Prepared by Coby Harmon University of California, Santa Barbara Westmont College

1-1
Copyright 2015 Pearson Education Inc. All rights reserved.
Prepared by
Coby Harmon
University of California, Santa Barbara
Westmont College
3
Learning Objective
1. Explain why accounting is the language of
business
1-2
EXPLAIN WHY ACCOUNTING IS THE

LANGUAGE OF BUSINESS
Accounting is an information system
1-3
Measures business activities
Processes data into reports
Communicates results to decision makers
Is the language of business
LO 1
EXPLAIN WHY ACCOUNTING IS THE

LANGUAGE OF BUSINESS
Exhibit 1-1 | The Flow of
Accounting Information
People make
decisions
1-4
Business
transactions
occur
Companies
report their
results
LO 1
Who Uses Accounting Information?

Individuals
Investors and
Creditors
Manage personal bank accounts
Decide whether to rent or buy
Budget monthly income and

expenditures
Regulatory
Bodies
Nonprofit
Organizations
1-5
LO 1

Individuals
Investors and
Creditors
Regulatory
Bodies
Investors want to know how much

they can earn on an investment
Creditors want to know when they

are going to be paid
Nonprofit
Organizations
1-6
LO 1

Individuals
Investors and
Creditors
Internal Revenue Service (IRS)

requires businesses, individuals,
and other organizations to pay
taxes
U.S. Securities and Exchange

Commission (SEC) requires public
companies to provide financial
reports
Regulatory
Bodies
Nonprofit
Organizations
1-7
LO 1

Individuals
Investors and
Creditors
Regulatory
Bodies
Nonprofit
Organizations
1-8
File periodic reports with the IRS

and state governments
LO 1
Two Kinds of Accounting

Financial Accounting
For decision makers outside
the entity
1-9
investors
creditors
government agencies
the public
Managerial Accounting
Information for managers
budgets
forecasts
projections
LO 1
Organizing a Business
Exhibit 1-2 | The Various Forms of Business Organization
Proprietorship
Partnership
LLC
Corporation
1. Owner(s)
Proprietor-one
owner
Partners-two or
more owners
Members
Stockholdersgenerally
many owners
2. Personal
liability of
owner(s) for
business
debts
Proprietor is
personally liable
General
partners are
personally
liable; limited
partners are not
Members
are not
personally
liable
Stockholders
are not
personally
liable
1-10
LO 1
Proprietorship
1-11
Single owner
Tend to be small retail stores or solo providers of

professional services
Proprietor is personally liable for all the businesss debts
Business records should not include the proprietors

personal finances
LO 1
Partnership
1-12
Two or more parties as co-owners
Income and losses flow through to the partners
Many include retail establishments, professional service

firms, real estate, and oil and gas exploration companies
General partnerships have mutual agency and unlimited

liability
A limited-liability partnership lessens risk to the partners
LO 1
Limited-Liability Company (LLC)
1-13
Business (not the owner) is liable for the companys

debts
May have one owner or many owners, called members
Members have limited liability
LLCs income flows through to the members, just as if

they were partners
LO 1
Corporation
1-14
A business owned by the stockholders
Able to raise large sums of capital from issuance of stock
Formed under state law
Legally distinct from its owners
Stockholders have no personal obligation for the

corporations debts
continued
LO 1
Corporation
1-15
Double taxation
Corporation pays income tax
Shareholders taxed on dividend distributions
Stockholders elect the board of directors, which
Sets policy
Appoints officers
LO 1
3
Learning Objective
2. Explain and apply underlying accounting
concepts, assumptions, and principles
1-16
EXPLAIN AND APPLY UNDERLYING

ACCOUNTING CONCEPTS, ASSUMPTIONS,
AND PRINCIPLES
Accountants follow professional frameworks for measurement
and disclosure of financial information.
Generally Accepted Accounting Principles (GAAP)
Financial Accounting Standards Board (FASB) formulates
GAAP
1-17
LO 2
Exhibit 1-3 | Conceptual

Foundations of Accounting
Accountings
Objective
Fundamental
Qualitative
Characteristics
Enhancing
Qualitative
Characteristics
Constraints
LO 2
1-18

Accountings
Objective
Fundamental
Qualitative
Characteristics
To be relevant, information must
Make a difference to the decision maker
Enhancing
Qualitative
Help
Characteristics
1-19
predict or confirm value
Be material
Constraints
LO 2

Accountings
Objective
Fundamental
Qualitative
Characteristics
To make a faithful representation, the information must
Be complete, neutral (free from bias), and free from error
Enhancing
Qualitative
Focus
Characteristics
on the economic substance of a transaction, event, or
circumstance
Constraints
Faithful representation makes the information reliable to users

1-20
LO 2

Enhancing
Qualitative
Characteristics
Comparability: Accounting information capable of being compared

Constraints
with information from other companies in the same period
1-21
LO 2

Enhancing
Qualitative
Characteristics
Verifiability: Information capable of being checked for accuracy,

Constraints
completeness, and reliability
1-22
LO 2

Enhancing
Qualitative
Characteristics
Timeliness: Information made available to users early enough to

Constraints
help them make decisions
1-23
LO 2

Enhancing
Qualitative
Characteristics
Understandability: Information sufficiently transparent so that it

Constraints
makes sense to reasonably informed users of the information
LO 2
1-24

Cost Constraint: Cost of disclosure should not exceed the

expected benefits to users
LO 2
1-25
Assumptions and Principles

Entity Assumption: Organization stands apart from other
organizations and individuals as a separate economic unit
Continuity (Going-Concern) Assumption: Entity will

remain in operation for the foreseeable future
Historical Cost Principle: Assets should be recorded at their

actual cost
Stable-Monetary-Unit Assumption: Effect of inflation is

ignored, based on the assumption that the dollars purchasing
power is relatively stable
1-26
LO 2
International Financial Reporting

Standards (IFRS)
1-27
Developed by the IASB
Used by many countries around the world
Application of GAAP for public companies in the United

States is overseen by the U.S. Securities and Exchange
Commission (SEC)
SEC is studying whether and how to require all U.S. public

companies to adopt some version of IFRS
LO 2
International Financial Reporting

Standards (IFRS)
1-28
Having a uniform set of high-quality global accounting

standards makes financial statements more comparable
across borders
Most commonly used accounting practices are essentially

the same under both U.S. GAAP and IFRS
FASB is working hand-in-hand with the IASB toward

convergence of standards
LO 2
3
Learning Objective
3. Apply the accounting equation to business
organizations
1-29
APPLY THE ACCOUNTING EQUATION TO

BUSINESS ORGANIZATIONS
Assets and
Liabilities
Financial
statements are
based on the
accounting
equation
Exhibit 1-4 | The

Accounting Equation
1-30

Assets and Liabilities
Assets
Liabilities
Owners
Equity
1-31
Economic resources
Expected future benefit
Outsider claims
Expected future sacrifice
Insider claims
Stockholders interest in the assets
LO 3
Assets and Liabilities

What are some of The Gap, Inc.s assets and liabilities?
Assets
Liabilities
Cash and cash

equivalents
Inventories
Property, plant, and
equipment
Accounts payable
Federal and state income

taxes payable
Long-term debt
Current portion of longterm debt
1-32
LO 3

Owners Equity
Assets
Liabilities
Owners
Equity
The accounting equation can be written as
1-33
Assets = Liabilities + Stockholders Equity
Assets = Liabilities + Paid-in Capital + Retained Earnings
LO 3
Owners Equity
Assets
Liabilities
Stockholders
Equity
Paid-in Capital
Common Stock
Paid-in capital: amount stockholders have invested in the

corporation
1-34
LO 3
Owners Equity
Assets
Liabilities
Paid-in Capital
Stockholders
Equity
Retained
Earnings
Common Stock
Retained earnings: amount earned and kept for use in the

business
1-35
LO 3
Owners Equity
Assets
Liabilities
Paid-in Capital
Revenues
Stockholders
Equity
Retained
Earnings
Revenues: inflows of resources that

increase retained earnings by
delivering goods or services to
customers
1-36
LO 3
Owners Equity
Assets
Liabilities
Paid-in Capital
Revenues
Stockholders
Equity
Retained
Earnings
Expenses
Expenses: resource outflows that decrease retained

1-37
earnings due to operations

LO 3
Owners Equity
Assets
Liabilities
Paid-in Capital
Revenues
Stockholders
Equity
Retained
Earnings
Expenses
Dividends
Dividends: distributions to stockholders (usually cash)

1-38
generated by net income

LO 3
Owners Equity
Expenses
decrease
Revenues
Dividends
increase
decrease
Retained
Earnings
1-39
LO 3
Owners Equity
Exhibit 1-5 | The Components of Retained Earnings
1-40
LO 3
Illustration
Blue Diamond Corporation has current assets of $360 million;
property, plant, and equipment of $600 million; and other assets
totaling $220 million. Current liabilities are $210 million and longterm liabilities total $560 million.
Requirements
1. Use these data to write Blue Diamond Corporations
accounting equation.
2. How much in resources does Blue Diamond Corporation
have to work with?
3. How much does Blue Diamond Corporation owe creditors?
1-41
4. How much of the companys assets do the Blue Diamond

Corporation stockholders actually own?
LO 3
Illustration
totaling $220 million. Current liabilities are $210 million and longterm liabilities total $560 million. What are the companys total
resources?
Assets
$ 360
600
220
$ 1,180
1-42
Liabilities
Stockholders
Equity
$ 210
560
$ 770
(Amount in millions)
$ 410
LO 3
Illustration
totaling $220 million. Current liabilities are $210 million and longterm liabilities total $560 million. How much in resources does
Blue Diamond Corporation have to work with?
Assets
$ 360
600
220
$ 1,180
1-43
Liabilities
Stockholders
Equity
$ 210
560
$ 770
$ 410
LO 3
Illustration
totaling $220 million. Current liabilities are $210 million and longterm liabilities total $560 million. How much does Blue Diamond
Corporation owe creditors?
Assets
$ 360
600
220
$ 1,180
1-44
Liabilities
Stockholders
Equity
$ 210
560
$ 770
$ 410
LO 3
Illustration
totaling $220 million. Current liabilities are $210 million and longterm liabilities total $560 million. How much of the companys
assets do the stockholders actually own?
Assets
$ 360
600
220
$ 1,180
1-45
Liabilities
Stockholders
Equity
$ 210
560
$ 770
$ 410
LO 3
1-46
Advance slide in presentation mode to reveal answers.

LO 3
3
Learning Objective
4. Evaluate business operations through the
financial statements
1-47
EVALUATE BUSINESS OPERATIONS Exhibit 1-6

THROUGH THE FINANCIAL STATEMENTS
Question
Financial
Statement
Answer
Income statement
Revenues
Expenses
Net income or (net loss)
Why did the companys

retained earnings change
during the year?
Statement of
retained earnings
Beginning retained earnings

+ Net Income (-Net Loss)
Dividends declared
Ending retained earnings
What is the companys

financial position at yearend?
Balance sheet
Assets = Liabilities + Owners

equity
Statement of cash
flows
Operating cash flows

+/ Investing cash flows
+/ Financing cash flows
Increase (decrease) in cash
How well did the company

perform during the year?
How much cash did the

company generate and
spend during the year?
1-48
Advance slide in presentation mode to reveal financial statement and answer.

LO 4
EVALUATE BUSINESS OPERATIONS

THROUGH THE FINANCIAL STATEMENTS
Data flow from one financial statement to the next
1-49
Income
Statement
Statement of
Retained
Earnings
Balance Sheet
Statement of
Cash Flows
LO 4
The Income Statement Measures Operating

Performance
Income Statement
Also called statement of operations
Reports
Revenues and gains
Expenses and losses
Bottom line of net income or net loss for the period
Net Income = Total Revenues and Gains - Total Expenses and Losses
1-50
LO 4
The Income Statement Measures Operating

Performance
Exhibit 1-7 | The Gap, Inc., Consolidated Statements of Income
1-51
LO 4
The Statement of Retained Earnings Shows

What a Company Did with Its Net Income
Retained Earnings
1-52
Portion of net income reinvested into the business
Net income increases retained earnings
Net losses and dividends decrease retained earnings
Net income (net loss) flows from the income statement to

the statement of retained earnings
Corporations not obligated to pay dividends
LO 4
The Statement of Retained Earnings Shows

What a Company Did with Its Net Income
Exhibit 1-8 | The Gap, Inc., Consolidated Statements of Retained Earnings
1-53
LO 4
The Balance Sheet Measures Financial

Position
Balance Sheet
Also called statement of financial position
Reports three items:
1-54
Assets
Liabilities
Stockholders equity
Dated at the moment in time when the accounting period

ends
LO 4
Assets on the Balance Sheet

Current Assets
Expected to be converted to cash, sold, or consumed during

the next 12 months or within the businesss operating cycle
if longer than a year
1-55
Includes
Cash and cash equivalents
Short-term investments
Accounts and notes receivable
Inventory
Prepaid expenses
Cash is the liquid asset

thats the medium of
exchange
Cash equivalents include
money-market accounts or
other financial instruments
that are easily convertible to
cash
LO 4

Current Assets

1-56
Includes
Accounts and notes receivable
Inventory
Prepaid expenses
Includes stocks and bonds

of other companies that the
company intends to sell
within the next year
LO 4

Current Assets

1-57
Includes
Accounts receivable
Inventory
Prepaid expenses
Amounts collectible from

customers from the sale of
goods and services
LO 4

Current Assets

1-58
Includes
Accounts receivable
Inventory
Prepaid expenses
Merchandise that a
company sells to
customers
LO 4

Current Assets

1-59
Includes
Accounts receivable
Inventory
Prepaid expenses
Amounts paid in
advance for costs that
include advertising, rent,
insurance, and supplies
LO 4

Long-term Assets
Expected to benefit the company for long periods of time
Includes
1-60
Property and equipment
Accumulated depreciation
Long-term investments
Intangibles
Tangible assets that include

land, buildings, computers,
and equipment
LO 4

Long-term Assets
Includes
1-61
Intangibles
Amount of the historical cost

of plant assets that has been
allocated to expense in the
income statement over time
as the asset has been
used in producing revenue
LO 4

Long-term Assets
Includes
1-62
Intangibles
Includes stocks and bonds

of other companies that the
company does not intend to
sell within the next year
LO 4

Long-term Assets
Assets with no physical

form, such as patents,
trademarks, and goodwill
LO 4
1-63

Exhibit 1-9 | The Gap, Inc., Partial Consolidated Balance Sheets
LO 4
1-64
Liabilities on the Balance Sheet

Current Liabilities
Debts payable in the next year or within the businesss

operating cycle if longer than a year
Includes
Accounts payable
Income taxes payable
Accrued expenses
Current maturities of
long-term debt
Amounts owed to vendors

and suppliers for purchases
of inventory
LO 4
1-65

Current Liabilities

1-66
Includes
Accounts payable
Accrued expenses
long-term debt
Tax debts owed to the

government
LO 4

Current Liabilities

1-67
Includes
Accounts payable
Accrued expenses
long-term debt
Includes other liabilities such

as interest payable on
borrowed money, accrued
liabilities for salaries,
utilities, and other expenses
that are owed but have not
been paid
LO 4

Current Liabilities

1-68
Includes
Accounts payable
Accrued expenses
long-term debt
Portion of long-term
liabilities that the company
will have to pay off within the
next year
LO 4

Long-term Liabilities
Debts due beyond one year or the companys normal

1-69
Includes
Long-term notes payable
Bonds payable
LO 4

1-70
LO 4
Equity on the Balance Sheet

Stockholders Equity
Represents the stockholders ownership of the businesss

assets
1-71
Includes
Amount represents the par

value of the shares issued to
stockholders
Common stock
Additional paid-in capital
Retained earnings
Treasury stock
Accumulated other comprehensive income (loss)
LO 4

Stockholders Equity

assets
1-72
Includes
Common stock
Retained earnings
Treasury stock
Amount of cash received on

initial sale of the companys
stock in excess of the par
value
LO 4

Stockholders Equity

assets
1-73
Includes
Common stock
Retained earnings
Treasury stock
Portion of net income

reinvested into the business
LO 4

Stockholders Equity

assets
1-74
Includes
Common stock
Retained earnings
Treasury stock
Accumulated other
comprehensive income (loss)
Amounts paid by the

company to repurchase its
own stock
LO 4

Stockholders Equity

assets
1-75
Includes
Common stock
Retained earnings
Treasury stock
Accumulated other
comprehensive income (loss)
Items of gain or loss that are

allowed by the FASB to
bypass the income
statement and be recorded
directly into stockholders
equity
LO 4

1-76
LO 4
The Statement of Cash Flows Measures

Cash Receipts and Payments
The Statement of Cash Flows reports three types of
activities
1-77
Operating: Cash flows from selling goods and providing

services to customers
Investing: Cash flows from the purchase and sale of

long-term assets
Financing:
Borrowing and repayment of borrowed funds
Equity transactions, such as issuing stock, paying

dividends, and repurchase of company stock
LO 4
Exhibit 1-10 | The Gap, Inc.
1-78
Illustration
Assume SB Technology, Inc., is expanding into Australia. Identify
the financial statement where decision makers can find the
following information about SB Technology, Inc. In some cases,
more than one statement will report the needed data.
Financial Statement (s)
a. Revenue
a. Income Statement
b. Dividends
b. Statement of Retained Earnings,

Statement of Cash Flows
1-79
c. Current liabilities
c. Balance Sheet
d. Total assets
d. Balance Sheet
e. Selling, general, and
e. Income Statement
administrative expense
LO 3
Illustration
Identify the financial statement where decision makers can find the
following information about SB Technology, Inc.

f.
1-80
Ending cash
balance
f.
Balance Sheet, Statement of

Cash Flows
g. Cash spent to
acquire a building
g. Statement of Cash Flows
h. Ending balance of
retained earnings
h. Balance Sheet, Statement of

Retained Earnings
i.
i.
Net income
Income Statement, Statement of

Retained Earnings, Statement of
Cash Flows
LO 3
Illustration
Identify the financial statement where decision makers can find the
following information about SB Technology, Inc.

j.
Income tax expense
j.
Income Statement
k. Common stock
k. Balance Sheet
l.
l.
Income tax payable
Balance Sheet
m. Long-term debt
m. Balance Sheet
n. Adjustments to reconcile
net income to net cash
n. Statement of Cash Flows
provided by operations
1-81
LO 3
3
Learning Objective
5. Construct financial statements and analyze the
relationships among them
1-82
CONSTRUCT FINANCIAL STATEMENTS AND

ANALYZE THE RELATIONSHIPS AMONG THEM
Income Statement
1-83
Reports revenues (net sales) and expenses of the year
Reports net income or net loss
If revenues exceed expenses, there is net income
If expenses exceed revenues, there is a net loss
LO 5

Statement of Retained Earnings
1-84
Opens with the beginning retained earnings balance
Adds net income (or subtracts net loss)
Net income comes directly from the income statement
Subtracts dividends declared
Reports retained earnings balance at end of the year
LO 5

Balance Sheet
Reports assets, liabilities, and stockholders equity at the

end of the year
Reports that assets equal the sum of liabilities plus
stockholders equity
Reports retained earnings, which comes from the statement

of retained earnings
1-85
LO 5

Statement of Cash Flows
Reports cash flows from operating, investing, and

financing activities
Each category results in net cash provided (an increase)
or used (a decrease)
Reports whether cash and cash equivalents increased

(or decreased) during the year
1-86
Shows the ending cash and cash equivalents balance
LO 5

Exhibit 1-11 | Relationships among the Financial Statements (in millions of $)
1-87
LO 5
Exhibit 1-11 | Relationships among the Financial Statements (in millions of $)
LO 5
1-88
Exhibit 1-11
1-89
LO 5
What Do Decision
Makers Look For?
Question/Decision
What to look for
Can the company sell its products?
Sales revenue
Increasing or Decreasing?
What are the main income measures to

watch for trends?
Gross profit, Operating income, and

Net income
What percentage of sales revenue ends

up as profit?
Divide net income by sales revenue
Can the company collect its receivables?
Compare % increase in receivables

to % increase in sales
Can the company pay its liabilities?
Compare assets to liabilities
Where is the companys cash coming

from?
Observe the line items on the cash

flow statement
1-90
LO 5
3
Learning Objective
6. Evaluate business decisions ethically
1-91
EVALUATE BUSINESS DECISIONS

ETHICALLY
Economics
Legal
Ethical
1-92
Decision should maximize the economic

benefits
Proposition that free societies are

governed by laws
Recognizes that while certain actions

might be both economically profitable
and legal, they may still not be right
LO 6
Decision
1. What is the issue?
2. Who are the stakeholders, and what are the consequences
of the decision to each?
3. Weigh the alternatives.

4. Make the decision and be prepared to deal with the
consequences.
1-93
LO 6
Copyright
This work is protected by United States copyright law and is
provided solely for the use of instructors in teaching their courses
and assessing student learning. Dissemination or sale of any part of
this work (including on the World Wide Web) will destroy the integrity
of the work and is not permitted. The work and materials from it
should never be made available to students except by instructors

using the accompanying text in their classes. All recipients of this
work are expected to abide by these restrictions and to honor the
intended pedagogical purposes and the needs of other instructors
who rely on these materials.
1-94

Prepared by Coby Harmon University of California, Santa Barbara Westmont College

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1-1

Copyright 2015 Pearson Education Inc. All rights reserved.

Copyright 2015 Pearson Education Inc. All rights reserved.

EXPLAIN WHY ACCOUNTING IS THE

Measures business activities

Processes data into reports

Communicates results to decision makers

Is the language of business

Copyright 2015 Pearson Education Inc. All rights reserved.

EXPLAIN WHY ACCOUNTING IS THE

Copyright 2015 Pearson Education Inc. All rights reserved.

Who Uses Accounting Information?

Manage personal bank accounts

Decide whether to rent or buy

Budget monthly income and

Copyright 2015 Pearson Education Inc. All rights reserved.

Who Uses Accounting Information?

Investors want to know how much

Creditors want to know when they

Copyright 2015 Pearson Education Inc. All rights reserved.

Who Uses Accounting Information?

Internal Revenue Service (IRS)

U.S. Securities and Exchange

Copyright 2015 Pearson Education Inc. All rights reserved.

Who Uses Accounting Information?

File periodic reports with the IRS

Copyright 2015 Pearson Education Inc. All rights reserved.

Two Kinds of Accounting

Copyright 2015 Pearson Education Inc. All rights reserved.

Copyright 2015 Pearson Education Inc. All rights reserved.

Tend to be small retail stores or solo providers of

Proprietor is personally liable for all the businesss debts

Business records should not include the proprietors

Copyright 2015 Pearson Education Inc. All rights reserved.

Two or more parties as co-owners

Income and losses flow through to the partners

Many include retail establishments, professional service

General partnerships have mutual agency and unlimited

A limited-liability partnership lessens risk to the partners

Copyright 2015 Pearson Education Inc. All rights reserved.

Business (not the owner) is liable for the companys

May have one owner or many owners, called members

Members have limited liability

LLCs income flows through to the members, just as if

Copyright 2015 Pearson Education Inc. All rights reserved.

A business owned by the stockholders

Able to raise large sums of capital from issuance of stock

Formed under state law

Legally distinct from its owners

Stockholders have no personal obligation for the

Copyright 2015 Pearson Education Inc. All rights reserved.

Corporation pays income tax

Shareholders taxed on dividend distributions

Stockholders elect the board of directors, which

Copyright 2015 Pearson Education Inc. All rights reserved.

Copyright 2015 Pearson Education Inc. All rights reserved.

EXPLAIN AND APPLY UNDERLYING

Generally Accepted Accounting Principles (GAAP)

Financial Accounting Standards Board (FASB) formulates

Copyright 2015 Pearson Education Inc. All rights reserved.

Exhibit 1-3 | Conceptual

Exhibit 1-3 | Conceptual