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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. 1 2 Chapter 1 An Introduction to the Role of Accounting in the Business World 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 4 Chapter 1 An Introduction to the Role of Accounting in the Business World 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. Chapter 1: An Introduction to the Role of Accounting in the Business World 5 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.