Chapter 1
Accounting as a Form of
Communication
After studying this chapter, students should be able to:
◼ Explain what business is about (Module 1–LO1).
◼ Distinguish among the forms of organization (Module 1–LO2).
◼ Describe the various types of business activities (Module 1–LO3).
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Chapter Outline
MODULE 1 THE NATURE OF BUSINESS
Module 1
LO 1
The Nature of Business
Business consists of all 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.
Module 1
LO 2
Forms of Organization
One way to categorize organizations is to distinguish between those that are organized to earn money and
those that exist for some other purpose.
Business Entities
Business entities are organizations operated to earn a profit. Legally business entities are one of three types:
◼ Sole Proprietorships
⚫ A business organization with a single owner.
⚫ Many small businesses are sole proprietorships.
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⚫ Public accounting firms, law firms, and other types of service companies are often
partnerships.
⚫ Not a taxable entity. Individual partners pay taxes on their proportionate share of the
business’s profits.
◼ Corporations
⚫ Corporations control the majority of private resources in the U.S, even though sole
proprietorships and partnerships dominate in number.
Ease of transfer of ownership.
• Sale of stock to another owner through a broker if stock is actively traded.
Limited liability: stockholder is only liable for the amount contributed to the business.
• Sole proprietors and general partners can be held personally liable for the debts of
the business.
Nonbusiness Entities
◼ Exist to serve the needs of various segments of society.
◼ An organization operated for some purpose other than to earn a profit.
Organizations and Social Responsibility
◼ U.S. business entities recognize the societal aspects of their overall mission and have established
programs to meet these responsibilities.
Module 1
LO 3
The Nature of Business Activity
Business activities can be categorized into one of three types: financing, investing, and operating.
Financing Activities
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◼ Includes the sale of stock or borrowing to finance operations.
◼ Liability: an obligation of a business. Notes payable, bonds payable, accounts payable.
Investing Activities
◼ Once the funds are generated from financing activities, the money is now available to invest in
assets.
Operating Activities
◼ Once funds are obtained from financing activities and investments are made in productive assets,
a business can begin operations.
◼ Every business is organized with a purpose in mind:
Summary of Business Activities
◼ Exhibit 1-3 summarizes the three types of activities conducted by a business. Actual businesses
have many different financing, investing, and operating activities going at any one time.
MODULE 2 ACCOUNTING AND FINANCIAL STATEMENTS
Module 2
LO 4
Users of Accounting Information and Their Needs
CHAPTER 1 ACCOUNTING AS A FORM OF COMMUNICATION
Users of Accounting Information and Their Needs
Exhibit 1-4 summarizes the various users of financial information and the types of decisions they must
make.
◼ Internal users:
⚫ Primarily the managers of a company since they are involved in the daily affairs of the
business.
◼ External users:
⚫ Anyone outside of the company. Those not directly involved in the operations of the business.
⚫ Limited access to information because not directly involved in the operations of the business.
⚫ Need different information than managers of the business.
⚫ Certain external users require the information be presented in a specific manner.
IRS has authority of the law to ensure they get the required information.
Stockholders and creditors rely on financial statements for their information.
Using Financial Accounting Information
The Financial Decision Framework is used to help make investment decisions:
1. Formulate the Question.
3. Analyze the Information Gathered. The information in the financial statements can be used to
perform:
• Ratio analysis (looking at relationships among financial statement items).
• Horizontal analysis (looking at trends over time).
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Module 2
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.
The 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.
The Balance Sheet
◼ Sometimes called the statement of financial position.
◼ The financial statement that summarizes the assets, liabilities, and owners’ equity of a company.
◼ Snapshot of the business at a certain date.
The Income Statement
◼ Sometimes called the statement of income.
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The Statement of Retained Earnings
◼ Explains the change in retained earnings during the period.
◼ Summarizes the income earned and dividends paid over the life of the business.
◼ Net income increases retained earnings and net losses decrease retained earnings.
The Statement of Cash Flows
◼ Summarizes the cash flow effects of a company’s operating, investing, and financing activities for
the period.
Relationships Among the Financial Statements
◼ Income statement computes the net income (loss).
Looking at Financial Statements for a Real Company: Chipotle
There are certain fundamental points about all statements that should be noted.
Chipotle’s Balance Sheet
See Exhibit 1-7 for the balance sheets for Chipotle.
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◼ Amounts presented in thousands of dollars.
Chipotle’s Income Statement
See Exhibit 1–8 for Chipotle’s Income Statement.
◼ Comparative income statements for three years are shown.
MODULE 3 CONCEPTUAL FRAMEWORK OF ACCOUNTING
Module 3
LO 6
Conceptual Framework of Accounting
Bookkeeping is the part of accounting that deals with record-keeping. Accounting requires judgment in
communicating relevant information to financial statement users.
Conceptual Framework for Accounting
◼ The framework is the foundation for the specific principles and standards needed by the
profession.
Economic Entity Concept
◼ One identifiable, specific entity should be the subject of the financial statements.
Asset Valuation: Cost or Fair Value?
◼ Cost principle requires assets to be originally recorded at the cost to acquire them.
⚫ Also called historical cost or original cost.
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Going Concern
◼ The assumption that an entity is not in the process of liquidation and will continue indefinitely into
the future.
Time Period Assumption
◼ An artificial segment on the calendar used as the basis for preparing financial statements.
Module 3
LO 7
Setting Accounting Standards
Management of a company is responsible the preparation of the financial statements. These statements
must conform to GAAP.
◼ GAAP, Generally Accepted Accounting Principles, are the various methods, rules, practices,
Who Determines the Rules for Financial Statements?
The process is a joint effort among the following:
◼ Securities and Exchange Commission (SEC): the federal agency with ultimate authority to
determine the rules for preparing statements for companies whose stock is sold to the public.
⚫ For the most part, the SEC has allowed the accounting profession to establish its own rules.
⚫ The annual report filed with the SEC is the Form 10–K.
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◼ International Accounting Standards Board (IASB): organization formed to develop worldwide
accounting standards.
The Audit of Financial Statements
◼ Financial statements are the responsibility of the company’s management.
Module 3
LO 8
Introduction to Ethics in Accounting
Why Should Accountants Be Concerned With Ethics?
Ethics plays a critical role in providing useful accounting information.
◼ In recent years, the news has been filled with reports of questionable accounting practices by some
companies.
◼ Companies may use aggressive accounting practices to misrepresent earnings.
◼ Be aware when it appears as if GAAP may not have been used to resolve particular accounting
issues.
⚫ Turn to the professional framework for guidance.
CHAPTER 1 ACCOUNTING AS A FORM OF COMMUNICATION
• A dilemma is likely to occur when a company is considering a decision about
accounting methods or disclosures and when one of the following takes place:
2. Analyze the key elements in the situation.
• Who may benefit or be harmed?
• How are they likely to benefit or be harmed?
3. Determine what alternative methods are available to report the transaction, situation or event.
• Which of the alternatives is most relevant and a faithful representation? Timeliness is
4. 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.
The Changing Face of the Accounting Profession
At the start of the new millennium, many corporate scandals let to some of the largest bankruptcies in the
history of business.
◼ Examples of some the companies involved in the financial reporting crisis:
⚫ Enron: an economic entity decision as to whether various entities, under the control of Enron,
should be included in the company’s financial statements.
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⚫ 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.