1. Chapter 1Chapter 1
Accounting: The Language
of Business

2. Learning ObjectivesLearning Objectives
After studying this chapter, you should be able to:After studying this chapter, you should be able to:
 Explain how accounting information assists in makingExplain how accounting information assists in making
decisions.decisions.
 Describe the components of the balance sheet.Describe the components of the balance sheet.
 Analyze business transactions and relate them toAnalyze business transactions and relate them to
changes in the balance sheet.changes in the balance sheet.
 Compare features of proprietorships, partnerships, andCompare features of proprietorships, partnerships, and
corporations.corporations.

3. IntroductionIntroduction
 AccountingAccounting - a process of identifying, recording,- a process of identifying, recording,
summarizing, and reporting economicsummarizing, and reporting economic
information to decision makers in the form ofinformation to decision makers in the form of
financial statementsfinancial statements
 Financial accountingFinancial accounting - focuses on the specific- focuses on the specific
needs of decision makers external to theneeds of decision makers external to the
organization, such as stockholders, suppliers,organization, such as stockholders, suppliers,
banks, and government agenciesbanks, and government agencies

4. The Nature of AccountingThe Nature of Accounting
 TheThe accounting systemaccounting system is a series of stepsis a series of steps
performed to analyze, record, quantify, accumulate,performed to analyze, record, quantify, accumulate,
summarize, classify, report, and interpret economicsummarize, classify, report, and interpret economic
events and their effects on an organization and toevents and their effects on an organization and to
prepare the financial statements.prepare the financial statements.

5. The Nature of AccountingThe Nature of Accounting
 Accounting systems are designed to meet theAccounting systems are designed to meet the
needs of the decisions makers who use theneeds of the decisions makers who use the
financial information.financial information.
 Every business has some sort of accountingEvery business has some sort of accounting
system.system.
 These accounting systems may be very complex orThese accounting systems may be very complex or
very simple, but the real value of any accountingvery simple, but the real value of any accounting
system lies in the information that the systemsystem lies in the information that the system
provides.provides.

6. Accounting as an Aid toAccounting as an Aid to
Decision MakingDecision Making
 Accounting information is useful to anyoneAccounting information is useful to anyone
who makes decisions that have economicwho makes decisions that have economic
results.results.
• Managers want to know if a new product will be profitable.Managers want to know if a new product will be profitable.
• Owners want to know which employees are productive.Owners want to know which employees are productive.
• Investors want to know if a company is a good investment.Investors want to know if a company is a good investment.
• Creditors want to know if they should extend credit, howCreditors want to know if they should extend credit, how
much to extend, and for how long.much to extend, and for how long.
• Government regulators want to know if financialGovernment regulators want to know if financial
statements conform to requirements.statements conform to requirements.

7. Accounting as an Aid toAccounting as an Aid to
Decision MakingDecision Making
 Fundamental relationships in the decision-Fundamental relationships in the decision-
making process:making process:
Event
Accountant’s
analysis &
recording
Financial
Statements
Users

8. Financial and ManagementFinancial and Management
AccountingAccounting
 The major distinction between financial andThe major distinction between financial and
management accounting is the users of themanagement accounting is the users of the
information.information.
 Financial accountingFinancial accounting serves external users.serves external users.
 Management accountingManagement accounting serves internal users, suchserves internal users, such
as top executives, management,as top executives, management,
and administrators withinand administrators within
organizations.organizations.

9. Financial and ManagementFinancial and Management
AccountingAccounting
The primary questions about an organization’sThe primary questions about an organization’s
success that decision makers want to know are:success that decision makers want to know are:
What is the financial picture of the organization onWhat is the financial picture of the organization on
a given day?a given day?
How well did the organization do during a givenHow well did the organization do during a given
period?period?

10. Financial and ManagementFinancial and Management
AccountingAccounting
Accountants answer these primary questionsAccountants answer these primary questions
with three major financial statements.with three major financial statements.
 Balance SheetBalance Sheet - financial picture on a given day- financial picture on a given day
 Income StatementIncome Statement - performance over a given- performance over a given
periodperiod
 Statement of Cash FlowsStatement of Cash Flows - performance over a- performance over a
given periodgiven period

11. Financial and ManagementFinancial and Management
AccountingAccounting
 Annual reportAnnual report - a document prepared by- a document prepared by
management and distributed to current andmanagement and distributed to current and
potential investors to inform them about thepotential investors to inform them about the
company’s past performance and futurecompany’s past performance and future
prospects.prospects.
 The annual report is one of the most commonThe annual report is one of the most common
sources of financial information used by investorssources of financial information used by investors
and managers.and managers.

12. Financial and ManagementFinancial and Management
AccountingAccounting
 The annual report usually includes:The annual report usually includes:
 a letter from corporate managementa letter from corporate management
 a discussion and analysis of recent economic events bya discussion and analysis of recent economic events by
managementmanagement
 footnotes that explain many elements of the financialfootnotes that explain many elements of the financial
statements in more detailstatements in more detail
 the report of the independent auditorsthe report of the independent auditors
 a statement of management’s responsibility fora statement of management’s responsibility for
preparation of the financial statementspreparation of the financial statements
 other corporate informationother corporate information

13. The Balance SheetThe Balance Sheet
 What are the different sections of theWhat are the different sections of the
Balance Sheet?Balance Sheet?

14. The Balance SheetThe Balance Sheet
Sections of the balance sheet:Sections of the balance sheet:
 AssetsAssets - resources of the firm that are expected to- resources of the firm that are expected to
increase or cause future cash flows (everything the firmincrease or cause future cash flows (everything the firm
owns)owns)
 LiabilitiesLiabilities - obligations of the firm to outsiders or- obligations of the firm to outsiders or
claims against its assets by outsiders (debts of the firm)claims against its assets by outsiders (debts of the firm)
 Owners’ EquityOwners’ Equity - the residual interest in, or remaining- the residual interest in, or remaining
claims against, the firm’s assets after deducting liabilitiesclaims against, the firm’s assets after deducting liabilities
(rights of the owners)(rights of the owners)

15. The Balance SheetThe Balance Sheet
The balance sheet equation:The balance sheet equation:
Assets = Liabilities + Owners’ EquityAssets = Liabilities + Owners’ Equity
oror
Owners’ Equity = Assets - LiabilitiesOwners’ Equity = Assets - Liabilities

16. The Balance SheetThe Balance Sheet
HAMILTON COMPANYHAMILTON COMPANY
Balance SheetBalance Sheet
December 31, 1997December 31, 1997
AssetsAssets LiabilitiesLiabilities
Current assets:Current assets: Current liabilities:Current liabilities:
CashCash $ 4,525$ 4,525 Accounts payableAccounts payable $ 9,800$ 9,800
Accounts receivableAccounts receivable 2,0402,040 Wages payableWages payable
3,7653,765
Total current assets $ 6,565Total current assets $ 6,565 Total liabilitiesTotal liabilities
$13,565$13,565
Plant assets:Plant assets:
LandLand $ 9,755$ 9,755
EquipmentEquipment 6,5006,500 Owners’ EquityOwners’ Equity
Total plant assetsTotal plant assets 16,25516,255 Hamilton, capitalHamilton, capital
9,2559,255
Total liabilities andTotal liabilities and
Total assetsTotal assets $22,820$22,820 Owners’ equityOwners’ equity $22,820$22,820
==========================
==========================

17. Balance Sheet TransactionsBalance Sheet Transactions
 The balance sheet is affected by every transactionThe balance sheet is affected by every transaction
that an entity encounters.that an entity encounters.
 Each transaction has counterbalancing entries thatEach transaction has counterbalancing entries that
keep total assets equal to total liabilities andkeep total assets equal to total liabilities and
owners’ equity, i.e., the balance sheet equationowners’ equity, i.e., the balance sheet equation
must alwaysmust always be balanced.be balanced.

18. Balance Sheet TransactionsBalance Sheet Transactions
 Just as the balance sheet equation must alwaysJust as the balance sheet equation must always
balance, the balance sheetbalance, the balance sheet must also alwaysmust also always
balance.balance.
 A balance sheet could be prepared after everyA balance sheet could be prepared after every
transaction, but this practice would be awkwardtransaction, but this practice would be awkward
and unnecessary.and unnecessary.
 Therefore, balance sheets are usually preparedTherefore, balance sheets are usually prepared
monthly or on some other periodic schedule.monthly or on some other periodic schedule.

19. Transaction AnalysisTransaction Analysis
 Transactions are recorded inTransactions are recorded in accountsaccounts, which are, which are
summary records of the changes in particularsummary records of the changes in particular
assets, liabilities, or owners’ equity.assets, liabilities, or owners’ equity.
 TheThe account balanceaccount balance is the total of all entries tois the total of all entries to
the account.the account.

20. Transaction AnalysisTransaction Analysis
 For each transaction, the accountant mustFor each transaction, the accountant must
determine:determine:
 which specific accounts are affectedwhich specific accounts are affected
 whether the account balances are increased orwhether the account balances are increased or
decreaseddecreased
 the amount of the changethe amount of the change
in each accountin each account

21. Types of OwnershipTypes of Ownership
 Three basic forms of ownership:Three basic forms of ownership:
 Sole proprietorshipsSole proprietorships
 PartnershipsPartnerships
 CorporationsCorporations

22. Types of OwnershipTypes of Ownership
Sole ProprietorshipSole Proprietorship
 A separate organization with aA separate organization with a singlesingle ownerowner
 Tend to be small retail establishments andTend to be small retail establishments and
individual professional or service business - forindividual professional or service business - for
example, a single dentist, attorney, or publicexample, a single dentist, attorney, or public
accountantaccountant
 The sole proprietorship is an individual entity thatThe sole proprietorship is an individual entity that
is separate and distinct from the owner.is separate and distinct from the owner.

23. Types of OwnershipTypes of Ownership
PartnershipPartnership
 An organization that joins two or more individualsAn organization that joins two or more individuals
who act as co-ownerswho act as co-owners
 Dentists, doctors, attorneys, and accountants tend toDentists, doctors, attorneys, and accountants tend to
conduct their activities as partnerships. Some canconduct their activities as partnerships. Some can
be large international firms.be large international firms.
 The partnership is an individual entity that isThe partnership is an individual entity that is
separate and distinct from each of the partners.separate and distinct from each of the partners.

24. Types of OwnershipTypes of Ownership
CorporationCorporation
 An “artificial entity” created under state lawsAn “artificial entity” created under state laws
 Corporations haveCorporations have limited liabilitylimited liability - corporate- corporate
creditors have claims against corporate assets only.creditors have claims against corporate assets only.
 Individual investors are at risk only up to the amountIndividual investors are at risk only up to the amount
they have invested in the corporation. Creditors cannotthey have invested in the corporation. Creditors cannot
hold investors liable for the corporation’s debts.hold investors liable for the corporation’s debts.

25. Types of OwnershipTypes of Ownership
CorporationCorporation
 Owners are calledOwners are called shareholdersshareholders oror stockholdersstockholders..
 Publicly owned vs. privately ownedPublicly owned vs. privately owned
corporationscorporations
 PublicPublic - Shares in the ownership are sold to the- Shares in the ownership are sold to the
public on a stock exchange; the corporation canpublic on a stock exchange; the corporation can
have many thousands of shareholders.have many thousands of shareholders.
 PrivatePrivate - Shares in the ownership are owned by- Shares in the ownership are owned by
families, small groups of shareholders, and shares arefamilies, small groups of shareholders, and shares are
not sold to the public.not sold to the public.

26. Types of OwnershipTypes of Ownership
Management by the owners:Management by the owners:
 Sole proprietorshipSole proprietorship - The owner is an active- The owner is an active
manager in day-to-day operation of the business.manager in day-to-day operation of the business.
 PartnershipPartnership - Partners are usually active- Partners are usually active
managers in day-to-day operations of themanagers in day-to-day operations of the
business.business.
 CorporationCorporation - Shareholders usually do not- Shareholders usually do not
participate in the day-to-day operations of theparticipate in the day-to-day operations of the
business.business.

27. Advantages and Disadvantages ofAdvantages and Disadvantages of
Forms of OwnershipForms of Ownership
CorporationsCorporations
 AdvantagesAdvantages
 limited liabilitylimited liability
 easy transfer of ownership - shares of stock can beeasy transfer of ownership - shares of stock can be
bought and sold easily (stock exchanges)bought and sold easily (stock exchanges)
 ease of raising ownership capital - many potentialease of raising ownership capital - many potential
stockholdersstockholders
 continuity of existence - life of the corporationcontinuity of existence - life of the corporation
continues even if its ownership changescontinues even if its ownership changes

28. Advantages and Disadvantages ofAdvantages and Disadvantages of
Forms of OwnershipForms of Ownership
CorporationsCorporations
 DisadvantagesDisadvantages
 possibility of double taxation - corporation pays taxpossibility of double taxation - corporation pays tax
at the entity level and its owners pay taxes onat the entity level and its owners pay taxes on
distributions of earnings to themdistributions of earnings to them

29. Advantages and Disadvantages ofAdvantages and Disadvantages of
Forms of OwnershipForms of Ownership
Proprietorships and PartnershipsProprietorships and Partnerships
 AdvantagesAdvantages
 no taxation at the entity level - income of soleno taxation at the entity level - income of sole
proprietorship and partnership is attributed to theproprietorship and partnership is attributed to the
owners as individual taxpayersowners as individual taxpayers

30. Advantages and Disadvantages ofAdvantages and Disadvantages of
Forms of OwnershipForms of Ownership
Proprietorships and PartnershipsProprietorships and Partnerships
 DisadvantagesDisadvantages
 unlimited liability - creditors of the business can look tounlimited liability - creditors of the business can look to
the owners’ personal assets for repaymentthe owners’ personal assets for repayment
 not easy to transfer ownershipnot easy to transfer ownership
 not easy to raise ownership capital - few, if anynot easy to raise ownership capital - few, if any
individuals interested in a particular proprietorship orindividuals interested in a particular proprietorship or
partnershippartnership
 no continuity of existence - changes in ownershipno continuity of existence - changes in ownership
terminate the proprietorship or partnershipterminate the proprietorship or partnership