Copyright 2009 The Learning House, Inc. Accounting Organizations & Basic Precepts Page 1 of 12

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1 The Learning House, Inc. Accounting Organizations & Basic Precepts Page 1 of 12

2 Introduction Accounting Organizations and Basic Precepts For many students, Principles of Accounting is their first taste of the business and accounting disciplines. This lesson begins with a discussion of the nature of a business, the different types of businesses (service, merchandising, and manufacturing), and the types of business organizations (proprietorship, partnership, corporation, and limited liability corporations). Next, you will learn the role of accounting in business and briefly summarize the development of accounting principles. The accounting equation will also be introduced, and you will see how business transactions affect accounts in the accounting equation. This lesson ends with examples of how to prepare all four financial statements using the accounting equation information and with a discussion of how the four financial statements are interrelated. Describe the Nature of a Business Organization Most everyone has heard the term business. In general, a business is an organization in which basic resources (inputs), such as materials and labor, are assembled and processed to provide goods or services (outputs) to customers. Businesses come in all sizes, from a local coffee house to the Ford Motor Company, the latter of which sells several billion dollars worth of cars and trucks each year. A business customers are individuals or other businesses that purchase goods or services in exchange for money or other items of value. There are three major types of businesses: Service Businesses a type of business which can be described as selling intangible goods or selling one s self -one s expertise, one s capabilities, one s reliability, and one s skills. Examples are a hair salon, an accounting firm, or a child care center. Merchandising Businesses a type of business that purchases merchandise at wholesale cost and sells it at retail cost. Examples of merchandising businesses include a bridal boutique, a jewelry store, or a big retailer like Old Navy. Manufacturing Businesses a type of business in which one creates the product, in whole or in part, that one is selling. Examples of a manufacturing business include a furniture factory, an automobile factory, or even a small specialized business like a recycled products business. The Learning House, Inc. Accounting Organizations & Basic Precepts Page 2 of 12

3 There are four basic types of business organizations: Proprietorships a type of business which is unincorporated and owned and managed by one person. This organization style has a low cost of organizing, is used by small business, and is limited to the financial resources of the owner. Proprietorships comprise a large majority of business organizations in the United States. Partnerships a type of business in which more persons, called general partners, manage the business and are equally liable for debts. While other individuals, called limited partners, may invest, they are not directly involved in the operation of the company and are liable only to the extent of their investment. Corporations a type of business that is a legal entity created through the laws of its state of incorporation. Anyone who operates a business, alone or with others, may incorporate includes ownership divided into shares of stock and sold to shareholders (or stockholders). Limited Liability Corporations this type of business combines attributes of both the partnership and the corporation. However, an LLC can elect to be taxed as a partnership. The three types of businesses service, merchandising, and manufacturing may be organized as a proprietorship, partnership, corporation, or limited liability company. In the United States, most large businesses are organized as corporations. Many large corporations have a great number of owners, or shareholders. A major company may be owned by a million or more people, many of whom own fewer than 100 shares of the company s stock. A business stakeholder is anyone or any entity that has an interest in the economic performance of a business. Stakeholders can include: Owners (or stockholders) are interested because they provided the major financing for the business in order for the business to begin and continue its operations. Banks and other long-term creditors have an economic interest in recovering the amount they loaned the business, plus the interest. Managers and employees (internal stakeholders) are interested because their jobs depend upon it. Product or service market stakeholders include customers who purchase the business s products or services, as well as the vendors who supply the inputs to the business. Various governmental agencies are interested from a tax perspective. City, county, federal, and state governments collect taxes from businesses within their jurisdictions. In addition, workers are taxed on their wages. The better a business does, the more taxes the government can collect. The Learning House, Inc. Accounting Organizations & Basic Precepts Page 3 of 12

4 Describe the Role of Accounting in Business. What do you think of when you hear the term accounting? Merriam-Webster s Online Dictionary (2007) defines accounting as the system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results; also : the principles and procedures of accounting. Accounting can also be described as an information system that provides reports to stakeholders about the economic activities and conditions of a business. Individuals use accounting information every day in managing their finances, such as when preparing income tax returns, budgeting everyday expenses, applying for college loans, etc. The goal of accounting can be illustrated using the following equation: Goal of accounting = Record + Report + Interpret economic data for decision makers Different accounting data may be needed by different people and organizations. For example, a loan officer evaluating an application for a short-term loan and a public utility commission contemplating a rate increase would not consider the same type of accounting information. The owner of a company would be interested in the company s profit for reasons such as buying more equipment or taking home more money each week, while the IRS would be interested in the same company s profit from the perspective of how many taxes it owes. Examine the Development of Accounting Precepts or Principles and relate them to Practice If each company s management could record and report financial data as it saw fit, comparisons among companies would be difficult. Therefore, standards for recording business transactions must exist, as well as rules for determining profit if information is going to be useful for decision makers. The first two standard setting organizations in the United States were the Committee on Accounting Procedures (CAP), established in 1938, and the Accounting Principles Board (APB), which replaced the CAP in Both of these organizations were committees of the American Institute of Certified Public Accountants (AICPA). Pronouncements issued by these two bodies are still considered to be Generally Accepted Accounting Principles (GAAP) today unless they have been specifically amended or replaced by subsequent announcements. Because GAAP impacts how companies record and report, all stakeholders are interested in the setting of these principles. The Learning House, Inc. Accounting Organizations & Basic Precepts Page 4 of 12

5 Investopedia (2007) says: Accounting standards are crucial in an efficient market, as information must be transparent, credible and understandable. The Financial Accounting Standards Board (FASB) sets out to improve corporate accounting practices by enhancing guidelines set out for accounting reports, identifying and resolving issues in a timely manner and creating a uniform standard across the financial markets (para. 2). The FASB, formed in 1973, is an independent board responsible for establishing and interpreting generally accepted accounting principles. FASB standards are officially recognized as authoritative by the Securities and Exchange Commission (SEC) and AICPA. The standard setting activities of the FASB are published and made available on the FASB website. While there are numerous concepts and principles issued by GAAP that govern how accounting data is accumulated, this lesson will focus on the business entity concept and the cost concept. The business entity concept is important because it limits data in an accounting system directly to the activities of the business. This means the owner of a business should not place any personal assets on the business balance sheet. The balance sheet of the business must reflect the financial position of the business alone. Also, when transactions of the business are recorded and personal expenditures of the owner are charged to the owner, these items are not allowed to affect the operating results of the business. The entity must be identified so that the accountant can determine which economic data should be analyzed, recorded, and summarized in reports. The following example may help in illustrating the business entity concept. If an individual owned a hair salon, a video store, and a car wash, how would the owner know the profitability of each? The owner would know the profitability of each by keeping separate accounting records for each business. If a building is purchased for $100,000, that amount should be entered into the buyer s accounting records. The seller may have been asking $150,000 for the building up to the time of sale. The buyer may have initially offered $95,000 for the building. The building may have been assessed at $175,000 for tax purposes. The buyer may have received an offer for $150,000 the day after it was sold. These latter amounts have no effect on the accounting records because they did not result in the exchange of the building from the buyer to the seller. The cost concept is the basis for entering the exchange price, or cost, of $100,000 into the accounting records for the building. The cost accounting principle states that accounting for purchases must be at their cost. When an asset is exchanged for another asset, then an objective value needs to be assigned to the asset. The objective principle states that accounting will be recorded on the basis of objective evidence. To put it most simply, this means that accounting entries need to be based on fact and not on personal feeling. Define the Accounting Equation The Learning House, Inc. Accounting Organizations & Basic Precepts Page 5 of 12

6 The accounting equation is the starting point in understanding accounting. It is defined as: Assets are properties or economic resources that a business owns, regardless of whether they are fully paid for. Liabilities are debts that a business owes others. Owner s Equity is the owner s initial investment when s/he starts the business and can be further divided into capital stock (owner s investment) and retained earnings (residual earnings made up of revenue, less expenses). An easy way to understand owner s equity is to compare it to equity that a homeowner has in her/his home. A homeowner s equity is that portion of her/his home s value that would be received if her/his home was sold -it is what would be left over after paying off the mortgage. In the same way, the owner s equity in a business is the owner s residual interest, or what would be left over if all of the business assets were sold and the business debts paid off. To illustrate, if the assets owned by a business amount to $150,000 and the liabilities amount to $50,000, the owner s equity is equal to $100,000, as shown below. Assets - Liabilities = Owner's Equity $150,000 - $50,000 = $100,000 A business earns money by selling goods or services to customers; this amount is called revenue. For example, a store sells some type of product or products; a doctor provides some type of medical services; a lawyer provides legal services. Revenue ALWAYS increases retained earnings. Revenue occurs when the sale or service takes place, NOT when the money changes hands. Expenses are defined as outflows of assets, generally cash that a business incurs in order to stay afloat and conduct daily operations. Common expenses include salary expense, utilities expense, and rent expense. Expenses ALWAYS decrease retained earnings. Expenses occur when they are incurred, not when they are paid for. Usually at least once per month, the owner may withdraw cash or other assets from the business for personal use, not for business use. These withdrawals are called Dividends and ALWAYS decrease retained earnings. All business transactions affect the accounting equation and can be stated in terms of the changes in the elements of the accounting equation. Transactions will make the assets, liabilities, and owner's equity increase or decrease, or in some cases, remain the same. Business transactions include: 1. Receipts of Cash 2. Payments of Cash 3. Events that create an obligation to pay out cash in the future 4. Events that obligate another party to pay the business cash in the future The Learning House, Inc. Accounting Organizations & Basic Precepts Page 6 of 12

7 5. Sale of a product or completion of a service for a customer this is known as earning revenue 6. The use of products or services in running the business this is known as incurring an expense You will see how business transactions affect the accounting equation by studying some typical transactions. As a basis for illustration, look at a business organized by John Smith. 1. John opens a business bank account with a deposit of $180,000 in exchange for capital stock in John's Dry Cleaning Service. 2. John buys land for his business, paying cash of $141, John builds a building on his land, paying the builder $15,000 and still owing the builder $21, John sells some of his land he will not need for $11,000. The buyer promises to pay John the $11,000 next month. 5. John charges some office equipment: $5, John gets a check for $1,500 as partial payment from the buyer of his land. 7. John pays $3,000 of his debt for his office equipment. 8. John pays salary to his assistant: $ John pays the utilities bill for the month: $ The company pays John $500 in dividends. 11. John receives cash of $3,000 from customers for dry cleaning performed during the month. 12. John performs $1,000 of dry cleaning for customers on account. The 12 items above are business transactions which will affect the accounting equation, which is illustrated in the chart below. The Learning House, Inc. Accounting Organizations & Basic Precepts Page 7 of 12

8 Describe Factors that Affect the Reporting of Financial Statements and Explain How They Interrelate This objective introduces the four financial statements of a corporation (in order of preparation Income Statement, Retained Earnings Statement, Balance Sheet, and the Statement of Cash Flows) and explains how they interrelate. Financial statements are reports prepared by accountants that summarize the financial affairs of a business. This objective also introduces the concept of matching, which is one of the most important concepts in accounting. The matching concept principle states that the revenue for one time period is matched up or compared with the related expenses for the same time period. If revenues and expenses are not properly matched, then the amount reported for net income is incorrect, making every statement thereafter incorrect. All statements have a three line heading. The first line of the heading is always the company name. The second line of the heading is always the name of the statement being prepared. The third line is the date portion of the heading and varies among the financial statements. The Income Statement and the Retained Earnings Statement summarize transactions for a period of time, while the Balance Sheet shows a snapshot of the business as of a particular date. The income statement lists revenues earned and expenses incurred for a specific period of time resulting in net income or net loss. The excess of the revenue over the expenses is called net income or net profit. If the expenses exceed the revenue, the excess is a net loss. A sample income statement for XYZ Corporation would look like the following: The Learning House, Inc. Accounting Organizations & Basic Precepts Page 8 of 12

9 The net income (loss) from the Income Statement and any dividends paid to the owners of the business is used in calculating the ending retained earnings balance on the Retained Earnings Statement. A sample Retained Earnings Statement for XYZ Corporation would look like the following: The Balance Sheet lists the ending balances for assets, liabilities, and owner s equity, which is made up of the capital stock (owner s investments) plus the ending retained earnings balance from the Retained Earnings Statement. As a result, the balance sheet balances. A sample Balance Sheet for XYZ Corporation would look like the following: The Statement of Cash Flows is a summary of the cash receipts and cash payments for a specific period of time, such as a month or a year. A sample Statement of Cash Flows for XYZ Corporation would look like the following: The Learning House, Inc. Accounting Organizations & Basic Precepts Page 9 of 12

10 To illustrate the reporting of financial statements, look at the previous example of John s Dry Cleaning Service. The Learning House, Inc. Accounting Organizations & Basic Precepts Page 10 of 12

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