1
chapter
1
Introduction to
Accounting and Business
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OPENING COMMENTS
For many students, Chapter 1 of Accounting is their first taste of the business or accounting disciplines.
The teaching challenge is to get students to understand and accept the importance of learning business and
accounting concepts. This will make the course more than just another requirement that students must
complete to graduate. Because this chapter will set the tone for the entire course and their business
careers, avoid the temptation to rush through the material.
Chapter 1 begins with a discussion of the nature of a business and the different types of businesses
(service, merchandising, and manufacturing) and types of business organizations (proprietorship,
partnership, corporation, and limited liability corporations). Next, the chapter describes internal and
external users, and how their needs affect accounting systems. The chapter then moves onto business
ethics, and discusses how individual character, firm culture, and laws and enforcement affect ethics as
well as the accounting/business frauds of the 2000s. The roles of accounting in business and accounting
professions/careers are discussed. Following this introductory information, the text explains Generally
Accepted Accounting Principles (GAAP), the business entity concept, and the cost concept. The
accounting equation is introduced, and then the discussion of how business transactions affect accounts in
the accounting equation begins. When transactions are analyzed, changes in assets, liabilities, and
owner’s equity are stated as “increases” or “decreases”—the terms “debit” and “credit” are not introduced
until Chapter 2. The rules of using at least two accounts, selecting those account names, and maintaining
the equality of the equation are discussed using several transactions for a business called “NetSolutions.”
Next are examples of how to prepare all four financial statements using the accounting equation
information and with explanations of how the four financial statements are interrelated. The chapter ends
with an explanation of the ratio of liabilities to owner’s equity and how it is particularly important to
creditors.
2 Chapter 1 Introduction to Accounting and Business
After studying the chapter, your students should be able to:
1. Describe the nature of a business and the role of accounting and ethics in business.
2. Summarize the development of accounting principles and relate them to practice.
3. State the accounting equation and define each element of the equation.
4. Describe and illustrate how business transactions can be recorded in terms of the resulting change in
the elements of the accounting equation.
5. Describe the financial statements of a proprietorship and explain how they interrelate.
6. Describe and illustrate the use of the ratio of liabilities to owner’s equity in evaluating a company’s
financial condition.
KEY TERMS
account form
account payable
account receivable
accounting
accounting equation
assets
balance sheet
business
business entity concept
business transaction
Certified Public Accountant (CPA)
corporation
cost concept
earnings
ethics
expenses
fees earned
financial accounting
Financial Accounting Standards Board (FASB)
financial statements
generally accepted accounting principles (GAAP)
general-purpose financial statements
income statement
interest revenue
International Accounting Standards Board (IASB)
liabilities
limited liability company (LLC)
management (or managerial) accounting
manufacturing business
matching concept
merchandising business
net income (or net profit)
net loss
Chapter 1 Introduction to Accounting and Business 3
objectivity concept
owner’s equity
partnership
prepaid expenses
private accounting
profit
proprietorship
public accounting
Public Company Accounting Oversight Board (PCAOB)
ratio of liabilities to owner’s (stockholders’) equity
rent revenue
revenue
sales
Sarbanes-Oxley Act (SOX)
Securities and Exchange Commission (SEC)
service business
statement of cash flows
statement of owner’s equity
unit of measure concept
STUDENT FAQS
• Why do I have to take this course since my major is not “Accounting”?
• Why is “Accounting” so important?
• Why can’t I just use a computer program to do all my accounting?
• Why is the accounting equation set the way it is? Why could it not be “Owner’s Equity – Assets =
Liabilities” or “Liabilities – Assets = Owner’s Equity”?
• Why are Net Income and Cash not the same?
• Why do people call revenue by so many names?
• Why do the financial statements have to go in a certain order?
• Why is Cash the first asset listed?
• What is the difference between revenues and assets?
• What is the difference between expenses and liabilities?
• Why does the balance sheet report the accounts at a point in time while the income statement and
statement of owner’s equity report the activity for a period of time? Shouldn’t they all report for a
period of time?
• Why use a ratio to judge a company’s ability to pay its obligations rather than dollar amounts?
• What are the liability differences between sole proprietorships, partnerships, corporations, and LLCs?
4 Chapter 1 Introduction to Accounting and Business
OBJECTIVE 1
Describe the nature of a business and the role of accounting and ethics in business.
SYNOPSIS
The first objective starts with a list of the three types of businesses: service, merchandising, and
manufacturing. It defines each types of business and gives examples. The role of accounting in business is
discussed along with the two types of users: internal and external. Exhibit 1 shows the various users and
the data they require. Accounting information must be not only relevant and timely but also trustworthy.
The failure of individual character and a culture of corporate greed led to the businesses in Exhibit 2
being convicted of accounting and business fraud. Opportunities for accounting are increasing as
regulations increase, and people are beginning to realize the importance and value of accounting
information. Exhibit 3 provides a list of accounting career paths and salaries.
Key Terms and Definitions
• Accounting – An information system that provides reports to stakeholders about the economic
activities and condition of a business.
• Business – An organization in which basic resources (inputs), such as materials and labor, are
assembled and processed to provide goods or services (outputs) to customers.
• Certified Public Accountant (CPA) – Public accountants who have met a state’s education,
experience, and examination requirements.
• Ethics – Moral principles that guide the conduct of individuals.
• Financial Accounting – The branch of accounting that is concerned with recording transactions
using accepted accounting principles (GAAP) for a business or other economic unit and with a
periodic preparation of various statements from such records.
• General-Purpose Financial Statements – A type of financial accounting report that is
distributed to external users. The term “general purpose” refers to the wide range of decision–
making needs that the reports are designed to serve.
• Management (Managerial) Accounting – The branch of accounting that uses both historical and
estimated data in providing information that management uses in conducting daily operations, in
planning future operations, and in developing overall business strategies.
• Manufacturing Businesses – A type of business that changes basic inputs into products that are
sold to individual customers.
• Merchandising Businesses – A type of business that purchases products from other businesses
and sells them to customers.
• Private Accounting – The field of accounting whereby accountants are employed by a business
firm or a not-for-profit organization.
• Profit – The difference between the amounts received from customers for goods or services
provided and the amounts paid for the inputs used to provide the goods or services.
• Public Accounting – The field of accounting where accountants and their staff provide services
on a fee basis.
• Public Company Accounting Oversight Board (PCAOB) – A new oversight body for the
accounting profession that was established by the Sarbanes-Oxley Act.
• Sarbanes-Oxley Act (SOX) – An act passed by Congress to restore public confidence and trust in
the financial statements of companies.
• Service Business – A business providing services rather than products to customers.
Chapter 1 Introduction to Accounting and Business 5
Relevant Example Exercises and Exhibits
• Exhibit 1 – Accounting as an Information System
• Exhibit 2 – Accounting and Business Frauds
• Exhibit 3 – Accounting Career Paths and Salaries
SUGGESTED APPROACH
The first class of your semester/quarter often sets the tone for the rest of the term. Many instructors
believe it is easier to spark classroom discussion if you can get each student to speak on the first day of
class and to write something about themselves. Objective 1 provides a good opportunity to encourage
early class participation. Your students will be familiar with most of the terms introduced in this learning
objective. Use the first writing exercise and classroom discussion suggestions to get students talking
about business and accounting.
The text defines accounting as “an information system that provides reports to users about the economic
activities and condition of a business.” Accounting is also known as the “language of business.” The
goal of Objective 1 is also to make this definition meaningful and to make students aware of the uses of
accounting data.
To spark discussion, you may want to ask students what they think of when they hear the term
“accounting.” You could also ask what accounting information they or their families need in managing
their finances (such as information for preparing income tax returns, budgeting everyday expenses,
applying for personal loans, mortgage loans, or college loans, etc.).
This objective also introduces ethical conduct as it applies in the business setting. You may want to
supplement text material by discussing the codes of professional ethics for accountants. The role of
individual character, firm culture, and the laws and enforcement should be discussed as well as integrity
and objectivity. This is a wonderful time to discuss these topics because we have such a long list of
examples such as Enron, WorldCom, etc. Ask the students if they themselves, friends, or family members
have lost money due to any of these companies. Some will have never heard of these companies while
some will have very good stories to tell in the classroom.
It may be important to point out the reason these ethical codes are necessary. Accountants are privy to a
variety of private and often sensitive information about businesses. Without these ethical codes, the
accountant can be in a position to impact the businesses future in a significant way, either positively or
negatively. This trusted relationship between business and accountant requires that the accountant live by
these codes of conduct.
The Institute of Management Accountants and the American Institute of Certified Public Accountants
codes of ethics are excellent items to review and are shown in Transparency Masters (TM) 1–1 and 1-2
respectively. It is important to illustrate how these codes can be used to help accountants make difficult
decisions. Four cases, which should stimulate a class discussion on ethics, are described in the Class
Discussion section below.
6 Chapter 1 Introduction to Accounting and Business
You may want to refer to your college or university “Student Code of Conduct” as an example of ethical
codes for students. You may want to hand out to each student your school’s “Student Code of Conduct”
and discuss it or have whoever is in charge of your “Student Code of Conduct” policy, such as Dean of
Students, discuss issues relating to classroom learning, testing, and cheating. To spark discussion, ask
your students to develop a “Student Code of Conduct” for your course. Controversial issues you could ask
them to consider are whether or not their code of conduct should include a policy on attending classes,
tardiness, cell phone ring/usage, what is considered cheating (electronically as well as manually), or the
proper use of the solutions to test questions, exercises, and problems transferred electronically. Most
colleges are constantly working on updating student code rules relating to technology.
This learning objective also provides the opportunity to stress that accountants do more than just prepare
tax forms!
You may want to describe the differences between public and private accounting and then discuss the
specialized fields in accounting. Specialized fields are shown in TMs 1-7 through 1-9.
If you want to emphasize the many employment alternatives available in accounting, ask students to bring
in examples of advertisements for accounting positions from a local newspaper. If you know of an
accounting professional with an especially interesting or unusual job, you may want to invite that
individual to speak to your class. Even if this speaker must be scheduled later in the term, it will help
emphasize the diversity in the accounting profession and dispel the “bean–counter” image.
You may also want to research the requirements for becoming a CPA in your state and share those with
your students, or better yet have the accounting majors do it as a group project. Direct your students to
your state CPA society (such as the OSCPA for the State of Oklahoma at Web site
http://www.OSCPA.com or TSCPA for the state of Texas at Web site http://www.TSCPA.org). You may
even want to direct them to the student membership within your Society’s Web page. Students gain a lot
of information from this site.
WRITING EXERCISE—The Definition of Business
Everyone has heard the term “business.” Ask your students to write short sentences/phrases that describe
a business they have recently used. After giving them a couple of minutes, ask your students to share their
ideas as you make a list of their key phrases. Next, ask your students to use these ideas to write a
definition of “business.” You may want to compare their definitions to the one provided in the text, which
defines a business as “an organization in which basic resources (inputs), such as materials and labor, are
assembled and processed to provide goods or services (outputs) to customers.”
CLASS DISCUSSION—Types of Businesses
Have the class provide the names of businesses they have used in the past week. Include places they have
shopped, eating establishments, products they use every day, and services they have used. When listing
products, name the manufacturer; for iPod, for example, the manufacturer would be Apple. List these on
the board or overhead.
Chapter 1 Introduction to Accounting and Business 7
Show a list of the three types of businesses (these are shown in TM 1-20):
Service Businesses
Merchandising Businesses
Manufacturing Businesses
CLASS DISCUSSION—Ethics in Accounting
Read one or more of the following cases to the class and discuss whether or not the accountant acted
ethically. You can stimulate discussion by playing “devil’s advocate”—arguing an opposing view to
whatever opinion is first offered. (You may want to use TMs 1-3 through 1-6 in presenting these cases.)
1. Lauren Smith is the controller for Sports Central, a chain of sporting goods stores. She has been
asked to recommend a site for a new store. Lauren has an uncle who owns a shopping plaza in the
area of town where the new store is to be located, so she decides to contact her uncle about leasing
2. John Jones is the chief accountant for the Southwest district office of Security Life Insurance
Company. While preparing the fourth-quarter sales report, John overheard the company president say
that he would close Security’s Phoenix office if it did not meet its fourth–quarter sales quota. John’s
best friend from college works at the Phoenix office.
3. Tech-Smart Computer Company recently discovered a defect in the hard disks installed in its model
R24 computer. The hard disk head in these units retracts too violently whenever the computers are
8 Chapter 1 Introduction to Accounting and Business
turned off. As a result, the hard disks are destroyed after the computer is turned on and off
approximately 500 times. Tech-Smart has sold 4,000 model R24 computers nationwide.
4. Tom Brown, the controller for MicroTech Software Company, is responsible for preparing the
company’s financial statements. He learns that sales for the first quarter of the year have dropped so
dramatically that the company is in danger of bankruptcy. As a result, he applies for an accounting
position with another software company that competes with MicroTech. During his job interview,
LECTURE AID—Accounting as an Information System
The goal of accounting can be illustrated using the following equation:
Goal of Accounting = Record + Report + Interpret Economic Data for use by decision makers
Ask your students to name those who would be interested in the economic results of a business. List their
responses on the board. When complete, the list should contain many of the following:
1. Owner
3. Bankers
5. Managers
7. Customers
8. Competitors
After compiling this list, you may want to ask students to state what economic data each of those listed
previously would be interested in seeing and why. Examples follow:
Interested In
Reason
1. Owner . . . . . . . . . . . . . .
Sales
Is advertising effective?
Profit
Can I take home more money each week?
Cash
Can I afford to buy more equipment?
2. Investors/Stockholders. .
Profit
Is my investment making money?
Dividends
What dividends are being paid?
3. Bankers . . . . . . . . . . . . .
Debts
Can this business repay a loan?
4. IRS . . . . . . . . . . . . . . . .
Profit
What taxes does this business owe?
5. Managers . . . . . . . . . . . .
Expenses
Am I keeping expenses within my budget?
Sales
Will I be eligible for a bonus this year?
6. Employees . . . . . . . . . . .
Profit
Can my company afford raises?
Is my job secure?
GROUP LEARNING ACTIVITY—Accounting as an Information System
The ethics cases provided on TM 1-3 through 1-6 can be assigned to groups to discuss and present a brief
explanation to the class as to their opinions and recommendations.
INTERNET ACTIVITY
Ask your students to research some nontraditional accounting careers. Two government organizations
who hire accountants to help with investigations of fraud and criminal activities are the FBI and the IRS.
Web sites for these organizations are:
10 Chapter 1 Introduction to Accounting and Business
http://www.jobs.irs.gov
Please note: Since Web site addresses frequently change, it is always a good idea to try these Web sites at
the beginning of each term to check the accuracy of the Web addresses.
OBJECTIVE 2
Summarize the development of accounting principles and relate them to practice.
SYNOPSIS
Generally accepted accounting principles (GAAP) are used to prepare financial reports. This allows users
to compare one company to another. In the United States, these principles are the responsibility of the
Financial Accounting Standards Board (FASB). Companies that are publically traded are also guided by
the Securities and Exchanges Commission (SEC). The FASB works with the International Accounting
Standards Board (IASB) to reduce differences between international and U.S. standards. This help makes
global investment and business easier. This chapter also introduces the four forms of business entities:
sole proprietorship, partnership, corporation, and limited liability company. The cost concept requires that
amounts are recorded at the actual price paid. The price paid is the primary objective measure as offers,
appraisals, and opinions can be unstable over time. Financial data must also be recorded in a common unit
of measure; GAAP requires dollars to be the common of measure.
Key Terms and Definitions
• Business Entity Concept – A concept of accounting that limits the economic data in the
accounting system to data related directly to the activities of the business.
• Corporation – A business organized under state or federal statutes as a separate legal entity
• Cost Concept – A concept of accounting that determines the amount initially entered into the
accounting records for purchases
• Financial Accounting Standards Board (FASB) – The authoritative body that has the primary
responsibility for developing accounting principles.
• Generally Accepted Accounting Principles (GAAP) – Generally accepted guidelines for the
preparation of financial statements.
• International Accounting Standards Board (IASB) – An organization that issues International
Financial Reporting Standards for many countries outside the United States.
Chapter 1 Introduction to Accounting and Business 11
Relevant Example Exercises and Exhibits
• Example Exercise 1-1 – Cost Concept
• Exhibit 4 – Forms of Business Entities
SUGGESTED APPROACH
This objective introduces students to the Financial Accounting Standards Board (the FASB) and
Generally Accepted Accounting Principles (GAAP). It is important to stress that the FASB sets the
standards that govern the rules of financial accounting. These rules are defined in the GAAP. The
International Accounting Standards Board (IASB) is the international equivalent of the FASB.
Optional discussion: International Financial Reporting Standards (IFRSs). You may want to mention that
work is currently under way to reach consensus on a set of worldwide accounting principles as the
business world becomes increasingly global.
Additionally this objective introduces the business entity concept, the cost concept, the objectivity
concept, and the unit of measure concept–––four principles that govern how accounting data are
accumulated. Remind students that accounting data would be inconsistent from company to company if
standardized procedures were not followed.
WRITING EXERCISES—Business Entity and Cost Concept
Ask students to write an answer to the following questions. These exercises are shown in TM 1-10.
1. Sally Vertrees purchased a personal computer for use at home. Sally owns a dental practice. She
occasionally uses the computer for a task related to her dental practice; however, the computer is used
primarily by Sally’s children. Can the computer be recorded as an asset in the accounting records of
Sally’s dental office? Why or why not?
12 Chapter 1 Introduction to Accounting and Business
Possible explanation: This is a violation of the business entity concept. Purchasing items for
2. Jason Thompson purchased an office building 10 years ago for $780,000. The building was just
appraised at $1.25 million. What value should be used for the building in Jason’s accounting records?
Support your answer.
CLASS DISCUSSION—Types of Business Organizations
Ask for students to name examples of each type of business. Next, list the four types of business
organizations (these are shown in TM 1-21):
Proprietorship
Partnership
Corporation
Limited Liability Corporation
Again, ask students to name examples of businesses in each category. Explain that in the early chapters of
the text, they will be learning about accounting concepts related to service businesses organized as
proprietorships. Take a page from the local phone book and ask students to identify each business by
type.
You may also want to emphasize the following key facts about business organizations:
2. About 10 percent of businesses are organized as partnerships and/or limited liability companies.
Chapter 1 Introduction to Accounting and Business 13
OBJECTIVE 3
State the accounting equation and define each element of the equation.
SYNOPSIS
This objective defines assets, liabilities, and owner’s equity and uses the accounting equation
(Assets = Liabilities + Owner’s Equity) to explain their relationship.
Key Terms and Definitions
• Accounting Equation – Assets = Liabilities + Owner’s Equity.
• Assets – The resources owned by a business.
• Liabilities –The rights of creditors that represent debts of the business.
• Owner’s Equity – The owner’s right to the assets of the business.
Relevant Example Exercises and Exhibits
• Example Exercise 1-2 – Accounting Equation
SUGGESTED APPROACH
This objective asks the student to state the accounting equation: Assets = Liabilities + Owner’s Equity.
TM 1-11, which presents an alternative way to describe this accounting equation, is an effective lecture
aid.
This objective also asks the student to define each element of the equation. Most students easily grasp the
meaning of the terms “assets” (resources owned by a business) and “liabilities” (debts). “Owner’s equity,”
however, is not a simple concept.