page 14).

Illustration 1-7 Increases and decreases in equity

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 1-8 demonstrates the transaction-identification process.

Illustration 1-8 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 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

In order to analyze transactions, we will examine a computer programming business (Softbyte Inc.) during its first month of operations. As part of this analysis, we will expand the basic accounting equation. This will allow us to better illustrate the impact of transactions on equity. Recall that equity is comprised of two parts: share capital—ordinary and retained earnings. Share capital—ordinary is affected when the company issues new ordinary shares in exchange for cash. Retained earnings is affected when the company earns revenue, incurs expenses, or pays dividends. Illustration 1-9 (page 16) shows the expanded accounting equation.

If you are tempted to skip ahead after you've read a few of the following transaction analyses, don't do it. Each has something unique to teach, something you'll need later. (We assure you that we've kept them to the minimum needed!)

Illustration 1-9 Expanded accounting equation

TRANSACTION 1. INVESTMENT BY SHAREHOLDERS Ray and Barbara Neal decide to open a computer programming company that they incorporate as Softbyte Inc. On September 1, 2014, they invest €15,000 cash in the business in exchange for €15,000 of ordinary shares. The ordinary shares indicates the ownership interest that the Neals have in Softbyte Inc. This transaction results in an equal increase in both assets and equity.³

Observe that the equality of the basic equation has been maintained. Note also that the source of the increase in equity (in this case, issued shares) is indicated. Why does this matter? Because investments by shareholders 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 rather than revenue from operations. Additional investments (i.e., investments made by shareholders after the corporation has been initially formed) have the same effect on equity as the initial investment.

TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte Inc. 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. Share Capital—Ordinary also remains at €15,000, the amount of the original investment.

TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte Inc. 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 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 PROVIDED FOR CASH Softbyte Inc. receives €1,200 cash from customers for programming services it has provided. This transaction represents Softbyte's principal revenue-producing activity. Recall that revenue increases 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 equity.

The two sides of the equation still balance at €17,800. Retained Earnings decreases when Softbyte incurs the expense. Expenses do not have to be 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 Softbyte has used the benefits. Advertising Expense is included in determining net income.

TRANSACTION 6. SERVICES PROVIDED FOR CASH AND CREDIT Softbyte Inc. provides €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 equity.

Softbyte earns revenues when it provides the service, and therefore it recognizes €3,500 in revenue. In exchange for this service, it received €1,500 in Cash and Accounts Receivable of €2,000. This Accounts Receivable represents customers' promise 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 expenses.

The two sides of the equation now balance at €19,600. Three lines are required in the analysis to 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 equity.

Observe that the payment of a liability related to an expense that has previously been recorded does not affect equity. Softbyte recorded the 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). This transaction 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 equity. Softbyte already recorded this revenue (in Transaction 6) and should not record it again.

TRANSACTION 10. DIVIDENDS The corporation pays a dividend of €1,300 in cash to Ray and Barbara Neal, the shareholders of Softbyte Inc. This transaction results in an equal decrease in assets and equity.

Note that the dividend reduces retained earnings, which is part of equity. Dividends are not expenses. Like shareholders' investments, dividends are excluded in determining net income.

Summary of Transactions

Illustration 1-10 summarizes the September transactions of Softbyte Inc. to show their cumulative effect on the basic accounting equation. It also indicates the transaction number and the specific effects of each transaction. Finally, Illustration 1-10 demonstrates a number of significant facts:

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

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

   (b) Specific types (kinds) of items within each component.

2. The two sides of the equation must always be equal.
3. The Share Capital—Ordinary and Retained Earnings columns indicate the causes of each change in the shareholders' claim on assets.

Illustration 1-10 Tabular summary of Softbyte Inc. transactions

There! You made it through 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 brief (10- to 15-minute) review of the transactions, to make sure you understand them before you go on to the next section.

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. A retained earnings statement summarizes the changes in retained earnings for a specific period of time.
3. A statement of financial position (sometimes referred to as a balance sheet) reports the assets, liabilities, and equity of a company 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 1-11 shows the financial statements of Softbyte Inc. Note that the statements shown in Illustration 1-11 are interrelated:

1. Net income of €2,750 on the income statement is added to the beginning balance of retained earnings in the retained earnings statement.
2. Retained earnings of €1,450 at the end of the reporting period shown in the retained earnings statement is reported on the statement of financial position.
3. Cash of €8,050 on the statement of financial position 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 1-11. We describe the essential features of each in the following sections.

Income Statement

The income statement reports the success or profitability of the company's operations over a specific period of time. For example, Softbyte Inc.'s income statement is dated “For the Month Ended September 30, 2014.” It is prepared from the data appearing in the revenue and expense columns of Illustration 1-10 (page 21). The heading of the statement identifies the company, the type of statement, and the time period covered by the statement.

The income statement lists revenues first, followed by expenses. Finally, the statement shows net income (or net loss). When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.

Alternative Terminology notes present synonymous terms that you may come across in practice.

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

Note that the income statement does not include investment and dividend transactions between the shareholders and the business in measuring net income. For example, as explained earlier, the cash dividend from Softbyte Inc. was not regarded as a business expense. This type of transaction is considered a reduction of retained earnings, which causes a decrease in equity.

Retained Earnings Statement

Softbyte Inc.'s retained earnings statement reports the changes in retained earnings for a specific period of time. The time period is the same as that covered by the income statement (“For the Month Ended September 30, 2014”). Data for the preparation of the retained earnings statement come from the retained earnings columns of the tabular summary (Illustration 1-10) and from the income statement (Illustration 1-11).

Illustration 1-11 Financial statements and their interrelationships

The first line of the statement shows the beginning retained earnings amount. Then come net income and dividends. The retained earnings ending balance is the final amount on the statement. The information provided by this statement indicates the reasons why retained earnings increased or decreased during the period. If there is a net loss, it is deducted with dividends in the retained earnings statement.

Statement of Financial Position

Softbyte Inc.'s statement of financial position reports the assets, liabilities, and equity at a specific date (September 30, 2014). The company prepares the statement of financial position from the column headings and the month-end data shown in the last line of the tabular summary (Illustration 1-10).

Observe that the statement of financial position lists assets at the top, followed by equity and then liabilities. Total assets must equal total equity and liabilities. Softbyte Inc. reports only one liability, Accounts Payable, on its statement of financial position. In most cases, there will be more than one liability. When two or more liabilities are involved, a customary way of listing is as shown in Illustration 1-12.

Illustration 1-12 Presentation of liabilities

The statement of financial position is like 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 transactions, (3) its financing transactions, (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 Inc.'s statement of cash flows in Illustration 1-11, cash increased €8,050 during the period. Net cash flow provided from operating activities increased cash €1,350. Cash flow from investing transactions decreased cash €7,000. And cash flow from financing transactions increased cash €13,700. At this time, you need not be concerned with how these amounts are determined. Chapter 13 will examine in detail how the statement is prepared.

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, labor unions, and economic planners.

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 accounting standards and the measurement principles. Accounting is based on standards, such as International Financial Reporting Standards (IFRS). IFRS 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.

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 + Equity

Assets are resources a business owns. Liabilities are creditor' claims on total assets. Equity is the ownership claim on total assets.

The expanded accounting equation is:

Assets = Liabilities + Share Capital—Ordinary + Revenues − Expenses − Dividends

Share capital—ordinary is affected when the company issues new ordinary shares in exchange for cash. 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. Dividends are payments the company makes to its shareholders.

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 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. A retained earnings statement summarizes the changes in retained earnings for a specific period of time. A statement of financial position reports the assets, liabilities, and 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. 12).

Basic accounting equation Assets = Liabilities + Equity. (p. 12).

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

Convergence Effort to reduce differences between U.S. GAAP and IFRS to enhance comparability. (p. 8).

Corporation A business organized as a separate legal entity under corporation law, having ownership divided into transferable shares. (p. 10).

Dividend A distribution of cash or other assets by a corporation to its shareholders. (p. 13).

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).

Equity The ownership claim on a corporation's total assets. (p. 13).

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 + Share Capital—Ordinary + Revenues − Expenses − Dividends. (p. 15).

Expenses The cost of assets consumed or services used in the process of earning revenue. (p. 13).

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. 8).

Faithful representation Numbers and descriptions match what really existed or happened—they are factual. (p. 8).

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) An organization that establishes generally accepted accounting principles in the United States (GAAP). (p. 8).

Generally accepted accounting principles (GAAP) Accounting standards issued in the United States by the Financial Accounting Standards Board. (p. 8).

Historical cost principle (cost principle) An accounting principle that states that companies should record assets at their cost. (p. 8).

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. 22).

International Accounting Standards Board (IASB) An accounting standard-setting body that issues standards adopted by many countries outside of the United States. (p. 8).

International Financial Reporting Standards (IFRS) International accounting standards set by the International Accounting Standards Board (IASB). (p. 8).

Liabilities Creditor claims on total assets. (p. 12).

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. 9).

Net income The amount by which revenues exceed expenses. (p. 22).

Net loss The amount by which expenses exceed revenues. (p. 22).

Partnership A business owned by two or more persons associated as partners. (p. 10).

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

Relevance Financial information that is capable of making a difference in a decision. (p. 8).

Retained earnings statement A financial statement that summarizes the changes in retained earnings for a specific period of time. (p. 22).

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

Share capital—ordinary Amounts paid in by shareholders for the ordinary shares they purchase. (p. 13).

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. 22).

Statement of financial position (balance sheet) A financial statement that reports the assets, liabilities, and equity of a company at a specific date. (p. 22).

Transactions The economic events of a business that are recorded by accountants. (p. 14).

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 turmoil over toxic (misstated) assets at many financial institutions. 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, recent internal control requirements 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, an independent accountant, such as a chartered accountant (CA) or 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 CAs and 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.

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

Many accountants 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 (USA), Nokia (FIN), or Samsung (KOR). 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 corporate failures, 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 International Red Cross (CHE) or the Bill and Melinda Gates Foundation (USA), 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, tax authorities, law enforcement agencies, and corporate regulators all employ accountants. There is also a very high demand for accounting educators at colleges and universities and in 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 theft and fraud occurring at companies. This includes tracing money-laundering and identity-theft activities as well as tax evasion. Insurance companies hire forensic accountants to detect insurance frauds such as arson, and law offices employ forensic accountants to identify marital assets in divorces.

“Show Me the Money”

How much can a new accountant make? Take a look at the average salaries for college graduates in U.S. public and private accounting.⁴

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

Serious earning potential over time gives accountants great job security. Here are some examples of upper-level salaries for U.S. managers in corporate accounting.

Illustration 1A-2 Upper-level U.S. 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.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 1A

9 Explain the career opportunities in accounting. Accounting offers many different jobs in fields such as public and private accounting, government, and forensic accounting. Accounting is a popular major because there are many different types of jobs, with unlimited potential for career advancement.

GLOSSARY FOR APPENDIX 1A

Auditing The examination of financial statements by an independent accountant in order to express an opinion as to the fairness of presentation. (p. 30).

Forensic accounting An area of accounting that uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud. (p. 30).

Management consulting An area of public accounting ranging from development of accounting and computer systems to support services for marketing projects and merger and acquisition activities. (p. 30).

Private (or managerial) accounting An area of accounting within a company that involves such activities as cost accounting, budgeting, design and support of accounting information systems, and tax planning and preparation. (p. 30).

Public accounting An area of accounting in which the accountant offers expert service to the general public. (p. 30).

Taxation An area of public accounting involving tax advice, tax planning, preparing tax returns, and representing clients before governmental agencies. (p. 30).