Chapter 1
Accounting Principles and the Financial Statements
Learning Objectives
1. Dene accounting, and explain the concepts underlying accounting measurement.
2. Dene nancial position, and state the accounting equation.
3. Identify the four basic nancial statements and their interrelationships.
4. Explain how generally accepted accounting principles (GAAP) and international nancial
reporting standards (IFRS) relate to nancial statements and the independent CPA’s
report, and identify the organizations that in-uence GAAP.
5. Identify the users of accounting information, and identify business goals, activities, and
performance measures.
6. Explain the importance of ethics in nancial reporting.
Section 1: Concepts
Concepts
Accounting measurement
Business transactions
Money measure
Separate entity
Assets
Liabilities
Owner’s equity
Lecture Outline
0. Accounting is an information system that measures, processes, and communicates
nancial information.
0. Accounting is a link between business activities and decision makers.
0. Management must have a good understanding of accounting to set nancial goals
and make nancial decisions.
0. Management must not only understand how accounting information is compiled
and processed but also realize that accounting information is imperfect and should
be interpreted with caution.
0. Categories of accounting
A0. Financial accounting—accounting information for external decision makers; reports
are called nancial statements.
B0. Managerial accounting—accounting information for internal decision makers
II0. Four questions must be answered to make an accounting measurement.
0. What is measured?
0. When should the measurement be made?
0. What value should be placed on what is measured?
0. How should what is measured be classied?
V0. There are three basic forms of business organization.
0. Sole proprietorship—one owner
00. The owner takes all of the prots or losses of the business.
00. The owner also has unlimited liability.
0. Partnership—two or more owners
00. Two or more owners share prots or losses based on a predetermined
arrangement.
00. Unlimited liability can be avoided by forming a limited liability partnership.
0. Corporation—owned by many owners (the stockholders) but managed by a board
of directors
00. A corporation is a business unit chartered by the state (when articles of
incorporation are led) and considered a separate legal entity from its
owners.
00. The liability of corporate stockholders is limited to their investment.
V0. A balance sheet discloses a business’s nancial position by showing the relationship
among assets, liabilities, and owner’s equity.
0. The accounting equation is Assets = Liabilities + Owner’s Equity.
0. Assets are a company’s economic resources, such as cash, receivables, inventory, and
equipment.
III0. Liabilities are the present obligations of a business, such as amounts owed to banks,
suppliers, employees, and others.
IX0. Owner’s equity represents the claims of the owner of a business to the net assets of the
business. It is made up of the owner’s investment and all earnings not paid back to the
owner in the form of withdrawals.
X0. Net income is the excess of revenues over expenses; net loss is the excess of expenses
over revenues.
Summary
Accounting is an information system that measures, processes, and communicates
nancial information about an economic entity. Accounting is a link between business
activities and decision makers.
The goal of accounting is to assist decision makers. Managerial accounting provides
information to internal decision makers, such as managers, whereas nancial accounting
communicates nancial information via nancial statements to external decision makers.
Most businesses publish nancial statements that report their protability and nancial
position.
Accounting includes the design of an information system that meets the user’s needs.
To make an accounting measurement, the accountant must answer the following questions:
0What is measured?
0When should the measurement be made?
0What value should be placed on what is measured?
0How should what is measured be classied?
Accounting is concerned with measuring specic transactions of specic business entities in
terms of money. Business transactions are economic events that aDect the nancial
position of the business. Business transactions may involve exchanges of value (e.g., sales,
borrowings, and purchases) or nonexchanges (the physical wear and tear on machinery and
losses resulting from re or theft).
The money measure concept states that business transactions should be recorded in terms
of money. Financial statements are normally prepared in terms of the monetary unit of the
business’s country (dollars, pesos, etc.). When transactions occur between countries using
diDerent monetary units, the amounts must be translated from one currency to another
using the appropriate exchange rate.
For accounting purposes, a business is treated as a separate entity, distinct from its
owners, creditors, and customers.
The three basic forms of business organization are sole proprietorships, partnerships, and
corporations. Accountants recognize each form as an economic unit separate from its
owners. A sole proprietorship is an unincorporated business owned by one person. A
partnership is much like a sole proprietorship, except that it has two or more owners. A
corporation, unlike a sole proprietorship or partnership, is a business unit chartered by the
state and legally separate from its owners (the stockholders).
In this book, we begin with accounting for the sole proprietorship because it is the simplest
form of accounting. At critical points, however, we call attention to its essential diDerences
from accounting for partnerships and corporations.
Financial position refers to the relationship between economic resources and equities at a
given time, which is shown on the balance sheet. The accounting equation shows this
relationship in mathematical form. The basic accounting equation is as follows:
Assets = Liabilities + Owner’s Equity
Other forms of the equation are:
Assets – Liabilities = Owner’s Equity
Assets – Owner’s Equity = Liabilities
The left side of the basic accounting equation shows the resources (assets) of the business;
the right side shows who provided these resources. The resource provider consists of owner
(listed under “owner’s equity”) and creditors (evidenced by the existence of “liabilities”).
Therefore, it is logical that the total dollar amount of assets must equal the total dollar
amount of liabilities plus owner’s equity.
Assets are the economic resources of a business. Examples of assets are cash, accounts
receivable, inventory, buildings, equipment, patents, and copyrights.
Liabilities are the present obligations of a business. Examples of liabilities are money
borrowed from banks, amounts owed to creditors for goods or services bought on credit, and
taxes owed to the government.
Owner’s equity represents the claims of the owner of a sole proprietorship to the assets of
the business. It is equal to the net assets, or the assets that would be left after all liabilities
are paid.
Owner’s equity consists of the initial investment made by the owner, any subsequent
contributions or investments made into the business, and earnings not distributed back to
the owner in the form of dividends since the business’s inception.
After the owner’s initial investment, additional investments and earnings that have been
generated by the business’s income-producing activities and kept for use in the business are
added to owner’s equity. Owner’s equity is aDected by three kinds of operating transactions:
revenues, expenses, and owner’s withdrawals. Revenues are the increases in owner’s
equity resulting from the operation of the business. Expenses are the decreases in owner’s
equity that result from operating a business. When revenues exceed expenses, the
diDerence is called net income; when expenses exceed revenues, the diDerence is called
net loss.
Relevant Examples and Exhibits
Exhibit 1 Accounting as an Information System
Exhibit 2 Examples of Foreign Exchange Rates
Exhibit 3 Number and Receipts (Revenues) of U.S. Proprietorships, Partnerships, and
Corporations
Exhibit 4 The Accounting Equation
Teaching Strategy
A good place to begin is with a discussion of business goals and activities. Exhibit 1 in the
text not only illustrates accounting as an information system but also indicates the
measurement, processing, and communication functions of accounting.
Students may have diIculty distinguishing between accounting and bookkeeping. Perhaps
the use of a Venn diagram, with bookkeeping as a small circle within a much larger circle
identied as accounting within an even larger circle (MIS), will help them make the
distinction. As they learn accounting, students will also tend to focus on the bookkeeping
aspects only. Remind them that theory, terminology, nancial statement disclosure, and
other such topics also need to be learned.
Students often ask if computers have displaced accountants. Explain that although
computers are a useful tool, particularly for routine, repetitive processing, higher-level
analytical skills are required to interpret information, and professional judgment is required
to make good decisions.
Distinguish between nancial and managerial accounting. The discussion of internal versus
external users can be integrated with learning objective 5 on the users of accounting
information.
Short Exercise 1 can be used in class to test students’ knowledge of terminology.
List the four questions that must be answered before an accounting measurement can be
made. Perhaps you can provide a sample transaction and have your students answer these
questions. Students will already have a feel for what a business transaction is, but they
probably will not know the diDerence between an exchange and a nonexchange transaction,
so providing several examples may help. Refer to Exhibit 2 on exchange rates, explain how
they are used, and point out that they change daily. Explain how euros are replacing many
European currencies. Obtain copies of annual reports prepared in other currencies to show
students. Asking students to supplement the list of countries and their respective currencies
in Exhibit 2 may invite input from students of diverse backgrounds and is an opportunity to
stress the global nature of business today.
Finally, explain that for accounting purposes, a business and its owner(s) are always
considered separate entities. This concept can be reinforced by telling students that
maintaining the separation between business and owner is often a challenge in a small
family business when its owners write a check on the business’s account for groceries, take
a computer home, or give their children a company automobile to drive. For legal purposes,
a sole proprietorship or a partnership and its owners are not considered separate.
Point out that the sole proprietorship and the partnership are similar in many respects, but
that the corporation is signicantly diDerent from the other two forms of business
organization (in terms of formation, owners’ liability, duration, transfer of ownership, and
legal entity). Students have diIculty understanding the diDerence between the concepts of
separate legal entities and separate accounting entities. Students often think that
corporations always have multiple owners.
Relate material to the traditional form of organization of CPA rms. Tell students that
pending legislation would permit CPA rms to incorporate. Ask students why rms might
prefer incorporation.
To explain the concepts of nancial position, the accounting equation, and the balance
sheet, you can point out that all three represent two ways of looking at the same company:
the assets are the resources of the company (the essence of which is “expected future
benet”), and the liabilities and owner’s equity represent those who provided the resources
(creditors and the owner).
To reinforce the elements of the accounting equation, refer to a local business and ask
students what assets and liabilities it is likely to have. Students have diIculty grasping the
concept of equity. Explain that it represents the owner’s claims on the assets of the business
or net assets after the creditors’ claims have been met.
To illustrate the eDects of transactions on the accounting equation, you may wish to discuss
an end-of-chapter problem in which the accounting equation is updated for each transaction.
Be sure to total columns after each transaction to illustrate that the accounting equation
must always be in balance. A common misconception is that each transaction must have an
increase and a decrease.