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Chapter 1
Accounting as a Form of Communication
After studying this chapter, students should be able to:
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Explain what business is about (LO1).
Distinguish among the forms of organization (LO2).
Describe the various types of business activities (LO3).
Define accounting and identify the primary users of accounting
information and their needs (LO4).
Explain the purpose of each of the financial statements and the
relationships among them and prepare a set of simple statements. (LO5).
Identify and explain the primary assumptions made in preparing financial
statements (LO6).
Identify the various groups involved in setting accounting standards and
the role of auditors in determining whether the standards are followed
(LO7).
Explain the critical role that ethics plays in providing useful financial
information (LO8).
Chapter Outline
LO 1
What is business?
Business is all of the activities necessary to provide the members of an
economic system with goods and services.
 Classification of business by type of activity:
 Product companies - provide goods or product
 Suppliers - supply raw materials needed to make the product
 Manufacturers/Producers - transform the raw materials obtained
from the suppliers into a finished product
 Distributors - sell the finished product to others
 Wholesalers - ell to retail outlets
 Retailers - sell to consumers
 Service companies - provide a service. Service providers are
becoming increasingly important in today’s economy.
LO 2
Forms of Organization
Business entities are organizations operated to earn a profit:
 Sole proprietorships:
 A form of organization with a single owner
 Many small businesses are sole proprietorships
 Economic entity concept: the affairs of the business and the owners
must be kept separate. A single, identifiable unit must be accounted
for in all situations.
 Economic entity concept is an accounting concept, not a legal
concept. Therefore, a sole proprietorship is not a taxable entity.
 Any profits earned are included on the tax return of the owner
 Partnerships:
 A business owned by two or more individuals
 Partnership agreement - determines how profits will be divided and
how much each partner will contribute. Can be oral or written.
 Public accounting firms, law firms are often partnerships
 Not a taxable entity: Any profits earned are taxed on the return of
the owners.
 Corporations:
 Corporations control the majority of private resources in the US,
even though sole proprietorships and partnerships dominate in
number.
 Business organized under the laws of a particular state
 Articles of incorporation must be filed with the state. Once
approved, a corporate charter is issued and corporation can sell
stock.
 Share of stock –a certificate that acts as evidence of ownership in a
corporation
 Stocks can be sold on organized stock exchanges (New York Stock
Exchange or American Stock Exchange)
 Advantages of a corporation:
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Ability to raise large amounts of money in relatively brief
period of time by:
 Sale of stock: ownership in corporation
 Sale of bonds: a certificate that represents a
corporation’s promise to repay a certain amount of money
and interest in the future
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Ease of transfer of ownership
 Sale of stock to another owner
 Limited liability: stockholder is only liable for the amount
contributed to the business
 Sole proprietorships and general partners do not have
limited liability
Nonbusiness entities:
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An organization operated for some purpose other than to earn a profit
Exist to serve the needs of various segments of society
Lack of identifiable owner
Even though there is a lack of a profit motive in nonbusiness entities,
still need information provided by an accounting system
 This type of entity uses fund accounting
 Hospitals, municipal government, colleges, are nonbusiness entities
 Although nonbusiness entities are organized specifically to serve
members of society, business entities have become more sensitive to
their social responsibilities.
LO 3
The Nature of Business Activity
Business activities can be categorized into either: Financing activities,
Investing activities or Operating activities:
 Financing activities:
 How a business obtains money (capital) for its needs
 Accounting is called the “language of business” and has its own
unique terminology
 Includes the sale of stock or borrowing to finance operations
 Liabilities: an obligation of a business. Notes payable, bonds
payable, accounts payable
 Capital stock: - the dollar amount of stock sold to the public.
Indicates the owners’ contributions to a corporation
 Stockholder (shareholder) provides permanent form of financing
and will not be repaid
 Creditor (lender) expects repayment of the amount loaned plus
interest
 Investing activities:
 Once the funds are generated from financing activities, the money is
now available to invest
 Includes the purchase of assets for the business
 Assets: a future economic benefit to the business. Accounts
receivable, patents, cash are examples
 Not all assets are tangible in nature
 Inherent tie between assets and liabilities
 Most liabilities are settled by transferring assets (mostly cash)
 Operating activities:
 Once investments are made in assets, company can begin
operations
 Includes the sale of products or services and the costs incurred to
operate the business
 Revenues are the inflow of assets resulting from the sale of goods
and services. Represents the dollar amount of sales of products and
services for a specific period of time
 If a cash sale, asset received is cash
 If a credit sale, asset received is an account receivable
 Expenses are the outflow of assets resulting from the sale of goods
and services. They are the costs incurred in operating a business.
LO 4
What is Accounting, and What Information Do Users of Accounting
Reports Need?
Accounting is the process of identifying, measuring and communicating
economic information to permit informed judgments and decisions by users of
the information.
Internal users:
 Are primarily the managers of a company
 Have easier access to information than external users
 Can access financial information in a format that best suits their needs
 Management accounting – the branch of accounting that provides
company’s managers with information needed to plan and control their
areas of responsibility
External users:
 Are anyone outside of the company
 Have limited access to information since they are not directly involved
in the operation of the business
 Need different information than managers of the business
 Financial accounting is the branch of accounting concerned with the
preparation of financial statements for outside use.
 Stockholders (and potential stockholders) who need information to
decide to hold, buy, or sell investment in stock
 Bondholders, bankers, and other creditors who need information to
aid in lending
decisions
 Government/regulatory agencies (IRS, SEC, ICC, FTC)
 Global companies must consider the reporting requirements in
foreign countries where they operate
 Others: suppliers, trade associations, stockbrokers
Financial Decision Framework:
 Used to help make investment decisions
1. Formulate the question
2. Gather information from the financial statements and other sources
3. Analyze the financials
4. Make the decision
5. Interpret the results
LO 5
Financial Statements: How Accountants Communicate
Financial accounting is the branch of accounting concerned with informing
management and outsiders about a company through financial statements.
 Accounting equation:
Assets = Liabilities + Owners’ Equity
 This equation is the foundation for the entire accounting system
 Left side, assets, are valuable economic resources that will provide
future benefit to the company
 Right side indicates who provided, or has a claim to, those assets
 Liabilities from creditors
 Owners’ equity is the owners’ claims on the assets of an entity
 Stockholders’ equity (or shareholders’ equity) is used to refer to the
owners’ equity of a corporation
 The mathematical difference between a corporation’s assets and its
obligations or liabilities
 Stockholders’ equity arises in two distinct ways
 The investments by stockholders (capital stock)
 Retained earnings, which represent the income earned less
dividends paid over the life of the entity
There are four financial statements:
1. The balance sheet (sometimes called the statement of financial position) is
the financial statement that summarizes assets, liabilities, and owners’
equity at a specific point in time, usually the end of a month, quarter, or
year.
 The entity’s status at that point in time
 The balance sheet must be in balance. Assets = Liabilities plus owners’
equity
 Company can have a calendar year-end or can chose a year-end after
the end of its peak season (fiscal year)
2. The income statement (statement of income) summarizes the revenues
and expenses for a period of time (month, quarter, year)
 Flow rather than status—summarizes the flow of revenues and
expenses for a period of time
 Revenues less expenses = net income. Also called profits or earnings
3. The statement of retained earnings explains the change in retained
earnings during the period
 Net income increases retained earnings and net losses decrease
retained earnings
 Dividends are distributions of net income of a business to its
stockholders
 Reduce retained earnings
 Dividends are not an expense and therefore do not go on the income
statement
 The basic format to compute the change in retained earnings is:
Beginning retained earnings + Net income – Dividends = Ending
retained earnings
4. The statement of cash flows summarizes the cash receipts and cash
payments during the period from a company’s operating, investing, and
financing activities.
 The statement shows readers where the company got cash and how it
used that cash
Relationships among the financial statements
 Income statement: compute the net income (loss)
 Statement of retained earnings: compute the ending balance of
retained earnings using net income from the income statement
 Balance sheet: the ending balance of retained earnings from the
statement of retained earnings is used to compute stockholders’ equity
 Statement of cash flows: the net increase or decrease in cash is used to
reconcile the beginning cash balance to the ending cash balance (on the
balance sheet)
LO 6
The Conceptual Framework: Foundation for Financial Statements
Bookkeeping is the part of accounting that deals with record-keeping.
Accounting requires judgment and communicating relevant information to
financial statement users.
Conceptual framework: foundation for standards, principles, and assumptions
for preparation of published information. This framework aids accountants in
their preparation of the financial statements.
 Economic entity concept: one identifiable, specific entity should be the
subject of the financial statements
 Personal transactions of the owners and business transactions kept
separate
 Cost principle requires assets be recorded at the cost to acquire them
 Also called historical cost or original cost
 Once recorded at cost, how should assets be valued on subsequent
balance sheets?
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 Under current accounting standards, certain assets are valued at
historical cost on all balance sheets until the company disposes
of them since cost is objective, or verifiable by an outside
observer
 Certain assets are valued on subsequent balance sheets at
market value if the amount can be objectively determined
 Use price asset could be sold for, rather than the price it
could be bought for
Going concern assumption assumes the business will continue
indefinitely and is not in the process of liquidation
 If a business is in the process of liquidation, market value may be
more relevant than cost
The monetary unit is the yardstick used to measure amounts in the
financial statements (e.g., U.S. dollars)
 Assume that the monetary unit is relatively stable
Time period assumption states that although we cannot know how
successful a business is until the end of its life; information is needed
before then, so companies report at even intervals of time (e.g.,
annually). Break down the indefinite life into artificial segments.
GAAP, Generally Accepted Accounting Principles, are the rules,
methods, practices, and other procedures that have evolved over time
in response to the need to regulate the preparation of financial
statements.
Accounting as a Social Science
Accounting is a service activity. Its purpose is to provide financial information
to decision makers.
 It is a social science as opposed to a physical science
 The principles that govern financial accounting (GAAP) develop in
response to changing business conditions
LO 7
Setting Accounting Standards
Who Determines the Rules of the Game:
Joint effort:
 Securities and Exchange Commission (SEC): a federal government
agency that oversees publicly traded companies (“listed stocks”)
(www.sec.gov). It has the ultimate authority to determine the rules for
preparing statements for companies whose stock is sold to the public.
 Financial Accounting Standards Board (FASB): the group in the private
sector with the authority to set accounting standards (www.fasb.org)
 American Institute of Certified Public Accountants (AICPA): a
professional organization of CPAs that serves as an advisory body to the
FASB and administers the CPA exam (www.aicpa.org)
 CPA is an individual who has passed a uniform exam administered by
the AICPA and has met other requirements as determined by
individual states
 Public Company Accounting Oversight Board (PCAOB): a five-member
body created by an act of Congress in 2002 to set auditing standards
 International Accounting Standards Board (IASB) - organization
responsible for the development of worldwide accounting standards
(www.iasb.org)
 U.S. standard setters continue to work closely with international
community
The audit of financial statements:
 Financial statements are the responsibility of the company’s
management
 Audit: the process of examining the financial statements and the
underlying records of a company to render an opinion as to whether
the statements are fairly presented
 Primary objective of an audit: to assure stockholders’ and other users
that the statements are fairly presented
 Auditor’s report: the auditor’s opinion (not a statement of fact)
concerning the fairness of the presentation of the financial statements
 Public accounting firms provide external audits for their clients
LO 8
Introduction to Ethics in Accounting
Because some companies have filed reports of questionable or aggressive
accounting practices, decision makers need to:
 Ask questions, do research, and not just accept everything as fact
(decision maker outside a company)
 Be alert to pressures on the decision-making process involving bias,
deception, and even fraud that may distort the disclosed information
(decision maker inside a company)
 Be aware when it appears as if GAAP may not have been used to
resolve particular accounting issues.
When ethical dilemmas are encountered, accountants should use their
profession’s conceptual framework to resolve the issues. Accounting
information should be:
 Relevant – information that is useful to the decision-making process
 Provide clear information about past financial events that is helpful in
predicting the future
 To be relevant, information must be timely.
 A faithful representation – information should accurately represent
what it claims to represent
 Reliability includes:
 Verifiability – documentation from one or more independent
parties that supports the accuracy of the information
 Neutrality – the presentation of information is free from bias
toward a particular result.
The Ethical Decision Model:
 Identification - recognize the ethical dilemma
 analyze the key elements in the situation
 Analysis
 analyze the key elements in the situation
 determine the alternative methods available to report the
transaction, situation, or event
 Resolution – select the best or most ethical alternative, considering all
of the circumstances and consequences
Accountants and Ethical Judgments
The primary goal of accounting is to provide useful information to aid in the
decision-making process
 Accountants take on a serious responsibility because external parties
rely on the financial statements to make important decisions
 Accountants must make subjective judgments about what information
to present and how to present it- this is why accounting is a profession.
The Changing Face of the Accounting Profession
Examples of some the companies involved in financial reporting crisis:
 Enron: an economic entity decision as to whether various entities,
under the control of Enron, be included in the company’s financial
statements
 WorldCom: the decision as to whether certain costs should have been
treated as expenses rather than assets
 Accounting firms’ independence is questioned when these accounting
firms are rendering nonaudit services while simultaneously rendering
an opinion on the company’s financial statements.
The Sarbanes-Oxley Act was passed by Congress in 2002 to bring about major
reforms in corporate accountability and stewardship. The provisions of the act
included:
 The establishment of the Public Company Accounting Oversight Board
(PCAOB)
 Requirement that external auditors report directly to company’s audit
committee
 Prohibition of public accounting firms who audit a company from
providing any other services that could impair their ability to act
independently in the course of their audit
Lecture Suggestions
LO 2
Have students name businesses that they use or that they work for.
Then have them classify the business by type – supplier, manufacturer,
distributor, retailer, or service company. Finally, have them classify the
business as to how it is organized – sole proprietorship, partnership,
corporation, or nonbusiness entity.
LO 4
Who are the internal users of financial information? Ask students to
name as many as they can. How does management accounting
information help them? Who are the external users of accounting
information? What financial data would be of interest to each of these
external users? Why is the information they need different from what
internal users need?
LO 5
Focus on the word balance in the balance sheet and the accounting
equation. The balance sheet must balance: assets equal the total of
liabilities plus owners’ equity.
Summarize Top of the World’s financial statements (from Examples 1-4
through 1-7) to show how the income statement and the statement of
retained earnings bridge the gap between the balance sheet of one period and
that of the following period:
JULY, 1, 2011
Assets
Liabilities
Equity
Stock
Retained
earnings
July 1, 2011
JULY 1, 2011 – JUNE 30,
2012
$0 Revenues
0
0
0
0
Expenses
Net Income
Dividends
Retained income
$0 + 2011-2012
JUNE 30,
2012
$8,00 Assets
0
6,000 Liabilities
2,000 Equity
(800) Stock
1,200 Retained
earnings
$7,300
$1,20 = June 30,
$1,200
4,100
3,200
2,000
1,200
RE balance
income retained
0 2012
RE
balance
LO 5
Students have a difficult time understanding the concept of equity. Have
students think about their equity in their assets. If they purchased a car for
$10,000 and took out a $3,000 loan, what is their equity in the car? Put
this transaction into the accounting equation to see that the left side
represents the economic resources and the right side represents the claims
to the resources.
LO 5
The reader can find many pieces of desired financial information (net
income, dividends paid, cash balance) in more than one place in the
statements. Students should learn to “read” the statements, to become
familiar with what is in them, and where it is located. This familiarity will
help them keep the more complicated detailed topics in perspective as you
progress through the book.
LO 6
What accounting assumption principle has been violated in each
situation below:
1. Melissa is the owner of Missy’s Tea Shop, a sole proprietorship.
She purchases a new computer for her use at home. Melissa
records the computer as an asset of Missy’s Tea Shop.
2. Houston Electronics purchased an office building several years
ago for $500,000. The office building could be sold today for
$850,000. The accountant will now show the building as an asset
on the books for $850,000.
3. Henry is a new accountant for Acme Foods. He is extremely busy
and has decided that he can prepare the financial statements
every two years.
4. The Candle Store is having financial problems. It has no plans to
liquidate, but decides to use market value to report their assets
since they plan on moving to a smaller store.
Solution
1.
2.
3.
4.
Economic entity concept
Cost principle
Time period assumption
Going-concern assumption
LO 7
Students think they “know” what an auditor does, but do not have a clear
conception of the specifics. Conduct a brief discussion in class of how an
auditor really “audits” the books. What specifically do they do? How do
you become a CPA? You get some wide-ranging answers, and can shed a
lot of light on the subject by leading the class around to some real facts to
replace ill-formed notions.
LO 8
The AICPA code of ethics can serve as a good discussion tool. Thinking
about some of the recent major frauds, and discuss, what if any ethics
rules were broken. Is unethical conduct always illegal? What are the
consequences of a CPA not adhering to their code of ethics?
Projects and Activities
LO 4
Users of Accounting Information and Their Needs
Outside assignment: The competition
In this chapter of your textbook, many examples are drawn from the financial
statements of Kellogg’s Company. How does it compare to other similar
businesses?
To answer this, you obviously need to know who the competition is. In an
interview, someone asked Peter Lynch, the now-famous former manager of
Fidelity Investments’ successful Magellan Fund, where he got his ideas about
which companies to invest in. One of his sources, he said, was the
supermarket! He was not trivializing the question. We all spend a great deal of
time shopping or using services, so our first exposure to a company is
frequently its product or service. A good product or service comes from what
may turn out to be an interesting company.
One place to learn about products is where they are sold. Another place to
lean about a company and their products is to do research is on the internet.
All major companies have their own website. These websites often give the
history of the company, and links to their corporate financial information. By
looking at the website of the company and the websites of its competitors, we
can learn a lot about the company and the industry. For example, it may be
interesting to look at the websites of Southwest Airlines
(www.southwest.com) and one of its competitors, United Airlines
(www.united.com).
Solution
There is, of course, no “right” answer to this question, or, countless right
answers could be given. Students begin to learn where to find information.
The sources are everywhere. Comparisons can begin anywhere. For retail
products, comparisons can begin in stores. The student might like to “try out”
the product. By contacting company websites or toll free information lines, a
student can research a particular company. Comparative studies can be done
using the internet. Of course the library, and the helpful reference librarians,
will supply material for this assignment. Students do not necessarily need
sophisticated electronic databases to continue their research, although these
are certainly useful and great to have. Your school’s resources may be limited,
and the students need to open their minds to various means of inquiry,
available in “hard copy,” including books, newspapers, magazines, and
journals.
The quickest way to research is by using the Internet. Students can go to a
company’s Web site and find financial information. They can access
information by using sites such as Hoover’s Online (www.hoovers.com) or to
the SEC’s website (www.sec.gov)..
Encourage students to share current events and good reference sites with the
class throughout the semester. Each student (or a group of students) can be
responsible for a specific company. It is very interesting to have the class
choose an industry to follow during the semester. Each student (or group)
could follow a specific retailer, restaurant, service company, computer
manufacturer, Internet company, etc.
LO 5
Financial Statements: How Accountants Communicate
Outside assignment: Prepare your own balance sheet
Do you have your own personal balance sheet? Before you say, “No, I’m not a
business, so I don’t have accounts or anything,” think about this question.
Financial records, and the statements that result from them, are a way of
recording formally what already exists physically. Don’t you already have some
assets, like a bank account, a car, a stereo and TV, perhaps furniture? How
about liabilities? Do you owe anyone money?
Set up a balance sheet form similar to the one in your textbook in the review
problem (Greenway Corporation). Instead of using the accounts for Greenway
Corporation, fill in your own name, and your own “accounts.” Approximate
the costs of your assets if you do not know their exact cost, in accordance with
the principles you are learning. Are you going to list any of them at market
value? Why or why not? What is the difference between the total of your
assets and your total liabilities?
Solution
Your students may need a bit of guidance to get started, mainly because they
do not think of their possessions as “assets.” Begin by reviewing the definition
of an asset. They will see that a balance sheet is not an abstraction created
from nowhere, but a way of writing down what physically exists. Students may
be asked to prepare a personal balance sheet when they fill out a loan
application. The bank has asked, in essence, for a balance sheet, although not
in so many words. The historical cost concept is introduced here, in the
question of cost versus market value. Students may debate what their assets
are “worth.” They finish by calculating their own “equity” or “net worth”
(using the old phrase), that is, what they own outright with no outside claims
or liens. Doing this in personal terms makes the concepts more “real” than
doing it for some abstract company whose “equity” means nothing to a
student.
In-class discussion: Why do we need so many statements?
The balance sheet gives the company’s status at the end of a chosen
accounting period. It includes the results of all the operations that took place
during this period. Why do we need to have an income statement and
statement of retained earnings, which simply expands upon the retained
earnings account? If we wanted detail, couldn’t we just include it as part of
the retained earnings section of the balance sheet?
Solution
Many students, when they begin to prepare financial statements, mix up the
statements. A very common error is that students will include all the revenues
and expenses in the retained earnings section, come up with a net, subtract
dividends, and show, then, the ending retained earnings. In other words, they
include the income statement and statement of retained earnings in the
balance sheet. Then, they repeat them again when asked for the individual
statements (and probably grumble to themselves that this sure is a lot of extra
work). It is useful to review the intent, and different purposes, of the
statements so that students see them as individual pieces of information.
In-class discussion: Dividends
Students have learned that dividends are a distribution of income, not an
expense. What is the difference? Why can’t the corporation list them as an
expense, since dividends are just another amount of money paid out to
somebody? This concept is important in other business courses (i.e., finance).
Therefore, students need to become comfortable with the concept as quickly
as possible.
Solution
The key concepts here are
 To whom are the dividends paid?
 Is the company required to pay dividends?
 Are dividends paid in the process of earning revenue?
Expenses are incurred to earn revenues. Dividends are not a part of the
revenue process. Expenses imply an obligation, whereas no requirement to
pay dividends exists. The company may (or may not) feel that they should pay
dividends, but are not required to do so. Finally, expenses involve payments to
outside parties: suppliers, employees, banks. Dividends are paid to the owners
of the company. In other words, they are withdrawals by the owners. Return
to simple proprietorships or partnerships to reinforce the difference between
an expense and a withdrawal.
In-class discussion: GAAP
Although regulations promulgated by the SEC and the IRS, for example, carry
legally prescribed penalties, the standards used by the accounting profession,
under which published statements are prepared, carry no such penalties. If
nothing will happen to a company that does not follow generally accepted
accounting principles, why do so? What prevents a company from deviating
from these conventions if it sees an advantage to doing so?
Solution
Here is a question of peer pressure, which students understand very well. If
the principles are indeed “generally accepted,” then they are also generally
used, and the company that does not use them will stand out. Since
corporations are dependent upon outside parties for their revenues
(customers) and for major financing (lenders and stockholders, as well as
short-term creditors), they want to maintain the trust of these parties. They
cast a shadow on this trust if they do not adhere to accepted professional
practice, and thus decrease the comparability of their published statements to
those of other similar companies.
Students will point out that the company will get a bad audit report. This may
be an acceptable consequence if the company has already decided to deviate
from accepted practice. But they do have some concern for the opinion of
those outside the company. An unfavorable audit report will erode credibility
as a company. Further, even though the FASB has no legal authority, other
bodies do, as mentioned, and they require statements prepared in accordance
with generally accepted accounting principles, and impose some of their own
rules.
GAAP is difficult to escape for a public company. On the other hand, private
companies are less subject to these rules, because they are not required to
publish financial statements. Few of these private entities can go very far
without buying on account, or borrowing money from banks, and creditors
generally require audited statements, which again have to conform to GAAP.
LO 6
The Conceptual Framework: Foundation for Financial Statements
In-class discussion: The independent auditors’ opinion
Consider the following excerpts from an audit opinion:
In General Motors’ 2008 10-K, Deloitte’s audit opinion contained a “going concern”
clause:
“The accompanying consolidated financial statements for the year ended
December 31, 2008, have been prepared assuming that the Corporation will continue
as a going concern. As discussed in Note 2 to the consolidated financial statements,
the Corporation’s recurring losses from operations, stockholders’ deficit, and inability
to generate sufficient cash flow to meet its obligations and sustain its operations raise
substantial doubt about its ability to continue as a going concern. Management’s
plans concerning these matters are also discussed in Note 2 to the consolidated
financial statements. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.”1
Answer the following:
1. What is the general purpose of an auditors’ report?
2. What is a going concern? Define it in your words, don’t quote the book.
3. Are losses, restructuring, and the disposal of segments necessarily
precursors to the demise of the company?
4. What, in your words, are the auditors saying about this particular
company?
5. What do you think the term “qualified opinion” means?
6. If the auditor’s state in their opinion that there is substantial doubt
about its ability to continue as a going concern, does that mean that the
company will go out of business in the near future?
1
General Motors Corporation, 2008 10-K, p. 138.
Solution
1. The auditors’ opinion is just that, an opinion. It is, importantly, an
unbiased opinion, by someone independent from the company.
Auditors perform tests in accordance with PCAOB auditing standards to
verify that the statements were prepared in accordance with generally
accepted accounting principles, consistently applied, and that no
material errors were found. Readers gain additional reassurance about
the intent of management, stated in the management letter, to convey
accurate, complete information about the financial status and results of
the company.
2. A going concern is a business that will continue to operate indefinitely.
3. Large and/or recurring losses often prompt restructuring and selling of
unsuccessful segments of the business, or segments that no longer fit
into the future plans of the business, in order to return the company to
profitability. When too many employees have to be let go, or when too
many assets are sold, doubt exists about the ability of the company to
carry on its business with whom or what remains.
4. In the case of this particular company, the auditors are saying that there
is doubt about the ability of the company to continue due to its inability
to generate sufficient cash flow and its recurring losses from
operations.
5. When auditors have reservations about the accounting treatment of a
material item, or about the company’s future, they will attempt to
resolve the conflict with the management of the company. This is the
management’s opportunity to correct the perceived deficiency if
possible and get a “clean” report. If the issue cannot be resolved easily,
the auditors feel that they must make financial statement users aware
of the problem, and will thus refer to it in their opinion, giving thereby a
“qualified” opinion. The severity of the qualification varies with the
significance of the problem, and the auditors’ perception of the
company’s ability to continue operations without correcting it. Few
companies want to publish an annual report with a qualified opinion,
since that opinion says that some difficulty, either in comparability with
other companies’ reports, consistency with the company’s own prior
years, or with the firm’s ability to operate indefinitely, exists. The
subject company’s problems were so severe at that point in time that a
qualified audit opinion was the least of their worries.
6. It is important to understand that the auditor’s are issuing an opinion based on
the facts that they have. It does not mean that the company will definitely go
out of business in the next few years. General Motors underwent major
restructuring in 2009. The 2010 10-K for General Motors has the following
opinion: “In our opinion, such consolidated financial statements present
fairly, in all material respects, the financial position of General Motors
Company and subsidiaries at December 31, 2010 (Successor) and 2009
(Successor) and the results of their operations and their cash flows for
the year ended December 31, 2010 (Successor) and the period July 10,
2009 through December 31, 2009 (Successor), and the results of
operations and cash flows of General Motors Corporation and
Subsidiaries for the period January 1, 2009 through July 9, 2009
(Predecessor) and the year ended December 31, 2008 (Predecessor), in
conformity with accounting principles generally accepted in the United
States of America. Also, in our opinion, such financial statement
schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly, in all material
respects, the information set forth therein.”2
General Motors was able to survive. Other companies who have
received a going concern clause have not been as lucky.
Take the case of Borders, Inc. The 2010 10-K for Borders has the
following opinion from the auditors about going concern: “The
accompanying financial statements have been prepared assuming that
Borders Group, Inc. and subsidiaries will continue as a going concern. As more
fully described in Note 2 and Note 17, on February 16, 2011, Borders Group,
Inc., Borders, Inc. and certain of its domestic subsidiaries filed a voluntary
petition for reorganization under Chapter 11 of the United States Bankruptcy
Code. Uncertainties inherent in the bankruptcy process raise substantial doubt
about the Company’s ability to continue as a going concern. Management’s
plans in regard to these matters are also described in Note 2 and Note 17. The
accompanying financial statements do not include any adjustments to reflect
the possible future effects on the recoverability and classification of assets or
2
General Motors Company, 2010 10-K, p. 141.
the amounts and classification of liabilities that may result from the outcome
of this uncertainty.”3
Unfortunately, on July 18, 2011 Borders issued a press release stating:
“Borders Group reported today that, in accordance with the terms of its
financing agreement, the Company will submit to the Court for approval
the previously-announced proposal from Hilco and Gordon Brothers to
purchase the store assets of the business and administer the liquidation
process. Borders said that, in the absence of a formal proposal from a
going concern bidder, it did not require an auction prior to presenting
the proposal to the Court at a scheduled hearing on Thursday, July 21,
2011.“Following the best efforts of all parties, we are saddened by this
development,” said Borders Group President Mike Edwards. “We were
all working hard towards a different outcome, but the headwinds we
have been facing for quite some time, including the rapidly changing
book industry, eReader revolution, and turbulent economy, have
brought us to where we are now,” he added.”4
LO 7
Who Determines the Rules of the Game?
Outside assignment: How does FASB make the rules?
Visit the web site for the Financial Accounting Standards Board
(www.fasb.org). Under the tab “About FASB, read about the organization.
What is its mission? Who are the members? What are their qualifications? Are
they no more than rulemakers (don’t we have enough already?) How does the
process of developing a new standard begin? What process does the Board go
through before the standard becomes a part of accepted practice? What are
the latest developments?
Also visit the web site for the International Financial Accounting Standards
Board (www.ifrs.org). Under the tab “About Us,” read about the organization.
What are its objectives? Who are its members?
Solution
FASB:
3
4
Borders Groups, Inc.,FYE 1/29/10 10-K, p. 70.
Borders Group, Inc., press release, July 18, 2011, http://media.bordersstores.com/pdf/BordersNoAuctionNewsRelease.pdf
This independent board has seven members, appointed for five-year terms,
from business, public accounting, and academe. They are paid substantial
salaries for their full-time service. Members of the Board are required to sever
all connections with their previous firms or institutions. They monitor the
profession and, as they become aware of the need for a change in current
practice, they thoroughly investigate the situation, using the services of FASB’s
large research staff, and draft position papers. Comments from members of
the profession are solicited and carefully considered, and a number of
successive modifications to the original position may be made, before a
standard is finally adopted. The process may take two or more years and is
referred to as due process. (Comments about the latest developments will
vary.)
IASB:
The IFRS Foundation is an independent, not-for-profit private sector
organisation working in the public interest. Its principal objectives are:
 to develop a single set of high quality, understandable, enforceable and
globally accepted international financial reporting standards (IFRSs)
through its standard-setting body, the IASB;
 to promote the use and rigorous application of those standards;
 to take account of the financial reporting needs of emerging economies
and small and medium-sized entities (SMEs); and
 to bring about convergence of national accounting standards and IFRSs
to high quality solutions.5
The IASB is the independent standard-setting body of the IFRS Foundation. Its
members (currently 15 full-time members) are responsible for the
development and publication of IFRSs, including the IFRS for SMEs and for
approving Interpretations of IFRSs as developed by the IFRS Interpretations
Committee (formerly called the IFRIC). All meetings of the IASB are held in
public and webcast. In fulfilling its standard-setting duties the IASB follows a
thorough, open and transparent due process of which the publication of
5
http://www.ifrs.org/The+organisation/IASCF+and+IASB.htm
consultative documents, such as discussion papers and exposure drafts, for
public comment is an important component. The IASB engages closely with
stakeholders around the world, including investors, analysts, regulators,
business leaders, accounting standard-setters and the accountancy profession.
6
LO 8
Introduction to Ethics in Accounting
Outside assignment: Ethics: What does it mean to you?
The topic of ethics is discussed in this chapter. It is a recurring theme
throughout the book because it is a critical item in accounting as it is in any
profession. Take a few minutes to ask yourself what ethics means to you. In a
brief paragraph, give your own definition of ethics (please do not simply quote
something out of a dictionary, but rather give your own personal meaning).
Consider what the accountants might have felt at some of the companies
embroiled in the current scandals.
Now describe how you see ethics applied to business in general, and to
accounting in particular as far as you have been introduced to it. Why is it
important? What do you hope to learn as this course continues that will help
you solve the ethical dilemmas that you will inevitably meet in your continued
schooling, and in your professional life?
This last question is difficult. You have defined what ethics means to you, your
own standards, and what you wish to learn. Do you live by the rules you
define? Think carefully. Are there instances where your actual performance
falls short of what you say is correct?
Solution
This assignment can have two parts. Assign this at the beginning of the course
as an outside assignment, with possibly a brief in-class discussion. Return the
students’ papers, but keep copies of them. At the end of the course, once
more assign this, with slightly different wording (see assignment material for
Chapter 13). At this point the students are also asked to compare their
responses at the beginning and end of the course, and assess the progress
they have made in this area.
6
http://www.ifrs.org/The+organisation/IASCF+and+IASB.htm
Outside assignment: Accounting Careers
The financial accounting course can be an opportunity for a business major to
choose accounting as a career. It is a great time to encourage students to
explore career opportunities.
Have students interview accountants about their careers and share their
findings with the class. Students can research the Web to obtain salary
information.
Have the students go to the AICPA website (www.aicpa.org). Click on the
“Career” tab to see different career paths available, salary information,
mentoring, and diversity initiatives. Discuss the varied opportunities available
to accounting students.
Encourage students to get involved with your school’s student accounting
organizations. It is a great networking opportunity.
Have students bring in advertisements for accounting positions from the
internet, the newspaper, and professional publications.
The many accounting financial statement frauds have highlighted some
interesting, non-traditional accounting jobs that are available. Have students
go the website for the Association of Certified Fraud Examiners
(www.acfe.com) to see what a CFE does. The IRS hires criminal investigators
to help them fight fraud. Students may want to check out their job duties at
www.irs.gov. Even the FBI hires accountants. Have the students go to
www.fbi.gov to see the many different duties for FBI agents.