1. The Role of Accounting in Business
CHAPTER 1

2. Learning Objectives
After studying this chapter, you should be able to:
Describe the types and forms of businesses, how businesses make money, and business stakeholders
Describe the three business activities of financing, investing, and operating
Define accounting and describe its role in business
Describe and illustrate the basic financial statements and how they interrelate
Describe eight accounting concepts underlying financial reporting
Financial Analysis: Describe and illustrate how the rate of return on assets can be used to analyze and assess a company’s financial performance

3. Learning Objective 1
Describe the types and forms of businesses, how businesses make money, and business stakeholders

4. Types of Businesses
Businesses come in all sizes—from your local hardware store to Lowes Home Improvement centers. The objective of most businesses is to earn a profit, or to receive more value for the goods or services provided than the cost to make or provide those goods and services.

5. Forms of Business Proprietorship Partnership Corporation
Limited Liability Company
Forms of Business:
Setting up a business can follow several different formats. A proprietorship is owned by one individual and is the easiest form of business to establish. Over 70% of businesses in the United States are organized as proprietorships.
A partnership is similar to a proprietorship, but it is owned by two or more individuals. About 10% of the businesses in the United States are organized as partnerships. About 20% of businesses in the United States are organized as corporations. A corporation operates as a legal entity separate from its owners, called stockholders. The ownership of a corporation is divided into shares of stock, which each stockholder purchases to gain ownership interest in the corporation.
Limited Liability companies combine the ownership attributes of a partnership and corporation. This format operates mainly like a partnership but owners have limited liability, which is an advantage of the corporate structure.
There are many considerations while choosing a form of business. A proprietorship is the easiest business to form, however, a proprietorship has the disadvantages of unlimited liability for the proprietor and an organizational life that could be limited by the life of the owner. Proprietorships and partnerships also have a more difficult time than corporations in raising capital. However, a corporation, being a separate legal entity, is taxed separately from its owners.

6. Differences in Forms of Business
This table summarizes the similarities and differences among formats of organization discussed. While a manufacturing business, merchandising business, or service business can be organized under any of these formats, business that require a large amount of resources, such as a large manufacturer or merchandiser, usually are organized as corporations.

7. How do Businesses Make Money?
By providing goods and services to customers so that they can make a profit
To maximize their profits, companies may use one of the following two strategies:
Low-cost strategy
Premium-price strategy
Examples of each?
Companies try to maximize profits by earning high revenues while maintaining low costs. Increasing a company’s profits can be achieved by either increasing revenues, decreasing costs, or both. However, competitors usually try to do the same thing. Two general strategies are used to gain advantage over competitors.
(1) Low-cost strategy: here a company designs and produces products or services at a lower cost than its competitors.
(2) Premium-price strategy: here a company tries to design and produce products or services that serve unique market needs, allowing it to charge premium prices.

8. How do Businesses Make Money?
Here are two examples of companies that employ low-cost and premium-price strategies.

9. Business Stakeholders
Business stakeholders can come from several areas. Stakeholders can be generally classified into one of the four categories:
Capital Market: Capital market stakeholders provide financing for a company to start up, expand, or continue business. Banks and creditors expect to recover the original amount loaned plus interest. Stockholders want to maximize the value of their investment in a business.
Product or Service Market: Product or service market shareholders purchase the company’s products and services or sell their products and services to the company. A customer has a stake in the continued health of a company in order to be assured they will receive their product or service. Likewise, a supplier has financial interest in the company; A supplier expects to be paid for the goods or services they provide to the company.
Government: Government stakeholders can be federal, state, country, city, or other regulatory bodies. The more successful a company, the more it will pay in taxes.
Internal: Finally, internal stakeholders include managers and employees who depend on the continued success of a company in order to remain employed.

10. Business Stakeholders
Business stakeholders can come from several areas. Stakeholders can be generally classified into one of four categories:
Capital Market - Capital market stakeholders provide financing for a company to start up, expand, or continue business. Banks and creditors expect to recover the original amount loaned plus interest. Stockholders want to maximize the value of their investment in a business.
Product or Service Market - Product or service market shareholders purchase the company’s products and services or sell their products and services to the company. A customer has a stake in the continued health of a company in order to be assured they will receive their product or service. Likewise, a supplier has financial interest in the company; A supplier expects to be paid for the goods or services they provide to the company.
Government - Government stakeholders can be federal, state, country, city, or other regulatory bodies. The more successful a company, the more it will pay in taxes.
Internal - Finally, internal stakeholders include managers and employees who depend on the continued success of a company in order to remain employed.

11. Learning Objective 2
Describe the three business activities of financing, investing, and operating

12. Business Activities Use business assets to acquire more assets:
tangible (machinery, buildings, computers, etc.)
intangible (patents and goodwill)
Borrowing from a 3rd party
Investing in the business
All companies engage in three basic business activities:
Financing activities: Often times, the very first activity of a business is a financing activity—when an owner deposits some of their own money to start up the business. Financing activities of a business include borrowing transactions and owner investments into the company. Borrowing creates liabilities; a liability represents a legal obligation to repay a creditor at a point in the future based upon terms set by the creditor. A business can also be financed by its owners making investments in the organization. An owners’ investment differs from a liability in that future repayment from the company is not expected.
Investing activities: Investing activities involve using funds provided from either financing activities, operating activities, or other investing activities to start and operate the business. Depending on the nature of business, a variety of different assets may be needed.
Operating activities: Operating activities are the activities a business enters into to earn revenues and generate profits. Costs or expenses need to be incurred by a business in order to sell their product or service.
Use assets to earn revenues and profits
(Revenues < expenses = net loss; Revenues > expenses = net income

13. Learning Objective 3
Define accounting and describe its role in business

14. Objectives of Financial Accounting
Sometimes called the “language of business”, accounting is an information system that provides reports to stakeholders about the economic activities and condition of a business
Essentially, it summarizes the financial performance of the firm for external users
The two major objectives of financial accounting are:
To report the financial condition of a business at a point in time
To report changes in the financial condition of a business over a period of time
Accounting is a language because it is the primary way a business can communicate information to its stakeholders. The role of accounting is to provide information about the financing, investing, and operating activities of a company to its stakeholders. Depending on the stakeholder, different information will provide different value. For example, a creditor will be interested in information related to the economic performance of the company and its ability to repay its obligations in the future. Managerial accounting is the branch of accounting that provides information to the internal users of the company. Financial accounting is associated with preparing financial statements and reports for external users.

15. Two Major Objectives of Financial Accounting
The objectives of financial accounting are achieved by recording the events affecting a business and then summarizing the impact of these events on the business in the financial reports and statements of the company.
The first objective, reporting the financial condition of a business AS OF A POINT IN TIME, can be thought of as a still picture or snapshot of the company’s financial condition at a specific moment in time.
The second objective, reporting the financial condition of a business OVER A PERIOD OF TIME, can be thought of as a moving picture of activities and performance of a company over a period of time.
Financial Condition
As of a POINT IN TIME
Financial Condition
Over a PERIOD OF TIME

16. Learning Objective 4
Describe and illustrate the basic financial statements and how they interrelate

17. Financial Statements Income Statement Retained Earnings Statement
Balance Sheet
Statement of Cash Flows
Financial statements report the financial condition of a business at a point in time and changes in the financial condition over a period of time. This slide lists the four basic financial statements and their objectives. In general, the financial statements are prepared in the order shown here.

18. Income Statement
Summary of revenue and expenses for a specific period of time (e.g., month, quarter, or year)
Reports the change in financial condition due to the operations of a business
Uses the matching concept: Expenses for the period are matched against revenues for the same period Revenue – Expenses = Net Income
The income statement summarizes revenue and expenses for a period of time in order to determine how well a company has performed and achieved its objective of generating profits. The time period covered by an income statement may vary depending on the needs of the stakeholders. This time period may also be called a fiscal period.
Since the objective of business operations is to generate a profit and profit can not be generated without revenue, the income statement begins by listing revenue. Revenue is followed by listing the expenses incurred in generating the revenue. By reporting the expenses and related revenues for a period, the expenses are said to be “matched” against the revenues. When revenues exceed expenses, the company has net income. A net loss results if expenses exceed revenues. The goal of a company is to maximize profits by either increasing revenues, decreasing costs or both. Businesses might survive net losses in the short run, but since a net loss decreases the overall assets of a company, in the long term, a business must earn net income to survive.
During 2012, Hershey generated sales of $6,644, expressed in millions of dollars. Following the revenues, Hershey’s expenses are listed and they include cost of sales, selling and administrative, interest, income taxes and other. During 2012, Hershey earned net income of $661 million. The net income can be good or bad depending on the user. A creditor may determine that the net income indicates sufficient profitability to repay an obligation. However, a stockholder may be disappointed that the $661 million of net income on $6,644 million of sales is not as successful when measured against a competitor’s performance.

19. Retained Earnings Statement
Reports changes in financial condition due to changes in retained earnings during a period
Retained earnings is the portion of net income retained by the business
Retained earnings represent the accumulated profits of a business that have been reinvested in the business rather than being paid out as dividends to the owners. Often times in growth companies, all earnings are retained in the business to fund expanding operations. Since retained earnings depend on net income, the time period covered by the retained earnings statement will be the same as the income statement.
In 2012, Hershey began the year with $4,708 million in retained earnings. The $661 million of net income is the same net income amount reported on the income statement. During 2012, Hershey also declared dividends of $341 million resulting in $5,028 remaining in retained earnings at the end of 2012.

20. Assets = Liabilities + Stockholders’ Equity
Balance Sheet
Reports financial condition at a point in time
Measured by total assets and claims to those assets:
A balance sheet reports the dollar amounts associated with the assets of a company and the sources of financing for those assets. As covered in the previous learning objective, a business can be financed by borrowing or owner investment. The balance sheet must therefore report the financial condition of a company at a point in time. The balance sheet is represented by the accounting equation of Assets = Liabilities + Stockholders’ Equity.
The balance sheet for Hershey shows total assets as of December 31, 2012 of $4,754 million. Total liabilities at the same point in time amount to $3,706 million and total stockholders’ equity is reported at $1,048 million. Total liabilities and equity add up to $4,754 million, which is equal to the total assets.
Assets = Liabilities + Stockholders’ Equity

21. Balance Sheet – Preparation
Step 1: Each asset is listed and added to arrive at total assets
Step 2: Each liability is listed and added to arrive at total liabilities
Step 3: Each stockholders’ equity item is listed and added to arrive at total stockholders’ equity
Step 4: Total liabilities and total stockholder’s equity are added together
Step 5: Total assets must equal total liabilities and stockholders’ equity
The balance sheet is prepared by listing the accounting equation in a vertical rather than horizontal form using 5 steps. For preparing the balance sheet, each item under asset, liability, and stockholders’ equity is listed and added to arrive at their respective total amounts. The total of liabilities and total of stockholders’ equity are then added together. The total of liabilities and stockholders’ equity must equal the total of asset.

22. Statement of Cash Flows
Reports the change in financial condition due to the changes in cash during a period
Net change in operating cash flows
Net change in investing cash flows
Net change in financing cash flows
The statement of cash flows reports events that affect a company’s cash account during a fiscal period. However, the statement itself is prepared as of a point in time, like the balance sheet. The statement of cash flows is organized around the three business activities of financing, investing, and operating.
During 2012, Hershey’s operating activities generated a positive cash flow of $1,095 million. Hershey’s investing activities used $473 million primarily to purchase property, plant, and equipment. Hershey’s financing activities used $967 million of cash, primarily due to repayment of debt, payment of dividends, and repurchase of stock. Hershey also received $380 million by borrowing from creditors. Overall, during 2012, Hershey’s cash balance increased by $35 million to arrive at an end of period cash balance of $728 million. Another way to look at this statement is that Hershey generated $1,095 million of cash from operations which they used to expand operations and pay stockholders. This would indicated that Hershey is in a strong operating position.

23. Statement of Cash Flows – Operating Activities
Net cash flows from operating activities is reported first
Cash flow from operating activities is a focus of stakeholders
Operating activities are transactions that involve the acquisition or production of products and services and the sale of those products or services to customers
The net cash flows from operating activities is reported first because the cash flow from operating activities is a primary focus of many of the company’s stakeholders. Creditors use cash flows from operations to assess if operating activities are generating enough cash to repay future obligations. In the long-term, a company can not survive without generating positive cash flow from operating activities.

24. Statement of Cash Flows – Investing Activities
Net cash flows from investing activities is reported second
Cash receipts from selling property, plant, and equipment are reported in this section
Cash used to purchase property, plant, and equipment is also reported in this section
Negative cash flow from investing activities is normal for an expanding company
Net cash flows from investing activities is reported second because investing activities directly impact the operations of a company. Property, plant, and equipment can provide the foundation for operations and growth in an organization. Investing activities can involve the acquisition or sale of long-term assets for cash during a period. A rapidly expanding company would expect a negative net cash flow from investing activities. In contrast, a company that is downsizing or selling off assets or segments of its business would expect positive cash flows from investing activities.

25. Statement of Cash Flows – Financing Activities
Net cash flows from financing activities is reported third
Any cash receipts from issuing debt or stock are reported in this section
Cash payments on debt and dividends are also reported in this section
Financing activities are transactions between a company and its creditors and owners. Cash flows in, when cash is borrowed for a long-term financing objective or stock is issued for cash. Cash flows out, when a debt is repaid, dividends are paid, or stock is repurchased.

26. Integrated Financial Statements
Preparing the financial statements in the order of income statement, retained earnings statement, balance sheet and statement of cash flows is important because the financial statements are integrated. Net income on the income statement links the income statement to the statement of retained earnings. Then, the final retained earnings balance from the statement of retained earnings is also reported on the balance sheet. Finally, the balance sheet and statement of cash flows are linked by the cash account.
For the Hershey Company, #1 shows the net income of $661 million on both the income statement and the statement of retained earnings. #2 then shows the ending retained earnings balance of $5,028 million both on the statement of retained earnings and also as a part of stockholders’ equity on the balance sheet. Finally, #3 integrates the balance sheet and the statement of cash flows by the cash balance of $728 million.

27. Integrated Financial Statements
Net income from the income statement is linked to the retained earnings statement
Retained earnings is linked to the stockholders’ equity in the balance sheet
Cash balance from the statement of cash flows is linked to cash in the balance sheet
The financial statements are integrated as follows:
First, the income and retained earnings statements are integrated. The net income or net loss reported on the income statement also appears on the retained earnings statement as either an addition to, if net income, or deduction from, if net loss, the beginning retained earnings.
Next, the retained earnings statement and the balance sheet are integrated. The retained earnings at the end of the period on the retained earnings statement also appears on the balance sheet as a part of stockholders’ equity.
Next, the balance sheet and statement of cash flows are integrated. The cash on the balance sheet also appears as the end-of-period cash on the statement of cash flows.

28. Learning Objective 5
Describe eight accounting concepts underlying financial reporting

29. The Accounting “Rules”
Financial statements illustrated in the preceding section are prepared using accounting “rules” called generally accepted accounting principles or “GAAP”. These rules are necessary in order for stakeholders to be able to compare among companies and across time. Within the United States, the Financial Accounting Standards Board or “FASB” has the primary responsibility for developing accounting principles. The FASB publishes Statements of Financial Accounting Standards as well as interpretations of these standards. Many countries outside of the United States use generally accepted accounting principles adopted by the International Financial Reporting Standards Board or IASB. Currently, the FASB and IASB are working together to reduce and eliminate deficiencies and develop a single set of accounting principles.

30. Eight Accounting Concepts
BUSINESS ENTITY
COST CONCEPT
ACCOUNTING PERIOD
GOING CONCERN
ADEQUATE DISCLOSURE
MATCHING CONCEPT
UNIT OF MEASURE
The business entity concept limits the economic data recorded in an accounting system to data related to the activities of the company. A company is viewed as an entity separate from its owners, managers, and other creditors.
The cost concept only considers the amount initially entered into the accounting records for purchases, usually their cost or purchase price. Property values assessed for taxes, market values, and other appraised values are not used for recording assets by a company.
The going concern concept assumes that a company will continue in business indefinitely. While it is unknown how long a business will continue, unless information exists that raises doubts about a company’s ability to continue, the company is assumed to be a going concern.
The matching principle requires companies to recognize the expenses used to generate revenue in the same accounting period in which the revenues are recognized. Revenue recognition relates to when revenue would be recorded. Revenues are normally recorded at the time a product is sold or service is rendered. At the point of sale, the sales price has been agreed on, the buyer acquires ownership, and the seller has a legal claim against the buyer for payment.
The objectivity concept requires that entries in the accounting records and data reported on financial statements be based on verifiable or objective evidence. In some cases, estimates and judgment factors would have to be used, but the most objective evidence available should be used.
In the United States, since the dollar is our national currency, all economic data must be recorded in dollars. Even though relevant non-financial data can be used in financial statements, transactions and activities of a business are measured, summarized, reported, and compared using dollars.
Financial statements are required to include any necessary footnotes or other disclosures that would contain all the necessary and relevant data for a stakeholder would need to understand the financial condition and performance of a company.
The accounting period and concept requires that accounting data be recorded and summarized in financial statements for periods of time. The financial history of a company can be traced through a series of balance sheet and income statements over a period of time.
OBJECTIVITY CONCEPT

31. Financial History of a Company
The financial history of a company may be shown by a series of balance sheets and income statements. If the life of a company is expressed by a line moving from left to right, the financial history of the company may be graphed as shown.

32. Accounting Frauds
The reliability of the financial reporting system is important to the economy and for the ability of businesses to raise money from investors. That is, stockholders and creditors require accurate financial reporting before they will invest their money. The shown exhibit is a partial list of financial reporting frauds and abuses. Such scandals and financial reporting frauds threaten the confidence of investors.

33. Guidelines for Ethical Conduct
Many companies have ethical standards of conduct for managers and employees. In addition, the Institute of Management Accountants and the American Institute of Certified Public Accountants have professional codes of conduct. How does one behave ethically when faced with financial or other types of pressure? Guidelines for behaving ethically are shown.

34. Learning Objective 6
Financial Analysis: Describe and illustrate how the rate of return on assets can be used to analyze and assess a company’s financial performance

35. Rate of Return on Assets
A measure of a company’s profitability
Expressed as a percentage or as an amount per dollar invested
For example: a 12% rate of return on assets could also be expressed as $0.12 return per $1 invested
Average total assets
Rate of Return on Assets
Net income before taxes and interest expense =
Financial statements are often used in analyzing and assessing a company’s financial condition and performance. One can assess the company’s performance simply by comparing the financial statements and financial ratios at different time periods or by comparing the same with competing companies.
One such ratio is rate of return on assets, which is used to compare a company’s performance over time and with competitors. It is calculated as net income before taxes and interest expense by average total assets. This ratio measures a company’s ability to earn profits using the assets it owns.
Here, taxes are excluded to minimize differences among company tax strategies and tax structures. Interest expense is excluded to minimize differences in how companies are financed.
The ratio is expressed as a percentage or as an amount per dollar invested. For example, a 12% rate of return on assets could also be expressed as $0.12 return per $1 invested.

36. Rate of Return on Assets
Apple is 3.8 (38.1% %) times more profitable than Dell Inc.
Let us now look at an illustration. All the amounts are in millions. First, average total assets is calculated for Apple Incorporated and Dell Incorporated by adding total assets at beginning of year and total assets at end of year and then dividing by 2.
Using these values, the rate of return for both the companies is calculated by dividing net income before taxes and interest expense by average total assets.
Note that Apple is 3.8 times more profitable than Dell Incorporated, as measured by the rate of return on assets. Apple’s profitability is largely due to its innovative technology.

37. End of Chapter 1