CHAPTER

1 Accounting Principles and

the Financial Statements

Principles of
Accounting

12e

Needles
Powers
Crosson

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LEARNING OBJECTIVES

 LO1: Define accounting, and explain the concepts

underlying accounting measurement.
 LO2: Define financial position, and state the accounting
equation.
 LO3: Identify the four basic financial statements and their
interrelationships.
 LO4: Explain how generally accepted accounting principles
(GAAP) and international financial reporting standards
(IFRS) relate to financial statements and the independent
CPA’s report, and identify the organizations that influence
GAAP.
 LO5: Identify the users of accounting information, and
identify business goals, activities, and performance
measures.
 LO6: Explain the importance of ethics in financial reporting.

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SECTION 1: CONCEPTS

 Accounting measurement: measuring business

activities by recording data about them for future use
 Business transactions: economic events that affect a
business’s financial position
 Money measure: the concept that all business
transactions are recorded in terms of money
 Separate entity: the concept that a business organization
is distinct from its owners, creditors, and customers
 Assets: economic resources that are expected to benefit
the company’s future operations
 Liabilities: a business’s obligations to pay cash, transfer
assets, or provide services to other entities in the future
 Owner’s equity: the claims by the owner of a business to
the assets of the business; sometimes said to equal net
assets

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Concepts Underlying Accounting Measurement

 Accounting is an information system

that measures, processes, and
communicates financial information
about a business or other economic
entity.
– An economic entity is a unit that exists
independently, such as a business, hospital,
or governmental body.
– As shown on the next slide, accounting is a
link between business activities and
decision makers.

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Accounting as an Information System

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Financial and Managerial Accounting

 Accounting is usually divided into

financial accounting and managerial
- accounting.
External decision - Internal decision makers
makers use financial use information provided
accounting to by managerial
evaluate how well a accounting about
business has achieved operating, investing, and
its goals. financing activities.
 These reports, called  It provides managers
financial statements, and employees with
are a central feature of information about how
accounting. They report they have done in the
on a business’s past and what they can
financial performance. expect in the future.

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Financial and Managerial Accounting

 It is important to distinguish accounting

from bookkeeping and management
information systems.
– Bookkeeping is the process of recording
financial transactions and keeping financial
records. It is mechanical and repetitive and
is usually handled by computers.
– Management information systems
(MIS) consist of the interconnected
business subsystems, including accounting,
that provide the information needed to run
a business.

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Accounting Measurement

 To make an accounting measurement,

the accountant must answer four basic
questions:
– What is measured?
– When should the measurement be made?
– What value should be placed on what is
measured?
– How should what is measured be classified?

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Business Transactions

 Business transactions are economic

events that affect a business’s financial
position.
– A transaction can be an exchange of value (a
purchase, sale, payment, collection, or loan)
between two or more parties.
– A transaction also can be an economic event
that does not involve an exchange, such as
losses from fire, flood, explosion, and theft;
physical wear and tear on machinery and
equipment, and the day-by-day accumulation of
interest.
– To be recorded, a transaction must relate
directly to a business entity.
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Money Measure

 All business transactions are recorded in

terms of money. This concept is called
money measure.
– The monetary unit a business uses depends on
the country in which the business resides. In
the United States, the basic unit of money is
the dollar.
– In international transactions, exchange rates
must be used to translate from one currency to
another. An exchange rate is the value of one
currency in terms of another.
– The next slide illustrates the exchange rates of
several currencies in dollars.

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Examples of Foreign Exchange Rates

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Separate Entity

 For accounting purposes, a business

organization is a separate entity,
distinct not only from its creditors and
customers but also from its owners.
– It should have its own set of financial
records, and its records and reports should
refer only to its own affairs.

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Forms of Business Organization
(slide 1 of 2)

 Three basic forms of business organization

are recognized as separate entities.
– Sole proprietorship—a business owned by 1
person
 The owner takes all the profits or losses of the
business and is liable for all its obligations.
– Partnership—a business with 2 or more owners
 The partners share the profits or losses according to a
prearranged formula.
 A partnership must be dissolved if a partner leaves or
dies.
 The partners have unlimited liability, which can be
avoided by organizing as a limited liability partnership.

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Forms of Business Organization
(slide 2 of 2)

– Corporation—a business unit chartered by

the state and legally separate from its
owners
 The owners are called stockholders because
their ownership is represented by shares of stock.
 The stockholders do not directly control the
corporation’s operations but elect a board of
directors to run the corporation for their benefit.
 Stockholders enjoy limited liability, which means
that their risk of loss is limited to the amount
they paid for their shares.
 Stockholders can sell their shares without
dissolving the corporation, so the life of a
corporation is unlimited.

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Number and Receipts (Revenues) of U.S.
Proprietorships, Partnerships, and Corporations

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part.
Concepts Underlying Financial Position

 Financial position refers to a company’s

economic resources, such as cash,
inventory, and buildings, and the claims
against those resources at a particular
time. Another term for claims is equities.
 Every company has two types of equities:
creditors’ equities, such as bank loans,
and owner’s equity. The sum of these
equities equals a company’s resources:
Economic Resources = Creditors’ Equities +
Owner’s Equity

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Concepts Underlying Financial Position

 In accounting terminology, economic

resources are called assets and
creditors’ equities are called liabilities,
so the equation can be written:
Assets = Liabilities + Owner’s Equity
-This equation is known as the accounting
equation
(A = L + OE).
-The two sides of the equation must always
be equal, or “in balance,” as shown on the
next slide.

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The Accounting Equation

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Assets

 Assets are the economic resources

that are expected to benefit the
company’s future operations. They
include:
– monetary items (cash and money owed to
the company by customers)
– nonmonetary, physical items (inventories,
land, buildings, equipment)
– nonphysical items (rights granted by
patents, trademarks, and copyrights)

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Liabilities

 Liabilities are a business’s present

obligations to pay cash, transfer assets,
or provide services to other entities in
the future. They include:
– amounts to suppliers for goods or services
bought on credit (called accounts payable)
– borrowed money such as bank loans
– salaries and wages owed to employees
– taxes owed to the government
– services to be performed

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Owner’s Equity
(slide 1 of 2)

 Owner’s equity represents the claims

by the owner of a business to the
assets of the business.
– Theoretically, owner’s equity is what would
be left if all liabilities were paid.
– It is sometimes said to equal net assets.
– We can define owner’s equity this way:
Owner’s Equity = Assets − Liabilities

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Owner’s Equity
(slide 2 of 2)

– Owner’s equity is affected by the owner’s

investment in and withdrawals from the business
and by the business’s revenues and expenses.
 Owners’ investments are assets that the owner puts
into the business.
 Withdrawals are assets that the owner takes out of
the business.
 Revenues are increases in owner’s equity that result
from operating a business.
 Expenses are decreases in owner’s equity that result
from operating a business.
 When revenues exceed expenses, the difference is
called net income.
 When expenses exceed revenues, the difference is
called net loss.

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part.
SECTION 2: ACCOUNTING APPLICATIONS

 Describe the income statement

 Describe the statement of owner’s
equity
 Describe the balance sheet
 Describe the statement of cash flows

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Financial Statements

 Four major financial statements are

used to communicate accounting
information: the income statement,
the statement of owner’s equity, the
balance sheet, and the statement of
cash flows.

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Income Statement

 The income statement summarizes the

revenues earned and expenses incurred
by a business over an accounting period.
– Many people consider it the most important
financial report because it shows whether a
business achieved its profitability goal—that
is, whether it earned an acceptable income.
– To show the period to which the statement
applies, it is dated “For the [Month/Year]
Ended [Date]”

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Income Statement for Roland Consultancy

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Statement of Owner’s Equity

 The statement of owner’s equity

shows the changes in owner’s equity
over an accounting period.
– Owner’s equity is affected by investments
in the business by the owner, net income
(or loss), and withdrawals by the owner.
– The net income or loss on the statement of
owner’s equity comes from the income
statement.

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Statement of Owner’s Equity for
Roland Consultancy

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Balance Sheet

 The purpose of a balance sheet is to

show the financial position of a business
on a certain date, usually the end of a
month or year.
– For this reason, it is often called the
statement of financial position.
– The date on the balance sheet is a single
date, whereas the dates on the other three
statements cover a period of time.
– The amount of the owner’s capital account
on the balance sheet comes from the ending
balance on the statement of owner’s equity.

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Balance Sheet for Roland Consultancy

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Statement of Cash Flows

 The statement of cash flows focuses

on liquidity, that is, balancing the inflows
and outflows of cash to enable the
business to operate and pay its bills
when they are due.
– Cash flows are the inflows and outflows of
cash into and out of a business.
– The statement of cash flows is organized
according to three major business activities:
 Cash flows from operating activities
 Cash flows from investing activities
 Cash flows from financing activities

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Statement of Cash Flows for
Roland Consultancy

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Relationships Among the Financial Statements

 As shown on the next slide, the statement of

cash flows is related directly to the other
three financial statements.
– Net income comes from the income statement.
– Withdrawals—and investments by the owner—
come from the statement of owner’s equity.
– The other items in the statement represent
changes in the balance sheet accounts.
 The heading at the top of each statement
identifies the company and the kind of
statement.

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Income Statement, Statement of Owner’s Equity,
Balance Sheet, and Statement of Cash Flows for
Roland Consultancy

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part.
Generally Accepted Accounting Principles

 To ensure that financial statements are

understandable to their users, a set of
generally accepted accounting
principles (GAAP) has been developed
to provide guidelines for financial
accounting.
– They encompass the conventions, rules, and
procedures necessary to define accepted
accounting practice at a particular time.
– They evolve to meet the needs of decision
makers, and they change as circumstances
change or as better methods are developed.
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GAAP and the Independent CPA’s Report

 Many companies of all sizes have their

financial statements audited by an
independent certified public accountant
(CPA).
– Independent means that the CPA is not an
employee of the company being audited and has
no financial or other compromising ties to it.
– An audit is an examination of a company’s
financial statements and the accounting systems,
controls, and records that produced them. It
ascertains that the statements were prepared in
accordance with GAAP.

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Large International Certified Public Accounting
Firms

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Organizations That Issue
Accounting Standards

 Two organizations issue accounting

standards that are used in the United
States:
– The Financial Accounting Standards Board
(FASB) has been designated by the Securities
and Exchange Commission (SEC) to issue
Statements of Financial Accounting Standards.
– The International Accounting Standards
Board (IASB) issues international financial
reporting standards (IFRS). The SEC allows
foreign companies to use these standards in
the United States.

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Other Organizations That Influence GAAP
(slide 1 of 2)

 Many other organizations influence GAAP:

– The Governmental Accounting Standards
Board (GASB) is a separate but related body
to the FASB that issues accounting standards
for state and local governments.
– The Internal Revenue Service (IRS)
interprets and enforces the tax laws that
specify the rules for determining taxable
income. In some cases the rules conflict with
good accounting practice, but they are
important nonetheless.

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Other Organizations That Influence GAAP
(slide 2 of 2)

– The Public Company Accounting Oversight

Board (PCAOB) is a governmental body that
has wide powers to determine the standards that
auditors must follow.
– The American Institute of Certified Public
Accountants (AICPA) is the primary
professional organization of certified public
accountants.
– The Securities and Exchange Commission
(SEC) is a governmental agency that has the
legal power to set and enforce accounting
practices for companies whose securities are
offered for sale to the general public.

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Professional Conduct

 The code of professional ethics of the

American Institute of Certified Public
Accountants governs the conduct of CPAs.
The code requires CPAs to act with:
– Integrity—be honest and candid and
subordinate personal gain to service and the
public trust.
– Objectivity—be impartial and intellectually
honest.
– Independence—avoid all relationships that
impair or appear to impair objectivity.
– Due care—carry out professional responsibilities
with competence and diligence.
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Professional Conduct

 The Institute of Management

Accountants (IMA), the primary
professional association of managerial
accountants, has a code of professional
conduct that emphasizes that these
accountants have a responsibility:
– To be competent in their jobs
– To keep information confidential unless
authorized or legally required to disclose it
– To maintain integrity and avoid conflicts of
interest
– To communicate information objectively, without
bias
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part.
SECTION 3: BUSINESS APPLICATIONS

 Profitability: the ability to earn

enough income to attract and hold
investment capital
 Liquidity: the ability to have enough
cash to pay debts when they are due
 Ethics: a code of conduct that
addresses the question of whether
actions are right or wrong

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Decision Makers: The Users of
Accounting Information

 The people who use accounting information to

make decisions fall into three categories:
managers (internal users), outsiders who have
a direct financial interest in the business, and
outsiders who have an indirect financial
interest.

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Management

 Management is responsible for ensuring

that a company meets its goals of
profitability and liquidity.
 To make good decisions, owners and
managers need answers to such questions
as:
– What were the company’s earnings during the
past quarter?
– Is the rate of return to the owners adequate?
– Does the company have enough cash?
– Which products or services are most profitable?

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Users with a Direct Financial Interest

 Investors—owners and stockholders—

have a direct financial interest in the
success of their companies.
 Creditors—those who lend money or
deliver goods or services before being
paid—are interested mainly in whether
a company will have the cash to pay
interest charges and to repay the debt
on time. They study a company’s cash
flow to determine its liquidity.

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Users with an Indirect Financial Interest

 Tax authorities—federal, state, and local

 Regulatory agencies—such as the SEC
for publicly traded corporations
 Labor unions
 Advisors of investors and creditors
 Consumer groups, customers, the
general public
 Economic planners—such as the
President’s Council of Economic Advisers

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Governmental and Not-for-Profit Organizations

 These include hospitals, universities,

professional organizations, and charities.
 Their functions include:
– raising funds from investors, creditors,
taxpayers, and donors
– deploying scarce resources
– planning how to pay for operations and to
repay creditors on a timely basis
– reporting their financial performance to
legislators, boards, and donors

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Business Goals and Activities

 A business is an economic unit that aims

to sell goods and services at prices that
will provide an adequate return to its
owners.
 The two major goals of all businesses are:
– Profitability—the ability to earn enough
income to attract and hold investment capital
– Liquidity—the ability to have enough cash to
pay debts when they are due

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Business Goals and Activities

 All businesses pursue their goals by

engaging in the following activities:
– Operating activities—buying, producing,
and selling goods and services; hiring
managers and other employees; paying taxes
– Investing activities—buying resources for
operating the business, such as land,
buildings, and equipment; selling those
resources when no longer needed
– Financing activities—obtaining capital from
creditors and from the company’s owners;
repaying creditors; paying a return to owners

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Business Goals and Activities

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Financial Analysis

 Financial analysis is the use of financial

statements to determine that a business
is well managed and is achieving its goals.
 The effectiveness of financial analysis
depends on:
– Performance measures: Profitability is
commonly measured in net income, and
liquidity is commonly measured by cash flows.
– Financial ratios: The ratio of earnings to
total assets can be used to assess profitability,
and the ratio of cash flows to total assets can
be used to assess liquidity.

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part.
Ethical Financial Reporting

 Ethics is a code of conduct that addresses

the question of whether actions are right or
wrong.
– Ethics is especially important in preparing
financial reports because users must be able to
trust that the reports are accurate and disclose
all relevant facts.
– The intentional preparation of misleading
financial statements is called fraudulent
reporting and can result from distortion of
records, falsified transactions, and
misapplication of various accounting principles.

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Ethical Financial Reporting

 In response to the accounting scandals at

Enron Corporation and WorldCom, the
Sarbanes-Oxley Act of 2002 was
passed.
– It regulates the financial reporting of public
companies and their auditors.
– It requires chief executives and chief financial
officers of all publicly traded U.S. companies
to swear that, based on their knowledge,
their quarterly statements and annual reports
filed with the SEC are accurate and complete.

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©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.