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CHAPTER
1
An Introduction to the Role of
Accounting in the Business World
The purpose of a system of accounting is to provide financial information about businesses to interested
parties including investors, creditors, and others.
Business Entity Types
Service, manufacturing, and merchandising firms are the three major types of businesses. A service
business, e.g., dry cleaning, entertainment, and CPA firm sells services, not products. Manufacturing
firms, e.g., clothing and furniture manufacturers, transform raw materials into finished products.
Merchandising companies include wholesalers and retailers. Wholesalers are the link between
manufacturers and retailers. United Stationers is a wholesaler of business products. Wal-Mart is a major
retail concern.
Forms of Business Organization
There are three major forms of business organization: sole proprietorships, partnerships, and
corporations.
A sole proprietorship has only one owner. These entities are easily formed. A major disadvantage is
that of unlimited liability, the owner is ultimately liable for the firm’s debts. Earnings of the firm are
taxed to the owner.
A partnership is co-owned by two or more people. General partners have unlimited liability for the
firm’s debts. Earnings are taxed to the partners.
Corporations are separate legal entities. Owners are identified as stockholders. A major advantage of
corporations is limited liability of the shareholders. The major disadvantage is double taxation of
earnings—once at the corporate level and again (as a dividend) at the shareholder level.
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Internal/External Use of Accounting Information
Accounting data is used inside and outside the company. Company managers use accounting information
to determine such things as which product lines to expand or discontinue, while investors use accounting
data to decide whether to invest in a certain company.
Financial Statements
Four major financial statements (reports) are designed to allow a “view” of the company from different
perspectives. At year end the first financial statement prepared is that of the Income Statement. This view
is focused on the results of business transactions with customers. Economic inflow from the customer is
termed revenue, sales, or fees earned. The cost of satisfying customer demands (economic outflow) is
termed expense. The income statement details the revenues and expenses of the business, usually for a
year, sometimes for shorter periods. If revenues exceed expenses, the business has been profitable. Other
terms that indicate the profitability of a business are net earnings and net income. If expenses exceed
revenues, the business has incurred a net loss. This is the only financial statement that details the
revenues and expenses. Because the owners are responsible for the operation of a business, any net
income (profit) increases stockholders’ equity while a net loss decreases stockholders’ equity.
Because the Income Statement is the first financial statement prepared at year end, the end of year
balance (net income) is readily available to be carried forward to the subsequent statement (stockholder’s
equity) and there blended with the results of other owner activity during the period. The Statement of
Stockholders’ Equity allows a view of these changes in the components of ownership equity from the
beginning to the end of the company’s fiscal year (or shorter period). The two major components of
stockholders’ equity are paid-in capital (amount paid in for stock) and retained earnings. Retained
earnings is the cumulative sum of earnings, less dividends, to shareholders since the business has been in
operation. In summary format, information from the Statement of Stockholders’ Equity is carried to the
Balance Sheet.
The purpose of the Balance Sheet is to allow (at the end of the fiscal period) a view of the economic
resources (assets) under management’s control on that specific date and to disclose the parties who have
legal claim on those assets. Assets are either loaned by the creditors (to whom the business is liable
(liabilities) or represent stockholders’ investment or earnings generated by management. The two parties
of legal claim are creditors and owners; therefore, the dollar value of assets under management’s control
must equal the dollar claims on those assets. Assets must equal liabilities plus stockholders’ equity, i.e.,
A  L  SE . This balanced equation is, in fact, the Balance Sheet prepared at year end.
The Statement of Cash Flows isolates one asset account (cash) and prepares a summary of the
movement of cash into and out of the business. These sources and uses of cash are grouped into three
categories—operating, financing, and investing activities. It is possible for a firm to have a positive net
income and a negative cash flow for the same year. Over several years, however, successful businesses
will generate positive operating cash flows. The rules, concepts, and principles for financial statements
are GAAP (Generally Accepted Accounting Principles). The FASB (Financial Accounting Standards
Board), a private sector body, is the principal rule-making body for the accounting profession.
Where Are Accountants Employed?
Accountants may work in private or public accounting. An accountant employed by IBM is in private
accounting. A Certified Public Accountant (CPA) employed by a public accounting firm such as Deloitte
and Touche is said to be in public accounting.
The most prestigious certification an accountant can earn is the CPA certificate. It is the only
accounting certification issued by a government agency (state board of accountancy). Other certifications
(CIA, CMA) are issued by private membership organizations.
Chapter 1: An Introduction to the Role of Accounting in the Business World 3
Choose the best response to the following questions. Answers will be found at the end of Chapter 14.
1.
The Financial Accounting Standards Board is responsible for establishing:
a. The American Institute of Certified Public Accountants
b. Generally Accepted Accounting Principles
c. The Securities and Exchange Commission
d. The Code of Professional Conduct for Accountants
2.
All of the following are forms of business organization except:
a. Sole proprietorship
b. Sub S corporation
c. Conglomerate retailer
d. Limited Liability Partnership (LLP)
3.
In which of the following forms of business organizations are the personal assets of the
owners protected from debts of the business?
a. Corporation
b. Partnership
c. Proprietorship
d. Retailer
4.
According to the FASB, the primary objective of financial reporting is to provide
information:
a. To the Securities and Exchange Commission (SEC)
b. About the profitability of the business
c. To the International Account Standards Board (IASO)
d. Useful for making economic decisions
5.
The accounting equation for a corporation can be stated as:
a. Assets = Liabilities + Stockholders’ Equity
b. Revenue – Expense = Net Income
c. Beginning Equity + Changes = Ending Equity
d. Beginning Cash + Financing and Operating Cash = Ending Cash
6.
All of the following are primary financial statements except:
a. Financial Statement Footnotes
b. Income Statement
c. Statement of Stockholders’ Equity
d. Statement of Cash Flows
7.
The statement which represents a summary of the revenues and expenses of a business is
called the:
a. Statement of Stockholders’ Equity
b. Statement of Cash Flows
c. Income Statement
d. Balance Sheet
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8.
All of the following statements report the results for a period of time (“movie” vs.
“snapshot”) except the:
a. Balance Sheet
b. Income Statement
c. Statement of Cash Flows
d. Statement of Stockholders’ Equity
9.
The amount of net income shown on the income statement also appears on the:
a. Balance Sheet
b. Statement of Cash Flows
c. Statement of Financial Position
d. Statement of Stockholders’ Equity
10.
Which of the following financial statements is generally considered to be the least important
to decision makers?
a. Statement of Stockholders’ Equity
b. Balance Sheet
c. Statement of Cash Flows
d. Income Statement
11.
The Balance Sheet communicates
a. Assets, liabilities, and owners’ equity at a point of time.
b. Revenues less expenses during a period of time.
c. Beginning balance plus income less dividends.
d. Operating, investing, and financing activities.
12.
The Income Statement communicates
a. Assets, liabilities, and owners’ equity at a point of time.
b. Revenues less expenses during a period of time.
c. Beginning balance plus income less dividends.
d. Operating, investing, and financing activities.
13.
The Cash Flow Statement communicates
a. Assets, liabilities, and owners’ equity at a point of time.
b. Revenues less expenses during a period of time.
c. Beginning balance plus income less dividends.
d. Operating, investing, and financing activities.
14.
Net income and dividends paid to the stockholders are found in the
a. Balance Sheet.
b. Income Statement.
c. Retained Earnings Statement.
d. Cash Flow Statement.
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15.
The measured growth of a firm resulting from its regular operations during the year is found
in the
a. Balance Sheet.
b. Income Statement.
c. Retained Earnings Statement.
d. Cash Flow Statement.
16.
Retained earnings may be described as
a. That which is owed and must be paid in the future.
b. That which will be used for future growth.
c. That which represents the amount invested in the firm by its owners.
d. The total measured past growth of a firm less the amount distributed to the owners.
17.
Equity investment may be described as
a. That which is owed and must be paid in the future.
b. That which will be used for future growth.
c. That which represents the amount invested in the firm by its owners.
d. The total measured past growth of a firm less the amount distributed to the owners.
18.
A statement that “the balance sheet presents fairly the financial position of a company” is
found in the
a. Management’s letter.
b. Auditor’s report.
c. Footnotes to the balance sheet.
d. President’s letter to the shareholders.
19.
An independent auditor
a. Is an employee of the firm who is employed to produce financial accounting statements.
b. Is hired by the United States government to minimize fraud that might occur in firms
whose shares are traded on the New York Stock Exchange.
c. Accepts or rejects the statement that the financial accounting statements fairly represent
the financial position and results of operations and are constructed consistent with
GAAP.
d. Both b and c are correct.
20.
CPA is an abbreviation for
a. Corporate Proprietary Accountant.
b. Certified Production Accountant.
c. Consumer Protection Agency.
d. Certified Public Accountant.
21.
GAAP is an acronym for
a. General Asset Accounting Procedures.
b. Good Agency Accounting Procedures.
c. Generally Accepted Accounting Principles.
d. Good Accounting Activity Principles.