CH 01

ACCOUNTING: CHAPTER
The Language
of Business 1
© 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Learning Objectives
After studying this chapter, you should be able to

1. Explain how accounting information assists in
making decisions
2. Describe the components of the balance sheet
3. Analyze business transactions and relate them to
changes in the balance sheet
4. Compare the features of sole proprietorships,
partnerships, and corporations
© 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 2 of 43
Learning Objectives
After studying this chapter, you should be able to

5. Identify how the owners’ equity section in a
corporate balance sheet differs from that in a sole
proprietorship or partnership
6. Describe auditing and how it enhances the value of
financial information
7. Explain the regulation of financial reporting
8. Evaluate the role of ethics in the accounting
profession
The Nature of Accounting
• Accounting is the process of identifying,

recording, summarizing, and reporting economic
information for decision makers
• Accountants present this information in reports
called financial statements
Accountant’s
Analysis and Financial
Event Users
Recording Statements
Accounting as an Aid
to Decision Making
• Accounting information is useful to anyone
making decisions that have economic
consequences
• These decision makers include
– Managers
– Owners
– Investors
– Politicians
Financial Accounting
• Financial accounting serves external

decision makers:
– Stockholders
– Suppliers
– Banks
– Government agencies
Management Accounting
• Management accounting serves internal

decision makers:
– Top executives
– Department heads
– College deans
– Hospital administrators
– Other managers within the organizations
The Annual Report
• The annual report is prepared by management

and informs investors about the company’s past
performance and future prospects
The Annual Report
• The annual report includes

– A letter from corporate management
– Management discussion and analysis
– Footnotes explaining many elements of the financial
statements in more detail
– The report of the independent auditors
– A statement of management’s responsibility for
preparation of the financial statements
– Other corporate information
The Annual Report
• A company’s financial statements can also be

found in Form 10-K, which it files annually with
the Securities and Exchange Commission
• The three major financial statements are the
– Balance sheet
– Income statement
– Statement of cash flows
The Annual Report
• The balance sheet focuses on the financial

position of a company on a particular day
• The income statement and cash flow statement
focus on the company’s performance over time
The Balance Sheet
• The balance sheet (also called the statement of

financial position) shows the financial status of a
company at a particular instant in time
• The left side lists the resources of the firm
• The right side lists the claims against those
resources
Assets= Liabilities + Owners’ equity
The Balance Sheet
• Assets are economic resources that the

company expects to help generate future cash
inflows or reduce or prevent future cash outflows
– Examples: Cash, inventories, equipment
• Liabilities are economic obligations of the
organization to outsiders (creditors)
– Example: A debt to a bank in the form of a note
payable
• Owners’ equity is the owners’ claim on the
organization’s assets
The Balance Sheet
• Open account – the practice of making most

purchases on a credit basis instead of cash
basis
• Accounts receivable are assets that result from
the sale of goods or services on open account
• Accounts payable are liabilities that result from a
purchase of goods or services on open account
• Inventories are assets held by the company for
the purpose of sale to customers
Balance Sheet Transactions
• Every transaction of a company or entity affects

the balance sheet equation
– An entity is an organization that stands apart from
other organizations and individuals as a separate
economic unit
– A transaction is any event that affects the financial
position of an entity and that can reliably recorded in
money terms
• An account is a summary record of the changes

in a particular asset, liability, or owners’ equity
item
• The double-entry accounting system records
each transaction in at least two accounts
• A compound entry affects more than two
balance sheet accounts
Transaction 1: Initial Investment of $400,000

Assets = Liabilities + Owners’ Equity
Cash Lopez, Capital
(1) + $400,000 = +$400,000

(Owner Investment)
Transaction 2: Loan of $100,000 from Bank

Cash Note payable Lopez, Capital
(1) + $400,000 = +$400,000

(2) + $100,000 = + $100,000
Bal. $500,000 = $100,000 $400,000
$500,000 $500,000
Transaction 3: Acquire Store Equipment

for Cash, $15,000
Cash Store Equipment Note payable Lopez, Capital
Bal. $500,000 = $100,000 $400,000

(3) -15,000 +15,000 =
Bal. 485,000 15,000 = 100,000 400,000
$500,000 $500,000
Preparing the Balance Sheet
Biwheels Company
Balance Sheet January 3, 20X2
Assets Liabilities and Owners’ Equity
Cash $485,000 Liabilities (note payable) $100,000
Store equipment 15,000 Lopez, capital 400,000
Total assets $500,000 Total liabilities

and owners’ equity $500,000
Types of Ownership
• Sole proprietorship – a business with a single

owner
• Partnership – an organization that joins two or
more individuals who act as co-owners
• Corporation – a business organization created
under state laws in the Unites States
Corporation
– Publicly owned corporation – A corporation owned by

the public through the sale of shares; it may have
thousands of owners
– Privately owned corporation – A corporation owned by
families or a small group of shareholders; shares are
not publicly sold
– Corporation stockholders have limited liability
• Creditors have claims against the corporation
assets only, not the personal assets of the owners
Advantages and Disadvantages
of the Corporate Form
• Advantages • Disadvantages
– Limited liability – Unfavorable tax laws
– Easy transfer of – Regulation
ownership
– Ability to raise capital
from hundreds or
thousands of potential
stockholders
– Continuity of existence
– Prestige
Accounting Differences Among
Legal Forms
• Proprietorships and partnerships
– Owners’ equities are labeled capital
– Owners’ equities are recorded in the capital account
• Corporations
– Owners’ equities are labeled stockholders’ equity or
shareholders’ equity. Total capital investment is called
paid-in capital
– Owners’ equity is recorded in two parts:
• Common stock at par value
• Paid-in capital in excess of par value
The Meaning of Par Value
• Par value (or stated value) – the dollar amount

printed on the stock certificate
• Paid-in capital in excess of par value (or
additional paid-in capital) – the difference
between the total amount the company receives
for the stock and the par value
• Common stock is recorded at the par value
• Common shareholders are owners who have a
“residual” ownership in the corporation through
the purchase of common stock
Stockholders and the
Board of Directors
• Shareholders elect a board of directors to look
out for their interests
• Members of a board often include CEOs and
presidents of other corporations; university
presidents and professors; attorneys; and
community representatives
• The chairman of the board may also be the top
manager, the chief executive officer (CEO)
Stockholders and the
Board of Directors
• The board’s duty is to ensure that managers act
in the interest of shareholders
• When boards do their duty in monitoring
management, the corporate form of organization
is effective
Stockholders Board of Directors Managers
Credibility and the Role of Auditing
• The separation of owners and managers creates

potential problems in getting truthful information
about the performance of a company
• Shareholders must rely on managers to tell the
truth
• The auditor examines the information that
managers use to prepare the financial
statements and provides assurances about the
credibility of those statements
The Certified Public Accountant and
the Auditor’s Opinion
• Third party assurance about the credibility of
financial statements is provided by audit
professionals called Certified Public
Accountants (CPAs)
• CPAs are public accountants who offer services
including auditing, preparing income taxes, and
management consulting to the general public on
a fee basis
• Each state has a Board of Accountancy that sets
standards of both knowledge and integrity
The Certified Public Accountant and
the Auditor’s Opinion
• An audit is an examination of a company’s
transactions and the resulting financial
statements
• The auditor’s opinion describes the scope and
results of the audit and a judgment that the
financial statements prepared by management
are accurate
The Accounting Profession
• Public accountants offer services to the general

public for a fee
• Private accountants work for businesses,
government agencies, and other nonprofit
organizations
Public Accounting Firms
• The four largest public accounting firms are

– Deloitte Touche Tohmatsu
– Ernst & Young
– KPMG International
– PricewaterhouseCoopers
• 97% of the firms listed on the NYSE are clients
of these four firms
Public Accounting Firms
• Each firm has annual billings in excess of $1

billion
• All firms must follow generally accepted
accounting principles (GAAP)
– The broad concepts and detailed practices of
preparing and distributing financial statements
Standard-Setting Bodies
• The Financial Accounting Standards Board

(FASB) is responsible for establishing GAAP in
the United States by issuing FASB Statements
• The Securities and Exchange Commission
(SEC) is responsible for authorizing the GAAP
for companies whose stock is held by the
general investing public
• The FASB and SEC work closely together and
seldom have public disagreements
• The International Accounting Board (IASB)

– Is responsible for developing high quality,
understandable and enforceable global accounting
standards
– Has 12 full-time and 2 part-time members
– Standards will be adopted by the European Union for
financial statements prepared after 2005
• The American Institute of Certified Public

Accountants (AICPA) is the principal
professional association in the private sector that
regulates the quality of the public accounting
profession
Sarbanes-Oxley Act
• Established the Public Company Accounting

Oversight Board to regulate public accounting
and to set standards for audit procedures
through the issuance of generally accepted
auditing standards (GAAS)
• Prohibits public accounting firms from providing
audit clients with certain non-audit services
• Requires rotation every 5 years of the lead audit
or coordinating partner and the reviewing
partner on an audit
Sarbanes-Oxley Act
• Provides regulation of corporate governance

– Requiring boards to appoint an audit committee
composed only of “independent” directors
– Requiring CEOs and chief financial officers (CFOs) to
personally sign a statement certifying the
appropriateness and fairness of their companies’
financial statements
– Increasing criminal penalties for knowingly
misreporting financial information
Professional Ethics
• Members of the AICPA must abide by a code of

professional conduct
• The Institute of Management Accountants has a
code of ethics for management accounts
• Auditors and management accountants have
professional responsibilities concerning
competence, confidentiality, integrity, and
objectivity
Professional Ethics
• Ethical standards are personal and depend on

the values of the individual
• A successful manager must recognize the
ethical dimensions of a situation and act with
absolute integrity
Professional Ethics
• Despite the criticism of accounting ethics,

accountants were responsible for revealing the
problems in many of the recent corporate
scandals
• Companies often rely on accountants to
safeguard the ethics of the company
• WorldCom and Enron whistle-blowers became
two of the three 2002 Persons of the Year in
Time magazine
Career Opportunities
for Accountants
• Accounting provides an excellent training ground
for future managers and executives
• More CEOs started out in finance or accounting
than any other area
Nonprofit Organizations
• Fundamental accounting principles also apply to

nonprofit organizations
• The Governmental Accounting Standards
Board (GASB) regulates disclosures for
governmental organizations
• The FASB regulates financial reporting for other
nonprofit organizations

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ACCOUNTING: CHAPTER

After studying this chapter, you should be able to

After studying this chapter, you should be able to

• Accounting is the process of identifying,

• Financial accounting serves external

• Management accounting serves internal

• The annual report is prepared by management

• The annual report includes

• A company’s financial statements can also be

• The balance sheet focuses on the financial

• The balance sheet (also called the statement of

Assets= Liabilities + Owners’ equity

• Assets are economic resources that the

• Open account – the practice of making most

• Every transaction of a company or entity affects

• An account is a summary record of the changes

Transaction 1: Initial Investment of $400,000

Cash Lopez, Capital

(1) + $400,000 = +$400,000

Transaction 2: Loan of $100,000 from Bank

Cash Note payable Lopez, Capital

(1) + $400,000 = +$400,000

Transaction 3: Acquire Store Equipment

Cash Store Equipment Note payable Lopez, Capital

Bal. $500,000 = $100,000 $400,000

Assets Liabilities and Owners’ Equity

Cash $485,000 Liabilities (note payable) $100,000

Store equipment 15,000 Lopez, capital 400,000

Total assets $500,000 Total liabilities

• Sole proprietorship – a business with a single

– Publicly owned corporation – A corporation owned by

• Par value (or stated value) – the dollar amount

Stockholders Board of Directors Managers

• The separation of owners and managers creates

• Public accountants offer services to the general

• The four largest public accounting firms are

• Each firm has annual billings in excess of $1

• The Financial Accounting Standards Board

• The International Accounting Board (IASB)

• The American Institute of Certified Public

• Established the Public Company Accounting

• Provides regulation of corporate governance

• Members of the AICPA must abide by a code of

• Ethical standards are personal and depend on

• Despite the criticism of accounting ethics,

• Fundamental accounting principles also apply to

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